10 thoughts on investment risk in a 2D world

In late November, we attended a Carbon Tracker and PRI conference for the launch of a new research report entitled: “Two degrees of separation: Transition risk for oil & gas in a low carbon world“.

The research, produced by the Carbon Tracker Initiative in partnership with five European institutional investors and the Principles for Responsible Investment, analyses the alignment of the world’s largest 69 oil and gas companies’ capital expenditure programs, as tracked by global industry database Rystad, with a scenario where global warming is limited to 2 degrees Celsius as agreed by the world leaders.

The guest speaker was Mark Fulton, a world expert on carbon asset risk in global fossil fuel companies. Sydney-based, Mark is also a Morphic Asset Management shareholder and adviser.

Australian-listed companies within the research universe included Oil Search, Woodside Petroleum, Origin Energy and Santos.

 

Here are ten key takeaways which look important in assessing investment opportunities and risks in a two degree capped (2D) world:

1. If 2D is to be met, no new coal mines are needed anywhere in the world.

2. Liquefied Natural Gas (LNG) companies are some of the most at-risk of developing further projects that prove value destroying.

3. Oil refineries are among the most at-risk assets in the carbon complex as there is already massive refining overcapacity for a 2D world.

4. ASX-listed Oil Search is in the top ten oil players ranked by the percentage of its upstream capex not expected to be viable in a 2D world, according to Rystad.

5. Around two-thirds of the potential oil and gas production which is surplus to requirements in a 2D scenario is controlled by the private sector, not as many believe, by state-controlled oil companies.

6. Saudi Aramco is better positioned than most people think it is. Very little of its planned capex looks like being money losing. This means that its long-awaited upcoming float may fare better than some have suggested. It also means that Saudi Arabia may have more capital to redeploy in domestic long-term growth investments than feared. That in turn is good for world peace, and probably also can reduce oil price volatility over the next two to five years.

 

Figure 1 – Companies’ potential upstream capex outside the 2D budget

 

Source: Rystad Energy, CTI analysis

7. The sluggish response of oil company share prices to recent rises in the oil price from below US$50 a barrel to above US$60 a barrel may reflect a) that oil company shares were already expensive, relative to oil, and b) investment markets are starting to value large oil companies on a run-off basis, with the additional risk that many will invest in money-losing capital expenditure before they bite the bullet.

 

 

Figure 2 – Energy stocks Index (XLE:US) vs Oil price (CO1:COM)

 

Source: Bloomberg, Team Analysis

8. Most studies use out-of-date cost assumptions for renewables in assessing the competitiveness of fossil fuels. Even those who update them regularly struggle to model the dynamic ongoing cost reduction. The Middle East can now get solar energy for two US cents a kilowatt hour (kWh). Building a new coal power plant would cost seven to ten US cents a kWh. Supercritical coal plants – which are the most efficient – cost more than ten US cents a kWh. For a forty-year asset, considering that solar costs are falling so fast, that is not a plausible investment decision. This is why AGL’s decision to close the Liddell coal-powered plant seems so much more rational than the government’s request to keep it operating.

9. Grid level storage is the missing piece in making carbon transition viable. This is also one of the most challenging as batteries need to fall significantly in cost. But trends are encouraging.

10. Opportunities are increasingly emerging for long short ethical funds like ours to arbitrage winners and losers in what remains a very under-researched field.

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