Are Oil Stocks at Risk of Crashing?

Oil stocks are currently doing well because oil prices are high and expected to remain so for a time. But some experts warn that oil stocks and other fossil fuel assets could face severe repricing as investors start to factor in demand peaking later this decade or in the early 2030s. A recent report commissioned by activist nonprofit The Sunrise Project warns for example that "climate change mitigation policies, changes in consumer preferences and technology developments" could "wipe off the value of fossil fuel projects." This could cause "borrowers to default on their debts, in turn leaving banks and insurers insolvent and causing knock-on effects across the financial markets." So could oil stocks really crash anytime soon?

In his 2020 letter to CEOs, asset manager BlackRock's boss Larry Fink predicted that there will be "a significant reallocation of capital" as climate becomes a "defining factor" in investors' and companies' long-term strategies. He also predicted that this reallocation will happen "more quickly than we see changes to the climate itself" because "markets pull future risk forward." Technically, this is done through discounting, which attributes a present value to future costs and benefits.

Determining Demand

If investors started to believe that oil and gas demand will fall within the next decade or so, then prices would fall too because the most expensive resources would no longer be needed, and so would earnings and valuations. The International Energy Agency's net-zero scenario sees for example oil prices at $35 per barrel in 2030 and $24 in 2050 — versus $82 and $95 in the base case scenario.

But this is partly factored into current stock prices, says Dutch asset manager APG's Martijn Olthof. HSBC's oil analyst Kim Fustier concurs. "We typically use a 1% terminal growth rate beyond 2030 in our DCF [discounted cash flow] models for oil and gas companies," she tells Energy Intelligence. This is in nominal terms, below HSBC's assumed 2% annual inflation rate, and therefore equivalent to minus 1% in real terms. It is substantially below what analysts typically use for companies growing in line with the economy — or 1%-2% beyond inflation.

"One could argue that our assumptions are not conservative enough," Fustier concedes. "But we don't know when global oil and gas demand will peak, and the oil majors are diversifying into new energies which have a much longer growth runway." This likely means continued growth in energy demand well beyond 2030, she says. "You're probably better off valuing the current upstream, refining and fuel marketing businesses assuming shrinking volumes over time, keeping things like petrochemicals relatively constant, and then adding some growth for new businesses," Olthof notes.

Surprises After 2030

Corrections could however be much more dramatic. DCF calculations involve explicit forecasts over 5-10 years, and a terminal value which typically amounts to more than half of a company's total value. Terminal value calculations are based on the last projected cash flow and a long-term growth rate — such as minus 1% in HSBC's oil models. Few surprises are to be expected in the next 5-10 years, but views differ radically over what can happen beyond 2030, Credit Suisse's Rob Santangelo told the recent Southern Methodist University energy conference. While all climate friendly scenarios show fossil fuels peaking "relatively soon," the difference in valuations "depends on terminal values and is really a view of the plateauing of this industry over time."

This can generate a lot of volatility, Santangelo emphasized. He used the transition from whale oil to fossil oil in the late 19th century as an illustration. "Prices became much more volatile throughout the transition off whale oil as people were looking at investment and making decisions about what the terminal value of that investment was, and effectively raising the cost of capital." He believes similar patterns are likely to emerge in the current transition away from fossil fuels.

Energy Intelligence calculations suggest that valuing an oil company with HSBC's long-term growth assumption of minus 1% per year is about 25% lower than with a more standard rate of plus 2%. But a more radical decrease rate of minus 7% per year, which would lead oil demand from today's 100 million barrels per day or so to 25 million b/d in 20 years, would cut the company's value by another 25%. A more aggressive discount rate of 15% instead of HSBC's 7%, which would reflect the increasing risk and cost of investing in the oil industry, would almost wipe out the company's terminal value, and bring its total value to less than half its current level.