The Future of Oil June 2016

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The price of oil has nearly doubled since the lows of $27 per barrel reached at the end of January. The growing consensus among market analysts is that a market recovery is underway, with one analyst going as far as predicting that oil will reach $85 per barrel by Christmas. A glance at the evidence greatly supports this – OPEC’s failure to agree on a quota hasn’t curtailed the price rally, there is a steady drop in non-OPEC (read US shale) output, and a summer driving season is giving oil demand a boost. In fact, analysis after analysis now forecast a slow but sustained recovery due to the combined effects of supply disruptions, naturally declining production rates and growing demand particularly from China and India. The IEA predicts that the supply glut will fall from the 1.3 million barrel per day (bpd) recorded in early 2016 to 0.2 million bpd by the end of the year. If the trend continues, the spectre of a supply shortfall will become a reality within a few years, due to the $500 billion investments that have been shelved over the past two years. In the short-term, supply disruptions in Nigeria, Libya, Venezuela, Kuwait and Canada, have accelerated a rebalance in the market. The situation in Nigeria appears most onerous as renewed militant activities have knocked off up to 40 – 50% of its 2.4 million bpd production capacity, with a high likelihood of more attacks to follow. However, new oil entering the market is offsetting these, mostly temporary, supply disruptions. First, 0.7 million bpd of Iranian oil has been added this year, with an additional 0.3 million bpd anticipated by the end of the year. Second, global storage is at the highest recorded level ever, exceeding 3.2 billion barrels among OECD nations. As a result, inventory drawdown is likely to accelerate over the year especially if the price rally is sustained. Third, the completion of some long-term offshore and tar sands projects will introduce about 0.5 million bpd production capacity by the end of 2017. Fourth, but the most crucial factor, is the willingness of nimble US shale producers to ramp up production quickly to stem the losses of the past year. Therefore, the danger exists that prices rise so much that they prevent the market from rebalancing. Companies like Pioneer Natural Resources and Continental Resources Inc have gone on record to state that they will resume drilling when prices stay above $50 per barrel. Compounding this is the existence of over four thousand drilled but uncompleted wells that can be brought online within weeks to take advantage of the oil price rally. In fact, many shale drillers will start completing their backlogs of unfinished wells when prices reach the $55 to $60 range. A small increase in the number of rigs operating in the US over the previous week is foreshadowing a reversal in declining US production. And with drilling already ramping up in the Middle East as Gulf producers gear up to defend their market share, a ceiling for the oil prices will be arrived at shortly. In the long term, the oil and gas industry faces daunting environmental pressures. That we live in a warming planet is a scientific fact buttressed by eight successive months of record-breaking temperatures spurred on a strong El Niño. For a few years now, concerns about global warming have continued to fuel a divestment movement that has advocated redirecting investments from fossil fuel companies, with Bill and Melinda Gates Foundation being the latest high-profile organisation to sell off such holdings. Good intentions have never been a compelling driver for investment decisions, yet investing in fossil fuel companies is no longer the safe choice it once was. In May, G7 nations for the first time set a deadline of 2025 for the ending most fossil fuel subsidies. Also, a crucial implication of the Paris agreement, which was reaffirmed by 175 countries in April, is that some fossil fuel reserves are unburnable. It is estimated that to limit global warming to the oft-stated 2 oC, 80% of coal, 30% of oil and 50% of gas reserves will have to remain in the ground. This is one factor, among others, highlighted in a report by the respected Chatham House, that has rendered the business model of multinationals obsolete. Without a viable alternative, the world is likely to remain addicted to oil as only about 45% of produced oil is used for transportation.  Oil serves mankind in so many other vital ways, being a key component in the production of varied essentials from fertiliser to synthetic fabrics, hence ensuring that we can produce enough food and garments to feed and clothe over 7 billion people. As a result, many oil majors have been able to ride out downturn without being worse for wear, as they were able to fall back on their chemicals portfolio to stem their losses from the oil production side of their business, with Exxon & Total even turning a profit in 2015. However, even in the absence of viable alternative chemical feedstocks, the increasing frequency of major climatic events may force the issue in the long run. Indeed, scientists are now predicting sea levels will increase by twice the rate that has been previously estimated, which will cause extreme flooding in many of the world’s coastal cities within a few decades. And the fingerprint of climate change is all over the wildfires that raged in Alberta in May and shut in 1 million bpd Canadian production. The irony is that climate change is already affecting the oil markets, just not the way that environmentalists may have hoped.It is in the medium term that oil will face its most serious challenge as the 45% of oil used for transportation will begin to face stiff competition from other energy sources on the power grid, due to the proliferation of electric vehicles (EVs). The reception of the Tesla Model 3, a mass-market EV with a 200+ mile range on a single charge, has sent shockwaves beyond the automobile industry. It is due for release next year, yet the number of reservations has exceeded 400 thousand, an unprecedented figure. By comparison, only 100 thousand BMW 3-series, the benchmark for the market segment, is sold annually in the US. These numbers reveal that EVs have progressed beyond the early adopter stage, and in a recent survey, 80 percent of buyers reported looking at an EV when in the market for a new car. With the GM Volt, the first 200+ mile range mass-market EV debuting later this year, and BMW, Volkswagen, Nissan and now Mercedes-Benz announcing plans to introduce 200+ mile EVs within the next three years, the age of the EV has arrived. Bloomberg predicts that by 2023, EVs will create an oil glut similar to one experienced this past couple of years. The world needs energy and in the coming years, demand for energy will indeed rise, but the assumption that this increase will result in a corresponding growth in oil demand is incorrect. The oil industry faces a decade that will begin with short-lived boom followed by a slow, sustained and inescapable decline. Organisations only need to look at a few business case studies to appreciate the predicament that they face – Kodak, Xerox and recently, Nokia are cautionary tales of companies that held dominant positions in the photography, computing, and mobile markets respectively. They stood still and failed to innovate, only to watch their market share get swallowed by enterprising upstarts. Organisations in the oil industry face a similar dilemma – either wind down with falling oil demand or evolve to become energy companies. To survive, organisations will need to leverage their expertise and resources to solve energy challenges of the coming decade:The challenge brought on by the EVs becomes even more compelling when one recognises that most energy demand forecasts have dismissed the impact of EVs. For example, only recently the EIA estimates that EVs will make up only 2% of vehicles in the US by 2030. In the past, such forecasts greatly underestimated the growth of renewable energy, yet renewables accounted for 90% of global power investments in 2015. The reason is that the costs of renewable energy have declined so greatly over the past five years, that solar and wind are now competitive with gas power generation. The impact has been so profound that global greenhouse gas emissions have fallen for the first time in a year that the world experienced a global GDP growth, thereby decoupling economic growth from emissions. Gas prices are also depressed due to oversupply and LNG overcapacity, so much so that new build coal power generation is being crowded out of the market. According to data compiled by Bloomberg, more than half the assets in the global coal industry are now held by companies that are either in bankruptcy proceedings or don’t earn enough money to pay their interest bills. Peabody Energy, the world’s largest coal holdings, has filed for bankruptcy, a harbinger of things to come for the oil industry.
  • develop photovoltaic solar cells with enhanced energy efficiencies,
  • develop advanced materials to make lighter and more reliable wind turbines,
  • build energy storage infrastructure to deal intermittent renewables and peak energy demand,
  • develop biochemical and advanced thermal processes to provide alternative chemical feedstocks,
  • develop carbon capture, utilisation and sequestration technology because it is the key to unlocking unburnable carbon.
The oil industry is notoriously conservative, yet, there is a growing recognition of the need to evolve. Over the last couple of months, Total, Shell, and Exxon have announced major initiatives to focus on alternative energy, with Total, in particular, having a target to be a top 3 solar company within 20 years. Although this is not the first that such companies have dabbled in alternative energy, the urgency created by prevailing economic drivers may be the key unlocks the winning formula. Engineering companies, equipment manufacturers and technology providers must also find a role for themselves in this changing landscape if they are to endure. As opposed to cutting loose talented employees, such organisations should direct them to tackling energy challenges, and invest in the research that will give them a leg up. This requires not only great management but also courage and leadership. An industry that has conquered uninhabitable deserts, freezing arctic landscape and unseen ocean depths to produce oil is one that can and should rise to meet this challenge.

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