New IEA capex numbers entail upside oil price risk & asset-stranding risk.

Mark Lewis of Kepler Cheuvreux (no url):  “The International Energy Agency yesterday published a special report entitled World Energy Investment Outlook (WEIO 2014), and we think the stand-out takeaway is the very large increase the Agency sees in the amount of upstream oil capex required over 2014-35 under its base-case scenario (the New Policies Scenario, or NPS)”
….”compared with the estimates it gave in its 2013 World Energy Outlook (2013 WEO) published only last November. Whereas the 2013 WEO estimated global upstream oil capex over 2013-35 at $9.4trn, in yesterday’s WEIO 2014 the IEA raised this figure by $1.9trn to $11.3trn (all numbers in constant 2012 $).
Despite raising its estimates for upstream oil capex by 20%, however, it has maintained the same assumptions for demand and oil prices in its base-case scenario (the NPS) as set out in the 2013 WEO, with Brent crude still expected to rise only gradually over the next two decades to $128/bbl by 2035 (in constant 2012 $) from $109/bbl in 2012. We find this counter-intuitive, as if the expected capex required to meet demand is now 20% higher under the NPS than previously assumed, we would also expect the required price to incentivise this investment to be higher.
That said, the IEA does acknowledge that the much higher capex burden it now foresees being necessary to meet global demand over the next two decades makes the market more vulnerable to upside price risk, and states that the Middle East becomes more important beyond 2020 and that “there is a risk that investment fails to pick up in time to avert a shortfall in supply, because of an uncertain investment climate in some countries and the priority often given to spending in other areas” (WEIO, p.51). If this were to happen, the IEA states that “the result would be tighter and more volatile oil markets, with a price $15/bbl higher in 2025” (WEIO, p.51).
In fact, though, the risk of insufficient investment is not just a hypothetical risk in a decade or so: with most of the majors having revised their capex plans downwards in the last few months, the risk of insufficient investment impacting supply is already today a clear and present danger.
The risk of higher oil prices than the IEA’s base-case scenario assumes was something we already drew attention to in our report Stranded Assets, Fossilised Revenues (24 April 2014, see page 7), while we also highlighted in that report our view that the cost of renewable-energy technologies will likely continue to fall over the next two decades. As a result, to the extent that this latest IEA report underlines the upside price risk to oil, we are re-inforced in our view that the next two decades could see an accelerated shift away from oil in the global energy mix – and hence a risk of stranded assets for the oil industry under a scenario not only of climate-policy induced demand destruction (if a binding global climate deal were at some point to be reached) but also under a scenario of high and rising prices — as renewables become increasingly competitive against both oil and fossil fuels more generally in future.
IEA raises estimate for upstream oil capex over the next two decades by $1.9trn versus last year’s WEO
Figure 1 below compares the IEA’s upstream capex estimates for oil by region over 2013-35 as published in its 2013 WEO only a few months ago with the Agency’s updated estimates as just published today in the WEIO 2014. As can be seen, the IEA’s updated estimate for cumulative investment out to 2035 is  $11.3trn (in constant 2012 $),  which is $1.89trn higher than the $9.4trn it estimated in the 2013 WEO last November. This represents an increase of 20%.

Figure1: IEA’s estimate of cumulative upstream oil capex necessary out to 2035 under NPS (constant 2012 $)
2013 WEO * WEIO 2014* Change ($bn)** Change (%)**
OECD 3,354 4,087 733 21.8
Americas 2,826 3,488 662 23.5
o/w US 2,060 2,021 -39 -1.9
Europe 450 500 50 11.1
Asia/Oceania 77 98 21 27.3
Non-OECD 6,041 7,197 1,156 19.1
E . Europe /Eurasia 1,180 1,345 165 13.9
Asia 664 1,079 415 62.5
Middle East 872 1,578 706 81.0
Africa 1,507 1,291 -216 -14.3
Latin America 1,818 1,905 87 4.8
TOTAL 9,394 11,284 1,890 20.1
Source: *IEA, 203 WEO, and IEA World energy Investment Outlook, June 2014 (© OECD/IEA); ** Kepler-Cheuvreux calculations

As can be seen, by far the biggest increases are in North America (+$662bn, although excluding the US the increase is 700bn, as the  US is actually down slightly versus November), and the Middle East (+$706bn).  Asia is higher by $415bn, Eurasia by $165bn, and Latin America by $87bn, but Africa is actually lower by $216bn.
The IEA emphasizes that most of this upstream investment is required to replace lost production from depletion at existing fields (WEIO 2014, pp-59-60):
“From an estimated $700bn in 2013, global upstream oil and gas expenditure rises steadily throughout the projection period, reaching an average of more than $850bn annually by the 2030s. More than 80% of this spending is required just to keep production at today’s levels, that is, to compensate for the effects of decline at existing fields. The figure is higher in the case of oil (at close to 90% of total capital expenditure).”
It is precisely because most of the upstream oil capex is to replace declining output at existing fields that the IEA does not see much risk of stranded assets arising for the oil industry from tighter climate legislation over the next decade or so (if a global climate deal were to be reached), although it does see a higher risk thereafter.  This is emphasized on page 86 of the WEIO 2014 report:
“(…) investment in upstream projects is insulated, to a degree, against the risk of becoming stranded by climate policies, because output decline is a natural phenomenon for all oil and gas fields and these declines are steeper than any conceivable rate of policy-induced decline in demand. Nonetheless, once a credible path towards decarbonisation is in place, projects at the higher end of the supply cost curve, particularly those that feature both long lead times and relatively high carbon-intensity, face significantly higher commercial and regulatory hazards.”
As we explained in our report Stranded Assets, Fossilised Revenues (see pp. 6-7, and pp. 27-30), this is very much in line with our own reasoning on this point. That is to say, in so far as the oil majors generally have proven reserves-to-production ratios of 10-15 years, we think they would be free of stranding risk over the next decade or so (i.e. for the time it takes to exhaust their proven reserves at current production rates) should a binding climate deal be reached in this timeframe.  However, as we have also explained before (in both Stranded Assets, Fossilised Revenues, and our Alert of 21 May, Carbon Risk and Stranded assets: Shell Clams Up Instead of Opening Out), we think that in the event of a binding global climate deal being reached in the next few years there would be significant risk of asset stranding  beyond the next decade for those resources already discovered but not yet developed.
However, we have acknowledged before and do so again here that a 450-ppm climate deal does not appear in sight any time soon. In our view, however, that does not mean the that oil industry can afford to be complacent about asset-stranding risk, because we also see a medium to longer-term threat to their business model from high and rising oil prices. And it is in this respect that we find the WEIO 2014 so interesting: in our view, the IEA’s updated assumptions on upstream capex only serve to underline the upside risk to oil prices over the next two decades.
Despite higher capex, the IEA has maintained its existing oil-price assumptions from the 2013 WEO
On prices, the WEIO 2014 (p. 51) says the following: “Gradual depletion of the most accessible reserves forces companies to move to develop more challenging fields; although offset in part by technology learning, this puts pressure on upstream costs and underpins an oil price that rises to reach $128/bbl in real terms by 2035”. It then adds (WEIO 2014, p. 59): “In our modelling, the price trajectories for the various fuels are derived so that these investments yield reasonable rates of return, so it is also reasonable to expect that the required investment will be forthcoming”.
Yet the important point in our view is that the IEA was already assuming that prices would rise to $128/bbl in real terms by 2035 in the WEO 2013 when its cumulative capex estimates for the upstream oil industry over the next two decades were $1.9trn lower than they are now in the WEIO 2014 . As a result, we are somewhat puzzled that this base-case price forecast has not been revised upward given that the IEA’s assumptions regarding cumulative upstream capex are now 20% higher than they were six months ago.
That said, the IEA does acknowledge upside risk to its base-case oil-price assumptions.
… although the WEIO 2014 does acknowledge upside risk to its base-case assumptions on oil prices
On page 59 of the WEIO 2014 the IEA enters the following crucial caveat to its unchanged assumptions on oil prices:
In our modelling, the price trajectories for the various fuels are derived so that these investments yield reasonable rates of return, so it is also reasonable to expect that the required investment will be forthcoming. In practice, good foresight will be required as to future regulatory and market conditions. Investor and company investment decisions are determined by their judgements as to the nature of regulatory and other risks, and their perceptions of future market opportunities. There is always the risk that investment will turn out to have been insufficient, driving energy prices higher or even creating energy shortages and thereby stimulating a new cycle of investment.” (Our emphasis)
It then goes on to highlight the risk that investment in the Middle East in particular might not be forthcoming to the level assumed in its updated base-case scenario (this investment will be crucial as the WEIO 2014 assumes that Middle East oil production increases from 28mbd in the early 2020s to more than 34mbd by 2035).
Yet illuminating as the IEA’s analysis of the risks to investment in the Middle East’s upstream capacity occurring in a timely manner is (and pages 67-70 of the WEIO 2014 are well worth reading in this respect), we think there is a much more immediate and telling example of stalling investment in the upstream oil industry, and this concerns the capex cutbacks that most of the international majors have all announced since the beginning of this year.
The oil majors are now actually cutting back on capex, thus further underlining upside price risk
Over the last two months, most of the world’s major international oil companies have announced cutbacks to their capex plans as costs have begun to outstrip prices. This is despite the fact that oil prices have been stable at record-high real levels for the last three years. A very good recent example of the pressure that high costs are putting on upstream investments despite historically high prices is the decision announced by Total last week to shelve its $11bn Joslyn oil-sands mine in Canada. The head of Total’s Canadian division is quoted in the article just linked to as follows: “Joslyn is facing the same challenge most of the industry world-wide [is], in the sense that costs are continuing to inflate when the oil price and specifically the netbacks for the oil sands are remaining stable at best – squeezing the margins.”
All of which indicates to us that the upstream oil  industry is already struggling to make the returns that shareholders require for the kind of upstream risks that are now being taken and that the industry therefore needs higher prices today  provide them with the  necessary incentive to continue investing.
In other words, the IEA’s caveat that “there is always the risk that investment will turn out to have been insufficient” is not some hypothetical future risk: it is a reality already today, and therefore underlines the upside price risk against the IEA’s unchanged base-case assumptions.
WEIO 2014 implies higher oil prices and in our view a longer-term stranding risk for the oil industry
As explained in our report Stranded Assets, Fossilised Revenues the risk of stranded assets for the oil industry exists not only under a scenario of much tougher climate legislation that might in future lead to a structural fall in demand for oil, but also under a scenario of high and rising oil prices as renewable technologies become more competitive. Indeed, for a number of reasons we think that the current dynamics of the oil industry are unsustainable, the most prominent of which we would list as follows:
·         The increasing capital intensity of the upstream oil industry (as underlined in spectacular fashion today by the $1.9trn increase in the IEA’s capex assumptions over the next two decades);
·         the increasing reliance on Natural-Gas Liquids (NGLs) to fill the supply gap – which have significantly lower energy density than crude oil — in the face of stalling crude-oil production since 2005;
·         declining exports of crude oil globally since 2005 as OPEC consumes more and more of its own production; and
·         the ever-present but recently heightened geo-political risks in key oil-producing regions.
On the basis of all these challenges we were already arguing that there could be significant upside risk to the IEA’s base-case scenario for oil prices over the next two decades (see Stranded Assets, Fossilized Revenues, p.7), and for all the reasons just elucidated above in analysing the revised capex assumptions of the IEA as set out in the WEIO 2014, we are now even more persuaded of the upside risk to oil prices over the next two decades.
Meanwhile, in stark contrast to the observed long-term trend in the oil industry, the renewable-energy industry has achieved tremendous cost reductions in recent years, and we think this trend is likely to continue over the next two decades. And of course, other things being equal, the steeper the upward trajectory for oil costs and prices into the future, the greater the incentive will be to accelerate the deployment of renewable-energy technologies and to achieve greater energy-efficiency savings.
This suggests to us that there could be a real risk to the oil industry from rising oil prices under a business-as-usual scenario, as combined with continuing reductions in the costs of renewable technologies this could drive the accelerated substitution of oil in the global energy mix over the next two decades. In turn, this would risk creating stranded assets over the medium to longer term both for the oil industry itself and – owing to the central role of oil in energy pricing more generally – for the global fossil-fuel industry as a whole.
The implications of such a scenario would be momentous, as it would mean that the oil industry potentially faces the risk of stranded assets not only under a scenario of falling oil prices brought about by the structurally lower demand entailed by a future tightening of climate policy, but also under a scenario of rising oil prices brought about by rising demand under increasingly constrained supply conditions.”