Oil: an obituary?

Sunset befalls a pump-jack mining crude oil.

News of US oil ‘selling’ for -$37 per barrel left many feeling comically bewildered as to how one of the world’s most important commodities could be worth less than $0. Despite being the lifeblood of industrialised nations and the most important source of energy since the 1950s, oil is facing attack from all directions.

Growing political pressure for countries to move away from fossil fuel dependency, the rise of renewables, geopolitical tensions among the world’s largest fossil fuel producers, and the advent of American shale oil into global markets have made exploration and extraction a far less profitable enterprise than it once was. Some have even speculated that the decline of the petroleum industry is imminent. Is the oil industry set for an inevitable death or does it still have a future in the global economy?

The Oil Industry: A brief introduction

The petroleum industry is one of the largest in the world – generating over $3 trillion in revenue annually. The industry has created behemoths such as John D. Rockefeller’s 19th century Standard Oil and in the 20th century giants such as British Petroleum, Royal Dutch-Shell and Saudi ARAMCO. The industry is made up of three main types of firms; upstream, midstream and downstream. 

Upstream businesses are companies that are involved in the exploration and production (E&P) of oil and gas. They survey regions across the world for potential reserves. Once they find areas with substantial amounts of fossil fuels, they usually proceed to negotiate with the relevant government to lease rights to extract the petroleum. The drilling and servicing of oil wells are normally contracted out to drilling companies that drill the well before E&P companies proceed with production. Drilling companies also service the wells which can include perforating, logging, and maintenance, for example. 

Midstream companies focus on transportation, unprocessed petroleum to refineries. This is done through a variety of methods such as trucks, pipelines or shipping. These types of firms are dependent on the success of upstream businesses for their success. 

Downstream firms are the refineries where the crude oil is processed. They separate it into more useful chemicals such as kerosene, diesel and petrol through processes including fractional distillation. 

OPEC and the US Shale revolution

Competition in most industries is usually expected, with companies fighting to sell as much of their goods or services at the lowest price or highest quality possible. The economics of the oil industry are in that sense unconventional. For example, the largest petroleum company in the world is the state-owned Saudi ARAMCO, which was valued at $2 trillion at the start of 2020. Many states around the world, particularly in the Arabian Peninsula, have nationalised oil companies. Revenues from these companies have been responsible for most of the extraordinary economic growth and development much of the region has enjoyed post-World War II. Therefore, these states have an incentive to regulate/influence the supply and demand to keep prices high enough for them to make a profit. 

The Organization of the Petroleum Exporting Countries (OPEC), founded in 1960, does just that. OPEC is made up of 13 member states, with Saudi Arabia the de facto leader. They account for 44% of global crude production and control 79% of the world’s proven reserves. To a large extent, OPEC operates as a price-setting cartel – restricting the amount of oil they as member states produce so as to influence prices and keep them at levels that maximise the amount of money member states make by selling their product on the global market.

However, the ability of OPEC to control prices has never been perfect. Throughout the late 20th century and since the early 2000s it has faced constant competition from producers globally. When OPEC cut production to raise prices, non-OPEC producers would regularly step in to fill the void, resulting in a downward pressure on prices. A similar tale ensued with the rise of US shale. Technological innovations allowed US firms to extract oil from shale rock, opening up deposits that were previously unprofitable to upstream companies wishing to drill and extract petroleum from these rocks. Markets enjoyed an influx of crude, heavily contributing to the fall in prices from over $100 to to less than $50 per barrel of crude between 2014-15. The price of Brent crude has since averaged around $57 between 2015-2019.

Oil, Coronavirus and the 2020 Russia-Saudi Price War

From the start of 2020 the Coronavirus pandemic has shaken the world, with over 9 million confirmed cases and just under 500,000 confirmed deaths worldwide. The public health crisis that ensued as a result of the virus has ravaged the global economy, sending it spiralling into a recession as businesses and nations entered into a temporary stasis in an effort to curb the spread of the disease. The closure of economies around the world resulted in demand for oil falling off a cliff as businesses cut costs and ceased operations to reflect the fall in domestic and global demand for their products. 

In response to the drastic fall in demand, OPEC, led by Saudi Arabia, attempted to strike a deal with member states and informal allies, dubbed as “OPEC +”. The goal was to instigate coordinated production cuts by member states to stop the price of Brent crude falling to unprofitable levels, similar to the agreement Saudi Arabia and Russia came to with the impact of US shale on prices in 2016. In March 2020 Russia rejected OPEC’s proposal of production cuts. Soon after, Saudi Arabia announced discounts of $6-8 per barrel to its customers in Europe, Asia and the US. It also increased its production of crude from 9.7 million barrels per day to 12.3 million and Russia responded with an increase in production of crude by 300,000 barrels per day. With an enormous influx in the supply of crude, prices plummeted. This oversupply led holders of US crude futures to pay people to take their futures contracts off of them, resulting in the unprecedented negative prices reported on April 20th.  

Although the two states eventually agreed to cut production in early June, the fall in the price of crude oil, coupled with the severe economic fallout as a result of the Coronavirus pandemic, hit the industry hard. Despite the fact that prices have recovered significantly since April, to approximately $40 per barrel, it is well below the $50 breakeven price for US shale. Furthermore, $40 is still a lot lower than last year’s average price of $64, making it a lot harder for firms to avoid insolvency, let alone maintain profitability. 

E&P firms in the US have drastically reduced their production levels and laid off workers in a bid to cut costs. Regardless, a wave of bankruptcies has swept through the US shale industry and there are serious concerns on whether it will be able to recover. Saudi Arabia, the world’s second-largest oil producer, issued a series of austerity measures, tripling VAT and suspending the cost of living payments it introduced in 2018. Around the world oil companies continue with issuing redundancies, lowering production levels and suspending dividend payments to shareholders in a bid to preserve cash and reduce costs. 

Oil: A commodity in perpetual crisis

Oil is no stranger to price shocks. This is its third price collapse in 12 years. In July 2008 the price of oil soared to $128 due to geopolitical unrest and consumer fears about the wars in Afghanistan and Iraq. In 2014, OPEC’s failure to successfully coordinate cuts production to counter the stream of US shale resulted in the price of crude falling from over $100 a barrel to below $50. In 2020, a failure to cooperate on the part of OPEC and its allies resulted in prices hitting record lows and unnecessarily exacerbated the impact of the coronavirus pandemic on the industry.

The periodically erratic nature of the oil market means that petroleum is increasingly becoming a less worthwhile investment. Coupled with a push for and greater investment in renewables, there seem to be indications that the sector has reached its twilight years and is in decline.

The biggest oil companies in the world – British Petroleum, Royal Dutch Shell and Exxon Mobil – have all pumped billions into renewable energy projects. Royal Dutch Shell, for example, has committed to achieving net-zero carbon emissions by 2050. For much of the world, the tide has turned. Countries are waking up to the colossal challenge that climate change poses to human civilisation. Public pressure is causing governments around the world to change their environmental and energy policies, steering their nations progressively towards the direction of a carbon-neutral future. 

The Renewable Reapers

A wind farm in Biedesheim, Germany
A wind farm in Biedesheim, Germany.

A global push for a carbon-neutral future has resulted in a spike in investments of renewable energy sources. Since 2004 investment in renewables has skyrocketed. In 2018, global investment in renewable energy capacity hit $272.9 billion, surpassing investments in fossil fuels. Global investment in renewables was set to hit $2.6 trillion by the end of 2019. 

This surge in investment did not occur purely because of public sentiment but primarily due to tremendous improvements in the cost-competitiveness of renewables. The cost of electricity for solar energy and wind have fallen by 81% and 44% respectively and renewables are now the cheapest option for new energy projects around the world. In June the UK went a full two months without burning coal for power production, with electricity being sourced from renewables instead. This is indeed a remarkable achievement for a nation that relied on coal for about 40% of its energy just a decade ago. As innovations continue to make green energy cheaper and more price-competitive there is little doubt that in the coming decades they will make up a large segment of national power grids, not only in developed nations but in emerging markets as well. 

Despite the success of renewables and a surge in their popularity, there are a few disadvantages that might harm their growth. 

Firstly, fossil fuels guarantee a consistent and predictable flow of electricity onto power grids, whilst renewables are a lot more volatile. Unexpected clouds and rain can reduce the amount of electricity solar panels can produce. Wind turbines will only produce electricity when it is windy. However, the use of smart grids and data analytics can help and is aiding in increasing the efficiency of power generation from renewables, helping keep them price-competitive. 

Secondly, there are also issues regarding space efficiency and environmental concerns. Solar farms, for example, can take up acres of space and therefore can only be installed in rural areas. Wind farms, whilst also needing large acres of space, can have negative impacts on local habitats. This is because the blades pose a threat to local wildlife such as birds and bats. Approval for such projects may take a long time or even be blocked in areas where wind farms could generate the most electricity. 

Nevertheless, many would argue the need to prevent permanent and irreversible environmental damage caused by high CO2 levels in our atmosphere stemming from the use of fossil fuels is a good reason to keep developing renewable energy. Notwithstanding the aforementioned issues, investment in renewables has continued to grow throughout the decade and although the Coronavirus pandemic may slow this growth , the long term trend is that renewables are here to stay, and they are on course to disrupt the oil industry’s global dominance in energy generation. 

With the increased public scrutiny of the oil industry and a push by activists and the public for renewables, is this the end for the petroleum industry or are enunciations of the end of oil grossly exaggerated?

Oil: A Definite but uncertain future

In the immediate aftermath of the Coronavirus pandemic and the fall of oil prices, E&P businesses will and are already struggling to remain profitable. They produce and sell crude on international markets and are most exposed to changes in price. McKinsey has suggested that this may result in larger E&P businesses buying out smaller companies, but this is dependent on how confident firms are of the petroleum industry’s future and whether or not capital could be put into investments that seem more worthwhile in the long term, such as renewables. Midstream businesses will also face issues going forward if the market does not recover. Due to high regulation, their ability to cut costs is restricted as they have to meet legal standards for storage and transportation to stay in business. Thus, their success is in many ways tied to that of upstream as they are responsible only for the transport and storage of petroleum. 

Downstream businesses, the refiners, are arguably in a better position than upstream and midstream businesses because there is greater flexibility for them to be more competitive in the short and long run. For example, refiners that can refine ‘heavy’ crude, which is harder to refine but cheaper than ‘lighter’ forms of crude, which are generally more expensive. This will aid them in staying competitive in the long run. Furthermore, they have a wider variety of customers than their upstream and midstream counterparts. Products from the refining process include jet fuel, asphalt base for road construction and petrol for cars. Post-COVID 19, as industries resume operations, demand for petroleum products will pick up again and in the short term, refiners will benefit from the lower cost of crude and possibly profit from it, as they did in 2016.

Analysis from McKinsey suggests that demand for oil will peak in 2030 before declining steadily. Energy companies around the world will likely invest more resources in renewable energy to make it not only more price-competitive but also profitable. Nonetheless, bear in mind that these are all predictions made in the haze of uncertainty that the Coronavirus pandemic has brought with it, and that nothing is truly certain. 

Overall, the industry will, for the short to medium term, play a key role in the energy sector and the global economy as a whole. This is because petroleum is used in many parts of the economy, from airlines to shopping bags to computer hardware and printing ink. It will continue to fulfill this vital role. Nevertheless, as renewables become cheaper and commercially viable, they will continue to displace oil’s dominance in energy production and help propel oil into a steady decline in the decades to come. 

This Post Has 4 Comments

  1. Rithik

    A great article tackling a burning issue – talking about what could happen post-Covid is particularly interesting; all firms should be looking at this!

  2. Aditya

    An elaborate case on the prospects of oil, especially it’s contrast again renewables, look forwarding to see how this is embodied in the future landscape!

  3. Tycho Ambachtsheer

    Wonderful article, interesting read!
    Thanks,
    Tycho

    1. Ishmael Liwanda

      Thank you Tycho!

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