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[Episode #6] – Transition from Oil


The recent history of oil production and prices, the future of the oil industry, the potential for transitioning away from oil and the opportunity for EVs, and ERCI - the Energy Returned on Capital Invested. And in the news segment: the oil industry's latest moves and announcements about climate change; three important trends we should recognize in the retirement of yet another US coal plant; and a new report from Carbon Tracker calls IEA and EIA on the carpet for consistently overestimating future demand for fossil fuels, and consistently underestimating the growth of renewables.

Guest: Mark Lewis is Head of Research and Managing Director at Carbon Tracker, a non-profit company based in London which publishes research on the financial aspects of climate risk. Prior to Carbon Tracker, Mark was Managing Director and Head of European Utilities Research at Barclays (2015-18), Chief Energy Economist at Kepler Cheuvreux (2014-15), and Managing Director and Global Head of Energy Research at Deutsche Bank, where he worked for 14 years until 2013. In addition to his experience as a sell-side financial analyst, Mark spent one year as Deputy Head of investor relations at E.ON at the beginning of the Energiewende, and two years as a credit analyst covering the European utility sector at Standard & Poor’s. In total, Mark has over 20 years’ experience as a financial analyst covering global energy and environmental markets.

On Twitter: @MCL1965

On the Web:  Carbon Tracker

Recording date: September 5, 2015

Air date: October 28, 2015

Geek rating: 6

Chris Nelder: Welcome Mark to the Show.

Mark Lewis: Hi Chris thanks. Thanks for the invitation to speak.

Chris Nelder: So you've noted that the capital intensity in upstream oil and gas has been rising at a dramatic rate in recent years, it tripled in real terms between 2000 and 2013 but that only resulted in a 11 percent increase in production and as we both know this is because oil is becoming more expensive and difficult to produce where we're now going into using fracking and producing tight oil, going to the Arctic and deepwater, turning low grade tar sands into synthetic oil and so on. So in fact your huge Toil for Oil report one year ago you estimated that North American conventional crude consumed 24 percent of global upstream CAPEX in 2013 but only delivered 7 percent of global crude oil production. So what does this tell us about the future of oil production?

Mark Lewis: Right. It tells us we have a big problem. I think that's the first thing to say. I mean the numbers you just quoted say it all I think. We've invested more and more in each year until the last two years where you've seen. Certainly this year, a very dramatic downturn in industry CAPEX, the first major downturn in industry CAPEX that we've seen for a long time, and that's not feeding through immediately into falling production, although and I'm sure we'll pick up again on this in a moment. But although we are starting to see the signs of a fall in production now in the U.S., but I think it basically tells us that the easy oil, the cheap oil that's easy to access is very clearly behind us and the industry now has to invest more and has to explore in areas that are much more difficult to access to get out the oil. And I think what that tells us is geology is winning the battle against technology and if investment continues to slow down in the face of the current low oil price we're going to have a major supply side shock within the next three to four years.

Chris Nelder: Well that's a frightening prospect but I don't disagree with you. So in fact we're seeing one kind of energy transition going on from fossil fuels to renewables. But there's also another kind of transition going on from cheap conventional oil and gas to expensive unconventional oil and gas. And so that raises an interesting question as more of the depleting cheap stuff gets replaced by the new expensive stuff. The fundamentals are that prices should steadily increase but yet we've seen oil prices crash over the past year and stay far below the price that's needed to bring new supplies online in the future. So let's unpack that a bit. I mean first why are prices so low and how much of that might be due to overproduction on the supply side versus weak demand?

Mark Lewis: Right. Well I think disaggregating those two drivers is a pretty tricky thing to do, and I think they've both had a contribution in different ways. My own personal hunch is that in the short run the supply side of the equation has been the main driver. You've seen a huge increase. If we go back to compare the current level of production from the United States in particular, a huge increase from the level of around 2010 when we were barely at a million barrels a day and we're currently at somewhere around four and a half million barrels a day of shale oil production. And I think that has been the major driver of this short term situation where we do appear to have a significant over supply. I say short term because I remain convinced that whilst demand slowed in 2014 it still grew. I mean I think if you look at the International Energy Agency, the figures show that the global demand for oil increased by about 700,000 barrels a day in 2014. This year it's on track for a much bigger increase. Closer to 1.5 maybe even 1.6 million barrels a day, half of that alone is going to come from the United States where you know consumers are responding very vigorously to lower gasoline prices and so forth. So, but no doubt 2014 after three years of oil prices being above $100 a barrel I think there was a slowdown and I guess that was to be expected. But these much lower oil prices are now very clearly feeding into higer demand. So you know I'm very skeptical of this idea of peak demand for oil. I think you're still seeing the global demand for oil increasing even in 2014 as we just said, it was it was slower than it had been in previous years. We got an increase of 0.7 million barrels a day and we're going to see a much bigger increase, twice that level at least this year and possibly next year as well. So I think it's been a combination of both. I think the real problem Chris is the way I formulated it is coming back to your first question and tying it into this second one, what appears to be happening in the supply demand dynamic is that the world economy, in order to grow at the kind of levels we've been used to over the last two three decades let's say robust global growth of 3 to 4 percent global GDP per year, you really need oil prices to be below $100 a barrel. But coming back to your point about the cheap conventional crude being behind us, the oil industry finds it very difficult to grow supply if the oil price is not above $100 a barrel. So the supply side needs $100 a barrel plus to grow supply, the demand side needs less than $100 a barrel for the consumer to feel confident about growing. So I think that's, that's really where the delicate balance has to be struck. And I think you know the world managed that for three years between 2011-2014 and then we got the slowdown in demand last year.

Chris Nelder: Yeah, what Stephen Kopits rather brilliantly called the narrow ledge of oil prices.

Mark Lewis: Absolutely, right.

Chris Nelder: So what should we expect to happen in the next few years. I mean on the one hand we should expect reduced investment in future supply to produce shortages and higher prices in the future. If demand is reasonably strong, but now the demand seems to be so weak and such an X-factor, I really wonder about that. I mean if we are truly entering sort of a global deflationary situation there is the risk that prices remain low which would create an even worse potential shock on the supply side in the future. But that really sort of depends on demand, is to me an unusually murky question right now.

Mark Lewis: I agree. I mean and I think that is the really frightening specter that is out there because I think if oil prices remain at current levels it would be a sign that there is a more serious deflationary spiral taking hold in the world economy. And clearly you are not going to see the oil industry investing if prices remain at these levels, so you will get into a vicious circle. If that's how things start to develop. Whereby low prices, OK they're great for consumers. But if there's a deflationary slump starting it's a very, very, very murky question. I think murky is the right word, the word that you are using there. I always come back to the point however, that at the end of the day we lose 4 million barrels a day per year roughly of global oil production simply due to the ongoing natural decline in oil fields. And therefore at some point, the price cannot remain depressed beyond a certain point because the global oil supply will start to fall very dramatically. I mean if we had three or four years of oil prices at current levels, $50 a barrel, then I think we're looking at such a major supply crunch four or five years down the line that prices would have to go back up again. But I mean I take your point. If we're really on the verge of a much more significant and serious deflationary episode in the global economy here then I think all bets are off. And I think all traditional conventional economic theory in looking at the global economy possibly comes into question. The one thing I would say is that we've already had, and I think this is a point that is easily forgotten. We would never have had, I don't think the very dramatic increase in U.S. shale oil supply over the last four or five years unless we had had this absolutely unparalleled period of very low interest rates in the United States indeed globally. So I think it's very clear that the world economy itself has in some sense been on if not on life support then certainly on a large amount of medication. And if that medication starts to have less and less of effect on the global economic body, if I can put it in those terms, then you do wonder if demand will really come under further pressure. So that to me is scary.

Chris Nelder: No, I think that's an essential point. Yeah absolutely. I mean the entire fracking industry was driven by debt and they could not have had the debt at the levels that they got it if interest rates hadn't been so low I mean that's really kind of a fundamentally important point. And now we've got this giant debt overhang in the sector and I think that's actually becoming maybe more of an important factor here thanabsolute production levels. So what can we say now about the future of the industry. I mean they seem to be pulling out all the stops slashing CAPEX, laying off staff to protect their dividends since so much of the money invested in them is coming from pension funds and other fixed income investors so they absolutely have to protect that. Will they be able to stay profitable and keep paying those dividends are those fund managers beginning to get nervous about that?

Mark Lewis: Oh they are getting nervous. Definitely. I mean I've done I would say in the last 12 months I've done maybe 200-250 investor meetings. And what we have to remember is that there was concern about the long term sustainability of the oil majors. Let's break this down into the oil majors as a group on the one hand and then the shale players and the independents on the other, so come to the oil majors because they're the ones that really play to your point about dividend payments being absolutely central to the investment case. Those companies, there were question marks already about the sustainability of their business model even before the price crashed at the end of last year. And if you remember in January of last year in 2014 Shell came under pressure from one of its leading institutional investors, public letter to the chairman of Shell saying you've been increasing your CAPEX over the last five years, tremendously again this plays back to your first question, we're not seeing the commensurate increase in returns that we would expect to see for the extra investment and the extra risk that you are taking. Can we please have more capital discipline and can we please start to see a greater level of concern about the remuneration of shareholders. So I think it's a very important point to remember that there was a question mark about the appropriate level of risk reward that investors were getting for investing, and even after a three years where oil prices have been above $100 a barrel. So you fast forward 12 months, 18 months to this situation today where we've now had oil prices in the doldrums for many many months. And that situation is only all the more critical. So I think there is a very big concern out there and I would say it is amplified by the fact that, OK low oil prices in the short-run are sometimes seen as a deterrent to the faster development of renewable energy and so forth. But, I mean I don't think anybody who thinks about this deeply really considers a short term fall in the oil price to be of genuine significance as far as the development of alternative and renewable technology is concerned. So the investors I speak to are also becoming more concerned about the medium to long-term threat to the oil industry of renewable energies, and electric vehicles so they're fighting, they're beginning to have to fight many different fires here. So I would say very clearly the answer is yes there is huge concern out there.

Chris Nelder: Yes. So on the one hand they're nervous about the profitability of the existing business, and on the other hand they're nervous about whether or not renewables are actually challenging that business in the future.

Mark Lewis: Exactly.

Chris Nelder: So you and I have discussed the risk that EVs posed to oil demand and we're both bullish on EVs in the long term. But you know I keep looking at that 0.4 percent market share for EVs both in the U.S. and globally. And I wonder how long will it take for that to turn into a real actual challenge to petroleum. I mean what are your thoughts on that at this point?

Mark Lewis: Well, I mean I think there's different ways you can ask the question, the way I look at it is to say if you look at how the oil industry plans for the future, if you look at how the International Energy Agency, the EIA in the U.S. and all the oil majors when they do their oil demand forecasting look at the world. They kind of assume that there isn't going to be any viable substitute for oil as a transportation fuel certainly as a road transportation fuel for the next two decades. The emerging economies such as China or India are going to carry on growing very fast over the next two three decades. And therefore this burgeoning middle class in those countries is going to carry on supporting the long term growth of the industry. Now this is where it gets very critical for the oil majors. I mean I wouldn't begin to argue that that cheap producers, you know the Saudi Arabia's is the Iraq's, the Middle East OPEC countries. There's always going to be a demand for their product for the next five six decades. The problem that the oil majors have is that they are the marginal producers, they are the ones that are producing the expensive barrels of oil. And in the future those barrels as we were commenting earlier in the course of this conversation, those barrels are only going to become ever more expensive as they're forced to migrate to more and more expensive areas and the risk it seems to me, is that and Let's take the example of the Arctic and Shell's recent decision to press ahead with exploration in the Arctic. Shell have told us publicly that any investments they make in the Arctic will probably not produce oil until the end of the next decade, late 2020s or even 2030 and beyond. Now if your ploughing billions and billions of dollars over many years into projects that wont yield production until 12 or 15 years down the line the risk is that by that time China or India are not seeing the growth in demand for oil that those investments are being premised upon because renewable technology has improved so much and electric vehicles have become much more attractive. And remember China and India, let's just focus on China. China has a huge interest in migrating away from oil and towards electric vehicles. Number one because the quality of their air in their big cities is so bad. And one of the main reasons for that is pollutants from cars. And number two, they certainly do not want to increase their dependence on foreign imports of oil by any more than they absolutely have to. So it seems to me there are very strong political arguments that will push China towards encouraging the use of electric vehicles over conventional gasoline driven vehicles. And you only have to look at the competitiveness of electricity as a fuel source versus petrol or gasoline today. I mean it's cheaper to run an electric vehicle today once you've got it. That the obstacle is that it's going to cost you more up front to buy it and you're going to have range anxiety issues, so what you really need, and I'm convinced this will happen over the next five to 10 years on a very large scale is number one you need the private sector to bring down the cost of the batteries to improve the battery technology. And this is exactly what Tesla and Elon Musk are currently in the process of trying to do and I think you see many of the other large auto manufacturers doing this same thing. And number two you need the public sector, to build out the infrastructure, to build out charging stations in cities. We're seeing this, you know if you come to Paris you'll see that you can hire electric vehicles now, very easily, almost as easily as you can hire bicycles in Parisians streets. So I think the global move towards ever greater rates of urbanization there's going to be a lot of investment in the world's major cities in improving transportation within cities. This is a huge focus for all urban planners at the moment so I just think it's very, very risky for the global oil and gas majors to be investing in very large, very expensive projects in the expectation that the world is always going to have this same addiction to oil when actually, the competitiveness of electric vehicles is going to be improving very dramatically over the next 10 years.

Chris Nelder: Indeed.Well speaking on that point you've become increasingly focused on energy transition as have I, and now turning your attention more specifically to the Energiewende in Germany and kind of related policies in Europe. You have developed a really interesting concept I think in this energy return on capital invested. So long time energy students will certainly be familiar with the concept of energy return on investment. How much energy you get in return for the energy that you invest in producing a new source of energy. So what is this energy return on capital investment concept and how is that helpful to understanding energy transition?

Mark Lewis: Well, it's just a way of looking at a given potential investment and saying if for a given amount of money, say you have 100 billion dollars lying around in your drawer at home. I used in the report you referenced, I took a hundred billion dollars as being a sum where you could do a meaningful comparison between investing in oil at different prices, investing in solar, investing in wind, just to see what kind of energy return you would get for a given level of financial investment. So and what I found was that if you invest $100 billion dollars in oil projects that have a breakeven cost of $100 a barrel, then even today with today's renewable energy technologies you would get a larger amount of energy over the lifetime of the project by investing in solar PV today, than you would investing in let's say oil sands projects in Canada at $100 a barrel. If you assume, then I think it's a very reasonable assumption, that you wanted to use the oil from those projects for road transportation purposes. After all, 60 percent of all the oil we consume on a daily basis worldwide is used for road transportation, and of course the big problem with using oil in road transportation is that you lose most of the energy in every barrel of oil that is consumed for road transportation purposes. It just gets burned and lost in the atmosphere through heat waste because the internal combustion engine is so inefficient. Whereas electric vehicles are much more efficient, so if you're looking at in on a net energy return on capital invested basis what you find is you would get more energy for a $100 billion dollar investment today in solar PV, certainly utility scale solar PV, than you would by investing $100 billion dollars in Canadian oil sands projects with a breakeven of $100/barrel. By the way, you know investing a hundred billion dollars in wind, and again assuming you want to use the wind energy generated specifically for the purposes of powering an electric vehicle, use renewable energy for powering an electric vehicle, because of the much lower loss of energy in an electric vehicle than in an internal combustion engine vehicle, you would be competitive with oil even at $50 a barrel. So you take the current oil price, comes back to a point I was making a bit earlier, even at $50 a barrel you know that's not necessarily a deterrent to the development of renewable energy, wind energy, onshore wind energy you'd get a higher energy yield over the lifetime of the project by investing a $100 billion dollars in wind today than you would investing a $100 billion dollars in oil projects with a breakeven cost of $50 a barrel. And by the way I don't think there are many if any large scale oil projects with a breakeven cost of $50 a barrel today, that the oil and gas majors would be able to have access to.

Chris Nelder: Not new projects.

Mark Lewis: Right. Right. Exactly. So that's kind of the point behind that analysis and I think you know that's something I'm refining, I'm working on that and I'll have more to say on that in the near future.

Chris Nelder: Well that's a fascinating concept. I think that kind of a metric might actually become much more interesting as time goes on and as we're looking at sort of the progression of EVs and you know the future of transportation. I don't think it's something that, I don't think I've heard of anywhere else except from you. So...

Mark Lewis: Right. Well thanks yeah.

Chris Nelder: That's a super interesting idea. Well Mark I really appreciate you taking the time to be on the show today.

Mark Lewis: Great pleasure Chris.

Chris Nelder: That was Mark Lewis speaking with us from Paris.