Why Exxon Mobil Corporation (XOM) Could Be Entering an Endless Pit

Exxon Mobil Corporation’s (NYSE:XOM) biggest assets are the billions of barrels of oil it has in the ground, waiting to be extracted. That’s what has had many XOM stock holders interested in the company for so many years. Of course, not all oil reserves are equal; oil in Saudi Arabia costs very little to pump, while extracting oil from shale and oil sands only makes sense when oil prices are relatively high.

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U.S. Securities and Exchange Commission rules state that Exxon can only put the oil and gas reserves, which it can profitably recover on its balance sheet.

Whenever prices fall, XOM will have to write off oil reserves that it can no longer extract at a profit, even though it still owns the oil and could extract it if prices rose. The company must leave it in the ground, and the oil becomes a “stranded asset”.

This isn’t a new concern; the Secretary-General of the Organization for Economic Cooperation and Development (OECD) highlighted the risk of stranded assets in the oil industry in 2013, and Mark Carney, governor of the Bank of England, did so in 2015.

And XOM stock suffered the consequences in February. Low oil prices made extraction of oil from Exxon’s Canadian oil sands projects unprofitable. Under SEC pressure, the company wrote down its reserves by 14% — it had spent $20 billion developing these reserves, money that may be down the drain now.

Could this happen to Exxon stock again? And if so, what could force the company to leave more oil in the ground?

For one thing, further downward pressure on global oil prices could lead to more write-offs. But even if oil prices do not fall much lower, XOM’s fossil fuel reserves face the threat of regulatory action against climate change, making it more difficult for it to produce oil.

Let’s examine these two threats to Exxon stock.

Two Threats to XOM Stock

If renewable energy and electric cars replace fossil fuels, oil may end up being left in the ground, harming oil companies like Exxon.

I discussed Tesla Inc’s (NASDAQ:TSLA) three-pronged attack on the fossil fuel economy in February.

Tesla is doing several things that threaten XOM stock. It’s developing electric cars that use rechargeable batteries instead of burning gasoline. With its “gigafactories”, Tesla is lowering the costs of batteries, which could incentivize people to install more solar panels and wind turbines, which need a place to store excess power. And Tesla plans to install “solar roofs” in the fourth quarter this year.

Fitch Ratings sounded the alarms in October 2016, warning of the threat electric cars posed to oil companies. Fitch warned of a “death spiral” as investors sell both debt and stocks from oil companies, resulting in a higher cost of capital for the industry.

Are electric cars a threat to oil companies and stocks like XOM stock? Cuneyt Kazokoglu, the head of oil demand at FGE, an energy consultancy, doesn’t think so.

First, electric cars depend heavily on government subsidies and incentives. When these are withdrawn, demand for electric cars collapses. Second, battery technology may be improving, but it has a long way to go before it even comes close to oil in terms of energy density.

Third, while the production of electric vehicles is increasing, they still make up a small share of new car sales. Fourth, even if concern over “peak oil demand” or “peak car” in the West proves justified, the demand for vehicles is projected to grow rapidly in Asia, and many of these will probably run on oil.  

The second risk will materialize and threaten oil companies like Exxon, even if energy prices start rising. If concern over climate change continues, governments might take further action to limit carbon dioxide emissions. This would mean that only a fraction of oil reserves could be pumped.

Researchers estimated a carbon budget at 565 gigatons of carbon dioxide to 2050, while known fossil fuel reserves make up 2,795 gigatons, making 80% of these “unburnable”.

Oil companies like XOM could get around this by storing the carbon dioxide (a process known as carbon capture and sequestration), but progress remains slow.

Institutional investors are concerned about oil companies. Last month, Blackrock, an asset manager with trillions of dollars under management, threatened to vote directors who ignored these risks off the boards of companies that BlackRock owns shares in.

Some doubt that governments will take action to limit global carbon dioxide emissions, since developing countries like China and India need cheap sources of energy, and renewable energy still has a long way to go before it can meet these needs. And now President Trump is rolling back emissions cuts.

But Trump’s position on climate change may be unique among world leaders, as the Sierra Club, an environmental group, claimed. And Trump is very unpredictable; talk of a carbon tax recently surfaced, although the White House later denied it.

BP plc (ADR) (NYSE:BP) warned in January that if oil companies think fossil fuels will be phased out, either because of new sources of energy or because of government regulations, they will pump as much as they can, causing a collapse in oil prices.

This could trigger a “race to the bottom” in oil prices, they’d have the incentive to get out as much as they could profitably extract. This is bad news for oil companies heavily invested in expensive oil projects that require a high price of oil to break even, such as oil sands and Arctic oil. Most of the oil wells where oil can be extracted at a very low cost are in the Middle East.

Bottom Line on XOM Stock

What does this all mean for oil companies like Exxon? How serious are these concerns?

Some dismiss concerns of a “carbon bubble”, as IHS did in 2015. IHS argued that oil company valuations are based on proved reserves, and 90% of these will be used in the short- to medium-term. And a 2016 study found that stranded asset risk is already baked into oil company valuations.

It’s very difficult to predict who will be right, as there are a lot of wild cards that will impact the oil industry and XOM stock. What will the demand for energy look like in ten years? How fast will progress in developing sources of renewable energy go? Will governments cut back on carbon dioxide emissions and continue supporting renewable energy? Could carbon capture and sequestration come to the rescue of fossil fuels?

XOM executives will have to think about these questions and more. The further in the future this happens, the less the impact on Exxon stock today. But long-term investors should think about this too. 

As of writing, Lucas Hahn did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media, https://investorplace.com/2017/04/exxon-mobil-corporation-xom-endless-pit/.

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