How much longer will the good times roll for fossil fuel companies?

Welcome back. You’d think this would be a heady time for investors in US oil and gas companies, as the Trump administration promises to unleash a new age of fossil fuel expansion. Yet those stocks have been underperforming the wider market of late. The Dow Jones US Oil and Gas index is down by 1.2 per cent over the past year, compared with an 11.3 per cent rise for the S&P 500.

Investor caution on this sector is justified, as I highlight below. And a new study suggests they should be ready for much bigger declines to follow over time.

Have a good weekend.

Green transition

Who will be left holding oil assets when the music stops?

The latest long-term forecast from Opec, the club of petroleum exporting nations, predicts that the world will use 120mn barrels of oil per day in 2050 — up from 104mn barrels today. Oil companies from ExxonMobil to BP to Equinor are ramping up their fossil fuel investments in anticipation of strong demand for decades to come.

But what if they’re wrong? With a US president crying “drill, baby, drill,” some have written off the world’s chances of weaning itself off fossil fuels to any significant degree by mid-century. Yet the risk of peak oil demand remains real, for oil companies and their investors, who include governments and savers around the world.

A new attempt to quantify that risk came yesterday, in a study carried out by the UK Sustainable Investment and Finance Association with analysis firm Trex. They looked at the outlook for fossil fuel asset valuations under the Announced Pledges scenario developed by the International Energy Agency, which portrays how the global energy system could develop if governments meet their climate targets.

Counting the cost

The researchers found that this would lead to $2.3tn in asset writedowns and other financial losses by 2040 as resources were left in the ground due to insufficient demand, which would weigh on prices too. They also modelled how these losses would be distributed — an exercise that led to some interesting results.

In absolute terms, governments and investors in the US, Russia and China would take the biggest hit, with respective losses of $546bn, $402bn and $184bn. In fourth position was the UK, with potential losses of $141bn — despite its relatively modest position in the global fossil fuel industry.

While the UK accounts for only 2 per cent of global GDP, and only 1 per cent of physical fossil fuel assets vulnerable to “stranding”, it accounts for 6 per cent of the world’s potential financial losses from stranded assets. Those losses, the researchers found, would amount to more than £2,000 per UK citizen, reflecting the country’s outsized financial exposure to the global fossil fuel industry. A major part of this hit, they noted, would be taken by the UK pension fund sector, which would be on the hook for losses of £15.2bn ($19.6bn).

Of course, all of this assumes that governments will meet their emissions reduction commitments — something that was in doubt even before Trump shredded US climate policy. Still, it’s worth noting that the IEA’s Announced Pledges scenario used in this study is considerably less ambitious than its Net Zero Emissions scenario, which assumes net carbon emissions can be eliminated by 2050.

And even under the IEA’s far less ambitious Stated Policies scenario — in which governments barely go any further to meet their climate goals than the policies they’ve already announced — global stranded assets would still amount to $872bn, the researchers found, with the UK’s share totalling $49bn.

Who are the optimists?

Hopes of meeting the Paris Agreement goals in full now look highly optimistic. But in its own way, so does the Opec forecast of continued strong growth in oil demand. The shift to electric vehicles is a dire threat to the single biggest source of this demand. Chinese sales of EVs are set to overtake those of combustion-engine cars this year. Other nations are moving in the same direction, albeit mostly at a slower pace, as costs come down and charging infrastructure improves.

While sea and especially air transport will be harder to decarbonise, they account for only 15 per cent of crude oil demand. Oil purchases for petrochemical production continue to grow — but that sector accounts for less than a sixth of total crude oil demand, meaning even rapid expansion is unlikely to outweigh the decline in demand from road transport.

That’s borne out by the IEA’s latest annual oil report, which predicts that demand growth will turn negative in 2030. Perhaps the IEA is getting carried away, and Opec’s analysts have a more reliable perspective? Perhaps — though it’s worth noting that the IEA has repeatedly had to revise upwards its conservative predictions for clean energy growth.

For investors managing their financial exposure to fossil fuels, this is largely a question of timing. Despite weak performance in recent months, those who’ve been overweight the sector in the past five years have been rewarded: the Dow Jones US Oil and Gas index rose 105 per cent, compared with a 94 per cent increase for the S&P 500 index. But as soon as it becomes clear that oil demand is entering structural decline, the reassessment of asset values may be painful.

“The energy transition is already under way, even without any additional policies being implemented,” said Willemijn Verdegaal, co-chief executive at Trex. Investors in fossil fuel companies should ask themselves, she added: “Is this the risk we want to be taking? Do we want to be left holding this when the music stops?”

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