Article

Oil Shock

The global oil industry has been hit with a shock in the last two months. And while that may reflect a short-term phenomenon, profound structural changes loom in the near future.

by Christian Roselund
February 2020

At the time of writing this article, the coronavirus had killed more than 2,100 people, with over 75,000 confirmed cases, as one of the deadliest epidemics of the early 21st century. And while the vast majority of both infections and deaths have been in one city—Wuhan in China’s Hubei Province—travel restrictions and requirements that employees not go to work have effectively shut down large parts of the nation.

Any slowdown in the world’s second-largest economy and largest manufacturer has global impacts. Earlier this month the International Energy Agency (IEA) estimated that demand for the world’s most-traded commodity, petroleum, will fall by 435,000 barrels per day in the first quarter of 2020, the first such quarterly contraction in the decade following the global financial crisis of 2007–2008. Over the full year 2020, the IEA has reduced its forecast for demand growth by nearly one-third. And this may be a conservative estimate, as it assumes that Chinese demand will return to normal during the second quarter, despite the virus still raging in Wuhan.

It is perhaps an understatement to say that this has been a bad start to the year for oil. Despite repeated cuts to production over the past few months, the price of oil started falling on January 6, with West Texas Intermediate Crude declining from a high of over $63 per barrel to under $50 per barrel less than a month later.

This decline in price has been mirrored by declines in the stock prices of the entire oil industry, with the main oil industry exchange traded funds (ETFs) showing similar declines during January and early February. This includes such giants as Exxon-Mobil, which saw its stock fall from more than $70 per share to under $60. And it follows a difficult year in 2019, with more than 50 oil and gas companies filing for bankruptcy in the first nine months alone.

There are other indicators of trouble in the sector. On January 31, Jim Cramer, the host of MSNBC’s Mad Money, said he would no longer invest in fossil fuel stocks, stating that “they are done” and that the industry is “entering the death knell phase.” And as all of this was happening, electric vehicle maker Tesla’s stock price vaulted to over $800 per share.

Short-Term Versus Long-Term

In the more than 160-year history of the modern oil industry, there have been plenty of downturns. Like any commodity, the industry has gone through repeated cycles of tight supply and high prices, followed by surplus and falling prices. The fate of states and nations has at times hung on these supply and demand dynamics, with low prices crashing economies and regimes that are overly dependent on oil.

Times of limited supply and rising prices have also sparked exploration. The technical progress that allowed the exploitation of shale reserves over the last fifteen years has led to a super-abundance of oil and gas, in the process both depressing prices and turning the United States into the world’s largest producer of crude oil.

Kingsmill Bond, a new energy strategist at think tank Carbon Tracker, describes the coronavirus’ impacts on oil demand as a “classic cyclical story.” However, he is concerned with longer trends. The dramatic fall since January 6 masks a slower, but more damning, decline, with oil stocks falling in value across the board over the last 16 months. By May of last year, the oil and gas sector’s share of the S&P 500 had already fallen to 5 percent—the lowest level since 1990.

Notably, in Jim Cramer’s statement that he was “done with” fossil fuel stocks, he did not cite the coronavirus, but rather the divestment movement, noting that the “world has changed.” This movement away from fossil fuels has gained steam in recent months, with BlackRock’s announcement that it would push companies to transform their energy use as merely the latest indicator of what Cramer had emphasized—that money managers are increasingly wary of fossil fuel investments.

And even some oil companies are responding. A leading example is Ørsted transforming itself from an oil and gas company to one that plans to be carbon neutral by 2025. Total and Shell have also begun to make modest renewable energy investments, and BP’s recent net zero pledge implies a move beyond hydrocarbons.

Peaks

Bond says that while divestment has been “part of the story,” it alone cannot change the fortunes of the oil industry. “Divestment would not be sufficient were it not for the expectation that reality would take over.”

Carbon Tracker is explicitly warning of a pending peak in global oil demand, as part of a larger peak in fossil fuel demand. A 2018 report by the think tank forecast that this overall demand for fossil fuels will peak in 2023, and in citing Shell’s “Sky” scenario it foresees a cascading series of peaks for different fossil fuel resources in the first half of the 21st century.

It is important to differentiate this prediction from the peak oil theory, which has been advanced for decades. The various manifestations of peak oil were largely based on the expectation that oil production would decline as the cost of extracting oil would exceed its value, an argument that has largely been invalidated by the emergence of cost-competitive extraction of oil and gas from shale deposits using hydraulic fracturing (“fracking”).

By contrast, the predictions that Bond and others are making do not center on supply, but demand. Carbon Tracker’s thesis is that as renewables become a larger share of electricity supply and end-uses such as transportation and buildings are electrified, this will put pressure on different fossil fuels, bringing down prices and causing them to compete with each other and with ever-cheaper electricity.

And while in past decades it has been difficult for the energy source that dominates one end-use to substitute for another, Bond says that increasing electrification and other changes are making energy more “fungible.” “There are a great number of ways to substitute demand for oil, and that’s going to be the story of this decade,” explains Bond.

And this can happen much earlier than most incumbents and investors expect. In analyzing past transitions, such as the move from horses to cars and steam power to electricity, Bond notes that fast-moving challengers wiped out the growth in incumbent industries when they only had 2–3 percent market share.

For future oil demand, the growth in electric vehicles (EVs) is particularly important. EVs comprised 2.4 percent of the global market for new automobiles in 2018, and this share continues to rise every year. And despite growth in the global market for both automobiles and gasoline due to increasing demand from the developing world, it is only a matter of time before the deployment of EVs first wipes out growth in demand for gasoline, and then starts to eat into the absolute volume of oil consumption.

Some of these peaks have already arrived. Global coal use peaked in 2013 and demand has largely stagnated since. Likewise, oil demand in the OECD (industrialized) nations peaked in 2005, and despite a minor rally starting in 2015, 2018 levels were still 7 percent below that peak.

Since 2005, the growth in global oil demand has come from developing nations including China and India; however in China the rate of EV adoption was 4.5 percent in 2018—much higher than the global average—suggesting that China will transition its vehicle fleet off of internal combustion engines and petroleum as a fuel earlier than the West.

And while the oil industry is betting on plastics to counterbalance the growth that is lost to EVs, the recently announced ban on single-use plastics in China suggests dangers to that strategy as well. “Across every section of oil demand, you have new ways that people are looking to provide the energy services that oil provides,” explains Bond.

Consequences

It may be tempting for casual observers to think that a peak in oil demand would not be terribly consequential. After all, even though global coal demand peaked in 2013, coal use still remains high, and has been relatively steady for the past five years.

However, the loss of growth has had profound impacts on the coal industry. This is particularly true in developed nations like the United States where production costs are the highest and less and less coal is burned every year, which has led to a string of US coal bankruptcies. Similarly, the publication OilPrice is predicting that 2020 will be the year of bankruptcies in the oil sector, with the number exceeding even that in 2019.

For financial markets, absolute volumes are largely irrelevant, and growth is what matters. Energy journalist and Energy Transition Magazine contributor Gregor Macdonald, who covered the dynamics of pending fossil peaks in his 2018 work Oil Fall, has summed up this relationship by stating that “markets are tragically sensitive at the margins.”

And when the prospect for future growth dries up, so does investment, which shifts to sectors that can grow. Carbon Tracker warns of “falling prices, rising competition, sector disruption, and stranded assets” as likely characteristics of the disruption that it expects at the peaks of fossil fuel demand. This is exactly what happened to the European electricity sector, where fossil fuel demand peaked 2007, leading to a crash in European stock prices.

The volume of fossil fuel assets at risk is profoundly large at around $25 trillion, but the think tank also warns of severe economic damage to petro-states such as Iraq, Kuwait, Oman, and Saudi Arabia, where fossil fuel rents represent a quarter or more of gross domestic product.

As such, Bond suggests that the disruption that has happened in the first six weeks of 2020 is only a foreshadowing of what is to come. He notes that executives and investors in other sectors such as coal and the European power sector generally did not anticipate the disruption that they were subject to, and points not only to the coal industry but also the collapse of GE and its exit from the Dow Jones Industrial Average following a $23 billion write-down on its turbine division. “The oil sector will be subject to the same forces as all of these other sectors have before them,” warns Bond.

At the end of the day, it will be necessary to first curb and then sharply reduce global oil consumption to keep the world below catastrophic levels of warming. Market indicators suggest that this peak will arrive during this decade, and this change will be painful to incumbent industries, communities, and even whole economies. In the first quarter of 2020, oil investors may be getting a first taste of that future.