The world is mobilising to tackle climate change and it will be critical for oil and gas debt issuers to clarify what part they could play in a decarbonising world and how the transition will affect their business models.
In October 2018, the Intergovernmental Panel on Climate Change published a report which pointed out the benefits of mitigating a global rise in temperatures to 1.5°C.
Conversely, there would be vastly more damage – including rising sea levels and severe heat – if temperatures increased by 2°C.
These targets explain why a growing number of economies have committed to achieving net-zero emissions by 2050.
There has also been a significant rise in investor-led climate change initiatives in recent years.
These include the Climate Action 100+, which seeks to engage with the world’s largest corporate greenhouse-gas emitters, and the Transition Pathway Initiative, which assesses how prepared companies are for a low-carbon economy.
Given that the transition to a low-carbon economy requires reduced hydrocarbon consumption, the oil and gas industry is set to be significantly affected.
There has also been a significant rise in investor-led climate change initiatives in recent years.Oil and gas demand
Yet analysis by the International Energy Agency (IEA) suggests that the absence of additional policy action, coupled with population and economic growth, means that demand for oil and gas is likely to keep growing until 2040, while coal demand should remain stable.
Since demand is expected to rise in this baseline scenario for the next 20 years – a period that extends beyond the tenure of current corporate management teams – it is no surprise that firms are not in a rush to address the energy transition.
Yet critics suggest that the IEA has underestimated the growth in renewables in the past, which warrants caution for investors and suggests there is a need to question the scenarios.
Indeed, BP recently said that oil demand could peak in the early 2030s.
Transitioning to this new low-carbon economy – and the associated decline in demand for hydrocarbons – is a gradual but increasing material risk for oil and gas companies.
While scope 1 and 2 emissions (direct emissions and those generated from used and purchased electricity, respectively) are easier to tackle, they only account for 20 per cent of the total generated by oil and gas firms.
Scope 3 emissions, or those arising from combustion of the fuel by end users, are more problematic.
Regardless of whether firms commit to becoming net zero, all oil and gas companies will need to make changes as demand for hydrocarbons falls.Tackling them requires firms to make more fundamental changes, including altering their business models or using offsets.
Becoming net zero will be more difficult for pure exploration and production companies, given that they do not have direct control over end-market products and therefore the scope 3 emissions that account for the majority of oil and gas emissions.
The alternative would be to continue producing while sequestering CO2.
But with carbon capture and storage (CCS) technology in its infancy – and the lack of a global carbon price – there are few incentives for making such a commitment.
Regardless of whether firms commit to becoming net zero, all oil and gas companies will need to make changes as demand for hydrocarbons falls.
Challenges
Disciplined capital expenditure will be key, as companies will need to ensure that new investments are consistent with the marginal cost of supply for limiting warming to well below 2°C.
As demand falls, so will this marginal price. For some firms, the transition challenges will be too great, and they will instead need to focus on low-cost production, reducing their level of production, returning cash to investors and eventually winding down all operations.
As the transition gathers pace and demand for hydrocarbons declines overtime, it is essential for credit investors to select issuers that are well positioned to alter their long-term strategic thinking.
Oil and gas companies with high-quality assets that can break even at low prices are attractive.
Becoming net zero will be more difficult for pure exploration and production companies.As greater scale allows companies to further reduce costs, companies in attractive basins are likely to benefit from increased consolidation.
In addition, strong balance sheets and sufficient liquidity should help firms navigate the associated decline in prices and potential uptick in commodity-price volatility going forward.
Despite the challenges, we believe there are companies that are well-positioned to tackle the transition to a low-carbon economy in the years ahead.
Audra Delport is deputy head of credit research at the international business of Federated Hermes
