BLOG – 04.29.21

The Deepwater Dilemma

Von Thompson, Vice President - Gulf of Mexico, Xodus

In this uncertain time for the energy market, what we can be sure of is that carbon will become an increasingly important cost component going forward, emissions must reduce and volatility is here to stay.

This volatility means that there will be a “risk premium” for capital, and that windows of opportunity and investment horizons will shorten. Therefore, we believe the two drivers of projects will be assumed or actual cost of carbon and the pricing and the availability of capital.

The only way that many future oil and gas projects will succeed is through flexibility and collaboration between operators, service companies, contractors, financiers and governments. Governments around the world have the added dilemma of balancing carbon reduction against three competing forces: energy security, energy sector employment and regional industrial development.

Carbon budgets mean we know that we cannot continue to grow our consumption of oil and gas, and we must try to help developing nations in other ways. We also know that we cannot turn off the taps tomorrow or we would provoke civil unrest as our living standards plummeted.

Tough decisions in reducing emissions

Carbon emissions have risen ten-fold since the industrial revolution. If we were to continue as is, as more nations industrialise, we would see another ten-fold increase within a few decades.

The UN climate predictions suggest that if we are to limit global warming to 1.5C, we must start to reduce carbon emissions by 7.6% per annum for each year for a decade. To put that into context – around 60% of emissions are attributed to energy usage and producing and burning hydrocarbons is part of that.

If we are to play our part in target emission reductions, we will need to stop using hydrocarbons to produce hydrocarbons and find a way to remove the carbon released from our energy supplied to customers that reach the atmosphere.

For many years carbon emissions have been considered free of charge.  They are not part of the economic models we were taught as young engineers and have often been considered in internal business cases as an after-thought.

Traditional business cases need to account for carbon costs as a matter of course, not as a surprise add on. The cost of carbon is unpredictable because it is entirely set by political policy. There are currently 60 pricing initiatives already in place across 45 countries but after COP 26, which takes place in Glasgow, Scotland in November, we can expect a sharp rise.

The rapid falls in the price of electricity generation, the rise in low-cost electronic control and carbon taxes means carbon reduction aligns with the financial goals of shareholders. Unfortunately – and this can be hard for us to swallow – the value of some hydrocarbon reserves may be greater underground than if they are raised to the surface.

Change of mindset

With greater scrutiny on environmental, social, and governance (ESG) activity, companies are now regularly analysing carbon impacts. Several are finding that deep-water assets in the Gulf of Mexico (GoM) are often the most carbon-friendly in their portfolio in comparison to other offshore regions or, closer to home, Permian Basin fracking.

The main drivers for this are the existing infrastructure in place, the absence of flaring due to pipelines as well as fewer drilling and completion activity. With the addition of greater returns, it means the GoM will continue to be an attractive investment opportunity for many years to come.

Although oil and gas financing is continuing to drop in absolute terms, banks are continuing to lend to the IOCs due to these companies carrying less reputational risk than independents.

However, the implications for asset impairment, stranded assets and more loan impairments are potentially huge. The large number of US bankruptcies in the last two years and the relatively large loan losses have made regulators more cautious. Banks are now required to hold more capital reserves in support of their oil and gas loan books which has influenced the amount of capital available.

Carbon policies combined with rapid progress in electrification has led to nervousness around financing traditional oil and gas investments. This uncertainty comes from the long timeframes required between investment and final production mingling with the uncertainty of future cash generating potential.

Projects have restricted access to public markets meaning that project finance is likely to remain on internal lender balance sheets for longer. This leads to higher required returns (to compensate for the risk) and short pay-back times (to minimise risk exposure). As well as economic issues, project backers are also exposed to political, regulatory and reputational risks as public opinion shifts.

When you take all this into account, it is no surprise that projects that would traditionally have been money-spinners are stuck due to capital restrictions. If we are to succeed in unblocking technically viable deep-water projects which meet the “normal” internal rate of return (IRR) and payback horizons investment hurdles, we are going to have to do things differently.

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