In Paris in December 2015 world governments agreed to limit global warming to below dangerous levels. To achieve the target of holding the increase in global temperatures to well below 2˚C and pursuing efforts to limit it to 1.5˚C, countries agreed to increase their climate action commitments on a 5-yearly cycle. Further specific targets were added: to achieve global peaking of greenhouse gas emissions (GHG) as soon as possible and to reach GHG neutrality in the second half of the century.1 This goes further and faster than anything previously agreed and signals that unabated combustion of fossil fuels must end by 2060.
In November 2016 the Paris Agreement came into force as governments responsible for at least 55% of total global GHGs deposited their instruments of ratification. The huge task that lies ahead in terms of delivering an economic transition that keeps the climate safe will now require an informed and sustained engagement between fossil fuel companies and the rest of society. Tackling a problem of this magnitude will need all stakeholders to play a part – not just ‘energy decisionmakers’. This paper focuses on the challenges faced by one subset of fossil fuel companies, the oil and gas majors, and sets out their options to plausibly respond.
Executive summary
- The international oil companies (IOCs) and national oil companies (NOCs) face an existential threat from the transition to a low-carbon economy consistent with the Paris Agreement and its goal of a 1.5/2˚C limit to global warming. The IOCs and NOCs are simply too big to be allowed to fail. The industry does need to adapt and change: ‘do nothing’ is not viable option.
- In terms of reserves, in 2012 the NOCs’ share of the world’s total oil reserves had reached nearly 70% (and 50% for gas) compared to <10% in the 1970s. Given access to low-cost reserves is mainly controlled by NOCs, this means potentially a higher proportion of IOCs’ reserves could be ‘stranded’ compared to NOCs’.
- For the IOCs decisions about changes in business strategy, and notably changes to capital expenditure and dividend policy, must be taken in the face of significant uncertainties. To limit asset stranding risk, key questions need to be answered about over what timeframe, where and how they should respond to changing policy and market dynamics to maximise value to shareholders and to society.
- Answering these questions will require a different approach to business strategy and planning to that used in the past. IOC shareholder value may be better secured by investors engaging with companies to deliver a managed transition towards business strategies/models compatible with a 1.5/2˚C warming limit.
- Five plausible, though not necessarily credible, strategies to evolve IOCs to become 1.5/2˚C-compatible are identified. ‘First one out’, ‘Last one standing’ and ‘Planned transformation’ are all credible responses to serious loss of demand due to climate policies (and carry the risk of what to do if demand is not destroyed.) ‘Drift’ and ‘Ostrich’ – as the names imply – are not. All are plausible responses from the companies, which is why they are assessed here. ‘Planned transformation’– both to renewable energy (RES) and to services tie-up with NOCs – are the only strategies that are representative of real diversification and carry with them the option of splitting the business.
- ‘First one out’ is a capital return-based strategy deployed by a company that has a strong portfolio of high-production and low-cost assets that ‘sees the writing on the wall’ regarding the 1.5/2°C target. There is a strong argument to be made that this approach is the most preferable since it allows financial markets to reallocate capital to other sectors instead of the IOCs.
- A ‘Last-one standing’ strategy would be deployed by a financially strong company that prioritizes becoming the biggest and lowest cost producer with vast low-cost reserves and downstream assets based where they can be used to maximise control over local markets. The closest current example of this strategy appears to be that of ExxonMobil or Shell. A ‘Last one standing’ strategy will need to have a strong analytical underpinning of market opportunities and how the 1.5/2°C transition might unfold and affect those markets.
- ‘Drift’ is a mix-and-match strategy that would be adopted by a company aiming to optimise its portfolios within shrinking markets. There is a deliberate wait-and-see approach. This strategy risks the company remaining the same size or shrinking as markets are squeezed, especially if one of the other companies in the market is deploying a ‘Last one standing’ strategy. Much the ‘Drift’ strategy’s success will also be linked with the fate of NOCs and home governments struggling to deal with falling public revenues from oil. It is not deemed a credible approach.
- ‘Planned transformation’ comprises a company strategy to diversify out of oil into gas and/or clean energy. Investors are likely to be skeptical about this strategy not least because stock markets traditionally undervalue the stocks of conglomerate businesses. A subset of ‘Planned transformation’ is ‘Services tie-up’ where a technically strong IOC would manage projects for an NOC and be rewarded by some mixture of cost recovery and profit sharing.
- ‘Ostrich’ is a default strategy adapted by a company failing to take a proactive approach to managing its fortunes. This is not deemed a credible option.
- With a growing number of investors calling for oil and gas groups to align themselves with the low-carbon transition embodied in the Paris Climate Agreement, managements will now need move quickly to take a clear view on how to respond to industry headwinds. Much of the internal management conversation will concern whether to focus on maximising dividends or optimising longer term value through advantaged capex and over what timeframe.
- After selecting a strategy, and in the face a great uncertainty, managements will need to hold their nerve and be willing to adapt as events unfold. They will also need a strong story to tell both to investors and wider stakeholders. The risks of each strategy need to be considered in the context of an early or late energy transition and against a backdrop of NOC dynamics.
- To support decision-making, the energy outlooks used by the IOCs need to be improved to better inform analysis and discussion of the energy transition choices. In addition, war gaming against a backdrop of different possible realworld 1.5/2°C transition scenarios to understand how business planning decisions and strategies by the IOCs and later the NOCs might affect company value will be useful.
1 Current Intended Nationally Determined Contributions (INDCs) submitted by countries currently add up to 50% probability of limiting global forecast temperature rise to 2.7°C by 2100, but more momentum can be expected – especially given rapid technology innovation and growing support/awareness of risks from progressive business, investors and city networks.
