The oil industry revolution will not be televised

Some of these describe changes that will occur within the industry, such as the use of big data or the exploitation of shale resources, but others argue that external forces—primarily climate-change policies and advancing electric vehicle technology—could have an impact on demand not unlike the switch from kerosene lamps to electric light bulbs. The external forces are clearly the most threatening to the industry, since they imply serious pressure on demand regardless of the industry’s actions.

This article will address, first, the repeated tendency to predict revolutionary upheaval in the petroleum industry; next, the likely impact of climate-change policies; then, expectations for electric vehicles to cause peak oil demand; and finally, the real changes that have occurred—or not—for the industry environment.

The end of days

The frequency with which energy industry revolutions have been predicted—and with great confidence—in the past serves as a cautionary tale. Sometimes, this reflects expectations of decline in the old, mature business sectors, such as natural resource production. Other times, threats to the business from new technologies are cited. And some believe that the industry’s structure needs to be transformed. Most have not proved out.

The end of oil has been predicted since the early years of the industry, but since the first oil crisis, even high-ranking industry executives have sometimes embraced the argument. In 1977, Rawleigh Warner, chief executive officer of Mobil Corp., said, “The oil business has come to maturity, and with this maturity comes a new set of challenges…oil companies have no other choice. They must diversify or go the way of the buggy-whip makers.”6 Two decades later, ARCO Chief Executive Officer Mike Bowlin said, “We’ve embarked on the beginning of the Last Days of the Age of Oil.”7 It is noteworthy that neither company still exists, while competitors have thrived.

The fad for predicting upheaval, revolution, and transformation is common in many industries, but there is usually much more smoke than fire. The idea of revolution is much more exciting than business-as-usual and so is guaranteed to get more attention in the media. Nobody pays to hear a talk entitled “Next year same as it ever was” when they could listen to a whiz-bang speech on the exciting future that’s just ahead. Brain Blum describes industry newcomer Shai Agassi with little more than a trial balloon drawing hordes at a conference, while Daniel Yergin, a prominent consultant, was ignored.8

That tendency was definitely on display with the adoration of Enron Corp.’s supposed management revolution. During the late 1990s, the idea of a “virtual corporation” was promoted by Enron’s leaders, such as Jeff Skilling, who said, “If you’re stuck with a whole bunch of concrete that you can’t move, you’re in trouble. …We have a marketplace now that can provide virtual integration, getting all those components quicker and cheaper. These big companies will topple over from their own weight.”9 Yet when Enron went bankrupt shortly thereafter, it was the “bunch of concrete” that brought in revenue, not the less-tangible pioneering concepts.

Other strategies, such as breaking up vertically integrated oil corporations or privatizing national oil companies, have been popular at different times and implemented sporadically with a mixed degree of success. Mergers and acquisitions have repeatedly changed the face of the industry, but at heart, it remains one of producing, transporting, refining, and marketing oil and gas, espresso machines in service stations notwithstanding. Oil companies might have executives with expertise in convenience store management, but chief executive officers are usually from the oil field and refinery ends of the business.

As an example, the current buzzword “datamining” has become the flavor of the month on Wall Street (and in Silicon Valley), but the relevance to the petroleum industry seems more limited, since they have long been data-intensive. Linear-programming models in the mid-twentieth century optimized refinery operations, and from the early 1990s, 3D seismic has improved the search for resources. Oil companies were amongst the prime customers for supercomputers, in fact.

Microscopic analysis of consumers is important in some fields, but far less in commodity production. Despite the best efforts of oil companies, few consumers exhibit loyalty to gasoline brands.

No one (currently) comparison shops at gasoline stations and then orders fuel online, and if it becomes possible to do so, the impact would be on the retail sector, which the oil majors have largely abandoned. Wholesale operations should be unaffected by the new retail economy.

And given that natural gas in North America is a free market, consumers have no incentive to bargain shop; in the rest of the world, deals are between a few producers and consumers. There is no Amazon for LNG, and although the spot market is finally growing, the major players will never be more than a few score: your neighbor might sell scarves on Ebay, but not LNG.

Which is not to say that internet technology is not having an effect on the industry. The impact of the internet (and now virtual reality) has not been as revolutionary on oil demand as some originally predicted. Certainly, the evolving retail sector could depress gasoline consumption, and a drop in travel is quite possible, and the data seemed to support it, as Fig. 1 shows. Vehicle miles traveled and airline passenger miles have not declined (excepting during the 2008 recession), but the growth rate has slowed appreciably in recent years. Virtual reality could accelerate that trend.

The climate-change policy threat

The public concerns about climate change need to be taken very seriously, but the likely impact over the next decade on oil and gas appears questionable. Various reports point out that urgent action would seem to be dictated by international agreement; the Potsdam Institute for Climate Impact Research noted: “In the landmark Paris Climate Agreement, the world’s nations have committed to ‘holding the increase in the global average temperature to well below 2°C. above preindustrial levels…but realistically only if global emissions peak by the year 2020 at the latest.’”10

But remember that the industrial nations agreed in Kyoto to a Protocol whose targets were only met halfway, despite widespread enthusiasm at the time of the signing. Similarly, some countries, like Germany, which have taken aggressive political stances on climate change have actually increased greenhouse gas emissions due to a decision to close nuclear power plants, while a number of nations also have sharply reduced their financial support for wind and solar power, reducing investment noticeably. Indeed, while China is praised for its environmental stance, it continues to build a large number of coal-fired power plants, which are one of the major GHG emitters.

So, the impact on the petroleum sector of aggressive climate-change policies shouldn’t be exaggerated, in part because gas producers should benefit. Substitution of gas for coal in power stations has proved not only economically profitable in the US but is one of the largest sources of reductions in GHG emissions. And gas turbines are still more widely used to provide backup power for intermittent renewable energy.

The threat to transportation fuels receives much of the attention because the automotive sector touches most consumers directly, but most of the suggested GHG reductions come from sources other than transportation: only 18% of needed GHG reductions by 2050 to meet the 2° target, according to International Energy Agency.11

Further, the cost of GHG reductions through switching to battery electric vehicles is about ten times that of nearly every other approach. McKinsey developed a cost curve for carbon dioxide reductions that ranges from savings of €150/ton of CO2 equivalent to a cost of €60/ton,12 while subsidies for battery electric vehicles are estimated at 4-8 times the highest level on the McKinsey curve.13 Even the optimistic cost projections for lithium-ion batteries will not solve this problem.

It is always difficult to predict government policies in the long run, and perhaps foolish to suggest they will be economically rational rather than polemical, but indications now are that oil demand is not near a peak and certainly unlikely to decline sharply in coming years as the result of aggressive climate-change policies aimed at the transportation sector.

Demand destruction through technology

The petroleum industry has been through at least two major periods of significant demand destruction, when kerosene demand dropped in the late 19th century, and the 1970s and 1980s, when global residual oil demand dropped as large-scale fuel switching occurred. Is it possible that transportation fuels, which absorb about two thirds of the global barrel, could shrink enough to make a difference to the industry in the near future?

Again, advocates of a given fuel or technology are always quick to argue that they are on the verge of a breakout, and that it will result in mass upheaval in the related industries. One consulting group argues that the advent of autonomous unmanned vehicles (AUVs), largely electric, will have a major impact within a few years, saying “We are on the cusp of one of the fastest, deepest, most consequential disruptions of transportation in history.”14 This will mean “[t]he impact of the collapse of oil prices throughout the oil industry value chain will be felt as soon as 2021.”15

Which might sound threatening except for the frequency of previous such warnings. For example, two prominent efficiency experts insisted in 2004, “New manufacturing and design methods can also make these radically more efficient vehicles cost-competitive and uncompromised, as illustrated by a 2.38-l.-equivalent/100-km midsize sport utility concept car designed in 2000 by Hypercar Inc.”16 (80 mpg) Few aspects of that design have been adopted by the industry, nor has the public embraced expensive, efficient vehicles outside of niche markets.

Fig. 2 shows various projections of the adoption rate of electric vehicles, ranging from gradual to rapid, with the large oil companies typically the most conservative. However, given that the industry is still in its infancy, all such forecasts are highly speculative and there are three reasons to be skeptical.

The first stems from the sharp drop in sales in markets where subsidies were removed, including in Denmark, Hong Kong, and Georgia; many consumers still show a strong preference for size and power rather than reduced emissions when purchasing vehicles. Second, battery electric vehicles are in many ways much less functional than ICE vehicles, as range is both constrained and highly uncertain, and recharging remains seriously inconvenient. Finally, while battery costs have dropped sharply and performance has improved, the industry has already achieved economies of scale, meaning progress should be slower in the future. All in all, skepticism about the adoption rate of battery electric vehicles seems warranted.

Historically, adoption of large consumer products has not been as rapid as many think electric vehicles will be. Classic case in point, the diesel engine, developed for railroad locomotives, had huge advantages over the steam engine, including much lower maintenance costs and obviating the need to refill water tanks. Yet while steam engines are nearly gone from the railroad industry, the process took decades, as Fig. 3 shows. (First diesel locomotive design was made during World War I, but the first commercial product was introduced in 1937.17)

Ultimately, it appears as if commodity producers like oil companies are much less vulnerable to technological change than are other economic sectors. Shifts in retail operations have meant little for producers of consumer goods, and this doesn’t appear likely to change.

Real changes

The balance of power between resource owning governments and production companies remains an important factor in the health of the industry, but one poorly understood. Although many in the private sector decry lack of access to petroleum resources and resource nationalism more generally, the truth is that the tectonic shift was in the 1970s, when the large Middle East producers nationalized their foreign operators.

Since then, resource nationalism has cycled back and forth, with a benign environment for explorationists in the 1990s, a reversal in the 2000s, and now, apparently a return to a more business-friendly situation. This demonstrates that resource nationalism tends to move counter to oil prices: low oil prices mean a “buyers’” market (for exploration and production companies), and governments must accommodate them to earn higher production and revenue, while high oil prices allow governments to be less concerned about making businesses welcome, squeezing their earnings and only hesitantly allowing access.

The failure of the Chavista Revolution in Venezuela has gone a long way towards changing governments’ attitudes towards government interference in the private sector, but the potential election of Lopez Obrador in Mexico could slow that process. Should recent reforms in Mexico prove successful, and to be later emulated by Venezuela, more supply will keep pressure on prices and other producers. This, combined with likely expansion in Iran and Iraq, will mean that the higher cost projects will remain less attractive.

The shale revolution

Without a doubt, shale operations are different from many other upstream developments. The most expensive shale well rarely exceeds $10 million in cost, while even a small offshore development can be ten times that, and deepwater fields are $1 billion and more. This has allowed many small players to prosper, especially in the more open regulatory environment of the US.

Of course, there are still economies of scale to be had, partly by sharing infrastructure (pipelines, etc.) but also by being able to move rigs from one location to another nearby with ease. This helps to explain why some of the smallest players have failed and are being bought up by larger companies, although the early shale mania resulted in heavy debt burdens that were largely responsible for the recent bankruptcies. Still, the growth of shale resembles the rise of the independent companies in Africa in the 1960s challenging the big gulf producers, or the attractiveness of gas turbine power plants compared to massive nuclear installations.

The big oil companies (in which I would include independents like Hess Corp. and ConocoPhillips) have disadvantages when it comes to shale production. Small companies can quickly test numerous production methods without waiting for committees either to approve or evaluate them afterwards. Innovation of this type is traditionally easier for small shops than massive organizations. Of course, many small producers got into financial trouble for throwing money into shale areas without adequate study.

But the primary innovation has now been accomplished; experimenting in new shale basins now resembles tinkering more than invention, arguably. Which means the advantage for a small firm has declined, at least in that regard. The majors can offset with economies of scale the advantages of a nimble competitor, although expect new basins to be the primary target of the small wildcatters, including those overseas.

And majors still have significant advantages over small firms, especially in the form of deep pockets, as the many bankruptcies after the 2014 price drop showed. Large companies had the capital and assets to allow them to survive a major drop in revenue, but also the diversification that helped them cope with varying prospects in, for example, US shale gas basins compared with deepwater oil production. In many ways, the history of the petroleum industry is one of tension between the nimbler small companies and the larger, more robust majors and there is little to suggest that will be changing.

Survival of the fittest

It is amusing to see groups like CarbonTracker argue that expensive petroleum projects are unattractive because of climate-change policies, instead of because of their poor financials. The impact of possible carbon taxes on Canadian oil sands projects is drastically outweighed by the higher costs due to their remote nature and the lower quality of the crude produced, as witness by the fact that they continue to expand, albeit more slowly since prices fell.

The lower production costs of most Middle Eastern oil will always be a major challenge for the oil industry, and probably more so if climate-change policies cause demand growth to slow, a lengthy recession occurs and Gulf countries pursue expansionist production policies.

The ultimate approach for a large petroleum company (as with many industries) is to remain openminded about the future, and flexible in response to potential market changes, whether driven by politics, economics, or technology. Evaluating different scenarios can be very valuable but becoming committed to one possible future path is roughly the equivalent of concentrating all your company’s investments in one geographical area. Diversification is one of the oldest lessons in economics and remains a valuable one.

References

1. Kerr, Graham, Dec. 12, 2017, offshore-technology.com. https://www.offshore-technology.com/features/oil-gas-ready-next-industrial-revolution/

2. Butler, Nick, Financial Times https://www.ft.com/content/6c9a9626-ad82-3ca5-854c-424ddd187be2

3. Sattler Casey, August 2017. http://beta.energyintel.com/world-energy-opinion/testing-times-for-exxon/

4. Blasi, Alessandro, July 28, 2017. www.iea.org/newsroom/news/2017/july/commentary-witnessing-the-ongoing-transformation-of-the-oil-and-gas-industry.html?utm_content=buffer57f90

5. Romm, Joseph, Oct. 31, 2016. energypost.eu/electric-car-revolution-may-drive-oil-investor-death-spiral/

6. Rawleigh Warner, “Petroleum Faces Transition Period,” in Petroleum 2000: Oil & Gas Journal, August 1977.

7. www.resilience.org/stories/2007-11-11/opinions-oil-company-executives-peak-oil/

8. Blum, Brian, Totaled: The Billion Dollar Crash of the Startup that Took on Big Auto, Big Oil, and the World,” p. 23.

9. Levy, Adam, “Enron CEO Skilling Takes Company in New Directions,” Bloomberg May 1, 2001. https://www.anderson.ucla.edu/documents/areas/adm/loeb/02g6-3.pdf

10. Rahmstorf, Stefan, and Anders Levermann, “2020: The Climate Turning Point,” p. 3, April 2017.

11. International Energy Agency, Global EV Outlook 2016: Beyond One Million Cars, Paris 2016, p. 7.

12. Deich, Noah, “What the McKinsey GHG Abatement Curve tells us about CDR,” Sept. 4, 2014. www.centerforcarbonremoval.org/blog-posts/2014/09/24/what-the-mckinsey-ghg-abatement-curve-tells-us-about-cdr

13. Belzile, Germain, and Mark Milke, “Are Electric Vehicle Subsidies Efficient?” Montreal Economic Institute, June 2017. Actual costs will depend on the energy mix in the electricity used and the respective costs of petroleum and electricity, but the difference in costs for BEV versus other approaches to GHG reductions is so large that the uncertainty is not very relevant.

14. RethinkX, p. 6, Arbib and Seba, 2017.

15. Ibid., p. 8.

16. Lovins, Amory B., and David R. Cramer, “Hydrogen, Hypercars, and the Automotive Transition,” International Journal of Vehicle Design, Vol. 35, No. 1-2, 2004.

17. https://www.american-rails.com/diesel-locomotives.html

About the author

Michael Lynch is president of Strategic Energy & Economic Research and a distinguished fellow at the Energy Policy Research Foundation in Washington, DC. He has degrees in political science from MIT and worked as a researcher there for roughly 20 years, also serving as chief energy economist at DRI-WEFA (not part of IHS). His publications have appeared in six languages and he has served as president of the US Association for Energy Economics as well as on the editorial boards of many journals, including Oil & Gas Journal.