Slippery road ahead for oil

Slow recovery: A ConocoPhillips refinery in California. According to Schroders, the long-term structural pressure on the oil industry is likely to stay even when the pandemic eases due to the subdued travel demand and a shift to cleaner sources of energy. — Bloomberg

THE Covid-19 pandemic has undoubtedly changed the outlook for the oil market.

Already under pressure prior to the coronavirus outbreak due to tighter regulation from governments to control carbon emissions, the oil industry’s tough rough ahead has only been exacerbated by the impact of the global health crisis.

According to Schroders senior economist Irene Lauro, the long-term structural pressure on the oil industry is likely to stay even when the pandemic eases.

“After delivering strong returns at the beginning of the new millennium, the fossil fuel industry started to underperform the S&P 500 in 2014 on the back of plummeting oil prices, ” she says.

“This trend is likely to continue, given the ongoing downward pressure on oil prices from subdued travel demand and a potential shift to cleaner sources of energy such as renewables, ” she argues.

In her recent note titled “Green or brown? Why the colour of the recovery matters to investors”, Lauro points out that a great deal of demand for oil comes from the transportation sector, and that has been hit dramatically by lockdown measures which brought cars, trucks, trains and airplanes to a standstill.

“Comments from the airline industry indicate that travel demand will likely remain depressed until there is a vaccine or treatment for the coronavirus, ” she writes.

Over the week, the International Energy Agency (IEA) said the Covid-19 pandemic has caused more disruption to the energy sector than any other event in recent history, leaving impact that will be felt for years to come.

Its assessment is that global energy demand is set to drop by around 5% this year, while energy-related carbon dioxide (CO2) emissions are expected to decline by 7%, and energy investment by 18%.

The estimated falls of 8% in oil demand and 7% in coal use stand in sharp contrast to a slight rise in the contribution of renewables, the IEA says. The reduction in natural gas demand is around 3%, while global electricity demand looks set to be down by a relatively modest 2% for the year, it adds.

Amid the collapse in global economic activity due to the Covid-19 pandemic, annual CO2 emissions are expected to decline 2.4 gigatonnes (Gt) to around 31 Gt, a level where they were a decade ago.

“Emissions tend to move hand-in-hand with macroeconomic activity and so they are expected to bounce back as the recovery gathers momentum. After all, a brown recovery, in which we would continue to rely on fossil fuel for energy, is what’s happened after previous crises: but what if this time is different?” Lauro questions.

Energy firms’ response

Brent crude oil futures are currently trading at around US$42-US$43 a barrel, that’s down about 36% year to date (ytd). US crude futures, on the other hand, are currently trading at US$40-US$41 a barrel, down 34% ytd.

In response to lower energy prices, Schroders notes, there have been several write-off announcements from oil companies in recent months. This, the fund management company says, suggests oil and gas (O&G) worth billions of dollars may be left in the ground.

“But pressure to decrease carbon intensity and efforts to cut emissions are also playing a role. If this is the case, then even if oil prices recover so that extracting reserves becomes profitable, a large chunk of these assets could be left in the ground, ” Lauro argues, adding many energy companies are stepping up their efforts to transition to a low carbon economy.

She notes any attempt to limit global carbon emissions is going to mean a reduction in the quantity of fossil fuels we burn.

“Yet present valuations of energy companies, for example, implicitly assume that their energy reserves have future market value. If this changes, there will be consequences for equity markets, ” Lauro says.

She points out that while oil companies have already written off a substantial amount of fossil fuel reserves in the face of the Covid-induced collapse in energy demand, Schroders’ analysis highlights that a lot remains in the ground.

“Risks of a stranded assets scenario have not been priced in, ” Lauro says.

“We use MSCI data on companies’ potential emissions to find that the stock markets of countries such as the US, Russia, China and India could see a reduction in returns, should climate policies be implemented in a low carbon transition, ” she explains.

According to Lauro, structural changes are needed to accelerate the transition to a low-carbon economy. Only fiscal and regulatory policy can boost a de-carbonisation of the energy sector through reduced reliance on fossil fuels, increased energy efficiency, and increased use of renewables.

In the first quarter of the year, while investment in the O&G industry declined dramatically, investment into renewable energy boomed, registering the strongest quarter in a decade, Lauro says, citing fDi Markets data.

“Even more importantly from a financial investor perspective, the renewable energy sector significantly outperformed the fossil fuel industry since the start of the pandemic, ” she adds.

Recent research highlights that investment in clean energy creates three jobs for each job lost in the fossil fuel sector, and for each US$1mil shift from fossil fuels to clean energy, an average of five additional jobs are created. This research, however, focused only on the short-term employment effects of reducing fossil fuel production while boosting clean energy production.

“As green energy is a young industry, the decarbonisation of the energy sector is likely to involve increases in manufacturing and installation of renewable and efficiency technologies, providing much-needed support to employment when governments are trying to reboot their economies, ” Lauro explains.

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