Oil sector faces rising threat to investment
Upstream funding risk to future oil supplies emerging
Doubts over the future of the global oil and gas industry could be stoked further if appetites for lending and investment in the fossil fuel sector continue to wane.
- Boost to fossil fuel divestment lobby
- Oil majors mostly self-financing
- LNG project financing could be squeezed
Climate change, the rise of renewable energies and the prospect of peak oil demand are already knocking dents into the long-term investment outlook for the oil sector. But the prospect of a widespread retreat from funding by multilateral lenders and investment from sovereign wealth funds is emerging as a new threat.
Norway’s sovereign wealth fund said in November it plans to drop oil and gas stocks from its $1 trillion fund to cut its exposure to the sector. A month later, the World Bank said it will cease to finance upstream oil and gas after 2019, citing a target to bring its lending in line with Paris climate agreement goals. The moves add new momentum to the divestment from fossil fuels by global insurers and pension funds wary of reputational risk and exposure to stranded fossil fuel assets.
Norway’s SWF fund has for years been held aloft as a global benchmark for financial prudence and transparency that other SWFs aspire to copy. If Norway ditches its oil and gas investments, could it have a domino effect, triggering a more widespread pullback in fossil fuel investments? Most market watchers don’t think so. As Europe’s biggest oil and gas producer, Norway is simply reducing its existing exposure to the sector given the considerable value locked up its large reserves of oil and gas.
“You can argue in terms of expectation management, whether cutting [oil and gas investment] that way is the right way to do it,” said Paul Horsnell, head of commodities research at Standard Chartered. “[But] I don’t think that fund has an angle on the oil industry that they think it’s going to finish before anyone else. That fund… is predicated on the end of oil.”
Norway’s fund has been instructed by parliament to help fight climate change. Last year, it sold out of coal companies, a move which followed divesting from heavy polluters and companies involved in deforestation. In many ways Saudi Arabia’s planned IPO of Saudi Aramco next year and longer term moves to cut its dependence on oil are an example of the same logic. Abu Dhabi has also floated plans to move away from reliance on fossil fuels to establish itself as a “global center of excellence in the renewable energy”.
Project-financing at risk
But, writing off Norway’s move as merely a logical rebalancing of its investment portfolio maybe a mistake. Ireland, with no significant oil but some gas reserves, saw its parliament vote in February in favor of legislation that will drop fossil fuel investments from its Eur8 billion strategic investment fund. Citing “catastrophic climate change”, the decision stands as a benchmark for countries and funds keen to promote clean energy.
A lot is at stake if moves by Norway’s much bigger SWF and the World Bank are emulated. The International Energy Agency estimates $640 billion is required in upstream spending every year between 2017 and 2040 to avoid a potential shortfall in global oil supply.
With a broader pullout by oil investors, the thinking goes, stock valuations might slip and upstream spending could fall, raising the risk of a future oil supply shortage and higher prices. The biggest risk is to smaller producers.
Depressed stock valuations could raise debt-to-equity ratios, making their equity financing problematic and more costly. If more multilateral development banks call time on loans for fossil fuels, developing countries could be forced to shelve or delay some upstream projects. Particularly at risk would be LNG export projects, given their high cost, long lead time investments that often rely on project financing.
Self-financing Big Oil
For the wider oil markets, the threat to future supply from a growing financial sector aversion to oil sector lending and investment is not so clear. Almost all final investment decisions to develop major new upstream oil and gas projects in recent years have come from oil majors.
Multinational oil majors are largely self-financing, adept at scaling their capital spending to fit cash cycles. Indeed, global investment into new upstream projects plummeted by nearly 50% since 2014 due to belt-tightening amid the price slump. Having reset their costs through the 2014 down cycle, oil majors are already turning the page on a string of dismal earnings. Cash flows have recovered sufficiently for many to cover their capital spending plans and dividends without taking on new debt. Shell in November flagged a return to all-cash dividend payments for the first time in two years and BP started buying back its own shares, both clear signs of growing confidence in the sector. A return to share buybacks at a time when the oil sector is underperforming the wider markets amid doubts over the pace of recovery may even be a blessing in disguise.
“We note that large oil and gas companies are currently funding capital investments from free cash flow and looking to buy back shares so may benefit from some short-term drops in their share prices,” said Mark Schwartz, head of equity research at S&P Global Platts Analytics.
Alternative upstream financing from the East is also an option. The price downturn and growing focus on climate change has not slowed China’s appetite to secure oil and gas assets across the globe to help meet its dependence on imported energy. In 2016 alone, Chinese national oil companies increased their overseas equity production to an estimated 3 million b/d. Global oil traders are also becoming increasingly proactive with pre-payment crude supply deals which help bridge producer’s funding gaps.
Even so, news of recovering profit margins and an uptick in upstream spending will do little to temper the dire warnings over massive stranded assets in the industry from some quarters. Groundless or not, rising angst over future funding for some oil and gas projects could prove self-reinforcing if oil investments lose out to spending on clean, renewable energy.
“The mood music from the media doesn’t suggest that a 30-year investment in oil is a good one. Long-term prices aren’t that supportive and it just continues to weigh down on the conventional investment in oil,” said Standard Chartered’s Horsnell. “Now that’s fine if it turns out we don’t need that investment after all, but I think it’s probably more likely that we do.”