The Norwegian government has created an expert group to consider whether its $840bn sovereign wealth fund should divest from fossil fuels. Leaving aside the irony of this particular fund choosing to go fossil free, the oil fund is two orders of magnitude larger than the biggest investor to have done so to date, so it marks a significant escalation in the debate.
One of the most striking things about the fossil divestment campaign is that it is not content merely to make a moral case, it also claims that divestment makes sense from a financial perspective: to avoid a growing “carbon bubble” that might pop soon.
This argument has proved harder to dismiss than many expected. The share prices of most of the world’s coal-mining companies have fallen steeply in the past two years – by more than 75 per cent in several cases. In the US, new air pollution regulations are making coal an expensive option in power generation and utilities are switching to cheap shale gas instead. Coal demand has fallen by 20 per cent as a result, and 50GW of additional coal closures are expected in the next three years.
True, coal demand has been stronger in Europe, but this is temporary. EU clean-air directives require closure of much coal-generation capacity over the next decade. Even in China, which now accounts for half of global coal demand, analysts are starting to point to the possibility that economic rebalancing, slower growth and air pollution worries may mean demand will start to fall before 2020.
This would mean that coal is not simply facing the downswing of the usual commodity cycle, but the possibility that the sector may be entering permanent decline.
This gloom, coupled by coal’s small total market cap, means that Norway’s expert committee could come to the painless conclusion that the fund need not invest in pure-play coal miners in the future.
But is the same true for oil? All is not well in the oil sector either. Oil company share prices have underperformed the market as a whole in the past two years – in some cases by 20-30 per cent, though they have not fallen in absolute terms.
Oil majors have been deploying capital expenditure at record levels, but have delivered much lower returns than they managed in the past. Their mature fields are in decline and require high levels of maintenance investment, while too many of their new fields are located in challenging basins that are proving extremely expensive to develop. Costs have skyrocketed.
Adding to the industry’s woes is a new theory from analysts that oil demand might peak by 2020, decades ahead of industry expectations. Demand is already starting to fall in rich countries as a result of aggressive fuel-efficiency standards and changing driving habits. The theory suggests that in emerging economies high oil prices will make current fuel subsidies unaffordable, exposing drivers to the full rigours of market prices, and slowing demand growth as a consequence.
These bearish views have certainly got investors’ attention, but, unlike coal, few investors seem to have been persuaded to divest. Oil companies are still hugely cash generative – they are responsible for a generous slice of the world’s dividend payments. Unlike pure-play coal, it would by no means be a painless decision to divest.
Instead investors are calling for oil companies to place much more emphasis on capital discipline and cost control. Rather than abandoning the sector, investors want to make it more resilient to risk by encouraging companies to spend capital more frugally, on projects that generate higher returns and would still break even in the event the peak-demand theory turns out to be true.
Oil companies seem to be listening. Capital discipline is the new watchword. In recent weeks both Exxon and Shell have announced reductions in their capital-expenditure plans, and a renewed emphasis on cost control and high-quality projects.
Perhaps this offers the right recipe for Norway’s oil fund: selective divestment from the fossil fuels least likely to have a future in a carbon-constrained world, together with the judicious use of its muscle as a large oil industry shareholder to push companies to take a more cautious and resilient approach to future capital expenditure.
Divestment campaigners may not be satisfied, but this strategy does address their concerns about “stranded assets” and “carbon bubbles” directly. Lower rates of capital expenditure focused on high-quality projects will reduce the risks of a carbon bubble inflating.
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