The Real Bitumen Bubble
Is Canada’s energy sector dangerously overvalued? That’s what some people are saying – and they might be right
by Max Fawcett
From a distance, it may look like the energy companies headquartered on the top floors of Calgary’s office towers were spared the worst of the flooding that washed through the city in June. But don’t be so sure. Yes, they generally avoided the physical ravages the flood inflicted on other businesses. But the long-term cost to their bottom lines may prove to be far more significant – as much as $5.7 trillion.
That figure is from a March 2013 report by the Canadian Centre for Policy Alternatives. It represents the collective carbon liabilities for Canada’s energy companies in a hypothetical world with a $200-per-tonne cost of carbon. And while such a scenario is highly unlikely given the catastrophic consequences the imposition of a $200-per-tonne carbon tax would have on the global economy (and therefore the miniscule probability governments would pursue it), the notion that Alberta’s energy companies may not be able to convert their proven and probable reserves into producing assets is plausible. So too, therefore, is the possibility that the sector is fundamentally – perhaps even dangerously – overvalued by investors.
Why, you ask?
Because if the companies convert those reserves into producing assets, and their counterparts around the world do the same, we won’t have a hope of remaining within the carbon “budget” that the International Energy Agency repeatedly warns must be adhered to if we want to keep global temperature increases to no more than two degrees Celsius. The world’s leaders agreed upon the threshold in the 2009 Copenhagen Accord and it’s the one the scientific community believes separates manageable effects and a global catastrophe. To avoid blowing through that carbon budget, which accounts for the amount of carbon that can be put into the atmosphere between 2000 and 2050, the CCPA says Canadian energy companies may not be able – or allowed – to convert as much as 89 per cent of their resources into production. Those potentially stranded resources, they say, and the market’s unwillingness to recognize the risk associated with them, has created a potentially destructive “carbon bubble” that could blow a hole in the Canadian economy – and the pocketbooks of investors.
But what does this have to do with a freak flood in Calgary? That devastation will serve as a powerful reminder that climate change is a threat and will provide further ammunition to an environmental movement looking to take a shot at the oil sands wherever and whenever it can. There may not be a direct correlation between companies like Suncor and Canadian Natural Resources pouring billions into developing the oil sands and the June flood. But it will be another point in an increasingly rich data set that suggests our leaders need to do something about climate change, and soon. When they do, it could well be Alberta’s energy sector that ends up paying the steepest price.
The notion that Canada’s energy companies have hidden liabilities totaling $5.7 trillion – a figure 17 times larger than their collective market capitalization and 13 times their assets – is open for debate, and perhaps even a bit of ridicule. For one thing, there’s a chicken-and-egg quality to it, given that, by definition, the liability wouldn’t be realized until the resource was produced, and companies aren’t in the business of selling petroleum products at a loss. Likewise, the idea that Canada’s portion of a global carbon budget would – or should – be based on its percentage of global GDP or population, rather than its share of global oil and gas reserves, seems fundamentally flawed.
Still, if the conclusions of the CCPA report are suspect, the basic concept that informs them – the need for a global carbon budget – is on much sounder footing. Yes, there’s some quibbling about the size of it – the CCPA report uses a budget of 500 gigatonnes, which it says would give the world an 80 per cent chance of keeping global temperature increases below the critical two-degree level, while the IEA uses a more generous budget of 1,000 gigatonnes that offers only a 50-50 chance of meeting the two-degree goal. Either way, there’s little dispute that a budget of some sort is needed. David Hone, the climate change advisor for Shell, has said “there is really nothing to argue about in terms of the math itself. It is certainly the case that current proven reserves will take us well past two degrees Celsius if completely consumed.”
And while there are plenty in the energy sector who won’t take the CCPA report seriously, the left-wing think tank isn’t alone in sounding the alarm about the financial risks associated with potentially stranded carbon resources. HSBC Global Markets released a report earlier this year that made a similar case for European super-majors like BP, Eni and Shell. And while the valuation metrics they used were more sophisticated than those deployed by the CCPA, they provided a similar, if not quite so hyperbolic, conclusion, suggesting that the real risk was posed by a decrease in the demand for oil, and that this, combined with some reserve write-downs that would result from a lower pricing environment, could shave as much as 60 per cent off of the market capitalization of European energy stocks. (Using a carbon cost of $50 per tonne, the CCPA’s modeling yields an overvaluation of $844 billion.)
Standard & Poor’s chimed in on the issue in a March note that suggested a carbon-constrained future could include downgrades to the credit worthiness of certain companies. “Low or insufficient replacement of developed reserves would likely put pressure on these companies’ business risk profiles over the medium to long term,” it said. “We note that under a meaningfully lower long-term oil price, the commercial viability of undeveloped reserves and hence the core business model could come into question unless development costs also fall. This could potentially result in a downgrade of more than one notch if we were to place less reliance on undeveloped or probable reserves than at present.” More ominously, S&P said Canadian firms with significant exposure to the oil sands are the most at risk under their assumed scenario. And as most savvy investors know, if the bond market starts to price a risk in, the equity markets won’t be too far behind.
Professor Ujjayant Chakravorty, who teaches economics at Tufts University in Massachusetts and is a former Canada Research Chair in natural resource economics, thinks a price on carbon is coming. But, he says, that’s not automatically bad news for the energy sector. “What the firms will have an incentive to do, which they don’t have right now, is come up with better ways of using that oil,” he says. “And I think you will see some radical changes in the way these products are used in the future, in terms of technological improvements.” Chakravorty likens it to the discussion that took place in the U.S. over acid rain and the need to regulate sulfur emissions. “The predictions were that if you put a cap on sulfur emissions, many firms would go out of business. Guess what happened? Very few firms actually went out of business. I think, to some extent, the same thing’s going to happen,” he says. “Once it affects your bottom line, you have to be innovative – there’s no other way. The next option is to get out of business.”
What does this mean for Alberta’s publicly traded energy companies? In the short term, not much. Until there’s a price put on carbon, and until the markets price that into their valuation models, there’s no real incentive for them to change the way they do business. Indeed, a company that doesn’t aggressively replace its reserves through exploration, drilling and development in today’s market is a company that won’t be around for long. As Canoe Financial portfolio manager Rafi Tahmazian says, “These companies are not discounting any change. No way.”
For people who invest in energy companies, though, it’s a different story. That includes NEI Investments economist Jamie Bonham, whose Vancouver-based firm has $5 billion in assets under management. While Bonham rejects the notion that there’s a carbon bubble, as the CCPA report suggests, he does think it points to a weakness in how we value oil and gas companies. “There’s a market failure at the moment in terms of valuing what the impacts of potential climate change and climate change legislation will be,” he says. “At some point I do think we come across a nexus – I don’t know if we’re there yet or not – where building up reserves shouldn’t be the be-all and end-all of how you value a company if the odds are strong that it’s going to be very difficult to ever produce those reserves.”
And while there are those, like environmentalist and author Bill McKibben, who have suggested people concerned about climate change ought to divest their holdings in energy companies (and encouraged large institutional holders like pension funds and public endowments to do the same), Bonham thinks that misses the point. “The problem we have is a demand problem,” he says. “Nobody’s forcing us to burn oil, and so until we find a way around this demand conundrum, attacking the producers of it will only drive them into vehicles over which we have even less influence, like private corporations or state-owned companies. I don’t see that as progress.” Interestingly, neither does Brock Ellis, one of the co-authors of the CCPA report. “The solution is not to punish the private sector,” he says.
Instead, the solution may lie within the private sector. Bonham, for one, thinks the environmental movement ought to use capital markets as a carrot rather than a stick. “It’s more productive to put the money towards companies that are doing something well, and at the very least using your role as a shareholder to convince the companies you do own to move towards a more progressive stance on these issues, to be more innovative, and to reward them when they do move that way. I think that’s absolutely a better approach, a better use of the markets – and probably a more realistic one as well.” And he says as more fund managers make the same kinds of decisions, the market will begin to reward proactive companies with premium valuations and punish reactive ones with a discount. “My guess is that some of the companies that don’t react to what will be a changing marketplace are going to pay the price for it, at some point.”
They haven’t yet. But according to Chakravorty, the day they’re going to have to decide if they’re leaders or followers is rapidly approaching. “Sooner or later there’s going to be a carbon budget, and there are two types of strategies that companies can adopt,” he says. “The first is that they can close their eyes and be an ostrich, and deal with it when it gets there. But in my opinion that’s not an optimal strategy, because they may be lagging behind – it may be too late in the game. The other option is to be proactive and say, ‘OK, it’s coming – let’s do it. Let’s use this additional time to develop some improvements in efficiency and put some money in R&D.”
He points to DuPont, the giant chemical company that initially resisted the push to ban CFCs before deciding instead to get out ahead of the issue. “The whole industry was against it. DuPont was the biggest producer, and it realized, ‘Hey, we’re the big gorilla in this market. If we start doing R&D, we might actually be more competitively placed.’” Today, DuPont has a much larger share of the market than it did before the debate over CFCs began, and he thinks the same thing could happen in Canada’s energy sector. “There may be some short-term impacts. If I’m employed by one of these inefficient companies, I may lose my job in the short run. But over a 10- or 15-year time span, you’ll see all of this play out in a positive way, because more efficient firms will take over.”
And while the idea that a price on carbon would hurt the profitability of Alberta’s energy companies in the short term is nearly an article of faith, it’s not clear whether that pain would be any greater than what they’re currently experiencing. As the Pembina Institute’s Simon Dyer has pointed out, the lack of market access the industry has spent the last couple of years contending with has put a far bigger hurt on their bottom lines than even the most aggressive carbon price would. A $40-per-tonne price on carbon (like the one that Alberta Environment Minister Diana McQueen has apparently been considering) would cost producers about 75 cents per flowing barrel, after royalty rates and taxes (and rebates associated with both) are accounted for. The current carbon tax in Alberta, meanwhile, only adds a dime to the cost of a barrel of crude, while the Pembina Institute’s recommended model, which includes a $100-per-tonne price, adds $3 in additional costs.
When producers are facing per-barrel discounts of as much as $30 due to a lack of market access that’s based, at least in part, on negative perceptions of their industry and its commitment to environmental stewardship, one would think a price on carbon might actually save them money. “If it’s $3 per barrel, but you get to close a significant discount, why wouldn’t you take that chance? I’m not really sure,” saysthe Pembina Institute’s P.J. Partington.“In the long run, it’s pretty clear that it’s an investment that makes sense for the oil and gas industry.”
The Black Death
If the world’s leadership does agree on some form of a carbon budget, it won’t be the oil and gas sector that necessarily bears the brunt of its attention. That honour would belong to anyone in the business of extracting and selling coal, which, on a per-unit basis, is far more carbon-intensive than even the most brazenly inefficient oil sands project. Despite making up a tiny fraction of the energy sector’s total market capitalization, coal reserves account for more than 25 per cent of the potential carbon emissions associated with Canada’s proven and probable resources.
And as former Green Party activist and recently elected B.C. MLA Andrew Weaver has pointed out, curbing our addiction to coal – a problem that’s particularly vexing in the developing world – would take us a long way down the road towards addressing climate change. After all, if the oil in place in the oil sands – all of it – were put into productive use, it would add 0.36°C to world temperatures. If all of the world’s natural gas resources were consumed, it would add 2.86°C. But using the world’s coal resources would add a cataclysmic 14.8°C. As the authors of the HSBC Global Markets report on stranded fossil fuel resources noted, “It is clear that reduced usage of coal is the key to stabilizing and eventually reducing annual carbon emissions.”
On the other hand, a carbon budget might be good news for natural gas producers and those with significant exposure to the commodity. As the least carbon-intensive of the major fossil fuels, and the only one that can be easily deployed to replace coal-fired electricity generation, it would stand to benefit from any decision that places a price on the intensity of carbon emissions. “It’s a great way of clarifying the choices and tradeoffs we’re making with new developments,” says the Pembina Institute’s P.J. Partington. “That’s why a price signal can really help accelerate those decisions and make sure the stuff we’re building is compatible with the budget we should be staying within.”