The Future of Oil – The View from June 2017

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At the end of May, as OPEC and other oil producers reached an agreement to extend oil production cuts until March 2018, most analysts expected the market to reward the announcement with some form of price rally. This anticipation was reinforced by a minor price recovery that was largely driven by statements in the build-up to the meeting, which strongly hinted at an extension. Surprisingly, the official announcement of the extension triggered a price decline that completely wiped out all the gains enjoyed since the original agreement was announced. What gives? The popular explanation is that analysts were expecting stronger action from OPEC, and so responded with a sell-off (of oil futures) as the disappointment of getting only an extension took root. Some are now advocating for deeper cuts that will force the market to rebalance sooner. Even so, it’s prudent to probe further and ponder how the extension of the cuts will play out in light of other energy developments. The last time I gazed into the oil market crystal ball, I predicted a price ceiling, which swiftly arrived in early January, as Brent crude breached $57 per barrel (pb) and hasn’t since crossed that number. OPEC and its partners have reported historic levels of compliance to the agreed cuts, yet a price rally has been stifled primarily as a result of the increase in US shale/tight oil production, just as predicted. Furthermore, oil demand has been sluggish this year, acting as an additional hindrance to the OPEC-led cuts and kept prices stabilised around the $50 mark. Over the 6 months, since the cuts were initiated, the wider energy landscape has continued to undergo seismic transformations. Renewables have achieved record low prices that make them competitive with fossil fuels for power generation. China & India, both expected to drive oil demand growth in the next decades, have made colossal plays for electric vehicles (EVs) that will alter future demand outlook. And last month, President Trump pulled the US out of the Paris agreement, appearing to strike a blow against renewables in favour of fossil fuels. How will these and other developments unfold in the oil industry?

Short term

When OPEC decided to turn open its taps in late 2014 and defend its market share from US shale producers, it was banking on its comparatively low production costs to drive the high cost US producers out of the market. In the 2 years of attrition that followed, shale producers displayed remarkable resilience, relying on efficiency gains, hedging and deep cost cutting to stay above water. During this period, global oil production surpassed consumption by around 2 million barrels per day (bpd), resulting in massive oil stockpiles that brought storage tanks to the brink of overflowing. Hence, the cuts announced by OPEC and its partners at the end of 2016 were designed to bring inventory down to manageable levels. A combined 1.8 million bpd of oil was to be kept off the market, with the assumption that rising oil demand, mostly from the Asian giants, would push down stockpiles. So far, the approach has achieved limited success, as inventory levels have fallen at a much slower pace than anticipated. The spectacle of floating storage clogging up ports worldwide began to ease up, even though developed countries have largely held on to their stockpiles. Consequently, extending the cuts for a further 9 months should eliminate what has been the amassed. Nimble US Shale producers have ramped up production at an astonishing pace, especially from the Permian basin, to benefit from the improved prices that the cuts triggered. They were initially projected only to add 400k bpd of supply this year, yet have already added 600k bpd half way through the year, and are now projected to exceed 800k bpd by year’s end. They have managed to do this by moving swiftly to bring online a huge number drilled but uncompleted wells, and have continued to drill more wells. The increased production has kept US storage levels stubbornly high, but there are now signs that additional production will be harder to come by. Efficiency gains appear to be approaching their limits and completion costs are beginning to rise. Haliburton, the large service provider, recently announced that it’d be charging higher rates in response to rising demand for its drilling services. More service companies are likely to take similar steps. Moreover, if WTI prices hover below $45pb for an extended period, then a significant chunk of the production will become economically unviable. Beyond US shale, there are other supply concerns that will hinder the effectiveness of the extended cuts. Over the next 9 months, OPEC and its partners will find it increasingly difficult to hold the line, as cash-strapped countries that have been hit particularly hard by a downturn now entering its third year, would be unable to resist the urge to cheat. Officially, compliance to the agreement has been strong, yet the historical compliance record of countries like Russia for similar agreements is spotty, which means that it is highly probable that additional supply will find its way to market. In fact, doubts about the official numbers are on the rise due to the re-emergence of floating storage in Asia, a clear indication of a supply glut. Next, we have OPEC nations that were initially exempted from the cuts. Nigeria and Libya have enjoyed some success in getting their domestic unrest under control, enabling them to ramp up production to add a combined 350k bpd in May. After months offline due to sabotage, Forcados pipeline begun to export up to 250K bpd of Nigerian oil this month, an amount that is more than 10% the combined cut. Within a week though, this milestone was swiftly balanced by the shutting in of the Bonny Light 200k bpd pipeline due to a leak. This pipeline is expected to return to full operation in August, meaning that Nigeria will continue to bring additional supply to market. The other exempt country, Libya, recently exceeded 800k bpd from 570k bpd before the cuts. Its target is to achieve 1 million bpd shortly and eventually reach its pre-civil war production level of 1.6 million bpd. It is presently stymied by a lack of expatriate expertise and spare parts. Over the last 6 months, Saudi Arabia has displayed a willingness to shoulder deeper cuts than it agreed to, balancing out additional production from its OPEC partners. The amount of supply that can potentially return to the market from both Nigeria and Libya must surely test its mettle to continue to take one for the team. Other significant sources of additional supply are Canada and Brazil, who are both on track to add 200k bpd to the market this year, on the back of projects initiated when prices were at $100pb. These projects are only about to commence production, and combined with additional supply from exempted countries and “cut cheats”, will lessen the effectiveness of the extended cuts. Oil demand has also failed to meet expectations so far, falling short of the 1.33 million bpd demand growth predicted by the International Energy Agency (IEA). Demand usually picks up in the second half of the year, especially as the summer driving season in North America and Europe gets underway and gives demand a seasonal boost. On the back of this, oil stockpiles will slowly decline in the second half of the year, and put the market on the road to rebalance. The market is presently spooked by the suspicion that OPEC has no exit strategy for the cuts. What happens at the end of March 2018? Will we see a repeat of the last 3 years, where OPEC and its partners open their taps to defend market share, while US shale producers continue to weather the storm, leading to a rise in inventory levels? Such a scenario isn’t far-fetched, since US shale producers have access to cheap credit that enables them to take massive (and often successful) bets, and eagerly avail themselves of financial tools like hedging to lock in higher prices for longer and keep production viable even in the leanest of times. The IEA also projects that non-OPEC production will grow by 1.5 million bpd next year, an amount that exceeds its forecasted global demand growth of 1.4 million bpd. So even if OPEC decides to extend the cuts beyond March 2018, it will only be allowing non-OPEC producers to fill the void.  As things stand though, one can count on the extended cuts setting a floor for prices, that will be arrived at shortly. US Shale producers will continue to provide a ceiling that will become active again later this year. And barring any significant supply disruptions, this equilibrium will prevail over the short term.

Long term

The oil industry must be assessed in the context of climate policy and the wider energy industry, as regulations and competition with alternative energy sources will define its fortunes in the coming decades. It is getting harder to ignore climate change and its attendant risks, regardless of political leanings. For example, last year shattered temperature records worldwide, with the temperature of the Arctic rising at twice the rate of the global temperatures, a situation that could lead to ice-free Arctic summers by 2040. At the other end of our pale blue dot, the Antarctic is turning green as the growth rate of moss has shot up over the past decades. Along with prolonged heat waves in the Northern Hemisphere, the bleaching of reefs globally and the rise in ocean acidity, these unmistakable signs reveal that climate change is taking hold, a situation that will only quickly worsen without strong, decisive and united global action. The Paris Agreement represented the first step of such a united global action. Although the agreement is some distance away from what is required to keep warming below 2 oC, an optimistic view prevailed that nations would progressively commit to steeper emission cuts as the agreement gets reviewed every 5 years. Hence, President Trump’s decision to ditch the Paris Agreement on the grounds of unfairness to the US energy industry, despite numerous US companies like Exxon voicing their support for the agreement, shattered such rose-tinted yearnings. Other nations have doubled down on their climate commitments, yet the US President’s decision is a significant blow to global climate action. As a counterweight, distinguished individuals like former New York Mayor Mike Bloomberg and Physicist Stephen Hawking, have banded together with leading companies that include the oil multinationals BP, Exxon, Shell and Total, to launch Climate Leadership Council. The Council is advocating for the introduction of a carbon tax on fossil fuels, as the most effective way to reduce carbon emissions. The moral case for action remains strong, as it is the least fortunate nations, such as low-lying islands in the South Pacific who have emitted little, that are currently feeling the brunt of a warming planet. And progress is being made in curtailing emissions, as according to BP’s recently released Statistical Review of Energy, the global consumption of coal has declined for 2 consecutive years. Coal is the dirtiest of fossil fuels, and both developed countries like the UK and emerging nations like China, have decisively turned away from it. It is also becoming clear that it is an economic argument, not a moral one that is driving this shift. In the US for example, economic viability, not climate activism, has been the force behind the decline of coal power generation. Since 2011, coal has been savaged by cheap shale gas, with fuel-switching seeing gas become the dominant energy source on the US grid. Gas emits half the amount of carbon as coal and has greatly contributed to reducing US emissions. Closely following on the heels of gas are renewables – solar photovoltaic (PV) and wind turbines – that have experienced a near constant drop in costs, amounting to 50 – 80% over the past 5 years.  So even as the current US administration signalled its intention to gut its Environmental Protection Agency (EPA) and decline to enforce the Clean Power Act initiated by the previous administration, US utility companies continue to increase the amount of renewables in their portfolios. Globally, renewables have accounted for more than half of all new power generation capacity added to the grid for 2 years in a row. At the same time, investments in renewables have fallen because they are becoming even cheaper, leading to more capacity installed for every dollar invested. China, the largest emitter in the world, announced a colossal investment totalling $360 billion in renewables by 2020, and along with India, has moved to cancel over 100 coal projects this year alone. Many analysts now see a subsidy-free future within reach for several technologies and in many locations. In its New Energy Outlook 2017, Bloomberg New Energy Finance (BNEF) projects solar to become cheaper than coal globally by 2021, which will lead to carbon emissions from power generation peaking in 2026. Solar PV is already the cheapest energy source in some places, and costs will continue to drop. PV efficiencies will also improve and further compound the advantages of solar. The downside to renewables is that they are intermittent energy sources, and require storage to balance out electricity supply and demand. Batteries are increasingly being deployed for storage, providing power at night and when the wind is not blowing. Fortuitously, while the storage capacity of big lithium-ion battery systems more than doubled over the last year, the prices of these units have halved since 2014, and will certainly fall further as more large battery factories get built globally. Previously, oil was immune to competition from the wider energy industry, as it holds an unmatched position as the go-to-fuel in the transport sector. The industry focused on how the fuel efficiency standards, which nations use to mandate the manufacture of more efficient vehicles that travel further on a gallon of fuel, would impact oil demand. In developed countries, for example, efficiency gains from such mandates have led to a drop of 10% of oil consumption since 2005, shifting demand growth to emerging giants of Asia. The emergence of electric vehicles (EVs) as a viable alternative to internal combustion engines (ICE) is exposing oil to competition from other energy sources in the transport sector. Countries such as Norway, the Netherlands and China, are leading the adoption of EVs for passenger cars. Bloomberg recently published an article projecting that the combination of efficiency gains, EVs and fuel switching (to gas and biofuels) will reduce oil demand by 20 million bpd by the year 2040, compared to the current demand level of 97 million bpd. At a result, recent conversations on oil demand have centred around when, and not on if, demand will peak. Multinationals have put forward competing predictions on when this will occur. The European duo of Shell and Statoil are anticipating peak demand to arrive between 2025 to 2030, while their US counterparts, Exxon and Chevron, are joined by BP, Total and the IEA in expecting peak demand sometime after 2040. The most significant challenge to oil industry remains the action of capital markets. Following its decision last year to price climate change risks in its investments, BlackRock Inc. (the world’s largest asset manager worth $5.4 trillion) recently backed a resolution by shareholders of Occidental Petroleum Corporation that asked the company to assess long-term impacts of climate change on its business. The motion easily passed and was quickly followed by a similar vote by shareholders of Exxon, which was also successful. Such non-binding resolutions increase pressure on oil companies to report on the impacts of climate change and the restrictions on fossil fuels that are part of the Paris Agreement. Other multinationals, like BP and ConocoPhillips, have moved ahead of the curve and already publish reports on how rising temperatures would impact their businesses. Furthermore, 7 multinationals, including Total, Shell and Statoil, have diversified and invested almost $15 billion in renewables over the past four years as a hedge, according to the Oil and Gas Climate Initiative industry group. Wood Mackenzie estimates that for oil companies to gain a renewable market share that matches the 12% they currently hold in oil and gas, they must spend $350 billion on solar and wind by 2035. These developments appear to cast a shadow over the long-term viability of the oil industry. However, it is pertinent to remember that transport goes beyond land, and includes sea and air. Thus, not all the oil used for transport can be replaced with batteries at the moment. Extending batteries to air transport is impractical without a substantial improvement in battery energy density (i.e. the amount of energy stored per kg) that approaches the performance provided by light hydrocarbons. Most crucially though, only 45 – 60% of oil consumed is used in transport, with the remaining utilised in the manufacture of chemicals, and demand for chemicals is forecasted to rise in the coming decades. Consider the presumed slayer of big oil – EVs – upcoming models will require plastics for numerous dashboard components, fabrics for upholstery and foam for seats. Plastics, synthetic fabrics and foam are only of few examples of the hundreds of chemical products that are produced from oil and the world will still be required even after we’ve stopped burning oil for fuel. Biotechnology has the potential to provide alternative chemical feedstocks. Microorganisms and algae are currently being engineered to convert biological or other cheaply available material to hydrocarbons, which can then be substituted for oil fractions in chemicals manufacture. A significant breakthrough is needed before such processes can produce the yields that make them economically viable. And even if one arrives, it may take a decade before such technology is ready for commercialisation. Consequently, chemicals will be a ready-made market for oil that is displaced from the transport sector, albeit not all of it. Climate change risks will require the oil industry to deploy carbon capture and sequestration (CCS) technologies to curtail carbon emissions. Though technically proven, majority of CCS technologies involve significant costs and energy requirements. Thus, it is the low-cost producers, particularly in the Persian Gulf that will continue to dominate the oil market, especially in a carbon-constrained future characterised by a slow and sustained decline in demand.

Medium term

It is the interim between the short and long term that will see tremendous upheavals in the oil market that will largely be driven by technology. The proliferation of EVs will be the first manifestation of this transformation. Although they currently amount to less than 2% of the global passenger car fleet, EVs experienced a sales growth that is 8 times faster than the overall car market in the past year. Treading the innovative strides of Tesla, every major manufacturer is preparing to launch a 200 mile per charge model by 2020, a distance that eliminates range anxiety. As a plethora of choices become available, and charging points become ubiquitous, demand for EVs is poised for sustained growth. For example, Chevy Bolt, the first mass-market 200 miles per charge EV, was introduced to the US market in December 2016. It won the car of the year award at the Detroit auto show earlier this year, and General Motors plans to expand across the country in August. This will happen a month before Tesla delivers its mass-market vehicle to the market, the Model 3, a car that received almost 400k reservations within days of its launch a year ago. This illustrates genuine competition between EVs, a situation that can only benefit the market. Tesla is also forging ahead to launch an all-electric, heavy duty, long range, semi-truck in September, entering the haulage market that is presently dominated by diesel-powered vehicles. Various automakers like Daimler, Volvo, Scania and Cummins, have already been trialling electric trucks of various sizes, while Toyota is focusing on hydrogen fuel cell trucks. So Tesla won’t have it all in this market, another segment that will experience exponential growth as such as these EVs become available, due to the enormous fuel saving potential of an all-electric semi-truck. At present, EVs are more expensive than their ICE counterparts, with battery cells accounting for 50% of the costs. A report by McKinsey & Company released earlier this year documents an 80% drop in the cost of batteries over a 6-year period, revealing a continual match towards lower cost EVs. And according to Benchmark Minerals (a research group), 14 mega-factories are presently being built or planned, which should lead to a further drop in battery costs. In fact, research by BNEF reveals that EVs will achieve cost parity with ICE by 2025. It is the Asia giants, India and China, that will lead the way. Prompted by choking air pollution, both nations have set highly ambitious EV targets. India has the stated goal of selling only EVs by 2030, while China, currently the largest EV market, has reaffirmed its strict EV quota by mandating automakers to sell enough EVs or hybrid vehicles that equate to 12% of auto sales by 2020. Whether both targets can be achieved remains in question. India is on track to be the third largest EV market by 2020, and the government in China is backing EVs with the kind of zeal it directed at the solar industry a few years ago, a situation that has led to 9 of the 15 battery mega factories mentioned earlier located in China. Tesla is even rumoured to have reached an agreement to build a second “giga” factory in China. Other advances like self-driving vehicles, a technology on the cusp of fruition, should result in improved vehicular efficiencies, regardless of the kind of vehicle it is deployed in and will contribute to reducing gasoline or diesel demand. Ride-sharing services, another innovation that has the potential to alter vehicle ownership structures greatly, will also have an outsized impact. Many analysts expect both technologies to reduce energy demands, yet it is also possible that demand for transport will rise, as both technologies increase accessibility of vehicular transport to elderly and disabled passengers. These technologies are even more compelling when applied to EVs. Consider taxis, for example, EVs hardly require servicing as they possess far fewer moving parts. Such an advantage, combined with the reduced fuelling costs (electricity is far cheaper than gasoline or diesel) and the longer life of EVs, greatly reduces operational costs and inverts the cost comparison with ICE for lifetime costs. These benefits make EVs a no-brainer as taxis even at present. So in the near future, incorporating self-driving will eliminate the requirement for a driver, which is the biggest operational cost of taxis. Then, adding ride-sharing will be the gravy that enhances the operational efficiency of the vehicle.  Therefore, as more EV models become available, taxi fleets will swiftly move to replace ICE with EVs. What will happen to oil demand as EVs begin to enter the market?  In IEA’s Oil 2017, global oil demand is forecasted to grow by more than 1 million bpd annually over the next 5 years, with demand crossing 100 million bpd in the 4th quarter of next year. IEA envisions economic expansion in China and India as the primary driver of this growth. However, China and India’s recent pivot towards EVs calls the IEA’s projections into question and demand for gasoline in Asia will peak much earlier than expected as millions of people in both countries purchase EVs over the next decade. The IEA has promised to update their demand forecasts in light of these developments. On the other hand, there is a rising likelihood of an oil supply shortfall by 2020, due to the low levels of investments in oil production over the past couple of years. US shale producers are projected to add up to 5 million bpd over the next 5 years, yet this is only a fraction of new production that is required to replace natural production declines (30 million bpd over the same period) and satisfy demand growth. Other shale reserves around the world may come into play, as there has been a massive push for shale development in Argentina by multinationals like Shell, Exxon and Total. The question of how transferable US shale technology to other geologies remains, considering the disappointing experience in locations such as Poland and Ukraine. Technology will also play a role in boosting the efficiency of oil production and processing. Companies such as BP, Pioneer Natural Resources and Eni have indicated a willingness to apply some form of artificial intelligence to improve drilling. Also, the leading industry software provider, Aspen Technologies, recently released an asset optimisation product that relies on big data, machine learning, and predictive analytics to drive down oil processing costs and decrease unplanned shutdown events. Such efficiency gains in oil production and additional shale production will struggle to satisfy additional demand in the medium term. Yet, a surge in investments in conventional production, especially deep-water, will eliminate the probable supply shortfall. Wood Mackenzie has reported that oil prices at $50pb can sustain some deep-water projects. The industry has been able to cut costs over the past couple of years, which has allowed BP and Shell to greenlight deep-water projects in the Gulf of Mexico. Such fields are prolific, each with the potential to add 100k’s bpd supply to the market. Therefore, if a few more of such projects get approved over the next couple of years, then the supply shortfall presently projected to arrive around 2020 will be curtailed. Exxon only just announced a $4.4 billion project to develop the massive Lisa field off the coast of Guyana. The project is estimated to break even with Brent crude at $46pb, so the decision by Exxon to move forward is a ringing endorsement of Wood Mackenzie’s assessment.

What Next?

The oil industry faces a straight race between a supply shortfall and peak demand. If prices persist around $45pb for a significant period, then production is unlikely to grow to the levels required to starve off a shortfall by 2020, as prices below $50pb will be unable to support the investments needed. And if investments do not pick up, then the industry will get one last boom before peak demand arrives. The definition of an oil boom in this new paradigm is one where prices exceed $60pb. Such a boom becomes more likely if the extended OPEC-led cuts succeed in bringing inventories down to the 5-year average. Yet, it would only take a 1 – 2 million bpd supply disruption for prices to rally, a prospect that can’t be ruled out considering the current state of global affairs. Of particular concern is the unrest in Venezuela, a country that analysts now say is primed for a Soviet-style collapse, putting its 2.5 million bpd supply at risk. Barring any disruptions, there remains only a 3-year window for an oil windfall, as once the policy actions by China and India take hold, the deployment of EVs will begin to adversely affect oil demand by 2023. Afterwards, the falling costs of batteries, efficiency gains, fuel-switching and the spread of self-driving technology and ride-sharing services, will all combine to bring about peak demand between 2025 and 2030. At the same time, the industry will experience a shift as oil will be increasingly valued as a chemical feedstock and less as a transport fuel. Organisations need to take concrete steps to position themselves for the coming upheaval and avoid the kind of collapse that has been experienced in the coal industry. Multinationals like Shell and Total have made shrewd moves by divesting into renewables and participating in initiatives like the Climate Leadership Council. Such activities must accelerate to enable such companies to hold onto their leadership positions in the global energy landscape. Engineering companies, service providers and equipment manufacturers also need to leverage their expertise by taking bets that will boost their chances of survival in this new landscape. Amid change lie enormous opportunities – energy storage (such as compressed air storage), industrial CCS (for refineries, petrochemicals, steel and cement) and biotechnology (as an alternative route for chemical feedstocks) – are just 3 areas out of many that will experience exponential growth in the coming decades. As the world moves to a greener and sustainable energy system, the time has arrived for the companies that led the way in the 20th century to break the mould, and evolve from being oil companies to become energy companies.

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