Why the Oil Industry Cannot Afford to Retire… Yet!

This is the first in a two-part series on the emerging climate-related financial risk of unfunded oil and gas asset retirement obligations.

The oil industry may be nearing retirement sooner than expected. As reported by Bloomberg, the International Energy Agency (IEA) estimates that by 2040 efficiency improvements could eliminate the need for about 11.6 million barrels of oil demand a day. Adoption of electric vehicles could take away another 5.2 million barrels per day, and widespread switching to alternatives including natural gas and biofuels could displace about 13.5 million barrels a day.

All these things together, which the IEA says will be required to limit global warming to the 2°C target under the Paris Agreement, indicate that oil demand will peak around 2020 and by 2040 decline by about 20 million barrels a day. That’s 36 million barrels a day (13.14 billion barrels a year or $657 billion a year at $50 per barrel) less than the average oil company forecast for 2040—a gap larger than OPEC’s current production. Some oil companies have acknowledged this possibility. Shell believes oil could peak somewhere between 5 and 15 years, while Total sees a surge in battery powered vehicles causing demand for oil to peak in the 2030s.

The possible early retirement of the oil industry is a risk for investors. But there’s another problem... the oil industry cannot afford to retire. When the oil industry retires it will have to pay massive unfunded statutory liabilities to decommission production assets and restore the environment.

The risk to investors is as simple as 1–2–3. First, increasing supply and declining demand reduce profit. Second, oil companies must eventually retire unprofitable production assets from service. Third, permanent retirement of these assets will trigger strict joint and several legal obligations to decommission the assets and restore the environment in order to protect human health and safety. If market conditions trigger an industry-wide decline, the industry’s environmental debts will come due sooner than expected. Cash will run out as revenues drop, debt payments rise, and credit dries up.

This is not a forecast of what may happen in the far off future. This scenario is playing out now in the North Sea where offshore decommissioning costs are skyrocketing just as revenues are falling, operating costs are rising, many production assets are operating at a loss, and regulators are seeking greater security for decommissioning obligations.

The industry’s reported retirement obligations are highly material, but actual costs may be significantly larger. The discounted present value of the reported 2015 retirement obligations of the eight super major oil companies totaled $126 billion, amounting to an average of 12% of their combined market capitalization. Remove the discounting and this $126 billion estimated liability balloons to $246 billion, assuming an average payment period of 30 years, an average discount rate of 8.0% (the U.S. industry average), and an inflation rate of 2.5%. If the expected maturity of these obligations accelerates due to early retirement, the significant effect of discounting on reported present value accounting estimates will evaporate.

Worse yet, industry analysts and the industry’s own financial reporting suggest that the underlying undiscounted cost estimates are too low. According to Boston Consulting Group (BCG), industry forecasts suggest that actual spending on decommissioning could be 1.5 to 2.5 times reported accounting estimates. Industry consultant IHS Markit forecasts that spending on global decommissioning projects will increase 540% from approximately $2.4 billion a year in 2015 to $13 billion annually by 2040, a 7.0% compounded annual growth rate. Total decommissioning payments between 2010 and 2040 are estimated to be $210 billion.  Our analysis of historical financial reporting data suggests that annual spending growth rates over this period may instead hit double digits and result in far greater aggregate costs to the industry. Unwary investors may be unpleasantly surprised to learn that the industry’s retirement obligations are much bigger than believed.

Accounting for liabilities is not the same as saving for them. People have trouble planning for retirement and so do companies. Decommissioning obligations are much like corporate pension liabilities. Complex accounting, measurement difficulty, excessive optimism, and frequent examples of gross underfunding characterize both. But unlike pension liabilities, decommissioning obligations are not subject to independent actuarial determinations of minimum funding obligations, and they cannot be discharged in bankruptcy. Because the industry has not saved for these obligations, it must keep producing income from some form of business activity to pay for its retirement. Failure to plan is planning to fail.

Is the asset retirement problem as large as the unfunded pension problems of the past? Yes, it is much larger and much more serious. At least in the pension case, there was some funding. It simply was not adequate. With respect to asset retirement obligations, there is essentially no funding. There is no oil company ‘lock box’ of savings to fund these obligations.

Investors could end up paying for the industry’s failure to save for retirement. With respect to environmental obligations, state and federal regulators have de jure or de facto priority over both stockholders and financial creditors in U.S. bankruptcy. The recent coal bankruptcies showed that in an industry-wide downturn creditors can be wiped out entirely by more senior mine decommissioning liabilities (more on this in part two of this series). Similarly, investors are at risk of paying much of the cost to fulfill the oil industry's unfunded retirement obligations.

All retirees are not created equal. Oil companies now tilting toward renewable energy, such as Norway’s Statoil, are best placed to fund their own asset retirement. Exxon Mobil—due to its age and size—is perhaps one of the most vulnerable. Similarly, some companies are exposed to greater risk from retirement obligations than others due to varying legal, tax, accounting and operational considerations. All retirees are not created equal, and investors need to know the differences.

Stranded assets beget stranded liabilities. Carbon Tracker has reported that between 60-80% of fossil fuel reserves of publicly listed companies are ‘unburnable’ if the world is to avoid global warming of more than 2°C. The financial risk is that capital expended to find and develop these reserves could become wasted on stranded assets. In a 2°C scenario unburnable carbon equals stranded assets. Less understood is that unburnable carbon will necessarily also give rise to ‘stranded liabilities’ in the form of unpayable asset retirement debts. Unless oil companies, regulators, and investors begin collective efforts now to accurately measure and report the true scale of the problem, there is little chance of a timely solution.

Part two: Coal is the “canary in the coal mine” for the oil industry.