Capital costs rise on sustainability concerns
An intensifying investor focus on sustainable investing and the climate emergency is impacting the oil and gas sector
Investors are increasingly focused on the threat of global warming and the need to rapidly decarbonise the global economy, with up to $118tn of funds committed to making climate risk disclosures by 2020.
And they are responding by divesting oil and gas holdings, or, at a minimum, fully integrating sustainability into their investment process, driving an incrementally negative view of the sector. Consequently, the sector's weighted average cost of capital (WACC) has risen, causing a valuation derating, reduced capital availability and low market liquidity.
This negative increase in the industry WACC occurs in several ways. Firstly, capital flows out of the sector as new issuance declines and investors reduce or eliminate holdings altogether.
Banks might face a ‘climate Minsky moment’ unless they improve their understanding, Mark Carney
More meaningfully, a risk-based asset devaluation also occurs as the implied equity risk premium required to own energy investments over other sectors or asset classes increases. The higher risk premium is driven by concern over lower long-term oil prices and peaking oil demand due to factors such as the electrification of the transport sector, an asset level risk of the industry’s reserves becoming ‘stranded’ and finally a rising political risk that companies will have to pay for the carbon cost of their product through regulation or taxation. The net effect is to structurally de-rate the sector, as the tobacco and coal sectors previously experienced.
The structural derating is observed in both the poor absolute performance of oil and gas shares and a structural decline in valuation metrics, with oil companies trading on high dividend yield premiums to the market, despite strong balance sheets and free cash flow generation. Similarly, midstream infrastructure companies in the US yield over 10pc despite widespread sovereign debt trading at negative yields, implying little or no ‘terminal value’ in many oil assets and a high implied WACC being applied to distant cashflows.
This listed market derating also threatens returns from private equity (PE) funds focused on energy, given market or corporate exits are a key value driver.
Global banks are also increasingly integrating carbon risks into lending practices, with Bank of England governor Mark Carney recently suggesting banks might face a ‘climate Minsky moment’ unless they improve their understanding and disclosure around carbon risks exposure.
The inverse to this derating is a structurally lower WACC applied to renewable energy companies, such as the rerating upwards of the Danish company Dong, now rebranded by Orsted, when it sold its oil fields and became a pure play offshore wind developer. The problem for the oil sector in simply switching investments to renewable energy is that, in many cases, renewable energy assets generate a lower structural return on capital than the oil assets they own, and they face fierce capital competition from other sectors.
Management teams have no choice but to react to this change, whatever their views of the underlying reasoning. They must address both their own sustainability impact, striving to minimise internal emissions and to offset the carbon impact of their product, and also their elevated WACC by changing their capital funding mentality and asset investment criteria.
$118tn: funds committed to climate risk disclosures by 2020.
As the market increasingly values oil companies solely on their short-term sustainable cash dividend, the sector must only invest in high return assets that can both pay the dividend and supply enough reinvestment capital to sustain production and revenues.
Paradoxically, the current negative sentiment across the sector is suppressing investment levels below the long-term rate needed to sustain current production. Once previously sanctioned projects come on stream and US shale matures due to its capital intensity, oil prices may strengthen due to continued underinvestment.
Despite this, the industry is unlikely to be rerated even in a higher oil price scenario and only companies seen to be addressing climate change, investing in structurally high return assets and committed to paying a significant and sustainable cash return to investors are likely to prosper.
James Mills is head of private investments and business development at Arosa Capital Management, an alternative investment manager focusing on investments in energy and related sectors