The debate gets thorny on reserves and emissions

The 92220 Evening Star was the last steam locomotive built by British Rail, back in 1960. It was retired five years later, as diesel and electrification consigned the age of steam to history.

Building an engine and using it for only five years is a great way to waste investment. Which is why there’s a raging debate in the fossil-fuels business about stranded assets — the oil, gas and coal left in the ground. Given Earth’s diminishing capacity to absorb greenhouse gases without potentially catastrophic effects, there is an implied cap on how much more oil, gas and coal can be used. And, as with the Evening Star, rival ways to power transportation threaten to overturn the internal combustion engine’s dominance.

So producers increasingly face questions about whether some of their oil and gas reserves will ever actually be produced — with obvious implications for their stocks.

Royal Dutch Shell released a report late last week designed to address such concerns. The company estimates that 80 percent of its proved oil and gas reserves will be produced by the end of 2030. Given that’s only 12 years away, the thinking goes, the bulk of the value in Shell’s production business looks pretty safe even if energy begins to transition from fossil fuels through the 2020s.

Of all the majors, Shell just naturally has a more robust argument on proved reserves not getting stranded; hard to strand what you don’t have. That said, the company also says threequarters of its proved-plusprobable reserves — a more ambiguous gauge of what’s underground — should be produced by 2030. This points us toward a thornier aspect of the debate.

Probable reserves, undeveloped reserves and resources are all other components of an oil major’s valuation. Their value rests on investment to bring them to the surface and onto markets. Over the past decade, the big five Western majors generated $1.5 trillion of cash flow from operations. But four out of every five of those dollars were plowed back into the business.

That’s why Shell’s 80 percent figure is useful but doesn’t capture the full risk profile. It would have much greater significance if oil majors were simply run as sunset businesses, with most of their cash flow distributed to investors.

As it is, they are very much going concerns with large capital expenditure budgets that will add to proved reserves year after year. So, even if 80 percent of Shell’s proved reserves at the end of 2017 are apparently safe for the next 12 years, what proportion will be when we get to, say, 2022? This isn’t a question to be considered in terms of whether oil demand keeps growing or is about to fall off a cliff. Valuations ultimately rest on returns, not quantities of oil and gas.

The amount of oil and gas on the books today is only part of the equation for value. What matters more is how much profit can be squeezed out and what the majors do with that money.

Valuations ultimately rest on returns, not quantities of oil and gas.