Energy Challenges - Part II: Fossil Fuels Opportunities & Challenges
In Part I, I explained how energy is interconnected with our daily lives and how we believe it is critical for global economic expansion. Any supply disruption may cause price spikes that can threaten national security and impact the standard of living for many. In Part II, I’d like to examine further the challenges traditional energy sources— fossil fuels — have faced and their impact. Then, I’ll close by highlighting the opportunities for investors and the industry.
The Traditional Energy Landscape
The traditional energy industry, which involves drilling for oil and natural gas, is incredibly capital-intensive. Capital investment is required to grow production capacity, maintain proper reserves, and transition to more environmentally friendly facilities and practices. In the past decade, years of cheap and abundant energy led policymakers to focus on developing alternative energy to expedite the clean energy transition, demonizing critical oil and gas contributions— and thus neglecting energy security. The reality is that even after decades of investing in alternative energy sources like wind and solar, they are nowhere near replacing traditional energy, let alone meeting growing energy demand. The challenges for renewable energy development remain — including inferior battery technology, which is needed to solve renewable intermittency issues during prolonged adverse weather conditions, outdated transmission infrastructure, and lack of electric vehicle (EV) infrastructure for broader consumer and industrial adoption.
We believe that all the renewable energy development above would require enormous new public and private capital and cheap oil and gas. This is because much of this development uses traditional fossil fuels to build out infrastructure, and when the price of fossil fuels becomes too expensive, it is not financially palatable to build out the green infrastructure. Without those conditions, our rapidly evolving, highly energy-dependent society is creating increased demand without the increased supply to satisfy it. The challenges are even more significant for the traditional energy industry as there are increased restrictions posed by policymakers, increased costs of developing new fields and doing business, increased shareholder demand for dividends and share buybacks instead of reinvesting in new oil and gas projects, and an increased corporate push for “green” transition.
During and post-COVID, the U.S. government injected trillions of dollars to promote economic recovery and boost demand; however, not all countries reopened simultaneously, causing supply chain bottlenecks. Too much demand chasing limited supply triggered inflation in the price of goods. This condition, combined with lower-than-expected labor participation, led many parts of the world into the worst inflation in decades.
Given the importance of Russia for oil exports and Ukraine for wheat exports, inflation has become harder to contain as the war between the two countries heads into its ninth month. Since Europe imports most of its oil and refined products from Russia, the potential of shortages and looming sanctions against Russian barrels have triggered the worst energy crisis the continent has ever faced. European Union (EU) sanctions against Russian crude oil begin on Dec. 5, forcing EU countries to accumulate enough oil and gas to fill storage in advance of the winter months. Though this is a win for the EU in the short-term, it does not address long-term concerns about energy supply. And while the U.S. can release almost 200M barrels of Strategic Petroleum Reserves (SPR) this year, how long will the reserves last? Furthermore, the developing countries that cannot compete with developed countries for energy could be forced to shut down energy-intensive manufacturing and/or will experience blackouts.
We feel the challenge for our society and policymakers is to ensure energy security, sustainability, reliability, and affordability in a holistic way that allows the oil and gas industry to grow while incentivizing them to reduce their carbon footprint.
Here, countries must seek to balance geopolitical tension and set aside political agendas.
In a tight supply and high inflationary environment, the spare capacity of The Organization of the Petroleum Exporting Countries (OPEC) has become essential to restoring price stability. Russia, the second largest crude oil exporter, and a member of OPEC+, declared war against Ukraine and has funded the war by selling oil and refined products to the world because there is no competition for Russian oil after all the other global sources have been exhausted. Logically, OPEC should support the world with spare capacity. Instead, OPEC has been slow to bring back the production cut during the pandemic — despite much higher oil prices and requests from world leaders to increase pumping. According to Bloomberg, as of October, OPEC total crude production stood at 29.9 mil bbl./day, well below the 34 mil bbl./day production capacity seen in 2016 when the barrel of oil hovered around $60 per barrel. Even as Europe faces the most significant energy crisis in modern history, OPEC announced a 2 mil bbl./day production cut during their October meeting.
This begs the question from many pundits: where is the spare capacity?
There are three intertwined factors:
1) Short-Term Inaccessibility. The majority of OPEC spare capacity comes down to three members: the United Arab Emirates(UAE), Saudi Arabia, and Iran. Altogether, these countries hold 76% of OPEC 4.08mil bbl./d estimated spare capacity. Unfortunately, there are obstacles to accessing this spare capacity in the short-term. Iran is under sanctions due to its nuclear ambition, so approximately 1.32 mil bbl./d spare capacity is off the table. Saudi Arabia needs five years to increase its production capacity to 13mil from the current 11mil bbl./day. That leaves UAE, which has the least amount of spare capacity among the three about 780k bbl./d. UAE has already increased its production noticeably from the coronavirus pandemic low, but it is limited in how fast it can ramp up the production and restriction imposed by OPEC.
2) Diminished ability of OPEC as a swing producer. Many other OPEC members, such as Angola, Libya, and Algeria, are currently at production capacity and many oil and gas-producing sites are in a natural production decline due to a lack of investment and economic instability.
3) Willingness vs. Ability. It is noble for world leaders to put climate ambition front and center when oil prices are low; however, these same leaders promote division rather than cooperation when they call for more oil production when the energy prices are high. The truth is that investment in the oil and gas industry is crucial to lowering energy prices in the short-term and creating the capacity for viable alternative energy sources long-term.
Oil majors and U.S. independents facing policy uncertainty
Because energy businesses are capital-intensive, requiring heavy investment up front and execution in the long run, uncertain policy can significantly impact long-term strategic business plans.
Consider the Keystone XL pipeline. With declining oil volumes from Mexico and Venezuela, this cross-border pipeline project was designed to deliver as much as 830k bbl./d of Alberta tar sands oil per day to Gulf Coast refiners. This project is critical for energy security and affordability, especially given today’s high energy prices, because it would ensure oil supply from Canada and reduce the pressure to release millions of SPR. After years of construction and billions of investments, President Biden signed an executive order to revoke the license granted to TC Energy for the Keystone XL pipeline in 2021.
Another challenge is balancing shareholder demands and corporate activists. Shareholders request the return of capital through dividends and share buybacks while corporate activists push for a “green” transition – which would necessitate capital reinvestment.
Both of these dynamics – uncertain policy and balancing shareholder and activist demands – profoundly impact energy companies’ long-term capital allocation, thus limiting their ability to adjust to short-term phenomena.
In addition, oil well productivity is declining. The U.S. Energy Information Administration’s (EIA’s) most recent drilling productivity report indicates that the productivity of legacy wells and newly drilled oil and gas wells continues to fall compared to last year. This is to be expected – during a lower oil price environment, only top-quality acres can be economically drilled, and as those top tier acres are exhausted and producers move to lower tier sites, well productivity begins to fall. Moreover, nearly one mil bbl./d of total production came from the completion of drilled but uncompleted wells (DUCs). These wells were prepared before the coronavirus pandemic but ultimately were not completed when oil prices collapsed in 2020. In 2021, energy companies completed 50% more wells than they drilled as they drew down their DUC inventory, leading to a fast production boost. At the end of September, there were only 4,333 DUCs – the lowest level since the EIA dataset began in 2013.
On the other hand, key oil majors did not keep up with production replacement – Proven fossil fuel reserves declined yearly from 2017 until 2021. The reserve replacement ratio (RRR) is the amount of oil added to a company's accounts divided by the amount extracted for production. Between 2016-2020, the organic reserve replacement ratio of the global integrated oil majors was approximately 45.6%. At this rate, it is not hard to gauge that oil drillers are unlikely to sustain future production.
Lastly, Strategic petroleum reserves are at their lowest level since 1984. Historically, Strategic Petroleum Reserve (SPR) releases have been unsuccessful in reducing oil prices and instead indicate a tight physical crude market. The larger the release, the faster the market is ahead. As of Nov., SPR inventory stood at 396M barrels, the lowest level since 1984, after President Biden released about 197M barrels this year. The planned buyback at $72 per barrel to replenish the SPR seems unlikely as OPEC announced 2 million bbl./d production cuts last month while U.S. inflation is at a multi-decade high.
Challenge leads to opportunities for those who are prepared.
OPEC’s new World Oil Outlook predicts oil demand will increase by 13M barrels daily to 110M in 2045. Of this investment, 78% focuses on oil and gas drilling and production, and the remainder is spread between logistics, transportation, storage, and refining oil and gas for immediate consumption. At the time the report was published, many thought the forecast was too optimistic; however, with the constrained supply outlook today, even a modest demand growth points to sustained tightness in the market – and opportunities for investment.
Investment in long-life, low-depletion Proven Reserves (Canada) as well as short-cycle assets (U.S.).
· Canadian Oil Sands. Despite relatively high start-up costs, once reaching scale, Canadian oil sands can be produced at low operating costs with low capital needs for production growth. Since the decline rates are low, reserve life is long, which may provide sustainable production and free cash flow even in lower-price environments, and has the ability to ramp up when prices improve. Canadian energy companies have been consolidating these assets in the past few years as oil majors have been pressured to both cut emissions and invest in renewable energy by divesting those assets.
· U.S. Shale Assets. Short-cycle U.S shale assets allow capital to recoup sooner than in long-cycle conventional oil and gas projects. There are several key basins – Marcellus, Appalachian, Haynesville, and Utica for natural gas and Permian, Bakken, Eagle Ford for petroleum. Many U.S. Independent drillers now own some of the best shale assets after having consolidated assets from other weaker players during the low oil price environment in the past few years. We believe capital investment will continue to improve the quality of those acres thus enhancing their return profile.
· Overseas Expansion. Capital requirements point to downstream capacity expansion overseas. The downstream sector may remain tight in the short to mid-term, with the deficit of expected refining capacity vs. required refining capacity peaking at about 2.7 mil bbl./day in 2023 and 2024. Most of these additional capacity expansion opportunities will be in Asia-Pacific, the Middle East, and Africa, where demand growth is expected to come from.
Technologies may optimize production and lower costs. Revolutionary advancement like Enhanced Oil Recovery (EOR) has enabled the U.S. to significantly increase its oil and natural gas production and move closer to energy independence. Hydraulic fracturing and horizontal drilling may allow drillers to extract crude oil from tight shale formations by injecting liquid and materials at high pressure and accessing many layers of rocks while 3D seismic provides more accurate information to drillers to avoid dry holes – saving time and capital. These technological innovations and enhancements enable the U.S. to leverage with the Middle East and Russia and avoid energy crises like the one Europe is facing now. Investing in technological advancement can lead to production capability expansion, which may be the most cost-efficient way to generate strong cash flow in the future.
Techniques may reduce carbon footprint through Carbon Capture, Direct Carbon Capture, Carbon Sequestration, and Re-purposing. Achieving a low-carbon economy would require trillions of dollars per year. The massive capital investments required would necessitate both public and private capital participation. Government incentives like 45Q, an expanded tax credit for carbon sequestration, could be essential. If incentives like these were enhanced and adopted worldwide, technologies like Direct Air Capture (DAC) could be economical. DAC is expected to remove atmospheric emissions from hard-to-decarbonize industries, capture carbon dioxide, then store or reuse it as a feedstock to produce products such as low-carbon fuels, cement, or plastics.
Oil majors and U.S Oil Independents have taken major steps to develop carbon reduction capabilities, aiming to achieve carbon neutrality. For instance, expanding closed-loop gas capture, eliminating routine flaring and implementing continuous leak detection can reduce emissions materially.
Last, despite record profits reported by oil majors and energy independents, the sector is only 5.4% of the S&P 500 Index weight, half of its weight ten years ago when West Texas Intermediate (WTI) oil priced at almost $6 per barrel cheaper. Back then, the U.S held 695M barrels of oil and refined product in the Strategic Petroleum Reserve vs. 396M today. Looking ahead, primary oil exporter Russia is expected to face long-term consequences after the invasion of Ukraine. So, any demand growth points to sustained tightness in the market, resulting in higher oil prices for longer. Higher oil prices and more incentive programs like 45Q will continue to help the energy industry move toward carbon neutrality while providing affordable energy.
Affordable, reliable, secure, and sustainable energy sources are considered essential to improving living standards, supporting economic expansion, and sustaining social stability. They produce the energy that powers our homes; transport us from destination to destination; fertilize crops, and even create the items we use daily – including, but not limited to, clothes, cooking implements, and smartphones. The main contributors to supply shortages causing high energy prices today are years of restrictive energy policies that expedited a premature energy transition and underinvestment in infrastructure. To support sustainable economic growth, policymakers should consider a holistic solution that includes all energy sources.
 All crude oil data is from Bloomberg unless otherwise specified.
 Mil bbl./day refers to the amount of crude oil, measured in millions of barrels produced or consumed in one day
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