Expensive endgame: Oil prices will rise in energy transition, good for oil EMs
International oil companies’ green shift will constrain supply, potentially boosting prices, helping oil-producing EMs
A thought-provoking conversation over a pint at the Archduke
Two decades ago, I was a precocious new political analyst in Shell’s scenario planning team. I was sitting at the Archduke pub on London’s Southbank with several of the company’s economists, who asked me an excellent question: “Where do you think oil companies lose the most money to political risk?” I’d been hired to work on Russia and the Caspian, complex countries emerging from communism, but my mind immediately went to Nigeria, given the death of Ken Saro-Wiwa at the hands of the Nigerian military regime in 1995, which was still fresh in many people’s minds despite Nigeria’s transition to democracy with the election of Obasanjo in 1999.
I was quickly put in my place. One of my colleagues argued that, at least in certain circumstances, developed countries could ultimately be greater political risks. Problems in emerging markets were spectacular when they happened but, generally speaking, they were offset by the favourable and stable royalty regimes that such countries needed to attract international investors in the first place. By contrast, developed countries do not need to work as hard to attract capital, so can raise tax rates after oil companies are committed to projects and lower them again when they need to attract new investment.
Two decades later, the oilmen at the Archduke have mostly been replaced by tourists, and those who are still there are more likely to be talking about wind, solar and hydrogen over their pints than their latest endeavours on the frontiers of oil production. My colleague Janet Ogunkoya argues that Africa, which relies on international oil companies (IOCs, also known as oil majors or supermajors) more than other regions, could be particularly negatively affected as IOCs transition away from oil and gas in favour of renewables. I agree that IOCs are likely to withdraw from EM oil and gas production, but might return to those same countries to invest in renewables. But, even if Janet and I are correct that IOCs will move away from EM oil, the energy transition may help EM oil producers, at least in the short to medium term.
The end of the Oil Age doesn’t mean the end of oil…
Perhaps the most famous encapsulation of the energy transition comes from former Saudi oil minister Yamani, one of the founders of OPEC, who famously remarked that “The Stone Age did not end for lack of stone, and the Oil Age will end long before the world runs out of oil.” He was obviously right: the Stone Age ended because technology got much better, and the oil age will end soon both because the environmental impact of oil is intolerable and because technology is getting good enough to replace it.
However, there is another angle to Yamani’s comment: The world still uses a lot of stone today, mostly as aggregate for construction. And even after we reach net zero, the world will still use a lot of oil and gas. We will use it for non-energy purposes, like manufacturing plastics, chemicals, lubricants, fertilisers and advanced composites, and we will still burn it as a niche fuel, including for military and construction vehicles and for some aviation, marine and small-scale power generation applications.
To think about the role that oil will retain, let’s consider one of the most aggressive scenarios for the energy transition, the International Energy Agency’s Net Zero by 2050 scenario, which keeps the global temperature rise below 1.5 degrees Celsius and sees the world reach net zero greenhouse gas emissions by 2050. To give you a sense of how this unfolds, Net Zero by 2050 assumes that no new internal combustion engine vehicles will be sold after 2035. Oil production falls by 65% from today to 2050, but that fall is much smaller than for the other hydrocarbons. Unabated natural gas falls by 88% and unabated coal falls by 98%.[1] By 2050, the share of oil consumption for non-energy use has risen by 14% to 41% of total oil consumption. Oil use for energy declines, while non-energy use remains stable at c30 exajoules per year.
Figure 1: Oil still has a role to play in the International Energy Agency’s aggressive Net Zero 2050 scenario
…as new owners extend the lifespan of the IOC’s divested assets…
But the path for oil demand could certainly be higher than in Net Zero by 2050. One can easily imagine that governments will backslide and postpone on climate commitments, as they have so many times before. Indeed, a degree of backsliding is perhaps inevitable — the only question is how much backsliding will happen.
Today, a sort of corporate backsliding is happening by stealth, as IOCs have responded to investor pressure to divest their dirtiest assets by selling them to smaller players, so-called Independents, that typically lack the ESG credentials and concerns, or indeed the environmental track records, of their larger counterparts. These new owners of IOC assets are unlikely to invest in significant new projects, but they will reduce costs, including perhaps by loosening environment standards where they have exceeded regulatory requirements, and their lower cost profiles will allow them to operate these fields for much longer than IOCs themselves had planned.
…and Bezos and Branson have shown that demand may not fall as quickly as we expect…
Net Zero by 2050, like most all long-term scenarios for global energy, assumes that we won’t find another compelling source demand for oil. Indeed, Net Zero by 2050 anticipates a 7% reduction in total global energy consumption by 2050. Careful policy design will be required to do this while closing the development gap and improving the living standards of the poor. For example, Net Zero by 2050 assumes that use of biomass for heat and cooking ends is completely replaced by cleaner energy sources by 2030.
At the other end of the income spectrum, July 2021 saw two spectacular demonstrations of potential future energy demand growth:[2] first flights by billionaire environment philanthropists Richard Branson and Jeff Bezos on their tourist space vehicles from Virgin Galactic and Blue Origin, respectively. Analysis by the Breakthrough Institute found that a two-and-a-half-hour trip, with five minutes of weightlessness, on Virgin Galactic uses more than seven times more energy per passenger than a flight from London to Singapore, or roughly twice as much energy as the average American consumes each year.
Figure 2: Virgin Galactic shows the possible future energy demand from spaceflight
Billionaire tourism is not the only factor boosting demand for spaceflight. Commercial demand is also growing, as the amazing progress of the private spaceflight industry continues to push down satellite launch costs, while digital applications and desire for national satellite capability (eg China’s BeiDou navigation system and the UK’s investment in OneWeb) drive demand.
Geopolitical competition is also returning to space, with China and the US racing back to the moon — this time with the goal of a permanent human presence — and then on to Mars. To consider the scale of this undertaking, remember that the original Apollo programme consumed 4% of US GDP and led to the development of what is still the most powerful rocket ever constructed. I dream of a zero-carbon, solar-powered space that will lift humans away from Earth’s fragile ecosystem to a geostationary satellite where they can board nuclear plasma-powered rockets for their onward journey as a multiplanetary species, but for the time being spaceflight requires massive fossil fuel consumption.
…so prices could rise in the oil endgame…
On the Net Zero by 2050 pathway, oil demand falls steadily. No new projects are needed, but existing projects are largely able to run their natural lifespan. The role of OPEC in oil markets steadily rises as non-OPEC production falls away, presumably due to a combination of regulation, capital availability, and falling demand. Prices slowly decline to 2050 in line with the decline in production.
Figure 3: OPEC’s dominance will grow as oil prices fall away
This is certainly a plausible scenario, but it is by no means the only way that this could play out. As oil demand falls, it is also likely to become even more inelastic than today. Non-energy oil demand is more influenced by demand for the goods that these products go into than by oil prices, and therefore is less sensitive to price movements than transportation demand. And, as oil is replaced with batteries for discretionary personal transport, demand for oil for transportation will also become more inelastic. As oil demand elasticity falls, oil markets will become more vulnerable to price spikes when demand surprises to the upside, or supply undershoots.
OPEC’s ability to manage prices will also grow. With a larger share of the market, OPEC will be more able to support prices. And the impact of its actions on prices is likely to be longer lived, as IOCs will not respond to higher prices with more exploration, nor will increasingly inelastic demand fall.
Moreover, with non-OPEC oil production dominated by smaller Independents, the OPEC countries, and especially sophisticated national oil companies (NOCs) like Saudi Aramco, may lead the world in production and exploration technology. Oil services contractors, like Schlumberger and Halliburton, will also be well-positioned for this world, lending their expertise both to Independents looking for cost-effective ways to extend field life and to smaller NOCs without Aramco’s levels of in-house technical capability.
The threat will be OPEC cohesion, recently on display in the UAE’s reluctance to agree to price cuts. If OPEC cohesion collapses, as individual members seek to pump as much oil as possible before the Oil Age ends, then Saudi Arabia will be left with the difficult choice of deciding whether to shoulder the burden of cuts largely on its own or allow prices to collapse.
…all of which could be good for EM oil producers
As Janet argues, ultimately EM oil producers will need to diversify their economies and exports. In the meantime, however, the oil endgame could be good for them. Countries with the lowest marginal cost oil will benefit the most, but we may also need to rethink marginal costs. IOCs may be forced to write off some of the capital costs when selling legacy assets, so the cost calculation could shift to focusing on only incremental operating costs. Onshore fields with low total cost, like those in Saudi Arabia, will remain the most attractive, but offshore fields with high initial capex and lower opex could do better than one might expect.
Looking more broadly, not only is the EM oil producers’ share of global oil production likely to rise, especially for OPEC countries, but their clout will, too. The dynamic that was described to me 20 years ago at the Archduke no longer applies. EM oil producers no longer need to constrain their treatment of their current oil investors in order to attract new ones in the future — the new ones won’t be coming anyway. As such, the balance of power has now permanently shifted back toward the EM oil producers themselves, and away from the IOCs.
Although legal frameworks vary from country to country and project to project, in general EMs will be more able to increase their take of their remaining oil revenue, potentially improving their fiscal position in the short term or at least damaging it less than many observers fear. Hopefully, they will use the fiscal breathing room to fund their longer-term diversification.
Thanks to my former Shell colleague, Wim Thomas, for making me aware of the energy usage of Virgin Galactic and its implications, and to my Tellimer colleague Stuart Culverhouse for his feedback.
[1] “Unabated” means burned without capturing and storing the CO2 that is emitted. Even if we included natural gas and coal with CCS, the cumulative fall across the two fuels in 74%.
[2] While there are many different chemistries for rocket fuel, many of them, for example, the RP-1 refined kerosene that powers Space X’s rockets, are refined oil products.
This article first appeared on Tellimer.com. To read it in full, go here.
