The Covid-19 crisis has changed a basic assumption underlying the profitability of oil: the sector’s presumed certainty that oil demand will not change over the long term.
The coronavirus-induced lockdown of economies, combined with a price war, saw West Texas Intermediate (WTI) fall into negative territory in April.
Prior to the pandemic, oil majors already faced heavy pressure from investors to adapt their business models to a low-carbon world. However, the crisis could lead to a fall in longer term oil demand, which would impact the expected profitability of the sector.
Already suffering oil industry
Adrian del Maestro, director of research and strategy at PwC UK, expects that ‘black swan’ events like Covid-19 will keep reoccurring and impact the oil business.
“One of the big themes for oil and gas companies is that they need to figure out how they [can] make their business model more resilient in a world where you have these kind of unexpected events,” he says.
A reoccurring lower oil price means that oil majors need to cut costs to stay profitable.
Del Maestro notes, however, that this crisis will create difficulties for the oil majors, as they have already increased the efficiency of their operations, which means that their scope for savings is limited.
According to a 2020 PwC report, written by Del Maestro and his colleague Drew Stevenson, energy sector leader, “many oil services companies have yet to fully recover from the 2014 oil price crash and have been operating on wafer thin margins”.
This is on top of the existing debt that the companies hold (see chart below).
While the industry can deal with a short-term oil price slump, the pandemic has changed the risk level of the business, says Stevenson, and market volatility is expected to continue.
Given this broader context, he believes that “it is a quite conceivable possibility that this whole situation may well be the catalyst to a faster transition” to a low-carbon economy.
In the UK, Stevenson points out the average lifting cost of crude oil in a region like the North Sea is about $15 or $16 per barrel. You are not profitable at $22 in the long term. You need to see prices coming back at some point to make a lot of regions break even,” he explains.
Changing oil demand outlook
Many oil majors have responded to the oil crash with capex cuts for 2020, while Shell and Equinor have announced they will slash their dividend payments to ensure financial stability.
Shell has stated it expects more than a short term impact from the crisis.
The firm’s chief executive, Ben van Beurden, said in a press briefing several weeks ago: “We do not expect a recovery of oil prices or demand for our products in the medium term, but both will recover over time.”
Oil demand may have already peaked
Others, however, believe that long-term oil demand is in decline.
Mark Lewis, global head of sustainability research at BNP Paribas Asset Management (BNPP AM), told Portfolio Adviser sister publication Expert Investor that the crisis creates a lot of uncertainties around forecasting oil demand.
He sees sectors that are highly reliant on oil suffering from the crisis in the longer term – namely travel, flight and automative.
This comes at a time when the cost of renewable energy has fallen dramatically.
Adding to this, the pressure to accelerate the electrification of transport in big cities will rise, he says, as people’s willingness to live with air pollution has changed.
Oil demand may have already peaked, says Kingsmill Bond, energy strategist at non-profit financial think tank Carbon Tracker, pointing to recently released energy demand figures for 2020 by the International Energy Agency.
“In their scenario, they expect oil demand to fall by a massive 9%, coal by 8% and gas by 5%. Meanwhile, they expect solar to continue to grow by 15% and wind by 10%.
“If these decline rates are right, this means that peak fossil fuel demand was almost certainly in 2019,” Bond says.
However, Amy Wong, head of European oil service at UBS Research, is unconvinced that both project opportunities as well as renewable energy investments could be scaled up quickly enough to replace oil and reach net zero emissions by 2050.
“We need to add renewables at a rate that is two to three times higher than the rate that we were adding, say last year,” she told Expert Investor.
Oil industry isn’t going to change old habits overnight
Andrew Grant, head of oil, gas and mining at Carbon Tracker, believes that it is too early to say what the crisis will mean for oil demand.
A lot, he says, will depend on how governments react in terms of stimulus plans and bailouts, the way society will change, and other factors, such as the response of investors.
Whether the oil industry will easily break away from its unsustainable business model appears questionable.
BNPP AM’s Lewis comments: “Clearly, nobody is naïve enough to think that such a massive industry as the oil industry is going to change its habits overnight.
“A given oil company can always find a reason to invest in a given project.”
And even if oil companies commit to net zero emission goals, this wouldn’t lead to a change in their business models per se, as they could still offset emissions, Lewis continues.
Grant explains that, before the oil price crash, only one or two oil companies were talking about reducing production or investments, but without this having any impact on the way they run their business.
“In the near term, 2020 to 2025, all of these companies were planning production growth, and not just production growth, but production growth faster than demand is growing at the moment, let alone in a Paris-aligned world,” he says.
Research by data provider Arabesque S-Ray confirms this.
Using its “Arabesque S-Ray Temperature Score”*, it found that, even without including scope 3 emissions (ie value chain emission) and despite setting net zero carbon targets, none of the large oil majors is currently aligned with the climate goals of the Paris Agreement.
ConocoPhillips has however recently reduced its emissions (see table below).
Investors driving change
How investors act will be a key factor when phasing out unsustainable business models, or turning them into sustainable ones.
Fiona Reynolds, chief executive at the Principles for Responsible Investment (PRI), explains that responsible investors “know that the transition to a zero-carbon economy is well and truly underway”.
“There is no turning back – but a low-carbon economy cannot be achieved without further investment in clean energy and new low-carbon technologies,” she says to Expert Investor.
In the eyes of responsible investors, such as those part of the initiative Climate Action 100+, the oil money-making wheel must inevitably stop.
BNPP AM’s Lewis emphasises that, most importantly, these investors think that the Paris Agreement poses a big risk to fossil fuel companies and that invested companies should take it seriously.
PRI’s Reynolds comments: “The collapse in oil prices could result in more action on climate change, because it is forcing oil companies to focus more quickly on how they can transition their way out of the pandemic, eg by increasing their investments in alternative energy.
“Oil companies will want to demonstrate that they can survive in the long term, albeit with a revised agenda.”
Laggards that don’t consider disruptive change in their long-term fundamentals may not be able to transition fast enough.
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