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IPE special report May 2018

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Global Energy: Something new under the sun

An overview of the global energy sector shows the world’s relationship with energy is being transformed, writes Carlo Svaluto Moreolo

At a glance

• The global energy mix is changing, reflecting developments in China and the OECD.
• Movements in the oil price are not necessarily correlated with investment in other sources of energy. 
• The world needs more energy in the future, but the correlation between GDP, energy and emissions seems broken. 
• The rise of emerging markets poses additional challenges to global energy.

The pace of change in the global energy sector is accelerating. As the 2015 World Energy Outlook (WEO) of the International Energy Agency (IEA) stated, “signs of change in global energy have multiplied”. The report was published in November last year but, since then, those signs have not waned.

The unprecedented situation in the global energy market is, of course, the sharp decline in oil prices. The price of Brent Crude collapsed from a high of $115 (€101) in mid 2014 to $28 earlier this year (figure 1). 

As Mark Lacey, manager of Schroder’s Global Energy fund, explains, this is one of the most significant decline in 32 last years. None of the previous declines (1986, 1992, 1997, 2000 and 2008) matched the one we have just witnessed, both in terms of the length and the extent of capital expenditure cuts (figure 2).

Two historical shifts caused this unparalleled decline: the ‘shale revolution’ in the US and the record low-interest-rate environment. The profitability of extracting oil and gas from shale formations has increased substantially over the past years thanks to technological improvements. This led to the oversupply of oil on the global market that sent prices tumbling. 

But the level of excess oil supply would perhaps have been more muted had interest rates not been so low. Rock-bottom rates have likely contributed to over-investment in the oil and gas sector, particularly in the US.

The slowdown of the Chinese economy is also seen as partly responsible for the decline in oil prices in 2014. According to BP’s 2015 Statistical Review of World Energy, China’s energy consumption growth rate slowed to just 2.6% in 2014, less than half of the average growth over the previous 10 years (6.6%) and the weakest rate of growth since the late 1990s. 

“The oil price collapse was good news from certain struggling economies, namely Europe, which is benefiting from lower import prices. However, the collapse has destroyed value in much of the oil and gas sector, as well as in many emerging market economies”

The oil price collapse was good news for certain struggling economies, namely Europe, which is benefiting from lower import prices. However, the collapse has destroyed value in much of the oil and gas sector, as well as in many emerging market economies. 

Oil powers through

More importantly, the price collapse has led many to question the conventional wisdom about oil economics. After all, it is reasonable to ask how the world would change if oil production remained significantly less profitable than historical levels. Would demand strength eventually bring the oil price back to its mean, or will a low price spur investment in other sources of energy?

Crude Oil (NYMEX)

The answer is perhaps less complex than it seems. As Lacey points out, around 65% of oil produced globally goes towards transportation. “Oil is essentially a transportation-focused fuel,” he adds. In fact, demand for oil has been particularly resilient – Lacey says last year it grew by 1.8m barrels of oil per day (b/d), one of the strongest figures on record. And there is plenty of empirical evidence that when gasoline prices are lower, people tend to drive more. 

Oil price recessions

So the slowdown in China, a large oil importer, should not be seen as a huge problem for global oil producers. During the past decades, the country’s net imports of crude were driven by the huge industrialisation process, which required diesel for power generation and goods transportation. 

But today, Chinese crude imports are being driven by consumption of gasoline. Lacey reckons 2.4m car units a month are currently being sold in China. This is a huge figure if compared with the 300,000 units sold in 2005, but still very small if compared with other parts of the world, which implies a massive growth potential. Vehicle penetration is still relatively low in China compared to Europe – and China’s population is almost three times that of Europe. 

More importantly, other countries promise to drive global growth in oil consumption. Lacey points out that vehicle penetration is increasing in India, opening a potentially huge demand source: “India is potentially the next China,” he says (figures 3 & 4). Therefore, once inventories in the oil industry start declining, we could see the oil price back up towards levels that make investing in oil fields profitable again. Lacey believes this will happen during the second half of the year and into 2017.  

China rebalances

There are at least three other structural trends driving change in the world’s relationship with energy.

The rebalancing act taking place in China is one, and the country’s plan to move to a less energy-intensive economy has serious implications for the energy sector. British oil giant BP, in its 2016 Energy Outlook, estimates that from 2014 to 2035, China’s energy intensity will decline by 46%. This is a structural trend that energy must investors keep firmly in mind. 

But as Spencer Dale, group chief economist of BP, said at the launch of the company’s Statistical Review in June last year, “although the slowdown in China’s energy growth is striking, the implied reduction in energy intensity – ie, the reduction in the average amount of energy needed to produce each unit of GDP – was not particularly exceptional relative to that seen over the past 20 years or so.” 

In other words, it is only natural that as the Chinese economy grows and rebalances, it will become less energy-intensive. In 2015, total energy demand from China was up 0.9% compared to the previous year, according to news agency Xinhua, while the forecast for 2016 is of slightly better growth.

And the fact that the country is becoming less energy-intensive does not mean that China will consume less energy in the near future. BP reckons that by 2035, the country’s energy consumption will have grown by 48%.  

The impact of China’s energy demand rebalancing is mostly seen on coal and natural gas. According to the company, the share of coal consumption in China will be 47% of the total energy mix in 2035, down from 66% in 2014. The share of natural gas will more than double to 11%, while oil will be stable at 19%.

This will translate into a 193% jump in demand for gas in the period, while demand for oil will grow by 63%, and coal by a mere 5%. Fossil fuels will, however, account for just over half of energy demand growth. The highest growing demand will be for nuclear (+827%), followed by renewables (+593%) and hydro (43%).

A changing composition

Along with the energy needs of China, global energy demand will also grow. The pace of growth will be reasonable, at 1.4% per year, but slower than in the 15 years (2.3% per year), according to BP’s 2016 energy outlook. By 2035, global energy consumption will have increased by 34%. 

India’s primary energy demand by fuel

And the energy mix will mostly reflect what is happening in China. The world’s reliance on fossil fuels, and on coal in particular, will decline. Gas will gradually take its place, and non fossil fuels, particularly nuclear power, will increase their weight in the energy mix. 

Over the 2014-2035 period, according to BP, fossil fuels will provide 60% of the additional energy. At the end of the period, 80% of total energy supplies will come from fossil fuels. This compares to 86% in 2014.

The IEA forecasts that, if the pledges made at the COP21 meeting in Paris in November last year are met, the share of non-fossil fuels in energy generation will expand from the current 19% to 25% in 2040.

“Fossil fuels remain the dominant form of energy powering the global expansion”, says BP’s 2016 Energy Outlook. 

The data does not make particularly good reading from an environmental point of view. The IEA recognises that “more is needed to avoid the worse effects of climate change”, and that at the current pace the objective of limiting global warming to 2˚C degrees is out of reach.  

But both the IEA and BP also recognise that “the direction of travel is changing”, as signalled by the decoupling of GDP and emissions. Emissions continue to rise, but at a slower pace, largely due the growing role of non-fossil fuels in global power generation. 

Decoupling

In fact, perhaps the most striking sign of change in the world’s relationship with energy is the decoupling of economic growth and carbon dioxide emissions (CO2 ). In March, the IEA confirmed what it had already highlighted in its 2015 WEO that global energy-related CO2 emissions had stayed flat in 2015, for the second year in a row, at around 32bn tonnes, with global GDP growing 3.4% in 2014 and 3.1% in 2015. 

“Two historical shifts caused this unparalleled  [oil price] decline: the ‘shale revolution’ in the US and the record low-interest-rate environment. The profitability of extracting oil and gas from shale formations has increased substantially over the past years thanks to technological improvements. This led to the oversupply of oil on the global market that sent prices tumbling”

The only other four cases where CO2 emissions were flat in the past 30 years were in the early 1980s, 1992 and 2009. These were all periods of global economic weakness. 

The two largest emitters of CO2 led the reduction. According to the IEA, China and the US both registered a decline in emissions of 1.5% and 2% respectively in 2015. 

In China, this was driven by the government’s explicit efforts to restructure the country’s economy, by reducing its reliance on energy-intensive industries. In 2014, said the IEA, coal generated 66% of Chinese electricity. While that figure still signifies a huge role for coal, it is ten percentage points less than in 2011, and it is forecast to decline further. 

Since 2011, the share of low-carbon energy supply in China, particularly hydro and wind power, has jumped from 19% to 28% of total generation, according to the IEA. Meanwhile, the US largely switched from coal to natural gas in power generation.

Third, energy efficiency is increasing significantly, thanks largely to a political push around the world. Europe is the chief example. Thierry Bros, a senior analyst with Société Générale, argues that the European Commission has been particularly successful at implementing energy efficiency across the continent. 

Higher energy efficiency in Europe, in turn, drives down demand. It also alters the secular correlation between GDP growth and the growth of energy demand. “Energy efficiency is a huge reality in Europe, and it alters the whole global picture. There is a political will behind it and we believe this will not stop”, says Bros.

In fact, according to BP, virtually all the growth in energy demand to 2035 will be generated by emerging economies. Demand from OECD countries will barely grow at all.

But the increasing demand for energy-efficient technology puts into perspective the developments in the electric vehicle (EV) market. The production of efficient internal combustion engine cars has a serious impact on demand for EVs. 

Schroder’s Lacey notes that, even with the most optimistic assumptions, EV sales will not result in a huge shock for the oil market. 

Total EV sales were about 485,000 units globally in 2015. Analysts estimate that EV sales could rise to 9m units in 2025, which equates to 234,000 b/d of lost oil demand, in a market approaching or greater than 100m barrels per day.

The picture could change by 2035, assuming continued exponential growth of EV sales. By then, all vehicles sold could be electric ones, equating to 2.6m b/d of lost demand. 

But we must consider physical constraints on the production of cobalt and lithium and the actual availability of suitable charging infrastructure and grid capacity. In short, electric cars need electricity. Lacey acknowledges that the developments in the EV market are a major uncertainty in the long-terms outlook for oil demand. 

Politics and markets

What perhaps is not going to change is the balance between political and economic factors that shape the energy sector. The global energy efficiency and environmental agendas, which are largely politically motivated, will continue to dominate the picture. The results can already be seen in the changing global composition of energy consumption and production. This is true both from a geographical perspective and from an energy source one.

But that is not to say that market forces will decline in importance. Among the most powerful ones are undoubtedly technological change and the rise of the Indian economy. The first will essentially dictate the pace of development of ‘unconventional’ forms of energy into the global mix, including renewable power. 

The second may counterbalance that process. According to the IEA, “India is set to contribute more than any other country to the rise in global energy demand over the next 25 years”. A speedy growth of the country’s energy sector may put more emphasis on more traditional sources of energy, including coal.

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