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Oil: Innovate Or Die

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Includes: ARMCO, BNO, BP, CVX, DBO, DD, DNO, DTO, DWT, HP, OIL, OILK, OILX, OLEM, OLO, OXY, PBR, RDS.A, SCO, SLB, SZO, TOT, UCO, USL, USO, USOI, UWT, WLL, WTID, WTIU, XOM
by: Giesbers Investment Strategy
Giesbers Investment Strategy
Long-term horizon, dividend investing, foreign companies, growth at reasonable price
Summary

Renewable energy sources are becoming cheaper and more abundant, and are already the cheapest electricity producers in some locations.

Electric vehicles will be the real disruptor since they will lead to renewable energy sources directly competing with oil.

Demand for oil will go down in the long term, and stranded assets could become a real problem.

Oil companies need to innovate to stay alive.

Many oil bulls are proclaiming that we can expect to return to levels of $100+ per barrel in a couple of years. In this article, I am going to explain why I do not think that this will happen, and why big oil companies would be wise to differentiate into different business areas than oil production to stay relevant in the long term.

The price of renewable energy sources

Renewable energy is getting cheaper and cheaper. In more than 30 countries, solar and wind are already cheaper than fossil fuels. Solar was the cheapest of the newly installed capacity of energy production in 2016, without subsidies. Even offshore wind, which is sometimes referred to as one of the most expensive sources of renewable energy, is already cheaper than fossil fuels in some countries.

orsted

Source: Orsted

Don't get me wrong, renewable energy sources are still more expensive in many countries than conventional ways of energy production. Also, sometimes they require subsidies to be competitive, though this will become less in the future when technologies improve and become more efficient. Oil is a mature industry, and though incremental efficiency improvements are still being made, the scope for new innovations leading to cost reductions is much larger in renewable energy technology than it is in oil. This means we can expect renewables to become even cheaper in the future.

One has to keep in mind though that most of these cost comparisons deal with electricity production, and not with fuel for vehicles. Oil still has some large benefits over renewables when you look at the transport market. But eventually, most people agree that renewables will replace oil as the primary source of energy for transport worldwide. The biggest disagreement among analysts is when this will happen.

Let me be clear: There will always be a demand for oil. It is an important component of many chemical processes (non-energy use), and our industries and in fact most of our economic infrastructure depends on it for now. But the expected long-term demand for oil as a component of chemical processes is no way near as high as the total demand for oil at this moment. Below you can see a pie chart of the energy consumption of oil in the EU in 2014. About 14.5% of oil is used for non-energy purposes, and this will be the demand that is likely to remain or grow. Other demand like that of aviation is also very difficult to replace.

euSource: Eurostat

Energy efficiency for transport: oil is still better

Energy-wise, using petrol to fuel your car is more efficient than using electricity to do so. This electricity needs to be generated, stored in the fuel cell of the car and then converted to kinetic energy, which drives the wheels of your car. At each step, efficiency losses occur. When you fuel your car with petrol, this fuel is converted to kinetic energy in your engine, which is more efficient than converting it three times. This brings us to two conclusions:

  • Charging your fuel cell with electricity produced by burning oil is very inefficient.
  • When electricity is produced by sustainable sources, it needs to be cheaper than oil by a big margin to offset the efficiency losses.

Note that there are also efficiency losses when oil is refined to petrol, and that this petrol has to be transported.

It is still much more efficient energy-wise to use biomass or normal petrol than to use electricity to drive a car. In the picture below, ethanol is compared to electricity to illustrate this asymmetry in energy efficiency.

eth elSource: Campbell et al., Science 2009

Global oil consumption

At the moment, world oil consumption per year is still growing, but it is only growing because world population is growing quicker than per capita oil consumption.

oil pppSource: Jean Laherre, 2013

Oil production per capita has peaked in 1979, and as we can see in the graph, it's not expected to ever return to peak levels.

Renewables still represent a relatively small amount of the total energy consumption. It is simply not possible to switch to a renewable electricity production overnight, even if it's cheaper in the long term. Also, many electricity plants have had a huge cost in the past, which explains why financially it might still be a prudent decision to keep operating them -- even if the alternative is cheaper on a dollar per KWh basis. Also, do not forget the sunk cost which went into these power plants, which makes it difficult for governments that often financed them to close them earlier than promised.

The link between oil price and renewables

One of the more interesting market reactions of the past couple of years was that lower oil prices did not result in trouble for the renewables sector. This seems illogical, since oil and renewables are natural competing technologies -- or are they?

The link between renewables and oil seems to be weakening for different reasons. First, they operate in different markets: renewables are mostly used for electricity generation, whereas oil's worldwide use for electricity generation has been less than 5%. Second, renewables are getting cheaper by innovations, and are expected to continue to do so in the future. Even oil-producing countries are starting to look to renewables as a serious option because of -- not in spite of -- the price slump in oil.

Electric vehicles: the real disruptor

The oil industry's major market is transport. This is why the shift to electric transport is so relevant for this industry. Oil is not generating significant amounts of electricity used for electric driving, and will not do so in the future (also, as we discussed earlier, this would be very inefficient energy-wise). Big oil companies realize this. Royal Dutch Shell (RDS.A) just acquired one of Europe's largest electric vehicle charging providers, NewMotion. Total (TOT) and BP (BP) have also taken action already, wanting to add EV charging stations to their petrol station network.

Thus, even big oil companies acknowledge that electric cars are the future, and they are acting accordingly. Bloomberg New Energy Finance estimates that by 2040, 35%-47% of new cars sold will be electric.

new electricSource: Bloomberg New Energy Finance

This estimate might seem high, but when you think about the targets some countries have set, it could also be on the low side:

  • France and Great Britain are planning to ban sales of new gasoline and diesel cars starting in 2040.
  • India said earlier this year that every vehicle sold in the country should be powered by electricity by 2030.
  • Norway has even bigger plans: All new passenger cars and vans sold in 2025 should be zero-emission vehicles.
  • Other countries like Austria, China, Denmark, Germany, Ireland, Japan, the Netherlands, Portugal, Korea and Spain have also set official targets for electric car sales.

If these targets are going to be met, 35%-47% of new vehicle sales being electric sounds very low. We have to note though that the U.S. government has not set official targets for electric car sales, and it makes up for a big part of worldwide car sales. Individual states have set targets, though.

All these sales of electric vehicles mean that worldwide electricity demand is going to increase the coming years. For many different reasons, it is not likely that this demand increase will be provided by the burning of oil or other fossil fuels. First, it is energetically inefficient. Second, it emits huge amounts of greenhouse gases. Third, it is very unlikely that fossil fuels will be able to compete with the price of electricity generation by renewable energy sources in the future.

Renewable energy sources are becoming a competitor of oil again

These future prospects of electric vehicles combined with the increase in demand of electricity mean one important thing: Though the link between renewables and oil might have become relatively weak the last couple of years, it is going to strengthen again. This time, though, it is likely that renewables will have the upper hand. Oil will still be necessary for many ways of transport that require huge amounts of energy, like airplanes and ships. But cars, trucks and tractors will be cheaper, more efficient and more environmentally friendly when they are electric. But the non-energy use of oil as a component of products and industrial processes is not going to disappear.

installed capacitySource: IRENA

This does mean that the demand for oil will suddenly drop. As you can see in the graph above, renewable energy sources are growing but they do not have a huge market penetration yet. Also, electric vehicles will need time to become adopted by the general public. The graph is influenced a lot by the inclusion of hydropower, which makes up a big percentage of renewable energy sources. Hydropower is a quite mature technology which is not expected to grow very rapidly when compared with other renewables. When you would exclude hydropower from the graph, the annual growth would look much more dramatic.

We do not know when oil demand will peak, but the International Energy Agency IEA estimates that this will not happen before 2040. Even if no new EVs are sold after 2030, old gasoline and diesel cars will still remain on the roads for a long time. This will mean that oil demand will not suddenly come to a halt, but instead shrink gradually.

Turmoil for oil companies

What does this mean in the long term for oil companies? In the first place, if the demand shrinks, so does the price, when supply remains the same. Oil reserves will be valued at a lower price. This is something which already happened during the oil price slump of 2015-16. Also, this means that companies could be stuck with stranded assets for which there exists no demand. In some deepwater fields, oil is currently already too expensive to produce.

The price decline of oil in the last couple of years was mainly caused by the supply side, what would happen if the demand side now also starts to falter, as it's almost certain to do somewhere in the future? Oil companies are well aware of the risk of demand drying up eventually, even if it could happen only in 2040. This means that they have a big incentive to produce and sell as much oil as they can for reasonable prices. This again leads to a supply side which is producing more oil than it can sell, even with OPEC action.

We are also already seeing countries that are suffering under low oil prices. Venezuela is in real trouble, and the economies of Azerbaijan, Russia and other countries are yearning for higher oil prices. Just like oil corporations, these countries are not stupid. They know that they will not be able to sell oil forever, and nobody wants to end up poor with a huge unsaleable oil reserve. Whenever the price rises to a profitable level, countries and big oil corporations have a big incentive to ramp up production again. This way, the price might rise by a bit, but not as high as it was. Struggling countries are not likely to find relief soon.

The planned IPO of Saudi Arabia's Aramco (ARMCO) is a writing on the wall for oil companies (and oil exporting countries) that it is time to innovate. Even with the recent news that Saudi Arabia is considering shelving the international IPO, this does not change the fact that they are still looking to sell a part of this huge company. In fact, if Aramco won't be publicly tradable, Saudi Arabia will likely increase the chances of having influence on the sales price of future parts of the company. In this way, Aramco will be more insulated from market movements. In any case, it is a very big step for a country like Saudi Arabia to sell a company that has contributed so much to their national wealth.

If even one of the economies that rely most on oil for their wealth is starting to sell a part of their stake, it's really time to extend your horizon. Oil companies look for different ways of generating profits, like European firms such as Shell, BP and Total are already doing with their investments in EV charging stations.

Conclusion

I see no reason for oil prices to recover to previous levels, certainly not to $100+ per barrel. Current developments in renewable energy sources will lead to lower prices for electricity. Also, electric vehicles will become cheaper than gasoline and diesel cars eventually. In this way, renewables will become a direct competitor for oil again, and this time they have the upper hand. The oil industry knows this and has the incentive to sell its oil assets on the market while they can, which drives up supply.

Some big oil companies are already differentiating their business by buying EV charging companies, and even Saudi Arabia is planning to sell a part of their stake in Aramco. Barring a huge global event like a war in the Middle East, I do not think oil prices will recover to previous levels. For big oil, it is time to innovate!

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Disclosure: I/we 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.