Oil accounts for around 40 per cent of current global energy mix, with natural gas accounting for a further 23 per cent. While, under existing policies, the International Energy Agency (IEA) expects renewable energy generation to double by 2035, world primary energy demand is on track to increase 43 per cent over the same period.
BP estimates that renewable energy will make up 27 per cent of the growth in global energy supply to 2030, just ahead of growth in coal, at 26 per cent, and gas, at 21 per cent. So what does this mean for the oil and gas economy?
Marc van Loo, head of energy & utilities and senior investment analyst at ING Investment Management, says: “Barring any new black-swan-like energy source, energy trends will cause some market share loss for fossil fuels, down from 87 per cent of primary energy supply today, but still remaining a material part of the primary energy mix within the next 25 years.”
Surprise black-swan events could be economic, technological or political. A decade ago, the development of US shale gas and tight oil would have been such an event. In a previously unimaginable shift, the United States is set to become one of the major global sources of oil and gas, with the IEA projecting the US will replace Saudi Arabia as the world’s largest oil producer by 2015.
Despite that growth, the margin of error in the global oil markets remain thin, at about two to three million barrels a day, as disruptions affect production in Iraq, Libya, Angola and while gas markets remain unsettled by the Russia-Ukraine impasse.
David Hemming, commodities portfolio manager at Hermes Fund Managers, says: “While US production growth is matching growth in global demand, all the major producing areas are going to run into issues with higher depletion rates, especially in tight oil plays.”
A result of high oil demand forecasts and decreasing supply has been the exploration of new higher- risk areas of oil and gas supply, ranging from Canada’s tar sands, pre-salt reserves off the coast of Brazil and in the Gulf of Guinea, and the Arctic.
Success in Canada has become a global model for the exploitation of tar sands and oil shale. Both the Middle East and China are interested in their domestic potential, while Israel is estimated to have potential reserves equivalent to 260 barrels of oil (bbl). The energy intensity of the technology means that such sources require high oil prices for the projects to be viable. While the last few years have seen Brent oil prices at a cyclical high, there are concerns from investors about the impact on return if the oil price falls. Mr Hemming says that, while the projects have a high marginal cost, they have easy-to-model resource boundaries, which helps in planning.
Everything that impacts on future energy mix depends on China – its attempts to reduce the country’s dependence on coal are already beginning to impact on the rest of the world
Following the 2007 discovery of oil off the coast of Brazil, there were predictions that output could double to five million barrels a day by 2013, making Brazil the world’s fourth largest oil producer. Recent finds off the coast of Angola, Cameroon, Congo, Equatorial Guinea and Gabon have encouraged hope that Africa’s reserves will be as strong. Yet in 2014, Brazil’s output has increased by only 20 per cent, with only 350,000 barrels a day coming from the pre-salt fields. Political and structural challenges have been an issue, but it is failings in Brazil’s infrastructure and domestic skills-base that have been cited as pushing up costs. The marginal cost of the oil is around $30 to 40bbl, which makes these fields an exciting opportunity.
Shell has estimated that the Arctic holds around 30 per cent of the world’s undiscovered natural gas and 13 per cent of its yet-to-find oil. Russia has already shipped its first oil from offshore Arctic waters, though the challenge with Arctic drilling is the technical and environmental unknowns, but a big discovery could mean relatively cheap oil, again at $30 to 40bbl.
The mixture of global energy supply, both in terms of type and origin, is likely to remain a function of demand, supply and economic cost. Mark Henderson, director of oil and gas at Westhouse Securities, says if these new areas of exploration are proved to be economic, “there will be a gold rush”, but it is economics that will dictate the viability of new exploration, nothing else. The oil market is cyclical and he says that the continuation of supply growth could see marginal costs in the oil industry fall below $40 bbl.
Existing conventional sources could also provide the necessary supplies to meet demand growth, especially if the continuing high price of oil has its expected impact on energy efficiency. Mr Henderson points out that energy intensity in Organisation for Economic Co-operation and Development countries is now a third of what it was before the oil shocks of the seventies and eighties, meaning lower consumption per unit of GDP.
And there are signs of a similar path in China, where energy intensity is slowing faster than predicted. Emma Wild, head of upstream advisory at professional services company KPMG, says: “Everything that impacts on future energy mix depends on China – its attempts to reduce the country’s dependence on coal are already beginning to impact on the rest of the world.”
Arthur Hanna, global managing director of energy business at Accenture, says that different predictions are dependent on views on the likelihood of different interventions, ranging from fossil-fuel subsidies to a carbon price. Mr Hanna says: “The future energy mix is not dominated by one form of supply, which has never happened before.” He warns though that predictions are still “missing energy demand management, and the impact and sources of innovation, local content, jobs and so on”. These latter elements are what enable the balance of economic, social and environmental concerns in energy policy.
Laszlo Varro, IEA director of gas and power, says that in order to understand potential change in the energy mix, we need to understand what drives demand for different fuels. According to Mr Varro, energy demand can be effectively split into three areas: electricity (where the most important source is coal); transport (predominantly oil); and heating (mainly gas).
He says that it’s useful to look at the dominant form of supply for each and how that might change. “Outside of transport, oil is being pushed out of every other sector in the economy,” he says. “On the other hand, you would need an astonishing shift in the fleet to challenge oil in the transportation sector.”
Coal in fact provided around half the growth in electricity demand in the past decade and is expected to remain the largest single source of power by 2035 – and its growth is of far more concern than oil. Mr Varro says that the world is adding a UK’s worth of electricity demand every nine months or a Germany every year. In terms of emissions, this is a critical issue.
What’s significant for new areas of oil exploration is that a fall in the marginal cost of oil could have a major impact on high-risk projects. According to Mr Hemming, current oil projects have an internal rate of return (IRR) of 15 to 20 per cent, so the question of how long those IRR’s can be maintained becomes ever-more important. He also believes that demand is manageable within existing reserves. “These new areas of exploration and production will only work at a certain price,” he concludes.