Recently we have witnessed wild swings in oil and gas prices due to a potential supply shock because of the Ukraine / Russia war countered with lockdowns in China that may have a big effect on short-term demand.
While this volatility creates some trading opportunities in the short-term, this report investigates fundamental longer-term supply and demand trends which are likely to influence spot prices over the next decade. This work supports our thesis that an oil price at around US$70/US$80 per barrel on average looks likely, even with an immediate solution to the Ukraine crisis. On this basis, we continue to hold a significant proportion of our portfolio in oil and gas exposed stocks as we feel that the market is not yet accounting for the fact that higher than average prices will persist for many years.
Source: au.investing.com
Longer Term Supply Dynamics
In addition to the extreme environmental pressures from governments and activist groups to stop new projects, new oil fields are getting harder to find and are of a poorer quality than in the past. The risk for oil producers has become higher and the approval process more stringent, so the number of new projects is more limited than ever. Combined with an industry that is now focussed on producing profits rather than growth, investment in new oil and gas projects is at its lowest level since 2007. At the same time, new oil and gas discoveries are at their lowest point in 75 years.1
As demand continues to grow, the industry should in theory be spending more each year to maintain output, not less. Additionally, it is getting more expensive to find new sources, resulting in a disconnect between what is needed on the investment side and what is happening on the ground.
Source: Bernstein, AFR, Wentworth Williamson Estimates
Even with the rapid increase in the oil price post COVID, the rig count has still not recovered to anywhere near pre-COVID levels and this should keep prices high.
Source: Rigcount and Wentworth Williamson Estimates
What about US shale?
In 2014, with prices above US$100 per barrel, shale exploration and production became profitable, turning the US into the largest producer of oil. Previously inaccessible oil deposits became available with technology that let producers drill vertically as well as horizontally. The increase in production turned the US into a net exporter of oil after importing for many years, creating an oversupply in the market. The oil price crashed as result.
However, the US shale boom was spectacularly unprofitable. Estimates by Deloitte put the free cash flow at negative US$300 billion for the industry from 2010 to 2019 along with impairments of more than US$450 billion.2 There was no discipline among producers as they all chased production growth and a lot of money was lost in the process.
With the current oil price, it begs the question on whether there could be a replay of the past? So far it seems not. The 2020 oil price crash due to COVID has seemingly brought a much higher level of discipline to the industry. Exploration has been cut and shareholders are demanding higher levels of dividends as well as share repurchases and are pushing for limited production increases after being burned before. Additionally, shale wells tend to have high depletion rates, most of the low-cost and easily accessible resources have already been drilled in the last boom, so it is not as easy to ramp up production as quickly as in the past.3
We think the supply dynamics of the oil and gas industry is supportive of higher prices for several years. Capital expenditure on new projects is low and there are very few new oil discoveries. Additionally, the industry seems much more restrained than in the past, with shareholders demanding larger dividends and returns rather than going through another boom-and-bust cycle. OPEC countries are also reluctant to flood the market with supply as they need around US$70 per barrel just to break even4 and government balance sheets need repairing after the huge COVID expenditures. OPEC is also struggling to increase output after it suspended a lot of maintenance during COVID.
Longer Term Demand Dynamics
While we are confident that supply will be challenged over the next decade it is worth digging deeper into the demand dynamics, as this is getting a lot of attention from companies and consumers looking to reduce their carbon footprint. We have modelled what we think oil demand will look like under what we believe to be very bullish assumptions for electric vehicles and other technologies that will decrease the global dependency on oil and gas usage.
Consensus is for demand for oil to be around 105-107 million barrels per day (mb/d) in 20305 compared to our estimate of 103mb/d. By 2040 our estimate for oil demand is about 100 mb/d while OPEC’s estimate is at 108 mb/d, therefore clearly our assumptions below are quite conservative.
Electric cars
Of the approximately 77 million cars sold globally last year, close to 9% were hybrids or electric vehicles (EVs).6, 7 This market share is growing quickly, especially in western countries, and the electric car fleet now stands at 17 million after 2021.
However, this is only a small portion of the over 1.4 billion vehicles in the world. Each year roughly 30 million cars get recycled or destroyed and almost all of these would be petrol-powered cars at the current time. With all these variables we have modelled what total oil demand would be from cars if EV sales grew at an exponential rate (note that our sales estimate for EVs is above the consensus).8, 9
In the Figure 1 and 2 below, all sales of vehicles are electric by 2034. Additionally, the number of vehicles scrapped each year increases from 2030 as we account for new technologies such as alternate means of transport. We also assume all cars scrapped are petrol and that all petrol cars become more efficient every year.
Figure 1 – Market Share of EV’s
Source: Wentworth Williamson Estimates
Figure 2: Effect on Oil Demand
Source: Wentworth Williamson Estimates
For now, we are ignoring the many teething issues that the EV industry is likely to go through, the most important being the supply of lithium for batteries. While it does not take that long to build new factories to produce batteries, to commission and build a lithium mine can take many years – especially in today’s climate.10 With skyrocketing demand for batteries comes increased demand for lithium and it appears the market cannot keep up. In the last 12 months alone, the price of lithium has already gone up over 700%. In our forecasts, just to be conservative, we are assuming that the EV industry can overcome all growth challenges.
Trucks
With regards to trucks, most of the electric models are in prototype or pre-production stage. There are several major technological issues to overcome, and one of the biggest is energy density. Diesel provides a much higher level of energy density compared to lithium-ion batteries; for example, a 1,000-litre diesel fuel tank weighing 800kg would deliver the same energy as a 20-tonne lithium-ion battery.11 With lower density comes lower range and a need to recharge or fill up more often. Trucks are mostly for commercial use so the more time spent having to stop the truck to refuel, the less time is spent getting to the required destinated and subsequently earning money. Some other issues with electric truck adoption are limited charging infrastructure, slow charging times and a lack of economies of scale.12
One of the alternatives being considered is hydrogen trucks and there is a lot of progress being made in developing green hydrogen to a cost competitive level. It is likely that in the future, hydrogen is the technology that will start to replace diesel. However, while it may not take long to reach cost parity with diesel (a recent study by Goldman Sachs suggested that cost parity could be reached as early as 2027) there is currently no infrastructure for refuelling points. A refuelling network is not a trivial thing to build either – hydrogen must be stored either at extremely high pressure, very low temperature or in a solution of solid metallic hydrides.
The same issues apply to the prospect of transporting of hydrogen which undoubtedly will involve additional costs. Transporting hydrogen in a solid form is the most promising avenue of research but with current technology, only a very low mass of hydrogen can be stored (no more than 2% to 3% of the total weight is hydrogen).13 Despite these challenges, human ingenuity finds a way to make things possible, so in our modelling scenario we have assumed that non diesel trucks will follow the same path as electric cars but with a 10-year lag (see Figure 3 below). Just to be clear, this is not in our base case, but we are trying to be conservative in our calculations. In later years, much like cars, we have assumed higher scrapping rates and increasing efficiency levels every year. The effect on oil demand can be seen in Figure 4.
Figure 3: Market share of non-diesel trucks
Source: Wentworth Williamson Estimates
Figure 4: Effect on Oil demand
Source: Wentworth Williamson Estimates
Aviation & Shipping
Even the most bullish advocates for cutting use of oil acknowledge that replacements for oil in aviation are decades away. Using biofuels is a potential option but there is no evidence that these are better for the environment as they require a huge amount of land to produce. Electric planes also run into the same energy density problem as trucks, and without a major step change in technology they are simply not feasible. Hydrogen also has its issues with the same storage and transportation issues mentioned above.14
In shipping there may be some alternatives, with a lot of research going into using ammonia as a source of green fuel. There are many challenges to overcome with this and most of them lie in the supply chain. There is already a global ammonia distribution system, but one would need different infrastructure to get it to ports in a way that ships can refuel. Additionally, ammonia is very toxic to people so new regulations are needed and storage facilities would have to be upgraded. Burning ammonia also releases nitrous oxide, an extremely potent greenhouse gas, so additional equipment will be needed to control these emissions which adds further cost. 15, 16
In our modelling we assumed 1% p.a. growth in demand from ships and planes to 2035 followed by a decline from 2040 onwards as ships running on green ammonia may become viable as technology improves.
Non-Combusted
In the non-combusted sector, there are a huge variety of applications for oil and gas and this demand will continue to grow even in net zero scenarios. Applications include waxes, lubricants bitumen, plastics, and fertilisers. Hopefully the world can wean itself off plastic in the coming years, but this is only a very small portion of the overall picture. The growth rate over the last 20 years in this segment has been 2.7% p.a.17 For our modelling purposes we assume 1% p.a. growth to 2040 with a slowing thereafter. This is a sector that is likely to grow particularly quickly in developing countries where there is a greater demand for food and roads.
Buildings & Industry
Two other sectors that account for a significant percentage of oil demand are buildings and industry. These uses include heating and cooking as well as oil used in vehicle construction and industrial processes. Demand in this segment has grown by 1.6% per annum over recent decades.18 For both segments we assume 0.5% per annum growth to 2030 followed by a flat-lining of demand for 5 years and then a 0.5% per annum decrease in demand to 2050. We think that actual demand will be higher since there are limited efforts into reducing emissions in this sector.
Power Generation
Lastly, we assume that demand in power generation will decrease by 1% p.a. to 2050. Actual demand has flatlined over the last couple of years, but we feel that a lot of oil power will be replaced by gas in time.
By modelling these assumptions, which we think are conservative, we find that oil demand peaks in 2030 followed by a long but very slow decline. Our numbers suggest that demand will not drop below today’s level until 2038. See our estimates in Figure 5.
Figure 5: Oil demand with Wentworth Williamson Assumptions
Source: Wentworth Williamson Estimates
Longer Term Gas Demand
For gas, the demand looks like it will be growing for many years to come. It will play an important role in power generation in the future as we transition to renewables because it provides stability to the grid when the wind doesn’t blow, or the sun doesn’t shine. This can be seen in Figure 6 below where power generation from renewables and gas have grown together with a high correlation.
Figure 6: Electricity Generation by Source, OECD, 2000-2020
Source: iea
Gas will likely continue to play a key role in industrial uses as well. It is used to make fertiliser, explosives, ammonium nitrate, methanol, and ammonia as well as many other products that are critical to supply chains. The ability to substitute gas is limited and demand for all these products is likely to continue growing over the next few decades. Additionally, residential and commercial demand is predicted to continue to rise as people are lifted out of poverty, as again substitutes are limited. The growth in gas demand can be seen in Figure 7 below.
Figure 7: Global natural gas demand per sector, 2005 – 2025
Source: iea
The price for gas has gone up even more than oil over the last few months. It was already at all-time highs when demand for gas in Europe skyrocketed during the winter, when the wind blew less than expected (see figure 8). With the war in Ukraine, the price is expected to stay elevated for a while longer as Russia supplies most of the Europe’s gas and holds almost of quarter of the world’s gas reserves.
Figure 8: LNG Japan/Korea Market price
Source: investing.com
Note: To get the price for a barrel of oil equivalent, multiply the number in the chart by 5.8. The price for a barrel of LNG is over US$200!
Looking at countries with the largest gas reserves, it is obvious that there are many potential geopolitical issues that could cause further price spikes.
Source: worldometers
Conclusion – Where to from here?
In the short term we think it is likely that the oil price will be very volatile – the world is not short of issues at this time. However, it should be noted that even before the Ukraine invasion, the oil price per barrel was already in the US$90s as energy supply from renewables is not an immediate substitute and in fact, may take decades to substitute fossil fuels globally. Recent geopolitical issues have simply amplified an already developing complication of an industry that has been starved of capital investment in recent years and therefore is incapable of rapidly ramping up production. We think that the supply/demand imbalance will be fixed in time but that the projects needed to fill this gap will need the oil price at around $80 per barrel to breakeven.
As a counter to our thesis, a demand shock, such as a global recession will immediately hit demand and impact spot prices, and this will not be good for our portfolio positioning over the short term. However, it will also most likely result in a collapse of desperately needed capital investment in fossil fuels and prices could recover very quickly.
The Wentworth Williamson Fund owns the following stocks that stand to benefit, either directly or indirectly, from elevated oil & gas prices over the next several years:
- Woodside Petroleum Limited (ASX:WPL) – Australia’s blue chip gas producer.
- MRM Offshore (ASX:MRM) – an offshore oil, gas and wind service provider.
- Fleetwood Limited (ASX:FWD) – Owns a fly-in-fly-out hotel in the soon to be ‘boom time’ Karratha city in Western Australia due to the massive Scarborough and downstream developments in the region.
_____________________________
