Oil majors face up to plunging asset values

In previous energy downturns, prices slumped but companies kept faith in their oil and gas investments. This time it might be different, as the prospect sinks in that the pandemic’s impact will endure.

Executives are shifting from crisis response to the longer-term outlook. Royal Dutch Shell warned this week it would slash up to $22bn from the value of its assets, a move that followed BP’s announcement that it could take a $17.5bn hit.

As the coronavirus cash crunch focuses minds, businesses — at least in Europe — also believe the crisis will only accelerate the energy transition towards cleaner fuels. 

“These companies have decided that some of the assets they have today are worth a lot less than they thought a year ago. In fact, not only are some of them worth a lot less, they are worth nothing,” said Luke Parker at consultancy WoodMackenzie.

Rather than a mere accounting technicality, he says the adjustments to medium and longer-term prices are a sign of upheaval in the sector that deals another blow to the investment case for hydrocarbon producers.

“Demand might still grow from here, and many companies are still chasing a share of that growth,” said Mr Parker. “But make no mistake, the likes of Shell and BP are already ushering in the twilight years.”

Chart showing investment cuts to conserve cash. Estimated capital spend ($bn), 2019 and both the original and estimated forecasts for 2020, as of 23 Apr 2020

Executives who for years rejected the prospect of “stranded assets” are acknowledging publicly the risk that swaths of their oil, gas and refining assets will be rendered uneconomic, with vast hydrocarbon reserves never being extracted and burnt. 

Environmentalists and activist investors have pounced on this as the first real recognition from big energy players that their businesses — despite still relatively robust demand for their products — are on a downward spiral.

The FT estimated earlier this year that unviable assets could amount to $900bn should governments aggressively seek to restrict the rise in global temperatures to 1.5C above pre-industrial levels. Some observers say the pandemic is ushering in a new era and the sum could be far higher.

Even before prices started to collapse, energy companies were cutting outlooks and planning asset writedowns late last year — from US oil major Chevron’s $10bn in impairments to €4.8bn in charges from Spain’s Repsol. 

Royal Dutch Shell’s plant in Torzhok, Russia: pre-crisis assumptions of oil prices at $75-$90 a barrel are now seen as hugely optimistic © Bloomberg

Some sceptics say the latest round of impairments, which do not affect companies’ cash positions, are just a part of corporate accounting and a matter of convenience as they face an unprecedented financial crisis.

“The energy transition has a role in the impairments because a company ultimately has to take a view on longer-term oil prices,” said Stuart Joyner, an analyst at Redburn. “But these latest writedowns are predominantly prudent accounting moves taken by the energy sector to reflect a lower price outlook for other reasons, notably the fallout from Covid.”

Many observers believe European oil majors’ pre-crisis assumptions of long-term oil prices of $75-$90 a barrel were hugely optimistic, and that the current environment provided cover for a levelling out that was always inevitable. 

Others say for BP it was part of a process to clear the decks, freeing it to adjust corporate strategy and capital allocation plans under new chief executive Bernard Looney. Shell is also preparing for a big organisational restructuring.

Both companies have been keen to shrug off pressure from activist investors and environmentalists who have accused them of not taking adequate measures to overhaul their asset portfolios and accounts for the energy transition.

Chart showing crude price outlook varies widely between Europe's majors

Nick Stansbury, head of commodity research at Legal & General Investment Management, said it would be a mistake to believe an accounting change necessarily indicates a fundamental shift in behaviour. 

“The price assumptions used for backward-looking impairment tests are of limited importance. They do not necessarily speak to the ranges of price assumptions being used to make forward-looking investment decisions,” said Mr Stansbury.

European companies are for now ahead of their US counterparts, although writedowns are expected across the shale sector. BP, Shell, Total and Repsol have taken steps to revise down their impairment price assumptions in the past year, with the energy transition and net-zero commitments at least partly driving their decisions.

Italy’s Eni still has a long-term price assumption of $70 a barrel, while Norway’s Equinor is banking on $80 oil, suggesting there may be more writedowns to come. The US oil groups do not disclose such assumptions.

As for the future, while some investors are keen that the majors wind down their hydrocarbon businesses and maximise shareholder returns, others back a diversification strategy. 

A BP plant in the Canadian oil sands of Alberta: many European companies have revised down their impairment price assumptions in the past year © BP

“Any self-respecting CEO is unlikely to find self-liquidation an appealing thought,” said Neil Beveridge at Bernstein. “Why put yourself out of a job? The alternative is that the oil majors of today reinvent themselves.”

Carbon Tracker, a think-tank, said the current environment would at a minimum prompt companies to ask if certain projects were fit for a low-carbon world. High price assumptions may mask the financial risk to marginal projects, it says in a new report.

“Impairment prices should be consistent with investment strategy going forward,” said Andrew Grant, the study’s author. 

But some industry observers note that should investment collapse, supply will drop, leading in theory to a rebound in prices and returns. It is then that the true motives of energy companies will be revealed. 

They will face a choice: whether to use that period to hasten the shift towards a greener future or to reinvest in existing hydrocarbon businesses that still provide the bulk of its cash.

The impairments have prompted shareholders to look inward. One top investor in big oil companies said the moves highlighted “the relatively poor return on capital achieved from historic capital allocation decisions” as well as the “challenges and uncertainties” of future plans — particularly if companies shift towards cleaner energies and low-carbon technologies.

As investors seek clues to what net-zero emissions commitments mean in practice and to how companies will reconfigure their businesses, another large oil investor said the latest impairments were a clear sign of where the sector is headed: “It is the direction of travel of the industry.”

Additional reporting by Attracta Mooney