$10 Oil? Better Believe It - Impact Of EVs On Oil Price

| About: iPath S&P (OIL)

Summary

We look at the impact of electrical vehicles (EVs) on oil demand and come up with a simple model.

There is a lot of uncertainty, but a case can be made that EVs will result in 8.5% drop in oil demand per year for a couple of years.

In such an environment, $10 oil is a realistic scenario.

We look at some ways to play the decline of oil demand.

Inspired by Tristan R. Brown's article on $10 oil, I decided to have a look at the impact of EVs on oil demand and consequently oil prices. I've come up with a simple model to estimate the impact and conclude that $10 oil is a real possibility. Let's see what can be derived.

Does electrification reduce oil demand?

The first question that should be answered is whether electrification results in lower demand for oil. At present only a tiny fraction of electricity is generated with oil. Coal, gas, hydro, nuclear and increasingly sustainable energy sources are used to generate electricity. At present, only 5% of electricity is generated using oil. With an ongoing move toward lower carbon emission fuels and sustainable energy sources, I see no immediate reason to assume the oil use to generate electricity will increase.Electricity production by fuel source. Source: tsp-data-portal.org

At the onset of the oil industry the lighter fractions, now used as fuel, were considered waste products. From this perspective, the argument of Tristan R. Brown that the oil is still needed to make the other products that come from oil makes sense. I, however, beg to differ. In present refining, an effort is made to produce lighter fuels. The heavier fractions are broken up to maximize fuel output for road vehicles. If they choose to favor heavier products and switch off the crackers in response to lower petrol demand, this will reduce oil demand significantly.

Even after optimization for heavier fractions some lighter products will remain. There are two options for this remaining fraction. Crack it to lighter products so it can be added to the natural gas sphere or chemically process it to combine the lighter fractions to produce heavier products. Both processes have well-known chemistry. The choice made has an impact on the displacement of oil by EVs. If combined to heavier products the displacement will be near 100%. If lighter fractions are cracked and added to the natural gas sphere the displacement will be lower. I've not found reliable figures on how large this lighter fraction is, it certainly depends strongly on the oil quality.

Assuming 5% of electricity will be generated with oil and lighter fragments are combined to heavier fractions, we get a 95% replacement rate. This ignores the difference in efficiency between electricity production and fuel use in vehicles.

How fast will fuel demand drop?

The answer to this question depends on how fast EVs will take over. New technologies introduced tend to follow an S-curve. A low number of early adapters. After reaching a tipping point a steep incline till near full penetration. Then followed by some late adapters. New technologies tend to get implemented faster than in the past. Combined with the long lifespan of vehicles, it seems reasonable that at the steepest part of the curve near 100% of car replacements will be ICE vehicles that will be replaced by EVs.

Technology implementation.
Source: michaelsenergy.com

Generally, the lifetime of a car is considered to be 15-20 years. Vehicles with high mileage and consequently higher impact on fuel consumption tend to be replaced much faster. Replacement rates for high mileage cars are typically 15%-20%. So, a mileage weighed replacement rate of 15% seems reasonable.

What is the impact on oil demand/supply?

The impact on oil demand can be estimated by the formula:

15% drop in fuel demand * 95% displacement rate * 60% fraction of oil used for road vehicle fuel

This means 8.55% decline in demand per year at the steepest part of the curve. Of course, the figures to plug into the formula are up for debate.

Price is not only determined by demand. Supply is an important factor in the equation, too. Supply is determined by new capacity coming online and the natural decline of existing oil wells. The capacity that comes online depends on how well demand is predicted and oil companies manage to time their projects accordingly. The natural decline rate of existing wells depends a lot on the well. On average, over all wells for the last decades it has been about 6%.

A big stretch, but let's assume that oil companies execute perfectly and no over capacity comes online in the downturn. Overcapacity might still increase by over 2.5% per year. This could occur for a couple of years in a row.

What does this mean for the price of oil?

In 2016, we've seen what just a couple of percent oversupply can do to the oil price. Based on the above, EVs may result in an overcapacity of 2.5% per year for a couple of years. Afterward, it takes some more time to digest the overcapacity. In an environment of declining demand, this could take quite awhile. In such an environment, $10 oil is very realistic.

Is it all gloom and doom?

There are a lot of moving parts that can't be predicted with any kind of certainty. As such, the figures mentioned are a shot in the dark. There may be some push back from economic growth, and it's by no means certain EVs will scale up as fast as predicted. Smart execution of oil companies can have a big impact, too. Timing of projects is an obvious one, but choosing projects with higher depletion rates to meet peak demand such as shale could also help closing the gap on the downturn.

How do to play the decline in oil demand?

Above, only a model and uncertain scenario is given. To make the most of it, one should consider the process that comes in play when EVs take over from ICE vehicles. Use the model to estimate the impact based on latest projections and adjust positions accordingly. There are a plethora of possible trades. Timing is, however, important.

Trading the commodity

The commodity itself can be traded through futures or any of the ETFs such as iPath S&P Crude Oil Total Return Index ETN (NYSEARCA:OIL), and is the most direct way to get exposure to the oil price.

The present recovery of oil prices may continue as demand still grows and time between production and consumption of oil is short. Short-term price action depends a lot on the OPEC production levels and how quickly shale increases production again. The moment that peak demand is reached and EV sales are ramping up fast, one could short oil. This way, you could profit from the oversupply and related price drop at the steepest part of the S-curve.

Trading oil companies

The pricing of oil companies is forward looking, this means that future expectations are priced in. The closer an event comes and the more consensus there is about the event the more it is reflected in the price. This means price movements are more moderate compared to trading the commodity. Oil companies are effected in two ways. A roughly 50% decline in volume over a few decades and, if EVs take over fast, several years of oversupply with dramatic consequences for the oil price.

Buy and hold investor should use the present recovery to exit their positions or otherwise to adjust to underweight the oil sector. Other sectors and industries are likely to outperform the oil sector over the next decade. For diversification, a small position might be held. One should look for strong diversified companies that can weather the storm. Think about oil majors like Royal Dutch Shell (RDS.A, RDS.B), British Petroleum (NYSE:BP), Exxon Mobil (NYSE:XOM), etc. These are companies likely to survive.

The most aggressive predictions place peak demand 5 to 10 years out. When this sinks in the first victims are the large expensive multi-year projects. Most noticeable deep sea projects as these need high oil prices to break even. Projects that come online near or past peak demand will have a hard time to earn back the upfront costs. Names that focus on this business are Seadrill (NYSE:SDRL), Transocean (NYSE:RIG) and Diamond Offshore (NYSE:DO). You might look at these companies as candidates to short.

Where offshore projects fall short, projects with shorter horizons and lower upfront costs and therefore less risk could benefit to meet peak demand. Shale with short lead times and low up front costs is in a good position to benefit. This benefit may be only short term as they too will fall victim to dropping oil demand after the peak. Companies to look at may be Devon Energy (NYSE:DVN), Chesapeake Energy (NYSE:CHK), EOG Resources (NYSE:EOG) and Whiting Petroleum (NYSE:WLL).

Pair trade

To lower risk and get more focused exposure, it is possible to set up long/short trades. An interesting approach might be to go short upstream that is affected most by low oil prices and go long downstream where cheap oil input and stable demand for chemicals helps margins. An example could be long Phillips66 (NYSE:PSX) and short ConocoPhillips (NYSE:COP).

Due diligence

The above suggestions are just that, suggestions on how you could approach this. Proper research and due diligence can help you to find the right companies and the right timing.

Takeaway

Predictions of $10 oil might seem extreme. Looking at the potential impact of electrification, a supply glut lasting a few years is very possible. In such an environment, $10 oil is likely.

The framework can give guidance on what to expect when EVs become mainstream. Depending on (changing) assumptions, one can get an indication of what it means for oil and consequently the impact on the industry.

Buying and holding oil-related companies is no longer a good idea, other sectors are likely to yield better results. A trading attitude will be a better approach.

Disclosure: I am/we are long RDS.A.

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.

Additional disclosure: I'm not an investment advisor and have no formal financial training. The information provided are my personal views and should not be considered investment advise. Before investing one should conduct due diligence.

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