Good Binge or Bad Binge? The Last Decade of Oil and Gas Investment

History is likely to view the last decade of conventional, mega-scale oil and gas investment as another bad commodity binge – but the “shale bubble” within it may turn out to be a good one, creating a price-responsive business model as well as new manufacturing style hydrocarbon infrastructure. Paradoxically, the high oil price regime may now also usher in yet another energy binge in terms of PV solar, wind and investment in electric grid technologies.

 

The Grand Investment

Investment in the oil and gas industry in the past decade or so has been on a grand scale.

Estimates suggest that somewhere in the region of $4-5 trillion were spent on oil and gas infrastructure projects, at a growth rate of over 15%pa, meaning the rate of spend by 2014 was almost 6 times the spend in 2004. Indeed, a third of all global investment since 2010 has been ploughed into commodities such as oil and gas.

Now, this may have been a good thing, creating  valuable infrastructure and developing new technologies – or it could have been just an undisciplined binge that was more or less speculation, inefficiently allocating capital to over-sized projects.

So which was it?

One answer may be found on the work of Ruchir Sharma, Head of Equity Strategy at Morgan Stanley, and author of recent work, The Rise and Fall of Nations.

Impressive title, and the book has large ambitions. It covers a vast amount of economic territory as Sharma maps out the countries he thinks will win and lose over the coming decade, based on ten criteria. These range from a country’s population growth rate and proportion of bad billionaires to good billionaires, through geography, to political and governmental actions and the type of investment being pursued.

It’s in this last area – investment – that Sharma reviews how effectively countries and companies spend their wealth

He makes two important points up front, echoed throughout the book.

First, investment in technology and manufacturing is critical to sustained growth – far more critical than spend on services and commodities. “Rich countries make rich things” as the saying goes.

Sharma usefully puts a number range on this expenditure: between 25-35% of GDP allows sustainable, robust growth in all the countries he has studied. Below this number, spend is too low and growth weak, roads and towns decay: above the range is the realm of speculation and excess, with capital likely being spent on frivolous projects, or gambling on economic outcomes.

Second, periods of major investment growth can be “good binges” or “bad binges”.

Good binges, oxymoron or not, are those where money is attracted into a new technology, or new infrastructure and factories. Even if there is a post-investment crash, valuable rail-roads and factories and skills remain, paving the way for a future renaissance. They are ultimately judged by what they leave behind.

The tech boom in the US in 2000-01 is often seen as a binge, but although many companies failed and went bankrupt, the investment led to the emergence of digital giants such as Amazon and Google, and a major fibre optic and wireless infrastructure. As importantly, the US was able to shrug off the downturn as most of the financial pain was borne by shareholders in the various start-ups, and did not contaminate the wider economy.

Bad binges, by contrast, leave behind little of productive value, in part because they are not driven by novel technology or innovation, but by investors rushing to capitalize on spiking prices. Real estate can be a classic bad binge, especially if funded by debt or bonds, which causes a drawn-out mess to clear up when the bubble bursts. The real estate crisis of 2008 in the US was a far more destructive binge, fuelled by debt, than the dot-com version.

So, what of oil and gas, the classic commodities.

Sharma’s view is pretty clear overall. Most over-investment in commodities results in a bad binge, at least for the producing countries involved. Its another way of stating the age-old “curse of resources”. The resource wealth is exploited, makes oil companies rich, makes the country’s millionaires into billionaires, generates high inflation and squeezes out investment in any other industry.

Booms are followed by collapse, and the country is often no better off. Of the 18 oil-exporting countries Sharma reviewed over a decade of high commodity prices, the average incomes in 90% had remained flat or declined.

Another way to look at this massive investment campaign, however, is through the effect on the international industry, and how this affects the supply of energy globally.

A Binge? Yes and No.

Was it actually a binge at all?

Taking Sharma’s rule of thumb of sustainable investment levels, at what rate, relative to company “GDP” did the international oil community invest.

The industry is pro-cyclical, and investment hungry as it seeks to replace large historic reservoirs with more productive oil and gas. By some estimates, 60-80% of capex for large international companies is used for replacing old oil with new – they have to run ever quicker to stand still.

The equivalent of GDP for corporations is usually calculated as profit plus wages (not revenue, as is often improperly applied). Using Exxon as an example, in 2006 it spent about 35% of its “GDP” on upstream capex. By 2013 this was over 110%.

The same pattern follows for the other majors. This is a rough calculation based on overall numbers – if the data is focused only on the upstream segment, the ratios would be even higher.

This means, by 2013, that, on average, the industry was aiming to replace its total asset base every five years – versus 10-15 years a few years earlier.

Clearly such ratios meet Sharma’s criteria for excessive spend, beyond natural, sustainable levels. And many studies have shown that as investment grew to such heights, inefficiency and complexity caused low productivity – a reasonable estimate is that over 50% of the spend was mainly waste, and of declining quality. By the end of the investment spree, the production levels of all the major oil companies was just the same as a decade before – that is, zero growth.

The chart below summarises these points, and has been discussed in previous posts (see Shaping Reality).

Good or Bad? Traditional oil and gas investment

One can argue that the oil and gas now available, and soon to be available, from prior projects offers cheap fuel for the next few years – Sharma himself argues that historically a boom of this scale leads to a decade or more of much lower commodity prices.

It also provides new oil and gas infrastructure that can later be expanded and developed more economically. And most of the debt was self-financed by the major oil companies, so only employees and shareholders bear the brunt of a downturn.

But in terms of what is left behind it is difficult to argue that any new technology or innovative fuel source or business model was developed.

The technology employed, in the main, was the traditional variants used for the past few decades, based on oil and gas extraction and separation. Deepwater and oil sands, although labeled “unconventional”, are extensions of existing know-how, rather than any significant step-out.

In terms of business model, the industry chose to place most of its high spend levels into a very inefficient mode of energy development: expensive, large-scope, single unit, major projects which run high risks of delays and cancellation. As a result, a large fraction of the trillions of dollars spent has been allocated to over-runs and postponed ventures.

More importantly, these more or less unique projects are also very difficult to replicate, and are unable to generate systemic improvements. They are learning curve dead-ends.

This multi-trillion dollar investment ultimately leaves behind a giant question mark:

Does the footprint secure the dominance of oil and gas as a relatively inexpensive primary energy source out into the 2050s and beyond, or has it financed a vast display of gradually obsolete plant and equipment?

Irrespective of the answer, the lack of any clear novel technological or commercial legacy from this high-cost extraction-based binge suggests, on balance, it was a bad one.

A New Hope

Whatever the case of the overall energy investment cycle, the emergence of shale oil and gas within it is a different story.

Sharma himself makes a specific distinction here between the traditional capex investment in major projects, and those in shale oil and gas.

The numbers are stark, and have altered the industry’s global economics.

In a single country, the US, total investment of around $350bn produced a technology that created a net increase of over 4 million barrels per day equivalent over 5 years. The traditional oil and gas investment portfolio invested over 10 times this amount in the past decade, but with zero increase in net production.

This makes the US, and multiple independent producers within it, the planet’s swing fossil fuel producer, wresting the mantle from large OPEC states, and pushing fuel prices much more closely toward basic supply-demand dynamics, rather than cartel control.

The contrast between manufacturing-style oil production and extraction-based could not be plainer –using new technology, the US has created its own energy security and cheaper global pricing.

Whilst multiple US mid-size shale players are likely doomed to bankruptcy as the cycle plays out, global energy users owe them a considerable debt.

As Sharma concludes:

“it has left behind a brand-new industry that had put pressure on older players to lower oil prices, providing cheap energy that made the US economy much more competitive…Just as the dot-com era in fiber optics and other technologies did a decade earlier, the shale bubble has created a new and valuable industrial infrastructure that can be used long after the boom is over.”

In short, a very good binge.

The best yet to come?

Continuing with Sharma’s view: the world may be facing a decade of lower oil and gas prices due to subdued demand growth, the overhang of product from the recent booms, and increasing energy competition from shale and other manufactured sources such as wind and solar.

Even so, with low fossil fuel prices, over-investment in new forms of technological energy remains likely.

The electric vehicle, PV solar and offshore wind industries already appear to suffer from problematic investment structures. Missed targets for EVs, multiple bankrupt solar companies and concerns about inappropriate subsidization for wind are often cited as reasons for being highly skeptical about their future viability and impact as technologies.

But like shale oil and gas, their development as elements of a wider process – not as distinct companies – seems relentless, with the greatest risk likely to be policy-based or from incumbent reaction, not technological.

Indeed, the speculative investments in these forms of energy may well herald an energy transition on a far, far greater scale than that wrought by shale oil and gas.

And their legacy of low-cost commercial scale manufactured energy may well be one of the best and brightest binges ever.