The biggest risk facing Big Oil that nobody’s talking about (yet)
Among the risks facing Big Oil stocks, most investors focus on the direction of oil prices. There is good reason for that—after all, profits and stock prices across the energy sector, including Exxon Mobil (NYSE: XOM) and Chevron Corporation (NYSE: CVX) have been crushed over the past two years due to falling energy prices.
But there's an even bigger risk that is going woefully under-appreciated among analysts and investors: stranded asset risk. This is the risk that, due to changes in global energy policy resulting from climate change, billions of barrels of oil equivalents may not be recovered at all. Nobody is talking about stranded asset risk right now, but as the coal industry knows all too well, heightened public and regulatory scrutiny of fossil fuel companies, due to their contribution to global climate change, can bring down an entire industry.
Here’s why it won’t be long before you start hearing a lot more about stranded asset risk.
Big Oil faces the music
People care about climate change to a degree not seen in years, if ever. It is easy to see why; climate change threatens the very survival of the human race. As global economies continue to burn fossil fuels, particularly in the emerging markets, the environment is bearing the brunt. Carbon emissions are rising at a troubling rate. Consider the growth of harmful carbon dioxide emissions from China and India, the two most populous countries in the world and two of the premier emerging markets, in the past decade.
This has put the world on a dangerous road toward what climate scientists refer to as “the path to 2 degrees Celsius.” This statement refers to the increase in global temperature that climate scientists widely agree leads to rising sea levels and other harmful environmental consequences.
In response to increasingly more vocal stakeholders, including shareholders, customers, and those who live near oil-producing fields, Exxon Mobil published a 30-page report called Energy and Carbon—Managing the Risks. In it, Exxon Mobil was quick to acknowledge the seriousness of stranded asset risk, writing “ExxonMobil engages in constructive and informed dialogue with a wide variety of stakeholders on a number of energy-related topics. This report seeks to address important questions raised recently by several stakeholder organizations on the topics of global energy demand and supply, climate change policy, and carbon asset risk.”
That was a breath of fresh air; it seemed that Exxon Mobil was finally going to address the very real risk of stranded assets, in a meaningful way. But investors and other stakeholders counting on a thorough discussion were likely disappointed. On the very first page, Exxon Mobil stated “we are confident that none of our hydrocarbon reserves are now or will become ‘stranded.’” The company seemed to dismiss the very concerns that it itself raised.
The recurring theme from Big Oil companies like Exxon Mobil was that, should global governments decide to crack down on fossil fuel exploration and production, it would doom under-developed nations to darkness and poverty. The rationale is that these emerging economies need to keep burning through oil and gas because their economic growth is still in its infancy. And while that may be true today, it won’t always be the case. Sooner or later, emerging markets like China and India will, for lack of a better word, emerge. Mature economies, like the United States, do not need to burn fossil fuel nearly at the same rate they did in the early 20th century. Once a country comes through its industrial revolution, the societal need for clean air and water beats its need to keep burning dirty fuels. Wealthy economies like the United States have realized the value of renewable forms of energy.
Take China for example. It produces an enormous amount of coal and oil, to nurse its economic growth. But the effects of this are very real—there are many areas of the country where citizens need to wear masks because the air pollution is so bad.
Why stranded asset risk needs to be built into valuation models
One of the most common ways in which energy companies are valued is their reserves. Management teams and analysts consistently point to reserves as a reason why Big Oil stocks deserve higher valuations. In the U.S. as a whole, oil reserves are at a 10-year high.
Billions of Barrels
Indeed, Exxon Mobil and Chevron have tens of billions of dollars’ worth of reserves sitting under the ground. Consider the scale of the numbers involved. Exxon Mobil produced 4 million barrels of oil per day last year. It added 1.4 billion barrels of oil equivalents to its resource base last year alone, and now holds a whopping 91 billion barrels of oil equivalents.
Ditto for Chevron. It produced 2.6 million oil-equivalent barrels per day, which represented 2 percent year over year growth from 2014 production levels. Furthermore, it added 1 billion barrels of net-oil equivalent proved reserves in 2015. Between its consolidated companies and affiliate companies, it has 11 billion net proved oil-equivalent reserves.
It goes without saying that the oil-equivalent reserves held by Exxon Mobil and Chevron represent a significant asset on their balance sheets, and the value of these reserves makes up a large piece of their market values. Should these companies have to write down the value of their resource base at any point in the future, it could potentially wipe out billions of dollars of shareholder wealth. This is a serious risk factor not just for Exxon Mobil and Chevron, but for U.S. energy firms as a whole—which is evident by the above chart.
The bottom line is that the mentality of Big Oil, regarding stranded asset risk, is to pretend the problem isn’t there. But it is, and it’s only a matter of time before the major oil producers need to formally acknowledge this risk in a more serious manner.
Companies to watch
EOG Resources (NYSE: EOG): The stranded asset risk is mitigated somewhat for Exxon Mobil and Chevron, because they are integrated, meaning they are not solely valued on their reserves. They also have large refining businesses. But this is not the case for exploration and production companies like EOG, which has identified more than 2 billion barrels of oil-equivalent net resource potential. The value of these reserves comprises the bulk of its market capitalization.
Analysts expect EOG to lose money this year. The average forecast is for a $2.16 per share loss in 2016, which would reverse the $0.06 per share profit from 2015.
Pioneer Natural Resources (NYSE: PXD): Stranded asset risk is heightened for upstream only E&P majors like Pioneer, one of the biggest oil producers in the country. It has 664 million barrels of oil equivalents in proved reserves, 47 percent of which consists of oil.
Pioneer lost $0.12 per share last year, which was only a modest loss. But analysts expect the company to lose $1.61 per share this year, and $1.29 per share in 2017.
Anadarko Petroleum (NYSE: APC): Another major E&P company, Anadarko is also at risk from stranded assets. It ended the year with 2.06 billion barrels of oil equivalents in reserves.
Analysts expect Anadarko to lose $3.37 per share this year, a far worse loss than the $2 per share loss incurred last year.
Bob Ciura is an independent equity analyst. Since 2012, his work has focused on fundamental investment analysis of publicly-traded companies in the energy, technology, and consumer goods industries. Bob has a Bachelor's degree in Finance and an MBA in Finance.