IEEFA update: In Exxon lawsuit, another indication of growing oil-industry peril
The lawsuit filed yesterday by New York’s attorney general against Exxon Mobil is a stark indication of just how risky investing in oil and gas companies has become.
The lawsuit asserts that the company defrauded shareholders by downplaying the business risk of climate change, and litigation poses obvious financial risk. It may even expose ExxonMobil—and possibly other oil and gas companies as well—to class-action lawsuits as shareholders develop a long-term damages theory.
Investors, who once considered the energy sector a source of stable returns, best look elsewhere.
The lawsuit hits upon a fundamental reality: That ExxonMobil’s reserve calculations, properly accounted for, would show a much smaller company with a significantly diminished long-term outlook.
Institutional investors especially must always balance the trade-off between the risk their investments carry, and the reward these investments offer. For decades, fossil-fuel rewards were excellent, and the risks minimal.
Oil and gas literally fueled the global economy and was linked in lock-step with economic growth.
That was then. The new risk-reward calculus upends the old, time-honored investment thesis of drill, drill, drill has run its course. Fossil fuel stocks now offer investors a lose-lose proposition, where current finances and economics offer smaller returns, and where future returns predicated on climate policy shifts throw company finances into a long-term lose scenario (see our recent report “The Financial Case for Divestment from Fossil Fuels”).
OVER THE PAST 10 YEARS OR SO, THE FOSSIL FUEL SECTOR, once the market leader, has underperformed the broader equity market. This trend has become particularly pronounced in the past five years, a time in which the sector has lagged almost every other industry. Instead of bolstering portfolio returns, energy stocks have dragged them down and investors have lost billions of dollars.
According to the risk-reward calculus of investing, if the rewards are lower, the risks should also be lower. But this is not the case here. The risks of investing in the sector have intensified, even as the rewards have diminished. Fossil fuel stocks are increasingly speculative. Revenues are volatile, growth opportunities are limited, and the outlook is decidedly negative.
The weakness is likely to continue as oil prices remain well below $100 per barrel and as they are buffeted by short- and long-term volatility shocks driven by market and political events.
Cash flow, rather than reserves, is the key metric of value now in the oil and gas industry and has forced a comprehensive reevaluation of the sector’s financial health. Investors increasingly view oil and gas companies—even the supermajors such as ExxonMobil and Chevron—as speculative holdings whose fortunes are intimately tied to the ups and downs of commodity markets.
Commodities are very different from stocks, especially stocks that have been mainstays of institutional and retail investors’ portfolios for decades.
As Dan Dicker, a well-known commodity analyst has noted, commodities “are time-sensitive instruments that regenerate and self-destruct every month … commodity futures contracts don’t care where the markets will be in six months. They only care about their price prospects on the day they expire.”
Because cash flow matters more now to investors, oil and gas prices matter. So the direction of oil prices, and the specific effects of prices on revenue and profit, increasingly determine how investors evaluate oil and gas companies.
And unfortunately for the oil and gas sector, it faces financial and political risks at either end of the price spectrum (see Appendix II of our report, “High- and Low-Price Environments”).
Even when prices were high in the early years of the shale boom, many companies spent more to acquire and develop new reserves than they were earning from production. To sustain their capital spending while maintaining robust dividend payouts, the sector borrowed heavily from the debt markets.
Such a strategy by any other mature industry would have set off warning bells, but the old reserve-focused investment thesis sustained investor belief that profligate capital expenditure programs would yield handsome profits.
THE NEW YORK LAWSUIT ONLY INCREASES THE MANY RISKS FACING THE INDUSTRY as the global economy is shifting toward less energy-intensive models of growth, fracking has driven down commodity and energy costs and prices, and renewable energy and electric vehicles are gaining market share.
Litigation on climate change and other environmental issues is expanding, and campaigns in opposition to fossil fuels have matured to the point that they are a material risk to the sector.
These multiple risks, taken cumulatively, suggest that the investment thesis that worked for decades has lost its validity.
The absence of a coherent, industry-wide value proposition that embraces the changes taking place in the global economy puts fossil fuel investors at a disadvantage. Successful oil and gas investing now requires expertise, judgment, a strong appetite for risk, and a deep understanding of how individual companies are positioned with respect to their competitors both inside and outside the industry.
Sophisticated investors today are treating oil and gas companies as speculative investments and are rightly skeptical of high levels of capital expenditures for exploration and drilling.
Passive investors who could once choose from a basket of oil and gas industry securities with little reason to fear they would lose money, are now turning to true blue-chip stocks with stable returns.
In short, awareness is growing around the fact that fossil fuel equities are no longer worth the risk.
Tom Sanzillo is IEEFA’s director of finance. He can be reached at [email protected]. Kathy Hipple is an IEEFA financial analyst. She can be reached at [email protected].
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