Oil: “The stone age didn’t end for lack of stones”
Sheikh Yamani, former oil minister of Saudi Arabia, 2006
However much discussion focuses on diversification, excellence in the core oil and gas businesses will be the foundation of any successful strategy. Although a number of companies and organisations do have forecasts for oil demand showing a peak and then decline, the range of timings is broad and no-one really knows. However, with a few exceptions (it is accepted that it will peak, and decline thereafter, although no-one knows how fast). Oil demand has already peaked in the OECD, so it is important to monitor developments in emerging economies as well as OECD demand decline rates. Depletion, however, creates opportunity, even as global demand slows.
World oil demand (Mb/d)
Source: Spencer Dale, BP, and Bassam Fattouh, OIES - ‘Peak Oil Demand and Long Run Oil Prices Insights’, The Oxford Institute for Energy Studies, Jan 2018
This slide shows that either the oil companies and commentators are extremely optimistic about the level and durability of oil demand – or that the global economy is going to miss the 2C target by a wide margin.
If the latter is true, economies will have to focus both on adapting to the effects of climate change and on tightening policy later, more expensively and more extensively. This would be a delayed version of the former case, with those companies whose investments are based on an assumption of higher demand for longer then finding themselves left with stranded assets. There is an asymmetric risk here for any one company: overinvestment leads to stranding, while underinvestment can be ameliorated by buying another company.
Although very painful, the oil price collapse of 2014-15 has been, in part, a blessing for the industry. It has forced companies to re-orient their investment programmes towards shorter life, lower-cost curve projects far faster and more comprehensively than consideration of climate change policies would have done. This, combined with the urgent need to reduce the breakeven price of their portfolios, puts companies in a far better position. As long as companies are not seduced by the recent price recovery and continue instead to focus on operational excellence and a resilient project pipeline, they will be as well placed as possible, given the uncertainties ahead. They at least have some flexibility, given their reserve lives of eight to 15 years and could choose to keep that at the shorter end. The producing countries, on the other hand, are far more at risk.
There will come a point where more radical actions may be appropriate: for example, consolidation or large-scale de-capitalisation. The timing is uncertain and will be influenced by factors beyond the industry’s control. If the combination of more fuel efficient conventional cars, faster take up of Electric Vehicles (EVs) (picture that S-curve) and the reduction/removal of fuel subsidies happen together, the demand path could shift quite fast. On the supply side, producing countries, with decades of reserve life and less strategic flexibility, could choose to use their lower cost of production to crowd out the quoted companies and monetise their oil as quickly as possible.
It is worth remembering that quite small mismatches of supply and demand can devastate the oil price, as we saw in 2014-15 when the oversupply was about 1.5m barrells per day (bbl/d). BP has estimated that 100m EVs in the global car fleet, whenever that is reached (estimates for EV take up vary wildly) would remove 1.5m bbl/d from demand.
Gas: Not quite as simple as a golden age of gas
There has been a clear and widespread shift to gas among the quoted companies. All describe this as “better positioning in the energy transition” – and indeed such a shift will reduce companies’ net carbon emissions significantly. However, it would seem that the political nature of power markets leaves gas as the residual choice, after decisions about coal, nuclear and renewables. If economies were starting from scratch, gas would certainly be an effective transition fuel in power generation. This may be possible in East Africa, for example, where gas is present and access to power is important for development. Unfortunately, with coal generally being a very affordable and abundant fuel choice, some developing countries such as India are adding new coal generation capacity. With 40-year life spans, this would hinder CO2 reductions for decades.
In addition, the existence of legacy assets, specifically coal generation, together with the incentivisation of renewables, has severely restricted the prospects for new gas generation in developed economies (Europe and the US). Coal remains at 38% of global generation capacity, just as it was in 1998. Interestingly, non-fossil power generation has a slightly lower share than in 1998, because the extraordinary growth in renewables has not outweighed the reduction in nuclear generation. Local markets will of course differ, depending on their legacy assets and political priorities.
Fuel shares in power generation
Gas remains more challenged than its lower carbon characteristics would suggest it should be. That is due to the absence of both a more effective mechanism (such as regulation, a stronger carbon price or both) for getting coal out of the system faster (in Australia, Europe and the US for example), and a broadly applicable carbon price, sufficient to deter developing economies such as India from building new coal generation. One strategy would be to create demand where gas occurs, and where access to power is a need, although this requires a price that creates both supply and demand. Creating end demand is also used to justify companies’ involvement in parts of the utilities sector. There may also be potential from using more gas as an input for petrochemicals, although this is dependent on the proximity of plants to gas supplies.
Could there be a significant increase in electricity demand from the adoption of EVs, creating space for gas generation or increased process for electricity in general? This seems unlikely: consumption has been falling in Europe (where there is also overcapacity in generation) and incremental demand is unlikely to reverse that trend, or make much difference in the US and China. The IEA estimates that the additional generation needed to meet EV demand will only be 1.5% of total global electricity demand in 2030, which is 6% of the increase due to electrification in industry, residential and commercial sectors. Their assumptions for EV take-up are conservative but, even so, the scale of incremental demand remains small. Bloomberg New Energy Finance (BNEF's) 2040 scenario estimates EVs consumption at 5% of projected global power. There will be structural growth in electricity demand in the rest of the world, but not massively driven by EVs. A wholesale shift to EVs may, however, be very damaging to fuel retailing: it is not clear yet how fast recharging could become or whether petrol stations will be the best location for doing it (for example, it may be that supermarkets dominate here, given that people are already parked for a period of time).
Access to power remains a critical issue for developing economies. While some will be supplied by renewables, especially where a distributed network allows access to rural areas unlikely to have access to a grid (as we have seen in mobile telephony), access to reliable electricity in cities remains crucial (and could displace oil used in back-up generators, helping to achieve the Paris targets). The IEA estimates that demand for gas will continue to grow, long after the demand for oil has peaked.
Refining and petrochemicals: Problem child or golden child?
Refining is already suffering from overcapacity in developed markets and the difficulty for private sector companies in accessing growth markets, which are in the grip of National Oil Companies (NOCs). The greater the substitution of electricity for petrol and diesel, the greater the pressure this will exert on legacy assets (in capacity and configuration). A shift towards gas rather than oil as a petrochemicals feedstock would further reduce demand for light (petrol and petrochemicals) and middle (diesel) distillates. A company with very low cost facilities and proximity to end markets and cheap feedstock may succeed in generating good returns, but beyond that, these negative trends are likely to continue.
There has been optimism expressed within the industry about the growth prospects for petrochemicals. These will be driven by the pace of development in emerging markets as they become increasingly sophisticated consumer societies. Demand is likely to grow strongly across the full range of products from lubricants to resins, adhesives, buildings materials and plastics. The IEA estimates that petrochemicals will drive 44% of oil demand growth between 2015-2040.
At the same time, there is an increasing insistence from the public (in developed countries at least) to “do something about plastic”. Calls for substitution of glass or paper/cardboard are often not optimum and the best progress will come from increasing the recycling of plastics. Estimates are that the impact of banning single use plastics would be very small on total petrochemical demand, whereas a much higher level of recycling might affect the growth of feedstock demand in the longer term.
Read the next chapter: The temptation of diversification