WoodMac: Upstream oil and gas face peak uncertainty amid record cash flows

At current oil prices, the upstream industry will generate cash, but it also is facing peak uncertainty as crucial decisions will be required on capital allocation, the pace of decarbonization, and future energy policy, according to Wood Mackenzie.

Issues facing the industry, including: the industry’s use of an incoming $1 trillion price windfall, whether Asian governments should do more to resuscitate declining gas production, and the future of exploration in the region were addressed at the firm’s Global Energy Summit Upstream Focus Day.

In previous upcycles, higher revenues and cashflow led to rising upstream spend, Wood Mackenzie said. But the energy transition has upset the outlook for oil and gas producers, changing the rules for not only international oil companies (IOCs), but also national operators and host governments, it continued.

“At current Brent prices the upstream industry will generate a wall of cash,” research director Kavita Jadhav said. “We estimate the 42 largest IOCs will generate a windfall of over $1 trillion if prices keep tracking above a $50/bbl industry planning price. But how to invest this bounty? A $80/bbl oil price gives companies options, and a chance to do it all – return cash to shareholders, maintain oil and gas investment, and accelerate investment in low carbon opportunities. The current upcycle presents a golden opportunity to reposition for a very different future.”

The energy transition has created unprecedented uncertainty over long-term oil and gas demand, changing stakeholder expectations and company strategies, Wood Mackenzie said, and creating a business model that is both resilient and sustainable is the challenge. 

One dilemma is creating an upstream business that is profitable but also decarbonizing. “Carbon now represents an existential threat,” Jadhav added. “The value at risk from just Scope 1 and 2 exposures of the world’s top IOCs is huge.” 

Under a $150/tonne carbon price, the world’s 38 largest IOCs would drop $465 billion in value, or 27% of their total value, Wood Mackenzie estimated. 

A temporary windfall, alongside higher global oil and gas prices, also raises important questions for governments across Asia. Falling domestic gas production increases exposure to international LNG markets and pricing. Spot LNG prices in Asia have more than quadrupled over the last few months to over $30/MMbtu. As security of supply concerns reverberate around the globe, should Asian governments be doing more to resuscitate declining gas production? 

“It may seem counter-intuitive and unpopular to talk about incentives for upstream investment at a time when IOCs are set for record profits, but a declining share of that upstream spend is being invested in Asia,” research director Angus Rodger said.

The current shortfall between Asian gas production and demand is nearly 5 million boe/d. With production on a downward trajectory and demand looking robust – due to both coal-to-gas switching and the need to back up intermittent renewables capacity - that gap looks set to hit 17 million boe/d by 2040, Wood Mackenzie said. 

This means Asia will continue to be the engine room for rising global LNG demand over the next 2 decades. While good for LNG producers, it will increase domestic governments’ exposure to global price swings and supply risks, Wood Mackenzie continued.

“But Asia isn’t gas resource short,” Rodger said. “Across Asia Pacific over 90 billion boe of resources is currently considered commercial and is currently onstream or under development. Another 47 billion boe is currently discovered but uncommercial. We have significant resources that are stranded due to high carbon footprints or unattractive fiscal terms.” 

The same challenges apply to the current suite of pre-FID gas projects across the region. Many have high levels of CO2 content, challenging economics, long lead-times and often a substantial history of delays and false starts. Other barriers to progress include above ground risks and relatively high government take.

“The world, and Asia in particular, may not be short of resources,” research director Andrew Harwood said. “But what it needs is advantaged barrels - low cost, low carbon oil and gas that can be rapidly commercialized. That is why it is crucial we continue to explore in Asia to find more of those advantaged barrels.”

Asia Pacific is well-positioned, with ample infrastructure giving rapid, low-cost access to hungry gas markets, Wood Mackenzie said. “And it can be done. Of the 32 billion boe that has been discovered with the drillbit across Asia Pacific over the last decade, a quarter is already onstream,” Harwood added. “Much of these resources, such as large shale and tight gas discoveries in onshore China, were enabled by ready access to major pipelines combined with government incentives.” 

One of the key questions debated at the upstream summit is the importance of the right fiscal terms. With a dearth of ongoing exploration activity, and a suite of large pre-FID gas projects that are urgently required to enhance domestic supply but are struggling to progress, governments need to rethink how to incentivize new investment, production and decarbonization.

“Because there is no guarantee that higher prices will lead to high levels of upstream reinvestment, as we have traditionally seen in the past, Asian governments need to compete more for international investment,” Rodger said. “The key is deciding what you want your fiscal policies to achieve – to harvest the remaining upstream value, incentivize new investment, or expedite the transition to renewables?”

The first tentative steps are already being made. For example, Australia is pushing forward with carbon capture and storage (CCS) regulation and accreditation, while this week Indonesia’s House of Representatives agreed on a carbon tax tariff of about $2.10/tonne of carbon dioxide equivalent (CO2e). But do these policies go far enough to move countries closer to their end goals, Wood Mackenzie asked.

Governments need to create adaptable fiscal systems that can evolve and support these new forms of investment. Rodger said: “It is crucial that fiscal terms complement and support the energy goals of each nation. The fiscal structures of previous decades are likely no longer fit for purpose in a world experiencing an accelerating energy transition.

“At the same time the upstream industry needs to work harder to communicate to regulators that upstream decarbonization at scale is not just an added cost. For many IOCS it is now joined at the hip to all other forms of upstream investment. If the decarbonization spend cannot be enabled, then the whole investment machine will grind to a halt.”