Big Oil Under Serious Threat

Includes: CVX, RDS.A, RDS.B, XOM
by: Shareholders Unite


Oil majors face serious challenges, for decades, resource nationalization has kept them out of many of the cheapest fields.

They're struggling to replace existing reserves and production with new reserves and production.

Climate change could present them with a staggering $28 trillion bill.

They are amongst the biggest and most profitable companies in the world, the big oil, gas, and (to a lesser extent) coal companies. But whether they're good longer-term bets for investors is very much in doubt. It isn't that the world is running out of carbohydrates, peak-oil keeps ever receding into the future.

However, instead of peak-oil, a series of important threats has emerged on the horizon threatening some of the core businesses of these companies. In no particular order, these threats are:

  • Oil nationalism
  • Field depletion
  • Climate change
  • Pollution controls
  • Falling cost of renewables

Together, these threats produce a pincer, rising marginal cost and reducing prices, a pincer that threatens the long-term viability of these companies.

Oil nationalism
This has been the oldest threat. Until four decades ago or so, the big oil companies had a firm grip on the world energy reserves, but a rising tide of nationalism has greatly reduced that grip on the world reserves of carbohydrates. Many of the biggest and cheapest fields to develop are now either out of their hands, or available only at greatly reduced conditions. It might be true that peak-oil isn't anywhere near, political peak-oil has already manifested itself in full force.

The true picture is rather bleak:

International Oil companies (IOCs) control less than 10 percent of the world's proved oil and gas resource base. Indeed the super-majors themselves account for only 3% of oil reserves and 2% of gas reserves, although they have 20% of production, through contractual arrangement with the NOCs. When ranked on the basis of proved oil and gas reserves, 17 of the top 20 oil and gas companies in the world are NOCs. Nearly 75% of the oil reserves are held by OPEC members. [PWC]

Once dominant, the super-majors now only account for 3% of world oil reserves and the national oil companies (NOCs) dominate them in terms of reserves.

Field depletion
Not only are the oil majors kept out of much of the biggest and cheapest fields (or if not, let in at much reduced conditions), their own existing big and cheap fields are slowly petering out:

the IEA said in its annual report. Without extra investment to raise production, the natural annual global crude oil depletion rate is 9.1%. The findings suggest the world will struggle to produce enough oil to make up for steep declines in existing fields, such as in the North Sea, Russia and Alaska. The effort will become even more acute as prices fall and investment decisions are delayed. Even with investment, the annual rate of output decline is 6.4%. [The energy collective]

With access to big, cheap fields ever more distant or onerous and existing fields declining with an average of 7% a year, companies are pushed out to replace the lost cheap reserves with expensive exploration finding expensive new reserves. And they're not really succeeding very well, here is Jim Chanos:

The central thesis behind Mr. Chanos' short position is that several major integrated oil companies have not replaced reserves in years and several companies are in fact liquidating. Mr. Chanos also points out that, based on a review of the financial statements of integrated oil companies, the group is spending 100% of cash flow on capital expenditures and is borrowing to pay a dividend.... The real story at Shell and the other majors is the inability to replace produced reserves with reserves of equal quality.

Indeed. The simple truth is that these companies, on average, have to replace mostly cheap existing resources running on empty with more (often much more) expensive new plays from unconventional resources like shale or coal bed, or deep sea. Technology, like fracking and horizontal drilling, helps mitigating this impact, but can't completely offset it.

And the companies haven't managed this difficult hand circumstances have dealt them very well. Exploration costs are rising steeply while crude production is down:

Such are the problems that many of the majors are cutting back exploration. Exxon Mobil (NYSE:XOM) by 6%, Chevron (NYSE:CVX) by 5% and Royal Dutch (NYSE:RDS.A) by a whopping 20% this year. Perhaps that's what will eventually increase the oil price again, but the majors face other challenges.

Climate change
We're not sure why climate skeptics have such a hard time accepting the scientific consensus in climate science while routinely accepting the results of pretty much any other science without questions asked. Fact is, the overwhelming majority of climate scientists argue that global warming is a real danger and burning fossil fuel a major cause.

Nobody disputes that carbon dioxide is a greenhouse gas and that levels of it have been rising inexorably due to the burning of fossil fuels.

Source: Business Insider

Some wiggle room for skeptics exist because measuring global temperatures is fraught with problems and climate is a complex system subject to many other forces and feedback loops, but the graph above doesn't lie.

While, as true Popperians, we accept that science is an evolving project and scientific consensus has been wrong in the past, to assume some kind of grand conspiracy of scientists on a worldwide scale in order to protect income streams seems folly to us. There simply isn't any proof in support, in fact, there isn't a single precedent of anything remotely like it.

Alternatively, there are numerous precedents for corporate interest "bending" information to protect income streams, from tobacco companies denying any harm of smoking to drug companies overstating the effectiveness of medicines or downplaying side effects. There is a reason we have something like the FDA. It's perhaps also no coincidence that climate skeptics are more prominent in countries with large energy companies.

This rather long introduction brings us to the following alarming figures:

The global fossil fuel industry faces a loss of $28 trillion in revenues over the next two decades if the world takes action to address climate change, cleans up pollution and moves to decarbonize the global energy system. [Greentechmedia]

Yes, that's what it says, $28 trillion. While this is spread over two decades, it's still a phenomenally big sum even for the big oil companies (who bear the brunt of this sum). How does this work? Well, it's based on the amount of reductions in emissions of CO2 to keep the rise in temperatures below the 2 degrees threshold, the International Energy Agency's "450 scenario." The consequences of this scenario can be assessed in the graph below:

In the second chart, you see that this has a rather substantial effect on the demand for fossil fuels, only the demand for natural gas keeps on rising, albeit at a rather reduced rate. Demand for coal and oil actually declines. Implementation of the 450 scenario isn't very likely though. However:

Kepler Cheuvreux says that its predictions do not rely on there being a global climate agreement struck in Paris at the end of 2015. The report notes that trillions of dollars are still at risk from unilateral and regional action, pollution controls such as those being implemented by China, and the falling of cost of renewables, which will likely displace more coal, gas and oil production.

Kepler Cheuvreux is the European brokerage which commissioned the report, which was written by a team led by Paris based analyst Mark Lewis, a former head of Deutsche Bank's carbon energy team.

Falling cost of renewables
Sometimes, a graph says more than a thousand words, and that is certainly the case with the following graph below, depicting the crash in solar energy prices compared to other energy sources.

Now, we are well aware that alternative energy sources still have problems. It's only competitive where there is a high incidence of sunshine combined with high energy tariffs, but that area is expanding. According to a Deutsche Bank report, the steep price decline:

has already rendered solar power competitive "without subsidies" in Japan, South Korea, Australia, Italy, Greece, Spain, Israel, South Africa, Chile, Southern California, Hawaii and Chile - in some cases because electricity prices are ruinous. (Italy's solar is not efficient but electricity retails at $0.38 per kilowatt hour, compared with $0.15 in Germany and the UK). These regions could be joined within three years by Thailand, Mexico, Argentina, Turkey and India, among others. [The Telegraph]

Another problem is that it produces intermittent energy. While in hot climates (which tend to have the highest sunshine incidence as well), this is convenient as it coincides with peak electricity (day-time airco use), energy storage which enables the use of alternative sources to be spread out when the sun doesn't shine (or the wind doesn't blow). But even here, there is lots of innovation and development.

But the bigger picture is simply this. There is no reason whatsoever that the inexorable decline in the cost of solar energy is about to come to any grinding halt. It might do, for one or two years, as supply and demand conditions tighten (we're currently experiencing a mild form of this), but a decade from now, solar energy will be considerably cheaper than today. That means that it's going to be competitive with fossil fuels in an ever increasing area.

The upshot
The future doesn't look all that bright for big integrated oil companies. Having declining access to the biggest and cheapest fields, at increasingly onerous terms, having their best fields decline and often being unable to discover enough replacement resources, at least not at the same conditions, the oil companies now face two new threats in the form of climate (and anti-pollution) actions (whether unilateral or joint) and sharp falls in the cost of renewables, most notably solar energy.

This is a slow grind, but a substantial one as the $28 trillion figure suggests. While still very powerful and profitable, the long-term fortunes of the big oil companies don't look bright.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.