Unusable reserves: it’s hot air, say analysts

“I think it’s a bollocks subject. I’m not interested in this kind of subject. I think this is complete hot air.”

These were the words of one sellside oil and gas analyst when asked about a recent report by the Carbon Tracker Initiative (CTI) which argues that, because of global warming, much of the world’s stock of hydrocarbon reserves can never be burnt, if we are to avoid runaway climate change.

And while the individual in question was more outspoken than most, his comments neatly encapsulate the mainstream investment industry’s apparent disinclination to take such arguments into account when valuing oil, gas and coal producing companies.

One buyside analyst at a major investment house shrugs off the CTI’s analysis by simply arguing that it would be difficult to factor such environmental concerns into its valuation models without knowing the shape of any future legislation limiting the use of fossil fuels.

Similarly, the manager of an energy fund states that the oil and gas majors typically have only 12 years’ worth of proven reserves on their books – or 20 years when “probable” and “possible” reserves are taken into account – and are therefore unlikely to be subject to any restrictions on their use in his opinion.

As reported in FTfm two weeks ago, the CTI calculates that the carbon potential of the earth’s known fossil fuel reserves is 2,795GtCO2 (gigatonnes of carbon dioxide equivalent). CTI, the first project of Investor Watch, a non-profit company set up to align the capital markets with efforts to tackle climate change, reckons some 745GtCO2 of this is held by the world’s 100 largest oil and gas companies and 100 largest coal companies, which had a combined market capitalisation of $7,420bn as of last February.

Yet last year’s United Nations Climate Change Conference in Cancun committed states to attempting to hold the global average temperature rise to 2°C above pre-industrial levels, beyond which the mainstream scientific community believes the effects could be catastrophic.

If this 2°C limit is to be met, the CTI, using estimates from Germany’s Potsdam Climate Institute, calculates that only 565GtCO2 of the 2,795GtCO2 of reserves can be burned within the next 40 years.

If this is the case, 80 per cent of the world’s known reserves are “unburnable carbon”, at least for the next 40 years, beyond which pretty much any discounted cashflow analysis would ascribe precious little value.

There is, of course, plenty of scope to quibble with these figures, which are by definition fairly imprecise. But if this analysis is even vaguely correct, and one believes both that man-made climate change is real and that nations will, eventually, start to take serious steps to counter it, then it might seem logical to factor it into the stock valuations of listed energy companies, which account for 20-30 per cent of market capitalisation on the bourses of Sydney, London, Moscow, Toronto and Sao Paulo.

Yet it seems fund managers and equity analysts are happy to put such concerns on the back burner when endeavouring to calculate the value of energy companies.

Lucy Haskins, an oil and gas analyst at Barclays Capital, freely admits her valuation methodology would be exactly the same even if global warming did not exist.

According to Ms Haskins, companies’ proven reserves account for the bulk of their valuation and, given their typical 12-year tenor, “it would be very difficult to argue that we would see only one-fifth of the value of these companies being realised”.

Interestingly, BarCap’s view that oil and gas producers will be able to exploit all their accumulated reserves is allied to a house view that renewable energy producers are poised for rapid growth in the coming decade.

The bank’s simultaneous enthusiasm for two sectors that could be seen as rivals is rooted in the International Energy Agency’s (IEA) forecast that global energy demand will be 36 per cent higher in 2035 than it was in 2008.

Richard Hulf, co-manager of Artemis Global Energy Fund, also relies strongly on the IEA projections.

“The IEA’s demand models show a rising trend of demand, especially from emerging markets. That is the primary thesis behind the fund,” says Mr Hulf. As such, he is content to calculate the value of hydrocarbon producers simply on the basis of the discounted cashflow from each of the assets (such as oilfields) they possess, with allowances for capital expenditure, debt and taxation.

“We apply our own judgment as to what is technically feasible, we don’t look at what is legally feasible. There are no restrictions on companies at the moment in terms of the amount of oil and gas that they can produce. These are private markets,” says Mr Hulf, who argues the IEA demand forecasts suggest renewable energy is an “interim feelgood factor”.

“It is not going to be a credible replacement for fossil fuels,” he adds.

Derek Pound, manager of the Jupiter Global Energy Fund, is another largely unmoved by the CTI’s analysis, arguing that even if restrictions on the production of fossil fuels were imposed, producers would instead benefit from higher prices.

“You would be restricting the supply of hydrocarbons and as it stands at the moment there is an entity that does that, called Opec, and when they do that it tends to have a firming impact on price.”

However, Mr Hulf does at least believe “green” arguments of this nature will become more relevant in the future.

“This sort of analysis is not going to change the profile of our fund in the next year or the next five years, but if I was talking to you in 10 years’ time I would expect we would have much less oil and gas in the fund,” he says.