Emerging opportunities in the energy sector
It used to be a simple equation: energy was produced, in just a few ways, and distributed to end-consumers who had very few alternatives to choose from. Today however, a vast range of energy sources are available and consumers are increasingly able to choose what type they would like to consume.
This trend is the result of a new paradigm shift taking place throughout the entire energy sector which includes, among other things, new technologies and ways of exploring and developing oil and gas resources as well as the increasing availability of alternative energy resources.
Let’s start by looking at the traditional energy sector. Today, oil and gas prospectors have changed their approach. Some reasons for this include growing consumer reluctance to accept energy from regions where extraction generates social instability, or because of the availability of better technology which enables safer drilling and new approaches.
Indeed, there is a broader shift taking place. After decades of investing and exploring oil and gas resources in developing regions, oil majors are tilting their investments towards wealthier countries, and in particular, deep water fracking, the perfect example of a technique that only five years ago was virtually impossible. Obviously, this comes with an immediate cost because security and regulatory requirements are stricter in developed countries, but on the positive side, the political stability and social welfare systems in these countries definitely offer more predicable cash flows. Furthermore, there are a few additional key reasons why producers are shifting which we discuss in more detail below.
Problematic sovereign risk issue
At the beginning of this century, oil companies spent about USD 345 million (per annum) on exploring for new oil resources. In 2012, oil companies spent about USD 1.27 billion (per annum) for research and development of new resources. While a decade ago the amount was almost equally split between developing and non-developed regions, the situation is very different today. According to Bernstein Research, more than 2/3 of the available budget for petroleum exploration and development spending by ExxonMobil, Shell, and Chevron is allocated to fresh prospects in developed countries. In what was probably one of the most powerful moves in the sector in recent times, Royal Dutch Shell decided to exit much of its Nigerian business as a result of an internal evaluation process which reconsidered its exposure in unstable regions. For similar reasons, Chevron decided to exit Chad and Exxon sold stakes in Iraq and Indonesia.
In the past oil companies considered that the trouble experienced e.g. corruption, kidnapping risks and damage to infrastructure was the price to pay in order to explore and develop a field. In more recent years, increased competition with state-owned companies and less attractive deals obtained from governments have substantially lowered the potential upside for oil companies. Furthermore, sovereign issues, especially in Africa and Central Asia, have further convinced many major oil companies to make the shift.
Feeling the heat due to high operational and political risks
The occasional accidents that do occur in the oil industry are expensive, not only in terms of human lives lost, but also in terms of environmental damage and material loss. In 1988, the North Sea oil and gas platform Piper Alpha sank following an explosion. Two-thirds of its operation team were lost. The material cost of this incident was USD 3.4 billion. In March 2001, Petrobras lost the floating offshore production platform P-36. The source of the problem was an explosion in one of its transit tanks. The cost of this accident was about USD 400 million. In 2010, Deepwater Horizon sank in the Gulf of Mexico due to technical failure. Because of the technical and practical difficulties, the Deepwater/Macondo spill lasted five months and the overall cost to BP was in excess of USD 50 billion. The operator of the field was subsequently banned from acquiring new acreage in the region, thereby limiting the company’s US related R&D spending for about 4 years.
At the time BP argued that they would focus on developments with more favorable geology going forward, but today because of its 19% stake in OAO Rosneft, a Russian-based producer, BP is once again back in the media. Rosneft took control of the bulk of Yukos Oil Co.’s assets when it was pushed into bankruptcy in 2005/2006, and following international arbitration it is now being asked to refund international investors in excess of USD 50 billion. Since the shareholders of Rosneft have to pay most of the liability, BP has a new potential liability of USD 10 billion.
These and other examples clearly show that exploring and developing oil and resources are connected to a number of geopolitical, environmental, geological and operational risks. The ultimate issue is, however, that penalty payments are often not accounted for in business plans; yet, they occur more often than in the past and at the expense of shareholders. Under such circumstances shareholders face lower dividend payments as well as a decline in value of their investments for a given period of time.
Today’s energy challenges
The ever growing demand for energy, the geopolitical tensions that arise around the exploration of oil and our dependence and consumption of oil related products should persuade politicians and economic leaders to reconsider the way energy is produced and made available.
The process of using and making energy (i.e. transforming an element into a force that can help humans create products) is as old as humanity, but what has changed in recent time is that the transformation process from element to energy has improved tremendously while at the same time the handling and consumption of energy is easier and safer than ever.
In recent years, alternative energy resources have been developed, but they haven’t yet made a major breakthrough. Why? We see some similarities with other historic situations, and the interesting parallel that can be drawn is that when groundbreaking new things have been developed in the past, it has always taken a long time to implement them. The bottleneck was, and still is, a lack of infrastructure. Even in today’s world, the major challenge for the energy sector is to develop and build infrastructure which responds to the demand and expectations of end-users.
The paradigm within the fossil fuel segment
Up until only recently, about 60% of the supply side offer was met by state-owned oil companies. This was an excellent way of keeping the supply-demand ratio well balanced because a state-owned producer ultimately had other higher ranking objectives than just immediate profit. However, with the arrival of independent producers operating in territories outside OPEC, the period in which oil output responds instantly to the world’s economic situation has come to an end. Independent producers are now acting in areas where exploration and production is more complex and more difficult, and therefore more cost intensive; hence, the exploration of reservoirs at barrel prices of below USD 60 is economically not profitable. This has been reflected in the futures market, where longer dated contracts have hardly moved below the USD 80 to 85 price band for the last 4 years.
Conventional oil exploration probably peaked in the years before 2010! However, studies show that there are plenty of resources around globe to cover consumption for the decades ahead. The reserves are not the issue, the concern is how to satisfy the ever constant increase in demand with today’s known extraction methods.
Today’s recovery factor from a new field is on average about 35% of the total available resource. For most fields, the new technologies coming online will allow this ratio to be driven up to well above 50%. Yet, there are plenty of unconventional fields such as sand fields and shale oil where exploration ratios will remain below average because of negative environmental consequences.
What is more, unconventional fields such shale oil fields have relatively short average lifetimes, with about 33% of the capacity exploited within the first 12 to 15 months. After this period, production per oil well declines relatively quickly and in less than 3 years the well becomes economically unprofitable to run and every company is required to analyze its investment opportunities before any drilling activity.
Changes in awareness and the growth of alternative energy
The present way of consuming energy is generating considerable pollution of the air, water and soil. Actually, while there is a lot of debate in the media, there is almost complete scientific consensus that climate change is very likely due to the increase in energy consumption and the resulting man-made greenhouse gases. One of the key financial questions arising from this is: Who is responsible for the cost and what kind of distribution factor can be applied to the different consumers? Today, consumers are aware that costs such as the rehabilitation of polluted soil or the decommissioning of nuclear power stations can no longer be put forward to the next generation. Placing a price tag on that non-definable cost factor is currently considered to be a penalty by consumers; however if the costs were advertised as insurance coverage against future liabilities, the take-up rate would probably be much higher than today.
Yet this principle is only valid if applied unilaterally, and this brings us to the point: there is a high level of global awareness about the issue, yet many governments have not ratified any treaty nor are they implementing any kind of “eco taxes” on energy; as a result, they are biasing competition not only in the energy sector, but across the entire economy. The fact that energy is cheaper in the US than in Europe has been the basis for a few European-based companies deciding to move part of their production to the US.
There is ultimately a market for alternative energy, as it responds positively to most of the concerns addressed above; however, its full development is far from realized and the implementation of an efficient alternative energy production and distribution network is still decades away.
In the coming days, we’ll publish a number of articles (see list below) which further develop the context behind this article. You are invited to share these articles.
Links to analyses of providers and enablers with a focus on:
- Investment opportunities in oil service companies
- Investment opportunities in energy transportation operators
- Investment opportunities in oil majors
- Investment opportunities in alternative energy providers
- Investment opportunities in power plants
- Investment opportunities in service providers and end-user infrastructure suppliers
- Beneficiaries of US oil exports