Q3 2021 Research Theme: Energy Transition Cannot Risk Energy Security & Reliability



A Wake-Up Call


As countries worldwide emerge from the Covid-19 health crisis, the global economy faces a fresh threat – an energy crisis prompted by resurgent demand amid an acute energy shortage.


2021 has seen Brent and WTI surge to new multi-year highs in the mid-$80s, US gasoline spike beyond $3.50/gallon, UK, European and Asian gas prices up five-fold to over $30/mmbtu (US gas merely doubled to $5/mmbtu!) and Chinese coal peak at $400/ton in October amid rolling power blackouts.


Political heat from spiking US gasoline prices no doubt prompted President Biden to part-implore, part-threaten OPEC+ to materially raise production quotas – a move swiftly rebuffed by the cartel, and also ask the FTC to determine whether the US oil & gas sector has engaged in illegal anti-consumer activities – always better to shift the blame onto others rather than the US administration’s own oil & gas policies which expose domestic E&P to greater risks and costs.


The irony of a US President begging OPEC+ to increase oil production while imploring global delegates at COP26 to reduce fossil fuel emissions was also not lost on most observers. However, he is far from alone amongst political leaders in making such incongruous comments, underscoring the complexity of weaning industry and consumers off fossil fuels toward Net Zero.


Several contributory factors may indeed prove transitory, such as heavy flooding across Shanxi province – China’s coal hub, Russia’s meddling with Euro gas supplies to pressure Germany’s approval of the Nordstream 2 gas pipeline, even the Chinese ban on Australian coal imports.


However, crude oil futures currently foresee no quick fix – the ‘scarcity premium’ for spot crude is the largest since 2013 with 12-month Brent backwardation recently exceeding $8/bbl. The pandemic has certainly laid bare the fragility and interdependence of global energy markets, and their vulnerability to shocks and the inherent intermittency of renewable energy. But, as we have written before, the roots of this crisis lie deeper: substantial, long-term underinvestment in upstream oil & gas exploration has resulted in a decade-long paucity of fresh discoveries and fast diminishing reserve replacement across the industry.


However, the energy transition now confounds the capacity additions normally prompted by high pricing: investors either demand returns over growth or exit the sector, banks and states alike have withdrawn financing for oil & gas projects and public oil & gas companies are rapidly diversifying into renewables while divesting oil & gas assets. Furthermore, such pressure on fresh oil supply is not matched by reduced oil demand which, like overall fossil fuel demand, remains largely inelastic in the face of high prices.


As one observer put it recently, “We’ve all decided that we want to stop investing in oil supply but no one told the consumer”. Unless the mismatch between supply and demand growth is addressed, high pricing for fossil fuels may thus prove endemic rather than cyclical.


One could hardly conceive a more opportune reminder to the attendees of the COP26 climate change conference summit. Unless and until energy security and reliability can be assured, there can be no successful global transition toward clean, renewable energy.


As economist Ed Yardeni recently observed: ‘Renewables aren’t ready for primetime. So instead of a smooth transition, the rush to eliminate fossil fuels is causing their prices to soar and disrupting the overall supply of energy’.


However incongruent and unpalatable this message is for the IEA and other observers, sustained investment in oil & gas productive capacity, particularly that of gas, will be required as a bridging solution for several decades until sufficient economic renewable energy generation and storage capacity exists globally to address concerns over energy security and reliability.


In the meantime, talk of a joint Strategic Petroleum Reserve (“SPR”) release of crude oil by the US and China did prompt a recent pullback in oil markets. However, such additional volumes will ultimately prove little more than a Band-Aid, unable to directly address current bottlenecks in refining capacity and, in terms of scale, unable to meaningfully alleviate tight US and global product markets.


Publication of the forthcoming SPR release, albeit by a broader syndicate – US, China, India, Japan, South Korea and UK, actually caused oil pricing to move up not down, reflecting market fears that OPEC+ would retaliate at its Dec 2nd meeting by pausing or rescinding their stepwise monthly additions to supply. Early days but potentially an own goal.

Global Oil Demand Could Exceed 101 MMBPD During 2022


Despite COVID flare-ups in the US, Asia and now Europe, global oil demand continues to rebound strongly with 2022 now forecast to average 100 – 101 mmbopd, beyond pre-Covid levels on the back of robust gasoline consumption and increased air travel. However, the US, China and India – the three largest oil consumers – have already hit record levels of oil demand this year despite subdued jet fuel demand due to ongoing travel restrictions; commercial airline capacity remains almost 30% below pre-Covid levels.


With travel restrictions easing and Asian power generators and energy-intensive industries switching to fuel oil or diesel from LNG and coal, there is a real possibility that global oil demand could swell to record levels during late 2022, potentially as much as 102 mmbopd.


Where will such oil supplies come from?


Recent US production growth – the strongest contributor to non-OPEC+ supply over the last decade – has proved lacklustre despite the improved 2021 pricing backdrop. Shale oil production remains almost 1 mmbopd below the peak levels of late 2019 and monthly production growth is anaemic compared to the prior 2017-2019 ‘gold rush’.


On the face of it this is hardly surprising given that at 408 rigs, the shale oil rig count still remains well short of pre-Covid levels despite having doubled year-on-year. But the situation is more complex – current US shale oil production is flattered by the harvesting of DUCs (drilled-but-uncompleted wells), rapidly drawing down the excess DUC inventories of mid-2020 when operators chose to bank rather than produce fresh wells.


Once DUC inventories ‘normalise’, expected by early to mid-2022, the shale oil rig count will have to increase significantly to deliver material production growth. Two factors will inevitably hinder this outcome: shale operators’ improved capital discipline, driven by ESG-led stakeholder pressure and a lack of external funding, and the growing levels of field depletion observed across major unconventional basins.


Geological, financial and political restrictions may thus prevent the US shale oil sector from achieving prior levels of production despite increased levels of field activity.


Sources: US EIA

Sources: Baker Hughes, Primary Vision LLC

Outside the US, the dearth of non-OPEC+ oil & gas discoveries over the last decade, as well as increased internal ESG-led competition for capital amongst the oil majors, will continue to weigh on non-OPEC+ production growth.


So, does OPEC+ possess sufficient spare capacity to meet what may prove to be a record call on its production? Saudi Arabia, Kuwait, Russia and the UAE are the only OPEC+ members with spare productive capacity available with no major technical or security-related issues.


Unless the U.S. and non-OPEC can step up to the plate, oil demand forecast for late 2022 may well come very close to exhausting OPEC+’s effective spare capacity.

Outside of demand destruction, such an outcome could easily see oil prices increase beyond $100/bbl (which by the way we do not see as constructive).


Oil Inventories Below 5-Year Lows - The Canary in The Mine


OECD commercial crude and product inventories are at their lowest level since 2015, some 250 mmbbls or 8% below the five-year seasonal average. Within the U.S. and more broadly across the OECD, oil product inventories have become extremely tight in recent months, trending below pre-Covid 5-year seasonal averages and lows – a result of burgeoning demand amid a weak non-OPEC supply response and tempered OPEC+ supply additions.


Sources: IEA

Sources: US EIA

International Gas – A Perfect Storm Driving Pricing to Record Levels


Moving to natural gas, as mentioned earlier, recent months have seen global gas prices hit record highs as utilities worldwide scramble for LNG cargoes to replenish extremely low inventories in Europe and meet insatiable demand in Asia, where energy shortfalls have caused power blackouts in China and elsewhere.


International Gas Benchmark Pricing, 2019 to date

Sources: US EIA, International Monetary Fund

With no immediate let up in international gas demand and pricing, U.S. LNG exports will remain high as domestic producers seek to maximise netbacks. Although Henry Hub pricing has doubled of late, the uplift remains somewhat muted compared to international markets due to U.S. LNG export capacity constraints and domestic gas production sufficient to ensure adequate gas in storage. U.S. gas inventories will likely enter winter just 2% below seasonal five-year average levels despite abnormal weather-related power consumption midyear, increased LNG exports and flat domestic gas production.


By contrast, Europe will enter winter with the lowest gas inventories in a decade – Europe’s gas storage facilities are just 76% full, well below the 5-year average. Certainly, Gazprom’s European gas inventories appear abnormally depleted, suggesting that the Kremlin may well be pressuring Germany to approve the Nordstream 2 gas pipeline. Global competition for additional gas volumes has caused European gas prices to climb five-fold this year as Asia, particularly China, buys up cargoes to address growing energy needs amid power blackouts and coal shortages caused by flooding.


Looking to the future, the imminent shutdown of the giant Groningen gasfield and closure of Germany’s nuclear power plants will do nothing but heighten the risks associated with any sudden cold snaps, while increasing Europe’s reliance on Russian gas imports.


The UK remains chronically short of gas storage capacity since the closure of the Rough facility in 2017. The UK stores less than 2% of its annual gas demand vs. 25% typically stored within the EU – a direct result of the UK government’s laissez-faire gas strategy that has long favoured a ‘just in time’ approach to gas imports and thus a heavy reliance on spot market pricing of piped gas and LNG cargoes. The consequences of the current perfect storm – low European gas inventories, energy blackouts in Asia, reduced interconnector capacity – are plain to see. The UK is now competing for increasingly scarce and expensive LNG cargoes on the spot market – a situation made worse by its conspicuous lack of storage.


Closing Comments


The energy transition remains in its infancy – renewable energy sources are not yet scalable, economic replacements for fossil fuels. As we stated earlier, however incongruent and unpalatable this may prove for the IEA and other observers, sustained investment in oil and gas productive capacity, particularly that of gas, will be required as a bridging solution for several decades until sufficient economic renewable energy generation and storage capacity exists globally to address concerns over energy security and reliability.


That said, for oil & gas companies, with their operations under increased scrutiny by regulators, investors and consumers alike – a low carbon footprint allied to environmentally responsible operations is fast becoming the ‘license to operate’.


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