‘Eyes Wide Shut’: Private investors face severe risk as oil and gas nears peak production

This article was published by The Energy Mix on Jan. 30, 2024.

By Mitchell Beer

Private equity investors are facing the transition out of fossil fuels with “eyes wide shut” and exposed to severe financial risk as peak demand for oil, gas, and coal gets closer, concludes a 48-page analyst note released last week by UK-based Carbon Tracker.

“It is increasingly clear that the energy transition is well under way,” and “projections for oil and gas consumption present a bleak prospect for the sector, regardless of what the industry may suggest,” Carbon Tracker writes. The International Energy Agency (IEA) is now projecting peak global demand for all three fossil fuels by the end of this decade, the report notes. And “once demand is irrevocably weakened, commodity prices are likely to fall; over time the market will increasingly reach consensus on the limited prospects for upstream companies, impacting returns.”

When that happens, revenue from new and existing oil and gas projects and the value of the companies themselves “are likely to decline in tandem,” the analyst note says.

Those shifts are likely to make a challenging financial environment for private equity even worse, Carbon Tracker warns. Limited partnerships (LPs) are already moving to less risky investments, like bonds, so that general partners (GPs) see less demand for their services. GPs that hold oil and gas assets are even more vulnerable, since oil and gas investments may be “particularly difficult to exit,” writes report author Maeve O’Connor.

The wider mix of investment risks in oil and gas includes:

• Lower prices and investment returns and higher decommissioning costs for oil and gas producers, along with future climate policy actions by governments;

• Lower returns and company valuations and higher costs of capital for general partners;

• Lower returns, lost access to investment dollars, flawed company valuations, and an inability to dump bad investments for limited partnerships.

“Pursuing a strategy of production expansion is increasingly risky, and GPs who direct portfolio companies to do so could see returns eroded as the transition accelerates,” Carbon Tracker writes. “GPs should consider fast transition scenarios when estimating future cash flows and valuing investments, allowing for the impact of potentially lower commodity prices.” And LPs should recognize that they’re putting their own returns at risk if their investors have any concerns about climate change or the energy transition.

The report looks at the UK’s and Norway’s aging oil and gas wells in the North Sea as a case study of the transition risks investors will face. A review of nine companies in the region that have received private equity investment since the mid-2010s shows that they’ll all lose more than 60 per cent of their available cash flow in even a moderate climate transition. They’ll also face higher costs to shut down operations and clean up behind themselves if production sites are decommissioned sooner than they planned.

Carbon Tracker also warns that 70 per cent of North Sea production in 2022 came from older extraction sites that were in the most carbon-intensive phase of their operations. Larger, international oil and gas companies are now selling those assets off to smaller buyers, meaning that they’re moving “from majors with ambitious climate targets to private equity-backed companies with significantly less ambitious targets for both operational and end use emissions.”