Stranded Assets: An Ocean of Oil

By Kim Iskyan

See if you can guess the common theme in these scenarios…

Your plane lands in Denver, and your connecting flight is canceled just as the snowstorm of the century moves in. So you’re stuck and snowbound as the entire airport is closed down for days…

A crippled boat topples over on the cracked thirsty earth, on what used to be the shores of the Aral Sea – before an endless drought and aggressive agriculture practically drains the world’s fourth-largest lake…

Around $900 billion worth of energy assets which, according to the Financial Times, could “evaporate” if governments move more aggressively to reduce carbon emissions (more on this below)…

If you answered that each of these scenarios is a cocktail of desperation and hopelessness, blended with isolation and served with a side of loss and despair, you are correct! (Sorry, you win nothing, except this informational and entertaining story… keep reading.)

The best word to sum up these situations? Stranded.

In the investment world, a “stranded asset” – the money equivalent of cooling your heels on a chilly airport floor, or a beached boat left for the vultures – is a resource that at one time produced income or held value but no longer does.

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It’s experienced an unexpected (or earlier-than-expected) write-down or collapse in value – and perhaps it’s gone from being an asset (worth something) to being a liability (costing you something). An asset can become stranded due to some kind of external change in technology, markets, policy, society, litigation, or something such as climate change.

For example… Let’s say you’re a top-notch oil lamp producer… Then along comes that annoying Ben Franklin and his electricity. It’s not long before your inventory – and your business – is worth close to nothing because the market that you serviced no longer exists, outside of little old ladies who don’t believe in the devilry of the light bulb.

More recently… The value of a New York City taxi medallion – a license to operate a cab – collapsed from $1.3 million in 2002 to $200,000 by 2014, as Uber and other ride-hauling apps entered the market. Now, there are still plenty of yellow cabbies on the streets today… But the value of driving a cab has collapsed – and the price of a NYC taxi medallion is never coming back.

How about that chunky rotary phone in your closet that used to be a centerpiece of your social life? Now, it’s only valuable for the grins of your grandkids when you display it as a relic of another era – priceless, perhaps, but virtually worthless in market terms.

And three months after the Fukushima nuclear disaster in March 2011, Germany decided to shutter eight of its nuclear power plants almost immediately and to phase out its remaining nine plants by 2022. The EUR2.4 billion paid by the government to nuclear power plant operators as compensation represented a small fraction of the estimated $12 billion per year total “social cost” of closing down just the first eight plants. The market price for abandoned nuclear power plants approximates the value of the coins on your dresser. That’s stranded.

The Biggest Stranded Asset in History

Right now, investors are grappling with the prospect of the biggest batch of stranded assets in history… nearly $1 trillion in fossil fuel reserves.

Under the terms of the Paris Agreement, 196 countries – including the United States, which reentered in February – agreed to aim to reduce the emission of greenhouse gases into the atmosphere. The objective is to limit the rise in global temperatures to 2 degrees Celsius (3.6 degrees Fahrenheit) above pre-industrial levels (with a reach-for-the-stars aim of 1.5 degrees Celsius).

Fossil fuels account for 89% of greenhouse gases, according to the Intergovernmental Panel on Climate Change. So the only way to prevent climate catastrophe – more 100-degree days in Siberia (this happened in June), and the 3.1 billion people on Earth who live within 60 miles of the coast having to grow scales since they’ll be permanently swamped – is to limit the usage of fossil fuels.

A widely cited 2015 study claims that around one-third of the world’s oil reserves, half of total gas reserves, and upwards of more than 80% of coal reserves will need to not be used – not brought up to the surface, and not burned into the atmosphere – to hit the 2-degree target, so that Mother Earth can still be breathing when our grandkids are adults.

This is an extinction-level challenge for the likes of Exxon, BP, Chevron, Saudi Aramco, and every other oil, gas, and coal producer, as the Financial Times explained in February 2020…

Vast swaths of oil, gas and coal reserves may never be extracted and burnt because doing so would intensify global warming, worsening freak weather events and threatening the loss of farmland and huge population displacement…

In that context of the climate emergency, the cost of writing off stranded assets could be seen as a small price to pay. But the amounts involved would be breathtaking. According to [Financial Times] estimates, around $900bn – or one-third of the current value of big oil and gas companies – would evaporate if governments more aggressively attempted to restrict the rise in temperatures to 1.5C above pre-industrial levels…

Oil and gas companies frequently write down, or decrease, the value of reserves to reflect a revised outlook on commodities prices. A big deep-water oil project that requires an oil price of $90 per barrel to deliver a 15% return – launched when it looked like oil prices would remain above $100 per barrel indefinitely – is a lot less compelling in a $60 per barrel oil environment.

In that case, a big oil company might suspend operations on the project and reduce the value of the project on its balance sheet (which is more of an accounting maneuver than anything else). It would still show the reserves as an asset, and it could resurrect the project if oil prices were to rise.

Finding the Next Thing

But a Paris Agreement-inspired stranding of assets is a different matter. It’s permanent and irrespective of the price of oil or any other bottom-line-driven factor. And it’s not like oil and gas production is a side hustle for the likes of Chevron or ConocoPhillips… This is like telling McDonalds, “Sorry, you can’t sell fast food anymore – figure something else out.”

U.K. energy major BP helped kick off the process of cutting off its own limbs in June, when it slashed $17.5 billion from the value of its oil and gas assets. The Financial Times opined that the write-down was “the biggest recognition yet among the largest oil and gas players that tens of billions of dollars worth of investment could be rendered uneconomic as the world pursues the Paris climate goals.”

A few months later, BP – which read the room as early as 2002, when it rebranded itself from British Petroleum, to Beyond Petroleum – said it would cut oil and gas production by 40% and aim to increase renewable-energy generation capacity 20-fold by 2030.

Will it work? BP’s history – which includes one of the largest oil spills in Alaska’s history (2006) and the biggest marine oil spill ever (Deepwater Horizon in the Gulf of Mexico in 2010) – doesn’t inspire confidence. Its marketing propaganda – the company’s purpose is to “reimagin[e] energy for people and our planet” and to “help the world reach net zero and improve people’s lives” – has the feel of an all-night Greek diner that’s trying to reinvent itself as haute cuisine.

And, of course, BP is just one of dozens of energy companies that are staring into the abyss. But since the FT’s February 2020 forecast that oil companies would need to throw overboard $900 billion in assets, investors haven’t blinked. The share price of the iShares Global Energy Fund (IXC), an ETF that holds a who’s-who of big energy companies, is roughly flat over the past year (though it’s been volatile, along with stock markets globally).

There’s still plenty of room to fall. And any forecasts while the process is still ongoing aren’t worth much. A 2016 report by global investment bank UBS about energy companies’ stranded assets concluded that “many public oil and gas companies appear to be reasonably valued… even under a ‘strong form’ of the stranded assets hypothesis” – which is broker-speak for “it can’t get any worse than this.”

(Since then, though, IXC is down around 20% – while the S&P 500 has roughly doubled.)

The Journey to Stranded

No asset is “stranded” overnight (unless it happens during a pandemic… more on that below). Oil lamps lingered for a long time before light bulbs found their way into houses… And the disruption of Uber took a few years to unfold. Plenty of people kept their door-stopper rotary phones even as mobile telephones replaced land lines and the idea of a “home phone.” Nuclear power had been under pressure in Germany for decades before the Fukushima disaster accelerated the trend.

After the fact, it’s easy to chart an asset’s path to “cheap”… as it devolves to “undervalued”… enters the realm of “contrarian” or “deep value”… and then further regresses to “impaired” and/or “left for dead”… before falling off a cliff to wind up at “stranded.”

This journey is easy to explain for stocks, for which there’s a liquid market and readily available comparables (neither of which exists for oil lamp shops or German nuclear power plants).

At each stage heading toward stranded, the valuation discount of the asset increases… that is, the price-to-earnings (P/E) ratio (in absolute terms, as well as relative to similar assets, and to its own historical levels) will decline as the share price falls, reflecting investors’ diminishing faith in the earnings power of the company. (Note that the P/E ratio could also increase if earnings actually do decline faster than the share price falls. No one said finance wasn’t confusing.)

A few bad trading days, a lousy quarterly earnings report, or a big fund that’s forced to liquidate a position in a hurry can result in a temporary “cheapness” in a stock. If the stock doesn’t have some deeper reason to deserve to be cheap, an efficient market populated by eagle-eyed investors will correct that soon enough.

But string a few of those sorts of situations together plus (for example) a general slowdown in the sector, and a stock can become “undervalued.” The discount rises, and the path back to valuation respectability is a bit more challenging.

Next, toss in some serious management missteps, an accounting scandal, or a bigfoot competitor that’s eating everyone’s lunch, and a stock enters the realm of “contrarian.” It’s very cheap, for very good reason… The company might recover, or – like a basketball player who ruptures their Achilles tendon – it might never be the same again.

Stocks in Argentina have a Frankenstein-like knack for coming back to life after being repeatedly left for dead. Throw a rock at a stock listed on the country’s stock exchange, and chances are good that it’s experienced at least four 80%-plus collapses over the past two decades and a similar number of triple-digit recoveries.

The Last Stop

Stranded is the last stop… As an asset steadily depreciates in value, it’s passed on – hot-potato-like – to the next guy who thinks that he can turn it around or that it’s on the cusp of rebounding. But eventually, the investor left holding the stranded asset winds up with nothing more than a cold spud.

Perhaps the savvy oil lamp shop owner sold his inventory to a discounter – a colonial-style factory closeout – not long after Ben Franklin found himself flying a kite in a thunderstorm. Somewhere down the line, someone was stuck with a warehouse full of oil lamps (space that perhaps, a few centuries later, was taken up by rotary phones).

A stranded asset is worthless at best… or (even worse) an ongoing liability for its owner. Just because an asset no longer holds value doesn’t mean that its owner doesn’t still have to pay rent, property tax, security, or upkeep for it.

And over the past year, a lot of assets have degenerated to stranded within a matter of months. As Bloomberg explained in April 2020…

Empty restaurants. Shuttered theaters and hotels. Grounded airplanes. At least at the moment, they all fit the definition of stranded assets subject to premature writedowns and operating losses. Everyone is getting a close look at the vast economic and human costs associated with investing in infrastructure that can’t be used, even temporarily. The threat of bankruptcy and restructuring suddenly spans the global economy from offshore drilling to retail.

An asset that’s stranded isn’t dead and gone forever… It still exists as a physical entity, and someone – no matter how reluctantly – owns it. A shuttered restaurant or an abandoned hotel may eventually get a second life with a different owner, after bankruptcy proceedings and under a different nameplate.

The initial investment made by the next investor is a lot lower than it was for the people who started it the first time around. Buying an asset at a fire-sale price means that it’s that much easier to make back your investment. The level of cash flow or net income required for the asset to be financially viable (that is, make money) is a lot lower.

Maybe those warehoused obsolete oil lamps are retrofitted as camping lanterns to be sold at a fraction of their original market price. But since the guy who acquired them paid pennies on the dollar, he can sell them for cheap… and still make money.

Beware of Being Stranded

It’s not just energy companies – or oil lamps, or taxi medallions, or theaters and restaurants, commercial real estate – that run the risk of holding stranded assets. Disruption and innovation can strand even the most seemingly robust assets…

Cattle. Producing one pound of beef requires 1,800 gallons of water (corn: 108 gallons), 10 pounds of grain, and 108,000 Btu (that’s enough energy to light a 60-watt light bulb for 22 days). Cattle do violence to the environment like spray paint on a 1970s New York City subway car. Today, even your local Burger King offers tasty – and price-competitive – plant-based meat substitutes for beef. How long, under the pressure of the same folks who brought us the Paris Agreement, before the market for cattle (and the land they graze on) starts to disappear?

Gold. What if the world’s oldest store of value is supplanted by cryptocurrencies? Unlikely. But weakness in the price of gold in recent months – despite the biggest infusion of liquidity by central banks (which should be good for the price of gold) – is due at least in part to cryptocurrencies entering the mainstream. Gold miners could be sitting on a lot of worthless shiny metal.

Your professional skills. The history of labor is speckled with examples of once-hot skill sets (building a car, typing a memo, managing a portfolio, depositing a check) rendered obsolete by technological innovation. Artificial intelligence is pushing up the professional ladder, tackling white-collar tasks that until recently were beyond the reach of computers. (Even the world of investment research isn’t untouched… Investment research firm Morningstar recently announced that robots will be writing fund reports.) Best to prepare – maybe via a rebranding like BP’s, only better – if it looks like your skill set is set to become a stranded asset.

Stranded assets are always eventually resolved. The snow on the Denver airport runways will melt… The stranded boat on the ex-Aral Sea will, with time, deteriorate into dust… And energy companies’ fossil fuel assets will be written off.

The key is to not be the person who’s left holding them at the end.

The post Stranded Assets: An Ocean of Oil appeared first on American Consequences.

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Author: <a href="" rel="tag">Kim Iskyan</a>

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