5 min read 4 Feb 20
Summary: Analysing the ‘energy transition’ involves confronting many paradoxes:
China is the world’s largest generator of wind power, and is home to over one third of the global installed base. Yet, it is also building as much new coal power capacity as the rest of the world combined. Electrification of the vehicle fleet seems an essential step, but an Electric Vehicle (EV) plugged into the US grid currently sources two times as much power from coal as it does from renewables. Plastic manufacturing is increasingly viewed as a tainted industry and something to be stamped out, yet greater use of plastic will be crucial in the light-weighting of vehicles to increase energy efficiency. Most glaringly of all, the push for decarbonisation comes at a time of intense power demand growth; in the 2010s, global power demand grew at twice the level of the 1990s, in absolute terms.
In areas such as Europe, with a clear regulatory framework, the direction of travel is one of rapid decarbonisation of the power mix and increasing costs for carbon-emitting industries through instruments like carbon credits. Good progress has been made already. The UK, for example, can justifiably be proud of its emissions reduction track record, cutting its absolute CO2 output by a third since 1980. The economy has grown strongly over this period, meaning emissions per unit of economic output have fallen by an even greater amount.
Yet, the trends in emerging markets (EM) are less encouraging. Displayed on the same basis in the following chart, growth in CO2 emissions from countries like India and China has continued unabated. The numbers are staggeringly large. For example, combined emissions growth from India and China in a typical year is equivalent to the entire annual emissions from a country the size of France.
It is not as simple as saying EM countries are going through their own ‘dirty’ phase of industrialisation. They are also assuming the manufacturing footprint of the developed world. While much of the UK’s emissions reductions have been achieved through coal-to-gas switching, renewable investment and greater energy efficiency, the country has also ‘offshored’ heavy industry. For example, UK steel manufacturing is down by roughly two-thirds since the 1980s. The UK still consumes steel, it is now just made elsewhere, with someone else incurring the emissions.
Among this frenzy of contradictory ideas and hard data, there has arguably never been a worse time to be a European Oil Major. Their asset bases have been built up over decades to supply a commodity for which demand still grows consistently. Yet, they now face increasing societal pressure to transition towards greener or renewable energy. This trend is growing across the world but the sentiment seems stronger in Europe than in any other region.
So far, the European Oil Majors have struggled to re-shape their corporate narrative. Their view of the world is defined, above all else, by the trend of rising energy demand. Looking purely at the world’s consumption patterns and the range of industry forecasts, it is difficult to argue with their logic.
If we are to take the International Energy Agency (IEA) transition scenarios as plausible pathways, between the most extreme and the most benign, demand uncertainty of 50 million barrels per day of oil production emerges by 2040 (equivalent to roughly half of today’s oil market).
The most ambitious trajectory (the Sustainable Development Scenario) is compliant with the Paris Agreement goal of limiting the rise in the global temperatures this century to “well below 2 degrees”. This scenario is no cakewalk. To achieve it by 2040, the IEA envisages wind and solar capacity needs to grow eight-fold, the electric car fleet must grow to over 900 million units, and the energy intensity of global GDP growth will need to halve, with carbon capture growing to absorb 5% of global emissions. All-in, such a scenario implies a 30% fall in oil demand over the next twenty years. At the opposite end of the spectrum, if the world continues on its current path, global oil demand will be approximately 20% higher than today’s levels by 2040.
All scenarios are open to academic debate, and the IEA analysis could be criticised for failing to go far enough; ignoring, for example, a complete rethink of how the world consumes power. The trouble with more rapid energy transition models (heavily incentivising EV adoption, for instance) is that they place a greater burden on existing power generation technologies in the shorter term and can, therefore, be counter-productive from an emissions standpoint. Even if the IEA scenarios are being generous to fossil fuel producers, such a wide range of outcomes raises questions about how sensible it is to invest fresh capital in new oil projects. The paradox for oil reserve owners is that production from today’s oil fields will gently decline, at a rate estimated to be between 3% and 7% per annum.
Even assuming a benign 3% decline rate for global oil production (absent further investment) implies that supply will undershoot demand even in the most ambitious transition scenario, opening up a material supply gap for oil in the 2040s.
The conclusion of this broad-brush analysis is that somewhere between 25 and 75 million barrels per day of new oil production capacity will have to be sourced and developed over the next 20 years.
This is an unhelpfully wide spread of outcomes, but helps to explain why the Oil Majors are proving equivocal about their future capital deployment. It also means these companies have the unenviable task of presenting to the world the idea that greenfield oil investment can be construed as ‘Paris compliant’.
This is an intractable problem for corporate communication, particularly for the European Oil Majors, and is why they are likely to strategically beef up their renewables exposure, whilst continuing with what they perceive to be high-return, globally-necessary upstream oil investments.
What seems clear is that the companies will not be rewarded for ‘growth for growth’s sake’, particularly in the upstream business. Yesterday’s priorities are redundant. High-carbon oil production or production in countries with poor environmental controls is no longer compatible with the expectations of society.
Investment in EV-charging technology carries industrial logic, given the Oil Majors’ large installed base in the form of the retail fuel network. The development of the hydrogen economy holds promise, but the production process (steam-methane reforming) produces nine times as much CO2 as it does hydrogen, so carbon capture and storage must be developed in tandem. Direct investment in renewable energy generation – through wind, solar, biomass and other technologies – only makes sense where the Oil Majors can monetise their competitive advantages: project management expertise, balance-sheet strength and managing government relationships. It is not obvious that low-complexity, unsubsidised onshore wind and solar meet these criteria, but – given its larger scale – offshore wind may make more sense.
The European Oil Majors must show that their investments develop low cost and low carbon barrels and can, therefore, compete even while demand growth first slows and then falls. Growing reserves life (reflecting the duration today’s production capacity can be sustained) will no longer be rewarded. It is notable that some of the Russian oil companies, with reserves lives of more than 25 years, have indicated they would currently be accelerating their rate of development were it not for the OPEC+ agreement to curtail production. Based on the trajectories considered earlier, the risk of stranded assets at the European Oil Majors seems fairly low. BP’s reserves life is around 14 years, while TOTAL’s and Shell’s are around 12 and eight years respectively.
Analysis of how the Oil Majors have turned over their asset bases is instructive. Using BP as an example, the following chart is split into two periods; broadly marking the consolidation super-cycle of the 1990s, which created the companies in their current form, and the resources boom and crash of the 2000s and 2010s. Over the long term, BP has had only limited reliance on inorganic expansion, selling almost as many assets as it has purchased. Exploration success has diminished slightly in the more recent period, while the company has begun to depend more heavily on technology and better reservoir understanding to grow (’Improved recovery’). ’Revisions’ are best ignored as they are exogenous and the result of changes in commodity prices, which have tended to inflate over the very long term.
The current phase of the global oil and gas industry is one of significant length in resources. There is no shortage of reserves to develop, particularly in countries such as the US with low fiscal and execution risk. With uncertainty around long-term demand, exploration seems a less justifiable use of capital, unless it targets gas, helps fill an existing facility or is exceptionally high return, because of tax breaks for example.
Considering one more chart, shown below, may provide another clue about the Oil Majors’ future behaviour – 2019 (annualised using 3Q19 data) was the lowest year for debt issuance across global energy since 2003.
Whether for ideological or economic reasons, the industry is being starved of capital. The fallout from this trend will last for years. Some smaller companies will cease to exist, either because they enter bankruptcy or are consolidated. The Oil Majors, who are not funding constrained, have a rare chance to buy ‘advantaged assets’ (large-scale gas, low-carbon oil, strategic fields). This is a new phenomenon. There have been oil and gas price crashes before, but they have typically been so brief that the bid-ask spread for M&A has remained wide. This down-cycle – the longest in the industry’s modern history – is starting to look different. Moreover, smaller companies are less well equipped to cope with the increased scrutiny and reporting standards which are only likely to grow in a carbon-conscious world.
This idea of consolidation raises the defining question for providers of capital to the energy industry, and presents yet another paradox. If the developed market Oil Majors are eventually also starved of capital through divestment of their equity or higher debt-financing costs, who will produce the oil and gas which most evidence points to us continuing to consume for several decades? Is it better that it comes from public companies which are accountable and whose board composition and actions are subject to shareholder approval, or should it be dominated by private or state actors, with less disclosure, and whose primary goals are energy security above all else?
Beyond physical production, the same argument can be extended to the ownership of the Oil Majors themselves. If developed market institutions will no longer lend or cannot hold the equity, how long will it be before sovereign wealth or emerging market state-champions – with differing priorities –start to take an interest?
All constituents, including investors, have a role to play in getting the energy transition right. Increasing corporate engagement about what sort of energy providers will continue to receive investment from public markets (through organisations such as Climate Action 100+) is helping to change the relationship between capital and energy projects for the better.
With an eye on the longer term, we may see the Oil Majors broken up, silo-ing their ‘dirty’ businesses and allowing investors to tailor their exposure in line with their objectives. Initially, small steps could be taken by creating separate listings for the Oil Majors’ venture capital arms – investing in new technologies such as carbon capture and storage, hydrogen or developing a portfolio of renewable assets in a particular region or of a particular type.
For now though, the high-quality assets of the global oil and gas sector gradually consolidating towards a smaller group of larger, more environmentally-attuned resource holders, seems the ’right’ answer for the world. At the same time, a winnowing out of the less attractive assets, higher up the cost curve, with higher carbon emissions, would help energy sector returns after a dire decade (in some senses, this Darwinian moment may already be underway in the US shale industry). As a result, at least until it becomes clearer that we don’t need to consume oil and gas, the European Oil Majors may even provide the best route to managing the world’s contradictory needs for abundant, consistent, accessible cheap power and lower-carbon emissions.
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