Oil's endgame

Most investors have been exposed, either directly or indirectly, to the vagaries of global oil markets at some point. But as major economies commit to replacing fossil fuels and fund managers increasingly tailor their portfolios to comply with environmental mandates, the question of ‘Big Oil’ has become much more binary. Put simply, is it a safe space for your capital any more? Or will the prospect of a disorderly realignment in oil markets – and consequent volatility – eventually favour the supermajors?

Income options still on the table

In April 2020, shockwaves rippled through financial markets when Royal Dutch Shell (RDSB) announced it was cutting its dividend for the first time since the second world war, following the pandemic-induced collapse in global oil demand. But 15 months on, and the Anglo-Dutch group is ready to “move to the next phase of its capital allocation framework”, thereby increasing total shareholder distributions to within the range of 20-30 per cent of cash flow from operations (CFFO), starting at the second-quarter (Q2) results announcement.

Buybacks aside, Shell shares yield 3.4 per cent based on its current dividend payouts, but that figure rises two percentage points when based on its pre-pandemic pay rate, while income yields for ExxonMobil (NYSE: XOM), Chevron Corp (NYSE: CCC) and BP (BP.) come in at 5.4 per cent, 5.2 per cent and 5.0 per cent, respectively. Share prices for the two US groups have retraced significantly since the sell-off in early 2020, so those yields aren’t just a function of share price weakness. With a lowly risk-free rate of return still in evidence, income options in short supply and speculation mounting over the next oil super-cycle, those yields can’t have gone unnoticed.

Yet, investors remain hesitant. It probably doesn’t help that some of the oil majors have indicated that global demand for oil peaked just prior to the pandemic at about 100m barrels a day, although that view is at odds with independent producers' projections (turkeys and Christmas spring to mind). There are also concerns that investments in the industry may be stymied by the push towards replacing the internal combustion engine with more environmentally-friendly alternatives. This could lead to smaller marginal producers, at least those most responsive to underlying price dynamics such as US shale drillers, being forced out of the market for want of development capital. Even some previously reliable private equity channels have dried up due to investor pressure over climate change.

Shale producers themselves have become noticeably more circumspect since Joe Biden entered the Oval Office, even given that many oil majors, including Shell and Norwegian state-controlled energy giant Equinor (NYSE: EQNR) have decided to offload productive acreage across the pond. Naturally, sale prospects would improve somewhat if the value of crude were to approach three figures.   

Some maintain that the US has effectively become the global swing producer due to the development of its unconventional oil and gas assets, but crude prices would surely ratchet up if US politicians allowed this corner of the market to wither on the vine. It’s worth remembering that when shale oil and gas production achieved critical mass in the US, it flattened the cost curve and, in doing so, displaced much more expensive (and environmentally questionable) sources of production, most notably oil sands.

Price retracement and lost replacement barrels

Regardless, lots more production is already more profitable than it was last year. Brent crude closed out 2020 trading at $51.80 (£37.44) a barrel after low-balling at around a third of that rate for the April monthly average. The price of the global benchmark has since risen by 44 per cent, but for obvious reasons it could be argued that last year’s slump was an aberration. The partial shutdown of the global economy and price disputes between Russia and Saudi Arabia led to an historic supply glut, with oil tankers idling in the Gulf of Mexico and major refining hubs elsewhere.

Investors witnessed an even more precipitous fall midway through 2014. By September of that year, fund managers had slashed their net position in crude-linked derivatives by 60 per cent. Again, the slump has been linked to production spats between Opec and non-Opec countries, exacerbated by a general slowdown in global economic activity. One theory even has it that Saudi Arabia cranked up supply in a bid to drive the crude price below the breakeven level for shale producers in the US, thereby forcing them out of the market. But the reasons why prices collapsed are less important than their impact on replacement barrels.

Analysis from Wood Mackenzie indicates that within 18 months of the 2014 crash, around 27bn barrels of future oil production had been cancelled, as oil industry budgets were slashed. Many of the cancellations were linked to offshore fields, which typically have higher break-even levels and longer lead times toward production.

Regardless of this year’s price rally, millions of replacement barrels have already been taken out of the equation since April 2020 and there is now a distinctly political element to take on board. On his first day in office, Joe Biden pulled approval for the Keystone XL oil pipeline and re-entered the Paris climate agreement, thereby setting out his stall in relation to fossil fuels. The newly installed US president also suspended new drilling lease auctions on federal lands, pledged billions in support of electric vehicle infrastructure and delivered a tax plan to congress that aims to dramatically reduce oil and gas subsidies.

So, on the face of it, one might argue that prospects for drillers have not only deteriorated since Donald Trump was forced to step down, but that the industry itself could be in terminal decline.

Then again, as highlighted in a recent Bearbull column, it will be hard to square the “contradictory dynamics of pursuing both ‘net-zero’ and economic self-sufficiency". Our in-house chimera may have a point, for if you take the time to weigh up projected demand levels with those lost replacement barrels, you’re left wondering where cogent assumptions end and wishful thinking begins.

Crude inventories, backwardation and Opec+

Assuming any further disruption is kept to a minimum, the International Energy Agency (IEA) estimates that global oil demand should return to pre-pandemic levels by the end of next year, or early 2023, but the agency makes the point that production gains are nowhere near the levels needed to prevent further inventory drawdowns.

Near-term demand growth will enable Opec+ producers to boost crude oil production by 1.4m bopd above the existing target. But the producer nations were unable to agree on the size of a planned increase at the cartel’s recent three-day meeting. Unusually, the blame for this latest spat was laid at the door of the UAE, which had called for a production baseline change if the existing deal was to be extended into 2022. Even after last week's partial compromise between the UAE and Saudi Arabia, analysts say the physical oil market remains incredibly tight.

OECD industry oil stocks have been steadily moving back towards their five-year average, with increased consumption and production limitations eroding last year’s overhang. However, we are now witnessing an even more dramatic turnaround across the pond. Some analysts believe that US crude inventories could soon hit historical lows, as refineries ramp up production and domestic supply fails to keep pace with the rapid growth in consumption.

We don’t know if the current dynamics in the US market will play out in other economies, but it is certainly having an impact on trader sentiment. With the oil market in backwardation, when barrels for immediate delivery command much higher prices than those marked for future delivery, traders are motivated to sell what product they have, putting further pressure on inventory levels. It represents a complete reversal from the early part of 2020 when oil for immediate delivery was trading at a steep discount to forward supply.

Two-speed electric vehicle transition

If you look at all the pledges made by both central governments and municipal potentates in relation to electric vehicle (EV) transition, coupled with those of the automakers themselves, it is hard not to conclude that the days of the internal combustion engine may be numbered. However, at risk of being labelled a cynic, government pledges are often made by politicians who will have been put out to pasture long before their promises are enacted.

Indeed, in its recently published paper 'Net Zero by 2050 – A Roadmap for the Global Energy Sector', the IEA notes that “most pledges by countries are not yet underpinned by near‐term policies and measures”. And even those made by the manufacturers are probably more pragmatic than their green-tinged PR machines would have us believe.

For instance, Volkswagen AG (VOW.DE), the world’s largest auto manufacturer, is targeting 60 per cent hybrid or EV sales in the European market by 2030 and is planning to phase out sales of vehicles powered solely by internal combustion engines in Europe between 2033 and 2035. You will note that there is certainly wiggle-room there regarding hybrid vehicles, presumably in case assumptions linked to the roll-out of infrastructure, or the availability of rare earth minerals, turn out to be unrealistic. At any rate, the group’s commitments for its US, Chinese, African and South American markets are unambitious almost to the point of irrelevance.

Toyota Motor Corp (JP: 7203) has been a pioneer in electrification with its Prius range, but last year the automaker’s president, Akio Toyoda – the grandson of the group’s founder – cast doubt on the practicality of largescale adoption, suggesting that, if badly managed, it could conceivably pose an existential threat to the global car industry, at least in its current form. Toyoda resorted to first principles, arguing that Japan would struggle to generate enough electricity to meet the increased demand, in addition to highlighting several other practical considerations.

Near-term EV sales growth may not be fast enough

I’m sure that somebody somewhere has done their sums on the practicality of the global EV rollout, but listening to politicians you sometimes get the impression that they think it will be achieved by the collective will of the populace. That certainly isn’t a given. Numbers from McKinsey & Company point to a slowdown in sales even prior to the disruption brought about by Covid-19. EV sales increased by an impressive 65 per cent from 2017 to 2018, but in the following year the number of units sold increased to 2.3m, a relatively modest 9 per cent.

And it’s not as if there is a lack of choice for motorists; automakers launched 143 new EV models through the year. Sales contracted by 25 per cent during the first quarter of 2020, although we shouldn’t read too much into that. After all, sales of plug-in passenger cars achieved a 4.6 per cent global market share of new car sales in 2020, against 2.5 per cent in the prior year.

Estimates vary, but the stock of plug-in EVs represented just 1-1.2 per cent of all passenger vehicles on the world's roads by the end of 2020, so metrics can appear a little erratic when you’re coming from such a low base. Nevertheless, the consultancy’s analysts make the point that “the days of rapid expansion have ceased – or at least paused temporarily”.

There is a regional element to all of this. EV sales growth in China and the US slowed appreciably through 2019, the former largely due to the removal of government subsidies. But EV sales increased by double-digit percentages in almost every European country, driven by “strong regulatory tailwinds and high purchase incentives”. Europe’s overall car market contracted by around a fifth in 2020, but new electric car registrations more than doubled to 1.4m.

Rare earth minerals a stumbling block

That point on subsidies and incentives is instructive, because even though the cost of batteries for EVs has been steadily falling as industry scale increases, the powertrain still constitutes around half the overall cost of an EV (with all the negative implications for depreciation rates). We have yet to reach the point at which shortages of critical inputs take prices in the opposite direction – governments may need to provide added incentives, not less, unless additional sources are secured. Rare earth minerals are set to become rarer still. According to Cristina Pozo-Gonzalo, a senior research fellow at Deakin University, annual demand for rare earth minerals has doubled to 125,000 tonnes in 15 years and is projected to hit 315,000 tonnes by 2030.

The IEA takes the view that governmental attempts to slow the rate of global warming will come up against a brick wall unless there is a sharp increase in the supply of metals required to produce EVs, solar panels and wind turbines, citing tightening markets in copper, lithium, nickel, cobalt and rare earth elements. Manufacturing capacity for EV batteries is certainly on the rise, with the continued roll-out of 'gigafactories' gaining momentum, placing additional pressure on global supply chains.  

Projections from Bloomberg New Energy Finance indicate that by 2025 EVs will reach 10 per cent of global passenger vehicle sales, growing to 28 per cent in 2030 and 58 per cent by 2040, the point at which the IEA estimates that EVs will constitute 7 per cent of the global stock. If those figures are broadly accurate, they represent a sea change in the supply and demand for rare earth minerals, to say nothing of the impact of the wider switch to green energy generation.

An extra 23m barrels per day to meet demand by 2040

Around a third of global crude oil production is currently used for transportation, with a high proportion of the remainder employed in petrochemicals and electricity generation. Crude oil demand in Europe has been falling even prior to Covid-19, but once the effects of the pandemic dissipate, the lion’s share of demand growth will be generated in Asian economies, where politicians face difficult trade-offs between economic growth and environmental policy.

We can’t be sure what proportion of overall crude demand will be lost to the roll-out of EVs, although it could be that current projections may be somewhat optimistic given the prospective impact of input shortages. Even under their accelerated energy-transition scenario, the analysts at McKinsey estimate that global crude oil production will need to increase by 23m barrels a day to meet demand by 2040.

That may be a tall order given the number of replacement barrels that have been sacrificed since 2014. So the imperative for oil companies is to convince institutional investors that they’re working towards fulfilling their environmental objectives, while maintaining current production levels.

Renewables, funded by oil and gas expansion?

Anders Opedal, chief executive of Equinor, recently reiterated the group’s mission to “create value as a leading company in the energy transition”, and there is evidence to suggest that the claim doesn’t amount to window-dressing. The group's plans to deepen its footprint in the renewable energy market will still entail an expansion, rather than a contraction, of its oil and gas production in the mid-term, with major investments upstream expected for up to a decade. It speaks volumes that Equinor, a self-styled “values-based company” has major shares in Europe’s three largest offshore fields: Johan Sverdrup, the Snøhvit gas field and the Troll oil and gas field. That’s a combined resource of 9.28bn barrels of oil equivalent, so it’s safe to assume that Norway’s national pension fund will be well-served for the foreseeable future.

A significant proportion of Equinor’s resource base is centred on natural gas. And given the change in the energy generation mix, that’s undoubtedly a positive. Other companies are correspondingly well-positioned to benefit from the changes under way. BP operates major natural gas production sites around the globe, from the Americas to Southeast Asia and the Middle East, though the group has indicated that it will be looking to sell around $25bn of assets by 2025. Bosses at Shell were mindful of the rapid switch away from thermal coal energy generation in Europe and elsewhere (not China), evidenced by its £35bn takeover of BG in 2016. And Gazprom (MCX: GAZP) recently received a major boost after it was confirmed that the controversial Nord Stream 2 gas pipeline from Russia to Germany will be completed this August.

The natural gas paradox

Natural gas is now the third-largest source of primary energy generation, and is fast closing the gap on thermal coal. It’s peculiar to think that prices for natural gas are likely to benefit from an accelerated transition towards solar and wind power generation. How could this be so? The reason is that natural gas has become, almost by default, the back-up fuel needed due to the intermittent nature of wind and solar power generation.

Nowhere is this better illustrated than Germany, which has been installing as much wind and solar power capacity as possible over the past two decades. But the more renewables that the country built into the system, the greater the need for natural gas. Indeed, Germany is committed to phasing out nuclear power generation by the end of next year. The move will mean a substantial increase in gas-fired capacity to make up for the closure of its six remaining nuclear reactors. Consequently, it is now considering the development of new LNG (liquefied natural gas) import facilities. It’s also becoming an increasingly crowded marketplace; the IEA estimates that global demand will ratchet up by almost 3 per cent this year, but it will be 14 per cent above pre-pandemic levels by 2030, thereby providing further incentive for exploration.