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There is now evidence that the unpopular oil majors are oversold. That spells opportunity for canny investors, writes Victor Hill.
The conventional wisdom is that the oil majors are doomed since, thanks to the “climate crisis”, mankind is transitioning to renewable energy. Green energy, they say, represents an existential threat to the oil industry. Oil is the mega business of the past − a ‘dinosaur’ play. The outgoing governor of the Bank of England, Mark Carney, made headlines after Christmas by predicting that almost £100 billion of UK pension holder’s assets could be made worthless by climate change.
Except that, as I often tell my readers, the conventional wisdom is almost always wrong. While there will be a relative decline in the clout of the oil industry in the global economy, it will continue to thrive. Indeed, we shall continue to use hydrocarbons, though in modestly declining quantities, long after the electrification revolution has been completed.
What’s more, as I have explained here previously, oil companies are investing in renewables so as to become diversified energy companies. There is now some evidence that the unpopular (or at least PR-challenged) oil majors are oversold. That means an opportunity for canny investors.
The global economy will continue to need oil
The oil industry still lies at the heart of the global economy. Despite the rise of renewables (and nuclear energy) in response to the climate crisis, global demand for oil remains robust. In 2018, the world consumed more than 100 barrels per day for the first time. According to some studies, consumption is expected to continue rising until some point between 2030 and 2040, when it is likely to begin to decline. Beyond about 2050, demand for oil is tricky to predict.
Close to 70 percent of global greenhouse-gas emissions are generated by the energy industry and oil still makes up the largest part of the global energy mix. Further to the dramatic rise in US shale output, which has transformed the composition of the global oil market, the US is pretty much self-sufficient in oil and gas for the first time. That has huge geopolitical consequences – not least of which is that America can imagine withdrawing from the Middle East altogether. It also means that one of the key factors in the determination of future oil demand is the stance that the US government takes.
Oil demand has increased by 30 percent over the past 20 years. The next two decades are likely to be pivotal for the oil industry, with reliance on oil expected to peak between 2030 and 2035. That is if developed countries such as the UK and France stick to their pledges to complete electrification of transportation by 2040 (though there will still be petrol and diesel-powered cars in developing countries long after that). In one scenario, the peak could come as soon as 2025 if the world accelerates the process of reducing carbon emissions.
Last year Barclays Bank Global Research (BGR) published a study analysing the potential evolution of oil demand. Barclays set out three broad scenarios which it called the “3Ds”: Deadlock, Development and Dynamism.
The Deadlock scenario envisages that plans to cut CO2 emissions will stall, consumption of oil will peak in 2040 and will flatline to 2050 at about 126 million barrels per day. Under the Development scenario, oil consumption will peak in 2030 and will have fallen to just over 105 million barrels per day in 2050 (still higher than today). Under the Dynamism scenario, the ‘disciples’ of Greta Thunberg will have things their way: consumption will peak in the late 2020s and will have declined to 69.6 million barrels per day by 2050 – a 30 percent reduction on today’s levels, despite a larger global population. But note that that will only bring global demand back to its 2000 level.
These models assume that the global population will be nine billion in 2040 and 9.7 billion in 2050 as compared with 7.7 billion today; that global GDP will rise by an average of 2.6 percent per annum; and that the number of people not connected to the electric grid will fall from about one billion today to 200 million in 2050. Total energy demand is set to rise by between 40 and 75 percent between 2019 and 2050. More of this needs to be provided by renewable sources in order to limit global warming to two degrees Celsius, and renewables could make up 30 percent of the global energy mix by 2050.
Passenger cars will consume much less oil thanks to electrification. However, BGR reckons that 97 percent of the global trucking fleet will still use the internal combustion engine running on gasoline and diesel. The assumption here is that battery technology will not advance sufficiently to make electric trucks viable over medium distances. The increase in oil demand from the global trucking industry will be partially offset by the application of AI to logistics, making routing much more efficient.
While there will be some electric-powered aircraft in operation on short haul routes (eg ’island hopping’) aviation will remain overwhelmingly dependent on fossil fuels. Demand for petrochemicals used, for example, in the production of plastics will continue to grow apace and will be 50 percent higher in 2050 than today.
To put the problem the other way round, electricity is expected to surge from about 18 percent to 40 percent of global energy consumption by 2040 and could reach 50 percent by 2050, according to Shell. That still leaves about half of global energy supplied by fossil fuels.
Green gas? Is that possible?
The Barclays study makes clear that gas will remain a significant part of the global energy mix, particularly for household heating. Currently, burning gas, mostly domestically, creates 35 percent of the UK greenhouse-gas emissions – with demand rising in the UK by 4.6 percent in 2018. But greener gas is now in prospect.
Centrica PLC (LON:CNA), which owns British Gas, has a target of reducing its carbon emissions by 25 percent by 2030, as a result distributing ’cleaner’ gas. The company has taken a 50 percent stake in Barrow Green Gas which generates and distributes biomethane. Biomethane can be produced from sewage treatment plants and anaerobic digesters; the latter is now commonplace on larger modern farms.
The argument for biomethane is that the CO2 that it produces when ignited was already taken out of the atmosphere when the plant material used was grown, so it is carbon neutral over the entire cycle. The main objection to biofuels is that plants grown specifically for biofuels occupy land that is needed to produce food.
Natural gas is likely to remain an important source of energy – despite the efforts of the UK government which will outlaw the installation of gas boilers in new-build homes after 2025. Natural gas is still relatively cheap. Electricity costs roughly two-and-a-half times the cost of natural gas per unit of energy produced. And biomass boilers are very expensive: Bright Blue has suggested that a British home would need to spend £7,000-£13,000 to install one.
Barclays Global Research – key conclusions
- Oil consumption is likely to peak between 2030 and 2035, with a long “plateau period” thereafter.
- In a world in which controlling emissions is paramount, this peak could come earlier, possibly as soon as 2025.
- Depending on the scenario, oil demand could range between 70 million barrels per day to 130 million barrels per day in 2050. This compares to current demand of around 100 million barrels per day.
- Oil is expected to remain a very significant part of the energy mix, even under the most optimistic low-emissions scenario.
Source: Barclays Global Research. Available at: https://www.investmentbank.barclays.com/content/dam/barclaysmicrosites/ibpublic/documents/our-insights/oil/oil-in-3d.pdf
Supply and demand
Oil and gas fields have what analysts term a “natural decline rate”. As oil is extracted from a field, so the pressure drops; as a result, each year output from that field falls. As such, if new investment were to cease today and no new fields developed, the industry’s existing capacity could be depleted to an estimated level of only 20 million barrels per day by 2050.
That implies that a supply-demand imbalance could be in prospect, even under Barclays’ Dynamism scenario which sees oil demand fall by more than 30 percent by 2050. Without ongoing exploration and investment (ie new oil wells), Barclays expects that there will not be enough supply to satisfy demand. In order to avoid a price spike, investment in oil and gas production is still needed so as to replace the output lost due to natural decline. With this in mind, it is reasonable to expect the industry to continue with business as usual for the foreseeable future.
Climate change – time to start worrying?
The Intergovernmental Panel on Climate Change has identified the need to limit temperature increases to less than two degrees Celsius above pre-industrial levels, but has set a target to limit increases to 1.5 degrees Celsius in order to mitigate the risks associated with climate change such as coastal flooding caused by rising sea levels. Therefore, the need to reduce CO2 and other greenhouse- gas emissions is now at the top of the agenda – as was evidenced at the Davos gathering in January 2020.
President Trump tells us we should be optimistic and close our ears to the prophets of doom. Yet sea- level rise is already apparent in America. I was recently in the Florida Keys, where climate experts are predicting a sea-level rise of 10-17 inches (25-43 centimetres) by 2040. Sugarloaf Key has already experienced a 10-inch sea-level rise over the last century. A sea-level marker dating from the 1930s is now about one foot under water. Monroe County recently alarmed residents by announcing that it does not have the cash to build flood defences.
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Since late September last year, about 30 people, not to mention an estimated one billion animals, have perished in the bushfires that have ravaged Australia. Twenty-five million acres of forest and bush have been burnt. About 8-9,000 insurance claims have been lodged, amounting to A$650 million. Last year was Australia’s hottest and driest since records began in 1910. Significantly, food-price increases have hiked inflation in Australia, with meat prices up by about 15 percent. Australia still does not have a target for net zero carbon emissions and is one of the world’s largest exporters of coal and gas.
Oil majors harness AI
The Azeri-Chirag Gunashli (ACG) oilfield lies about 60 miles off of Baku in the Caspian Sea. It is operated by BP (LON:BP.) which pumps an average of 584,000 barrels per day. The main problem for this important field is that it has a tendency to produce sand. In large quantities, sand can damage equipment and impede production. BP’s solution was to apply AI to the problem.
Back in 2017, BP’s investment arm took a $20 million stake in US-based AI firm Beyond Limits. Their software is helping BP to undertake more precision drilling and to avoid drill holes which are prone to sanding up. By using machine learning, operational risk can be minimised both upstream and downstream. Overall, oil companies are getting cleverer at what they do.
Oil as an industrial commodity rather than a fuel
More efficient renewable-energy technology – principally solar and wind power − will increasingly replace the use of oil as a combustible fuel. One view is that this will free up supplies to be used to produce more sophisticated carbon products, hydrocarbons and polymers. In this way oil will become more of an industrial commodity rather than just a fuel. Furthermore, the ability to chemically synthesise oil and gas from various plant materials will blur the line between renewable and fossil fuels.
The impact of the blockchain on the oil business
Simon Tucker, head of energy and commodities at Infosys Consulting (NYSE:INFY), thinks that blockchain technology – the technology that powers bitcoin and the other cryptocurrencies – is set to transform the oil and gas sector. Blockchain will have huge benefits both upstream and downstream. From scheduling equipment maintenance to managing exploration acreage records, blockchain offers a single, unalterable record of transactions and documentation between numerous parties. Distributed ledgers also create more efficient and transparent downstream activities, such as exchanging products, secondary distribution delivery documentation, demurrage and claims management. Mid-stream, it will revolutionise joint ventures, risk management, contracting and regulatory compliance according to Infosys.
Royal Dutch Shell and others: a diversification strategy
There are abundant examples of how established oil companies have been diversifying into green energy. Indeed, most of the annual reports these days carry pictures of windmills.
In December 2017, Shell (LON:RDSB) bought the Dutch-headquartered company NewMotion which rolls out electric-car charging points for homes and workplaces. It bought First Utility (now rebranded Shell Energy) shortly thereafter which supplies electricity and gas to 800,000 homes. It then purchased a 44 percent stake in Silicon Ranch Corporation which operates about 100 solar power arrays in the US. Shell’s renewable-energy division already included a 20 percent stake in in the massive Borssele wind-turbine array off the Dutch coast.
Similarly, Total SA (LON:TTA) acquired the battery manufacturer Saft in order to bolster its renewables business in 2016. BP (LON:BP.) bought a large minority stake in UK solar-power developer Lightsource for $200 million.
Saudi Aramco: expect the kingdom to sell down further
Last year Saudi Arabia revealed that it had enough crude oil in reserves to keep pumping at current rates for at least another 70 years. At the end of 2017, Saudi Arabia was sitting on an estimated 268 billion barrels of oil. By comparison, the UK’s remaining stock of oil under the North Sea will be entirely exhausted within two decades.
In his acclaimed 2005 book Twilight in the Desert, Matthew R Simmons predicted that Saudi Arabia’s oil wells were about to run dry. His analysis was based on the ageing status of several gigantic Saudi Arabian oilfields. But the kingdom’s oil industry and Saudi Arabian Oil Co. (TADAWUL:2222) always kept the figures secret. Aramco’s flotation in December last year – the largest IPO in history − has forced the kingdom to become more transparent about its output figures. Aramco typically pumps more than 10 million barrels a day, making it the world’s largest producer by far.
By selling five percent of the world’s largest oil producer, the Saudi state is cashing in on its huge reserves. The worst-case scenario would be to wait until demand for oil is in sharp decline; that might result in leaving much of its wealth stuck in the ground. Therefore, it is likely that the kingdom will sell off additional tranches of Aramco stock.
Interestingly, Saudi Arabia only overtook the Soviet Union as the number one oil producer in 1991 – the year the USSR dissolved. It maintained that position until 2015 since when the US has pumped more oil than anyone else¹.
Occidental Petroleum and friends – ‘negative oil’
Greta Thunberg claims that “nothing is being done” about climate change. Houston-based Occidental Petroleum (NYSE:OXY) begs to differ. They are talking about ‘negative oil’. This is the idea that the CO2 emissions produced by burning oil can at least partially be offset by the sequestration of carbon dioxide when the oil is drilled. Occidental claims to be injecting 20 million tonnes of CO2 annually back into rock formations in the Permian Basin (a shale field in Texas). This is equivalent to taking four million cars off the road. The Permian Basin has the capacity to store 150 gigatonnes of CO2. That is equivalent to 28 years of US emissions.
Occidental chief executive Vicki Holub, who was a leading light at Davos in January, claims that more CO2 is now sequestered in the process of oil recovery than is subsequently burned by cars and aeroplanes. This represents a massive expansion of carbon-capture and storage (CCS) technology which I predicted last year would become one of the leading industries of the 2020s.
In January, Swedish oil and gas firm Lundin Petroleum AB (STO:LUPE) launched its decarbonisation strategy − a roadmap for becoming carbon neutral by 2030. The strategy seeks to improve energy efficiency by cutting emissions from operations and developing advanced CCS systems.
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Lundin also plans to invest in renewable-energy projects as a means to generate its own net electricity consumption. It plans to limit carbon emissions and has set a target of below four kilograms of CO2 per barrel of oil equivalent (BOE) from 2020. It has set a further target of below two kilograms of CO2 per BOE from 2023².
Oil is not one commodity, but many
The global oil market consists of a huge variety of crude oils, from Canadian tar sands extracted with the help of steam and sand, to the lightest US condensates, the colour of which suggests a glass of fine white wine. Each crude stream possesses its own unique characteristics, and when refined, yields varying proportions of different refined products.
The oil industry consulting firm S&P Global Platts Analytics has created a kind of periodic table of oil, cataloguing 120 of the most important grades available on the international markets. Like the periodic table of the elements, the list starts with the lightest crudes and ends with the heaviest. The grades are classified by their specific gravity or density and sulphur content. Light crude oils have an American Petroleum Institute (API) gravity of 34 degrees or more, medium crudes have a gravity between API 25-34 degrees, and heavy grades are API 25 degrees or lower. Oil grades which have sulphur content lower than 0.6 percent are considered ’sweet’, while those with sulphur content above this level are classed as ’sour’.
The outlook for the oil price
As I write this in the last week of January, the newsflow is dominated by the development of the corona virus in China. Oil prices fell during the week of 27 January on concerns that a potential pandemic could drive a reduction in demand. According to Reuters, Brent crude futures fell by $1.28 to $59.41 a barrel, while US West Texas Intermediate (WTI) crude was down by $1.24 to $52.95 a barrel on 27 January. Saudi Arabia’s energy minister, Prince Abdulaziz bin Salman Al-Saud, expressed the view that the virus would swiftly be contained. A similar wave of pessimism hit the oil market back in 2003 during the SARS outbreak though in the event this did not cause a significant reduction in oil demand.
On the other hand, the oil price firmed in Q4 2019 on fears of a possible US-Iran conflict and the deteriorating civil war underway in Libya. On 20 July 2019, Libya’s National Oil Corporation reported the closure of the country’s largest oilfield, El Sharara, the previous day, resulting in a production loss of 290,000 barrels per day.
Brazil’s President Jair Bolsonaro announced last month that the country plans to boost oil production but that it has no plans to join OPEC. Mr Modi’s government in India signed a memorandum of understanding with Brazil to cooperate in the oil and gas sector.
Over the medium to long term, uncertainty concerning the long-run demand levels will have the potential to exacerbate price volatility.
Insert oil price chart
Greg (now Lord) Barker who used to run the UK’s climate-change strategy in the Cameron government, told an audience in Davos last month that there are going to be spectacular winners and losers in the 2020s, as the need to adapt to the climate emergency becomes a matter of urgent reality. He warned that we should expect ’stranded assets’, price shocks and more explicit carbon pricing: “Those companies which don’t recognise the carbon intensity of their business are going to be left on the side-lines”, he declared.
It is still not clear how proposed future carbon taxes (such as those envisaged in the Sustainable Markets Initiative launched by Prince Charles) will impact on the oil industry. Any such taxes will ultimately be passed on to consumers who will continue to live in a global economy where oil and gas is a substantial component of the energy mix. What is clear is that we have entered a decade or two which could be even more disruptive to conventional business models than the last two – especially in the energy sector. Some oil majors won’t make it to 2040 – others, who tread wisely, will.
Oil majors will increasingly have their work cut out to manage their public relations. Last October the National Theatre in London dropped Shell as a sponsor in response to agitation by indignant climate warriors. But investors should look beyond this kind of short-term noise.
The fact is that, the oil majors are likely to survive quite a bit longer in a world that still needs oil. From an investor’s point of view, oil stocks offer relatively low earnings volatility and mostly a decent dividend yield. There is a strong case to continue to hold at least one oil major in a diversified equity portfolio.
Companies cited in this article
|Royal Dutch Shell||LON:RDSB|
|Total SA||Euronext:FB/ LON:TTA/ NYSE:TOT|
|Saudi Arabian Oil Co.||TADAWUL:2222|
|Lundin Petroleum AB||STO:LUPE|