An increasingly carbon-constrained world could pose formidable challenges for the global oil sector, according to a report by Standard & Poor’s Ratings Services and Carbon Tracker Initiative.

The report, “What A Carbon-Constrained Future Could Mean For Oil Companies' Creditworthiness”, indicates that amidst an environment of existing challenges in the oil sector – including evolving government climate-related policies, uncertain future oil prices and rising operational costs – it is even more vital that investors consider the potential implications of future carbon constraints.

“Financial models that only rely on past performance and creditworthiness are an insufficient guide for investors,” says Michael Wilkins, head of environmental finance at Standard & Poor’s.  “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.  However, the effect on the majors would be more muted.”

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

The joint study selected three Canadian companies that focused on unconventional oil production – Canadian Oil Sands Ltd. (COSL), Canadian Natural Resources Ltd. (CNRL), and Cenovus Energy – as well as two international majors or integrated companies, BP and Royal Dutch Shell.

To assess the potential impact effect of climate policies consistent with the IEA's 450 ppm scenario, the research incorporated a lower demand outlook for oil products in the individual company forecasts through a resultant drop in oil prices. It then considered the rating implications of a stress scenario on the companies’ ratings today and over the next three to five years. The modelling was undertaken on the basis of S&P’s 2012 price deck assumptions with a continued decline to a lower long-term Brent crude floor price of USD65 per bbl by 2017.

Simon Redmond, a director in S&P’s oil and gas team, says: “Rating or outlook changes seem unlikely in the very near term, as the scenario is not materially different from the current price deck assumptions. However, as the price declines persist in our stress scenario of weaker oil demand, meaningful pressure could build on ratings. 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.”

Vicki Bakhshi, associate director, F&C Investments, says: “This report clearly demonstrates the value of integrating environmental, social and governance (ESG) issues into credit analysis. At F&C we believe that factors such as climate change and environmental regulation can impact on the performance of the companies we invest in. S&P’s report is very welcome in helping us to identify where the risks lie within the global oil sector, and ensuring that they are integrated into our investment analysis.”