Why Oil Will Never Be Replaced

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Includes: CNQ, IMO, SU, XLE
by: Michael Munro

Summary

With an ongoing oil glut, it seems that many people believe that the oil industry is at the start of a long term downturn, due to oil eventually being replaced.

Many believe that technological improvements in drilling, newly discovered oil reserves outpacing consumption, and reduced consumption due to electric vehicles will eventually kill the oil industry.

This article explains why oil consumption will increase for several decades, and why the price of oil will consistently rise beyond inflation in the long term.

Introduction

Since the collapse of oil prices last summer, it seems that there has been renewed talk about the worst case scenario for the oil industry. Over the last few decades we have had technology improvements leading to enormous oil deposits now being deemed recoverable, additional oil reserves being discovered, and the development of electric vehicles; this has led to the belief that oil will essentially become a useless commodity, and could potentially remain relatively cheap from this point on. Although it can be difficult to predict how many new deposits will be discovered or how technology improvements can improve the utilization rate of the current deposits, one can get a general idea of future oil consumption based on several variables. I am writing this article to refute the argument that oil will eventually be replaced by more efficient technology, and instead offer a discussion of why the rate of oil consumption will continue to grow for several decades. In addition, I will discuss why the price of oil will increase regardless of the remaining world wide oil reserves at the time.

The chart below shows the price of Energy Select Sector (NYSEARCA:XLE), a fund which corresponds to the Energy Select Index. We can see that as a whole, the energy industry has lost about 30% of it's value since last July.

XLE Chart

XLE data by YCharts

Why Electronic Cars Won't Kill The Oil Industry

I'll start with the most common argument against the replacement of oil: the belief that electronic vehicles will replace the vast majority of the demand for oil.

I think it is important to first get a snapshot of how oil is being consumed, and which of these consumption methods are threatened. Unfortunately, there does not seem to be any global data, so I used the United States data derived from the Energy Information Association (NYSEMKT:EIA). It is important to consider that there would be many variables that may suggest the United States would not the best representative sample of the world, however, this data should at least be somewhat accurate. According the EIA, this is how oil use is broken down in the United States:

    Gasoline

46%

Heating oil/Diesel Fuel

20%

Jet Fuel (Kerosene)

8%

Propane

7%

Natural Gas Liquids/Refinery Liquids

6%

Still Gas

4%

Petrochemical Feed-stocks

2%

Residual/Heavy Fuel Oil

2%

Asphalt and Heavy Road Oil

2%

Lubricants

1%

Therefore, we can see that almost half of all fuel is used for gasoline, likely the biggest threat to oil consumption due to electronic vehicles. Despite what many people believe, less than half of oil is used for gasoline; almost a quarter is used for diesel or heating oil, and almost 10% for jet fuel. Therefore, approximately 71% of oil is used for transportation, while only 46% of this is used for personal vehicles (neglecting diesel personal vehicles). I want to take the time to point out that there has been no evidence that we will be having electronic airplanes, cargo freighters, or large scale industrial equipment; therefore jet fuel and heating oil/diesel fuel should still be in demand as the population grows. We have had the technology for nuclear powered boats for decades, it has not proven to be economical or safe based on past experiences; although there has been some research into this, there to date has been no nuclear powered boats used for international trade. There seems to be no evidence of emerging products that would replace home heating oil with respect to cost, as home heating via electricity is currently less efficient than oil heating. So it seems that this chunk of the pie will still be in demand. There seems to be no indication that any of the other mentioned uses for oil would be replaced in the future, as we will continue to use oil for a variety of other purposes such as plastic or asphalt production. Therefore, in the absolute worst case scenario, only 46% of the overall use of oil should be affected by electric vehicles.

Now lets look at this 46% a little bit closer; are all personal vehicles going to become electric? I still think there will be certain classes of vehicles that would be very difficult to become completely electronic, such as larger trucks or recreational vehicles. In addition to this, there will be a significant time lag from when the technology becomes widely available to when it is popular. Then, we have to consider that people are not just going stop driving gas vehicles altogether, it would be a gradual phase-out that would occur over a couple of decades, to consider the average lifespan of a vehicle. Then we have the huge amount of the population that would likely still prefer to drive gas vehicles, as well as the effect of the developing world; countries with less money are likely to continue driving and fixing gas vehicles for several decades due to the lower cost.

Based on what I've been reading, it seems that almost all major automobile manufacturers are planning on releasing electric vehicles in the next decade. Lets take an extremely pessimistic view and assume that by 2030, the majority of vehicles sold become electric, and by 2040, gas cars are no longer mass produced. Even in this almost impossible scenario, as there will likely always be a market for people that "prefer" gas cars, it would still be around 2050 to 2060 before gas vehicles were completely off the road. With these assumptions in mind, the global use of automobile gasoline would likely peak until the shift towards electronic cars outpaced overall use of automobiles (which would be based on population and global economic situations); therefore in this almost impossible scenario, our gasoline consumption would increase as it has in the past, for at least a couple of more decades.

One important consideration is that people that predict that oil will become replaced essentially fall victim to their own argument; the shift towards electronic vehicles would only occur if it was more economical, which would assume that oil would have to become more expensive. If the market shift towards electronic vehicles was so significant, it would lead to a lower price of oil, which in itself would retard the growth of the electronic vehicle market. In order for electronic vehicles to beat out oil-powered vehicles in market share, there would need to be a long term cost advantage of electricity over oil. One last point that must be considered in this scenario, is that if the shift towards electronic vehicles was significant enough, the price of electricity would logically increase as well, and there would be enormous pressure to bring enough electricity to the grids.

Furthermore, when you consider that the US Energy Information Administration believes that by 2040 gasoline and diesel vehicles will constitute 95% of the market worldwide, it seems that the almost impossible scenario I outlined would not happen. Even if it did happen, it would take several decades to have any significant effect, and massive amounts of oil would be depleted by then. I do believe that the EIA prediction is somewhat overly optimistic for the oil industry, and it seems feasible that electric vehicles would be more than 5%; this, however, is just my personal speculation, based on the general interest of electric vehicles. I also live in a notoriously "left wing" city, where we are already seeing a lot of electric vehicles on the road.

The EIA proposes that personal vehicle oil consumption will only slightly increase from 2010 to 2040, while commercial transportation (shipping, rail, aircraft, commercial trucks, etc.) is expected to double. They posit that this is due to increased efficiency and use of electric vehicles being offset by population growth and increased demand from developing countries, most notably China. Overall, they predict that transportation use of oil would increase 40% by 2040.

One last consideration is that many automobile manufacturers have shifted towards increasing fuel efficiency, rather than replacing the combustion engine. I think that this has to be considered as a negative variable for oil consumption, as even if combustion engines were 95% of the cars by 2040, the overall consumption per mile may be significantly lower. This is a very difficult thing to predict as it would depend on future technology, and future buying habits; will people continue trending towards buying larger vehicles, or will the trend go the opposite way? The EIA predicts that the average MPG will drop from 45 mpg in 2010 to 25 mpg in 2040; this would roughly offset their prediction of overall vehicle use doubling by 2040, of which 40% is attributed to growth in China. One must keep in mind that the EIA is making a very bold prediction that the general market will be moving towards greater fuel efficiency, rather than electric vehicles; however, even if this prediction was wrong, the demand for oil would still be consistent.

Cheap Oil Will Be Gone Soon

Many would argue that the "cheap oil" was drilled a while ago, but this seems to be subjective. As a whole, however, there has been a general trend that the cost of oil production per barrel has steadily risen beyond inflation due to the natural effect of a free market economy; the more easily accessible oil has been drilled first, leaving behind increasingly difficult to access reserves. It is important to consider that most of the countries that have large reserves of easily accessible oil, or the Middle-East reserves, are pumping at an incredible pace; while the extremely large and expensive deposits of oil in Canada or Venezuela, are being pumped at much lower rates as they are not very economical at today's prices. Although technological advancements can delay some of this, it seems that this trend will inevitably continue with time. Therefore, because it would take so long for the world's dependence on oil to decrease significantly, the shift towards electric vehicles would not likely occur until a significant chunk of the current petroleum reserves are depleted. Despite the seemingly huge global reserves of oil, an enormous percentage of this is very expensive to drill, and this will constitute almost all of the remaining oil by the time the shift occurs towards electric vehicles.

Why "Future Discoveries" Won't Lower The Price of Oil

The next argument against oil, seems to be the wide-held belief that we will continue to discover more reserves of oil, and this would keep the price of oil low as the fear of hitting peak oil would be routinely delayed. Looking at the huge increase in global oil reserves over the last twenty years certainly adds a lot of strength to this argument, especially in North America as technology has turned dozens of billions of barrels into recoverable oil.

What is the problem with this argument? It is absolutely true that the global oil reserves will continue to increase over the next few years, and it will likely continue to increase beyond the amount of oil that is consumed annually. A better way to understand this situation is to consider that almost all of the new oil that will be discovered in the future, will be "expensive oil"; furthermore, any reserves that would be deemed recoverable due to technology improvements would almost be guaranteed to be more expensive, as the oil is considered to be non-recoverable due to the difficulty of obtaining the oil. So instead of focusing on the global oil production, consumption, and reserves several decades from now, instead look at the average cost of production several decades from now. Even if oil consumption fell to half of its current levels, the price of oil would still logically have to increase if the average cost of production was significantly higher than today; this price increase would logically go up due to the expense costs, regardless of the demand for the product.

The classic catastrophizing belief around oil has been that the oil reserves would almost run out, sending the price of oil to enormous levels, and inducing a worldwide economic collapse; therefore the belief was that declining reserves would ultimately lead to an extremely high price for oil. Therefore, the retort to this argument has been that the ever increasing oil reserves would not allow that scenario to happen. Instead, we are going to see the price of oil gradually increase in the long term as the price of obtaining the oil will increase, regardless of the demand.

Population Growth

Another obvious consideration that seems to be neglected, is that the global population is still growing at a rapid rate. We currently have a worldwide population of 7.18 billion people; By 2050, the United Nations Department of Economic and Social Affairs predicts that the global population will increase to over 9.5 billion people; this generally agrees with other estimates as well. Therefore, this represents an approximately 25% increase in population. Even if the oil consumption per person decreases significantly, the overall consumption would be largely offset by the continual growth in population. Also, keep in mind that over half of oil consumption is not used for personal vehicles, and this would likely continue to grow regardless of technology advancements. Also, the continual trend towards international trade would proportionately increase the role of commercial transportation.

Developing Economies

As of 2014, the United States had almost 5% of the world's population, and almost 25% of the personal vehicles. China, the world's fastest grower in automobile use, currently has less than 7% of the world's vehicles, and is expected to more than quadruple this number in the next 30 years. This is part of the reason why the OECD International Transport Forum suggested that by 2050, there would be 2.5 billion cars on the road; to put this in perspective, the global number of cars surpassed 1 billion in 2010, and have already grown to 1.2 billion since then. As more of the world starts to mirror the spending habits of the United States, this will logically increase the number of cars. Furthermore, this adds extra importance on the economic feasibility of electric cars, as price would likely be the most significant factor in developing economies.

Buying Opportunity

I believe that I have outlined a general argument as to why oil will never be replaced as a commodity, as the only significant threat seems to be electric vehicles, which will not likely have an enormous impact in our lifetimes. Why does this create a buying opportunity? Because this opinion seems to be in the small minority right now, as many speculate about the long term viability of the oil industry. It is unlikely the oil will increase significantly in the next few years due to the global oil glut, however, as more capital expenditures are reduced and mega projects are canceled, it is only a matter of time before this lack of long term production results in the pendulum swinging the other way, and oil-producers would be unable to meet global demand. This needs to occur for much longer, and more companies need to become insolvent in order for this trend to continue enough to shift the momentum. I believe a significant increase in the price of oil would occur afterwards, which would likely occur between 2020 and 2025; I will be explaining how I came to this conclusion in a future article.

I believe that the best way to profit for a long term oil investor, is to invest in the Canadian oil sands industry, as they are home to many projects with lifespans of several decades, and contain vast reserves with a higher cost of production; this makes Canadian energy companies seem like a poor investment right now, when it is in fact a fantastic buying opportunity. I believe that the safest way to invest in the Canadian oil industry for the long term, is to invest in one of the large diversified companies such as Suncor Energy (NYSE:SU), Imperial Oil (NYSEMKT:IMO), or Canadian Natural Resources Limited (NYSE:CNQ); this is because these companies are generally profitable in a downturn due to their downstream revenues, while also owning several projects with billions of barrels of reserves. So far, it seems that Suncor offers the best long term return due to their large cash and oil reserves, and continual positive earnings.

As I believe oil will likely continue in the $40-$60 range for the next few years, now presents a good buying opportunity for the long term or medium term investor; one could load up on oil companies waiting for an eventual large rebound, or one could play the swing trade in oil by buying in the $40's and selling in the $60's. Either way, oil has head into the $40's for the third time in the last few months; despite what the media says, the world is NOT ending, and it will go back up shortly. Take advantage of the irrational beliefs of others, by loading up on oil stocks over the next few months and years, especially right now as oil approaches new lows.

Disclosure: I am/we are long SUNCOR.

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.