Natural Resources
Comment
10 October 2022
It’s Complicated
The decision by OPEC Plus last week to cut production by a surprisingly large 2m bpd caused consternation amongst many, not least President Biden, and will have significant ramifications for both the current global energy crisis and geopolitics.
Ostensibly the cut purports to address member’s concerns over possible demand destruction as economic recession takes hold and that higher prices are required to encourage much needed investment into the industry. The latter rings true but the irony that global inventories of oil (and gas) are extremely low and high energy costs are a large cause of the potential economic slowdown seem to have been lost.
According to Adam Rozencwajg (of the NY based Goehring & Rozencwajg Resources fund) more than $2 trillion dollars have been diverted from the energy industry in the last decade, which is reflected by the sector’s weighting in investor’s minds. Currently energy accounts for only about 5% of the S&P, the long-term average is around 10% and the peak near 20%.
The Energy Intelligence Forum 2022, held in London last week addressed some of these issues. Saudi Aramco’s CEO Amin Nasser, alongside Shell CEO Ben van Beurden and Professor Lord Stern (LSE, Co-chair Global Commission on the Economy and Climate) were, participants. The discussions produced some interesting perspectives and perhaps some reality checks.
According to van Beurden global oil demand will continue to grow until at least 2030. Alternative forms of energy just aren’t ready yet and therefore higher prices and regulatory stability are needed to encourage future investment for more production in the short and medium term
The conundrum
The paradox of needing more fossil fuels now so we can need less fossil fuels in future was pointed out by Professor Stern who said that the energy transition is the “growth story of the 21st Century” but there is a “real chance of hitting 3 or 4 degrees of warming if we get it wrong”. “To achieve it we need more oil and gas over the next 5 years but not necessarily over the next 15”.
Goehring & Rozencwajg have done interesting work on this point in a paper published earlier this year. In their view it comes down to Energy Return on Energy Invested (“EROEI”) i.e. How much energy is required to generate a unit of power. Historically increases in economic growth have almost entirely been driven by improving EROEI and the abundant and cheap power that implies. Oil and natural gas have high EROEI, you get 30 times back what you put in, versus coal driven steam power at ~10:1 and burning wood at 5:1.
Once you consider the required steel, cement, copper, carbon fibre and inherent intermittency in power generation, the EROEI for wind and solar is ~ 3.5:1. Goehring & Rozencwajg argue that the huge reductions in the levelized costs of electricity from wind and solar have been largely driven by low interest rates and cheap and abundant power. The conclusion appears to be that if you want to achieve decarbonisation in the future, in the interim you need cheap energy and right now that means hydrocarbons.
And then there is Putin
The current energy crisis has clearly been exacerbated by the Russo-Ukrainian conflict but the seeds of it were sown some time ago. The last decade has seen huge reductions in capex in the oil and gas industry, driven on by the negative stance toward the industry adopted by many governments trying to grapple with the decarbonisation agenda.
Though obviously the pandemic set the scene, the consequences of underinvestment has seen energy costs in the USA going from the cheapest ever at the pandemic’s market nadir in Q2 2020 to the most expensive ever just two years later as the global economy recovered, and Putin got his tanks rolling westward.
Part of the US’s response to the turmoil in energy markets (and damaging domestic economic headlines ahead of mid-term elections) has been to try and flood the market. The US Strategic reserve (SPR) has been releasing about a 1m bpd but according to some analysts the SPR is about 60% done, and given the current geopolitical backdrop, the USA may not be too keen to run its strategic stockpile down much further.
It isn’t clear outside OPEC where else could significantly ramp up production, which explains renewed US diplomatic efforts to lift US sanctions on Venezuela and bring Iran to the table.
Despite President Biden’s best efforts to encourage more production from the Kingdom through a diplomatic reset with MBS in the summer, with this week’s larger than expected production cut, the Saudi’s have seemingly come out on the side of Putin, or at least not on the side of the West.
Perhaps the politics cover over a more fundamental problem
Some analysts think Saudi Arabia has in fact been close to its production capacity. Although claimed at about 12 - 13m bpd it has rarely been operating much above 10 -11m bpd and OPEC itself has been underproducing its own quota by ~ 3m bpd. Given the relatively high oil prices economic logic suggests that it’s more likely a reflection of depletion and geological limits rather than purely a conscious choice.
During the 2010’s US Shale production effectively accounted for almost all the demand growth until OPEC decided to go for market share rather than price and turned the taps back on. It looks less likely that the either rabbit can be pulled out of the hat this time though this week’s OPEC cut presumably allows some room in future for a reversal.
Mr Rozencwaig points out that although the US shale rig count is up ~40% this year, with only 5 to 6 years of quality drilling estimated being left in many plays, companies won’t want to accelerate capex further now and immediately contend with a very rapidly depleting reserve base, especially given that investors, as miners also know too well, still want to see cash returns rather than new investment.
If it wasn’t so before it is becoming clearer now that for many, and Europe in particular, energy security and transition are intrinsically linked. We need adequate supplies of oil and gas to enable the energy transition and we need gas to displace coal.
Meanwhile, according to the IEA global coal demand will reach fresh highs in 2023. As Amin Nasser was reported to have said at last week’s forum, in what was presumably a wry observation, “If you think about it, we are transitioning to coal”.
Charlie Cryer
Head of RFC Ambrian London
+44 (0)20 3440 6834
charlie.cryer@rfcambrian.com