OIL no Longer the Evergreen Asset Class: Has the Oil Demand Peaked.

OIL no Longer the Evergreen Asset Class: Has the Oil Demand Peaked.

Timing is everything when it comes to investing in commodities. In 2014, oil was considered one of the safest bets. The reasoning among big financial investors was straightforward. Regulation and technology might crimp demand in the industrialized west, but as more of the developing world’s poor moved into the middle class, oil demand and prices would remain strong. Skip forward to 2016, and many analysts, including those in strategic planning departments of big oil groups, are starting to warm to the idea of peak oil demand globally, not just in the OECD.

In part the exercise has been driven by shareholders and activists who say the companies are ignoring the risks to their business from a global climate accord. A number of organisations, notably the International Energy Agency but including oil companies such as Statoil, Shell, BP, Total and Conoco Phillips, are modelling outcomes based on a breakthrough in battery technology or that global temperatures rise by no more than 2 degrees Celsius.

These scenarios include rising solar energy and natural gas use, cheaper car batteries, urbanization supported by millennial ride sharing and public transport, and advanced, digital energy-saving technologies. Many of the studies project a fall in oil demand to 75m barrels per day by 2040, from about 95m b/d today.

After testing for oil demand sensitivities and found that a combination of factors; slower than expected growth in the developing world, improved logistics, advances in vehicle efficiency could, perhaps with a push from policy, see demand for oil peak, at least for a decade or two.

The implications are bigger than they might seem given the number of ifs that surround the idea that oil demand could peak. For the past three decades, investors have assumed that oil under the ground today will be more valuable in the future. That has led them to seek companies best positioned to deliver growth. But if the rise in oil demand is uncertain, all bets might be off. That means investors do not simply want exposure to crude. They will need to select a management team that is nimble, no matter whether demand rises, falls or remains flat.

Moreover, in a more competitive world where producers might have fewer opportunities to sell its product, all investable oil assets will not be equal. Investors will have to know what the production cost basis is for a company’s reserves or how well positioned their refinery network is to beat global competitors. Location of assets will matter. Owning a refining and marketing network in California, or Germany, where demand will almost certainly fall off, might be less attractive than in India or Malaysia.

The use of automation and other emerging technologies to drive returns will matter. Technology advancements had lowered the company’s production costs excluding taxes to $2.25 a barrel for horizontal, low enough to compete with Saudi Arabia. By contrast, operating costs in Canada’s oil sands are estimated at $37 a barrel.

For 30 years, the industry has operated under the principle that it will have difficulty meeting demand. Against that backdrop, adding reserves to the balance sheet was an end unto itself, sometimes more important to management than if those reserves could be profitably produced.

The thesis was that oil would become increasingly scarce as easy to reach reserves were depleted; the value of booked, warehoused reserves would appreciate with global prices and a day would come when even ridiculously expensive assets would be profitable to produce.

But if oil demand declines before those expensive reserves are needed, mindlessly booking reserves is not a strategy Wall Street will want to reward. Investors might ask more critically what a company’s revenues outlook will be this quarter or next, like most other ventures. Understanding which companies can pivot best to new realities will be key to smart investing in oil.

All investable oil assets will not be equal in a more competitive world.

-     -   Farzan Ghadially