Lecture 1: Introduction to key themes James Henderson April 2021 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.Starting two models for an oil and a gas field – revenues and prices 4.Inputting the costs – capital expenditure 5.Operating costs and paying the government 6.A power plant – a buyer and seller of energy 7.Calculating a discounted cashflow 1.Why is it important 2.How is it used to make decisions 8.Testing the investment decisions: running some numbers under different assumptions 9.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 •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 World Consumption (Exajoules) Share by Fuel (%) Coal fastest growing – indigenous Efficiency – GDP growth c.3% Gas very regional Oil more global Primary energy regional consumption by fuel (2019, %) •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 The growth in oil production and regional split •Middle East dominates supply but US has been rising fast due to shale oil •CIS also a major producer and exporter, mainly thanks to Russia •Overall demand has continued to rise by 1mmbpd per annum, but is the peak in sight? Production Consumption 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 Economic impact of COVID 19 the worst since World War 2 •This market balancing mechanism works in “normal” conditions •However, a major economic or social shock creates an uncontrollable outcome •The COVID 19 pandemic is a classic example of this – containment measures dramatically reduced travel and caused a sharp decline in overall energy demand •This affected all forms of energy consumption, but the most immediate impact was on oil demand The outlook for the global economy •A key question is whether the global economy will recover rapidly or over an extended period •Initial estimates were quite optimistic, and China does appear to be experiencing something of a V-shaped recovery •Europe was heading in a similar direction, but the latest lockdown measures and the potential for further waves could change the outlook COVID impact on oil demand •The impact on transport was immediate, as economies locked-down and people were forced to stay at home •Oil demand collapsed immediately and the oil price fell from around $70 to around $20 per barrel •There has now been a partial recovery to c.$40 per barrel, but the outlook remains very unclear Recovery in oil price has stalled as demand uncertainty continues •Concerns over a second wave have led to the oil price recovery ending •There is confusion over OPEC strategy as many countries are desperate not to reduce production as they need revenues badly Line chart of West Texas Intermediate, $ per barrel showing US oil prices top $50 after latest Opec+ deal 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 Global consumption declines 3.5% in 2020, bounces back 4% in 2021 Source: OIES, Nexant WGM IMPACT OF COVID-19 ON GAS MARKETS •NATURAL GAS PROGRAMME 16 •5 Year Demand Outlook post COVID •NATURAL GAS PROGRAMME Sources: Historic - IEA Projections – OIES, Nexant WGM •3.5% decline in gas demand on 2020 – return to 2019 levels in 2021 •Demand grows 2.5% a year to 2025 almost reaching the pre-COVID-19 projection •Largest declines in 2020 in Europe, North America and Russia •Across the board rebound in 2021 – Europe sluggish growth •Asia and Middle East lead the growth post 2021 Pre and Post COVID-19 Demand Regional Breakdown •IMPACT OF COVID-19 ON GAS MARKETS Key issues for Gas in the longer term •Gas demand can continue to rise as it displaces coal in the energy mix •In Asia, air quality is a key issue, and gas can have a major role to play •In Europe, net zero CO2 emissions is a major theme – gas is part of the long-term problem unless it finds a pathway to decarbonise • 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 then Covid-19 pandemic caused a decline in consumption •Winter 2020/21 provided a shock though 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 •Record low temperatures in NE Asia boosted power and gas demand •LNG inventories low, plus lack of availability of prompt cargoes •Supply disruptions also an issue – pipeline explosion in Nigeria one example •JKM at record high on Jan 8 at $21.45/mmbtu (up 158% in 1 month) • •NATURAL GAS PROGRAMME •GLOBAL GAS AND LNG OUTLOOK • •Shortage of LNG tankers also causing a problem •Increased shipping to Asia, with longer transport times, has reduced effective capacity •Congestion at Panama Canal also delaying US LNG exports to Asia •Rate for Atlantic shipping reached $300,000/day on Jan 8 • Perfect storm pushed Asian prices to record levels in winter 2020/21 Coal production and consumption by region (mt) •The majority of production and consumption is in Asia, and has grown rapidly •China and India are the key players, as coal is both countries’ major indigenous energy resource •Decline in North America driven by the arrival of shale gas Production Consumption Asia dominance Source of economic growth – cheap and available for power Displacement by gas an economic as well as an environmental issue China policy will be key – when will it be rich enough to really take action – contrast with India Decline in coal industry •The coal industry is in long-term decline for environmental and economic reasons •The US coal industry has collapsed over the past five years •Cheap gas prices have encouraged a switch from coal, especially in power sector •Coal is still important in many developing countries, especially in Asia Employment in US coal industry Global coal price (US$/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 Renewables Generation (TWh) 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? 2017-2019 would suggest the latter Carbon emissions fell sharply in 2020 but are rebounding •Will the world just revert to its previous trend or have we seen a fundamental shift in lifestyles? 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 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? Which scenario are we heading for? •What level of overall energy demand will there be? •How much policy implementation will there be to achieve climate targets? •What will the energy mix be? •Many of these questions will be answered by politicians, not the market – • 0 5 10 15 20 25 2017 ET ME LG RT Renew.* Hydro Nuclear Coal Gas Oil Primary energy consumption by fuel Billion toe 2040 0 10 20 30 40 50 1970 1980 1990 2000 2010 Evolving transition (ET) More energy (ME) Less globalization (LG) Rapid transition (RT) CO2 emissions Gt of CO2 Strategic thinking for the Energy Transtion •text – • What are the key signposts to tell us which scenario we may be facing? •Key differences in timescale and potential cost to the business •For example, EVs are a relatively short-term risk to the oil business with a fairly significant impact • Net zero target now a major company objective for BP •Sustainable development goals now a priority •What will this do to investor returns? •What are the priorities for key shareholders? • Equinor is slightly more nuanced – keep production growing while shifting business model •Equinor is rather between BP and Exxon – use current business to fund transition strategy •Logical but could cause conflict of interest over capital allocation • The ExxonMobil View •Oil and gas demand are in natural decline from existing assets •Demand still needs to be met, even if it does start to fall •The most efficient and low cost companies can prosper • •The world is going to continue on a similar path •Energy demand will rise and hydrocarbons will continue to have a vital role •Change will be slow and incremental • NOCs in Asia also see growth to fuel developing economies •India’s ONGC is very keen to find new hydrocarbons to reduce the country’s import bill and to supply growing domestic demand •In addition, gas to replace coal and also improve the environment • RWE is diversifying its asset base away from hydrocarbon-fired power •RWE manages a significant part of Germany’s lignite-fuelled power fleet •However, it is gradually reducing its exposure and selling off nuclear assets •Renewables becoming a the main focus of the business, but trading activity is also growing in order to offset volatility and intermittency risks • ENEL, Italy’s main power company, has committed to leadership in renewable power •Global renewables business model •Operates across the electricity value chain •Rapid increase in capacity and output • Key Questions for Company Management •How much profit can I generate? » •How can I grow the business? » •Where can I grow the business? » •What are the long-term prospects for my industry? » •What are my competitors doing? » •What rules must I abide by? » •What government support can I expect? » •What do my owners / shareholders want out of their investment? » •Have I got enough money to invest in my business? » •How do I stay competitive? » •How important is public opinion and how do I keep it on my side?