Oil & Gas Investment Risks Can No Longer Be Ignored
Don’t let the climate-change misinformation campaigns of conservative media outlets fool you. Fossil-fuel industry captains have fallen back on new defenses of the status quo as science makes the older ones untenable. Denial of climate change and its potential causes has been discarded in favor of subtler shields like energy “security” and the promise of innovation.
And a recent report from the International Energy Agency (IEA) makes it clear the fossil fuel industry can’t continue to block climate policy change. Too many plausible policy scenarios put future investment dollars at risk — the duty of executives and directors to their shareholders demands constructive policy engagement.
The IEA is a policy advisor to governments of wealthy nations. Formed in the wake of the 1973 oil shock, its mission is rooted in energy security. Their annual World Energy Outlook is widely used as the basis of energy forecasts for governments and industries. A skeptical observer would (and probably should) regard the IEA as something of a consensus view from the energy industry of non-OPEC nations.
The IEA, along with the fossil-fuel industry, has been dragged kicking and screaming into the climate change debate. It is somewhat notorious for underestimating the potential of renewable energy. Yet, in the wake of the Paris Agreement and growing pressure on governments to enact more sweeping climate legislation, the IEA has taken a look at the risk of energy transitions to the oil & gas industry.
The report’s conclusions, echoed by the oil & gas industry as a whole go something like this:
- No energy company will be unaffected by energy transitions. Oil & gas companies need to join a “grand coalition” (comprised of governments, industry, investors, civil society) to address climate policy.
- Oil & gas companies may need to diversify their energy portfolios into lower-carbon sources.
- There is much the oil & gas industry can do to reduce GHG emissions along the value chain of energy production.
- Most climate models envision a large role for carbon capture and sequestration (CCS) because renewables alone can’t satisfy most 1.5° or even most 2° climate pathways.
These key findings aren’t controversial. The real debate surrounds the magnitude of fossil-fuel use still required during and after a multi-generational energy transition concludes. Here, the IEA outlook remains fairly convenient for oil & gas interests. It acknowledges investment risks for new projects, but downplays them rather unconvincingly:
- Coal use has peaked and may decline rapidly under most 1.5° climate policy scenarios.
- Oil use may peak in the near future, but natural decline rates justify ongoing investment in existing wells as well as new projects.
- Natural gas use may actually grow sharply over the coming decades as it is the lesser of two evils compared to coal.
In its scenario based on current national commitments to address climate change, global natural gas production climbs over 30% through 2040 as reduced use in advanced economies is more than offset by a transition away from coal in China and India. The IEA forecast remains optimistic even in a sustainable development scenario (consistent with the Paris Agreement) — natural gas use in 2040 is only about 15% below current levels. The latest Intergovernmental Panel on Climate Change (IPCC) report shows the 2050 gas supply down by at least 13% in 75% of modeled pathways consistent with 1.5° of warming, and by 62% or more in 25% of modeled pathways.
The IEA expects oil use to fall about 30% by 2040 under a sustainable development scenario. But again, this is on the rosier end of IPCC projections — 75% of modeled pathways have oil production down 39% or more, and 25% of modeled pathways peg the decline at 77% or greater from 2020 to 2050.
The IEA’s forecasts for oil & gas demand in a world driving for sustainability are at least plausible and consistent with the IPCC. And a successful energy transition is far from assured. However, there is a debatable series of graphs deep in the report (page 59).
Source: International Energy Agency, The Oil and Gas Industry in Energy Transitions.
In the sustainable development scenario, Non-OPEC oil production is shown to be down roughly 30% in 2040 from 2018 levels. Meanwhile, OPEC oil production in the same scenario is forecast to fall closer to 35%. The IEA assumes low-cost OPEC producers, particularly in the Middle East, respond to a secular drop in demand with investment and production that is “limited in a way that maintains a floor under oil prices.” In other words, they assume OPEC producers absorb roughly the same decline in oil production as higher-cost sources like shale oil producers in the U.S. or bitumen developers in Canada.
Maybe. But while OPEC has consistently maintained a 35-40% share of global production in a world of persistent oil consumption growth, we don’t know how market shares could shift in a world of shrinking demand. There is no historical precedent. The IEA acknowledges the risk factor, and sketches out a scenario where low-cost OPEC producers and Russia boost production in an effort to capture greater market share in an era of falling demand. Their conclusion is this would lead to a collapse in prices and would be self-defeating. Yet, they don’t map out a more likely scenario where low-cost producers attempt to maintain production levels while high-cost producers slowly fall away as they are first to stop investing in new projects.
According to Rystad Energy, the onshore Middle East remains the cheapest source for new oil production (see chart above). The Middle Eastern OPEC nations of Saudi Arabia, Iraq, Iran, United Arab Emirates, and Kuwait produced 28 million barrels per day in 2018 — accounting for 28% of global production. If demand falls to roughly 70 million barrels per day in 2040, it is fair to conclude the five Middle Eastern OPEC producers have the best chance of holding their production steady vs. recent levels. If that occurs, and the 30 million barrel reduction in daily production is equally borne by the rest of the world, non-OPEC oil production would fall by nearly 50%.
Why does any of this matter? The IEA’s own analysis, taken a bit further, seems to undermine the argument that plenty of new investment is needed regardless of climate policy given annual well production decline rates.
The average annual decline rate of oil production without production from new fields is approximately 4.5%. If non-OPEC producers continued to invest in existing fields only, their production levels would drop roughly 60% by 2040. This isn’t too far from the potential supply needed using IEA’s optimistic sustainable development scenario combined with a higher market share for the low-cost producing OPEC members.
In short, the IEA’s fairly rosy scenario analysis still suggests new oilfield development for non-OPEC producers is increasingly risky from an investment perspective. Oil & gas producers can continue to try to delay or water down climate policy changes where political influence is strongest, but this invites its own problems. Activist tactics designed to delegitimize the industry may prove politically effective if oil & gas companies continue to take actions viewed as obstructionist.
Shareholders of Oil & Gas Companies Should Demand Constructive Policy Engagement…Now
First, shareholders should demand oil & gas companies cut off any remaining support to energy policy advocacy groups (i.e., think tanks) that do not address climate change. Although the industry has distanced itself from the most extreme climate deniers, like the Heartland Institute, it still funds groups that downplay climate change risks (e.g., American Enterprise Institute). Other subtle forms of sabotage occur when policy groups or “education” initiatives focus on energy poverty (e.g., Switch Energy Alliance) in an effort to appeal to the charitable instincts of the public.
The one advocacy tactic that shareholders should support is the growing push for innovative ways to reduce the emissions tied to fossil-fuel production and use. Some efforts at CCS may never prove economically viable. But NONE of the 85 available 1.5° pathways contemplate a fossil-free world by 2050, and the median case is coal, oil, and natural gas still account for one-third of primary energy. Public incentives to limit the damage of ongoing fossil fuel use should sensibly be part of the policy portfolio.
Shareholders should demand executives offer support for GHG emissions reductions targets in exchange for tax incentives to develop and deploy CCS, with the particulars the result of negotiation. Investment risks grow with every year of inaction that passes as more drastic steps are required to hit the climate bogeys promulgated by scientists. Shareholders should demand annual updates on the status of policy discussions around the world. Failure to pressure boards and executives into action should not lead to divestment. Divestment is a counterproductive abdication of responsibility. Instead, shareholder groups should double-down with more aggressive tactics — including nominating a new slate of directors.