Peak demand for oil before 2030
Thina Saltvedt from Nordea Group Sustainable Finance talks to us about the changing dynamics of the global oil industry, the era of OPEC dominance being replaced by a troika also comprising the US and Russia, where geopolitics are adding to oil price volatility. COVID-19 is causing an unprecedented oil demand shock, which could permanently alter investors' view of the oil industry and potentially accelerate the substitution of fossil fuels for renewable energy.
The oil industry has suffered three major shocks in only the past 12 years. In simple terms, how would you describe the difference between the oil shocks of 2008, 2014, and now in 2020?
Thina: The three shocks really are very different. Demand for oil is very closely linked to the level of economic activity. Demand for energy, including oil, rises when economic output grows. The 2008 oil shock was triggered by the plunge in economic output caused by the global financial crisis. The lower demand led to lower oil prices.
In 2014, we saw the opposite - a supply shock for oil. In summer of that year, a lot of US shale oil capacity started flowing into the market, creating excess supply and pushing down the oil price. Shale oil has been produced in the US since the 1960s, but had not been profitable at historically low oil prices. In the period between 2008 and 2014, the discourse on the oil industry was heavily oriented around 'peak oil'; the view that the world will one day run out of oil reserves. Add to this the Arab spring of 2011, when social unrest in oil nations like Libya, Syria, Yemen, Tunisia and Sudan reduced oil production, and that the industry kept investing to ramp up capacity. The resulting high oil prices helped fuel investments in the relatively high-production-cost US shale oil industry, and when this wave of additional oil hit the market, the response of OPEC – the biggest player in the market – was to flood the market with additional oil by increasing supply even further to reduce oil prices and make the US shale industry unprofitable. In the end, OPEC abandoned the attempt when the pain to the members' national budgets from lower oil revenues became unbearable.
To give a bit of perspective, Saudi Arabia overtook the US as the world's biggest oil producer in 1980. Russia lost half of its oil production when the Soviet Union collapsed and reached its original output again only in 2009. From the boom for shale oil, the US has regained ground and is since November 2019 a net exporter of oil. OPEC used to dominate the oil market, but now has to consider both Russia and the US serious rivals. And these three players all have different strategic interests.
OIL PRODUCTION US, RUSSIA AND SAUDI ARABIA SINCE 1966
Source: BP
In 2020 we have had both a supply and a demand shock for oil. In spring, Russia broke ranks from its agreement with OPEC to maintain supply cuts, having concluded that they only helped US shale oil to become more competitive. Saudi Arabia and OPEC responded by ramping up their production, triggering a price war with soaring supply pushing down oil prices. Right in the midst of all this, COVID-19 became a global pandemic. Governments worldwide started implementing travel restrictions and lockdowns to slow the spread of the virus. Consumers being stuck at home has evaporated travel demand and we have seen an unprecedented 30% collapse in global oil demand for over the course of only 2-3 weeks. This brought Saudi Arabia and Russia back to the negotiation table, so far responding with a roughly 10% cut in oil production.
The oil industry was not well prepared to deal with the supply shock and price declines of 2014. It has been riding on the transport sector lacking alternatives to oil to power its business. China's boom in the first decade of this century fuelled a supercycle for commodities, including oil. And the world kept consuming more oil all along the price journey from USD 30 to USD 150 per barrel. As a result, the global oil industry has not had a cost focus. It has been more a matter of meeting demand. For any other product seeing that kind of price increase, consumers would have simply substituted oil products with something else. But with no other viable option to power cars, ships, trucks and aircraft during this period, consumers have paid up, and the industry kept raising output. But transport players like airlines have responded by renewing their fleets with modern aircraft that consume less fuel and have lower emissions. So the oil industry faced the 2014 shock with a bloated cost base, customers who were already applying new discipline to fuel consumption, and a strongly growing focus on sustainability from authorities and consumers.
The OPEC countries are today competing head-on with Russia and the US in the oil market; is it only about supply and demand or is there a geopolitical power struggle dimension in this competition?
Thina: Yes, definitely. Control of proven oil reserves has historically been a very valuable source of power and influence. The alliance between the US and Saudi Arabia was forged already at the time of the second world war. This alliance was put to the test during the first OPEC oil crisis in 1973 when OPEC banned exports of oil to countries like the US and the UK as retaliation for their support of Israel during the Yom Kippur war. The resulting supply shortage gave rise to a global oil crisis of a magnitude we have not seen since then. There is a well-known image from Norway at that time showing the Norwegian king using the metro when rationing of petrol was introduced – a powerful illustration of how we were forced to change habits when we faced an actual and acute shortage of oil.
THE FIRST OPEC OIL CRISIS IN 1973: PETROL SHORTAGES IN THE US
Source: Wikimedia Commons
The key elements of the pact between the US and Saudi Arabia have been Saudi oil exports to the US and US arms exports to Saudi Arabia. This has strengthened Saudi Arabia's position in the Middle East, especially versus Iran. And the two US-led Iraq wars in 1991 and 2003 were arguably related to securing access to oil in the region. Massive US pressure has clearly been a factor in persuading Saudi Arabia to end the oil price war earlier this spring. There have been threats of US sanctions before, such as when the Saudi reporter and regime critic Jamal Kashoggi was assassinated by Saudi operatives in Turkey in 2018. But in the end, economic and geopolitical interests got the upper hand and President Trump did not press the case against the Saudis.
Russia is already subject to US sanctions and can use this as a negotiating chip for its behaviour in the oil market. But the US-Saudi relationship is changing. Now that the US is self-sufficient in oil, the benefits from its ties to Saudi Arabia relate more to its overall strategic interests in the Middle East. But there is a terror balance aspect to this situation, as any disengagement by the US could be met with a shift to buying arms from Russia or China instead. I think this complicated interdependence and political dimension to the oil market is another compelling reason why the world needs to wean off its oil dependence, in addition to the critical sustainability aspect.
The balance of power in the oil market has changed since 2014. Neither Russia nor Saudi Arabia should be keen to see the US remain the world's biggest oil producer. If they can see a post-COVID-19 oil price below 50-60 USD, the market dynamics can change, the US shale sector could lose competitiveness, and the Russians and Saudis could win back market share.
Historically, the debate on the future of the oil industry was oriented around ‘peak oil’, or supply eventually running out. In recent years, this seems to have shifted to ‘peak demand’, with energy demand shifting away from oil into renewables – which do you think will decide where the oil industry goes from here?
Thina: In the short term, I think the geopolitical dimension - the strategic agenda of the three big players in the oil market - will set the tone for where the oil price is headed. Longer-term, I think demand will be the crucial factor. Since the Paris Agreement of 2015, which seeks to limit global warming to two degrees, institutional investors' focus has shifted very strongly towards sustainability in investments, and this is affecting companies' behaviour and cost of capital. For the past five to six years, I have believed that we will reach a global peak demand for oil before 2030, after which demand will start to decline. This view was a hard sell back then, but has gained much more traction today. And the simple fact is, if the Paris Agreement targets are to be met, global oil consumption needs to be halved by 2040-50.
Historically, the prevailing view in capital markets was that oil is a finite resource that will one day run out. What the US shale oil revolution has taught us is that higher oil prices will stimulate new forms of exploration and production, giving us access to reserves that were previously uneconomical to exploit. In the past it was key for listed oil companies to show that they had a reserve replacement ratio of one or higher, that they were adding to their oil reserves faster than they were exploiting them.
Based on the reasoning that oil is a finite resource, they kept buying drilling rights in the belief that a growing world population, translating into a growing world economy, would one day make also marginal or more inaccessible oil fields economical to exploit. Today, they can no longer be sure that long-term demand will be there, or that there will not be significant financial burdens associated with exploration and production of fossil fuels. And this means the value of oil reserves is becoming more uncertain or even questionable. We are now seeing this in equity markets, although perhaps not so much yet in corporate bond markets.
In the past ten years, the cost for solar, wind and battery power has fallen sharply, and these energy sources are today competitive compared with fossil fuels. They are not currently competing head-on with oil, as very little oil is used for electricity production. But they will become strong alternatives for powering transportation. We are approaching a stage where electric vehicles are becoming competitive without subsidies. They are here to stay, there is no stopping it. But their proliferation could be slowed by lower oil prices.
What are the key drivers for the shift in demand towards renewable energy sources? Could any of them be paused or cancelled by a low oil price? What are the key obstacles today to a faster shift into renewables?
Thina: A change in mindset among investors has been a powerful catalyst for change. They have started to care about climate risks and sustainability, and this is affecting companies. It started with exclusion, not investing in companies that do not have a sustainable business. The coal industry was one of the first to feel the impact, suddenly not being seen as investable by the mainstream institutional investor base. Oil is next on their list. But just divesting non-sustainable companies from investment portfolios is not enough; sustainable companies contributing to reaching the Paris Agreement targets to invest in must also be found. I think this view on investments among institutions has accelerated just over the past year.
Also, up until 2019, a common view among investors was that signs, however small, of fossil fuel companies investing in renewables and starting to position themselves as energy companies instead of oil companies gave room for them to be perceived as sustainable. But now, a year later, a new view is emerging; that having just a symbolic presence and profile in renewables is not enough, and will not prevent you from risking being categorised as non-sustainable. Around the turn of the year, four oil majors, BP, Total, Shell and Equinor, all announced that they intend to change their footprints in order to contribute to a reduction of CO2 emissions. This is a striking example of how powerful an impact capital markets can have in driving change.
I think oil majors have to transform their businesses to become more sustainable in the coming years. Just consider what having faced three major oil shock just in the past 12 years will do the industry. It is characterised by long-term investments. In the North Sea, it typically takes ten years from when you start a project until you are able to sell oil from it in the market. Projects now being started on the Norwegian Continental Shelf may start production by 2030, when I believe we will already have passed peak demand for oil. Investments are made in oil fields which should be operational for 40-50 years. Will they really be needed? The oil industry has attracted investment after the 10-15 years of 'super-profitability' it enjoyed until 2014. But the playing field has changed. The market is dominated by three big players who are all distracted by geopolitical considerations. There are question marks over long-term demand for oil. And sustainability is becoming a hygiene factor for institutional investors. The prerequisites for a new run with super-profits are not there, and therefore investors may as well look elsewhere for optimal returns.
Some investors have been burned in the sector. The 2014 shock hit both oil producers and the oil services sector hard in Norway, and the latter employs even more people. There are oil services companies that have been unable to generate a profit since the 2014 crisis, who are now facing a new blow. Again. That is not a viable way forward. The industry could be seen as less attractive, not least if my suspicion that we will have a more volatile oil price going forward materialises. Renewables, on the other hand, are no longer as dependent on subsidies, are now better known and understood by investors, and have so far during the coronavirus crisis stood more stable and robust than during previous crises.
Should we expect that oil demand will recover to pre-pandemic levels? Or could the COVID-19 shock change demand patterns structurally?
Thina: I am actually hoping that our behaviour will changed a bit. Managers around the world are right now seeing that investments in good communications infrastructure is allowing massive cost savings, both traditional cash costs and CO2-related costs. And less travel also saves time, which is a productivity gain. We will still have physical meetings, but I think less than before.
If we have a period of reduced travel and transport in the wake of the COVID-19 pandemic, costs will continue to fall for renewables technologies. At the point when we see a recovery in economic activity to pre-crisis levels, I find it hard to see that we would go back to the same level of oil usage we used to have.
There is also a potential opportunity for policy makers in developing countries to remove oil subsidies. These have been tricky to touch in the past, with major protests against such initiatives in places like Nigeria and South America. But if there is any time when you will politically be able to get away with it, it is when fuel prices are really low. It is a golden opportunity to de-incentivise the use of fossil fuels.
Norway’s economy is highly dependent on the oil industry – how do you see the current oil shock affecting Norway during the COVID-19 pandemic, and in the long term? Can and should Norway’s government try to mitigate structural change?
Thina: The 2008 oil shock was very sudden and very unexpected. It was driven by a crisis in the global financial sector, and Norway responded with support for its oil and offshore sector, with the view that once the shock passed, oil demand would always be there. So we did not learn so much from that crisis.
The 2014 oil shock hit us right in the face. Norway had not envisaged that it would be out-competed as an oil producer. We had always assumed and planned for extracting all oil that we found in our waters. A collapsed oil price which remained low was a painful new reality to deal with. We again, as after the 2008 shock, supported our oil sector, but now have to ask ourselves if we were a bit too generous with that support. Not all companies were able to turn profitable again by the time COVID-19 hit us with a third oil shock. Some of them probably never will be. And perhaps the offered support should have been a bit more targeted in order not to be wasted; as giving life support to a patient who is beyond saving to begin with. The challenges these companies face are becoming greater since it is both about the volatile oil price and about migration from fossil fuels to renewables. In Norway we have contributed further to this, for example by electrification of vehicles. Owing to incentives, nearly half of the new cars sold in Norway are electric. The car manufacturers are able to use Norway as a testing ground for their new electric vehicles, which could help accelerate the adoption of electric cars by consumers.
When the Paris Agreement was signed in 2015, there was strong political focus in Norway on the economy's transition to becoming less oil-dependent, but the pace of transition has slowed. There are no other significant sectors in the Norwegian economy that have offered similarly high returns as the oil industry which you could plough capital and labour into. That has made the political challenge of trying to speed up a transfer of resources out of oil formidable. A new parliament is elected every four years and the parliament members and governing parties need to be mindful of how the immediate impact of their policies will be evaluated, even though they are hopefully trying to make the best strategic long-term decisions. This leaves a strong incentive for Norway's political decision-makers not to speed up an exit from oil before peak oil demand has actually arrived.
I think Norway should aim for a balance in its state support to mitigate COVID-19, ensuring that companies with viable businesses are not forced into default, while not slowing Norway's necessary workforce and know-how migration out of the oil industry by flooding it with unconditional, universal support. I think the support packages introduced so far by government live up to this pretty well. The support is directed more at the struggling oil services industry than at oil majors, which typically have sufficient liquidity to ride out the storm. And it aims to make currently loss-making projects profitable, letting corporates depreciate investment spending more quickly, taking the charges right away instead of over many years. This will make the projects start generating positive cash flows more quickly, and in return the state will get greater tax revenues from those future cash flows. But what if peak oil becomes the new reality and those future cash flows turn out to be lower than expected? If so, the state may not win back what it spent in support, or more, from future corporate tax payments.
The key objective for Norwegian state support should be to facilitate the redeployment of talent and competence from oil services and oil production to other areas where it can be leveraged and exploited, initially typically in closely related fields like offshore wind farms. This is also why it would make sense for the addition of a green stimulus package from the Norwegian government designed to stimulate that transition from fossil to renewables.