Aramco CEO puts oil majors’ unsustainable capex in perspective.

Mark Lewis for Kepler Cheuvreux: (e-mail circular, no url): “Saudi Aramco’s CEO, Khalid A. Al-Falih, warned earlier this week about the huge amount of investment that will be required to bring on new oil supply over the next two decades (a full transcript of Mr. Al-Falih’s comments is available on the Saudi Aramco website here).”
“As Saudi Aramco is the world’s largest oil company by both output and exports of crude oil, we think Mr. Al-Falih has a unique vantage point on global oil markets, and that his comments are therefore worth paying close attention to.
Why this matters: We highlighted the capex crisis facing the upstream oil industry earlier in the summer in our ESG Alert of 4 June, The $2 Trillion Question, and Mr. Al-Falih’s comments underline again the dilemma now facing the oil majors. On the one hand, nearly all the majors announced reductions in their capex budgets earlier this year in response to their declining capital productivity over the last few years (the huge increase in their combined capex over the last 10 years has actually been accompanied by falling output of crude oil). On the other hand, if the oil majors want to remain key players in the industry, cutting capex can only be a short-term solution. After all, the IEA actually raised its projections for the upstream capex required out to 2035 in June.
In this Alert, we recall the background to this debate over the oil majors’ future capex plans and the risk of stranded assets arising in future, and anticipate our forthcoming detailed report on what we see as the unsustainable dynamics of the oil industry. We also note that China has just signalled a significant investment in charging stations for Electric Vehicles (EVs), thereby underlining the long-term threat to incremental demand growth in the world’s most important growth market.
Our bottom line: higher oil prices will be no guarantee against the risk of future asset stranding. We have long held the view that higher oil prices will be necessary to bring on the new supply that the IEA projects will be needed over the next two decades, and the oil industry is obviously counting on this as well. However, we do not think that higher prices on their own will protect the oil industry from the risk of future asset stranding. This is because higher oil prices raise the question of affordability and also increase the incentive to switch to alternative energy sources, not least renewables (particularly as renewable-energy costs are falling rather than rising). As a result, we think the oil majors should be very cautious in particular about investing in  new high-cost, high-carbon projects as these will be the most at risk of stranding beyond 2025 (owing to long lead times for exploration and development, this is the kind of timeframe within which the larger high-cost projects sanctioned today will come onstream). Does it make sense, for example, as reported in the New York Times yesterday, for Shell to be developing a plan for new exploration in the Alaskan Arctic? Our view is that the oil majors need to fundamentally re-think their capital-allocation strategies for a rapidly changing world in which higher oil prices will only serve to accelerate the transition away from the oil age.
Capital productivity of oil industry has been declining in recent years, especially at the majors Figure 1 shows the upstream capital investment and the crude-oil production of 11 major international oil companies (the seven oil majors plus BG, Occidental Petroleum, Petrobras, and Statoil) over 2000-12.
As can be seen, the combined crude-oil production of these 11 companies has been on a downward trend since 2006, falling from 16.1mbd that year to 14mbd in 2012, while their combined upstream capex has continued to rise relentlessly over the same period. So long as prices were rising fast enough, rising capex could be justified even in the face of declining production, but with prices flat-lining since 2011 the majors have come under increasing pressure to reduce their capex and return more cash to shareholders, and that is why most of the majors announced in Q1 of this year that they now plan to reduce their capex over their updated capital-budgeting horizons.
Saudi Aramco CEO’s comments underline need for massive investments to deliver future oil supply: In a conference intervention earlier this week (also covered in this Wall Street Journal article) Mr. Khalid A. Al-Falih, commented on the need for big upstream oil investments to meet future supply requirements, and the need also for higher prices to encourage this investment. Mr. Al-Falih said that “rising costs and cost overruns are dragging many projects—and no one knows this better than those of you in the offshore industry, with project price tags in the tens of billions of dollars, and with significant financial and technical risks”. He also said that “even at Saudi Aramco, project costs have roughly doubled over the last decade despite deploying cutting-edge technologies and applying our robust project-management systems to mitigate cost escalation”.
However, while acknowledging that the industry’s rising cost base and capital intensity had led to recent capex cuts, he also emphasized that massive investments would continue to be necessary to grow the supply needed to meet future demand projections, and concluded that this would underpin long-term prices: “Many developed fields around the world are becoming increasingly mature, and offsetting their observed decline is not a trivial challenge. To meet forecast demand growth and offset this decline, our industry will need to add close to 40 million barrels per day of new capacity in the next two decades. […] To tap these increasingly expensive oil resources, oil prices will need to be healthy enough to attract needed investments. The other side of the same coin is that long-term prices will be underpinned by more expensive marginal barrels.”
Mr. Al-Falih’s comments are based on a bullish outlook for future demand growth. We think the logic of Mr. Al-Falih’s comments earlier this week is perfectly sound when he says that higher oil prices will be necessary to incentivize the investments needed to replace declining production from ageing fields, but the supply side is only one side of the story. Ultimately, Mr. Al-Falih is confident about the oil industry’s future because he sees continuing strong growth in demand over the long term driving prices higher via market forces:
“Despite some marvelous advancement by various hybrids and pure electrics, petroleum-based liquids will remain the fuels of choice, holding between 80 and 90 percent of transport market share in 2050 depending on the scenario considered. And while the bulk of demand will be concentrated in transport, petrochemicals will also contribute more, by growing at rates faster than GDP.” It is this bullish view on demand that makes Mr. Al-Falih confident that the industry – driven by market forces pushing up prices – can overcome the “significant hurdles” he acknowledges it currently faces, and to sign off by saying that “rather than storm clouds, I look forward to even brighter days ahead”.
In our view, though, the question is not so much whether higher oil prices will be necessary to incentivize future supply growth (as we have already acknowledged, we think this is absolutely the case), but rather at what point higher prices will raise questions of affordability and hence drive the substitution of oil in the global energy mix, not least by renewable-energy technologies. Indeed, the long-term advantage for renewable-energy technologies is that in stark contrast to the oil industry, their costs are falling not rising.
But affordability and the falling cost of renewables both threaten long-term demand growth for oil: The paradox at the heart of the oil market is the tension between the oil price required by the world economy to grow healthily on the one hand, and the oil price needed by the industry to grow the oil supply on the other. This is further complicated by the feedback loop between global GDP and oil, in that adequate supplies of oil currently remain crucial to the growth prospects of the world economy, so that if a period of lower oil prices were to curtail investment for long then supply would ultimately fall and the world economy’s growth rate decline (thereby further weakening demand for oil).
Despite the unprecedented efforts of central bankers, the world’s major industrialized economies are still struggling to return to the kind of sustainable growth trajectories they were on for most of the post-war period. With oil prices having averaged over $100/bbl for the last four years, we think this must, in part at least, be attributable to high oil prices. On the other hand, it is clear from the capex reductions announced by many of the world’s largest oil companies in recent months – and from Mr. Al-Falih’s comments earlier this week – that the industry will struggle to grow the oil supply unless prices are above $100/bbl (and perhaps well above).
As a result, if and when prices start to rise more aggressively in order to incentivize investment, there is a risk that capital outlays on high-cost, high-carbon projects will not generate the returns expected in future as affordability issues lead to lower long-term structural demand, especially as renewables will only become increasingly competitive as a substitute for oil over time, not least in the field of electric vehicles. And in this respect, the news that China is planning to ramp up its investment in EV infrastructure should be a flashing warning light on the dashboard of the oil majors.
China’s plans to invest in EV infrastructure are a straw in the wind: Bloomberg reported earlier this week that China is considering a $16bn investment in EV charging stations in order to help boost demand for electric cars. This comes after the Chinese Government has already put in place tax breaks for EVs, and mandated that Government ministries and departments purchase such cars for their official fleets. It also comes as China’s public policy more generally is now starting to engage much more seriously with the serious public-health issue of air pollution. As a result, we think it is reasonable to expect further policy incentives for renewable energy going forward, including EVs.
The reason this should be of concern to the oil majors is that the IEA’s oil demand-growth forecasts over the next two decades depend very heavily on China (China on its own accounts for 43% of global oil-demand growth over 2013-3 in the IEA’s base-case scenario), and the transport sector is the main driver of this growth. Given that a major policy shift towards incentivizing EVs could have a significant impact on China’s future demand growth, we think this should at the very least be a on the radar screen of the oil majors in terms of scenario planning and  future project appraisal.
Remember “Beyond Petroluem”? Oil majors need to become “Energy Majors”: Whilst we agree that higher oil prices will be necessary to grow the oil supply in future, we think the oil industry in general, and the oil majors in particular, face an increasingly uncertain future, not least owing to the questions of affordability and the increasing competitiveness of renewable-energy technologies that higher prices raise.
Against this uncertain backdrop, we think the majors should be asking themselves whether it makes sense to replace lost output from their existing projects on a barrel-for-barrel basis, or whether in fact they should be reducing their capital allocation to higher-cost new projects (i.e. those requiring >$100/bbl), and looking instead to invest the money thus freed up in renewables (note also that the higher-cost new projects are almost by definition the most carbon-intensive ones). This would enable them to become the Energy Majors of the future rather than ending up as the Oil Majors of the past.”