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May 21, 2015

No, the HSBC report doesn’t advocate for divestment. But it’s still pretty interesting

A recent “private note” to clients prepared by a team of Hong Kong-based “climate change strategists” from international financial services firm HSBC is being held up by divestment proponents as proof that the bank is “hopping on the divestment train,” with news of the announcement being seized on by Time Magazine, various activist blogs and (we realize this is redundant) the U.K. Guardian.

Of course, HSBC is a really big bank – currently the world’s third-largest, by assets – and employs more than 265,000 people worldwide. It also invests billions annually in global oil-and-gas related projects, and supports an entire research division devoted to studying and taking advantage of market trends in the oil and gas sector. All of which is to say: if HSBC really was advocating for fossil-fuel divestment, one suspects that’d come as a bit of a surprise to the likely hundreds of professionals at the firm who specialize in fossil-fuel investing – and the thousands of clients who rely on HSBC research and expertise to guide their investments in oil and gas projects.

Luckily for those hardworking men and women, though, even a cursory examination of the HSBC note indicates pretty clearly that the bank itself isn’t making any grand institutional announcements with respect to its position on divestment. And, actually, it isn’t really saying that its clients should go ahead and divest either.

Let’s take a look at some of the statements that appear in the report itself. You be the judge:

  • “Divesting fossil fuel stocks removes assets but dividend yields may suffer and portfolios become more concentrated.” (page 24)
  • “Fossil fuel divestment is a less straightforward decision, ethically, than historical decisions to divest from other sectors or countries, in our view. This is due to the systemic place which fossil fuels have in the energy mix and, by extension, in our lives.” (page 21)
  • “[T]o boycott all products derived from fossil fuels is extremely difficult. Coal, oil and gas are used for 75.6% of global power generation. Oil meets 95% of transport fuel requirements. Fertilisers, petrochemicals, construction materials are all highly dependent on fossil fuels, as are domestic heating and cooking.” (page 21)
  • “Remaining invested in fossil fuels retains an investor’s position as a stakeholder and therefor able to contribute to governance of the company – a seat at the table alongside civil society, regulators and employees.” (page 21)

So, no: the paper doesn’t actually recommend that investors dump their holdings in companies that produce fossil-related energy. But it does outline a few of the issues that the HSBC researchers believe might be important to folks who are considering the question.

Among those questions and considerations: what the global price market for commodities like oil, gas and coal is expected to be in the coming years; whether the emergence of new technologies might make fossil-related energy obsolete, or significantly cut into its market share; whether world governments may eventually get together to institute some sort of pan-universe carbon restriction regime; and whether these and other trends might conspire to render significant portions of companies’ fossil-fuel reserves “stranded” – adversely impacting firms whose valuations are tied to the production and sale of those assets.

For their part, the climate change researchers at HSBC believe all of these threats to fossil-related energy are real – if they didn’t, they wouldn’t have written the paper. But what’s interesting about the analysis is that it attempts to argue the point from a completely different angle than the one deployed most frequently by backers of the “stranded assets” proposition.

Here’s what the stranded-assets crowd believes, in brief. Oil and gas is a bad investment because 1) the implementation of restrictive global carbon policies is right around the corner (NB: don’t mention this to China) which promises to 2) prevent companies from producing their oil and gas reserves, 3) raising the price for those commodities so high that 4) consumers won’t even be able to afford a gallon of gas anymore, which eventually 5) will make renewable technologies much more cost-competitive, leading to 6) the end of the oil and gas industry as we know it. That, in a nutshell, is your standard, cocktail-party approved stranded-assets argument.

In contrast, the HSBC researchers believe that energy assets may find themselves “stranded” in the future not based on their price becoming too high, but based on the idea that the application of innovative technologies in the oil and gas space may end up flooding the market with more hydrocarbons than the demand dynamic can support, pushing the price for those commodities down, and adversely impacting the valuation of firms that produce and market those resources (stop us if this sounds familiar). Based on this analysis, then, the assets end up getting stranded not because some government somewhere decrees that they must be “kept in the ground,” but because the underlying price for the commodity is simply too low to justify its production.

In other words, according to HSBC: the oil and gas industry will continue to get better at what it does, applying innovative, cutting-edge technology to produce greater volumes of energy than was previously thought possible. And for its trouble, it should expect complete annihilation – because, thanks to this new supply, commodity prices will never rebound.

Of course, not everyone is a bear when it comes to future oil prices. Take this analysis, for instance. It was produced by a major international banking and research firm. According to its experts, oil prices will surge past $90 a barrel by the end of 2015; it’s among the most bullish predictions you’ll find right now. And for whom does this crack research team work? HSBC!

Anyway, just take a look at this section of the note to see what we mean. Here, the HSBC climate team outlines all of the “energy innovations” that may materialize over the coming years which could threaten the oil and gas industry. By now, of course, this list should be familiar – talking about greater energy efficiency; lower costs for renewable technologies (they don’t explain how low these costs would have to go to be competitive with too-cheap-to-meter oil and gas, hastened by over-supply); electricity storage, which would provide a nice boost to intermittent, isn’t-around-when-you-actually-need-it energy sources like wind and solar, etc.

But then, in a section that’s supposed to be about highlighting all these disruptive technologies that stand to threaten oil and gas, they include a technology being used … to produce more oil and gas. To wit:

Enhanced oil production. Supply can be increased from reservoirs already in production. Primary recovery of oil from a reservoir typically yields approximately 10% of the total oil, while secondary techniques (injecting water or gas to create pressure and drive it to a wellbore) allow as much as 40% total recovery. Enhanced oil recovery (EOR) allows 60% recovery and possibly more. …Should EOR become cheaper, i.e. should it become possible to significantly increase supply from existing wells, this would in turn increase the stranding risk for higher breakeven oil categories.

So there you have it, folks: likely the only example of a financial research you will ever encounter arguing that clients shouldn’t invest in an industry based not on the expectation that it will perform poorly in the future, but based on precisely the opposite of that: that it will continue to innovate and find new ways to deliver valuable products to customers, and do so at a lower cost and with greater efficiency.

If that strikes you as some reasonable investment advice, let us know — we may have a bridge somewhere north of Edmonton to sell you.