Written by Natalia Rialucky & Henning Huenteler
Royal Dutch Shell and the risk of Stranded Assets
As one of the six oil & gas supermajors and the fifth-biggest company measured by 2016 revenues[1], Shell is exposed to climate change related risks in various ways. Although this company offers countless fascinating perspectives on the topic, the focus of the following analysis will be the growing concern of stranded assets.
Stranded assets are defined as “assets that have suffered from unanticipated or premature write-downs, devaluations or conversion to liabilities.[2]” This definition leaves wide room for interpretation and it is not directly related to climate change. As stranded assets become increasingly important to the climate change discourse, the following list of potential climate-change related causes is introduced. These six reasons can contribute to the reduced economic potential of assets and put companies at financial risk.
| Environmental challenges | Climate change; natural capital depletion and degradation; air, land, and water contamination; and freshwater availability |
| Resource landscapes | Price and availability of different resources such as oil, gas, coal and other minerals (e.g. shale gas abundance, phosphate scarcity) |
| Government regulations | Carbon pricing (via taxes and trading schemes); subsidy regimes (e.g. for fossil fuels and renewables); air pollution regulation; the ‘carbon bubble’ and international climate policy |
| Technological change | Falling clean technology costs (e.g. solar PV, onshore wind); disruptive technologies; and electric vehicles |
| Social norms and consumer behavior | Fossil fuel divestment campaign; product labelling and certification schemes; changing consumer preferences |
| Litigation and statutory interpretations | Carbon liability; litigation; damages |
Source: Caldecott, B. and McDaniels, J. (2014b)[3]
All of these risks are relevant for an oil major like Shell, yet three of them are of particular importance for this case:
- Resource landscapes: The increasingly competitive price policies of OPEC and non-OPEC oil countries have caused a drastic price drop that remains at or slightly below the profitability of US shale producers[4].
- Government regulation: The Paris Agreement and the Nationally Determined Contributions (NDCs) by its signatories have demonstrated that a global commitment for climate action is not unrealistic. Future regulation could have a strong impact on the oil resources already in the balance sheets of Shell and its peers.
- Technological change: To date, solar and wind technology are able to produce electricity cheaper than any other resource and have pushed coal up the merit order in many electricity grids[5]. Electric vehicles have the potential to achieve similar success and replace Internal Combustion Engines (ICEs) as the standard in personal mobility[6].
The International Energy Agency “sets out an energy pathway to limit the global increase in temperature to 2°C by limiting concentration of greenhouse gasses in the atmosphere to around 450 parts per million of CO2”[7]. Under this scenario, the Carbon Tracker Initiative estimates that Shell will have accumulated 76.9 $bn of unneeded capex in its balance sheet between 2015 and 2025[8].
Shell used to dismiss the risk of stranded assets in public. In May 2014, at an oil price of US$ 110, and two months before the oil price began its decline to less than $US 50 per barrel, Shell has stated that the theory is fundamentally flawed in a letter to its shareholders, that seems to have been removed from its website[9].
Sixteen months later, Shell decided to write-off 7$bn of already invested capital by pulling out of their arctic exploration. A combination of the low oil price, the high production costs, estimated at over $100 per barrel by analysis[10], the disappointing initial result and public pressure by the #sHellNo campaign led to a historic financial loss.
For future oil investments, the sector has changed drastically. The short lead times and low CAPEX investments of US shale producers, as well as the OPEC price policies, have forced oil companies to favor asset-light and flexible resources. Shell will have to adjust to the new reality of the market and consider stranded assets a realistic threat to its shareholders. (798 words)
[1] Fortune 500, May 2017; http://beta.fortune.com/global500/royal-dutch-shell-5
[2] Caldecott, B. and McDaniels, J. (2014a), Stranded generation assets, Working Paper, Smith School of Enterprise and the Environment, University of Oxford, Oxford.
[3] Caldecott, B. and McDaniels, J. (2014b), Financial Dynamics of the Environment, Working Paper for the UNEP Inquiry, Smith School of Enterprise and the Environment, University of Oxford, Oxford
[4] Big energy fears peak oil demand is looming, Financial Times, March 2017;
https://www.ft.com/content/47dbcb80-08ae-11e7-ac5a-903b21361b43
[5] Wind and Solar Energy have reached unsubsidized grid parity in more than 30 countries; Renewable Infrastructure Investment Handbook: World Economic Forum, 2016;
[6] Here’s How Electric Cars Will Cause the Next Oil Crisis, Bloomberg February, 2016; https://www.bloomberg.com/features/2016-ev-oil-crisis/
[7] International Energy Agency, https://www.iea.org/publications/scenariosandprojections/
[8] The $2 trillion stranded assets danger zone: How fossil fuel firms risk destroying investor returns – Carbon Tracker Initiative, September 2015
[9] Shell hits back at ‘carbon bubble’ claims, The Guardian, May 2014;
https://www.theguardian.com/environment/2014/may/20/shell-hits-back-at-carbon-bubble-claims
[10] Can Shell afford Arctic oil?, The Guardian, August 2015;
https://www.theguardian.com/environment/2015/aug/12/can-shell-afford-to-drill-for-oil-in-the-arctic
[1] Fortune 500, May 2017; http://beta.fortune.com/global500/royal-dutch-shell-5
[2] Mark Carney warns investors face ‘huge’ climate change losses, Financial Times, September 2015; https://www.ft.com/content/622de3da-66e6-11e5-97d0-1456a776a4f5
[3] Caldecott, B. and McDaniels, J. (2014), Stranded generation assets, Working Paper, Smith School of Enterprise and the Environment, University of Oxford, Oxford.
[4] Caldecott, B. and McDaniels, J. (2014), Financial Dynamics of the Environment, Working Paper for the UNEP Inquiry, Smith School of Enterprise and the Environment, University of Oxford, Oxford
[5] Big energy fears peak oil demand is looming, Financial Times, March 2017;
https://www.ft.com/content/47dbcb80-08ae-11e7-ac5a-903b21361b43
[6] Wind and Solar Energy have reached unsubsidized grid parity in more than 30 countries; Renewable Infrastructure Investment Handbook: World Economic Forum, 2016;
[7] Here’s How Electric Cars Will Cause the Next Oil Crisis, Bloomberg February, 2016; https://www.bloomberg.com/features/2016-ev-oil-crisis/
[8] International Energy Agency, https://www.iea.org/publications/scenariosandprojections/
[9] The $2 trillion stranded assets danger zone: How fossil fuel firms risk destroying investor returns – Carbon Tracker Initiative, September 2015
[10] Environmental Finance, May 2014; https://www.environmental-finance.com/content/news/shell-considers-%E2%80%98stranded-assets%E2%80%99-risk-when-screening-projects.html
[11] Shell hits back at ‘carbon bubble’ claims, The Guardian, May 2014;
https://www.theguardian.com/environment/2014/may/20/shell-hits-back-at-carbon-bubble-claims
[12] Can Shell afford Arctic oil?, The Guardian, August 2015;
https://www.theguardian.com/environment/2015/aug/12/can-shell-afford-to-drill-for-oil-in-the-arctic
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hmmm outlook not so positive… interesting to see how drastically and how fast Shell can adopt to this new environment.
Shell’s plans to invest in new technologies, disruptive clean energy methods would be an interesting read. Also, would like to understand the difference between “asset light flexible resources” and the present investments.
In the end, a lot of oil-related Capex seems to be a numbers game and the risk of stranded assets inherent to the business model. Would be interesting to see Shell’s internal considerations on this topic. I cannot imagine that that don’t take it into account when making investment decisions and run a lot of elaborate scenarios to justify their investments.
For me, I’m unable to see the direct connection between the $7B artic write-down and the increasing environmental regulations. Large scale write-offs are common in the industry, because the time frame of the capex investments (3-5 yrs) means that market conditions change.
I agree that there are certainly many environmental pressures that will likely result in a tightening of regulations. This will make certain projects no longer feasible; however, I don’t expect to see write-downs in the magnitude of $70B. Regulation is not changing so fast that it can’t be built into the financial projections. For existing assets, they may become “stranded”; however, usually, they can be upgraded/retrofitted to no longer be “stranded”. Some of these retrofits align naturally with maintenance and overhaul schedules, which further reduces the impact.
Interesting read! I agree that Shell needs to address the issue of stranded assets, but it will be a though message to send to shareholders. Interestingly, there is a growing group of shareholders that are urging Shell to acknowledge the impact of climate change on it’s business and to finally become an Energy (instead of O&G) company. You can check the website here: https://follow-this.org/en/
Quite interesting to read, especially given our recent trip to Brunei where Shell is the main operator. However, I would argue that stranded assets for all majors is a result of not only environmental regulations but also low oil prices. The latter is the “normal” process in the industry where economics of a project change with the changing commodity price. But i do strongly agree that changes to environmental regulations pose a threat to the industry and can can kill operations as seen in several places across the globe.
Very interesting article. With oil reserves being a key determinant of the value of O&G companies, I think this issue will become increasingly important, not only for Shell, but also for other oil majors. Of course, prices will continue to fluctuate and production costs will change as a result of technological change, with consequences for asset valuation. But I agree with you that climate change (through its impact on regulations, as well as on consumer attitudes) was a key consideration in this write-down, and I suspect it will be again in future ones. Bear in mind that Shell’s CEO recently said that he thought that global oil demand could peak in 2021, as renewable energy and electric vehicles gain traction (https://www.ft.com/content/47dbcb80-08ae-11e7-ac5a-903b21361b43).
The SEC in the US is currently probing Exxon for its accounting of climate change (and potential overvaluation of assets: https://www.wsj.com/articles/sec-investigating-exxon-on-valuing-of-assets-accounting-practices-1474393593).
If anything, Shell’s $7bn write-down could be at the lower end of the spectrum. More generally, the value at risk because of climate change is a worry not only for the oil industry, but also for other sectors (including agriculture), and for all of us, if only because part of our pensions are invested in these companies.
Apart from climate change, another reason for stranded assets might be the mostly high oil prices enjoyed by the industry over the last decade. The increase in cashflow led to investment in ever-riskier assets that may be ahead of their time in terms of economics and available exploitation technology. An impetus to increase reserves and depletion of easy-to-access fossil fuels means having to explore in places like the Arctic. However, with improvements in global environmental policy, such as the introduction of a carbon tax, and growing renewables technology, this hard-to-reach oil may end up staying underground after all.