Fossil fuel angst darkens oil sector funding outlook

As global concerns over climate change gain pace, a growing movement to cut off institutional funding for fossil fuel projects is creating new headwinds for oil and gas producers.

More investors, shareholder activists and environmental groups than ever are pushing for investment funds to ditch support for oil companies, and the headline figures are alarming.

More than 1,000 institutions with managed investments worth over $8 trillion have now committed to divest from some or all fossil fuels, according to estimates by US-based environmental group 350.org.

On closer inspection, only a fraction of the total managed funds value is invested in fossil fuels and many funds have only sidelined investment in coal projects, not oil and gas —so far, at least. Nevertheless, the direction of travel is clear and the fossil fuel divestment movement is gaining traction.

The list of institutions that have started to cut their ties with fossil fuels is growing. Norway’s $1 trillion sovereign wealth fund is dropping most of its upstream oil holdings while Ireland became the first nation to divest its public funds from fossil fuels last year. The World Bank has committed to stopping funding new oil and gas developments from this year.

The moves by global asset management firms and investors to shun fossil fuels have not gone unnoticed by the industry itself. Last year, Shell specifically identified the fossil fuel divestment campaign in its annual report as a risk which could have “material adverse effect” on its share price and access to capital markets.

In March, Eldar Saetre, the CEO of Norwegian oil major Equinor, said the entire industry faces a “crisis of confidence”.

Climate risk costs

But opinions are still mixed on the immediate impact of divestment movement on funding flows for future oil and gas supplies.

Activists claim their movement is redirecting investments funds to cleaner energy alternatives, influencing boardroom strategy over fossil fuel projects, and denting returns from oil and gas spending. The threat of litigation over carbon emissions, onerous climate disclosure rules and the specter of huge writedowns on stranded assets, they say, will tip the hydrocarbon industry into terminal decline.

There is already evidence that smaller and medium-sized producers, which are more exposed to debt markets and bank financing, are feeling the pinch from a more cautious approach to funding oil projects.

“Globally we’ve seen much less appetite from the traditional banks to finance a project,” Jean-Michel Jacoulot, the CEO of UK-based upstream minnow Trident Energy, told an industry event in Equatorial Guinea in April. “If you have no capital market access and no willingness from traditional banks to invest, that’s an issue. We need to be able to attract financing to our projects... we need to demonstrate that this is a good business.”

A late 2018 survey of institutional investors by consultancy Redburn Research found that fears over the energy transition from fossil fuels are elevating capital costs for conventional energy projects.

While investment hurdle rates for wind and solar, and LNG projects, have remained relatively stable, the minimum required level of returns for deepwater oil, long-cycle oil megaprojects, and coal have risen sharply. The average base-case internal rate of return (IIR) required for an oil megaproject was 21% last year, up by seven percentage points from the early 2010s, according to the survey.

“The leading reason for higher hurdle rates in long-cycle oil and coal projects is the growing concern of investors surrounding energy transition,” the report’s author Rob West concluded in his findings.

Alternative funding

Although traditional Western financing sources may be more risk averse to oil and gas funding, other less ethically sensitive investors remain ready to buy up shares and extend credit if expected returns remain strong.

Last year, private equity investment in natural resources —oil and gas, timberland, farmland, water, and mining —hit a fresh record according to financial data provider Preqin. Meanwhile, China’s appetite for pumping billions of dollars into overseas energy projects appears unabated.

When oil majors began dropping out of Canada’s oil sands industry in 2015, local producers backed by Canadian banks and state and private Chinese investors stepped in to pick up the slack. Despite the exit of IOCs and widespread condemnation of “dirty” oil sands, the IEA still expects output from the industry to grow by 1 million b/d to hit 3.8 million b/d in 2040.

Banks themselves are still leaning in with financing for fossil fuels which has risen over the last three years, according to a report released in April by Rainforest Action Network and a group of environmental action groups.

Despite the growing aversion to fossil fuels, 33 Canadian, Chinese, European, Japanese, and US banks have financed fossil fuels with $1.9 trillion since the Paris Agreement was adopted (2016–2018). Bank financing for fossil fuels has increased each year since the Paris deal, hitting $654 billion in 2018, according to the report.

Capital structure

Oil companies are also fighting back. Hoping to win back the narrative over the world’s continued need for fossil fuels, majors are spending millions of dollars on advertising campaigns showcasing their growing tide of

and clean transport technology.

BP’s CEO Bob Dudley in October said that the divestment movement and the push to kick fossil fuels out of the global energy mix is counterproductive, potentially creating a “systemic risk to the financial system” from a future energy supply crunch and sharply higher energy costs.

The oil price recovery and cost efficiencies achieved since the 2014 price slump have also reduced the need for external financing for most producers.

Although the average cost of capital for listed oil and gas producers has been rising since 2014, it still remains half 2006 levels of close to 6%, according to the International Energy Agency.

“For oil and gas, we see less evidence of divestment actually having a material effect on what the industry is doing. We haven’t seen any huge increase in funding costs for oil and gas companies,” IEA analyst Michael Waldron said.

In terms of capital structure, Waldron notes oil majors are much less dependent on debt to finance spending so “it’s not a case of divestment drying up bank funding which is hurting these companies.” The world’s top 25 listed oil companies by production relied on equity to finance 75% of their spending last year, with 25% coming from bonds and other debts, the IEA estimates.

With the impact of the divestment movement on investment still limited, long-term investor appetite for the oil industry could be stifled more by concerns over impending peak oil demand than any lack of funds to develop the supply.