March 26, 2018//-How can Big Oil thrive amid increasing focus on electric vehicles and decarbonization? By capitalizing on higher barriers to entry, through consolidation, cost deflation and ultimately higher returns, according to Michele Della Vigna of Goldman Sachs Research.
We spoke with Michele on how he envisages this new Age of Restraint for the oil and gas industry.
Michele, you’ve said we’re on the cusp of a “new era of oil investing.” How so?
Michele Della Vigna: Historically speaking, the oil & gas sector goes through long, 30-year investment cycles driven by the market’s “risk premium” for long-term investments — the compensation demanded for taking the risk on funding new long-term supply.
Since 2014 we’ve been in what we call the Contraction phase of the cycle, as the market absorbed the oversupply generated by the 2003-2013 Expansionary phase. The market is now giving way to what we call the Age of Restraint, as the forward curve of oil flips to backwardation and costs reset approximately 50% lower, making new investments profitable once again.
This, however, does not lead to another inflationary cycle, as the market’s concerns over decarbonization restrict financing of long-term projects, which become the natural oligopoly of companies which can self-fund and manage political and technical risk: We call these producers the modern-day Seven Sisters, much like the Big Oil dominating the market in the 1950s, and see this as a new golden age for them.
But don’t oil producers benefit from a higher price environment?
MDV: That’s a common misconception. Prices tend to rise in the Expansion phase of the investment cycle, led by perceived future supply shortages. This fuels easy credit, market fragmentation and ultimately cost inflation and rising inefficiencies.
Cost inflation compounded at 10% per year in the 2003-13 period, destroying the producers’ returns and only partially benefiting oil services.
In contrast, during the Restraint phase, returns improve slowly but consistently, led by an oligopolistic market structure, better management of the supply chain, and advantaged resource access. We were last in this phase in the 1990s, where Big Oil outperformed the global market by 6% per year.
Another misconception you cite in your research is that decarbonization is bad for Big Oil. Walk us through that.
MDV: Sure. The focus on a Lower Carbon economy — and EV adoption in particular — is fueling the Age of Restraint by dis-incentivizing investments in long-cycle capacity. While shale provides enough short-cycle production to prevent the market from running into shortages, the lack of long-term investment keeps the physical markets tight and strengthens Big Oil’s oligopoly on long-cycle projects such as deepwater fields and LNG.
Concerns around EV demand displacement is taking more future supply off the market through lack of financing than it is likely to impact demand. We estimate that the EV impact on demand by 2030 is likely to be below 4 million barrels a day.
Yet the lost supply by 2025 because of the delay in sanctioning of new long-cycle projects since 2014 is already estimated at 6 million barrels a day. Decarbonization is actually having a net tightening effect on the oil market.
Goldman Sachs
