Oil and Coal Stock Valuation: What You're Missing

Like it or not, climate change and society's attempts to constrain it have a growing impact on companies' bottom lines. Nowhere is that more the case than for oil and coal companies. As carbon emissions become Public Enemy No. 1, the public discourse increasingly reflects the notion that companies with heavy fossil-fuel exposure may find themselves sitting on stranded assets.

The idea is that if global governments start passing legislation aimed at reining in carbon emissions, oil and coal assets may become unburnable, thus rendering them worthless. This prospect has some analysts and observers talking in terms of a "carbon bubble."

Share-price relevance
While there's a ton of sense behind the unburnable-carbon thesis, and indeed many analysts accept its general premise, it hasn't really piqued the interest of mainstream investors so far. That's because the likely effects on companies -- while potentially substantial -- are far enough in the future that they don't really change valuations much at standard discount rates.

That may be about to change.

Peak coal
Coal, for instance, has been suffering mightily without any help from a global climate deal. Demand has been dropping everywhere but China, and that country, too, has just made some aggressive moves to constrain coal-fired power-plant development in the wake of its "Airpocalypse" earlier this year. As China moves to contain its public-health catastrophe, Deutsche Bank estimates that Chinese coal consumption will have to decline in this decade if the country is to meet its own targets.

Citigroup this month published a research note titled "The Unimaginable: Peak Coal in China," in which it argues that a confluence of factors could lead to a flattening or peaking of coal consumption before 2020. If you've watched the free-fall of pure-play coal stock prices over the past few years, it's hard not to suspect that Citigroup might have a point.

Tipping point for oil demand
Citigroup didn't rest its case with coal, either. In March, it published a report called "Global Oil Demand Growth -- the End is Nigh," in which analysts argue that natural gas substitution and increased fuel economy are leading to a tipping point for global oil demand. Morgan Stanley and Goldman Sachs, meanwhile, have published various research pieces focusing on oil companies' rising costs and declining return on equity, and questioning their capital expenditure programs.

All of this adds up to a growing chorus of mainstream investors and analysts warning of real risk to coal and oil in the much nearer term than the market seems to expect.

It's all about the cost curve
So how do you take this down to individual stocks to see where their risks lie? In an excellent article for Responsible Investor, Craig Mackenzie -- head of sustainability at Scottish Widows Investment Partnership -- observes that risk depends entirely on where a company falls on the industry cost curve.

This is basic economics. When demand falls, the marginal producers at the expensive end of the cost curve become unprofitable and mothball or close capacity, while the producers at the cheap end remain profitable. ... [M]arginal oil projects require US$90/bbl to make a return. ... The cost curve is what, in practice, will drive the "unburnability" of carbon and potential asset stranding. As demand falls, expensive carbon will become unburnable first, cheap carbon later.

If Mackenzie's logic holds, you should be awfully worried about expensive projects like Canadian oil sands and Arctic drilling.

Taking this logic further, Mackenzie seeks greater emphasis on cost control and capital discipline, particularly around capital expenditure levels. He proposes that investors should scrutinize such measures as return on capital employed, or RoCE, and whether directors' compensation and incentives are linked to such measures of capital discipline so as to protect the quality of long-term growth.

The following table provides a snapshot of five of the world's top holders of carbon reserves. The rank indicates how the company compares with other top holders in coal and in oil and gas, respectively, as measured in Gigatons of carbon dioxide, or GtCO2. The capex ratio is the company's capital expenditure divided by total sales. I used my own calculations for RoCE: EBIT divided by total assets minus current liabilities. While some companies provide RoCE in their investor presentations, they don't necessarily calculate it the same way, and some don't provide it at all. Thus, I used my own calculations for the sake of consistency.

Sources: The Carbon Tracker Institute, The Motley Fool, Yahoo! Finance.

The selection of companies in this table is purely based on which of the top carbon holders in oil and coal were publicly traded on U.S. exchanges. We'd have to be careful comparing Peabody -- a small coal pure play -- to much larger, diversified BHP, for example. Still, it's interesting to note the differences in their ratios, especially considering how much better BHP's share price has held up in recent years. Also note BP's weaker RoCE and share price performance as compared with its peers.

Foolish bottom line
Now, we must never imagine that a single factor explains share price movements. Still, everything about the carbon bubble thesis and the idea that we should look at capital discipline and cost curve position makes sense to me. While sustainability and environmental issues don't always correspond neatly to near-term share price movements, this is one area where they might be intimately linked already.