Lecture 1: Introduction to key themes James Henderson April 2020 The Economics of Energy Corporations Outline of the course Overall objective – understand how senior management use economic models to make investment decisions 1.Introduction to key themes in the global energy market 2.Introduction to financial modelling as a management tool 1.Understanding some key concepts 3.Building the asset – estimating costs 4.Generating revenues – production and prices 5.Operating costs – running the plant and paying the government 6.Calculating a discounted cashflow 1.Why is it important 2.How is it used to make decisions 7.Testing the investment decisions: running some numbers under different assumptions 8.Answering your questions Increasing interaction between prices of hydrocarbons Assessment Overall objective – demonstrate understanding of cashflow models and output 1.Create a simple cashflow model, given set assumptions 2.Generate NPV and other results 3.Provide an analysis of simple scenarios 4.Write up results in short review (one page) Increasing interaction between prices of hydrocarbons World Energy Consumption – A Long-Term View •World energy consumption has grown dramatically in the past century, driven by and catalysing economic growth •Energy availability supports modern living standards and human development 3 periods – biomass, coal, oil and gas Entering period 4 – renewables Accessibility versus efficiency World Energy Consumption – A Long-Term View •The future looks very different with fossil fuel demand peaking •Renewables and other new technologies will take a much larger share •The key question is how fast this energy transition can technically and economically take place? 3 periods – biomass, coal, oil and gas Entering period 4 – renewables Accessibility versus efficiency Primary energy consumption since 1990 (mmtoe) •Overall energy demand has been growing by around 1% per annum •The key primary fuels have been hydrocarbons, which account for 80%+ of total energy consumption •Renewables are growing fast but from a very low base Coal fastest growing – indigenous Efficiency – GDP growth c.3% Gas very regional Oil more global Primary energy regional consumption by fuel (2018, %) •Fuel split is very different by region, and is generally driven by indigenous supply •Countries are reluctant to be over-committed to imports Compare Middle East and Asia North America and Europe very diversified Does not include biomass The growth in oil reserves and the regional split •Oil is not running out – proved reserves are up by 50% since 1995 •Middle East continues to dominate, but other regions are growing – the Americas in particular Oil reserves growing When will demand peak, not supply Unconventional and conventional Note Americas Decline in Middle East Oil is a global commodity •Oil is traded in multiple directions across the globe •Much of the trade originates from the Middle East and flows West and East •Prices are set relative to a set of global benchmarks Figures in mmt Trade routes key Liquid market helps security of supply Benchmark prices Shipping lanes key – control of large navies South China Sea Malacca Straits Gulf of Hormuz The global oil market is in turmoil due to Covid-19 •Travel has almost stopped, meaning demand for oil in transport has fallen •Overall demand has fallen by c.25mmbpd, or 25%, in the past two months •Storage tanks are full so traders are paying people to take oil away Figures in mmt Trade routes key Liquid market helps security of supply Benchmark prices Shipping lanes key – control of large navies South China Sea Malacca Straits Gulf of Hormuz Gas reserves by region (1998, 2008,2018) •The Middle East also contains huge amounts of gas, although Russia is the main exporting country •Gas reserves have grown dramatically as it has increasingly become an important fuel for power generation No shortage of gas 2 dominant regions Security of supply issues North America growth Gas production and consumption by region (bcm) •Europe and North America have traditionally been the largest consumers of gas •Major infrastructure in both regions facilitates indigenous production and imports •Asia, the Middle East and Latin America are growing fast, however Production Consumption Historically a more regional fuel Consumption in North America driven by production Europe declining demand Asia demand growth Middle East – substitute for oil Gas a less valuable (dense) fuel than oil Gas prices have been in decline for longer •Gas prices have been in cyclical decline since 2018 •Excess supply has been built due to high prices in the mid-2010s •Demand has not met expectations and now the Covid-19 pandemic has caused a decline in consumption •The longer term outlook for gas may be more positive, however Gas price in US, Europe and Asia Historically a more regional fuel Consumption in North America driven by production Europe declining demand Asia demand growth Middle East – substitute for oil Gas a less valuable (dense) fuel than oil Coal production and consumption by region (mt) •The majority of production and consumption is in Asia, and has grown rapidly •China and India are the key players, as coal is both countries’ major indigenous energy resource •Decline in North America driven by the arrival of shale gas Production Consumption Asia dominance Source of economic growth – cheap and available for power Displacement by gas an economic as well as an environmental issue China policy will be key – when will it be rich enough to really take action – contrast with India Decline in coal industry •The coal industry is in long-term decline for environmental and economic reasons •The US coal industry has collapsed over the past five years •Cheap gas prices have encouraged a switch from coal, especially in power sector •Coal is still important in many developing countries, especially in Asia Employment in US coal industry Global coal price (US$/t) A graphic with no description Shale gas killed US coal But employment issues are driving Trump policy Environmental policy driven by hydrocarbon resources and economic consequences Exporting CO2 issues Renewable energy consumption by region and source •Growth in renewable energy has been dramatic – it now accounts for around 9% of the global input to electricity •Europe has been leading the way, catalysed by policy initiatives in Germany •Growth in Asia accelerating, as search for indigenous energy continues Consumption (MMTOE) Source of Renewable Energy Renewables always indigenous Security of supply risk – intermittent What is the back-up fuel? What is real threat to hydrocarbons and when? Key drivers of energy consumption •Global population currently 7.3 billion, expected to reach 9.1 billion by 2040 •Population mainly in non-OECD countries, in many of which the alleviation of energy poverty is a huge issue •Economic growth is another key driver, leading to increased personal wealth and greater use of energy intensive products •Again non-OECD countries dominate growth, with their share of global GDP set to rise from 35% to 50% by 2040 Growing middle class demands Automation? Artificial intelligence? The shifting global energy economy •Rise of renewables now having a noticeable impact on hydrocarbons •Incremental demand growth is increasingly being accounted for by non-fossil fuels, leading to oversupply and lower prices •Are we seeing a new paradigm for oil, gas and coal pricing, with significant commercial and political consequences? Increasing interaction between prices of hydrocarbons Global energy prices – short and long-term trends •Are we in a new era of lower commodity prices, or will there be a further rebound as supply and demand re-balance? Increasing interaction between prices of hydrocarbons Power Sector Trends •GDP growth and power demand are closely correlated •Electricity demand continues to grow but mix of fuels is changing •Renewables the largest growing segment, but hydrocarbons still playing a major role •Existing capacity is cheap to use, even if new capacity is less welcome Natural gas demand growth driven by power and industry •Industrial demand is key to gas growth, especially petrochemicals •Demand from power sector also grows, although overall share falls 2020 2030 2040 0 100 200 300 400 500 1990 2000 2010 Industry Non-combusted Power Buildings Transport Bcf/d 600 Gas consumption by sector Gas share by sector 0% 10% 20% 30% 40% 50% 1990 2000 2010 2020 2030 2040 Industry Buildings Transport Non-combusted Power Increasing interaction between prices of hydrocarbons Wind power leads the way for renewables •Although renewable energy only accounts for 4% of total energy, it grew by 15% in 2018 •It accounted for all the increase in global power generation and nearly 40% of total energy growth •Solar is growing very fast (33% in 2018) but wind power still leads the way in terms of generation Solar Power continues to show rapid growth •China is leading the way, both as a consumer and as a developer of technology •The next generation of solar technology could have a dramatic impact and make a significant change to energy security issues History of CO2 Emissions •Carbon emissions have grown consistently to 2014, but were then declined in 2015 and 2016 due to sluggish economic growth and greater energy efficiency •Key question is whether we have reached a peak, or is this just a cyclical downturn? 2017 and 2018 would suggest the latter, given the return to growth Carbon emissions rebounded in 2018 •Growing economies = growing energy demand = growing emissions in the current global energy economy •Can we change course in time to halt this trend? Air pollution is becoming an almost more important short-term issue •Air pollution is a more immediate social and political issue than carbon emissions •China is well known for its poor air quality in many cities, but even in Europe a number of regions are well below acceptable levels •Governments are aware that a failure to react on a key health issue could lead to a violent backlash •Air pollution could therefore be a key driver towards a cleaner energy economy Having said that, in the longer term global warming is the key issue, and things clearly need to change if we are to meet 2 degree target Emissions intensity from power sector Energy demand and CO2 emissions in different IEA scenarios Demand must not grow… …and renewable output must Looking at the global carbon budget, the race is on to produce fossil fuels while you can •This has vast political and commercial consequences, as countries and companies have to react to a fast changing energy economy •The futures of Russia and the Middle East are closely bound up to the issue of whether this carbon budget will or can be enforced This leaves a vital question for companies / regions with large fossil fuel reserves •Coal reserves would last well over 100 years in most regions, while oil and gas reserves have a 50 year reserves life on average •This assumes that no further exploration is ever carried out •Will these reserves ever be produced, and perhaps more importantly who can get theirs out of the ground first? Fossil fuels reserves to production ratios (years) World Energy Demand by Fuel and Scenario •The outcomes for hydrocarbons are very different in scenarios that look at current likely outcomes versus outcomes needed to meet climate targets •In a world where we meet the 2 degree target, coal demand would halve from current levels and oil demand would fall by 25% •However, fossil fuel share would still be 58% in 450 Scenario Impact of fuel mix of various scenarios •The future of coal looks bleak if climate targets are to be met •However, in the long-term oil and gas also face very challenging futures Increasing interaction between prices of hydrocarbons Capital Spending in the Energy Sector •Uncertainty creates a reluctance to invest, but huge amounts of capital will be required to provide energy for a growing population •Two interesting questions emerge: –Will sufficient capital be found to maintain growth in renewables, especially is subsidies start to be removed? –Will there be sufficient incentive to invest in the hydrocarbons that will still be needed, if competition drives prices down? •How much should be left to markets and how might governments intervene?