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Stranded Fossil Fuel Reserves and Firm Value

by

Christina Atanasova*

and

Eduardo Schwartz†

October 2019

Abstract:

Do capital markets reflect the possibility that fossil fuel reserves may become “stranded assets”

in the transition to a low carbon economy. This paper examines the relation between oil firms’

value and their developed and undeveloped reserves. Using a sample of 770 international oil

firms for the period 1999 to 2018, we document that firm value increases with the growth of

developed oil reserves but decreases with the growth of undeveloped reserves. The negative

effect of undeveloped reserves is almost seven times stronger. Unlike developed, undeveloped

oil reserves require a major expenditure before they can be extracted. Our evidence is

consistent with markets penalizing future investment in undeveloped reserves growth due to

climate policy risk. When we decompose oil firms’ asset volatility into systematic and

idiosyncratic components, we find that systematic risk (asset betas) increases with the growth

in undeveloped reserves. Idiosyncratic risk is not affected by changes in oil reserves. This

finding is not consistent with undeveloped reserves being real options and instead it supports

the notion that firm value is affected by the systematic climate change risk. Our results remain

robust when we control for firms’ diversification of oil reserve location and the large drop in oil

prices in recent years.

Keywords: Climate change, stranded assets, undeveloped reserves, systematic risk, firm value.

JEL classification: G2, Q3, Q5

* Atanasova: Beedie School of Business, Simon Fraser University. E-mail: cva3@sfu.ca

† Schwartz: Beedie School of Business, Simon Fraser University; Anderson Graduate School of Management, UCLA

and NBER. E-mail: eduardos@sfu.ca

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“.... according to Carbon Tracker, a think-tank, more than half the money the big oil companies

plan to spend on new fields would be worthless in a world that halved emissions by 2030.” The

Economist, September 21st, 2019

“Stranded assets” are assets at risk of becoming obsolete from unanticipated or premature

write-offs due to regulatory or environmental changes. In this paper, we examine whether the

valuation of fossil fuel firms is affected by the risk that their reserves will become stranded in

the transition to a low-carbon economy. This possibility could cause considerable losses for

investors and other stakeholders of these firms thus highlighting the importance of pricing

climate change risks.

We focus on oil firms and their reserves as the markets for oil firms’ equities and crude

oil and many oil products are very liquid, whereas the markets for coal and coal firms’ equities

are more fragmented and less liquid, with the markets for natural gas in-between. Using a

sample of 770 international oil firms for the period 1999 to 2018, we analyze the effect of

“stranded assets” risk of developed vs undeveloped reserves on firm value. There is a distinction

between developed and undeveloped proved oil reserves1. The former are reserves which can be

extracted from existing wells while the latter are classified as reserves from new wells on

undrilled acreage or existing wells where a relatively major expenditure is required for

completion2.

Prior evidence suggests that investors are already considering climate change risks as

relevant. For example, Krueger, Sautner and Starks, (2019) document that larger long-term,

and environmental, social and governance (ESG)-oriented investors actively manage their

1 The U.S. Securities and Exchange Commission (SEC) uses the term “proved reserves” for oil and gas and “proven

reserves” for coal reserves. Proved oil reserves are the estimated quantities of oil that, with reasonable certainty,

are recoverable under existing economic and operating conditions. These estimates are based on available

geologic and engineering data.

2 Before 2010, the U.S. Securities and Exchange Commission, allowed only proved reserves to be publicly reported.

After 2010, firms can also report probable and possible reserves. Probable reserves are reserves that have an

estimated confidence level of approximately 50% of being successfully recovered. Possible reserves are those with

only 10% estimated probability of recovery. The SEC requires the lower probability of recovery to be verified by a

third party before an oil company can publicly report probable and possible reserves to potential investors.

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climate risk exposure (e.g. analyzing portfolio firms’ carbon footprints and stranded asset

risks). Krueger et al, however, show that perceived overvaluations of fossil fuel firms are not

large and that most investors do not consider divestment as the most effective approach for

addressing climate risks. Ilhan, Sautner and Vilkov, (2018) show that climate policy uncertainty

is priced in the option market. Specifically, the cost of option protection against tail and

variance risks is larger for firms with more carbon-intense business models.

Since both developed and undeveloped proved oil reserves are assets on the firms’

balance sheets, they should have a positive (or at least non-negative) effect on their value both

in levels and in changes.

3 This is not what we find in the data. Our results suggest that while

increases in developed oil reserves have a significant positive effect on firm value, the effect of

undeveloped reserves is economically larger and significantly negative throughout the sample

period. In particular, a one standard deviation increase in the ratio of barrels of developed

proved reserves to a US dollar of total assets increases firm value (the logarithm of Tobin’s Q)

by 0.14%. A one standard deviation increase in undeveloped proved oil reserves, on the other

hand, decreases firm value by 0.96%. Our evidence is consistent with markets penalizing firms’

investment in undeveloped reserves growth due to climate policy risk. The markets seem to

take into consideration, at least partially, that while these reserves require substantial capital

expenditures to be developed, they might never be utilized.

We show that our main results remain the same when we carry out several robustness

tests. First, we estimate our main results for the subsample of US firms only. Focusing on the

sub-sample of US firms allows us to carry out a cleaner test of our main findings. US oil firms

do not face exchange rate exposure as oil prices are set in US dollar. Also, in contrast to

markets in the other countries in our sample, which are fragmented, illiquid, and vulnerable to

manipulation, U.S. equity markets are subject to the most stringent regulation and monitoring

with trading costs half those of any other market. For the US firms in our sample, we collect

3 Oil reserves are by far the most important assets that oil firms own. Financial analysts and investors pay great

attention to information related to reserve changes released from these companies. For example, when the

Swedish oil company Lundin announced a significant discovery of oil and gas the Norwegian continental shelf in

2011, their share price appreciated more than 30% in one day. In January 2004, when Shell announced a 28%

downward revision of their proved oil reserves, their share price fell 12% over the 3-4 weeks following the

announcement.