Wednesday, September 27th 2023

Oil : How high can it go?

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Oil : How high can it go?


“…There is much talk this year of a market rotation from growth to value – just now, and for some time to come, oil and gas looks like prime value….”


After 2020’s annus horribilis the stuttering recovery of the oil and gas sector now seems to be shifting into gear. Brent crude prices touched $96 a barrel today, their highest level for seven years. With fears that an industry still emerging blinking into the light after the pandemic will not be able to meet rising global demand, some expect oil will top $100 a barrel later this year.

Just how high will the price go? How long will it last? And what does it mean for investors?

As the global economy continues to rebound from the Corona-induced slowdown Goldman Sachs forecasts OECD oil inventories will fall to their lowest levels since 2000 by the middle of the year, forcing Brent as high as $96 a barrel in 2022 and $105 a barrel in 2023. JP Morgan expects international demand to grow by 3.5m barrels per day this year, ending it at a record high. European gas prices reached a record high of €117.50/MWh in October, gas futures surging 11pc in December.

Higher energy bills are dominating today’s headlines, prompting even those governments pursuing robust green programmes to encourage fossil fuel production, most strikingly, perhaps, the liberal Biden administration, which has called on OPEC to step up supply to help bring prices down. Supply concerns have been compounded by fear of conflict: ongoing disruption in Libya, a drone attack near an oil depot in the UAE by Yemen’s Houthi rebels, and, of course, Russia’s military build-up on Ukraine’s border.

As energy prices rise, much of the industry is swinging sharply back into profit. So far this year ExxonMobil and Chevron have reported combined net annual profits of nearly $38.6bn, contrasted with combined losses of $27.6bn in 2020. It’s a reminder of the extraordinary revenues steady production in a favourable environment can generate. As BP CEO Bernard Looney told the Financial Times, ‘When the market is strong, when oil prices are strong and when gas prices are strong, this is literally a cash machine.’

The US shale industry, which suffered an abrupt reversal when Covid hit after several years of exponential growth, is resurging. The shale revolution’s Permian Basin, the engine behind US oil production, supplying some 40pc of the nation’s crude, broke its pre-pandemic production record in December, and is projected to generate five million barrels a day for the first time this month. The trend for smaller companies and private equity-backed groups to pick up North Sea assets is reasserting itself. Last month a new venture headed by IGas and RockRose Energy co-founder Andrew Austin acquired a minority interest in four fields that make up the Greater Laggan Area from French oil major TotalEnergies.

But despite higher demand and the profits it is generating, the industry is only gradually ramping up production.

It’s partly because of fossil fuel geopolitics. OPEC+ is sticking to a plan agreed in July to replace output cut at the outset of the pandemic, but so far only by 400,000 barrels a day each month. Indeed, some members of the group, notably Russia, have not been been hitting their monthly targets. Goldman Sachs estimates spare capacity among members will reach ‘historically low levels’ of about 1.2 million barrels a day by the summer.

Another reason is the industry’s wariness of repeating the mistakes of the 2000s – which led to the 2014 oil price crash – by over committing to capital spending. The majors are planning less capital spending on new production than in years past, noting investor demands to funnel cash back to shareholders. Exxon expects capex of between $21bn and $24bn this year, well down on 2019 plans to spend between $30bn and $35bn, and Chevron plans to spend $15bn this year, down from $20bn in 2019. Capital spending is still 75pc down on new projects from before the pandemic.

Then, of course, there are the increasingly tough constraints being imposed on the industry as many of the world’s major economies attempt to make serious inroads into 2050 net-zero targets. Pressure exerted by a growing web of climate change regulations and growing investor reluctance to fund fossil fuel exploration is casting an ever darker shadow over the sector’s licence to operate. A major report by the International Energy Agency last May said that the drop in oil and gas consumption required to achieve net-zero global emissions by 2050 meant no new oil or natural gas fields were required beyond those already approved for development. 

The ongoing dispute over the Cambo project in the North Sea is becoming a landmark case. Late last year Shell pulled out, a major victory for environmental groups keen to stop the UK developing new oil and gas reserves. Shell was defeated last year in a court battle with Milieudefensie, the Dutch wing of Friends of the Earth, which imposed a mandate on the supermajor to cut its carbon emissions by 45pc by 2030. The group has signalled its intention to take similar action against 30 multinationals – including BP, ExxonMobil, ABN Amro, ING, Unilever, Vitol and KLM – with entities incorporated in the Netherlands. Climate change-related cases have more than doubled since 2015. Private equity-backed non-listed operators, which had previously flown more or less under the radar, are also under much closer scrutiny.

The industry is also likely to have to brace itself for heavier taxes as well as tighter regulations. The UK industry looks set to be subject to a windfall tax as ministers come under mounting pressure to address a looming cost of living crisis: an increasingly unpopular industry recording strong profits off the back of soaring energy prices is a soft political target.

Actions speak louder than words…


But, amidst all of the noise, the industry’s ultimate confidence in the world’s medium-to long-term demand for oil and gas is indicated by its continued exploration for undiscovered oil and gas in remote regions. According to Wood Mackenzie 798 exploration and appraisal wells were drilled worldwide last year, somewhat down on 2019, but roughly the same number as in 2020. 

Shell drilled its first well offshore Namibia last month – a country with no history of oil production – in partnership with state-owned Qatar Petroleum, drilling hundreds of kilometres below 2,500 metres of water. Italy’s Eni has drilled its first well offshore Kenya in almost eight years. Exploratory wells such as these take at least six years to bring into production, with costs unlikely to be recouped until the mid-2030s.

They don’t make a noise about them, but such bold and costly exploration programmes testify that the majors think fossil fuel demand will be here for some time to come. When pressed, some make the case that as oil wells age, it often becomes harder and more carbon-intensive to extract the remaining crude, so developing new, more accessible deposits, can actually be greener than trying to wring oil out of old assets. OPEC has forecast that demand will support production of 109 million barrels a day to 2040 before plateauing. And Wood Mackenzie’s 2022 Global Upstream Outlook expects that continued high prices will support cash flows able to fund exploration spend of around $20 to $25 billion, generating discoveries of around 15 to 20 billion boe.

Continued exploration by the oil majors reflects the world’s continued dependence on significant fossil fuel extraction for some decades to come. Right now oil and gas still provide more than 84pc of global primary energy. The share supplied by renewables is growing fast, but is still only 5pc, with hydro providing 6.4pc and nuclear 4.3pc. Though developed economies can afford to transition to greener energy, developing countries, in which some 770 million people don’t have electricity, and 2.6 billion no access to energy for clean cooking, still need fossil fuels. Other economies are profoundly dependent on oil revenues: Nigeria’s public services, for example, were nearly destabilised when the pandemic forced the country to slash its hydrocarbons production. And our dependence on fossil fuels extends well beyond energy: petrochemicals provide crucial fertilisers, and are used in clothes, for packaging, medicine, cleaning and roads. Gas is used in hospital surgeries, in the agricultural industry, and for cooling nuclear reactors. Fossil fuels are woven tightly into the fabric of the global economy. And we are using more and more energy: we use three times as much energy as we did 50 years ago and at current growth rates – 2.4pc a year – that will soon double again. 

An International Energy Agency report notes that although a record amount of renewable electricity was added to global energy systems this year it remains about half of what is needed annually to be on track to reach net zero emissions by 2050. Indeed, it is unclear whether rollout of renewables at the pace required to allow the phasing out of the oil and gas industry in time to meet 2050 targets will be politically possible. Even the sector’s opponents, such as green advocate Holly Jean Buck, have their doubts. In her thought-provoking book Ending Fossil Fuels Buck quotes a remarkable study by Princeton University highlighting the tremendous demand on land and resources rollout of wind and solar sufficient to support the electrification of everything would make. As Buck puts it: ‘The rates for deployment would set new records each year: by 2050, there would be 5.7 terawatts or wind and solar capacity, at $6.2 trillion of investment … In this scenario, wind and solar farms span an area of 1 million km2. That’s equivalent to the combined land areas of Arkansas, Iowa, Kansas, Missouri, Nebraska, and Oklahoma (or an area roughly the size of France and Spain). This is all land that’s visually impacted by wind turbines, not where the turbine pad directly sits, but it’s still a stunning amount of land. Land for solar is equivalent to the size of West Virginia … and the entire Atlantic Coast is lined with offshore wind farms.’

As Buck notes – despite her objections – net-zero does not necessarily mean phasing out oil and gas altogether. The fossil fuels industry can continue in some form through a decades-long energy transition if it implements the growing range of ‘low carbon’ technologies that can significantly reduce emissions. These include enhanced techniques for detecting methane leaks, decarbonising fuel transport, electrifying operations, direct air capture (though machines that suck carbon from the atmosphere), enhanced oil recovery (injecting CO2 into depleted oil wells to get more oil), and, crucially, carbon capture and storage.

The industry has a very long way to go to implement these technologies at anything like sufficient scale to allow it to meet the net-zero commitments many companies are now setting. But as Wood Mackenzie reports progress is now being made, as it dawns on more and more companies that investment in low carbon will be the condition for their continued licence to operate. The project pipeline for carbon capture saw record growth last year, growing seven-fold.

Oil and gas as a hedge


Oil and gas stocks, then, would seem to offer a sound medium- to long-term investment as part of a diversified portfolio. There is strong demand in the short term. And there will be consistent demand for years to come. The world will not be able to live without hydrocarbons for decades. The industry will be subjected to increasingly stringent regulation as the global economy transitions. But that pressure will be necessary to hold the sector’s feet to the fire regarding its net-zero commitments. Governments know they cannot simply phase the industry out. They can, however, hold it to its promises.

A very interesting recent opinion piece by financial commentator Merryn Somerset Webb offers another reason for investment. Quite simply, oil and gas stocks offer a hedge against the damage that higher fossil fuel prices may cause other parts of the market. Referring to research by analysts Gavekal, Somerset Webb notes that there is a close relationship between oil prices and bull and bear markets. S&P 500 bull markets, as in 1922, 1949, 1982 and 2010, begin when energy is plentiful and cheap. Bear markets begin when it is not, as in 1912, 1929, 1968 and 2000. Ultimately, economic activity depends upon the supply of energy. If the cost of energy is rising, companies unable to add value or improve efficiency fast enough to absorb the costs will suffer lower profits, or have to put up their prices, or more likely both. That means inflation, and, in turn, jittery markets, as we are seeing now. Somerset Webb suggests that since ‘energy stocks’ strength may well be reflected in serious weakness elsewhere – you should hedge the former with the latter’.

Investors can track the oil and gas sector through various ETFs, or take a look at some promising hydrocarbons small caps – we suggested a dozen in our roundup a few weeks ago. There is much talk this year of a market rotation from growth to value – just now, and for some time to come, oil and gas looks like prime value.