A common method of valuing oil and gas projects is net present value (NPV), the sum of future free cash flows using a given discount rate (here 10%).
The NPVs of a company’s 2D-compliant portfolio and its BAU portfolio can be compared to give an insight into the cost structures of the two and their relative values. As the key driver of NPV is the oil price, the values of the two portfolios can be sensitised to different oil prices, and hence relative leverage to the oil price (and hence relative volatility) can be determined. This concept was explored in Carbon Tracker’s Sense & Sensitivity report.
As most producing projects are within the 2D budget, the 2D premium (the greater value of the 2D portfolio than the BAU portfolio) particularly comes out in relation to new projects, which are the focus on this indicator. The chart shows how the 2D premium across the global oil and gas industry would be around US$1.4trn if prices average around US$60/bbl going forward at a 10% discount rate. The 2D future can therefore be positive in value terms for the oil and gas industry overall as long as it aligns with it and does not bet on high demand and prices.
As the 2D portfolio constitutes the lower-cost portion of the BAU portfolio that fits within the 2D budget, it is lower cost on average. Accordingly, it has higher margins, and outperforms the BAU portfolio at lower oil prices.
Oil prices need to not only rise, but also be sustained at higher levels. For example high cost projects that were sanctioned based on the 3 years or so of US$100+/bbl prices pre-mid 2014 will have lost value for shareholders since. Some impairments have already been taken as a result of price cuts. In order for the high cost non-2D compliant oil projects to be worth developing (in aggregate), oil prices will need to average above US$100/bbl. Above this point, the oil price becomes so high that it is worth doing the additional high-cost projects – although this implies that global climate targets will be missed, assuming all else remains the same. (Other factors such as political risk will impact the actual oil price, but this is designed as a simple exercise to indicate relative price sensitivity of two production scenarios.) At lower oil prices, sticking to the smaller 2D compliant subset delivers significantly more value (or loses less) than going ahead with more expensive options.
It can also be noted that, due to the higher cost structure of the BAU portfolio, it is more geared to the oil price – that is, its value changes more for a given change in the oil price than the 2D portfolio. This implies higher volatility and higher risk, and accordingly investors calculating the NPV of the BAU portfolio should use a higher discount rate, which would reduce its value further compared to the 2D portfolio. This is outside of the scope of this exercise, but is noted for interest.
A further point that is worth considering on the topic of NPV is the concept of reinvestment risk. As noted, the NPV of a project is the sum of future discounted cash flows. However, in order for that value to be realised as a shareholder, the free cash flows must be distributed to investors via dividends. To the extent that any of these cash flows are not distributed, but are subsequently invested in future projects, this value is then transferred into the future (assuming that the company invests at its cost of capital) when that new project starts producing. In the case of conventional projects, this may be another ten years or more, when there will be even greater uncertainties relating to competing technologies and environmental regulations, and a greater difference between the 2D and BAU demand pathways. Therefore, even the value realised from the 2D portfolio is reliant on the company’s subsequent capital allocation decisions.
This is an example of how analysts could test the financial implications of a 2D scenario aligned strategy and integrate this kind of scenario analysis into their thinking.
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2 degrees of separation: Transition risk for oil and gas in a low carbon world
Produced in collaboration with Carbon Tracker