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Oil and gas investors need to weigh investment options

Producers and investors could be sitting on billions of dollars of unspent funding because of the current industry downturn

Some big oil and gas producers – as well as potential investors in the sector – may be sitting on billions of dollars of unspent funding from projects deferred during the current industry down-turn and hopes are high that a pick-up in demand in coming years will unleash a wave of fresh investment. But judging when and how much to invest will be far from straightforward, according to a new report.

A failure to correctly assess the impacts of oil price volatility, the changing financial environment and the speed at which policy to mitigate climate change risks will be implemented could lead companies to either over- or under-invest in exploration and production – with potentially severe repercussion either way.

Of these variables, the practical effect of the outcome of UN-backed global climate change talks in Paris at the end of this year is one of the hardest to predict, as it depends largely on the vagaries of short-term politics, according to the authors of Oil and Gas Mismatches: Finance, Investment and Climate Policy, a report from Chatham House, a UK think tank, published in July.

“You almost have a better chance of guessing what Chinese growth is going to be in three years’ time than what a government is going to do with its energy policy tomorrow,” says Beth Mitchell, an ex-fund manager, who co-wrote the report with former BP executive John Mitchell and former Chatham House energy team head Valérie Marcel.

Recent pronouncements by both the Chinese and US governments illustrate the point. Both have raised the bar in terms of their stated climate change policy this year, but are from certain to be converted into progress on the ground. In early August, the US president, Barack Obama, announced plans to introduce more ambitious US carbon emissions cuts targets and embark and a major renewable energy push. However, the measures could yet be blocked by a Republican-dominated Congress, so the energy industry has little idea of the future policies to which they will need to conform.

The Paris climate talks themselves could provide much-needed clarity, but that is far from a given, if the somewhat woolly outcome of last year’s edition in Lima and the ambiguous signals emanating from pre-Paris discussions are any indication. Paris might not produce a timetable for global carbon emissions cuts that will be as clear as the oil and gas industry would like.

This vagueness will lead to what the Chatham House report’s authors call a “Janus” risk. On one hand, heavy expenditure on oil and gas exploration could be wasted, if projects are scuppered by strong climate change mitigation policies. But, on the other, a cautious spending strategy could result in investment below the levels needed to meet demand, should climate policy outcomes be weaker than anticipated.

With some studies suggesting that almost half of global oil reserves could be left unburned in 2050, even without a particularly strong global carbon emissions policy (see table), the industry – including the developing world’s national oil companies (NOCs) in whose countries much of the oil and gas reserves lie – has some serious thinking to do over its longer-term strategy.

The larger international oil companies (IOCs) will be better equipped to survive an unexpected change in business conditions – given they typically have deeper pockets and 12-15 years of reserves – than smaller frontier explorers, and they have the option of switching from one country to another, unlike domestically-focused NOCs.

The big IOCs may be slashing capital expenditure now in the face of a low oil price, but most, if not all, will still be standing in five years’ time. Smaller players, however, often have limited reserves on their books and are dependent on the willingness of investors to take high-risk equity stakes in order to finance their operations.

Percentage share of unburned oil and gas reserves

 
Oil

Gas

 
End-2014

2050

End-2014

2050

Middle East

48

61

43

48

S & C America

19

13

4

5

North America

14

10

6

1

Africa

8

5

8

5

Russia

7

6

29

33

Other

4

4

10

8

Source: Chatham House report – 2014 figures, BP Statistical Review of World Energy 2015; 2050 figures, McGlade and Ekins, ‘The geographical distribution of fossil fuels unused when limiting global warming to 2°C’, Nature, Jan 2015.


Does shale have the edge?

While there is no shortage of investors dedicated to putting money into higher-risk assets, they may favour ploughing cash into the US shale sector – or indeed another sector entirely – rather than the pioneering conventional plays in, for example, the Mediterranean or offshore west Africa, given the very different natures of those investments.

The combination of high political and exploration risk, combined with a long lead time of several years before returns are realised from conventional production, even if exploration proves successful, was already making the sector a tough proposition for investors before the oil price collapse.

More stringent capital adequacy requirements imposed on banks in some countries following the global financial crisis also made them more risk averse in terms of lending.

“Many banks were restructured after the financial crisis of 2008–09. Some have wound down their expertise in the oil and gas sector and, as a result, are reluctant to fund projects that are complex and/or carry technical and political risk,” the report says.

Add to these factors, the low oil price, climate change policy and other uncertainties and those conventional resource-oriented smaller explorers face big challenges in attracting investment.

On the other hand, US shale producers – while they are affected by price concerns and would not be immune to the effects of tougher climate change policies – have already proved their resilience during the current difficult times for the oil industry. Production has actually gone up despite a plummeting rig count over recent months.

While this has been partly due to efficiency improvements and falling costs due to spare infrastructure capacity, the attractions of a faster rate of return for investors has also played a part in keeping shale producers afloat. While a shale well may become depleted in a couple of years, oil or gas production from it – and hence income – is almost immediate, allowing some shale-focused firms to finance much of their business through attractively high yield bonds in a generally low interest rate business environment.

One major uncertainty for US producers and indeed the global oil and gas industry as a whole is the pace that interest rates in the US, Europe and elsewhere will start to rise in the next year or two as the economies unwind their loose money programmes of recent years. Higher interest rates would require firms to offer more attractive returns to attract investment at a time when their cashflow is already tight.

Gas – at the mercy of political whim

Investment in gas production superficially may look a less risky proposition than that in oil, given the much-touted role of gas as a bridging fuel for the power sector in the transition to greater use of renewable energy. But the report’s authors suggest a cautious approach may be needed there too.

Aside from factors such as the high costs of LNG production and transportation, gas demand is also heavily dependent on governments’ domestic policies regarding power supply – and it is not necessarily a priority fuel, despite its relatively low carbon emissions compared to other fossil fuels.

“Government interventions in the power sectors of importing countries define the size of the market for gas in power generation after policies on coal, and nuclear and renewable energy have been applied,” the report says.

Germany is a case in point, where cheap coal and imports of electricity (including from nuclear-powered France) have played a larger role than gas in filling the gap left by the abandonment of the country’s nuclear power programme, despite the country’s avowed commitment to meeting EU emissions targets.

Meanwhile a combination of tough future climate change measures and further falls in the cost of renewables could also reduce planned expenditure on gas in some countries. That could potentially lead to global over-supply of gas.

While the Paris climate change talks might not provide the clear emissions reductions framework that oil and gas firms would like to see in order to reach investment decisions, demand is almost certain to be constrained in one way or another in coming years as lower emissions technologies are championed, even if hydrocarbons supply remains plentiful.

“Even if production of carbon-based fuels remains relatively cheap, the era of cheap consumption is drawing to a close,” says Mitchell.

That creates food for thought for everyone, from small shale producers to the NOCs, for whom the global oil and gas export market is already becoming an increasingly competitive place.

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