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Stranded assets – an insurmountable hurdle for oil companies?

29-10-2015 | Insight | Dirk Hoozemans

Are stranded assets going to strike a lethal blow to oil companies? Things haven’t got that far yet, according to analyst Dirk Hoozemans.

Speed read:
  • British central bank warns investors of ’potentially large losses’
  • Coal loses ground while gas gains share in the energy mix
  • Large oil companies benefit from the innovative strength of small niche players

Anyone who follows the oil industry cannot be unfamiliar with the term stranded assets. These are assets on corporate balance sheets that rapidly lose their value as a result of forced write-offs. This primarily affects utilities and exploration companies, where the traditional activities of finding and generating energy have come under pressure as a result of climate protection regulations. A few weeks ago, Mark Carney, the Canadian governor of the Bank of England, warned of the 'potentially large losses’ that investors could suffer if major oil companies are forced to write off their oil, gas or coal reserves.

This is the price investors will unwittingly have to pay for the fight against climate change. This pain may also extend to investors who probably consider themselves to be outside the danger zone, because oil companies have a heavy weighting in numerous equity indices. However you look at it, around 19% of the companies that together form the FTSE 100 are active in the energy sector in some way.

Robeco energy analyst, Dirk Hoozemans, approaches this subject analytically. “In the case of stranded assets you have to distinguish between fixed assets that are being written-off for economic reasons and those that are hit by climate issues. You might hope that the two would go hand in hand, in the same way that companies that pollute the most should also be the least profitable. But this is certainly not always the case.” After closing down its nuclear plants, Germany burnt more coal to generate electricity, because this is more profitable than gas which is much cleaner. But it does apply in the case of tar oils, which cause more pollution and have lower margins than regular oil. “Coal causes the most pollution, but is also the cheapest fuel and for this reason will still be with us for the foreseeable future. In the US, coal is used to generate around 50% of the electricity, that market share won't just disappear in a a year or two. And in China the percentage is much higher still.”

King Coal
Hoozemans thinks the write-offs that Carney warns of will not be so bad. “You only put reserves on the balance sheet if you have taken an investment decision”. There are three sorts of reserves in the energy sector – proven, probable and possible reserves. Only the first type are entered on the balance sheet as assets and may have to be written off, which then has an effect on the company's value and stock price.

Of course the tectonic plates are shifting in the energy sector. After the earlier switch from carbon to hydrogen, we are now witnessing a transition from oil to gas. “Gas is becoming increasingly important in the energy mix, King Coal is dead”, states Hoozemans. “Even in China it is evident that gas is gaining ground at the expense of coal. At the same time, the cost of renewable energy (solar and wind power) is falling and efficiency is increasing. In some parts of the world – California, Arizona, Hawaii – renewables are already competing with traditional forms of energy. However, at the same time, in Germany – where there is less sunshine – investment in solar power is still heavily dependent on subsidies."

The advantage of solar power and wind energy is of course that there are no input costs. But the wind doesn't blow all the time and the sun isn't always shining. And when the sun does shine, it is mostly in the middle of the day, while energy consumption peaks in the evening. Energy storage and distribution are therefore necessary, but current battery technology is not sufficiently advanced. The rise of the electric car will also have to overcome infrastructure-related challenges.

A dead end?
In his long-term outlook for the energy sector, Hoozemans expects "a falling coal price, stable oil price and rising gas price”. But the playing field has become more complicated than ever. “Politics versus the market; environmental interests versus economic ones. Technological innovation. Companies that are most attractive to investors are those that combine cost efficient growth with stable cash flow from large projects with long-term contracts."

‘Innovation happens in small companies – around the air hockey table in a low-key office somewhere’

So is there still a future for the oil majors? Hoozemans is optimistic. “You should not expect technological innovation from the Shells and Totals. These companies have invested so much in traditional energy extraction they are not just going to throw in the towel." But that doesn’t mean they are heading towards a dead end. "Innovation happens in small companies – around the air hockey table in a low-key office somewhere. But large players such as Shell can easily acquire innovative technologies once these enter a more mature phase. Shell also has an attractive LNG portfolio and is enjoying growth in its deepwater projects off the coast of Brazil; a sound basis for a solid dividend."

Oil and gas will continue to fulfill our basic energy needs for the time being. Neither does Hoozemans think that energy companies will becomes victims of climate change in the medium term. “And with the right strategy they can also play a role in the 'brave new world'. The current energy system will not capitulate that easily. The only change is gradual change." And even the major players realize that they have to move with the times.

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Source: The Atlantic

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