Fossil fuels put on notice – the party is about to end

The Australian and the global fossil fuel industry have been given stark warnings by two heavyweights of the international finance sector that their future will not just be constrained by political decisions to limit emissions, but by the lack of, or the high cost, of finance.

The first warning comes from Deutsche Bank, which says that China’s use of thermal coal is likely to peak within a few years, and by 2017 it could become a net exporter of thermal coal rather than a large importer.  This, says Deutsche Bank, is likely to have a significant impact on coal prices.

The implications for the Australian coal sector, and its massive expansion plans in ports, mines and rail infrastructure in Queensland and NSW – led by the likes of Gina Rinehart and Clive Palmer – is that the long term price of thermal coal will not be sufficient to make these investments profitable. They could, in fact, become the acts of the greatest futility if they go ahead.

The second warning comes from leading credit ratings agency Standard & Poor’s, which in a report released on Monday predicts credit downgrades and negative outlooks in the oil sector because of the potential carbon constraints driven by global climate change policies.

S&P says future carbon constraints need to be factored into credit assessments for the oil sector – along with uncertain future oil prices and rising operational costs – and financial models that rely on past financial performance are no longer adequate.

“By analysing the potential impact of future carbon constraints driven by global climate change policies, our study shows a deterioration in the financial risk profiles for smaller oil companies that could lead to negative outlooks and downgrades,” said Michael Wilkins, head of environmental finance at Standard & Poor’s. He says these downgrades could occur in the next three years.

S&P focuses in particular on three operators of the controversial oil sand mining industry in North America, and questions the business model of investing more capital in tar sands, noting that the companies analysed need to refinance nearly half of their $13.6 billion in corporate bonds in coming years, and may have trouble doing so.

“This research shows that credit ratings need to start looking at alternative futures, as a carbon constrained world will not see past performance of this sector be repeated,” it says.

Ironically, both the S&P and the Deutsche Bank reports came as one of the biggest oil producers in the world, Shell, delivered its own in-depth report that predicted that solar would emerge as the dominant energy provider in the world by the turn of the century.

Shell, which ironically quit the solar business a few years ago – although its Japanese offshoot Showa Shell owns Solar Frontier –  says that solar could provide between 37 per cent and 70 per cent of the world’s energy by 2100.

But even these scenarios are predicated on a world in which politicians and financiers respond poorly to the science and a world that fails to reduce emissions until the 2050s. Independent organizations such as the International Energy Agency suggest that needs to occur by 2020, however, but Shell’s optimistic view appears to be characterised by its reading (or lack of reading) of the science. It confidently predicts that emissions will not fall until the 2050s – when the link between Co2 emissions and changing climate will finally be proven.

Deutsche Bank, on the other hand, says action is quite likely, and much, much earlier. It points to the case of China where the new administration is under huge pressure to reduce air pollution levels, which have soared in the past 12 months to 40 times acceptable levels, and put the government under enormous pressure to take action.

In one scenario painted by the Deutsche Bank team led by chief economist Jun Ma, China’s imports of thermal coal would cease by 2017, nearly a decade earlier than most forecasts, and coal consumption would fall from 68 per cent of total energy consumption to 32 per cent by 2030. Clean energy consumption would grow by 12 per cent annually over 2013-2020. as more incentives were put behind solar, wind, gas and nuclear.

China, the second biggest coal importer in the world after the EU, would become a net exporter, tipping the balance in the global coal market. Deutsche Bank coal analysts say in a separate report that this would blow a hole in the global seaborne coal market and send thermal coal prices towards $70/tonne. Australia would be the hardest hit of any coal exporters because it has the highest marginal cost.

Indeed, Deutsche Bank says that even at $87/tonne, some 43 million tonnes of export production from Australia would be forced offline, and investments in Queensland’s Galilee Basin, such as the massive GVK Alpha coal mine part owned by Gina Rinehart, would be delayed. At such prices, these projects would not be profitable, and could not attract finance. It would also have significant profit impacts on current operations for Anglo American, BHP Billiton and Rio Tinto.

While Shell relies on a future scenario based on past experience, when fossil fuel giants have been able to influence global and individual country policy, the report by S&P, in conjunction with The Carbon Tracker Initiative, says that this view of the world may be no longer valid.

“Global energy use and the resulting emissions may have to change or we will have to adapt to a warmer world; arguably, it’s likely we will need to do both,” S&P notes. “As a consequence, financial models that are based on past performance and creditworthiness may not be relevant in the future.”

Carbon Tracker’s research director James Leaton  said emissions ceilings have clear implications for the future fundamentals of the oil sector, both in demand and price.  “The uncertainty around the future of carbon intensive fuels needs to be translated across credit analysis of business models going forward.”

Simon Redmond, a director in S&P’s oil and gas team, said even in the IEA’s 450pppm scenario, the outlook in the very near term for ratings changes in unlikely to be much different.

“However, as the price declines persist in our stress scenario of weaker oil demand, meaningful pressure could build on ratings,” he says. “First the relatively focused, higher cost producers, and then also more diversified integrated players, as operating cash flows decline, weakening free cash flow and credit measures, and returns on investment become less certain and reserve replacement less robust.”

The S&P report should not be seen is isolation. In January, HSBC said in its “unburnable carbon” report the market value of oil majors such as Shell, BP and Statoil were at risk because they could be forced to leave much of their resources in the ground. This message of risk, and its effect on financing, was taken up by Bloomberg New Energy Finance, whose recent conclusions that wind farms and solar farms were already cheaper than new build coal and gas-fired generation  in Australia were largely based around the rising cost of finance for fossil fuel generators, influenced primarily by carbon risk.

And in the past few weeks, investment banks such as UBS, along with Macquarie Group and Deutsche Bank have all noted how the solar industry is reframing energy markets in Europe, and beyond, and turning once profitable coal and gas fired generators into marginal businesses, and forcing many to close or to embrace a more rapid change to renewables and distributed generation.

Just last week, Duke Energy, the largest utility in the US, said the plunging cost of solar would redefine the traditional utility business. The second biggest, NRG, has already stated that solar will cause a revolution in the energy industry.

And to those miners who believe that India will remain a beacon in the fog, CLP Holdings, the Hong Kong based company that is one of the largest power companies in Asia, said it wouldn’t invest any more money in coal-fired generation in India following the disastrous results of its latest 1,200MW investment, which is losing money from lack of access to coal and poor quality supplies. It will focus entirely, it says, on renewables such as wind and solar from now on in India.