From: Issue 40

Too Much Carbon in Your Portfolio?

17 September, 2012

Why capital spending on energy is heading in the wrong direction

Written by James Leaton, Contributor

The debate at Rio+20 in late June was about “natural” capital. Just days earlier, world leaders attending the G20 summit in Mexico discussed the recapitalizing of European banks. Amid all this talk, extractives companies worldwide continue to plough massive amounts of capital into “unburnable carbon” – carbon that must be left in the ground if we are to avoid the worst impacts of climate change.

The Cancun Agreement in December 2010 captured an international commitment to limit global warming to two degrees Celsius above pre-industrial levels. It also recognized the potential need to tighten this target to 1.5 degrees. Companies and investors may talk openly in support of this two-degree framework, but the capital expenditure plans of the fossil fuel sector are keeping us on the path to six degrees of global warming.

The money deployed now will be used to develop a dirty energy resource for decades to come. It can take at least five years to explore for and develop a coal, oil or gas asset before it achieves full production. In the world of quarterly reporting this is relatively long-term thinking.

Zeroing in on oil, the industry is setting new records with its capital spending budgets, allocating $728 billion (U.S.) to exploration, development and production projects in 2012. The integrated oil majors are each spending more than $30 billion this year, with levels set to rise over the next five years.

It is worth noting that for publicly-listed oil companies the era of “easy oil” is over, as recognized by Royal Dutch Shell’s chief executive in 2007. This means that a rising proportion of investment is going toward developing "unconventional" fossil fuel technologies and reserves. Unconventional production includes deep-water oil and gas, liquefied natural gas, tight gas, coal bed methane, shale oil and gas, gas-to-liquids and oil sands.

The return on investment here can only match previous levels from conventional resources if the price of oil continues to rise. The higher up-front capital costs per barrel also mean that projects can take decades to produce a positive cumulative cash flow. Yet about 35 per cent of predicted production from the three largest independent U.S. oil majors will be from unconventional sources by 2018, up from 20 per cent in 2010.

A risky path to take? There are warning signs out there if we turn attention to the North American coal sector, which appears these days to be running out of options. The combination of cheap domestic gas and more stringent emissions regulations has made coal an expensive option. Consumption of coal in the U.S. in the first quarter of 2012 was at its lowest in 25 years. Power companies have cancelled a number of planned coal plants in the last six months. Exelon, for example, may have to take a 40-per-cent haircut on the value of the coal plants it is selling off. Ratings agency Moody’s downgraded Alpha Natural Resources at the end of June due to its exposure to Central Appalachian coal.

One wonders if this is coal’s Kodak moment. There are similarities here with the sub-prime crisis – mixing in high-risk products with an assumption that property prices will continue to rise. Extractives companies are moving quickly to wrap up baskets of high-risk, carbon- and water-intensive unconventional reserves. The ongoing viability of this model assumes that demand, prices and carbon emissions all continue to increase, with no alternative technologies becoming more competitive.

The oil sands are a case in point. In Canada, accounting rules are downplaying the levels of oil sands listed on the stock exchange. Current rules date back to the days of $40 per barrel of oil. At this price it made perfect sense for companies to only report reserves that were due for “imminent production.” Higher levels of reserves have started to appear in financial reports as they become economically viable at a higher oil price. The physical existence of the oil sands reserves is not questioned, but whether the planet can afford to burn these carbon-intensive assets should be.

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