The oil and gas industry, like many other commodity industries, has long been characterised by volatility, instability and periods of lower and higher prices.
There are many factors that feed into this dynamic – the time lags needed for producers to respond to price signals, availability of finance, investments in efficiency… the list goes on. For many of these features, we think there is little reason to suggest they will change fundamentally in the energy transition as a base case.
In other words, the industry was cyclical on the way up, and it will probably be cyclical on the way down. However, investors should ensure that capital allocation discipline occasioned by energy transition is deeply embedded, as upswings may represent the greatest risk depending on how they respond.
Low carbon outcomes mean lower prices, cross-cycle
At some stage, the Covid clouds will clear and the energy industry will be buoyed. Two weeks ago, the S&P Global Oil Index jumped 10% in a day on positive vaccine news. However, that doesn’t mean that the oil industry will bounce back to the good times of yesteryear in the long term. The psychological bias of expecting mean reversion to past norms is known as “the gambler’s fallacy” – the megatrend of the energy transition, however, fundamentally changes the energy sector arithmetic compared to history.
Our work has frequently pointed out that satisfying the levels of oil demand under low carbon pathways tends to imply a marginal breakeven price – i.e. the price producers need to believe in to incentivise the last barrel of oil to come onstream and satisfy demand – much lower than under “business as usual”. For example, our Fault Lines report estimated that the levels of oil demand over the next 20 years under the IEA’s 1.65 degree Sustainable Development Scenario could be supplied by assets that generate a reasonable 15% rate of return at oil prices in the mid-$40s, not a million miles from where we stand today.
Those expecting a return to steadily higher prices could have an unpleasant surprise in store.
Beware of spikes
In reality, does that mean the oil price will never cross $45 even if climate aims are successful? Probably not. It wouldn’t be a surprise to see shorter term prices above that level (and indeed below it). A lot of potential supply has come out of the market recently, there is certainly a chance we see spikes in the next few years.
If so, this will no doubt be used by some to pour scorn on the concept of stranded assets and to push for a return to planet (and value)-busting growth. But of course, the reality is that the stranded assets story is longer term – and indeed it is periods of high prices that sow the seeds of value destruction. It only took a few years of $100 oil in the 2010s to convince industry that it would last forever and to pour money into high cost projects accordingly, with much destruction of investor capital.
The shift to a world of annual demand reduction, rather than growth, will have profound consequences. While both may exhibit cyclicality, it is much easier to clear an oversupply if demand is rising at 1-1.5 million barrels per day (mbpd) every year than steadily falling by a similar amount. Combined with the need for fewer, lower-cost projects, this sets the scene for longer periods of lower pricing and lower cross-cycle means.
Will it be “different this time”?
In the future, we wonder if the greater understanding of the energy transition among investors, and their desire to avoid owning assets that don’t fit within a Paris-aligned world may at least partly save the industry from itself. Providers of capital may end up enforcing supply discipline in higher price periods and mitigating the headlong dash to oversupply. As well as helping mitigate value destruction in the sector, this restraint will also benefit the climate by preventing rebound effects.
There may well be opportunities for traders to make a quick buck from short-term moves in the price. Many have pointed out the dreadful performance of the energy sector in terms of stock returns over the last decade – $100 in invested in the S&P 500 a decade ago is now worth over $350; the same in the S&P Global Oil Index has lost the investor $30. However, that won’t last forever, and there will inevitably be times when the sector outperforms. High risk can mean volatility on the upside as well as downside.
Nonetheless, under the energy transition, shareholders should be aware that any short term rebound in prices will likely be shorter and to lower peaks than in the past. To prevent destruction of value – a likely outcome of companies investing to capture short-term (short-lived) bounces – shareholders should make it clear to management that a strategy of capital discipline and low costs is the only recipe for earning acceptable returns. The history of the oil industry over the past fifty years is littered with examples of management destroying value by believing that cyclical rebounds in prices are the ‘new normal’. They are not.
 As an aside – one could even view investors as effectively making up for the deficiencies of legislators, with a higher required cost of capital for higher carbon projects effectively replicating the effect of unfortunately inadequate or absent carbon prices. But one suspects that oil companies that apparently support a carbon price would be rather less excited about seeing the equation presented in cost of capital terms.