Firms can avoid wasting $500bn with managed approach to transition in IPR scenario even if demand rises short-term.
LONDON/NEW YORK, January 27– Surging oil prices may tempt oil and gas companies to make long-term investment decisions that cost shareholders dearly, but a cautious “managed” approach to the energy transition would do most to preserve shareholder value and help society achieve climate goals, Carbon Tracker finds in a report released today.
Oil prices have rebounded strongly as the global economy bounces back from the Covid pandemic, but this trend is unlikely to last because government climate commitments combined with the rapid switch to electric vehicles will drive down long-term demand for oil. The report warns companies to anticipate this shift and manage the decline.
Managing Peak Oil: Why rising oil prices could create a stranded asset trap as energy transition accelerates considers the financial implications of a future where demand increases into the mid-2020s and then falls rapidly. It finds that the best route to meet that demand while preserving value is to maintain a conservative approach to long-term investment and meet short-term demand with shale projects that can deliver new production quickly.
However, if companies invest in high-cost projects in the expectation of continued high prices the market could be severely oversupplied as demand falls, driving prices down. Hundreds of billions of dollars of investments could be wasted if new projects fail to deliver commercial returns.
Axel Dalman, Oil & Gas analyst and lead author of the report said: “Companies may see high prices as a huge neon sign pointing towards investment in more supply. However, this could become a nightmare scenario if they go ahead with projects which deliver oil around the time that demand stars to decline. Shareholders could face catastrophic levels of value destruction as prices fall.”
The report explores a non-linear demand pathway using the Inevitable Policy Response consortium’s Forecast Policy Scenario (FPS), commissioned by the UN PRI, which is consistent with limiting global temperature rise to 1.8°C. It shows how companies can manage the peak in demand, while reducing the risk of wasting investment, and preparing to wind down production in line with the Paris Agreement target.
High-risk projects which rely on a breakeven oil price of over $50 and would only start producing late this decade include:
- Kuwait Petroleum Corp’s $7.5bn Lower Fars Heavy Oil (Phase 2) project in Kuwait;
- ExxonMobil and Shell’s $6.7bn Bosi project in Nigeria;
- Petrobras, Shell and Galp’s $3.1bn Tupi project in Brazil;
- ExxonMobil, Equinor, Galp and Sinopec’s $3bn Bacalhau and Bacalhau Norte (Phase 2) project in Brazil
Falling oil prices over the last decade have seen the average breakeven price for projects approved by oil companies drop below $40 a barrel in recent years, reflecting companies’ growing awareness of the long-term implications of the energy transition underway.
However, the world is currently experiencing a strong rebound in oil demand and there are loud and growing calls for more investment. In mid-January 2022, Brent crude was around $80 a barrel, up from the mid-$50s a year ago, and is climbing towards $90. Investment bank, Goldman Sachs, says prices could reach $100 and forecasts around $85 for the next several years.
Mark Fulton, Chair of Carbon Tracker’s Research Council and a co-author, said: “A sustained surge in the oil price is not necessary as the industry can both meet peak demand and manage its way through that without wasting capital by applying discipline”.
Mike Coffin, head of oil & gas and also a co-author said: “We know demand will weaken as the policy response to the climate crisis and deployment of new technologies accelerates. For companies to effectively manage this transition, they must resist the temptation to invest heavily on short-term price signals. Failure to acknowledge the sea change risks wasting huge amounts of capital, delivering sub-par returns to investors, and locking-in emissions that take the world beyond Paris goals.”
The report warns that within the next five years the industry could face a sudden shift to rapidly falling demand for oil, driven by the clean technology revolution and government climate policies, with significant financial implications for investors.
Electric vehicle sales are growing rapidly. In 2020, the share of EVs in global car sales jumped to 4.6% from 2.7% in the previous year. The International Energy Agency (IEA)  says this figure could rise to a staggering 36% by 2030.
Governments strengthened their climate commitments at Cop26 in Glasgow, which the IEA says could now limit global temperature rise to 1.8°C. They face pressure to strengthen their commitments ahead of Cop27 in Egypt this November and put the world back on course for a 1.5°C. The IEA has said that there is no need for any new investment in fossil fuel production if the world aims to meet its widely accepted 1.5°C target.
The report models two cases in a world where demand rises up to 2026 and then falls sharply to 2040.
In a high-investment case companies approve projects up to a breakeven price of $60 – in line with European majors’ current price forecasts. This meets short-term demand up to 2026 but projects reach peak output just as demand starts to decline significantly. In a heavily oversupplied market prices plummet and high-cost projects risk becoming stranded.
If the oil price fell to an average $40 after 2026 – a conservative assumption – some $500 billion of investment could be wasted on projects which were no longer commercial. At an under $30 price scenario companies and investors could waste double that.
In a managed investment case companies only approve long-term projects up to a breakeven price of $30. They respond to short-term demand by favouring shale projects that can ramp up production quickly, approving them at a breakeven price of $50.
This would satisfy most short-term demand up to 2026, leaving a supply gap of 2mbd which OPEC and other producers can meet by deploying spare capacity. The report notes that it is in their interest to do so and prevent prices rising higher, which would accelerate the take-up of EVs and the transition away from oil.
This scenario would largely balance the market as demand falls after 2026, meaning that there will be less pressure on long-term oil prices. If they averaged $50 up to 2040 no investment would be wasted. Even if long-term prices fell below this level the report finds that this managed approach would waste far less investment than a high-investment strategy.
- The IPR FPS models oil demand growing at 1.6% a year to reach an additional 8mbd (compared to 2021 levels) by 2026 and then falling by 3.5% a year to 2040. The scenario results in a 1.8°C rise in global temperature.
- The report models supply using production and breakeven price data from Rystad Energy based on a 10% Internal Rate of Return. 10% is Rystad’s default benchmark and represents a conservative level compared to investor expectations and company cost of capital.
Once embargo lifts report can be downloaded here: https://carbontracker.org/reports/managing-peak-oil/
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About Carbon Tracker
The Carbon Tracker Initiative is a not-for-profit financial think tank that seeks to promote a climate-secure global energy market by aligning capital markets with climate reality. Our research to date on the carbon bubble, unburnable carbon and stranded assets has begun a new debate on how to align the financial system with the energy transition to a low carbon future. www.carbontracker.org