Up until now investor attention has focused on the downside risks to the publicly traded oil industry resulting from a transition to a low carbon future. Specifically the risk that companies will have to write down ‘stranded’ assets and face declining demand for their products. Yet there is a much bigger potential problem that investors may need to face: sovereign credit risk of state owned oil producers and escalating geopolitical conflict.
A new paper (Stranded Assets And Sovereign States) by the Council on Foreign Relations (CFR) and published in the National Institute of Economic and Social Research looks at the potential impact of stranded oil and gas assets. It argues that in most cases, it will be sovereigns, not private investors, who will bear the brunt of stranded oil and gas assets.
To put the exposure of sovereigns in perspective, the largest traded private oil companies, which include ExxonMobil, Royal Dutch Shell, Chevron, Total, BP, Equinor, ENI, and ConocoPhillips, hold total oil reserves of 49 billion barrels (Energy Intelligence, 2018). This represents only about 3 per cent of total proven world oil reserves of 1.7 trillion barrels. In comparison, the share of world oil reserves by nations that are members of the Organization of Petroleum Exporting Countries (OPEC) is 79 per cent, with Venezuela controlling 25 per cent, Saudi Arabia 22 per cent, Iran 13 per cent, Iraq 12 per cent, and Kuwait and United Arab Emirates roughly 8 per cent each (OPEC, 2018).
The CFR argues that state owned oil companies have had little incentive to accelerate that transition.
Petro-states were willing to hold back production and delay investment for exploiting undeveloped reserves because they believed that the value of those assets would rise over time, as oil output from older oil fields in North America, Europe, and Australia began to decline from natural physical geological limitations.
It’s also worth reflecting that autocratic regimes have used the wealth generated from oil to quell unrest from the poor and to keep the elite on side. According to the International Monetary Fund (IMF), approximately $550 billion a year is spent on energy subsidies. Half is spent by governments in the Middle East and North Africa, where on average it is worth approximately 20% of government revenues.
What has changed now is that oil seems to be in greater abundance, just at the time when uncertainty about future demand is emerging. Some oil dependent nations are ahead of the curve though in reducing their carbon impact.
The national oil companies of the Persian Gulf, notably Saudi Arabia, the United Arab Emirates, and Kuwait are among the NOCs taking the most ambitious measures to reduce energy consumption and emissions in oil production processes and facilities and to pivot to investment in renewable energy.
Still, not all national oil companies have developed strategies to address the question of stranded assets. Those with little access to credit, either because of mismanagement or sanctions are poorly positioned.
For example, Venezuela is highly exposed to stranded asset risk not only because it holds the largest oil reserves in the world but also because of the current dire situation of its national industry. The country’s internal problems have led to gross mismanagement of the sector, in addition to looting and other damage to most major facilities, that has all but crippled state firm PDVSA’s ability to operate…Before bureaucratic mismanagement, massive state economic decline, and then US sanctions hit the firm, PDVSA used to spend upwards of $3 billion to $4 billion a year just to arrest wellhead declines in its mature oil basins. Capacity expansions at the country’s extra heavy oil Orinoco Belt region would take tens of billions of dollars.
Access to capital isn’t likely to improve in a world in which investment institutions are seeking to divest from carbon intensive energy sources. Where it is available, it will come at a price.
Availability of this capital to finance a restoration of Venezuela’s oil sector remains unclear. The country is deep in debt, including over $20 billion owed to China alone, and it will take any government, including a new government, years to stabilise finances. Moreover, since many international oil companies will be less interested in amassing large reserves in the coming years, and the poor state of Venezuela’s fields and the country’s political instability weigh against foreign investment, Caracas will have more difficulty finding parties who will be willing to invest large sums into its oil sector. The longer Venezuela’s current internal political crisis continues, the harder it will be for the country to tap its oil reserves as a means to pay for its future.
Elevated oil revenues have historically supported government budgets. If these dry up over time national institutions will be destabilised even further.
In the International Monetary Fund’s October 2019 Global Financial Stability Report entitled “Lower for Longer” it notes that state-owned enterprise debt represents a “significant portion” of total emerging market debt securities. The IMF report notes that emerging market oil and gas state enterprise (SOE) leverage has nearly doubled over the past fifteen years at the same time these same firms are experiencing a decline in profitability. The IMF report also states: “IMF staff analysis indicates a widening in spreads in major SOEs can spill over to sovereign spreads and these spillovers have been rising in recent years, in contrast to the spillovers from sovereigns to SOEs” (IMF, 2019). For countries that already suffer from high debt levels, a worsening credit position in light of stranded asset risk for oil and gas national flagships could result in a worsening fiscal position for sovereigns.
But for countries that fail to prepare their populations may find a harsher reality. CFR argues that in some cases, governments may resort to increased internal repression as existing patronage systems become less sustainable in co-opting disparate political interests, while the nature of regional geopolitics is also likely to be affected.
As they come under increased pressure, the intensity of regional conflicts could subside as parties to disputes are constrained by loss of oil revenues (Gause, 2015). But there is also the possibility that petro-states will seek a substitute for the waning influence previously established by their vast oil and gas reserves. It is unlikely that threats of oil cutoffs can serve as a diplomatic coercive lever over time as consuming states become less worried about energy supplies and more reliant on domestically produced renewables and energy saving digital technologies. One option petro-states will be tempted to take is to assert their geopolitical interests more directly with brute military power rather than suffer a decline in influence. Viewed through this lens, recent military buildups in the Middle East by Russia, and Iran’s recent attacks on shipping and oil installations in the Persian Gulf, may take on deeper implications.
The paper concludes that:
“many resource-dependent economies could come under stress in the coming decades, just as climate change increases the burden on governments to respond. Moreover, as the oil intensity of the global economy lessens, the opportunity for petro-states to amass fiscal surpluses will shrink over time, requiring economic reforms and restructuring that will be politically unpopular at home.”
Those left behind will not do so quietly. The irony of this story is that those countries with some of the greatest energy resources (Venezuela, Iran and Russia) will be in no position to respond should the transition to a low carbon future be slower than consensus opinion imagines. If they get left behind stranded societies risk becoming unstable ones.