Running fast to stand still

Even by their tumultuous standards, oil markets have had an exciting two years. Prices collapsed to unimaginably low levels following a half-decade of high and seemingly predictable prices, then recovered sharply. Capex programs were cut, costs went into free-fall, and efficiency ruled the day. The political environment was quite volatile as well with major producers like Russia, Iraq, Libya and South Sudan, which together account for a substantial portion of global oil production, all getting tangled in geopolitical issues. Meanwhile, the signature of the Paris climate agreement cast a big question mark over the future of fossil fuels. And for the first time in a century, the accelerating technological progress of electric cars raised the prospect of technology competition aimed squarely at the citadel of oil demand – the transportation sector. From drilling costs to divestment movements, the industry is facing an unprecedented range of uncertainty as it charts its strategy forward.

But reports of oil’s death are premature. It is true that electric cars are indeed progressing remarkably and certainly have the potential to grow further. The cleanliness and efficiency of the electric engine, coupled with consumer excitement and Silicon Valley-type entrepreneurial determination, is creating a compelling combination for growth. Despite the excitement surrounding them, for now electric cars only displace 0.01% of global oil demand.

The past two years have also reminded us of the importance of prices. At the International Energy Agency, we have consistently been revising our assessment of oil demand in one direction: up. Altogether, it is now about 2 million barrels a day higher compared to our expectation when oil was at $100 per barrel. From SUV sales in China to increasing driving in the United States, examples of consumer reaction to lower prices abound. But looking forward, the picture is more complex.

Technological developments and energy policies will affect the demand trajectory. The IEA’s World Energy Outlook 2016 shows oil demand associated with passenger cars declining in the next 25 years. This is an astonishing result considering that the global car fleet is expected to add a billion vehicles in the next quarter century. Some of these vehicles will be electric but the bulk will have more efficient engines.

But one often-overlooked fact is that passenger cars represent only a relatively minor share of global oil demand growth. The bulk of that in the next decades will come from elsewhere – namely transportation outside of personal vehicles and petrochemicals. Shipping, aviation and heavy duty trucking will grow robustly as emerging markets experience rising incomes and increasing integration to the world economy. Since 2009, for instance the number of air passengers grew by 50%. Manufacturing of modern consumer goods – everything from televisions to refrigerators to electric cars as well – generally have supply chains spanning several continents, all being shuffled around by internal combustion engines.‌

The other major driver of oil demand growth in coming years comes from what is perhaps the most visible symbol of modern life – plastics. Forty years of social and political efforts to recycle packaging, for example, have only succeeded in eliminating one year of average global plastics demand growth. The growth in petrochemical demand alone is bigger than the reduction we expect to see from adding more electric cars. Taken together, this explain why under current policies the outlook still sees robust oil demand growth for several years to come.

It is very true that energy policy can and should change this trajectory. The scale of the climate challenge is way beyond the simple replacement of coal with gas; the energy transition will have to affect all fossil fuels, including oil. The energy trajectory that is consistent with the agreed climate goals (the World Energy Outlook’s 450 Scenario) has global oil demand peaking in 2018. It then declines by around 900,000 barrels per day every year by the 2020s. The question becomes whether this is possible in the absence of a global recession, and what the implications are for the oil industry.

The IEA’s 450 Scenario is not a forecast. It shows what needs to happen to achieve those climate goals, rather than what countries are collectively doing in real life. In other words, it rests on policy assumptions that are significantly beyond the ones that are being implemented. Under that scenario, oil demand’s relentless growth is reversed by three main changes.

First, a strong climate implementation accelerates the take-off of electric cars within a decade, leading to five times more electric cars by 2040 than current policies would imply. Getting there will require a sustained political will for large subsidies for several years before electric cars can become competitive on their own, as well as further technological developments of batteries and major charging network infrastructure rollout.

No matter how fashionable, electric cars alone can’t put oil demand on a climate stabilization path. Efficiency standards for the hundreds of millions of internal combustion engines that will still be sold, especially trucks, will need to be strengthened. Transportation systems will also need to smarten up, with public transit systems and congestion charges reducing driving, and high-speed trains replacing short-haul aviation. While there are no technological hurdles to this, social and political barriers are formidable.

Finally, achieving this goal of curbing oil demand growth will involve expanding technologies such as advanced biofuels, hydrogen and high efficiency processes. These are natural extensions to the technology and project management skills of the oil and gas industry, and will provide a natural transition for oil companies into a low carbon economy. It is possible – and from a climate change point of view even desirable – to have a peak in global oil demand in the foreseeable future, but this will require measures that go well beyond what is being implemented today.  

Regardless of the considerable degree of policy and technology uncertainty shaping the investment outlook, one main strategic conclusion remains: the oil industry needs to keep investing in its upstream sector. The large majority of upstream investment is not needed to meet demand growth; rather it is needed to replace depletion of existing production. But, strong climate policy pathways will change the pattern and scale of investment, and long lead-time, high capital intensity projects could be especially questioned. Some lessons from the previous cycle will need to be heeded.

The period between the financial crisis of 2008 and the collapse of oil prices in late 2014 was characterised by high and seemingly stable oil prices. Perhaps unavoidably, several years of smooth fluctuations between $100 and $110 per barrel created the illusion of predictability. Capital investment kept creeping up, but so did the cost of upstream projects. Large projects critical to the strategic future of the industry experienced delays, cost overruns and technical disappointments. The industry had to run faster just to stand still: major oil companies experienced declining returns even at high prices while swelling capital investments were needed to support a stagnating production. While some major oil-producing nations wisely saved part of their windfall in sovereign wealth funds, the oil price needed to balance their budgets kept creeping up while their long-discussed economic diversification policies did not materialise. The industry had never had it so good, but below the surface its vulnerabilities were also growing.

Ironically, it was not climate policy or electric cars that ended that cycle and unleashed a painful but necessary adjustment. Rather, it was the oil industry’s own innovativeness and technical ingenuity that precipitated this outcome. The oil and gas industry is often seen as quintessential “old economy,” and certainly some of its biggest names have been around for more than a century. Nevertheless, it has proven quite capable of disruptive innovation, for instance by deeply incorporating big data and digitalisation into its operations.

Of course, the most important disruptive innovation has been hydraulic fracturing applied to shale. Even though it is widely discussed, the scale and importance of the turnaround in the prospects of domestic production in the United States is still hard to grasp. Just a decade ago, the main topic of US energy policy discussion was the apparently unstoppable growth in oil and gas imports, and what it meant for energy dependency. Political declarations for energy independence were ridiculed in policy circles and late-night comedy shows as empty rhetoric. Today, with rapidly shrinking oil imports and net gas exports, the US industry is having the last laugh.

However, it is important to keep in mind that this was no free lunch. In the first half of this decade, more capital was committed year after year to oil and gas upstream projects in the United States than in Russia and the Middle East combined. This was way beyond the financing ability of US independents who represented a substantial proportion of all the corporate bond issues. Even before 2015, rapid learning by doing and technological progress kept costs stable in a high oil-price world while the rest of the industry struggled with cost inflation. In the end, the rapid upswing of production was possibly the single most important reason for the oil price collapse.

The last two years will likely prove to be a fruitful experience for the industry. Investment cuts of 20% two years in a row were unprecedented in the industry’s history. A decade of cost inflation was wiped out by a relentless focus on efficiency and reengineering projects. And just as it had during the production ramp up, the US shale industry led this change as well: in two years, the cost of shale project development was cut in half.

There are legitimate concerns that costs may creep up once more as investment recovers, but there is no doubt that a considerable share of the cost savings is structural and can be maintained. This results from a combination of technology and management dedication. Digitalisation of the oil industry enables better targeting of drilling, higher ultimate recovery rates as well as lower outage rates and higher capacity utilisation. The shale industry specifically benefits from longer horizontal sections, better targeting of sweet spots and multi-pad drilling, which leads to optimizing logistics. Perhaps as important as hard technology are the softer, managerial changes such as a relentless focus on reengineering, streamlining and standardising projects. In the meantime, major oil producing governments are acting with a new sense of purpose in reforming energy subsidies as well as investing into the non-oil growth potential of their countries. 

While there is a legitimate disagreement over the timing and intensity of technology competition to oil, there is no doubt that it is coming. The question is when, rather than if. Going forward, maintaining technological momentum and management discipline will be necessary. The US shale industry came perilously close to losing access to capital. Major international oil companies borrowed over $100 billion in order to maintain dividend payments. Activist investors are raising legitimate questions about incorporating climate policy into the industry’s strategy. The industry prospered through the ups and downs of the 20^th century thanks to its commitment to innovation and its perseverance in the face of challenges. To prosper in this next century, the oil industry will need to maintain its efficiency and discipline, continue to drive innovation and increase its strategic commitment to new sustainable technologies.