From the Economist's Chair: Oil in transition

Author David Fyfe, Argus Chief Economist

As the petroleum industry gathers in London for its annual IP Week jamboree, it seems assailed on several fronts along its planning horizon: economic downturn and coronavirus in the short-term; consolidation and slower supply growth from US shale in the medium-term; and looming “de-carbonisation” in the longer-term.

However, doom-mongers risk conflating oil’s quite separate cyclical & structural challenges. They may also be underestimating the industry’s adaptability and resilience. Nonetheless, the oil sector itself could do a much better job explaining why it will remain core to world energy supply for decades to come and how it plans to manage that reality responsibly. 

Not since the great recession of 2008/2009 has oil’s annual IP Week gathering begun amid so many glum faces. Cause for short-term concern, of course, is the near-total lock-down of Chinese industry and mobility since late-January due to coronavirus (COVID-19).

Notwithstanding the human tragedy of an epidemic that has claimed 2,000+ lives to date, and ruined the economic livelihoods of many, organisers of some IP Week events have cancelled for a combination of public relations, cost and fear-of-transmission reasons. 

Comparisons of COVID-19 with the SARs epidemic of 2003 are inevitable. That turned out to be a single-quarter affair, after which Chinese growth rebounded sharply. But SARs is not a particularly useful yardstick: the Chinese economy is now a much larger beast than in 2003, accounting for 20% of world GDP and 25% of inter-regional global crude oil trade.

And while there is no evidence so far that COVID-19 is more deadly or infectious than SARs, it will almost certainly have a heavier economic impact this time around. 

Assuming, the disease is contained, and infection levels recede, 2Q20 could see recovery begin, as Asian & global supply chains start to unblock. Our Consulting group in its latest Argus Fundamentals report assumes a calendar-2020 hit to global oil demand of around 400 kb/d vs. pre-epidemic expectations, tapering off from a 770 kb/d reduction in 1Q20 to 400 kb/d in 2Q20 and 275 kb/d in the second half of the year. 

This is a material adjustment, but still allows year-on-year demand growth to regain one million b/d, assuming Latin America and the MENA region begin to clamber off the floor after 2019’s economic slump. Both regions are commodity intensive, so that even anaemic oil demand growth from the OECD and China this year need not, by itself, prevent a global demand rebound.

A more serious scenario from an oil demand standpoint would involve curtailed Chinese refinery runs persisting to 2Q20 or beyond. This would risk crippling crude exports from the same MENA and Latin American producers currently expected to drive 2020 economic recovery. 

COVID-19 comes hard on the heels of 2019, a year in which the oil market coped with the seemingly contradictory currents of prevailing “risk-off” sentiment in commodities and weak demand, repeated supply disruptions & geopolitical risk, the threat of global economic recession, and an on-off US-China trade war amid a broader narrative of impending “de-globalisation”.

The fact that ICE Brent crude remained within a $50-$70/bbl range throughout this turbulence is testament to the industry’s adaptability and resilience. When demand slumps:

  • physical traders deploy infrastructure to re-direct product flows and smooth out regional and global imbalances;
  • refiners tweak crude runs and operating regime in line with shifting requirements;
  • OPEC+ producers adjust supplies in volume, quality and timing to better match market demand.

 

Market adjustments also occur when demand starts rising again. The industry habitually responds nearly instantaneously to changing market conditions, partly though its own ingenuity, integration and global reach, and partly thanks to the signals sent by transparent pricing benchmarks and market intelligence that Argus and other PRAs strive to provide.

With signs that the global recessionary bullet has now, arguably, been dodged (assuming COVID-19 proves short-lived), there is room for short-term cyclical optimism to re-emerge in the oil space once more. The global economy and oil demand will recover given time.

Downstream markets, storage and trade flows will be deployed to manage market over-hang until that occurs. And with OPEC+ seemingly in responsive mode, another price crash may have been averted. But the industry is, as ever, looking further ahead than just the next 2-3 years.

Medium-term headwinds also confront the shale oil and gas sectors in the US, which have been responsible for 35% of global gas supply growth and 75% of global oil supply growth in the last decade. With the liberalisation of hydrocarbon exports since 2015, US cargoes have become a key source of marginal supply for global markets.

This has been facilitated by both a massive industrial infrastructure build-out, and by the development of responsive international pricing signals, an area where Argus again has been striving to provide innovative solutions.  

Market analysts are prone to straight-line forecasts however, often failing to recognise inflection points as they occur. The recovery in US oil supply since the price crash of 2015/2016 has been dramatic. Total US oil production grew 800 kb/d in 2017, by 2.2 mb/d in 2018 and by 1.7 mb/d in 2019. Some have predicted 1 mb/d-plus annual growth can be sustained longer term.

But that seems unlikely, given that much of the historical growth was achieved under a highly-leveraged financial model. Growth is now clearly moderating, with Argus Fundamentals anticipating a slow-down to around +0.75 mb/d this year, levelling off nearer 0.5 mb/d annual growth in the medium term. Policy shifts in the event of a Democratic 2020 Presidential election win might re-enforce such a trend.

Physically, the slow-down is attributable to steep decline rates for production from older shale wells. Operators have extensively drilled the established sweet spots in US shale basins and are paring back drilling activity to rein in capex and boost free cash flow and shareholder returns.

Recent analyses suggest low-$50s WTI prices leave 40% of US producers unable to fund investment via free cash flow, a key requirement now for investors and lenders. Consolidation in the US shale space looks likely to continue apace. 

This does not herald an end to rising US oil exports, but rather “the end of the beginning” in the shale story. The “Klondike” phase when volume growth was valued above all else is arguably over. It will be replaced by a business that combines a more consolidated and robust financial model, healthy volume growth, more flexible export infrastructure and sustainable environmental footprint.

Comparatively short-cycle US shale will remain more price responsive than long lead-time conventional oil. However, as larger producers with deeper pockets and greater sensitivity to environmental concerns enter the space, the volatility of supply to changing price levels may also moderate. 

US shale also provides a handy bridge to the oil industry’s key long-term challenge: an environmental license to operate. Just as shale must “clean up its act” by reversing the US’ recent elevation to number three in the global league table of gas flaring, so the broader oil industry needs to explain why it will remain core to global energy supply for decades to come and how it will achieve that in a more environmentally sustainable fashion.

This is an orders-of-magnitude steeper structural challenge for oil than either short term market volatility or mid-term financial consolidation in shale. Increased reputational pressure is afflicting the oil value chain amid the awkwardly-named “energy transition” (in reality energy markets have been perpetually in transition).

However, the industry sorely needs to stand firm to demonstrate why it already has a societal license to operate, even if among the more extreme of environmental activists it has taken on quasi-pariah status.  

That an aggressive “de-carbonisation” agenda has emerged in the last 20 years is news to no-one in the oil industry. It is advocated most loudly by affluent voters and broadcast media in the developed world, and rather less so by populations hitherto deprived of reliable and affordable supplies of fuel and power.

Fully a billion people worldwide lack access to electricity and 2.5 billion lack access to clean cooking fuel, some twenty years into the 21st century. Energy transition needs to address that as a priority at least as important as environmental sustainability. 

The notion of oil and hydrocarbon displacement from the modern economy pre-supposes primacy for one single pillar of energy policy: environmental sustainability. But rational energy policy also includes other pillars:

  • energy access as a route to economic betterment;
  • resource availability;
  • reliability and security of supply and, critically;
  • economic affordability. 

 

Considering all these policy goals together is likely to result in broader societal gain than will the elevation of “climate” above all others. It may even hasten a true “energy transition” that embraces broader fuel diversification, a growing role for economically self-sustaining renewables, wide-scale electrification, greater use of EVs and renewable fuels in urban and suburban transport plus, crucially, a consistent, globalised, revenue-neutral system for taxing or pricing carbon. 

This latter factor is critical for genuine energy market transition, and is now largely accepted as such by most major oil companies. Widescale carbon pricing would provide a market-based system for achieving climate change objectives that avoids the excesses and unpredictability of short-term reversals in government fuel policy (Europe’s on-off love affair with diesel cars being only one example).  

But just as important is that carbon pricing provides the oil industry with the Teflon-coated license to operate that it so eagerly seeks. By definition, carbon pricing acknowledges that renewables alone cannot satisfy all the world’s future energy needs.

Yes, carbon pricing encourages renewables adoption, but it also facilitates the gains in energy efficiency of capital stock necessary to provide almost 40% of the CO2 reductions needed to mitigate global warming.

Eventually it can unlock the potential of CCUS technologies, which themselves would permit continued, environmentally benign use of oil, gas and even coal, in those markets where hydrocarbons are demonstrably the optimal fuel choice for local populations.

The industry needs to explain much more loudly and clearly that oil will continue to be used in road freight, air travel, shipping and petrochemicals for decades to come. Across all the IEA’s estimable scenarios for future energy demand oil retains a 25-30% market share by 2040, compared to 31% in 2018.

Enhanced ESG reporting, incremental renewables investment and company rebranding are all well and good, even necessary, for oil companies in the 2020s. But let’s not overlook that the world energy system by mid-century will still have oil at its core.

IP Week is an excellent forum for the industry to not just proclaim that reality, but also to start planning how to manage it for the greater good.  

 

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