Many now talk about crude oil heading to $10 a barrel. Such ideas stem from projections of technological changes favoring other sources of energy for economic or environmental reasons, in particular the evolution of Electric Vehicles (EV). It's no secret that the biggest source of demand for crude oil is its use as a transportation fuel. EVs will impact the demand for crude oil in the coming years. The below discussion provides an approach to estimating the price of crude oil in the long term.
Three questions are relevant here:
- What would be the extent of the impact on the demand for crude oil?
- How soon could we expect widespread adoption of EVs?
- How will crude price be determined in the new demand scenario?
1. What would be the extent of the impact on the demand for crude?
Profound, no doubt. Over half (65-70%) of a barrel of crude oil produces fuel for transportation. An additional 12% produces jet fuel which enjoys entrenched demand since aircrafts aren't going electric (not yet), so not relevant for now.
Burning oil to generate electricity for EVs entails high economic and environmental costs, so it’s unlikely to be used for that purpose unless some new groundbreaking technology makes it viable, à la petcoke gasification. For now, it is reasonable to assume that rising popularity of EVs will drive down the demand for crude oil in favor of other sources of energy.
As a side note, in addition to EVs, the rising popularity of uberPOOL-styled ride sharing will reduce vehicular movement per passenger thereby lower energy usage for transportation and, in turn, further lower the demand for crude oil.
2. How soon could we expect widespread adoption of EVs?
For EVs to become mainstream, the following has to happen:
- EVs will need to achieve cost parity with Internal Combustion Engine (ICE) vehicles measured as the Total Cost of Ownership (TCO) to the consumer.
- The necessary ecosystem will need to be in place.
Research suggest that EVs could achieve cost parity in a few years. However, most research consider static prices of crude oil and electricity. Similarly, they also consider static prices of the commodities which are going to be used heavily in EVs, but not very much otherwise, cobalt for instance. In doing so, they overlook the dynamic nature of the cost equilibrium.
Increasing EV popularity would put a downward pressure on the price of crude oil making it harder for EVs to match the cost of ICE vehicles. EV popularity will also put an upward thrust on the prices of other sources of energy and those of the commodities used heavily in EVs, thereby slowing down the fall in the total cost of EVs and in turn make it even harder for EVs to match the cost of ICE vehicles. Both the above would push cost parity further down in the future. By overlooking the dynamic nature of the cost equilibrium, most research underestimate the time required for EVs to match ICE vehicles in cost.
The necessary ecosystem includes power generation, power transmission and battery charging infrastructure besides development of regulations and industry standards, among other things. Power generation and transmission capacities differ by geography and could become potential bottlenecks. EVs will need much less servicing and changing of parts than ICE vehicles because EVs have fewer moving parts and hence suffer from less wear-and-tear. The after-market for EVs is going to be largely confined to battery replacement. So it wouldn't be hard for existing garages to cater to EV clientele.
3. How will crude price be determined in the new demand scenario?
The projection that EVs will cause a dramatic fall in the demand for crude oil is often followed by a simplistic projection that such a dramatic fall in demand will lead to crude price hitting rock bottom. Not necessarily. Let us take a closer look.
As of now, the total cost of an EV is higher than that of an ICE vehicle. But once EVs and ICE vehicles reach cost parity, then, at equilibrium, such price of crude oil that will just maintain the cost parity will act as the ceiling price for crude oil, provided the price is high enough to incentivize crude production with volumes matching the demand. Any change in technology for either EV or ICE vehicles could shift the equilibrium though.
The following chart highlights this important theory. As you can see, after EVs start to become cost-effective, oil price is determined by maintaining the cost parity. Of course the price should be higher than the cost of production.
Any shift in the equilibrium price should translate into the price of crude oil quickly, that is, the transition to the new equilibrium price should be quick. This is because much crude oil is produced from onshore near-surface oil fields which enjoy high operating flexibility. It means that a producer can switch the oil well pump on or off with ease in just a short while.
My own sense is that, even after EV technologies attain a fair deal of maturity, the total cost of ownership to the consumer will be high enough that crude oil will not hit rock bottom.
In the nearer term, a tug of war between Saudi Arabia and China will be a key determinant of the price of crude oil. Saudi Arabia is preparing to offer 5% of the equity of Aramco via an IPO at a hoped valuation of $2 trillion. The IPO could be floated in 2018.
Now, there are a number of challenges to taking Aramco public:
- Floating the IPO in Tadawul (Saudi stock exchange) could deter many foreign investors. Smaller investor base will result in lower demand for the stock and potentially lower valuation than hoped.
- Floating the IPO in London or New York might be perceived as selling the family silver.
- Investors will not like the way Aramco is run and the way Riyadh uses Aramco for state interests. Some examples - Aramco pays 85% tax, Aramco doles out natural gas to Saudi utilities for very low price or sometimes even for free, and it is controlled by the royal family.
Meanwhile, a consortium of Chinese state-owned oil companies has offered to buy 5% of Aramco straight up, which would obviate the need for the IPO.
Obviously, Saudi will want oil price to remain elevated to support Aramco valuation until its IPO concludes. It could do that by controlling exports. There is evidence that it is already doing that. Check here and here.
On the other hand, China will want oil to trade cheap so it could negotiate a favorable Aramco deal with Saudi. But what lever could China pull to influence oil price? China is known to be shoring up its Strategic Petroleum Reserves (SPR) as well as commercial inventories. China has been voraciously importing crude oil for over a year even as refiners, facing subdued demand, remained awash with oil. Such stockpile could be wound down at opportune moments to check any surge in the price of crude oil, thereby, protecting China's prospects on the Aramco negotiation table.
To reiterate, this tug of war between Saudi Arabia and China will prove to be the most important determinant of crude prices in the short term. China might slow down stockpiling at high price levels, possibly above $60 a barrel for Brent crude.
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