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Energy CEOs face seismic changes for their businesses

October 2018  |  SPECIAL REPORT: ENERGY & NATURAL RESOURCES

Financier Worldwide Magazine

October 2018 Issue


A decade ago, the media was mesmerised by articles about peak oil, or when the world would potentially no longer have reasonably priced oil. The world watched oil prices rocketing toward $150 per barrel. Books such as $20 a Gallon and Half Gone became popular by predicting the end of the ‘oil age’, not because we were running out of oil, but rather because it was too difficult to sustain its output. Oil prices would need to ratchet up to $200 a barrel or higher to induce more supply. The world was on the brink of an economic dislocation that would make past recessions appear mild. It actually happened in 2008, but not due to oil; rather, due to housing investment.

What kicked the peak oil movement into high gear was Houston energy investment banker Matt Simmons’ book, Twilight in the Desert, predicting the collapse of Saudi Arabia’s oil output. The book was the talk of the energy markets in 2005. Based on studying 40 years of detailed engineering articles, many written by technical professionals within the Saudi oil industry, the book was considered prescient about oil prices and the global economy.

A decade later, however, and crude oil prices sat below $30 per barrel, rather than hitting $200. ‘Lower for longer’ was the mantra guiding oil & gas industry chief executives, as they stripped down their companies in order to survive. From a world perceived unable to create sufficient supply to satisfy demand, the world was now drowning in oil.

Peak oil transitioned to peak oil demand. Swelling oil inventories confirmed that the industry was overproducing. How could this happen, based on peak oil theory? More importantly, what happened to demand? Oil demand actually continued growing, but the pace slowed from that seen in the early years of this century. The demand slowdown reflected the maturing of China’s economy, which had transitioned from an export-driven to a domestic consumption-oriented one. Commodities, including crude oil and natural gas, were no longer facing insatiable demand from China. The history of commodity cycles shows that when demand exceeds supply, prices soar. The corollary is that new supplies will be arriving soon. When demand slows, growing supply drives prices down. That happened with oil & gas.

Greater oil & gas output came courtesy of the American shale revolution. Marrying horizontal drilling with massive hydraulic fracturing technology, the US oil & gas industry was able to tap resources trapped in shale formations underlying hydrocarbon producing basins. This revolution spread to Canada and Argentina, and is now emerging in the UK, and importantly, in China. Although not all shale basins can be tapped, due to political and technological hurdles, the prospect of extracting greater output from producing basins has energy forecasters revising their estimates for future reserves, production and prices.

Paralleling the shale boom was an aggressive climate change movement. Concern over rising carbon emissions warming the planet and causing more frequent and stronger storms became a powerful social movement. Climate change began reordering national economies. The ‘war on coal’ was the most visible sign of the battle to restrict the world’s carbon emissions in hopes of avoiding a disastrous environmental and economic future.

Coal is not a part of the transportation sector, but success in de-carbonising the electric power sector has shown how, with the appropriate dedication and investment, consumption of the world’s dirtiest fossil fuel could be reduced. So far, most of the switch has been to natural gas, but in some regions, renewable fuels, such as wind and solar, have also undercut coal’s use. The evolving power generation fuel mix is providing a roadmap for what might be accomplished in the transportation sector if new technologies prove successful. This roadmap leaves oil company CEOs struggling to grasp how quickly these new technologies can alter their market.

Electric vehicles, powered by carbonless wind and solar power, could dramatically impact the future of the oil business. Carbon emissions from gasoline-powered vehicles are being restricted by the progressively higher fuel-efficiency standards mandated by most countries. Those same restrictions are being applied to diesel-powered vehicles, but recently this sector has been rocked by a multi-company emissions testing scandal that has called into question the ability of diesel vehicles to meet the standards while also meeting customer demands.

Despite cleaner gasoline and diesel vehicles, politicians want to restrict their sale and use in cities and countries because of the carbon coming from their tailpipes. An all-electric transportation sector will destroy the oil industry. But, is that a realistic expectation? Besides, how soon might it happen?

Transportation fuel demand is also being challenged by the emergence of new mobility systems. Ride-hailing has become a major business in many urban areas around the world. Mobility-as-a-Service (MaaS) has the potential to radically change the structure of the personal vehicle market. No longer will people need to own their own car since they can arrange transportation with a smart phone app at any time or place. Will this lead to greater traffic congestion and more vehicle miles driven?

MaaS envisions not only electric vehicles, but also self-driving ones that will permit passengers to do other things while travelling. MaaS also opens up personal transportation to segments of the population now dependent on others for their travel. The elderly, youths and the disabled will benefit from this service, adding to the number of trips and total mileage travelled. Aging populations and increased urbanisation will drive success in this market. Without a shift to zero-emission vehicles, the oil industry also benefits from the adoption of MaaS.

As oil & gas demand drivers are shifting, so too is how the industry operates. New technologies have enabled the petroleum industry to seek and extract resources from areas previously deemed inaccessible. On the other hand, oilfield technology is changing the traditional cycle-times for finding and producing oil & gas. The economics associated with these technologies are vastly different. Tradition necessitates high oil prices and long time-horizons, while new technology works well with lower prices. This technology clash heightens the growing investor pressure on energy company CEOs to boost their company returns on invested capital, meaning increasing profitability. Which technology best achieves that objective?

Growth in physical metrics is no longer the only measure of success for oil & gas companies, it has to come with increased profitability. Investors are also pushing companies to reduce their financial leverage as a way to dampen the volatile profit-cycle associated with commodity-oriented businesses. At the same time, investors are pressing CEOs to return much of the increased profitability through dividends and share buybacks.

Haunting investors watching the changing outlook for fossil fuels is the risk for stranded assets, should oil & gas demand evaporate. Destroying shareholder value is contrary to the mandate assigned to CEOs.

CEOs, investors, regulators and financiers are beginning to understand the critical questions facing the energy industry. Is the age of hydrocarbons ending? The history of energy transitions shows long periods of a fuel’s dominance before it was displaced by a more powerful, efficient and less-costly fuel. Are we on the cusp of another shift? Everyone believes so, but no one agrees to the timing.

Climate change, a more encompassing description of weather events, has become a tool to motivate the public into questioning fossil fuels’ impact on our environment. Climate activists and the media have mobilised the public into anti-fossil fuel campaigns, in favour of carbonless fuels. Politicians have been pushed to enact fossil fuel bans, or at least phase-outs, which puts the future of oil & gas at risk. While every phase-out or ban lies in the future, who knows if they will actually happen. Maybe the future will prove those actions too severe because renewables or alternative fuels are incapable of carrying the energy load. These are huge unknowns, and their timing, or even their eventuality, is uncertain, making long-term corporate planning by energy CEOs a challenge.

In the background of this debate over energy’s future is the issue of how developing economies are expected to lift their populations’ living standards without access to cheap fossil fuel power. This issue is at the heart of the dispute between developing and developed countries as they assess how to implement the 2015 Paris Climate Accord. Will the $100bn-a year promised by developed countries to help developing ones prove sufficient? None of this money has been paid so far, and no one knows who will pay it.

As oil & gas CEOs contemplate the future, they know that failure to invest in finding and developing new supplies may expose the global economy to an underappreciated downside risk. On the other hand, an early fall in oil & gas demand could destroy companies. Stranded assets and shareholder value destruction are outcomes no CEO wants to be associated with, let alone be held responsible for. Failing to delivery sufficient energy in the future might prove the lesser risk.

Energy transitions are ongoing. Commodity prices change in response. Will a new powerful energy source emerge, or will we go backward to less-efficient and more-costly renewables? Oil & gas CEOs need to make bets with their capital to sustain their businesses while not knowing whether their wagers will prove successful. Failing to invest may concede the energy market to another fuel. Decisions made today may be among the most significant these energy CEOs will ever make, and likely the most critical for the future of global economies and the environment.

 

G. Allen Brooks is a managing director at PPHB LP. Mr Brooks can be contacted on +1 (713) 580 2742 or by email: abrooks@pphb.com.

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