No Plan B
Big Oil’s Single, Fixed Strategy is Vulnerable
International oil companies have one strategy: they assume stable, growing oil demand and so invest continuously to expand reserves, production and revenue, to deliver enduring value. But they are also the highest cost producers in the oil market, reliant on expensive, long-term, large scale projects to develop new output.
Persistent low oil prices have starved them of capital to spend on such projects, dragging revenues down. The industry however assumes this investment hiatus will eventually “rebalance”, with supply shortages due to field decline causing prices to pick up, and major investment to restart.
However, if prices don’t recover, and demand continues to weaken, most companies are still publicly silent on what alternative model they will pursue.
Even if prices recuperate for a while, the competitive landscape has shifted significantly – and the industry risks becoming a residual high-cost player, caught between OPEC’s large resources, shale’s flexibility, and the growing competitiveness of alternative energy options restructuring overall demand.
Low-price and high-price scenarios should not distract from the fundamental fact the oil industry is undergoing major change – and oil companies are merely doubling down on their current growth strategies without a Plan B.
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Plan A – The Growth of Hard Oil
The international oil industry has one core belief, and one fundamental strategy based on it.
It believes that oil demand will always increase, and so it continuously invests (very) heavily in technologically or geographically challenging areas, where small, or national oil companies cannot compete.
For most of this century this has lead to over 10% annual growth in exploration and production expenditure, resulting in over $600billion pa at its peak two years ago. As a result, although major international oil companies account for only about 20% of total oil production, their capex has been over 60% of total spend.
This is because outside OPEC, Russia and US shale, the standard mode of meeting demand growth for international firms has been via giant energy mega-projects, in technologically or geographically challenged areas. These are the characteristics of oil-fields that national oil companies struggle to develop, so big oil firms have used high oil price cash-flows to tackle them. Unfortunately this has lead to huge cost over-runs (typically over 50%) and major delays of several years.
International oil firms therefore dominate the technical and financial landscape of the industry due to complexity – however, conventional, giant onshore fields in OPEC and Russia dominate the volumes.
As oil prices have slumped, the international firms have cut their capital budgets by up to 50%, and exploration by over 80%.
So how is the industry’s growth vision manifest today?
It is communicated via its key narrative “Rebalancing” which states the current slow-down is merely putting off until tomorrow the massive slug of investment required to re-boot oil’s future growth needs – (along with the implication that prices have to recover to facilitate this).
The World Needs A New Saudi Arabia – every 24 Months (again)
Rebalancing provides some very distressing near-term scenarios, such as the one used by Shell’s CEO last month – it foresees global natural decline rates of 5%, annual oil demand increases of 1-1.5 million barrels per day, and a trillion dollars of investment required each year to repair the looming supply shortfall.
Running with this analysis, the CEO of Total suggests the industry will be short of 10million bpd by 2020.
Given that an average deficit of less than 2milion bpd in 2011-2013 caused prices to peak near $150/bbl, that should serve to scare any oil customer witless.
Such a scenario, expressed also by many industry commentators, is quite extraordinary (although its has been mentioned variously before in relation to “Peak Oil”).
The decline rates plus demand outlined would require the creation of a new Iraq every year, or a new Saudi Arabia every 24 months – for a decade – to keep the oil market balanced.
These annual trillion dollar budgets would have to be funded via high oil prices – and given China, the EU and the US are the world’s largest fuel users, this is trillions of dollars that the car-driving public in those countries is not expecting to spend.
But an extraordinary scenario requires extraordinary evidence.
Demand and Decline
For all their sophistication, most scenarios pivot on a few critical, simple numbers.
Shell’s van Beurden highlights three major ones in his summary: expected annual demand growth, natural field decline rates, and capex required to fill the gaps.
The table below summarises this industry Rebalancing outlook, alongside an alternate model that’s also widely used.
The alternate uses an updated oil demand outlook from analysts McKinsey in their Peak Demand paper, using latest GDP forecasts, and decline rates are the most recent guidance offered by major oil companies such as BP and Chevron (p10 of appendix in link) – ie actively-managed versus the generic passive rate.
Capex is reset as a simple proportion of the Rebalancing number, and is in line with current expenditure forecasts for 2016-17.
Table 1 – Analysis of Rebalancing Scenario with Lower Growth / Lesser Decline
Two Scenarios – Same World
In many ways the two scenarios reveal two similar world views – growth, but to different degrees.
Rebalancing assumes a return to a norm of high growth, high investment – the resumption of a huge cycle of transportation development across a globe that needs gasoline, diesel and aviation kerosene in strongly increasing volumes.
The alternative scenario is more a business-as-usual world view. The lower GDP and oil growth levels are mainstream projections, without recourse to new technology or fuel policies, and the decline rates are actual industry best practice.
Under analysis, the Rebalancing scenario presents no extraordinary evidence to suggest extremely high volumes of supply will be needed. Its demand growth projection is at the top-end of current forecasts, and decline rates at the extreme low-end of industry best practice – in addition, large onshore fields in OPEC generally decline at slower rates than international portfolios.
The industry would be unable to meet such demands, and prices would soar – but the scenario seems no more than a straw-man, used to illustrate, rather than formulate the dangers of under-investment.
The business-as-usual outlook production requirements are in line with previous trends of 1-1.5mbpd growth over the past 30 years – and its is difficult to see what demand shock, such as Chinese hyper-growth, will occur in the current economic environment to force major supply gaps.
In addition, the production output of the previous decade’s investment will be coming on-stream across this period, along with the industry’s efforts to extract more from existing assets – some analysts expect that to be 2-4mpbd, about 50% of the requirement needed. Capex slows as the requirement for new production abates and prices remain calm.
Forcing the Future to Stay the Same
Simplistic as they are, these scenarios are important, because they are often used to sustain current strategies, or justify change.
But neither of them makes a case for transformation: the more familiar you make the world, the easier it feels to control.
Rebalancing is a highly self-contained world-view, and therefore runs the recent risk of the coal industry in underplaying realistic stress-case scenarios – it makes no reference to GDP changes, decline rate improvements or industry restructuring. It is a narrative for the status quo.
The alternate business-as-usual (BAU) case does respond to GDP and decline rates, but still assumes no significant industry reshaping.
So, although some active companies such as BP are setting up portfolios to deal with lower oil prices into the medium-term, these are “survival capex” modes that assume prices will still rise slowly, if not sharply, and that the essential structure of the crude oil market will remain unaffected for many years.
Their strategies are internally consistent, rational and achievable. But they remain sealed off from the grander world of energy around them, and follow the mantra of Exxon “Although prices will occasionally drop significantly, industry prices over the long term will continue to be driven by market supply and demand.”
Indeed – but what market, what supply and what demand?
BP prefaced their latest upstream production strategy by reference to the International Energy Agency transformational “450” scenario, by noting it predicted 45% of energy would be still be supplied by oil and gas by 2040, and hence the industry remained sound.
In fact, under the 450 scenario, oil demand declines from 2019 onwards at 1.5% pa reaching 60mbpd by 2040 – this is a level which could be satisfied at least in theory by OPEC, Russian and US shale output, rendering all other exploration and high cost production infrastructure obsolete.
No Plan B
What no oil company seems willing to do is indicate publicly how they would react if more assertive technology and energy policy scenarios occur – if Electric Vehicles (EV) did enter the transportation domain significantly, or if climate policies gained stronger momentum.
Even in a 5 year time frame transportation shifts to EV, urban planning initiatives, fuel consumption patterns, and policy promotion of renewables could pull the BAU scenario downwards, forcing negative demand growth.
In the near-term however, large oil firms will still be compelled to follow through on their growth strategy – keeping reserves and production at least stable, and exploration active.
This could push prices even lower, and encourage OPEC, Russia and US shale to step up production to a larger share of a diminishing pie.
High cost international firms may then become a “residual” slice of production between the declining overall demand and the increasing low-cost production.
Their continued investment managerially and financially in diverse, complex and dispersed portfolios would then become a major liability, as transformation would be slow and costly whilst energy requirements changed swiftly around them.
Given all this, the insistence high growth forecasts, or at worst business-as-usual is understandable to some extent as it aims to reassure investors, and indicate robust business health. In fact, it would be unusual for a major player to describe their worst threats to investors and share-holders – if they had no intention of changing course.
On that basis, and taking current strategies at face value, the industry narratives and strategies indicate a strong belief in the long-term status quo of the business.
In fact, looking too far into the future, although critical to survival, is often viewed as a distraction to management’s near-term execution. For example, its difficult to discern any major reaction to the rise of shale oil in any major oil company presentation even now.
But active and transparent risk management is a critical component of any oil industry business process. It is even legally mandated by 10K reporting requirements.
Without a credible proposal or framework to deal with a more significant downturn due to energy market restructuring, the industry is avoiding engaging with a key threat to its business model, or exercising its managerial skills to confront and tackle it.
It is therefore doubling down on a long-term growth strategy, and without a Plan B*.