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26/02/2016

Crude oil: Could the over-supply issue actually be an under-consumption problem?

Conventional wisdom amongst OPEC and leading oil companies suggests that low oil prices are temporary. Oversupply issues will eventually be addressed, the market will rebalance and prices will rise. This argument is built around the fundamental belief that oil demand will continue to grow for the foreseeable future despite gains in technology and increasing efficiency.

OPEC predicts that global oil demand will increase by 18.4 mbbl/d to reach 110 mbbl/d by 2040, rising over 25% from today[1]. This bullish projection is led by the view that consumption in road transport, the largest oil consuming sector (44% of total), will carry on growing strongly despite the apparent threat of electric vehicles, alternative fuels and improving efficiency. In fact, OPEC forecasts oil demand growth in all sectors except electricity generation, largely brushing aside any significant impact from renewables and cleaner sources.

Figure 1 : Global Oil Demand: OPEC’s view

Figure 1. Global Oil Demand: OPEC’s view

Source: OPEC World Oil Outlook 2015

If one assumes that there will be no major technological, political or social changes in the next quarter century, OPEC’s prediction looks right on track. But this seems highly unlikely amidst the technological revolution and global mind shift towards cleaner energy that is currently taking place.

So what if the consensus is wrong and demand grows at a slower rate than predicted? Several factors indicate that this could indeed be the case and that we may be at the tipping point of a structural shift that will shake up the oil industry and permanently transform demand. 

Technological breakthrough in electric vehicles

Most market participants currently find it difficult to understand just how substantial the impact of electric vehicles will be on crude oil demand in the medium to long term.

As it stands, three main issues are currently holding back electric vehicles: high battery costs, lack of charging infrastructure and range anxiety. Low oil prices aren’t helping much at the moment either - sales of electric vehicles in the US slowed by nearly a third over 2015 while fuel guzzling trucks and SUV’s surged[2].

Although the electric vehicle industry faces challenges, a technological breakthrough could improve competitiveness and eat into the market share in the road transport sector that OPEC is so confident will remain dominated by oil.

Figure 2 : Growth in electric vehicle sector

Figure 2. Growth in electric vehicle sector

Source: Goldman Sachs Global Investment Research

Goldman Sachs believes this will be the case. The investment bank forecasts that electric vehicles, both hybrid and full electric, will make up approximately 25% of global automotive sales in the next 10 years. This will be driven by a 60% fall in battery prices within 5 years, while range improves by 70% over the same period[3].

Although this advance will most likely be in developed countries in the near term, meaningful technological progress and further investment could propel electric vehicles into the driving seat for emerging markets as well, posing a significant threat to oil demand further out.

Improvement in energy efficiency and use of oil substitutes

According to the IEA, about 70% of cars today are subject to mandatory fuel efficiency standards. In 2005, that figure was less than 50%. It’s clear that efficiency measures and performance in the auto industry have stepped up over the past decade, but significant potential still exists in this industry and others.

Figure 3 : Share of global mandatory efficiency regulation of final energy consumption: IEA's view

Figure 3. Share of global mandatory efficiency regulation of final energy consumption: IEA's view

Source: IEA World Energy Outlook 2015

One example is in trucking, where only 50% of vehicles are currently tested suggesting room for improvement if a similar trend to cars is followed[4]. Another is in aviation, where the first emissions standards for commercial aircrafts are in the process of being introduced, a good first step in stimulating development of more fuel efficient aeroplanes[5]

An additional factor that could further suppress demand is the heightened use of oil substitutes in the transport, electricity generation and petrochemical sectors. Several options, ranging from natural gas to biofuel, are already being used by transport companies as they aim to gain a competitive advantage amidst the introduction of stricter emissions standards[6]. A similar trend is also being seen in the shipping industry where cleaner liquefied natural gas stands to become a viable alternative in the long term[7].

As more aggressive efficiency policies are introduced in an increasing number of countries and oil substitutes become increasingly viable, demand growth will continue to slow and oil companies should pay careful attention to this.

The mind shift to a greener economy

The Paris Agreement signed in December concluded the most ambitious and important climate deal since the Kyoto Protocol. The pledge is seen as a positive step to a greener economy and a large part of its success can undoubtedly be attributed to the shift in attitude across businesses and governments globally.

Figure 4 : Example global energy mix consistent with goal of keeping temperature rise below 2°C

Source: Friends of Europe, les amis de l’Europe

As a result, we should expect to see more aggressive government support for renewables, acceleration in mandatory energy efficiency policies and a phase out of fossil fuel subsidies. This presents a huge opportunity for countries and businesses to take on commercial and technological leadership in the coming years.

With oil currently contributing to approximately 36% of global CO2 emissions[8], more stringent targets will obviously have an impact on demand, the extent of which will largely depend on how aggressive government policy is on tackling climate change.

The oil industry should prepare for the possibility of a lower demand world

Although demand growth is slowing and could indeed face a structural shift in the future, we need to be pragmatic - oil will still be required for some time to come. Specifically, it is expected that global oil investments will need to be maintained at the current annual level of around $650 bn over the next 10 years just to compensate for the decline in production from existing fields[9].

Figure 5 : Low Oil Demand Scenario vs. Consensus

Figure 5. Low Oil Demand Scenario vs. Consensus

Source: Carbon Tracker 2015, Sia Partners Estimates

However, taking all of the above into account, a scenario where 2040 oil demand is below today’s levels of around 90 mbbl/d should not be ruled out. While in the short term we expect high price volatility as a result of strong supply, efficiency gains and geopolitical tensions, a permanent shift to lower demand could mean oil prices never reach previous highs again. Only time will tell, but the possibility of a lower oil consuming world in the next quarter century should not be underestimated by the oil industry and its investors. 

Article by Ryan Shellard - Consultant

 

References

[1] OPEC World Energy Outlook 2015

[2] US EIA Data

[3] Goldman Sachs Global Investment Research

[4] IEA World Energy Outlook 2015

[5] Time: “U.N. Agency Issues New Standards for Commercial Air Emissions”

[6] Sia Partners: Alternative Fuels for Road Transport

[7] Lloyds list intelligence: “Is this the future of LNG shipping?”

[8] Energy Transition Advisors: “Oil Demand: Comparing Projections and Examining Risks”

[9] IEA World Energy Outlook 2015 Q&A 

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