Can Exxon survive a $100 carbon tax per ton? No, unless it passes it on to the customer.
The Democrats just introduced a bill seeking $500 billion in climate damages from oil giants such as Exxon and Chevron. While I understand the desire behind this legislation and I am not opposed to a carbon tax, we all need to be careful about treating the carbon tax as a silver bullet with little to no unintended consequences. And we’ll make the case using Exxon as an example.
My co-author and fellow Forbes contributor Bob Eccles challenged the two of us to assess how a $100 per ton carbon tax would stress Exxon’s 2020 financials. What follows is an early and a relatively crude attempt at such scenario planning. We view the financial analysis of Exxon as a way of teeing up the complexity of dealing with Scope 3 and other policy issues. To get everyone on the same page, Scope 1 emissions are direct greenhouse gases (GHG), measured in tons, from Exxon’s operations such as production and drilling. Scope 2 are indirect greenhouse gas emissions from energy purchased by Exxon. Scope 3, the most controversial, includes the indirect emissions resulting from the consumption and use of oil and gas and chemicals sold by Exxon. It is important to note that Exxon has pledged a reduction of only Scope 1 and 2 emissions from operated assets (30% cut by 2025), not for Scope 3.
To avoid dragging you through the numbers, I summarize the questions we ask and the answers we uncovered.
Q1: What would a $100 carbon tax do to Exxon’s income statement?
If Exxon were to absorb the costs of only scope 1 and 2 carbon emissions, it would involve a $9.2 billion cash outflow a year. This is on top of the $1 billion per year that must be spent to meet its emission reduction goals. That’s a total of $10.2 billion. Exxon has to either cut dividends or capex to pay for the carbon offsets/taxes and promised emissions reduction.
Q2: What if Exxon does not want to cut dividends or capex?
All else constant, oil prices at the pump will have to increase by around $0.20 per gallon if scope 1 and 2 carbon costs were passed on and by $1.14 per gallon, if carbon costs of scope 1, 2 and 3 emissions were passed on consumers. There would have to be similar increases in prices to intermediary users of oil such as chemical companies. The price hike works out to a 38% increase over $3 a gallon price of gas at which retails today. To be fair, a higher oil price might force the market to innovate faster and come up with carbon-neutral fuels, a consideration we have not explored fully as of now.
Q3: What would a $100 carbon tax do to Exxon’s balance sheet?
Assuming a $75 price of oil per barrel as it is today, Exxon makes $22 of post-tax profit. Scope 1 and 2 carbon reduction costs will consume $4 a barrel. A scope 3 tax beyond $18 a barrel will hence render Exxon bankrupt. However, the carbon tax for scope 3 emissions for barrel of oil works out to $43 roughly. Hence, Exxon cannot absorb a tax on scope 3 emissions and stay financially viable.
You could argue that we are delusional to think in a capitalist society that the customers will not pay. You may say that as long as Exxon is allowed to operate as a free enterprise in a capitalist system, they will survive and, depending on the type of taxation, even thrive in a $100/ton carbon tax world. If there was an extreme case in which Exxon were taxed $100/ton on scope 3 emissions, as posited here, you might argue that they would most certainly pass all that onto the customer.
This important objection raises a deeper issue about what the social responsibility movement and regulators, as in the Democrats bill mentioned in the opening paragraph, want from oil and gas companies. My read is that the movement intends to pressure oil and gas firms to cut emissions under the threat of a carbon tax. Let’s say the technology to get to carbon neutral fuel does not pan out or the technology is not controlled by the oil and gas firms. Then what? We enact a carbon tax and pass on the tax to the customer. Is the carbon tax then an empty threat? More disturbing, the carbon tax pass through gives no incentive for Exxon and other oil giants to find ways to cut emissions. And, of course, we cannot possibly plant enough trees to absorb 652 million tons of carbon that Exxon produces in a year. Hence, the idea of carbon offsets is not really workable.
Is it reasonable to hold Exxon accountable for scope 3 emissions? The oil and gas industry might argue that consumers ought to reduce their addiction to oil over time. The other objection is that forcing accountability for scope 3 emissions will hasten the migration of oil production to foreign regimes where these costs are not likely to be enforced. Moreover, renewables require back-up power that is produced using fossil fuels. These are reasonable claims that deserve thought.
So, what is the bottom line? The $100 per ton carbon does not look good for Exxon even at relatively high oil prices of around $75 a barrel. It may be worth repeating that these numbers embed many assumptions. But the exercise raises disturbing questions: Does Exxon have the cash flow and the expertise to invest in remediation or new business models such as carbon capture? Will a carbon tax on scope 1, 2 and especially scope 3, as assumed here, cripple Exxon? Will most of our oil production then come from regimes such as Saudi Arabia and Russia that are potentially less likely to deal with carbon taxes and emissions reduction? Or, will the U.S. consumer or downstream businesses bear the 38% odd increase in price of oil? Will the government need to subsidize some or all of this increase? How will the government fund that subsidy?
We welcome feedback on the above. The next piece in this series will likely tee up the idea of a “climate stress” test.
On to the numbers:
These calculations are necessarily coarse as we need private data only privy to Exxon to get these numbers totally right. Nonetheless, it’s a start which can be improved with your feedback and suggestions (constructive criticism is especially welcome).
In particular, we considered three questions. Because there are a lot of numbers involved, you may want to focus on the underlined statements if you do not want to dwell on the chain of reasoning leading up to the conclusions.
Q1: What would a $100 carbon tax per ton of carbon do to Exxon’s income statement?
· Consider the daily production of oil and gas by Exxon as of 2020. Exxon’s 10-K states that it produced 857 million barrels of oil and 3.09 trillion cubic feet of gas in fiscal 2020.
· Based on EPA transformation factors of oil to emissions (0.43 tons of C02 per barrel of oil and 54.8 tons of CO2 per million cubic feet), the consumption of Exxon’s oil production generates roughly 540 million tons of CO2 a year. Exxon designates these as scope 3 emissions and hence keeps these out of their carbon reduction pledge.
· Exxon’s sustainability report says that scope 1 and 2 emissions are 112 million tons of CO2 in 2020. The company has committed to cutting scope 1 and 2 emissions from operated assets by 30% by 2025 (page 41 of the 2020 10-K). I don’t know how much of their emissions comes from non-operated assets. Assuming non-operated assets contribute 40% of scope 1 and 2, we are looking at reduction of 20 million tons of C02 which leaves around 92 million tons emitted. By the way, this cut is not free as funds have to be spent to engineer this reduction. Let’s say that Exxon needs an additional $1 billion a year to achieve the 30% reduction. There’s, of course, the question of how fast the $1 billion invested makes a difference. Because we can’t forecast output and how soon the investment cuts emissions, we’re using very round numbers and assuming they’re constant for five or 10 years.
· Assume that a carbon tax per ton is $100. If you think that’s too high, you can run your version of this with a $50 price.
· If Exxon were to absorb the costs of forecasted scope 1 and 2 carbon emissions of 92 million tons, it would cost them around $9.2 billion a year. This is on top of the $1 billion newly set aside for cutting emissions. That’s a total of $10.2 billion.
· I am not sure that Exxon has that kind of cash flow to spare. Why?
o The average operating cash inflows over the last three years is $28 billion a year. Q2 2021 annualized cash from operations was approximately $38 billion. Let’s go with $40 billion in forecasted operating cash flow.
o Page 48 of their 10K says Exxon plans on spending $16 to $19 billion a year on capex. However, post 2021, Exxon has guided to $20 – 25 billion per year. Let’s go with the mid-point of that range at $23 billion.
o Their dividend commitments every year are around $15 billion.
o Putting these numbers together, we are left with inflows of $40 billion and outflows of $23 billion for capex and $15 billion for dividends. That barely leaves $2 billion for carbon taxes/offsets and incremental capex for ensuring that the promised cuts happen.
o So, Exxon has to either cut dividends or capex to pay for the carbon offsets/taxes and remediation.
o Or, they have to borrow money. They hold roughly $61 billion of long-term debt on an equity cushion of $164 billion. So, Exxon can borrow more but borrowing to pay for recurring expense commitments is not a good idea. Plus, the company has committed to cutting debt. Costs of refinancing debt might also go up if lenders impose restrictions on loaning funds to heavy emitters. Remarkably, 10 years ago, Exxon actually had negative debt (no debt less cash on the balance sheet) and, while still investment grade rated, they have been downgraded three times by S&P.
2: What if Exxon does not want to cut dividends or capex?
Given that most firms hate cutting dividends, let us consider a scenario where Exxon tries to pass on the carbon cost to its consumers. If Exxon were to pass on only scope 1 and 2 carbon offset costs and costs of remediation, that’s around $11.5 billion on a barrel equivalent volume of 1.372 billion barrels of oil per year. That works out to a measly $0.20 per gallon at the pump [$11.5 billion/(1.372 billion barrels *42 gallons of gas per barrel)].
Now, let’s say Exxon were to also pass on scope 3 costs to customers. That’s 540 million tons of carbon *$100 a ton or $54 billion. Here, cost per gallon would go up by $0.94 per gallon ($54 billion/(1.372*42 gallons per barrel).
Bottom line, all else constant, oil prices at the pump will have to pay around $1.14 per gallon. This is not the end of the world. (Similarly, there would be increases in prices to intermediaries such as chemical companies. Selling to chemical companies is a business-to-business venture compared to selling to consumers and corporate customers will have more leverage but let’s ignore those considerations for now).
As a comparative data point, Netherlands charges $6.64 for a gallon of gas. Considering how price-inelastic our demand for oil tends to be, I presume consumers will grudgingly accept a 38% increase in today’s gas prices of around $3 a gallon. Of course, this might cause downstream inflation (food, for instance, will become more expensive because it needs to be shipped/transported using oil and so on). On the other hand, the price shock may spur faster innovation in carbon neutral technologies.
Q3: What would a $100 carbon tax per ton of carbon do to Exxon’s balance sheet?
Things get trickier here. Figuring out what a traditional impairment as per the accounting standards would look like is very difficult with public data as such assessments are required to be conducted oil field by oil field. Hence, what follows will not satisfy the technical accountant. Instead, let us assess the breakeven oil price below which Exxon’s financial viability becomes questionable. To that breakeven price, let us add a $100 carbon tax/price per ton. Ignore the time value of money to keep things simple.
· Page 120 of Exxon’s 2020 10-K reports the standardized measure of future cash flows from reserves. As per that disclosure, Exxon has 15.2 billion barrels equivalent of oil (BOE) and gas left in reserves (at 2020 oil prices). We acknowledge that oil and natural gas are distinct products with distinct pricing patterns. But that is a complication we have ignored for now. Given that the yearly production is roughly 1.3 equivalent billion barrels, Exxon has reserves for roughly 12 years of production.
· Property, plant, and equipment (PPE) on Exxon’s books attributable to upstream assets as per page 80 on December 31, 2020 are reported at $167 billion (net of depreciation). Therefore, the book value of oil left on the books is roughly $167 billion/15.2 billion barrels or $11 a barrel equivalent.
· But that’s not the end of the story. On page 120, production costs are projected to be run to $160 billion for 15.2 billion barrels or $10.5 and development costs to $83 bill or $5.46 a barrel equivalent. To be clear, we have added numbers for both consolidated subsidiaries and for equity companies. So, we are now looking at $16 due to production and development costs or cumulatively at $27 a barrel so far.
· The enterprise takes selling, general, and administration (SGA) every year to run and one has to pay other taxes every year. Page 65 of Exxon’s 10-K puts these numbers at $10 billion and $26 billion for 2020. I cannot tell for sure whether “other taxes” are already factored into the relatively high-income tax rate assumed by Exxon and discussed later. Hence, I will ignore “other taxes” to be conservative.
· Let us assume that 50% of the SGA is attributable to the upstream component of the business as Exxon is also active in chemicals and the refining business. SGA costs per barrel equivalent works out to $5 billion/1.3 billion barrels produced or roughly $4 a barrel. So, we are looking at $31 a barrel so far without income taxes.
· The future income tax rate is projected to be roughly 52% as per the standardized measure of future cash flows. The high rate is driven mostly by Asian, not U.S., production.
· I don’t know what the future price of oil would be. Let’s say the price at which Exxon sells its output is $75 a barrel, as it is today. At a $75 selling price, income tax will work out to 0.52*(75-31) or $ 22 per barrel. Hence, we are left with $22 of post-tax profit at the $75 oil price.
· Now, on to the carbon tax. Scope 1 and 2 emissions today are around 112 million tons. As argued earlier, let’s say that falls roughly by 20 million tons to a steady state of 92 million tons. Exxon has roughly 12 years of reserves left at today’s production rates. So, scope 1 and 2 emitted will work out to 632 (540+92) million tons. At $100 a ton, that works out to $63 billion. Spread over the 15.2 billion barrels and assuming carbon taxes are not deductible for income tax purposes, we are looking at adding a further $4 a barrel for carbon tax on scope 1 and 2 emissions.
· At this stage, we are left with roughly $18 of net profit per barrel. A scope 3 tax beyond $18 a barrel will render Exxon bankrupt.
· How much does the true scope 3 tax come to? A barrel of oil produces 0.43 tons of C02 in what Exxon designates as scope 3 emissions. That adds $43 a barrel of scope 3 carbon tax, which, obviously is much higher than the $18 net profit per barrel that we can spare, leaving Exxon with a loss of $26 per barrel.
In closing, we thank you for persisting with the numbers. We wrote the piece to serve as on opening salvo in a longer conversation about the strategies that the ESG movement and regulators should follow to cut emissions at oil and gas firms and the possible intended and unintended consequences. Feedback, positive and negative, is welcome.