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Oil will have to be written off at some point. But not yet!

Oil will have to be written off at some point. But not yet!

22-10-2018 | 5-Year outlook

Stranded assets do not currently threaten the prosperity of oil companies, which still have a role to play in portfolios, says Chief Economist Léon Cornelissen.

  • Léon  Cornelissen
    Léon
    Cornelissen
    Chief Economist

Speed read

  • Paris Agreement will create trillions of dollars of unburnable fuels
  • Big Oil is transitioning to a low-carbon future but moving slowly
  • Oil price hasn’t reacted, and it’s not yet time to avoid these companies
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The issue arises due to the Paris Agreement commitment by countries to limit global warming to 2 degrees Celsius above pre-industrial levels by 2100. It means that up to 80% of the world’s fossil fuel reserves cannot be burned, causing trillions of dollars’ worth of ‘stranded’ coal, oil and gas.

With oil and gas reserves possibly remaining unused due to the ongoing energy transition, investors are faced with a tough question: is it time to sell these carbon intense holdings or would that be premature? And are fears of incurring substantial losses due to an unavoidable write-down of useless stranded assets overdone?

Low-carbon future

In 2017, Big Oil started to position itself for a low-carbon future, with the European majors leading the way. Uncertainty will remain, as there is no roadmap for the energy transition, and no clear view as to how long it will take, or what the winning technologies will be.

One clearly identifiable trend is Big Oil’s increased investment in carbon-free energy. The oil giants reckon that oil supply will peak around 2020 and then fall 20% by 2030, fueled by the need to reduce production to meet the climate target of 2°C. To achieve this, part of the supply will be substituted by alternative sources such as solar and wind energy.

Spending on fossil fuel explorations by oil majors has already fallen sharply since 2014, as illustrated in the chart below.

The trend in worldwide capital expenditures in oil and gas has been broken.
Source: Datastream

Estimates of what can be burned and what needs to be left in the ground vary substantially, though according to the International Energy Authority, practically all of the oil majors’ so-called 2P (proven and probable) reserves can be extracted. In that case, it is the so-called 3P reserves (proven, probable and possible) in excess of the 2P reserves that run a big risk of becoming stranded.

This latter share represents only a couple of percentage points of the total value of oil majors, so the potential for it to become stranded could be considered a tail risk for oil companies as a whole. As the demand for oil continues to grow over the next five years, particularly from emerging markets, the transition to a low-carbon economy could easily be well underway later rather than sooner. Estimates as to when oil demand will peak have shifted and now vary from 2023 to 2070.

Oil price hasn’t reacted

Meanwhile, the oil price has not yet reacted to the prospect of much of it becoming unusable. With oil on its way out, the price is expected to go down over the longer term. But a lack of investment (e.g. in oil sands or in the Arctic) could eventually give rise to shortages, thus pushing up oil prices. So far, price behavior does not seem to be based on the transition to a low-carbon economy.

Supply side problems (in Nigeria and Venezuela, for instance), and the OPEC cartel’s successful rationing policies are the key factors influencing shorter-term price movements. The upside for oil prices is limited somewhat by the US shale revolution, as higher prices increase supply, illustrating the adage that the best remedy for higher prices is higher prices.

Against the backdrop of increasing global demand, this creates a dilemma for investors. Is it time to dispose of carbon holdings? Or is it too soon? And are fears of incurring substantial losses due to an unavoidable write-down of useless stranded assets overdone? At some point, the oil price has to drop significantly. Even Saudi Arabia has recently announced a plan to become carbon-neutral within a couple of decades.

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Oil and the index

Oil also remains an important part of stock market indices, despite the ongoing preference for the FANG internet stocks. Exxon Mobile, the largest of the oil majors, remains in the MSCI World Index’s top ten holdings, while the energy sector accounts for more than 6% of the MSCI World Index. As movements in oil prices are essentially unpredictable in the shorter term, and so far seem largely unaffected by the global transition to a non-carbon economy, investments in the energy sector still make sense.

Disregarding the sector would be inadvisable, as it offers interesting opportunities for active investors to add value. Over the last decade, the energy sector has added a unique risk to equity portfolios. Going forward we expect this to remain the case. Investors stand to benefit from the added portfolio diversification.

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