BP’s bold August strategy move for a faster pivot to cleaner energy shows the extent to which Big Oil has been forced to consider the financial consequences of climate change on fossil fuels.

The major’s much-vaunted shift to become an integrated energy company (IEC) and face the energy transition head-on took some by surprise.

The industry’s push into renewable energy, electrification and ever more ambitious pledges to pursue net-zero emission targets has been a slow but steady work in progress. But the COVID-19 pandemic has accelerated fears that oil demand could soon be in terminal decline, and industry moves to cut long-term price forecasts have been a wake-up call.

What stands out from BP’s game plan is a target to shrink its oil and gas flows by at least 1 million b/d of oil equivalent, or 40%, over the next decade. It marks the starkest admission yet by an IOC that the industry will struggle to develop its existing oil and gas resources without overshooting global emission targets. It has also refocused minds on the risks of future stranded assets.

With pressure over climate change building for years, some have seen the writing on the wall.

Back in 2015, BP’s own chief economist acknowledged that not all of the world’s oil will likely be consumed as the carbon payload of the world’s existing fossil fuel reserves far outweigh the volumes deemed consistent with meeting Paris climate goals. About two-thirds of the so-called “carbon bubble” consists of coal, but the world’s existing reserves of oil and gas make up the remaining third.

Last year, Carbon Tracker estimated the world’s listed oil and gas majors would need to cut combined production by 35% on average by 2040 to hold carbon emissions within international climate targets. From the demand perspective, S&P Global Platts Analytics expects to see 50 million b/d of demand destruction under a low-carbon scenario by 2050, when oil products would be almost displaced from road transport entirely.

Resource divestment trend?

Despite US oil majors ranked as holding the most potentially unburnable carbon on their books, it is the European oil companies who are feeling the most pressure to beat a new path.

Italy’s Eni expects its oil and gas production to plateau by 2025 under a major shift to renewable energy and greater reliance on natural gas to cut its emissions. Norway’s Equinor and France’s Total also lead the sector’s push to cleaner energy but have yet to call time on their fossil fuel growth.

Indeed, oil majors have traditionally remained upbeat over growing upstream volumes, confident of progress in cutting the carbon intensity of their operations by technology such as carbon capture and storage.

For that reason, BP’s pledge to shrink production has set the bar for its IOC rivals and could pave the way for a wider destocking of carbon-intensive, low-return upstream assets. Canadian oil sands and costly offshore projects in places like the Arctic have already been sidelined by many, and BP no longer plans to explore in new basins.

With clean energy firms becoming stock market favorites as investment pours into energy transition funds, the appetite for marginal oil and gas assets will only weaken. Higher capital costs as more investment funds shun fossil fuels could spell the end for billions of barrels of smaller, remote finds if they are left in the ground.

Carbon leakage potential

But big questions remain over how stranded assets are defined by different industry actors and whether the resources will be simply written off or sold to producers with less stringent investment criteria.

Defined by the IEA as projects that are no longer able to earn an economic return before the end of their economic life, that still leaves a lot of wiggle room for which assets become stranded.

Whether an asset is able to earn an economic return in the future is dependent on many factors that are continuously shifting including price forecasts, government policy, asset retirement costs, and targets for internal rate of returns.

BP’s production decline will mostly come through “active portfolio management,” or “high-grading,” as it sells off higher-cost, carbon-intensive projects to focus on low carbon energy.

But selling off late-life, marginal assets to other companies risks shifting the carbon to potentially smaller, less environmentally rigorous producers in a form of “carbon leakage.” It could also create huge future abandonment and clean up liabilities, which may ultimately fall to investors or taxpayers, according to Carbon Tracker.

In the US, for example, the costs of permanently retiring the millions of producing, idle and orphaned shale wells are exceeding industry expectations, exacerbating asset impairments and investment risk, the think tank believes.

“If companies and governments attempt to develop all their oil and gas reserves, either the world will miss its climate targets or assets will become ‘stranded’ in the energy transition, or both,” Carbon Tracker’s oil and gas analyst Mike Coffin said in a November 2019 report. “If companies really want to both mitigate financial risk and be part of the climate solution, they must shrink production.”

Announcing its commitment to the Climate Action 100+ initiative and divesting some coal holdings in January, BlackRock, the world’s largest fund manager, concluded stranded asset risk for fossil fuels is not yet priced into the market.

Friction with NOCs

As producers look to limit exposure to costs in a lower-carbon world, the debate over how assets are defined as stranded could cause friction between producers and resource-rich nations.

Bracewell, a UK-based energy law firm, predicts a rising tide of disputes over upstream assets as companies look to cut costs and redeploy capital, while at the same time producing states double down on maximizing revenues from oil and gas.

This tension between IOCs and NOCs will likely spill out into the renegotiation of production sharing contracts, Bracewell predicts. That could mean disputes over minimum work and expenditure obligations as producers seek to prolong the economic viability of some costlier, late-life projects.

“It seems almost inevitable that we will see more IOCs attempting to minimize further expense on assets which are no longer seen as economically viable or to defer their minimum work and expenditure obligations … however, reaching such an agreement will not always be possible,” Bracewell said in a recent note.

“Only time will tell whether assets have truly become stranded,” Bracewell said. “Whether because of a supply glut, fall in demand, pandemics, the energy transition or a combination of all of these factors, oil and gas assets are likely to look less appealing to investors than they did before the start of the year.”

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