BP in the Gulf and Beyond: The Changing Risk Profile of Unconventional Oil & Gas Development
July 22, 2010 3:00 PM
As BP gets closer, hopefully, to permanently containing the spill at the Macondo well in the Gulf of Mexico, the disaster has raised questions about BP’s future, that of its sector peers, and the prospects for further unconventional oil and gas production.
The Integrated Oil & Gas team of RiskMetrics ESG Analytics, part of MSCI, has considered these issues as part of our recently published annual company and industry reports. (We will present this research in a webcast on September 15th- click here in September to register). This article sums up our perspective on four key questions:
1) How much does the Gulf disaster really tell us about the future risk of holding BP?
2) How will this event affect the oil & gas industry going forward?
3) Which BP peers are positioned to better manage their health & safety performance, given the increased risk profile of unconventional oil & gas projects?
4) How might this extraordinary ESG precedent affect sustainable investment strategies?
How much does the Gulf disaster really tell us about the future risk of holding BP?
The Gulf disaster is, of course, unprecedented. Still, to establish a fair judgment of BP’s overall environmental, social and governance (ESG) risk, we must consider BP’s operational health and safety (H&S) performance in the context of its overall ESG performance. In our annual research review in July, we downgraded BP’s overall Intangible Value Assessment (IVA) ranking. It should be noted that BP’s H&S record was already problematic before 2010, and the firm was removed from KLD sustainability indices in 2007-2008, as has been reported by the Wall Street Journal.
In describing BP in our July IVA analysis of the integrated oil & gas sector, we stated:
We reiterate our stance outlined last year that, along with the [Canadian] oil sands projects, H&S remains one of BP’s weakest ESG areas. While BP’s statistical performance on major H&S indicators and the risk management systems design are better than peer average, BP’s poor historical track record of hydrocarbon spills, safety violations, and its cost-cutting drive on the safety budget make it a vulnerable operator. Despite this [H&S] setback, BP remains an attractive business from the perspective of carbon emissions risk management and has a sector-best alternative energy portfolio. BP’s access to resources in the petroleum-exporting countries remains constrained, and the overall solid risk management strategy for emerging markets needs to be strengthened in Russia. The company’s strong ESG capabilities for managing risks associated with the Canadian oil sands JV with Husky Energy will help hedge its exposure to unconventional resources in the developed market. ... [Emphasis added.]
We are often asked how we’ve integrated the collapse of the offshore Deepwater Horizon platform into H&S analysis. To explain this, it may be helpful to distinguish between our assessment of the disaster’s impact on environment and people, and its materiality for BP’s future financial performance.
From a traditional socially responsible investment (SRI) perspective, the magnitude of the accident makes BP an unattractive investment. But to put the firm in perspective, we must ask what this event really tells us about BP’s risk management, compared to that of its sector peers. In any complex system where lives are at risk, we must invoke the “zero tolerance” principle. An accident with one fatality is no “better” than an accident with 11 fatalities, because one fatality is one too many – any preventable workplace death is a fundamental failure of the system.
The Macondo disaster obviously reveals serious problems at BP, but the accident doesn’t prove that its sector peers are necessarily doing everything right. Therefore, we cannot assume that BP’s management system is worse than that of other companies, based solely on the magnitude of the spill. We must consider other metrics as well, as the ESG Analytics team does for all researched firms.
All that said, the scale of the spill will certainly impose immediate costs on BP. Beyond related fines and penalties, damage to the firm’s reputation with partners, investors, regulators and other stakeholders has a real impact on the bottom line. Because we believe that this damage will be financially material, we’ve downgraded BP within the IVA framework.
The event in the Gulf will force BP to review its enterprise risk assessment and the adequacy of its risk management controls. This should ultimately lead to better management of the conflict of interest between production and safety. This conflict is the primary challenge of the H&S function, which is perceived to be a cost center within the corporate framework of meeting production targets. A crucial aspect of risk management is workers’ willingness to report/take action about a potential incident, and the managerial mechanisms in place to encourage proactive behavior. BP must rebuild trust between workers, management, regulators and the public. This is an essential component of sustainable, efficiently-run companies.
How will this event affect the oil & gas industry going forward?
We believe that the Gulf disaster has highlighted three factors that will influence the evolution of the industry:
1) Projected post-Gulf increases in health & safety spending will put pressure on margins for unconventional oil & gas exploration, which is associated with a riskier environmental, health & safety profile. In the wake of the Gulf spill, regulators will probably push for companies in this space to invest more in health & safety. This investment will put pressure on producers’ margins, increasing recovery costs that currently sit at an average break-even range of USD 40-50/bbl with an 8-9% internal rate of return (IRR). Public disclosure of H&S investments is rare; in our analytical set of 25 integrated oil & gas companies it is available only from five firms – ENI, Gazprom, Petrobras, Rosneft and Total. We encourage investors to monitor other companies’ safety budgets in order to assess the companies’ potential improvements/deterioration of H&S culture and its impact on financial performance.
2) We anticipate potential long-term constraints on offshore drilling, or moratoriums on additional development. Our analysis of US offshore proved reserves, production, and the US overall oil consumption rate indicates that offshore drilling is not a good long-term bet from a US energy independence perspective. At present, the short-term production metrics look attractive, as current production from offshore (1.5 mm bbls/d) is a significant portion (30%) of the US total production of 5 mm bbls/d.
However, the long-term outlook is less optimistic. If the US were to supply its oil consumption needs from offshore resources alone, they would only last six months. As the US weighs this limited contribution to energy independence on one side of the scale, and the environmental and safety implications on the other, US commitment to offshore drilling will be shaky, unless the industry can employ technology and capital to properly hedge its associated environmental and H&S risks.
3) We project that having considered the externalities of possible offshore incidents, governments may choose to more aggressively pursue non-petroleum energy sources. Perhaps the easiest step in this direction would be an absolute reduction in petroleum demand. Great efficiencies have already been achieved in the EU. The US is pursuing some initiatives through a combination of green-focused economic stimulus projects, tightening of fuel standards, and efficient building standards. In fact, according to the Natural Resources Defense Council, a US environmental think-tank, if all existing energy-saving technologies were fully utilized, the US could reduce its oil use by 10 million bbls/d, which is roughly half of the nation’s oil consumption.
Even in the absence of targeted regulatory reforms to achieve reduction in petroleum use, we believe that market forces and increasing volatility in the oil markets could drive US oil consumption lower. In fact, four out of five of the latest global recessions (except for the Asian one in 1998) were triggered by spikes in energy costs, which the world’s economies were incapable of digesting. In the US, recessions have occurred when energy costs reach 4% of gross domestic product, or upon a rapid price spike of 50% year over year. Before the current recession, we observed a historically high price ceiling of USD147/bbl, beyond which economic contraction led to a subsequent collapse in oil prices. Businesses throughout the economy can be expected to reduce petroleum use to lessen the impact of such price swings on the bottom line.
Finally, a high oil price environment will stimulate another important petroleum demand-reducing measure, as it will be a major catalyst for clean-tech investment in the US.
Which BP peers are positioned to better manage their health & safety performance, given the increased risk profile of unconventional oil & gas projects?
As part of our H&S assessment, we have reviewed the Integrated Oil & Gas companies’ regulatory filings to identify current and prospective areas of offshore operations in the Gulf of Mexico, as well as offshore shallow and deepwater developments in other jurisdictions.
We place greater emphasis, and hence greater weight, on actual performance than on H&S policies. It is difficult to judge internal conflicts and soundness of managerial structures from information in corporate sustainability reports. However, it is possible to identify trends by looking at a company’s historical performance and its track record of operational integrity. In the absence of leading indicators, such as pre-accidents and pre-incidents – i.e., fatalities and spills that were prevented or avoided - we rely on the company’s historical performance on such indicators as its track record of industrial incidents, number and volume of hydrocarbon spills, and trends in such H&S statistics as fatalities, TRIR (total recordable injury rates) and LTIR (lost time injury rate).
Our assessment of the companies’ regulatory risk of offshore operations, risk management structures, and historical performance shows that the following companies are in the top quartile of the 25-company peer group regarding Health & Safety: Imperial Oil, Origin Energy, BG Group, OMV, Statoil and ConocoPhillips. Note that these companies may not all be overall ESG leaders, as performance on other IVA metrics will vary.
How might this extraordinary ESG precedent affect sustainable investment strategies overall?
This extraordinary event in the oil & gas industry, which may cost BP over USD 20 billion in direct costs and an unknown amount in reputational damage, has implications not only for the families of the victims, local communities, the environment, BP and competitors, but also for society in general, including investors.
As we define shareholder return in the context of a stakeholder society, environmental & social externalities are eventually priced into investment returns. Therefore, long term-oriented investors are learning to factor the effects of environmental and social externalities into their decision-making processes. Hence, the Gulf of Mexico spill could lead to significant changes in the mainstream financial community - perhaps even more than among socially responsible investors, who already account for ESG externalities.
We continue to believe that proper integration of ESG into the investment decision-making process lies in the analysis of inherent sustainability risks, and in evaluating how companies manage those risks. As with our recent analysis of BP and its competitors, we believe that this is best done through a review of actual performance across a broad spectrum of indicators, not just companies’ stated ESG policies.