COVID AND THE ENERGY TRANSITION

Paul Merolli and John van Schiak - Feb 01, 2021

In less than a year, Covid-19 has laid waste to traditional thinking in the oil industry. The Covid-19 pandemic has not only accelerated the low-carbon energy transition but overhauled the narrative behind it. Politicians, investors and populations now know what existential threats look like, and have upgraded the risks from climate change accordingly. Increasingly, they are calling for quick, decisive action. For both oil companies and producing countries, this makes the pandemic much more than a demand shock. In time, it will likely mark a turning point in the energy transition, from an often half-hearted and equivocal embrace of a low-carbon future to full-on momentum.

The pandemic has given a glimpse of what peak oil demand looks like, while prompting most forecasters, including Energy Intelligence, to bring forward predictions for that point. At the same time, the world’s largest economies are aligning behind greater collective effort for the energy transition, with China, Japan and others setting midcentury net-zero emissions targets and the US flipping toward aggressive measures to tackle climate change. The re-entry of the US into the Paris climate accord is just the beginning. The UN’s COP26 climate conference in Glasgow later this year should give the climate issue further momentum, just as Paris did five years ago. Large investors like BlackRock are reinforcing the trend by demanding that companies they invest in show how they will cope with climate change and decarbonization.

Changing global geopolitics explain some of this dramatic shift. China, the biggest engine of global oil demand growth, sees an opportunity to leapfrog the West on strategic industries like auto manufacturing and clean energy technologies. Under former President Donald Trump, a staunch supporter of fossil fuels, the US clung to its old ways. But the administration of President Joe Biden appears to be going all-in on climate, challenging China for leadership. This rivalry should only add to the momentum. China has come to dominate manufacturing the materials needed for clean energy, including solar panels, lithium-ion batteries used in electric vehicles, battery storage and wind turbines. The US’ share of solar panel manufacturing, by contrast, has fallen from 30% in the late 1990s to just 1% now. Yet Trump’s four years in power obfuscated fundamental, radical changes in the US Democratic Party on climate and energy that centrist Biden could not ignore. Generational shifts have also factored, with younger people taking climate action more seriously, regardless of political affiliation.

The pandemic is also providing a valuable tool for governments to accelerate strategic objectives related to the energy transition. After initially throwing money at their economies, countries are increasingly using massive stimulus packages to advance the low-carbon transition. Biden’s proposed $1.9 trillion coronavirus aid bill closely binds climate to economic recovery. Given the finely balanced Congress, Biden may need to compromise on the size and scope of his stimulus plan, but observers expect it to include plenty of climate initiatives. Biden on Jan. 27 signed an omnibus executive order to combat climate change domestically and elevate the issue as a top national security priority. “It is a safe bet that US financial regulators will increasingly affirm that climate change is a systemic risk to financial markets and start to integrate it into their supervision of key industries,” said Veena Ramani, head of Capital Market Systems at sustainable investment organization Ceres.

Against this backdrop, one key question is whether forecasts that assume renewed oil demand growth in coming years could prove to be optimistic. Energy Intelligence’s core “Accelerate” scenario for the energy transition assumes slow oil demand growth that puts a $60 per barrel ceiling on oil prices. But risk is now weighted more toward a "Boost" scenario, or further acceleration, than any substantial slowdown. "Boost" envisions the US rejoining the EU and China in ratcheting up its climate commitments and pushing others to step up action. This scenario is more bearish on oil demand due to pandemic-related changes in consumption patterns, and a rapid acceleration in electrification of transport and renewables penetration in power generation.

The Burden of Surplus Capacity

Looking to the supply side of the equation and the prospects for oil-producing countries further underscores how much the industry picture has changed in the last year. The world now has over 10 million barrels per day of spare production capacity as the low-carbon energy transition accelerates. The notion of adding capacity in this market might seem laughable to some, but for Opec, home to 7.8 million b/d of sidelined output, the situation presents a critical dilemma.

No one wants to be left with stranded assets that never are tapped, so producers must make sure that any oil developed from new upstream investments is produced. Given the perpetual cycle of output cuts that Opec now finds itself in, that's no sure thing. But alternatively, failure to invest may risk a supply crunch and price spike in the medium term that pushes consumers away from oil even faster than current environmental concerns do. The dilemma is stark, although Mideast Opec producers take some solace knowing that their output is both low-cost and low-carbon compared to most rivals.

Upstream outlays predictably plunged in 2020 amid the coronavirus crisis and price collapse, and the number of active drilling rigs in Opec countries fell to a 20-year low -- an insufficient number to maintain even today's curtailed production levels. Iran, which has seen its output decimated by US sanctions in recent years but now plans to ramp up, accounts for 1.7 million b/d of Opec's 7.8 million b/d of capacity. Non-Opec producers allied with Opec, led by Russia, have an estimated 1.9 million b/d voluntarily held back. In addition, economics have forced Canada, Norway and Brazil to shut in a combined 600,000 b/d, which could return this year as prices recover.

This year should offer some clues about oil demand in a post-Covid-19 world but investments will still carry significant risks. Some Opec heavyweights are sizing up new opportunities. Saudi Arabia is dusting off its 2020 expansion program. The Saudi leadership wants to add 1 million b/d to capacity, even as state oil giant Saudi Aramco wonders how it will fund the plan. The United Arab Emirates (UAE) is also considering a 1 million b/d capacity expansion by 2030. Oil officials worry they may end up sitting on costly idle capacity if Opec-plus production cuts, which are slated to run through March 2022, are kept in place for too long. In the UAE, some officials have started privately to consider whether Opec membership remains in the country's longer-term interests. Both Abu Dhabi National Oil Co. (Adnoc) in the UAE and Saudi Aramco have massive reserves that are central to their countries' economies. They are increasingly touting themselves not just as low-cost but also low-carbon oil producers, which they hope gives them a social license to continue producing well into the future. Aramco currently has production capacity of 12 million b/d, while Adnoc has 4 million b/d. Kuwait, Iraq and Iran also have the reserves to grow low-cost production.

For Opec members outside the Mideast, capacity was largely headed lower before Covid-19 struck -- a trend unlikely to reverse now. Since the 2017 implementation of the Opec-plus production deal, the 13 traditional Opec members lost 500,000 b/d of production capacity for a combined 33.8 million b/d, Energy Intelligence calculates. Beleaguered Venezuela collapsed by 1.3 million b/d, Angola fell by 350,000 b/d and Nigeria lost 100,000 b/d.

The fundamental problem is that the peaking of oil demand and its subsequent decline, whatever the path, are unlikely to match the future path of oil production capacity, which itself has become much harder to predict. Serious surpluses and shortages of oil seem inevitable in this new world.

Paul Merolli is editor of Petroleum Intelligence Weekly and John van Schaik is New York bureau chief at Energy Intelligence. This article is drawn from work that originally appeared in Petroleum Intelligence Weekly.