Why Coal Is the Canary in the Coal Mine for Oil
This is the second in a two-part series on the emerging climate-related financial risk of unfunded oil and gas asset retirement obligations (read part one).
The oil industry may be nearing retirement sooner than expected, and like many of us, it has not saved enough to retire comfortably. To see how this may turn out, we need only look at the recent history of the coal industry. In its failure to plan for retirement coal is warning us of what is in store for oil. Neither industry can simply shut down its operations and walk away without first decommissioning its assets and restoring the environment. By law, coal mines must be reclaimed and oil and gas facilities must be decommissioned, plugged and abandoned. In financial terms, both are called "asset retirement obligations," and both pose similar financial risks.
The widespread U.S. coal bankruptcies in 2015-16 offer important lessons for investors in industries subject to asset retirement obligations. Distressed coal miners struggled with high debt levels, low energy prices, new environmental regulations, the decline of steel production, and the conversion of coal-fired power plants to natural gas made abundant by shale drilling. Today, the oil industry faces high debt levels, falling oil prices, rising concerns about climate change, calls for a carbon tax, and competition from electric vehicles.
When the crisis struck the coal industry, it didn’t affect a few individual companies. It affected the entire industry. In the past, when a failing coal company filed bankruptcy, others were on hand to buy its assets, acquire the operating permits, and assume the asset retirement obligations. Business went on as usual. This time was different. This time there were no buyers to pick up the permits. If oil prices remain below break-even levels for an extended period, oil will face the same fate.
Surety bonds supposedly secured the coal industry's asset retirement obligations. But often the bonds were illusory “self-bonds” or otherwise insufficient to cover the cost of mine reclamation. There was no “there” there. The same could happen in the oil industry, but the financial impact will be much worse: in the coal mining industry third party regulators had approved mining company reclamation estimates and required some forms of security. In the oil industry, by in large, there is no independent third party review of estimated decommissioning costs and there is not even the pretense of requiring adequate security for decommissioning.
Faced with liquidations and mine closings, state and federal governments were forced to compete with other creditors for assets to fund mine cleanups. No doubt some sophisticated creditors, advised by their lawyers that pre-petition mine reclamation obligations could not possibly be considered post-petition administrative expenses, were shocked to learn that such obligations had “super priority” administrative expense status in U.S. bankruptcy, standing ahead of not only unsecured claims but also ahead of secured claims and even ahead of Debtor in Possession (DIP) funding. Environmental regulators showed they could strong-arm big concessions from senior secured creditors, including DIP lenders, in exchange for continuing operating permits on the few remaining profitable mines. The same bankruptcy rules and government leverage will apply to the oil industry.
Taxpayer pressure is now mounting to end the practice of self-bonding and to shore up security for mine reclamation. These long overdue steps will increase the operating costs for those coal companies that survived restructuring. Now even less profitable, these companies face the same economic headwinds that precipitated the industry collapse in the first place, albeit with a lighter debt load. Similarly, the U.S. Bureau of Ocean Energy Management is seeking to reduce its credit risk exposure for offshore decommissioning in the Gulf of Mexico. Other regulators are likely to take similar steps. Can the oil industry sustain higher carrying costs on its decommissioning liabilities?
The similarity in the financial risks posed by end of life environmental restoration obligations for coal and oil is striking. Indeed, the most significant difference is that the absolute and relative magnitude of the oil industry’s debt is much greater, subject to far greater uncertainty, and vastly more understated on corporate balance sheets. The canary is gasping. It’s time to recognize that the oil industry has an asset retirement problem and start taking steps to cooperatively and collectively solve it.