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Q4 2021 Research Theme: Energy Security & Reliability Are Paramount

Extraordinary Times Demand Extraordinary Measures – Yet Another Wake-Up Call

“Hate to say it, but we need to increase oil & gas output immediately. Extraordinary times demand extraordinary measures.” Not the words of a seasoned oil & gas industry executive, rather those of an outspoken evangelist for the energy transition, Elon Musk.

The unfolding tragedy of Russia’s war on Ukraine and the immediate and substantial impact on commodity prices should provide a stark reminder to politicians worldwide that energy security remains an integral and vital part of their duties to protect their citizens and safeguard their economies.

The popular appeal and thus broad political embrace of the Energy Transition has blinded many Western governments to the ever-present need to ensure the security and reliability of their energy needs.

Nowhere is this more true than Europe which, to quote a recent Bloomberg headline, has ‘sleepwalked into an energy crisis that could last years’. And that was written before Russia’s invasion of Ukraine!

Per our last letter, ‘unless and until energy security and reliability can be assured, there can be no successful global transition toward clean, renewable energy.’ Economist Ed Yardeni went further, bluntly stating that ‘Renewables aren’t ready for primetime.’

In a surprising volte-face, the EU Commission did recently endorse natural gas as a ‘transition fuel’, acknowledging that ‘there is a role for natural gas and nuclear as a means to facilitate the transition toward a predominantly renewable-based future’. Unsurprisingly, this pragmatic viewpoint prompted immediate challenges from environmental groups and Green politicians alike.

However, this EU endorsement of natural gas took place against a backdrop of significant and growing dependence on Russian gas, lower Gazprom gas deliveries to Europe, depleted gas storage and a Russian troop build-up on Ukraine’s eastern border.

Too little, too late – for too long all parties have ignored the ‘Russian Bear on the table’: energy security. European politicians instead focused on long-term GHG emission goals, pursuing a renewables-led energy strategy that deferred any immediate energy security concerns for the allure of long-term energy independence that renewable energy and storage is presumed to deliver.

Sadly, it has taken a European war for energy security to finally become an urgent issue for politicians across Europe and, given Russia’s outsize role in global energy markets, for politicians further afield.

But for all their recent rhetoric, one thing is certain: weaning their economies off Russian energy exports will not prove easy – Russia is the largest exporter of crude oil and refined oil products, the second-largest crude oil exporting country after Saudi Arabia, the largest natural gas-exporting country in the world and the third-largest coal-exporting country after Indonesia and Australia.

Buckle Up - Global Energy Markets Will Remain Tight,

Accompanied By High Pricing & Volatility

The global energy market was already in dire straits prior to this crisis: anemic supply growth is failing to match resurgent post-pandemic demand, global crude and product inventories stand at 8-year lows and OPEC offers little spare productive capacity.

The global economy now faces, according to the IEA, the biggest oil supply shock in decades. The IEA forecasts the potential loss of up to 3 million barrels per day of Russian crude oil and product from global oil markets by mid-year as Western sanctions, both formal and informal, take their toll.

The formal oil sanctions imposed to date are largely symbolic – Russian imports represent just 0.2%, 1.4% and 3.5% of Canada, Australia and USA crude oil and product consumption respectively.

Heavily beholden to Russian energy, the EU cannot afford to formally sanction Russian oil and gas; instead its member countries scramble to expediently diversify energy supplies.

Likewise, since Russia currently meets 20% of the UK’s diesel consumption, the UK has also not imposed sanctions, instead planning to phase out Russian oil and product imports by the end of 2022.

However, many intermediaries – oil traders, banks, insurance firms, shipping firms and refiners – are already ‘self-sanctioning’ for fear of running foul of sanctions or being seen to bankroll a rogue state.

Formal sanctions on Russian oil exports may be few in number and symbolic in scale, but the growing impact of ‘self-sanctioning’ by Western buyers and intermediaries is plain to see.

Urals – Brent Spread, Nov 2021 to date

Urals and other Russian benchmark oil prices have collapsed by more than US$25 per barrel. In normal times, cheap barrels seldom fail to find an end-market. Indeed, EU countries and others such as China are still buying Russian oil, and India’s Russian oil imports could soon triple to 0.5 million barrels per day.

However, the steep discount does indeed suggest a significant ‘buyers’ strike’ is afoot. With limited spare storage capacity, Russia will inevitably have to shut in a broad swathe of crude oil production.

But Russia’s oil production base cannot readily tolerate extended shut-ins. The multitude of pumpjack wells with high water cut will incur permanent reservoir damage if shut in for any prolonged period. Re-establishing oil flow in pipelines at very low temperatures is also not straightforward.

Strategic oil reserves have been tapped in a bid to calm oil prices while Western politicians scour the planet for additional oil supplies. Overtures to Saudi Arabia and the UAE – the only OPEC members with any material spare productive capacity – have thus far been rebuffed.

Iran may possess improved leverage in ongoing multilateral nuclear negotiations, since a deal could see up to 1.3 million barrels per day of Iranian oil ultimately returning to the market. But, even if a nuclear deal can be agreed, there still remain many hurdles to overcome – ensuring compliance prior to lifting sanctions, restoration of facilities and equipment – before material Iranian oil exports could resume.

In a major policy reversal, the US has even held preliminary talks in Caracas, potentially a prelude to the partial lifting of US sanctions on Venezuelan oil exports. However, any Venezuelan oil exports beyond a few hundred-thousand barrels per day will require substantial refurbishment of ageing infrastructure.

One further thing to note, crude oil cargoes are not as fungible as they might seem. With no two crude oils identical, refineries are configured to accept specific blends of crude to meet local demand for each refined product – gasoline, diesel, jet fuel etc. Hence sourcing alternate crude oil supplies at short notice represents not only a logistic challenge but also requires time to redesign and adjust refinery processes.

And let’s not forget gas. With Russia supplying 40% of Europe’s gas needs, Western leaders have been urging Qatar to boost LNG shipments to Europe. However, with contracts yet to be negotiated and investment in additional regassification and storage facilities required, such initiatives will take time to bear fruit.

Political feuds may yet see these initiatives flounder – Venezuela has long supported Russia, Saudi Arabia and Iran are bitter rivals, and Saudi Arabia and the UAE have long sought to isolate Qatar.

But turmoil in energy markets as ever prompts tectonic shifts in global geopolitics – realpolitik in action.

Current market volatility naturally reflects the uncertain outcome of all these supply-side initiatives balanced against the longer-term recessionary impact of high energy prices and the short-term impact of China’s swathe of lockdowns following a recent Covid outbreak.

With a rare consensus, the West, principally Europe, has decided that it must no longer rely on Russian energy. Beyond recent meetings to solicit increased OPEC production, sanctioned or otherwise, politicians on both sides of the Atlantic are calling for their domestic oil and gas producers to increase non-OPEC production. Coming hot on the heels of last year’s COP26 pledges to reduce fossil fuel investments, industry and investors might be forgiven for viewing such entreaties with some skepticism.

Boris Johnson just announced a new energy plan that will grant fresh offshore oil & gas exploration licences and heralded a ‘great national effort’ to wean the UK off Russian fossil fuels, although political pressure saw the 800-million barrel Cambo offshore oilfield project put on ice just last December.

Likewise, President Biden has urged U.S oil companies to boost production, despite his long-stated intention to wean the US off fossil fuels. Energy Secretary Granholm recently told oil executives “We are on a war footing … we need oil and gas production to rise.”

Pending any increased production from Saudi Arabia or the UAE, global oil markets will remain tight for a good while. Any diplomatic breakthrough with Venezuela or Iran will not see additional oil volumes hit the market anytime soon – such talks are more likely intended to jolt OPEC into action.

Even US shale oil production cannot be increased at the turn of a valve – with the DUC inventory overhang drawn down last year, on average it can take up to six months to drill, stimulate and tie-in unconventional wells before oil and gas production can commence.

With a tight oil market and OECD inventories at eight-year lows, elevated oil prices and volatility will persist, whipsawed by heightened geopolitical risks.

How Dependent Is Europe on Russian Oil & Gas Imports?

About half of Russia’s 7.8 mmbopd of crude oil and refined oil product exports go to Europe, in turn representing more than 30% of Europe’s overall oil consumption – hence Europe’s obvious reluctance to formally ban or sanction Russian oil and product imports.

Although excluded from EU sanctions, a growing number of European oil companies and intermediaries are ‘self-sanctioning’, suspending purchases of Russian crude oil and products. However, as mentioned earlier, it takes time to adapt refineries to process alternate crude oil supplies.

Of late, much has been written about Europe’s ‘addiction’ to Russian gas. As the chart below amply illustrates, such statements are no exaggeration.

Russian gas imports underpin almost 40% of Europe’s overall gas demand; 90% of such imports are supplied via pipelines, the rest via marine LNG tankers. Germany and Italy are by far Russia’s largest European gas customers, together importing 75 bcm annually to meet ca. half of their respective gas consumption. Italy is particularly exposed since Russia gas fuels ca. 20% of Italy’s entire energy needs.

Europe’s Dependence on Russian Gas Imports

Europe’s dependence on Russian gas is illustrated by the three-fold spiking of gas prices immediately after the invasion, given the Kremlin’s threats of supply disruption. To make matters worse, Europe had entered winter with gas storage at its lowest level in over a decade, due to a shortfall in Russian gas imports over 2021. European gas pricing actually peaked intraday at more than US$500 per boe!

European Gas Pricing, 2022 to date

This risk premium has since diminished as peace negotiations continue. A relatively mild winter and record LNG imports of late have also fortunately limited further drawdowns. EU gas storage is now 26% full, well below the 5-year seasonal average of 36% but just within the 5-year range.

However, traders remain on edge since there still remains a very real risk that Russia could still restrict gas imports into Europe or inflict damage on gas export trunklines that transit Ukraine.

EU Gas Storage – 2022 vs 5-Year Seasonal Average & Range

Russian gas imports typically underpin the summer replenishment of Europe’s winter-depleted gas inventories, ahead of the next winter season. Hence Europe’s reluctance to impose any immediate gas sanctions on Russia, instead announcing plans to curb such imports by two-thirds by year-end.

However, with over a third of its gas consumption historically supplied via pipelined gas from Russia, Europe will have to invest in additional LNG import/regassification capacity before material substitution of Russian gas imports by LNG cargoes can take place.

For example, with no LNG import facilities, Germany’s vice-chancellor Habeck has warned that next winter’s gas supplies were ‘not yet secured’ against the risk that the Kremlin could turn off the taps.

Europe’s continued dependency on Russian gas presages another volatile year for European gas prices.

‘Self-Help’ – Increased Non-OPEC Upstream Investment

Required To Underpin Energy Security

Global oil and gas markets were already fraught before Russia's invasion of Ukraine.

Supply growth to meet resurgent post-pandemic demand has proved wanting due to numerous contributory factors. Certainly, post-pandemic supply chain and hiring issues continue to slow vital equipment deliveries and field operations. But such factors will inevitably pass.

As discussed in prior letters, the largest contributory factors that continue to stifle non-OPEC supply growth are the industry’s substantial long-term underinvestment in upstream exploration and appraisal, now magnified by the ongoing rotation toward energy-transition related investments by oil majors.

Starved of capital, the scale of discoveries and reserve replacement have collapsed over the last decade. Last year, global oil and gas discoveries hit their lowest level in 75 years, as reported by Rystad Energy.

Global Exploration Success Has Collapsed Over the Last Decade

No international oil major has achieved a 100% aggregate reserve replacement ratio over the last five years i.e. entirely replaced cumulative oil production with freshly acquired or discovered barrels.

Such structural deficits in reserve replacement will not readily right themselves – external environmental pressures on the oil industry are inevitably diverting capital from upstream investment.

BP has actually dropped its oil and natural gas reserves replacement ratio as one of the company's key performance metrics, ‘as it no longer serves as a useful measure of our strategic performance’.

No finer illustration of an oil major charting a strategic route to become an oil minor.

US Shale Output Rising At A Modest, Measured Pace, Still Short of Pre-Covid Levels

US shale oil activity, as measured by horizontal well rig and frac spread count, has steadily increased month by month since the mid-2020 impact of the pandemic across the oilpatch.

However, at just 480 active rigs, the rig count still lies 20% below the pre-Covid level of over 600.

US Shale Oil Rig, Frac Spread Count, Jan 2020 to date

In turn, US shale oil production growth resumed once more from mid-2021 as the flux of fresh production outpaced natural declines.

US Shale Oil Production, 2017 to date

Shale oil production in the core basins – Permian, Eagle Ford, Niobrara, Bakken and Anadarko – stood at 7.7 million barrels per day in January 2022, still shy of the 2019 high of 8.4 million barrels per day.

What is abundantly clear is that, despite high oil pricing, shale oil players are in aggregate exhibiting greater capital discipline in this up-cycle – largely due to investor pressure but also supply chain issues, shortages of skilled employees and rising material costs.

However, US shale oil production is expected to surpass prior peak levels by 3Q22, lifting US light oil exports by up to 0.7 million barrels per day.

Rystad Energy forecasts that, if WTI pricing were to remain around or above US$100 per barrel, a further 1.5 million barrels per day of US tight oil production could be unleashed, resulting in US shale oil production of almost 10 million barrels per day by year-end 2023.

Closing Comments

The imperative for the West to invest in domestic, non-OPEC oil and gas production to strengthen and ensure its own energy security has never been more clear.

The popular embrace of renewable energy sources is laudable, and the energy transition will indeed underpin energy security in the long-term but, right here right now, the global economy’s continued dependence on oil and gas as primary energy sources has also never been clearer.

Of course, this broad political mandate to increase oil and gas production does not offer some form of environmental ‘free pass’ for the oil and gas industry. To the contrary, operators remain steadfast in their stated goals to reduce the carbon intensity of their operations.

The current oil and gas market may offer the best investment opportunities in decades, and we continue to believe that our investment strategy, focussed on proprietary technologies that allow oil & gas operators to reduce carbon intensity across their operations, is more relevant than ever.

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