Carbon constraints put creditworthiness oil and gas companies at risk

May 21, 2013 | 4 min read

The Carbon Tracker initiative is a non-profit think tank established to align the capital markets with efforts to tackle climate change. Together with the global credit-ratings agency S&P, it has studied how climate change risk might affect a sample of S&P rated oil companies — in response to investors' growing interest in this subject. Michael Wilkins, head of environmental finance at S&P, comments on the study: “Financial models that only rely on past performance and creditworthiness are an insufficient guide for investors… Our study shows deterioration in the financial risk profiles for smaller oil companies that could lead to negative outlooks and downgrades. However, the effect on the majors would be more muted.” James Leaton, Carbon Tracker’s research director, adds: “Bringing in emissions ceilings has clear implications for the future fundamentals of the sector — demand and price. The uncertainty around the future of carbon intensive fuels needs to be translated across credit analysis of business models going forward.”

Past performance will not be repeated

The three oilsands operators analyzed have issued US$13.6 billion of corporate bonds, with over 50% of these maturing post-2020. “The companies may find a very different context to try and refinance any of the debt which matures in the next few years. The uncertainty around the bonds which mature later, out to 2042, is not reflected in the current short outlook of a 3-5 year credit rating outlook. This research shows that credit ratings need to start looking at alternative futures, “as a carbon constrained world will not see past performance of this sector repeated because of the pressure to lower greenhouse gas emissions and because of rising operational costs for the oil and gas sector as finding and exploiting oil reserves becomes more difficult and companies' exposure to unconventional technology and hostile environments grows… (Brent crude oil prices have remained strong at about $110 per barrel (bbl) in recent years, but analysts are split on whether this price could drop or rise to more than $150.)”

Influences on the future of fossil fuels

As the report shows, currently, the regulation of greenhouse gas emissions is a patchwork of national and regional regulation. “A recent review of climate and energy legislation showed that 32 out of 33 major economies have taken action in some form^[1].” Additionally, governments worldwide have introduced a range of mechanisms, such as emissions trading schemes, carbon taxes, and emissions intensity targets. “Policy actions to moderate climate change also demonstrate that the future of fossil fuels cannot be determined purely by a carbon price. In Europe, feed-in tariffs (that is, top-up market subsidies for renewable energy producers) determine the competitiveness of renewable energy sources such as wind and solar power, while the market-based carbon price casts doubt over the viability of new coal plants. In the U.S., there is no federal carbon market, but there are requirements on corporate fuel efficiency, new restrictions on mercury emissions, and state-level measures on carbon emissions such as in California, while shale gas is shifting the power generation mix. In countries such as China, India, and Australia, the availability of water acts as a constraint on operations.”

North America as key test environment

The study focuses on North America, “largely because we believe it's a region where there's a high cost base in terms of development costs for oil sands and one of the areas with the greatest potential to reduce demand.” The fact that Canada with its considerable shale gas reserves could provide an alternative to OPEC oil import is also taken into consideration. To name a few other factors, “the U.S. Department of Transportation estimates new fuel economy standards for automakers will reduce oil demands by more than 2 million barrels of oil per day or 0.7 billion barrels a year by 2025. The Environmental Protection Agency has also issued standards for heavy trucks that reduce average on-road fuel consumption by 18% between 2014 and 2018.” Extra pressuring demand, the 2005 Energy Policy Act provides tax breaks of $1.3 billion for alternative motor vehicles and fuels and provides tax credit for hybrid vehicle owners. Also, in view of further worldwide climate negotiations, the World Energy Outlook 2012^[2] concludes that “without a significant deployment of carbon capture and storage, more than two-thirds of current proven fossil-fuel reserves cannot be commercialized before 2050” if the target of keeping global warming below 2 degrees C is to be met. The business risk of this “carbon bubble” was also addressed in a report by analysts at HSBC^[3] earlier this year.

Stress scenario’s

In their study, Standard & Poor's and Carbon Tracker consider two different types of companies. On one hand, moderately sized oil and gas companies with high exposure to Canadian oil sands and other unconventional fossil-fuel activities: Canadian Oil Sands Ltd., Canadian Natural Resources Ltd., and Cenovus Energy Inc.. On the other, two oil majors with increasing exposure to these kinds of carbon and water-intensive fossil fuels: BP PLC and Royal Dutch Shell PLC. “To assess the potential effect of policies consistent with the IEA's 450 ppm scenario, we have incorporated a lower demand outlook for oil products in our individual company forecasts through a resultant drop in oil prices. We've then considered the potential effect on our business and financial risk profile assessments, and hence the possible rating implications under the assumed lower demand scenario..Our stress scenario takes into account a declining trend in oil prices from current levels to a floor for Brent crude of $65 per bbl by 2017.”

Under the stressed scenario, the report states about the smaller companies — especially if they are relatively undiversified: “We see a deterioration in the financial risk profiles of these companies to a degree that would potentially lead to negative outlook revisions and then downgrades over 2014-2017”. The effect on the integrated oil majors would be more muted. “We anticipate that the benefits of diversification would dilute the adverse financial effects of lower oil prices under this stressed scenario in the near term. Over five years or more, under our assumed stress scenario, the impact of reduced oil demand, potentially lower profitability, and declining reserve replacement would likely also weigh on our business risk profile assessments of the companies under review.”

References

The Climate Legislation Study. GLOBE International and LSE Grantham Research Institute on Climate Change and the Environment, January, 2013.
World Energy Outlook 2012. The International Energy Agency, November, 2012.
Oil & Carbon Revisited, value at Risk from ‘unburnable’ reserves. HSBC, January, 2013.

This article may be reproduced according to our terms of use with attribution (and link, if online) to www.tias.edu. To be cited as: “Carbon constraints put creditworthiness oil and gas companies at risk, Ingrid Ramaan, www.tias.edu, May 21, 2013.

Report S&P and Carbon Tracker