A stranded asset is an investment that has become obsolete before the end of its useful life, creating a financial loss for an investor who had planned to profit.
With the prospect of disruptive technologies like electric cars, and tougher GHG policies aimed at curbing the use of hydrocarbons, some argue that today’s oil reserves could become tomorrow’s stranded assets. Is this a realistic view?
Like all contentious questions about the future, the answer is not a simple “yes” or “no.” There are a multitude of variables at play, which suggest that in a lower carbon scenario some oil barrels could well be stranded – notably those that have high carbon intensity, high cost and long payback periods. Conversely, oils that are of high quality, low cost and have short payback periods, are not likely to be stranded – in fact, they could be advantaged and deliver attractive investment returns over the long term.
From the perspective of climate change policy, the International Energy Agency (IEA) has put forward a potential scenario (the 450 Scenario) where the atmospheric carbon concentration is held to less than the critical 450 parts per million (ppm) – the level needed to prevent a temperature rise of greater than 2° Celsius long-term. The 450 Scenario assumes radical and quick changes in how society sources energy, including a drastic drop in the use of coal, a slower pace of natural gas growth, more renewable energy, expanded use of carbon capture and storage, strict efficiency standards, and a renaissance for nuclear power. For oil consumption, the 450 Scenario assumes that demand drops steadily by 20% to 74 MMB/d by 2040.
The 450 Scenario is not the IEA’s central scenario. At this point, government policies to limit GHG emissions are not stringent enough to stimulate this level of change. However, for discussion purposes let’s use the IEA’s 450 Scenario to examine the question of stranded assets in crude oil investing. Would some oil reserves be “stranded” under the IEA’s scenario of demand reversal?
Figure 1 shows the path of global oil demand under the IEA’s 450 Scenario, which we have split into two wedges. The first wedge, legacy oil, is oil that is produced from today’s existing oil wells and will continue to produce into the future at an assumed decline rate of 6%. This oil is unlikely to be stranded since the initial investment is a sunk cost, and the projects only need to cover their variable costs to keep operating.
The second wedge is all of the additional oil which must be produced to achieve the IEA’s top line demand estimate. A considerable amount of new oil projects must be developed to offset the almost 80% loss in legacy production by 2040. This continued need for new oil projects for the next few decades and beyond means that the majority of the value of oil reserves on the books of public companies must be realized, and will not be “stranded”.
While most of these reserves will be developed, could any portion be stranded in this scenario? The answer is surely “yes.” In any industry a subset of the inventory that is comprised of inferior products will be susceptible to being marginalized when there is declining demand for goods. In a 450 ppm world, inferior products in the oil business will be defined by higher cost and higher carbon intensity.
A more interesting question is whether the IEA’s 450 Scenario – if achievable – creates an opportunity for some oil producers? It seems counter-intuitive that an oil producer could have a competitive advantage in a lower carbon world, but consider that not all crude oils are equal in their carbon intensity. In reality, some crude oil types create three-to-four times less carbon dioxide in the extraction phase compared with their higher carbon counterparts. And for refining into light transportation fuels, some crude oils generate one-third as many GHG emissions as others.
In the 450 Scenario, the crude oils with smaller GHG footprints will not be stranded. To the contrary, they should benefit from lower costs and more demand for their products compared to higher carbon competitors. To help distinguish between the wide variation in different crude oils, and their carbon intensities, ARC Financial released a report in February – Crude Oil Investing in a Carbon Constrained World – that puts forward a method for estimating the GHG footprint of any crude oil development.
The IEA’s 450 Scenario in Figure 1 is helpful for testing strategy and reducing crude oil investment risk. Even in a scenario of declining oil demand, the relentless drop in legacy production guarantees that new crude oil investments will be required to feed long-term oil consumption. But not all oil reserves will have equal opportunity for development in a lower carbon world. This is the same as any other industry facing a slower pace of growth – the lowest cost producers will be advantaged, and the high cost projects with inferior products are most susceptible to being “stranded.” The oil industry is no different.