The Vulnerability of Oil Companies’ Reserves and Market Valuation
Julien Daubanes (Technical University of Denmark (DTU Management) and MIT (Center for Energy and Environmental Policy Research))
Climate action will make the production of carbon resources less profitable, reducing economically exploitable oil reserves and their value, with implications for the climate, the oil industry, and its investors. In this paper, we measure the sensitivity of economic oil reserves and study the role of this sensitivity in market valuation of oil companies.
Conventional financial analysis already estimates oil companies’ exposure to oil price movements, among other factors. Yet we claim that its standard model focuses on the impact of oil prices at the intensive margin and ignores changes in economic reserves.
First, we present a theoretical decomposition of the effects of an output price on firm’s value through the intensive and extensive margins, which we use to extend the conventional analysis of how oil price movements affect oil companies. We obtain a new testable model relating oil companies’ expected stock returns to oil price changes that features the elasticity of economic oil reserves. We validate this model by exploiting financial data. The model improves the prediction of expected stock returns. Its estimation, however, does not identify the elasticity of economic reserves.
Second, we measure the elasticity of economic reserves to the oil price by exploiting oil reserve data. We obtain time-varying elasticities of oil companies’ economic reserves, a new metric that we call EER.
Third, we use these EER estimates to explain oil companies’ stock returns.
Our results indicate an EER-premium, showing that the risk associated with more sensitive economic reserves is material to investors who demand compensation from oil companies for the possibility of stranded assets.
Besides our methodological contribution, and our results’ addition to the literature on transition risks, we provide new EER measures that have desirable statistical properties for the study of oil companies’ financial vulnerability and behavior.