Oil majors consider their future

A vertebra in the spinal column of the world economy is causing pain. As I write the price of Brent Crude is at US$59.99. According to the Knoema[i] website, the break-even oil price ranges from US$149.90 in Venezuela to US$60.50 in Qatar. So, on that basis, almost no one is making money in oil right now. Should we write off the oil majors or do they have a strategy we need to know about? It seems that they do have a kind of plan.

The Peak Oil hypothesis has been junked

The world’s big oil companies are preparing for a day when their major product will not be oil. Instead, they are planning to become energy providers.

I have been reading Energy Outlook 2017[ii] published by the oil industry economists at BP (LON:BP). If this reflects current thinking in the industry then it appears that the Peak Oil hypothesis has been junked. This was the idea first developed back in the 1970s by the American geophysicist and oil economist Marion King Hubbert. It states that there will be a point of peak oil production further to which production will steeply decline as established reserves run dry. During the course of this decline, as reserves are depleted – so Hubbert thought – the price of oil would soar to stratospheric levels with massively negative economic consequences.


BP’s study, in contrast, suggests that the world is overflowing with oil and other fossil fuel reserves – certainly more than enough to supply global demand until at least 2050 and probably well beyond. If oil producers thought that the price of oil was likely to rise significantly in the future then they would do better to leave it in the ground than extract it. But apparently they don’t think that any more, if ever they did.

Most of the oil in known reserves will never be extracted

The inexorable rise of renewable sources of energy – principally solar and wind-power – is already impacting the demand for oil and that is likely to intensify. In fact, BP thinks that a large proportion of today’s known reserves will never be extracted.

This suggests that oil prices are likely to remain flat or may even decline over the medium to long term. And this in turn suggests that there will be little economic incentive to develop new sources of supply, especially as new areas of exploration, such as the Arctic, where the Russians have ambitions, will come with much higher extraction costs. In the meantime, the abundance of oil resources may prompt low-cost producers to use their competitive advantage to increase market share.

Shale oil is cheapest

US shale reserves are the lowest-cost option for future oil production and are likely to attract more investment than competing projects such as deep water fields, according to consulting firm Wood Mackenzie[iii]. About 60 percent of the oil production that is economically viable at a crude price of $60 a barrel is in US shale, and only about 20 percent is in deep water.

Oil companies with substantial US shale assets like Norway’s Statoil (STO:STLO) are likely to be at a competitive advantage over the next few years. In contrast, producers that rely on oilfields in higher-cost regions such as the North Sea and the deep waters off West Africa will have to cut costs or face shrinking output.


After the oil price plunge that began two years ago, production costs have been cut across the industry, but nowhere more so than in the US shale fields. Average costs per barrel have dropped by 30 to 40 percent for US shale wells, but just 10 to 12 percent for other oil projects. US shale regions which two years ago were in the middle of the cost curve for future oil supplies are now at the lower end.

The Eagle Ford shale field of south Texas on average requires a Brent crude price of above US$48 a barrel to break even, according to Wood Mackenzie’s calculations, while for projects in the Wolfcamp (also known as Cline) shale formation in the Permian Basin in west Texas the break-even price is just US$39 a barrel.

The way forward

The way forward for the big oil multinationals, if they can’t invest in shale oil and gas, is therefore to follow the market and to invest in renewables. Renewables are the fastest growing fuel source, and will quadruple over the next 20 years, supported by continuing gains in competitiveness.

If the oil business is mature it is by no means in decline, however, as mankind will continue to use oil for the foreseeable future.

Oil demand will rise, but more slowly

In BP’s base case scenario, world GDP will almost double between now and 2035 driven by fast-growing emerging economies where more than 2 billion people will be lifted out of poverty. Rising prosperity will drive an increase in global energy demand, although the extent of this growth will be substantially offset by rapid gains in energy efficiency. Efficiency gains by petrol-powered cars alone will reduce global oil demand by nearly sixteen million barrels per day. Amazingly, while global GDP will increase by over 90 percent, energy demand will increase by only around 30 percent.

The share of hydrocarbons in the fuel mix will continue to decline, although oil and gas, together with coal, will remain the dominant sources of energy. Renewables, along with nuclear and hydroelectric power, will provide half of the additional energy required out to 2035.

Amazingly, while global GDP will increase by over 90 percent, energy demand will increase by only around 30 percent.

Gas will grow more quickly than oil and coal, led by US shale gas. The rapid expansion of Liquid Natural Gas (LNG) is also likely to lead to a globally integrated gas market. What is special about LNG is that it is mobile – it can now be relatively easily shipped across great distances with no need for pipelines. This means that disparities in the gas price in different locations will henceforth be subdued: gas will quickly be shipped to higher price markets by LNG tankers, thus stabilising prices.

Demand for oil will continue to grow but the growth rate will slacken. Transport will be overtaken as the main source of demand growth by the petrochemical sector because of the predicted take-off of electric cars. In fact, the number of electric cars will rise one hundred fold from one million in use today to one hundred million in 2035. That of itself will reduce global oil consumption by about one million barrels per day.

By the way, self-driving or “driverless” cars are expected to be much more fuel efficient than human-driven ones. Add to that the fuel-saving potential of the sharing economy – pooled cars, Uber, shared journeys and so forth – and the efficiency gains mount up even further.

China

China is now the world’s largest consumer of energy. But its rate of economic growth is slowing and the structure of its economy is changing. It is moving from an industrial economy with intensive energy consumption to a consumer-led economy where energy efficiency can be improved. China’s energy mix is changing as energy policy shifts away from coal towards natural gas, renewables and nuclear power.

Global coal consumption will peak, as the continuing reform of China’s economy causes demand for coal to slow sharply, although China will remain the largest growth market for energy overall.

In response to these challenges, China is becoming the global leader in renewables. Five of the world’s six largest solar panel manufacturers are Chinese[iv], as is the largest wind-turbine manufacturer, China Ming Yang Wind Power Group Ltd (NYSE:MY).

The climate question

The world economy will continue to electrify, with nearly two-thirds of the increase in global energy going into the power sector. In BP’s base case scenario, carbon emissions from total energy production will grow at less than a third of the rate of the past 20 years, reflecting gains in energy efficiency and the changing fuel mix.


But emissions overall will still continue to rise, though much slower than in the recent past. The stated objective of the Paris Agreement of Climate Change, signed in April last year, was to stabilise carbon emissions “as soon as possible” so as to cap global warming at 1.5-2.0 degrees centigrade above pre-industrial levels. On the basis of the BP’s Energy Outlook this is unlikely to happen.

That means that the concentration of carbon dioxide in the atmosphere will continue to rise to unprecedented levels. If standard current climate change science is correct (which is debatable) then we could be in trouble, whether oil companies diversify into renewables or not.

Conclusions

BP’s latest Energy Outlook implies that oil prices are likely to remain subdued for the foreseeable future. The most profitable companies will be those with significant US shale assets. Oil companies will respond by diversifying further into renewables. Given the abundance of known reserves and the need to focus on low-cost fields, the outlook for oil exploration companies is uninspiring.

In my Opportunities in Focus column for the MI March magazine I’ll be taking a closer look at precisely which companies active in the oil sector are best positioned to take advantage of these trends.

And if you are coming to the Master Investor show on 25 March you’ll receive a glossy hard copy of the magazine. See you there.

[i] See: https://knoema.com/vyronoe/cost-of-oil-production-by-country

[ii] Download at: http://www.bp.com/en/global/corporate/energy-economics/energy-outlook.html

[iii] See Financial Times, 13/07/2016 available at: https://www.ft.com/content/0a7a817a-4863-11e6-8d68-72e9211e86ab

[iv] See: https://www.theguardian.com/environment/2017/jan/06/china-cementing-global-dominance-of-renewable-energy-and-technology