The ESG Risk Atlas

Jun. 03 2019 — To calibrate the relative ranking of sectors, we use our environmental, social, and governance (ESG) Risk Atlas (see "The ESG Risk Atlas: Sector And Regional Rationales And Scores," published May 13, 2019). The Risk Atlas provides a relative ranking of industries in terms of exposure to environmental and social risks (and opportunities). The sector risk atlas charts (shown below) combine each sector's exposure to environmental and social risks, scoring it on a scale of 1 to 6. A score closer to 1 represents a relatively low exposure, while 6 indicates a high sectorwide exposure to environmental and social risk factors (for details see the Appendix). This report card expands further on the Risk Atlas sector analysis by focusing on the credit-specific impacts, which in turn forms the basis for analyzing the exposures and opportunities of individual companies in the sector.

Exploration And Production

Environmental exposure (Risk Atlas: 6)

We divide environment risks in the oil and gas sector into two types, as noted in our Key Credit Factors criteria for the industry. The first type of risk stems from inherent material exposure to greenhouse gas emissions. The second type concerns lower probability but potentially high impact risks on individual companies from pollution because of well head and transport spills and leaks, and increasingly water use and contamination risks. The most significant risk is the pace of the energy transition away from carbon-based fuels; this could result in stronger deviations from the industry demand forecasts outlined below. It is likely to be strongly influenced by long-term government policies for renewable energy as well as the pace of electric vehicle penetration growth. "Risk of secular change and substitution by products, services, and technologies" is clearly articulated as a risk in the Key Credit Factors criteria for oil and gas in the industry risk assessment section.

The combustion of carbon-based fuels, specifically oil-derived products and natural gas, results in carbon dioxide. Natural gas, largely methane, is another greenhouse gas itself (when released) and has 25 times the impact of carbon dioxide. Production activities can also be a direct source of greenhouse gases, through methane leaks, gas flaring or extraction methods.

Oil production (and prices) are more exposed over the longer term. According to many market projections, we are likely over the next two decades to reach a point known as peak oil, in which aggregate demand for oil will peak and then start to decline. However, demand will likely continue to increase significantly before that happens. This change would also affect demand for oil field services, result in stranded reserves, and likely weigh on prices, depending on the extent and timing of supply corrections, including the typical onshore conventional oil field decline rate of 4%-6% per annum. These demand factors could therefore impact ratings over the long term. These risks could also impact the sector through limits on funding availability. Funding constraints for banks and other investors are presently more common for coal producers, but may well increasingly affect other fossil fuel producers and the sector as a whole.

Also, the risk of pollution is material for companies producing and transporting hydrocarbons and may result in material financial and reputational damage. While infrequent and unpredictable, the occurrence of disasters with the magnitude of the Deepwater Horizon oil spill in the Macondo Prospect, can severely impact issuer credit quality due to the significant liabilities incurred from environmental remediation, government fines, and lawsuits from industries and consumers affected by the occurrence. Such liabilities totalled more than $60 billion in the case of Macondo. Oil tanker spills, even if vessels may not be operated by an oil company itself, equally can be a source of material litigation. Finally, the increased frequency of extreme weather events (such as hurricanes) have increased operational risk.

The environmental impact of plastic waste is another topic of consumer focus. Such plastics are largely derived from petrochemicals, which altogether account for about 14% of crude oil demand. Nonetheless, to the extent that plastics are used in construction, their carbon content is effectively sequestered. Water use and the risk of contamination of land and aquifers is particularly relevant for shale oil and gas producers, as a result of hydraulic fracturing activities. Many countries have stringent development, operating, and decommissioning requirements and potential penalties for companies that extract hydrocarbons. Moreover, many exploration and production companies, such as those operating in the Gulf of Mexico and North Sea, incur meaningful asset retirement obligations that we include as debt in our credit ratios.

Although a fossil fuel, we consider natural gas to be somewhat less exposed to environmental risk. This is because, when burnt for power generation, gas is significantly less polluting than coal. Hence, gas is seen as a vital bridge fuel in the energy transition to systemic decarbonization, which should support demand over the next two decades, even under a two degrees warming scenario. Comparing between gas producers and value chains, we note the higher total emissions arising from the liquefaction and delivery of liquefied natural gas (LNG) versus piped gas.

Social exposure (Risk Atlas: 5)

The key social risks in the oil and gas sector are based on its exposure to safety management, social cohesion, and ultimately consumer behaviour risks, which may lead to substitution of products. Our Key Credit Factors criteria for oil and gas also flags these factors that can influence producers' profitability, as well as substitution risks ultimately driven by consumer choices. Safety management is a key risk given drilling activities and sometimes harsh environmental conditions, especially offshore. Companies in the sector typically track and manage to incidents and have specific programs in place to educate workforces. The costs to ensure adequate safety and compliance with local regulations can be material, for example, in instances where crew time offshore is limited.

Social cohesion is another key risk, specifically in terms of licenses to operate, given land use and disruptions that drilling and production sites can typically create for local communities. Access to market can also be contentious, as shown by the Trans Mountain and Keystone XL pipelines in North America. Relationships to communities and governments are important in that a lack of shared benefits to them could create opposition. This can delay or raise costs for companies' reserve developments or even render them unviable, constraining growth and returns on capital. Our competitive position assessments capture both these qualitative aspects in competitive advantage and quantitative measures such as cash costs and full-cycle costs in operating efficiency.

Long-term consumer behaviour is likely to be increasingly influential in the energy transition away from carbon fuels and in reduced use of disposable plastics or those which are uneconomical to recycle. Low carbon transport is exemplified by the adoption of electric cars, albeit this is unlikely to have a material impact on oil demand in the next decade. Current long-term industry projections nevertheless still show fossil based fuels to account for the lion share (75% of more) of global primary energy demand in 2035 (potentially 30% for oil and 25% for gas), but substitution risk is real and could become more material in our view, depending on future government policies and competitiveness of batteries and renewable energy. Ultimately, the sustainability of oil and gas companies' business models depends on factors including the balance of supply and demand for oil and gas, and the all-in costs and funding to continue producing and delivering it to users.

Governance

While governance is best measured at the company level, we see the oil and gas exploration and production sector as having above-average exposure. This results from the strong compliance and oversight needed because of the sensitivities around bidding for and corruption relating to natural resources, particularly in emerging markets. Government ownership can exacerbate the sector's lack of transparency. Furthermore, the high severity of safety incidents also means board oversight and understanding of risk management and company culture have high importance.