Big Oil has reached a turning point. Peak demand is coming sooner than the oil gurus forecasted only a few years ago and may already be here. If so, what is the point of spending fortunes to find more oil, a product that might steadily lose value, or even become a liability, as demand sinks and governments embrace carbon-neutral futures?
For decades, energy investors assumed oil demand would rise – and they were right. In the past half-century, global oil consumption has roughly doubled, to 100 million barrels a day. Investors valued oil companies not just on the cash flow from rising output, but on the reserve replacement ratio: The most alluring companies reported a ratio of 1:1 (or greater), meaning they found at least one barrel of oil for every barrel produced, guaranteeing they would stay in business over the long term.
Now that model is being turned upside down.
This week, BP, the former British Petroleum, said demand may have peaked last year; if it hasn’t, it will in the next few years. Chief executive Bernard Looney said BP’s new goal is to produce less oil and gas, not more. The company plans to drop production by about 40 per cent over the next decade and replace the lost output with renewable energy. Doing so is also essential if BP is to meet its net-zero emissions goal by 2050.
The idea that investors can make endless fortunes from oil now seems like a quaint notion from the past. Oil prices topped out at US$150 a barrel in 2008 and have been on a roller-coaster ride since then, although there have been far more downs than ups. The recent peak came two years ago, when oil (of the Brent crude variety) stumbled north of US$80.
On Friday, the price was US$43, for a one-year drop of more than 30 per cent. Oil equities have fallen by about half in the past year. Canada’s biggest oil player, Suncor, is down 58 per cent. The pandemic and the work-from-home phenomenon have crushed demand for transportation fuels.
Yes, a vaccine could restore oil demand, but for how long? The black-to-green campaign is picking up momentum as the planet heats up and wildfires turn big chunks of California and Oregon to ashes. The European Commission this week said it wants European Union-wide greenhouse gas emissions to fall 55 per cent by 2030 over 1990 levels, an ambitious jump over its old target of 40 per cent. Consuming more oil would make that impossible to achieve.
The scenario does not necessarily mean oil investors are doomed. There is a way for them to profit from Big Oil’s gradual slide into irrelevancy as demand decreases and renewable energy picks up the slack.
That way is for oil companies to opt to kill themselves slowly by running down their reserves and not replacing them. The billions of dollars saved on capital spending – finding and developing new oil and gas reserves – could be used instead to finance fat dividend payments. In effect, oil companies would become income trusts, making them profitable for investors even at relatively low oil prices.
The self-liquidation model is not unique. The tobacco companies effectively chose that route as cigarette smoking became taboo. Philip Morris International, one of the biggest tobacco companies, has significantly outperformed the wider market in the past decade. Waning cigarette sales still hauled in big profits.
The other reason self-liquidation might be a compelling idea for publicly traded oil companies is that they have relatively high costs compared with the government-controlled oil giants of the Middle East, such as Saudi Aramco and the National Iranian Oil Company. The cost of pumping oil in the desert is a few bucks a barrel, producing profits even at prices that would hurt Big Oil and U.S. shale oil companies. In an era of declining oil demand, and possibly declining oil prices, the Western oil biggies can’t compete over the long term with the discount pumpers from afar.
There are, of course, variations on the self-liquidation idea. An oil company could recreate itself as a broad “energy” company, as BP seems to be doing. At some point, it and its rivals might shunt their hydrocarbon assets into separate companies that could be wound down over time as their sister companies concentrate on building renewable energy portfolios. A few hydrocarbon companies have already made a successful transformation into renewables. One is Denmark’s Orsted, which went from being the country’s grubby oil, gas and coal monster into the world’s biggest owner of offshore wind farms in less than a decade. Orsted’s stock market returns have been spectacular in recent years.
To be sure, the oil companies will resist the slow-motion suicide route. For decades, every bone in their bodies has been devoted to finding and pumping oil and gas in ever-rising quantities. Doing the opposite would be, culturally speaking, completely alien to them. Reservoir engineers cannot turn into solar or wind engineers overnight. But at some point, oil investors may force Big Oil to ease out of the hydrocarbon game. They will do so when they realize that the transformation could pay lavish dividends. At some point, a hedge fund will figure this out and swing into action.
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Eric Reguly