Peak oil demand and long run oil prices by Dale and Fattouh: a critique

Peak oil demand and long run oil prices by Dale and Fattouh: a critique

Dieter Helm

24th January 2018

Video presentation also available : Watch here

The challenge of climate change has left the oil companies on the back foot. What do they do? They are beholden to their shareholders, who look to their dividends and in many cases treat them as proxies for utilities. Those dividends are built on oil (and gas). So, however much they want to escape the straightjacket of the fossil fuels and the consequences of burning all of the oil they produce for the climate, they cannot help themselves. They are doomed to be oil and gas companies.

Some oil companies have begun to think outside the box. Shell is a good example: its chief executive recognises that the future is eventually electric; that climate change is eventually going to be existential to his company; and that Shell needs to prepare itself for the transition. It has gas as a transition fuel for electricity, it has begun to dip its toe in the electricity market, and it is trying to work out how to embrace electric cars. Yet even for Shell, the money is in the oil and gas, and these electric steps are set against a big move into US shale.

The BP line and BP’s shareholders

The line from BP has been rather more muted. Having tried to “go beyond petroleum”, it retreated, but now it is trying again – a bit. In a BP paper by Spencer Dale and Bassam Fattouh Peak oil demand and long-run oil prices a nuanced story is told, which has the effect of being very comforting to its oil investors.

The paper addresses the question of peak demand, having rightly given up on peak supply. It makes an obvious point that there is uncertainty about when peak demand might occur. It takes a line I set out in the Burn Out: the endgame for fossil fuels: that there is a revolution in the production technologies for shale oil (and gas) in the US, and that digitalisation is a disruptive technology.

So far, so good. It is not about when the demand for oil peaks, but what happens to price and quantity after it has peaked, and what that does to the behaviours of oil producers and oil companies now, before it has peaked.

Here is the good news for BP’s shareholders: the prospect is for lots and lots of oil to be burnt for decades to come, whenever the peak occurs; and, even better, the authors argue that the key oil producing countries will keep the price way above the marginal costs for the simple reason that they need higher prices.

The first is deeply worrying, and it should be for the directors of oil companies. For what it says is that we are not going to head off climate change, and that they will in fact be part of the causes of the climate change the world leaders are trying to head off. They predict that oil production will continue to violate the Paris Agreement and probably by a large margin. Their investors will be able to profit from this – for a long time to come. There are parallels with tobacco companies selling cigarettes.

Dale and Fattouh tell the investors: don’t worry too much about peak demand. It is highly uncertain and anyway the market for oil will still be (very) big, way out into the future, even if you are worried about long term liabilities for the world that your oil companies will help to bring about. Better still, OPEC and Russia will prop up the price. Why do Dale and Fattouh believe this? Because these countries need to balance their budgets.

I discussed this argument at length in the Burn Out and subsequently with Spencer Dale. Though he does not acknowledge the book or our discussions in this paper, our disagreement hinges on two specific points, and these are points which should make investors in oil companies a lot less relaxed than they would be if they took the Dale line.

The first key difference is over the speed and extent with which electrification of energy markets cuts into oil demand. Oil is used for two prime purposes: transport and petrochemicals. As I set out in the Burn Out, there are good reasons for thinking that electrification of transport is coming much faster than many thought even a couple of years ago. Dale and Fattouh argue that it does not much matter when peak demand comes, but this is to miss the point. It really does matter what the electrification of transport does to the demand for oil for transport – for climate change and the planet, and for the price of oil now as well as in the future.

On petrochemicals, gas is the immediate threat to oil, and shale gas has already made a big impact. Dale and Fattouh write about oil, not fossil fuels. It is perfectly possible that gas will have a longer transition life than oil.

Dale’s investors should take a good look in the mirror, and go to some of the international car shows. Of course it is obvious that the peak is uncertain and there is a lot of hype around electric models, but it does matter, and for a specific reason. As I set out explicitly and at length in the Burn Out the fact that a barrel of oil tomorrow might not be worth as much as a barrel today means that the incentives with regard to production change now. The easy OPEC collusion incentives very gradually give way to a battle for a share of a market for which the resource base exceeds the demand. Nobody wants it to be its oil that is left in the ground. It is much more costly to hold back production now. Tomorrow’s oil is going to worth less tomorrow than it is worth today.

Confusing needs with outcomes

Worse still for the oil producers, if they do manage to collude to rig the market now, it is bound to be temporary (indeed very temporary). Why? Because they simply encourage the new swing production in the US shale (and eventually elsewhere) to take up the slack, encourage E&P, and encourage widespread cheating – even amongst their own members. It’s just not a credible cartel, if it ever was.

Here is where my second profound disagreement with Dale arises. He said at the presentation of the last BP Statistical Review in 2017 that the oil price would go back up and then stay up for some time because the main oil producers need the money to balance their budgets. This is repeated in this new paper. These are now called the “social costs” of production, and these Dale argues have to be added to the marginal costs of production to get the price.

It is an extraordinary argument. The incentives are going through a paradigm shift to abundance of supply (admitted in the paper) but for investors, don’t worry, because the price will be higher because the key producers need a high price. This fails to distinguish between what producers would like to happen, and the reality of the position they find themselves in.

Think what this argument means. It must be a necessary condition that the producers hold the marginal barrels as they – and crucially only they – have the low marginal cost resources. They must also be able to agree. They must not cheat on each other. They must be the swing producers. All these conditions have to hold - jointly.

Is all of this – or any of it – true? Some of it has some traction in the very short term. It is true that Saudi Arabia and Russia held back increases in production over the last 12 months. But the costs of this have been limited, and Iran and Iraq have been in no position to fill up the gaps created. Instead, the US is now crossing the 10 mbd production line.

Slow or quick suicide

It is a strategy I would call “slow suicide”. Any very short-term successes come at a heavy price: they induce supply from elsewhere, speed the transition to electricity for transport and to gas for petrochemicals, and give renewables a leg up.

This slow suicide is not just about the substitution effects to other energy technologies. It is also ratchets up the free rider incentives for the core producers. How long are Iran and Iraq going to hold back on their potential? Sanctions might help, but not as much as the arch enemy in Saudi Arabia would like. It is not just that there are lots of non-OPEC and non-Russian supplies out there, but that the fight for the eventually diminishing market makes a step change to the free rider incentives inside the fragile cartel.

I suggest that investors take a sceptical view of the Dale and Fattouh “social cost” premium – or rather the monopoly tax the producers want to extract from the consumers. They should worry about peak demand, they should worry about the carbon emissions they will be causing if the demand holds up as Dale and Fattouh argue, and they should worry about the downward pressure on prices, and its self-fulfilling characteristics, as the recognition that a barrel tomorrow may be worth less than one produced today. They should not place such high values on the reserves that companies report, they should worry about the sustainability of the dividends of companies that rely on this market, and they should take with a pinch of salt the argument that because Saudi Arabia “needs” the money it will necessarily get it.

And finally, they should worry a lot about the political prospects for these authoritarian, inefficient and often corrupt oil-producing countries (in this, Dale is right, as set out in the Burn Out, to be sceptical about the Saudi “transformation” of its economy). Indeed the biggest risk – and for the investors in oil reserves the biggest short term opportunity – is that Saudi Arabia politically implodes. But then this will be a sudden shock, and a much more sudden suicide. The price of the marginal barrel is much more important on the way down than the way up. Producers have the unenviable choice: slow or quick suicide.

 Dieter Helm is the author of Burn Out: the endgame for fossil fuels

Published in 2017 by Yale University Press

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