ESG Focus | Dec 18 2020
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FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:
Part 1 of this series focused on the bigger picture for fossil fuels, and in this article, we drill down to the ESG trends affecting forecasts in the specific coal, gas and oil markets.
–Lining up the coal, gas and oil dominoes
-Post-covid price squeeze on the cards
By Sarah Mills
A decade ago, fuelled by China’s industrialisation, the fossil-fuel industry appeared unstoppable. Now, the impossible isn’t just possible, it is a reality.
Producers globally are falling like dominoes to the inexorable and sharply accelerating transition to renewables and vehicle-and-industrial electrification.
Investors barely had time to blink when covid and the Saudi-Russian oil war hit, before many major producers wrote down roughly one fifth or more of proved fossil fuel reserves.
The industry has its back to the wall and is kow-towing to ESG investors across the globe for the desperately needed funds that will ensure their survival as a back-up fuel to support the coming transition.
BHP Group ((BHP)), for example, has promised to disclose Paris-aligned production targets this year, including a target for scope3 emissions, which are generated downstream in BHP’s supply chain.
Offshore, BP announced it would transition to a new energy model based on low-carbon technology, as other majors dropped off leading indices, bleeding market capital.
The battle to survive structural decline is on.
The dominos: coal, gas and oil
Prior to covid, the highest carbon emitters, such as coal were proving to be the first casualties, and producers were expected to fall in emissions order.
But covid and Saudi-Russian oil wars have, in part, shifted the focus to price, according to the Institute for Energy Economics and Financial Analysis (IEEFA).
“The war will nip Saudi competitors in the bud,” says IEEFA’s director of Energy Finance Studies Australia, Tim Buckley.
“It will kill arctic deep-sea drilling which is expensive,” he says. “The highest cost energy producers will be the first to fall.”
Others expect the more climate-polluting coal seam gas and shale gas will be the first to fall (after coal), given the greenhouse effects of methane, and the sometimes-sloppy nature of production.
The latter may cause shale gas in particular to be the subject of exclusionary investing and climate regulation.
As the recent Grattan report points out, gas is no longer competitive with renewable energy, nor can it compete with oil at less than US$50 a barrel.
Oil is hanging on by the skin of its teeth thanks to the global infrastructure demand supporting it.
Meanwhile, coal and nuclear energy were the hardest hit energy sectors this year, according to S&P Markets Intelligence.
But the pair have very different prognoses, with nuclear energy forecast to grow to meet back-up demands in the electricity market as the renewables transition progresses.
Coal in a post-covid world
Thermal coal has extremely low prospects given its high carbon content and lack of economic viability, given plunging prices for solar.
As noted in previous articles, thermal coal is no longer economically competitive with solar on any metric, including total carbon footprint.
As the ABC notes, the world is shutting down coal plants faster than it is opening them thanks to a combination of covid and European regulations.
Coal’s only saving grace is that it offers a cheap and reliable base load, but solar, which is already cheaper, is falling at -10% to -20% in cost a year.
There are also several options in play to solve the base-load and battery problems, the most notable of which is the sharp reduction in storage costs.
Battery storage costs have fallen to US$100KWH, the point at which electricity becomes competitive with oil in the motor vehicle market, and are expected to be rolled out in 2021.
While coal may prove a back-up energy source during the transition to motor-vehicle electrification, it is expected to be short-lived given the rapid pace of development in both solar and battery technology.
Even in India, the country hailed as coal’s great hope, key coal executives have publicly stated that coal has a maximum life of two decades and they are seeking independence for both financial and political reasons.
Fossil fuel imports generally have been bleeding the Indian economy of much needed funds.
Coal imports are costing India US$200bn a year. Its coal import bill has already fallen -US$100bn a year and while corruption will play to coal’s favour, Prime Minister Narendra Modi still wants to keep as much of that US$200bn in the Indian economy as possible.
Modi has publicly expressed his intention to move to 100% electrification of fuel, reducing reliance on foreign fossil fuels.
Corruption may slow this transition but it is only a matter of time and countries such as India may benefit from green aid and social aid if they expedite the transition.
On the flipside, Prime Minister Modi opened up coal mining without end-use restrictions and provided financial incentives to attract investment in India, which has the fourth largest coal reserves, supposedly planning to become a net exporter – although, given its reserves tend to be dirty, one wonders who to, and whether it is a pitch for clean aid.
In every other large country, coal consumption is expected to decline. Most countries are also aware of the looming threat of ESG sovereign credit ratings on debt.
IEEFA’s Buckley warns investors should expect thermal coal prices to fall.
Buckley says 2020 will be a pivot point for global electricity supply and mark the long-term decline of coal-fired generation.
“They didn’t fall during covid because China closed down its production, but as the nation winds back up, expect coal prices to fall,” says Buckley.
Metallurgical coal is still hanging in there but the race is on to find a substitute; and it too is expected to face a reckoning post 2025.
KPMG expects metallurgical coal to trade between roughly US$140 a tonne and US$150 a tonne out to 2025. Newcastle benchmark thermal coal, meanwhile, is forecast to trade between roughly US$65 a tonne and US$75 a tonne. Meanwhile, the AUD is expected to trade between US64c and peak near US74c.
According to Mongabay, in the past few months, Japan’s three main private coal financing banks – Mitsubish UFJ Financial Group, Mizuho Financial Group and Sumitomo Mitsui Financial Group have announced they will reduce coal investments.
In July, Japan announced it would close 100 of its 140 coal plants by 2030 and is reconsidering the number of proposed plants.
In the same month, the Japanese government announced it would tighten public financing criteria for overseas coal plants, which would hit the state-funded Japan Bank for International Co-operation (JBIC).
Japanese banks have historically been the biggest financiers of coal-fired power in South-East Asia. South Korea and China are also primary financiers, accounting for more than 80% of global coal investment.
In April, South Korea announced a Green New Deal that included provisions to end most coal financing.
These decisions may affect China as it prepares for critical decisions on its massive Belt and Road Initiative.
While to date, the emphasis on renewables has been lower than expected, this could change depending on government policy; and on relations between US and China under a Biden government.
The IEA expects global coal consumption to decline by -8% this year – the largest drop since 1945, thanks to covid.
In the past year, countries have been forced to make capacity payments to underutilised coal plants, further damaging the industry’s prospects.
Covid, meanwhile, makes offshore financing issues something of a moot point given many host countries may be unable to complete coal projects because of finances.
For example, overcapacity has caused Bangladesh to pause approval of new coal power plants. India’s Adani, meanwhile, chose not to participate in the first ever coal mine auctions for the private sector.
Adani’s ‘Robbie’ Singh said Adani Group was de-emphasising commercial coalmining.
“Coal-related and mining-related businesses are becoming an increasingly insignificant part of the group’s portfolio,” Singh told Reuters reporters in August, adding the Carmichael project would be less ambitious than initially envisioned.
Carbon capture also appears to be an unlikely saviour.
The mothballing of Petra Nova carbon capture project in Texas, despite receiving a US$290m grant and a US$250m concessionary lending from JBIC, shows the likely fate of other coal-fired CCS initiatives, says IEEFA’s Buckley.
It was the only commercially operational coal-fired CCS project in the US and had been billed as a shining model of success.
But Buckley says it left many question marks over the economic viability of the industry given there was no publication of essential performance issues at the plant.
It is unknown as to whether it was economically viable and almost certainly wasn’t producing sufficient carbon credits to be used in offsets.
In the US, a -27% fall in coal demand could send coal companies bankrupt, says Buckley, precipitating an earlier than expected demise. The average utilisation of coal plants in the US is just 30%: “There’s not a coal company in America making money,” says Buckley.
Meanwhile, back in Oz, Michael West notes that Brookfield is working overtime to spin-out Dalrymple Infrastructure in a float and offload the Dalrymple Bay Coal Terminal by year end after being unable to attract bids from professional investors.
West reports that Brookfield is asking for $3bn-$3.5bn for a valuation of approximately 1.4-1.5x its regulated asset base – using a 5%-6% dividend as bait. The AFR reports a 7% yield.
It raises the question as to whether superannuation funds buying into the IPO will be answerable to their customers. Class actions are mounting.
In November, REST pension fund settled a landmark climate risk litigation filed by a 25-year-old member.
Also in November, law firm Equity Generation Lawyers filed a class action on behalf of young people globally to stop the government from approving Whitehaven Coal’s ((WHC)) Vickery Extension project.
Vickery is mainly a metallurgical coal mine, suggesting pressure is mounting sooner than expected for steelmaking coal.
The only thing working in coal’s favour, other than cheap base-load supply for motor-vehicle electrification, may be rulings on gas methane emissions.
Gas may not be all its been fracked up to be
As the efficiency, economy, and capacity of solar technology outpaces expectations, the prospects for the much-mooted ‘gas as a transition fuel’ phenomenon are thinning.
The IEA has forecast that gas should fall as a percentage of electricity generation out to 2040.
The agency has identified a path to transition to gas from higher emitting fuels using only existing gas infrastructure, suggesting it sees no need to build new gas infrastructure, at least not in the United States.
The IEA does spy growth in South-East-Asia; its STEPS model of future energy demand predicting a 30% rise in natural gas by 2040 from the region.
Given the average lifetimes of 20 years or longer for pipelines, wells and platforms, the agency argues that the time to begin planning for a wind-down of gas production is now.
The IEA’s transition path targets a reduction in methane emissions from oil and gas, the reform of fossil fuel subsidies; and the support and expansion of biofuels.
The Intergovernmental Panel on Climate Change (IPCC), meanwhile, forecasts that primary energy from gas will fall -25% by 2030 and -74% by 2050 from 2010, under a benign 1.5C climate-warming scenario; while oil would fall -37% by 2030 and -87% by 2050.
Methane the new emissions bogeyman
While IEEFA’s Buckley expects economics will force deep-sea drilling out of business first, many are punting on coal seam gas.
A further threat to gas is the rollout of technology that monitors global methane emissions.
Many climate scientists believe methane may be a greater threat to climate than carbon dioxide given methane is almost 90 times as potent a greenhouse gas as is carbon dioxide.
According to the IEA, greater transparency on methane emissions seems to be on the way and this could affect the environmental credentials of different sources of gas.
“Methane emissions along gas supply chains … remain a crucial uncertainty, although better data from companies and aerial measurements, including from satellites, should soon improve understanding of the sources of leaks from across the energy sector,” says the IEA.
“Methane abatement will come through alternative gases such as biomethane and low-carbon hydrogen and technologies like carbon-capture utilisation and storage.”
Methane issues could favour deep-sea-drilling given it is generally perceived to be cleaner than other sources; although methane measurements will soon determine the reality of this claim.
Coal seam gas and shale gas, meanwhile, are on the nose in ESG circles given documented high levels of methane leaks.
Energy consultancy firm Kayrros says satellite images show the number of methane leaks from the oil and gas industry increased by roughly one third this year, possibly reflecting the impacts of covid on industry budgets.
“Kayrros estimated one leak was spewing out 93 tonnes of methane every hour, meaning the daily emissions from the leakage were equivalent to the amount of carbon dioxide pumped out in a year by 15,000 cars in the United States,” reports Reuters.
With higher potential climate change implications than coal given methane leaks and flares, and poor production infrastructure, the shale gas sector is already feeling the capital pinch arising from ESG investment flows, not to mention the pain of oversupply.
Add to that its inherent viability issues (commentators refer to this state of affairs as the coal seam gas treadmill); and the slump in the oil price (keeping in mind the oil price has to rise to US$50 a barrel for the industry to be viable), the prospects for CSG are, compared to its halcyon days, poor.
Already, the industry (particularly the shale gas industry) is subject to massive bankruptcies and growing ESG pressure.
CSG does have an alternative revenue source in plastic production, but the plastic industry is facing intense regulatory pressure of its own and prices are falling in a globally over-supplied market.
Much will depend on technological advances in the plastic industry and process changes to industries such as construction before the outlook here is clear.
But as the market stands now, as recycling technology improves and renewably sourced plastics grow, CSG-based single-use plastic could well meet its waterloo before oil-sourced plastic.
Meanwhile, investors are being advised to beware of companies overstating gas reserves.
In Australia alone, Woodside Petroleum’s ((WPL)) Burrup project would become the most climate-polluting project ever developed in Australia. The equivalent of 35 new coal plants.
Santos ((STO)) aims to double production by 2025, opening up the massive Beetaloo gas basin and Narrabri gas projects.
Oil industry on the ropes
Covid, compounded by the Russian-Saudi oil wars, has erased an estimated one-quarter of global oil demand. Oil prices entered negative territory and equities have plunged and not recovered. Billions have been slashed from industry capital expenditure.
The longer covid drags on, the poorer the prospects for oil.
Robeco says the oil-price crash has seriously hurt oil-weighted producers, which are struggling to maintain profit and free cash over the near term, and which are replacing reserves to service debt in the medium to long term.
The adviser points out that those with large near-term debt maturities could be at risk of bankruptcy. Pundits observe that covid may have brought forward oil’s long-term decline by a decade or more.
Director of IEEFA, Tim Buckley, says the recent crash in the oil price underscores the industry’s underlying lack of profitability.
“The combination of the global coronavirus pandemic and the Saudi-Russian oil wars has exposed the vulnerable underbelly of the oil and gas industry,” says Buckley, talking to FNArena in March.
“Despite receiving massive global subsidies and tax breaks, the fossil fuel industry underperforms in good times, and severely underperforms in bad times.
“Exxon for example, after underperforming for a decade, has destroyed $150bn in shareholder value in just three months.”
“The industry, save for the oil out of countries like Saudi Arabia, which enjoy very low-cost production, is barely viable without support.
"The whole business model is based on externalising the costs of operations (to taxpayers) and internalising the profits, and it is still failing.”
Buckley notes the business model is only protected when the price of fuel exceeds US$50 to US$70 a barrel.
Brent Crude has recovered to only US$40-US$45 a barrel, which means eight months into covid, half the world’s oil reserves are now too costly to produce.
Meanwhile, the majors keep revising down their oil price forecasts.
At a global level, University of California dumped fossil fuels from its US$80bn portfolio, and Harvard University voted in favour of the endowment fund divesting from fossil fuels, just a few of many.
The IEA predicts that, depending on the pace of transition, peak emissions may have occurred in 2019. But it says without an additional policy push, it is too soon to see a rapid decline of oil.
“The era of growth in global oil demand comes to an end within ten years but the shape of the economic recovery is a key uncertainty.”
Platts Analytics Scenario Planning Service suspects peak oil may be delayed, expecting that after covid and 2022, emissions growth will most likely flatten to 0.2% a year before peaking in 2032 with declines in western consumption offset by growth in Asian economies.
It is a small matter of degree and there are many moving parts.
For example, a lingering covid could entrench work-from-home and reduce-air-travel trends, but the industry benefits from delayed replacement of older vehicles and an aversion to public transport.
Rising incomes in emerging markets and developing economies for mobility could underpin demand; but given developing economies are hardest hit under covid, that is likely to be muted without the refiring of the economy through renewable investment, says the IEA.
The Economist notes that Platts surmised in May that covid could shift its peak forecast to 15 years earlier “if behaviours shift dramatically and permanently across all sectors in response to COVID-1,” but that it was unlikely.
“Broadly speaking, a long-term slowdown in oil demand growth is in line with a 10-15 year time lag related to capital stock turnover,” says The Economist.
“As a result, there is still a substantial rate of near-term strength built into oil demand based on the current capital stock, as well as the trajectory of the post-pandemic economic recovery and low oil prices.
“Beyond 2030, persistent oil demand growth is primarily driven by three end-use sectors: aviation, marine, and chemicals with particular strength observed in the developing world.
“In the long run, macroeconomic drivers such as population growth and GDP growth support oil demand, while technology that improves efficiency and offers alternatives to oil consumption reduces it.”
Covid might change this outlook.
As reported in previous articles, aviation may take years to recover from covid due to the persistent fear of infection. Spending habits and income might also change.
On the other hand, recessions in developing countries could delay their climate-change responses.
The pace of electrification of the vehicle market will be critical. Energy efficiency is also growing in building and other areas of the economy, from mining, to food, to fashion.
Marie Fagan, the chief economist at London Economics International LLC also suspects peak demand may have been brought forward.
Fagan says economic crises tend to have two effects on oil demand: demand can reset at a lower level or stair-step down, and it may also grow at a slower rate because income elasticities of demand are smaller.
Her research suggests there will be a lower intensity of oil consumption to GDP in industrialising developing countries than was previously the case in countries like South Korea during its transformation.
“Income and price elasticities … matter less to oil demand than they did in the past,” says Fagan. “This implies flatter growth of oil demand, even when economies recover from a recession. Peak demand may be closer than it was projected before the crisis.”
The key factor, according to the IEA, is likely to be the plastic market. “Upward pressure on petroleum relies on its demand as a feedstock in the petrochemical sector,” says the agency.
It forecasts that, despite rises in recycling, plastic demand is expected to rise particularly in developing economies.
It is understood that in Australia, consumer goods and packaging and paper companies are understood to be under considerable pressure to adopt plastic-to-fuel options of recycling.
Oil and gas producers pivoting
Major fossil fuel producers are already pivoting out of oil and gas and most have committed or signalling commitments to net zero emissions by 2050.
Oil and gas companies have written off billions in oil and gas assets this year.
BP, for example, has written off up to US$17.5bn from its oil and gas assets, including early stage oil and gas exploration.
Exxon Mobil has warned that one fifth of the world’s oil and reserves will no longer qualify as “proved reserves” at the end of this year, if oil prices fail to recover by then, reports Bloomberg.
Speaking after BP’s second-quarter earnings announcement, Luke Parker, Wood Mackenzie VP Corporate Analysis said of guidance:
“We said back in February that no company of BP’s stature had gone as far or committed so unequivocally to transforming itself in the face of the energy transition. … BP’s oil and gas business will shrink dramatically, while the low carbon business will grow strongly.
“Oil and gas production is expected to fall by 40% by 2030 from 2.6m boe/d in 2019 to 1.5m. Refining throughput is expected to fall from 1.7m to 1.2m.
“BP will not be exploring any new countries. High-grading will be a big driver: BP’s new disposal program is targeting US$25bn of proceeds from 2H2020 to end 2025.”
BP is guiding to a 10-fold increase in investment in low-carbon energy and technologies by 2030, to about US$5bn a year. Within that, the company will deliver a 20-fold increase in developed renewables capacity.
Royal Dutch Shell has advised investors it is committed to net zero emissions by 2050 or sooner for all its products and is targeting emissions from its own operations and energy supply.
The Economist notes oil and gas companies are competing to sell billions of dollars’ worth of resources and cutting investment, and were doing so well before covid-19 hit the scene.
“Now the risk of costly stranded assets has grown more obvious. (In June), BP and Royal Dutch Shell, an Anglo-Dutch rival said they would take write-downs of up to US$17.5bn and $22bn respectively on assets … the oil majors are ever keener to own only the cheapest, cleanest reserves.”
The Economist notes that BP is the only super major to meet its divestment target of US$15bn, but that this came at the cost of its easier to sell petrochemicals unit.
China has also cracked down on the sector with a corruption purge, further reducing the market for buyers.
Best-in-class producers offer a protection from volatility
This is not to say there won’t be some short-term gains in fossil fuels, although at rock bottom prices, that wouldn’t require much.
One analyst created quite a buzz earlier this year by predicting a massive price spike.
J.PMorgan expects a mismatch in the transitioning to renewables could propel the price of oil to US$190 a barrel within five years, thanks to sharp cuts in upstream investment.
It is this type of volatility investors need beware, as an oil squeeze would affect companies across the board.
Wood Mackenzie is also an oil bull, noting China has been stocking up on cheap oil, and while the buying spree has slowed as China eats through the backlog, the analyst expects the trend will continue to rise each year from this quarter onward.
Chinese hedge funds meanwhile have been betting on an oil price recovery: “… according to Reuters’ sources, the so-called hermit investors are expected to hold the crude until the market structure continues to be in contango,” says Oilprice.com.
Clean oil is likely to be favoured over dirty oil, favouring quality refiners. This reflects on the likelihood of continued regulation, such as that introduced by the International Maritime Organisation in January.
Robeco recommends investors target higher quality, diversified, integrated energy companies and midstream energy companies with long-term take or pay contracts to transport that can withstand wild swings in prices.
The adviser notes that not only are these companies more resilient but, given ESG flows, they are more likely to benefit on the rebound.
Robeco favours more efficient, low-cost companies that are improving the asset quality across the portfolio by allocating investment to profitable low-carbon business, potentially laying the foundations for long-term growth.
“Our approach to investing in energy credits is focused on energy issuers whose activities reflect a positive contribution to the SDGs (United Nations’ Sustainable Development Goals), which in turn implies more reliable and stable financial performances over the long run,” says Robeco.
“On this basis, we would be positive about energy companies which are improving asset quality and reducing cost structure while actively and effectively working towards diversification.
“This involves diversification away from fossil energy towards more renewable energy sources, as well as diversification, generally, into other business activities.”
FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:
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