The oil and gas industry faces a host of challenges, including high and rising development costs, stagnant commodity prices, and geopolitical risks in regions such as Russia and the Middle East. But climate change may be the biggest threat of all, with potentially grave consequences for oil and gas companies' asset values and share prices.
The growing climate change threat
An overwhelming majority of experts contend that climate change is real and -- absent a concerted effort by international policymakers to curb carbon dioxide emissions -- could have dangerous and potentially irreversible consequences for our environment. To be sure, there are serious efforts under way to curb its impact.
During the 2010 Cancun Agreements, international lawmakers agreed to combat climate change and the host of known and unknown problems it presents by pledging to prevent global temperatures from exceeding pre-industrial levels by more than 2 degrees Celsius by 2050. Unfortunately, achieving this goal looks increasingly tenuous.
According to a report by London-based think tank Carbon Tracker and the Grantham Research Institute on Climate Change and the Environment at the London School of Economics, we must limit emissions to no more than 900 gigatonnes of carbon dioxide (GtCO2) over the period 2013-2049 if we are to keep, at 80% probability, the global temperature from rising 2 degrees Celsius above pre-industrial levels.
Now here's the big problem: Meeting that emissions target means that the vast majority of the global fossil fuel reserves owned by energy companies and foreign governments cannot be burned. Burning these reserves would release a whopping 2,860 GtCO2 into our atmosphere, which would raise the global temperature by well over 3 degrees Celsius, the report, titled Unburnable Carbon 2013, found.
Of those reserves, listed companies account for about 762 GtCO2, with foreign governments owning the rest. Now let's assume listed companies and governments were granted carbon budgets commensurate with the size of their reserves. That means listed companies would be allocated about a quarter of the global carbon budget, with the remainder going to foreign governments.
Under this scenario, listed companies -- like ExxonMobil, Chevron, Shell, and BP -- could harvest no more than a third of their existing reserves if the world is to meet its target, with an 80% probability, of keeping the global temperature increase below 2 degrees Celsius. That implies that about two-thirds of their reserves could be, at worst, worthless.
Implications for investors
Does this mean investors should discount these companies' values by two-thirds? If you believe the world's political leaders and business interests will somehow come together and agree on maintaining that target, then perhaps. But in the more likely case that we fail to act and end up exceeding the stated target, then no.
In short, the target of reducing carbon emissions and limiting climate change is inconsistent with the world's addiction to fossil fuels. We still rely overwhelmingly on oil, gas, and coal, which account for over 80% of global energy usage. And with no other scalable, reliable, and cost-effective options to replace these fuels, it doesn't look like we'll be curing our century-old addiction anytime soon.
For investors, this means that your fossil fuel stocks are likely safe for the foreseeable future. But in the improbable event that global leaders somehow scrape together and enforce a carbon reduction plan, fossil fuel stocks could be in trouble. Caveat emptor, as they say.