Top energy analyst charges Shell with asset-stranding risk “naivety”.

May 21, 2014 Climate, Finance, Gas, Oil 

Mark Lewis of Kepler Cheuvreux (client report, no url): In a letter to investors released on 16 May and drawn up “in response to enquiries from shareholders regarding the ‘carbon bubble’ or ’stranded-assets’ issue”,  Shell has followed ExxonMobil’s lead in (i) dismissing the idea that global climate policy might ever be tightened  in such a way as to pose any risk of asset-stranding to its portfolio of proven reserves, and (ii) effectively also arguing that the current pattern of fossil-fuel energy demand will not be threatened for decades to come, such that its more broadly defined resource base – and, by implication, its ongoing investments in new exploration activity — are not at risk of becoming stranded in future either.”
We find Shell’s point about its proven reserves a reasonable assertion, but its point about its broader resource base (and, by implication, its ongoing expenditure on new exploration activities) problematic. This is for two main reasons: (i) we think climate-policy risk is much more nuanced than Shell (like ExxonMobil before it) would care to admit; and (ii) we do not think that the risk of asset-stranding is limited to  a scenario of falling oil prices induced by a structural fall in demand resulting from tighter climate policy. On the contrary, we think that stranded-asset risk also exists under a scenario of elevated and even rising oil prices.
This is because rising oil prices over the last decade or so have essentially reflected rising costs, whereas in stark contrast the cost curves of renewable technologies have been falling sharply, and can be expected to continue falling over coming decades. This means that if oil prices continue to rise in future – and like Shell, we think this is the most likely scenario — then such a divergent cost dynamic will in our view only accelerate the move away from oil and towards renewables in the global energy mix (although it is fair to say the rate at which subsidies for renewables are adjusted or even removed altogether as the costs of different renewable technologies continue to fall will also play a role in determining the speed at which the global energy mix switches away from fossil fuels and towards renewables). In turn, this will create the risk of stranded assets for those oil companies that are in denial about the ongoing transformation of the global energy system, and  in this respect the disintermediation of EU fossil-fuel  generators by renewables over the last decade should be seen as a cautionary tale for the oil majors.
Against this backdrop, we here briefly review Shell’s main points as set out in its letter and then offer our own analysis of the risk of stranded assets faced by oil companies (we will publish a more detailed report on this subject in the near future). Given the similarity of Shell’s approach to that of ExxonMobil (as set out in the latter’s report Energy and Carbon –Managing the Risks published on 31 March), we find that Shell’s letter is open to the same criticisms we made in our Alert Exxon Dismisses Risk of Stranded Assets from Carbon: But We See Risks (1 April).
These criticisms relate to i) a naïvely binary approach to defining the scope of carbon risk, ii) complacency with regard to its current business model and risk of stranded assets even without tighter global climate policy, and iii) a general reluctance to acknowledge that there is even a debate to be had on the subject of carbon risk, when they could be taking the opportunity to engage with investors on this topic and to start recalibrating their business model away from high-cost oil projects towards the renewable energies of the future. Indeed, Shell’s letter looks to us to be designed more in order to close debate down rather than open it up, and as far as we can see offers no prospect of an ongoing dialogue with investors on stranded-asset risk. On the contrary from the tone of this letter Shell gives the impression that it has now said all that it thinks needs to be said and that it will now clam up on this subject.
Shell’s assessment of the stranding risk posed by a potential tightening of global climate legislation
Proven reserves: Shell states that its SEC-defined proven reserves have an R/P (reserves/production) ratio of 11.5 years, and that “we do not believe that at a minimum any of our proven reserves are at risk from any potential change in regulation from  climate change or the ‘carbon-bubble/stranded-assets’ concepts” (Shell letter, page 11).
We think it is reasonable of Shell to assume that to the extent all of its proven reserves would be exhausted within 12 years at current production rates then all of its currently producing oil assets are safe from the risk of stranding in the event of a future tightening of global climate policy. After all, the International Energy Agency (IEA) has already made the same point: in its 2013 World Energy Outlook (WEO), the IEA argues that “reserves that are already being produced from existing oil fields will produce without additional investment and, because the rate of natural decline exceeds any conceivable rate of demand drop due to climate policies, this category [of oil production] is unlikely to be stranded” (2013 WEO: p.436, our emphasis).
So far, so uncontroversial, then.
Broader resource base: However, where we think Shell is on much less solid ground is in then stating that “Some 60% of our disclosed resource base is either under construction or in operation meaning that it is potentially less exposed to regulatory changes in 10, 20 or 30 years (Shell letter, page 10, our emphasis).
Shell’s confidence that its broader resource base (2P+2C) would also be safe from becoming stranded in the event of tighter global climate policy over a 20-year and even a 30-year timeframe rests on two points:
i)                    The risk will simply not arise because a global climate deal of the kind required to restrict the average increase in global temperatures to no more than 2°C is simply not going to happen: “We also do not see governments taking the steps now that are consistent with the [IEA’s] 2°C scenario” (Shell letter, page 6);
ii)                   Even if a tough global climate deal were to happen, coal would bear the brunt of the emissions reductions entailed by such a deal, and Shell’s broader resource base would therefore still be safe: “In the IEA ‘450ppm’ scenario it can be seen that the major impacts during the time frame of our proved reserves and resources is actually not towards oil and gas but actually to the demand for coal. In fact, the demand for oil only drops slightly and the demand for gas increases” (Shell letter, pages 12-13).
We find both of these points problematic.
On the first point, Shell is essentially adopting exactly the same approach as ExxonMobil, its argument being that “the world will continue to need oil and gas for many decades to come, supporting both demand, and oil and gas prices” (Shell letter, page 1), and that “the world can tackle and resolve the climate issue over the course of this century, but not in less time than that (Shell letter, page 2, our emphasis). In other words, Shell is starting from the premise that the sheer weight of the incumbent global energy system, the need to meet growing energy demand in the developing world, and the political difficulty of reaching a deal mean that such a deal simply cannot and will not happen within a timeframe that would pose a risk of asset stranding either to Shell’s broader resource portfolio or its ongoing exploration capex.
However, whilst we have acknowledged before that a 450-ppm deal does not look at all likely in the near term (see our in-depth report Stranded Assets, Fossilised Revenues, 24 April 2014), we have also made the point that global climate policy is as much about the direction of travel as the speed, and in effectively dismissing the likelihood of policymakers ever getting genuinely serious in terms of policy ambition, we think Shell (like ExxonMobil before it) is giving itself a free pass in terms of the need to at least contemplate what a 450-ppm world would mean.
Just because it is not going to happen at COP-21 in Paris next year does not mean that a much more carbon-constrained policy framework will never be implemented. Viewed in this way, stress-testing for a much more carbon-constrained world whereby a global deal takes effect, say, from 2025, would simply be sensible risk assessment rather than outright psychological denial of the very possibility.
On the second point, whilst we agree that coal would bear the brunt of lost volumes sold under a deal consistent with a  450-ppm scenario, we have already set out in great detail how the financial impact of a 450-ppm deal would fall overwhelmingly on the oil sector (again, see our report Stranded Assets, Fossilised Revenues). As explained in that report, we estimate that under a 450-ppm climate deal the oil industry would stand to lose $19.3trn dollars of revenues over the two decades following its implementation, far more than the $5trn forgone by the coal  industry. Moreover, we think most of these forgone revenues would be incurred by high-cost, high-carbon projects (such as oil sands, ultra-deepwater, and shale oil), and Shell and the other majors are very well represented in oil sands and deep- and ultra-deepwater projects. Most of all, though, we think the risk of a deal being struck in future should be prompting Shell to think much harder about the wisdom of continuing to earmark capex  for new exploration in such high-cost, high carbon areas of development.
In short, according to Shell, there is no prospect of a global climate deal either in the near term or the foreseeable future that would lead to a structural reduction in oil demand and oil prices, and hence no risk of stranded assets affecting either its proven reserves or its broader resource base, or its ongoing exploration capex programme.
However, and in addition to the points we have just made regarding the stranded-asset risk beyond a 12-year horizon arising from a potential future tightening of global climate policy, we would argue that Shell’s approach to stranded-asset risk more broadly has a number of problems.
Our take: Shell’s approach to stranded-asset risk looks naïvely binary, complacent, and defensive
Below we look at the three broader problems we see with Shell’s approach to carbon and stranded-asset risk.
A naïvely binary approach: Whether a global policy framework consistent with a 450-Scenario is ultimately put in place or not, there is always also the risk of tighter legislation at the regional and national levels that could lead to stranded assets in certain markets. A good example of such a risk at the moment relates to the ongoing debate over the Keystone XL (KXL)  pipeline between Canada and the US. If President Obama ultimately decides to veto KXL, this could create stranded assets in the Alberta oil-sands plays both for Shell and other oil companies.
Second, there is the broader carbon-related risk that certain kinds of investments – notably high-cost, high carbon assets such as Canadian oil sands – could become socially unacceptable as investments for growing numbers of institutional investors over time. Indeed, this was one of the assets explicitly cited by As You Sow in its shareholder resolution that ultimately forced ExxonMobil to write the report it published at the end of March (see our Alert of 1 April for more on this point).
Complacency: We find Shell’s letter complacent regarding stranded asset-risk with regard to two points that have nothing whatever to do with climate-policy risk:  i) the asset-stranding its current increasingly high-cost business model is already potentially exposed to; and ii) the rapidly improving economics of renewable-energy technologies and the disintermediation risk this gives rise to.
On the first of these points, to the extent that rising oil prices over the last decade have already tempted Shell into investing in the disastrous Kashagan oil project – an investment that from a life-cycle point of view is increasingly at risk of  becoming a stranded asset – we think it is ignoring altogether an obvious example of stranding risk increasingly inherent in the majors’ pursuit of high-cost mega-projects.
On the second of these points, we think Shell’s assessment of the time it will take for fossil-fuels to be phased out of the global  energy mix blithely ignores the spectacular extent to which fossil fuels have been disintermediated in the European power-generation mix over the last decade, and hence  fails to consider the disruptive impact continuing improvements in renewable technology and storage could have on the oil industry in the future.
Moreover, if Shell is right that oil prices will  likely continue to rise in the future – and we think Shell is right on this point –then the incentive to deploy renewables at ever greater scale, and to accelerate the commercial development of electricity-storage technology, will only increase in coming years, thus creating the conditions for increasing disintermediation of the oil industry (although again, with the caveat that the pace of the energy transition will also to some extent be dictated by government policy on renewable subsidies).
Clamming up instead of opening out to engage with investors: Ultimately, our interpretation of Shell’s letter is that it has been written to close down debate on carbon risk rather than open itself up to an ongoing dialogue on the subject. Indeed, the tone of the piece throughout is that the very concept of stranded assets is a distraction that is used by “some interest groups […] to trivialize the important societal issue of rising levels of CO2 in the atmosphere”.
Leaving aside the obvious point that when it comes to the future of the oil industry Shell is itself an “interest group” par excellence, we find this latter statement indicative of a form of cognitive dissonance that permeates Shell’s letter. Consider: Shell is here accusing those who would question the wisdom of continuing to invest in high-cost, high-carbon oil projects of trivializing the debate over rising CO2 emissions while at the same time itself acknowledging that “there is a high degree of confidence that global warming will exceed 2°C by the end of the 21st Century” (Shell letter, page 1), and that “our scenarios take as pre-determined that climate change will rise up the public and political agenda” (Shell letter, page 2) and even that “regulatory priorities could well be relatively sudden”.
Yet at the same Shell’s fundamental position is that the world will continue to burn oil and gas for decades to come such that the fundamentals of Shell’s business model will not be at risk for decades, even though it implicitly acknowledges that this will only increase the risk of dangerous climate change in future. Is this coherent and is this a more serious approach to “the important societal issue of rising levels of CO2 in the atmosphere” than the trivializing approach Shell sees in those who would raise questions about stranded-asset risk?
In short, we think Shell is behaving like the proverbial policeman at the scene of an accident, effectively saying “move along here, there’s nothing to see on the subject of stranded assets”, when instead we think it should be looking to engage with investors and other stakeholders on a subject that is here to stay whether oil prices fall as a result of structurally lower demand in response to tougher climate legislation, or whether – as we think more likely – oil prices continue to rise over time in real terms and thereby accelerate the shift towards a renewables-based global energy system.
Indeed, we think that instead of clamming up on carbon and stranded-asset risk by disputing that there is actually a meaningful debate to be had on the subject, Shell should be recognizing that a new age of engagement on these topics has already begun, and that the companies that understand this are the ones that stand to benefit most in terms of investor perception and market reputation.”

 

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