Producer’s Breakeven Prices – Why Flip Flop?

Note: This article was published in Industrious Oil & Gas Magzine, issue 2, 2016
http://www.digionline.co.uk/indusoag/2016/issue2/#p=25


Not very long ago oil prices were traded at well below $20/BBL and OPEC anxiously come up with a mechanism which it named the 'OPEC Price Band' for between $22-$28/BBL. The principle for this price band, was that OPEC members find that  this price range as the reasonable minimum which is still sufficient for the growth of oil and gas industry and to meet the government cash requirements. However, only few years after this mechanism was introduced, oil prices got out of hand and OPEC was forced to abolish its price band in favour of higher market price. No doubt, oil producers always look for higher oil prices as it improves profitability, more funds for further development of oil and gas resources and to meet the growing cash requirements of governments.

Oil prices rose higher and higher and in July of 2008 peaked at $147/BBL - bravo for oil produces and oil exporters; however, terrible for the oil importing countries. There are many reasons for the elevation in oil prices from 2003 - market fundamentals, civil unrest/strikes in some of the major oil producing countries, flip/flop of inventories, speculators, hurricanes, conflict in Middle East, and higher cost of production etc. The world has also witnessed oil prices of over $100 during 2008, collapsing to below $40 late 2008 and early 2009. Again the world has witnessed era of sustained higher prices of over $100/BBL for quite extended period of time before plunging to below $30/BBL. The question is why were oil producers at one stage were quite satisfied with a self-imposed price band of $22-28/BBL and at another time not happy with a price of $50/BBL?

As the oil prices increase the revenue requirements of oil exporting countries also increases. In the regime of higher oil prices, cost of upstream and downstream also increases as happened during 2007/2008 - when daily drilling rates more than doubled and also the cost of steel and other materials skyrocket. The other obvious reason is that the governments are committed to improve the wellbeing of their people and therefore government expenditure increases for the development of infrastructure - roads, rail, ports, schools, hospitals etc, to further enhance/improve the quality of life for the masses. This perception that oil revenue is a cash-cow is held by all - suppliers to both governments and NOCs also inflate their prices to enjoy the profits of a high price-per-barrel environment. Due to this tendency, generally oil producing nations are stretched beyond their expected means and continue look for higher and higher oil and gas revenues. The easy pick is higher oil prices that could easily fulfil their budgetary requirements. Consequently, the fiscal breakeven oil prices also continue to move upward. In recent memory breakeven oil prices were over $100/BBL for some of oil producing countries; however, when oil prices slump down to below $45/BBL, most OPEC members see $70 a barrel as a fair price for oil. One may argue how come this flip flop of fair prices from above $100 to $70/BBL in a matter of months?

The oil and gas sector is the dominant source of governmental revenue in most of the oil exporting countries and therefore quite sensitive to the fluctuation of oil and gas prices. The governments generally form their expectations influenced by current or near term oil prices and assume that oil prices shall continue to move upward. In a regime of higher oil prices everything looks good and the tendency is to believe that high oil prices will continue. Based on their expectations of higher oil prices they prepare and approve public sector development projects hoping for higher oil based revenues. A government’s aggressive expansion plan is defeated when oil prices collapse. In a market of lowered oil prices the issue becomes one of how to finance the committed public sector projects - deficit financing, borrowings, issuance of bonds or using sovereign funds; essentially the basic principle of economics 'cut your coat according to size of your cloth'. Too optimistic a budget leads to deficit financing or drawdown from sovereign funds and putting unnecessary pressure on national oil companies (NOCs). To avoid such abrupt flip flop break-even prices a national government need to develop a compromising strategy, remove lavish energy subsidies, impose income taxes, downward adjusting break-even prices and adopt diversification policies away from the hydrocarbon sector; promoting non-hydrocarbon sectors to avoid further “catch 22” situations.

The Second Automotive Revolution: Implications for the Oil Industry

Note: This joint article published in "The Fuse" on March 9, 2016 - http://energyfuse.org/the-second-automotive-revolution-implications-for-the-oil-industry/ 

Andreas de Vries is a strategy consultant in the oil and gas industry. Salman Ghouri is an oil and gas industry advisor with expertise in long-term forecasting, macroeconomic analysis and market assessments.

Amongst auto industry insiders and experts there is a consensus that the future of transportation will be radically different from what it is today.

Given the fact that some two-thirds of crude oil demand is linked to transportation, one would expect the oil industry to pay close attention. Very little of that seems to be happening, though. ExxonMobil’s most recent energy outlook, for example, assumes that the auto industry will largely stay the same at least until 2040, namely. And Chevron has indicated that it plans on the basis of the assumption that the changes underway in the auto industry will not have a meaningful impact on the oil industry for at least another 50 years.

To evaluate which expectation is most likely right, one needs to review the reasons behind the auto industry’s – and other’s – investments in research around car connectivity, electric vehicles, fuel cell vehicles and autonomous driving. Are these expressions of a Second Automotive Revolution or not?

The trends behind the Second Automotive Revolution

Over the last 60 years the world has changed greatly, but without forcing any dramatic shifts in the auto industry. The increasing demand for transportation has been met by more and better conventional vehicles, rather than radically new forms of transportation. The adoption and tightening of emission control regulation around the world makes it impossible for this state of affairs to continue.

In addition, technological innovations are changing the transportation need that the auto industry caters to.

The internet, for example, is radically changing the way people interact (Facebook), learn (Google), do business (Alibaba), relax (Netflix) and spend (Amazon). Other areas that are presently on the cusp of being disrupted by technology are banking and healthcare. What all these digitization trends have in common is that they will reduce the need for people to travel. In the future, therefore, the need for road transport will most likely be less than it is today.

At the same time, car hailing and sharing services such as Uber and Lyft are changing the way people ensure for themselves access to cars. Essentially, these services provide easy and affordable access to fit-for-purpose cars, on demand, almost instantly. Continued progress in this area would further reduce the need for people to own a car in the future, while increasing the average utilization rate of cars.

The trends towards greater urbanization is also making car ownership less desirable. At present, 54% of the world’s population lives in the city. Air pollution, road congestion and limited availability of car parking spaces are already common issues for urbanites, meaning that continued urbanization will make these issues more pronounced.

The focus of the Second Automotive Revolution

The auto industry realizes that the world in which it operates will be fundamentally different in the future, and thus that the car of the future will also need to be fundamentally different. It is not entirely clear at this stage what the car of the future will look like exactly, but current research does indicate the direction of the change.

One focus area for research is the development of plug-in electric vehicles and fuel cell electric vehicles (which couple a hydrogen based electricity generation capability to an electric motor). This caters to the Millennials stated preference for renewable energy solutions since electric vehicles do not emit any tailpipe pollutants. Electric vehicles also have further advantages over traditional internal combustion engine powered vehicles, such as greater efficiency, as they convert some 60% of energy to power at the wheels compared to around 20% in the case of internal combustion engine powered vehicles, and better reliability and durability while requiring less maintenance since they have fewer moving parts. Electric vehicles can thus lower the cost of road transportation, while at the same time providing a more enjoyable driving experience, offering smoother and more powerful acceleration while being almost completely silent (which is why the sports car manufacturer Aston Martin sees a great future in electric vehicles).

That is not to say that there are no drawbacks attached to electric vehicles at present. For example, they tend to be more expensive and their driving range remains limited. But exactly these obstacles the Second Automotive Revolution is working to overcome.

Another focus of the Second Automotive Revolution is development of self-driving cars, formally “autonomous driving”. Most people see the act of driving as a necessary waste of time and would rather spend that time doing something else. Self-driving cars could make this possible. Autonomous driving would also prepare the car for the megacities of the future. It would solve the parking problem of cities as self-driving cars do not have to park in the city – after drop off they can drive off. It would also reduce road congestion since self-driving cars improve the flow of traffic, drive more safely thus reducing the number of congestion-causing accidents, and require less distance between them for safe driving so more of them could fit onto any given stretch of road. Since traffic jams are a major cause of air pollution, autonomous driving would effectively clear up the city skies. The fact that driverless cars can remove from traffic the 30 to 60 percent of inner city cars that are just driving around looking for parking will support both congestion and air pollution improvements.

The implications of the Second Automotive Revolution for the Oil Industry

The auto industry’s shift towards autonomous driving is effectively reinforcing its shift towards electric vehicles. Today’s cars tend to stand idle more than 94% of the time. Self-driving cars, however, would be on the road almost full-time. This means that reliability and durability will become of critical importance for the cars of the future, which gives the electric engines a major advantage over internal combustion engine.

Amongst electric vehicles, meanwhile, the plug-ins will have an advantage over fuel cells since the latter, in essence, is just a plug-in with fuel cell technology added on top to increase range – meaning fuel cells are inherently more complex than plug-ins and thus less reliable and durable.

The Second Automotive Revolution is therefore leading to a shift from the internal combustion engine to the plug-in electric motor. And by extension, to a shift in the energy mix, away from crude oil towards gas and coal since these are dominant in the electric power generation industry.

This shift will not be one-for-one, however, as self-driving electric cars will improve the overall energy efficiency of transportation. Their smoother driving will reduce fuel consumption per trip, as will their impact on flow of traffic and road congestion. Also, their enhanced safety will allow the auto industry to use materials lighter than aluminum, iron and steel, and thus reduce the weight of the car. The decrease in crude oil demand will therefore be only partially offset by an increase in gas and coal demand.

 
Exactly how large this offset will be, will to a great extend depend on the adoption of renewables for power generation. In this regard it is important to note that in 2015 renewable energy made up 68% of all investment in new capacity in the US. The year before, in 2014, renewable energy accounted for close to 50% of all new power investments globally. It is not unlikely, therefore, that once self-driving electric cars start having a real presence on the roads, which some argue will require 20 years at least, only very little of the resulting decrease in crude oil demand will translate into higher gas and coal demand.

The timing of implications of the Second Automotive Revolution for the Oil Industry

 
Currently, the offering in the “fully electric”-segment of the auto industry remains limited. Essentially all big car companies have indicated plans to aggressively expand in this area between now and 2020, however. This includes the German manufacturers BMW, Mercedes and the Volkswagen Group, Ford, General Motors, Volvo and Honda.

It is reasonable to expect, therefore, that starting 2020 consumers will be able to choose between conventional internal combustion powered vehicles, hybrids and full electric vehicles in every class of cars – SUVs, sedans, vans and even sportscars.

It is not impossible that at that moment plug-in electric vehicles will be (close to) cost competitive. So far, namely, their rate of improvement has outpaced expectations. For example, the cost of producing battery packs for electric vehicles is already below earlier cost projections for the year 2020. And as the industry’s familiarity with electric vehicles grows, the rate of improvement in electric technologies should be expected to increase.

 
Based on all this we foresee electric vehicles to become the preferred transportation option sometime between 2020 and 2030. If this is indeed achieved, the share of electric vehicles in the motor pool will expand dramatically during the 2030s. According to our calculations, a 10% share for electric vehicles in the US alone would easily remove more than 1 millions barrels from crude oil demand.

Which means that the changes currently underway in the auto industry should be expected to dramatically impact the oil industry well before 2040.

Andreas de Vries is a Strategy Consultant in the Oil & Gas industry, supporting companies to not only develop strategies but also execute them.

Dr. Salman Ghouri is an Oil & Gas Advisor with expertise in long-term forecasting, macroeconomic analysis and market assessments