Future Oil and Gas Investment – The Red Queen Scenario

“Well, in OUR country,’ said Alice, ‘you’d generally get to somewhere else – if you ran very fast for a very long time.” 

“A slow sort of country!“ said the Queen. “Now HERE, you see, it takes all the running you can do to keep in the same place. If you want to get somewhere else, you must run at least twice as fast.”

There is a much quoted analysis on the energy future that goes something like this.

The oil and gas industry has slammed the brakes on investment for the past two years because of the price collapse – and that is storing up major problems in the near future due to foregone production, and increasing demand. This looming mismatch will then lead to oil price hikes, which then funds the new investment cycle that repairs the supply hole that has opened up.

Much like Alice and the Red Queen in the quote from Through the Looking Glass above, you have to run very hard to stand still as reservoirs deplete.

In dollar terms, various analysts from Wood MacKenzie to Deloitte to Goldman Sachs quote massive levels of postponed or cancelled capex, recently measured in the trillions, that will have to be rapidly found and deployed once prices rebound, to make up for this lost epoch of low expenditure.

Rystad Energy, a consultancy, also notes that oil prices will have to recover to $100/bbl soon so that a new cycle of investment can get underway.

Meanwhile, significant spending is postponed, and job losses mount.

What this popular scenario fails to address is what the industry should do if prices remain at around $50/bbl for a further extended period. It assumes a larger cyclical force is at work that will push the value of oil up, and allow major project expenditure to recommence – whether this be the concerted efforts of OPEC, demand growth or most likely both.

But there are good reasons to believe the scenario is limited, and that the energy market needs to be considered in more detail rather than just on the basis of a single fuel, oil – especially when considering future capital expenditure.

Over the past decade, capex has soared to over $800bn pa in projects related to oil ($550bn) and gas ($250bn) development, a 15%pa growth rate. As noted in other posts, this level was unsustainable and inefficient, with cost over-runs of 50-80% on average, and schedule delays typically greater than 2 years.

And increasingly, the two fuels service two very different markets, which are growing more distinct over time.

Gas provides energy to industrial and commercial and residential power markets, directly and via electric power generation. In this it is competing increasingly with other energy forms – traditionally hydro and nuclear, but increasingly wind and solar PV, and the persistence of coal.

Oil mainly drives transport – vehicles and light trucks the majority along with aviation and shipping.

A good summary of this is shown in the annual charts developed by the Lawrence Livermore National Laboratory, and shown below for the US in 2015 – similar charts and proportions cover other leading economies.

For gas, the IEA sees overall demand growth slowing to 1.5% pa to 2020, versus 2% pa in its previous forecasts. The previous high investment in capacity, has now created an overall glut in for with for example LNG capacity creating an estimated market overhang of 60mt, or 20% of the global demand, by 2019.

Along with the tenacity of coal, and the rise of renewables this has led to a 50% price decrease in the past two years, which is persisting.

This means that the slow-down in capex for gas projects currently on the drawing board does not necessarily lead to any near-term pricing spike, or looming capacity crunch – a point made forcibly a McKinsey analysis this month. They expect none of 10 current major LNG onshore and floating projects to achieve sanction in the next 18months, due to high break-even values. That’s roughly $80-100billion worth of capex deferred, with limited impact on overall pricing expected.

What of oil?

Oil is the prime transportation fuel. Its price has also fallen over 60% due to demand shocks from lower Chinese growth in the past two years, whilst novel supplies of oil from especially shale / LTO has risen to over 10% of the total market from 1% a decade previously

Price has since recovered as demand has remained steady and supplies become disrupted, although in absolute terms it remains only at its average over the past century, and still over 50% below peaks a few years ago.

Given this, the oil market has diverged in 2016 markedly from the LNG one.

Looking forward, both high and low case scenarios for oil demand out to 2020 assume modest growth to around 96mb/d of oil by 2020.

Calculations by Accenture – below – on the required capex to achieve these targets for both oil and gas show a major slowdown in capital expenditure. From historic heights in 2014 the median estimate is for investment to fall a third for oil, and gas to remain flat.

In total, from the peak investment of about $800m pa in 2014, scenarios point to something close to a total of $550m pa looking ahead.

Even this investment picture could be revised lower in light of McKinsey’s analysis of the gas project overhang, and any shocks to oil / gasoline demand.

Its also clear for example that many IOCs are now turning their trimmed capex budgets toward LTO investments (Shell and Chevron for example), or improved oil recovery from existing fields.

Indeed, if global demand turns out at the lower end of estimates, increased efficiency in costs and output from these types of investments will lessen the burden of creating large new field developments, and at the limit, remove the necessity for any significant exploration expense going forward.

For the IOCs this is profound: the traditional upstream model of sustained exploration and high investment in frontier scale projects disappears, to be replaced by efficient smaller scale developments on the existing capital base for both oil and gas, along with increasing service support to OPEC expansion of established fields for oil.

Overall

A lower announced capex picture does not necessarily play through to a looming price spike in the near future.

Looking further out to 2020 and beyond, penetration of solar and wind further into the gas market, and EVs into the gasoline market impacting oil growth suggest the longer-term picture could also be benign for price.

Much, so much, can change of course.

But its worth taking away three points here in relation to investment:

• The capex picture of the past decade was not an efficient story – curtailed spending was necessary and is not automatically a future price spike waiting to happen
• At the very least, the investment picture should be broken down into the increasingly divergent gas and oil markets: gas, increasing competition and supply overhang; oil, transportation-focussed, increasingly dependent on global demand as much as OPEC supply.
• The industry investment structure will be different 2017 onwards from the previous decade: more focus on smaller or build-out projects with more scalable, phased returns.

This points to the industry beginning to contract in terms of investment scale, with the focus more on efficiency rather than size. For an industry built on a high-growth model to service dividends and fund more capex, this is a major downshift.

OPEC policy will remain a short-term risk in terms of price, but medium term this reduces markedly if alternative transportation fuels eg EVs become significant – a point, however, that has been made many times over many years.

So, like Alice, if the energy industry does want to get somewhere else by running faster, it may need to start thinking very differently about how it invests its future wealth, and avoid the Red Queen problem.