ARO WatchTracking the Trillion Dollar Retirement of Oil
The end of oil...
Analysis of the evidence reveals clear indications that the oil industry is in decline. Rapid cost reduction in renewable energy and battery storage, rising global ambition to combat the climate crisis, technological innovation, increasing energy efficiency, declining availability of low-cost hydrocarbon reserves, demand stagnation, global economic slowdown—the list of factors weighing on the fossil fuel industry goes on, and the weight is starting to show.
For ten years, the oil and gas industry has been declining as a share of the major market indexes even as domestic oil production has skyrocketed. The sector with the largest production growth—fracking—has been losing money by the billions, and the rosy picture on future development in the shale basins has lost credibility due to steep decline curves, problems with well spacing, and limited sweet spot acreage, among other issues.
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...Not the End of the World
Hydrocarbons built the world we know. Hydrocarbon energy has driven two centuries of global economic expansion. The exploitation of hydrocarbons propelled the United States on its rise to becoming the wealthiest nation on Earth, and our government has dearly coveted access to the 'master resource'.
We have fought wars over hydrocarbons. We have poisoned water and fouled the air in thousands of communities. We have scraped mountains off the face of the earth, drilled millions of holes in the ground, laid a length of pipeline that could reach the moon ten times, and we have fundamentally altered the chemistry of the atmosphere, increasing the amount of heat from the sun that gets trapped close to the Earth's surface.
Economic prospects for the oil and gas industry are bleak. But prospects for the rest of us don't have to be. It's time we start talking about retirement.
Asset Retirement 101
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What is an Asset Retirement Obligation?
Simply put, Asset Retirement is the process of resetting the landscape for new uses once extraction has ceased, and it refers to the decommissioning of long-lived physical assets—e.g. wells, pipelines, tanks, compressors, essentially any fixed equipment or facilities—at the end of their useful lives. Oil and gas companies are legally required to decommission out-of-use assets and return the land or sea to its condition prior to disturbance. Each time a company installs a well, platform, or pipeline, an Asset Retirement Obligation (ARO) is created. Financial reporting rules require that publicly traded companies track and report estimated future ARO costs as additions to corporate debt. AROs account for as much as 50% of reported debt in the oil and gas industry, yet you have probably never heard of them.
Below the Radar
Critical aspects of the ARO problem are shrouded behind opaque financial statements. Neither the full expected cost of industry cleanup, nor the timing of when and for how long the industry will be paying those costs can be determined by evaluating SEC filings. AROs are not strictly financial debts; they are duties to perform the decommissioning and remediation services required by law, and they ultimately cost whatever it takes to fulfill the requirements at the time the asset is decommissioned. These obligations are not priced and traded in the market like virtually every other type of debt, and they have no predetermined date of maturity. As such, there is no set or negotiated price, nor does the obligation correspond to an asset on a lender's balance sheet. Only one entity is responsible for pricing and tracking the obligation—the reporting company itself.
This bears repeating. AROs are the largest single type of debt in the oil and gas industry, and the pricing of these obligations—which is based on estimates and assumptions such as future oil prices and recoverable reserve volumes—is managed internally and without a market to challenge reported values.
In the absence of a strong regulatory presence ensuring accurate accounting and timely asset retirement, there is a clear incentive for companies to minimize AROs and defer decommissioning costs. As it happens, accounting standards leave room for significant manipulation of reported AROs, and regulators have historically been very accommodating to companies seeking to defer asset retirement.
Asset retirement has not been a critical issue for the last century of industry expansion. If a business is growing, producing billions of dollars in revenues, and regularly distributing large dividends, no one will notice an obscure obligation that isn't expected to come due for decades.
But the world energy system is changing, and the horizon for industry retirement may be approaching faster than most realize. Investors clearly have an interest in learning about the emerging threat of AROs, in particular that the fair value of AROs is likely much higher than reported, and regulators have extraordinary power to secure funds to cover legal decommissioning obligations, even over the interests of secured creditors.
In fact, bankruptcy recovery for creditors may be very low or zero in cases where the value of AROs exceeds the value of a company's assets. This scenario becomes ever more probable as the energy transition progresses and high-cost reserves become uneconomic to produce.
Photo by Geoffrey Whiteway from Stockvault
Even in light of the extraordinary powers of recovery vested in states, state regulators are inadequately protecting the public from shouldering abandonment costs. Security requirements are far too low to cover decommissioning, and as the industry approaches terminal decline, time is slipping away to ensure money is available to clean up the mess.
Critically, ARO risk knows no boundaries because AROs are not strictly financial matters–they represent physical disturbances to the landscape that carry potentially severe risks to public health and the environment. But neither are they purely environmental, because in bankruptcy they constitute massive costs that may take precedence over the interests of even the highest-priority creditors. So long as oil and gas companies continue to invest in developing costly new reserves that cannot be burned if the world is to prevent catastrophic warming, the risk rises that AROs will come due just as their associated assets are being written down.
Stranded assets beget stranded liabilities.
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Death by a Million Wells
There are around 1.2 million active wells in the United States. It is unknown how many more inactive and abandoned wells exist, though estimates indicate a similar figure of around 1.2 million, many of which are leaking and need to be replugged. It is difficult to comprehend the reality behind these numbers, so it may help to explore the Midland-Odessa region from the sky. This area is in the heart of the Permian Basin, a field once thought to be in decline until hydraulic fracturing opened up massive new shale reserves.
In the map below, wells are easily visible as pale pockmarks on the tan backdrop of the desert southwest. The Permian covers a large area of west Texas and southeast New Mexico, and drilling there continues at pace. According to the Texas Railroad Commission, the oil and gas regulatory authority in the state, over 187,000 wells have been completed in the Texas Permian to date, with around 10,000 more drilling permits approved. A satellite tour of the region gives a sense of the scale at which this industry has changed the landscape. Consider while you scan what it will take to restore this land to how it was prior to oil exploration.
There is no easy way to determine what the full cost to settle the oil industry's environmental debts will be. Each field has unique characteristics, and reclamation involves dozens of site-specific considerations. However, costs in various fields have emerged indicating that full decommissioning and remediation may average over $100,000 per well. A conservative average cost of $50,000 per well equates to $60 billion in AROs, leaving aside the enormous cost to decommission a million miles of pipelines, restore thousands of square miles of disturbed land, and continually monitor and replug millions of wells as the cement wears out, roughly every 20-30 years.
The US oil and gas industry faces potentially hundreds of billions of dollars in asset retirement expenses that will come due after underlying assets are no longer producing revenue, and for which there is no money held in reserve.
If the global energy system is transitioning away from fossil fuels, and oil companies are spending their current revenues looking for more oil, drilling more wells, and creating more AROs, how do they intend to pay for retirement?
Photo by Victoria Alberty-deGoede from Pixabay