Ominous future for the oil and gas industry

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The risks of investing in the oil and gas sector are increasing.

Major oil and gas producing economies will need to diversify and demonstrate a renewed commitment to reform, if they are to cope with the changing dynamics of global energy.

This was the assessment put forward by the International Energy Agency (IEA) in its Outlook for Producer Economies – a special report in the World Energy Outlook series.

It examined six resource-dependent economies: Iraq, Nigeria, Russia, Saudi Arabia, UAE and Venezuela. It assessed how they might fare to 2040 under a variety of price and policy scenarios.

The highs and lows seen in terms of oil prices over the past decade have exposed the structural weaknesses in many of the major exporters. Since 2014, the net income available from oil and gas has fallen by between 40 percent (in the case of Iraq) and 70 percent (in the case of Venezuela), with wide-ranging consequences for their respective economies.

Furthermore, the extent to which producer countries negotiate their transformations is likely to have major implications for energy markets, global environmental goals, and energy security.

“More than at any other point in recent history, fundamental changes to the development model of resource-rich countries look unavoidable,” said Dr Fatih Birol, the IEA’s executive director. “Following through with the announced reform initiatives is essential, as failure to take adequate action would compound future risks for producer economies as well as for global markets.”

Some of the world’s largest producers face strong pressures from rising numbers of young people entering the workforce. More than 50 percent of the population living across the Middle East is under the age of 30; the proportion is more than 70 percent in Nigeria. In many major producers, income from the oil and gas industry will not be large enough to provide for these growing populations, even in scenarios where oil demand continues to grow to 2040 and prices remain relatively robust.

Nonetheless, the IEA believes that energy will play a key role in any reform programme. Strategies will include capturing more domestic value from hydrocarbons, for example via petrochemicals; using natural gas as a means to support diversified growth; harnessing the large but under-utilised potential for renewable energy; phasing out subsidies that encourage wasteful consumption; ensuring sufficient investment in upstream developments; and playing a role in deploying new energy technologies, such as carbon capture, utilisation and storage.

Risks of oil and gas investment

An altogether less positive assessment of the health of the oil and gas industry was put forward by Tom Sanzillo, IEEFA’s director of finance, and IEEFA financial analyst Kathy Hipple. A lawsuit filed by New York’s attorney general against ExxonMobil is a clear indication of the risks involved in oil and gas investment.

The lawsuit asserts that the company defrauded shareholders by downplaying the business risk of climate change, and litigation poses obvious financial risk. It may even expose ExxonMobil – and possibly other oil and gas companies – to class-action lawsuits as shareholders develop a long-term damages theory.
According to IEEFA, investors who once considered the energy sector a source of stable returns, best look elsewhere. The lawsuit suggests that ExxonMobil’s reserve calculations, properly accounted for, would show a much smaller company with a significantly diminished long-term outlook.

For decades, fossil-fuel rewards were excellent, and the risks minimal. The oil and gas sector was linked in lock-step with economic growth.

However, today’s risk-reward calculations suggest that the time-honoured investment thesis of ‘drill, drill, drill’ has run its course. Fossil fuel stocks now offer investors a lose-lose proposition, where current finances and economics offer smaller returns, and where future returns predicated on climate policy shifts throw company finances into a long-term lose scenario.

Over the past decade the fossil fuel sector has under performed the broader equity market – a trend all the more apparent over the past five years. According to standard risk-reward calculus of investing, if the rewards are lower, the risks should also be lower. This is not the case in the fossil fuel sector.

The risks of investing in the sector have intensified, even as the rewards have diminished. Fossil fuel stocks are increasingly speculative. Revenues are volatile, growth opportunities are limited, and the outlook is decidedly negative.

The weakness is likely to continue as oil prices remain well below USD100 per barrel, while being affected by short and long-term volatility shocks driven by market and political events.

IEEFA suggests that the New York lawsuit only increases the many risks facing the oil and gas industry as the global economy shifts toward less energy-intensive models of growth. Fracking has driven down commodity and energy costs and prices, and renewable energy and electric vehicles are gaining market share.

Meanwhile, campaigns in opposition to fossil fuels have matured to the point that they are a material risk to the sector.

These multiple risks, taken cumulatively, suggest that the investment thesis that worked for decades has lost its validity, said the IEEFA analysts.
The absence of a industry-wide value proposition that embraces the changes taking place in the global economy puts fossil fuel investors at a disadvantage, said IEEFA. Successful oil and gas investing now requires expertise, a strong appetite for risk, and a deep understanding of how individual companies are positioned with respect to their competitors both inside and outside the industry.

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