During the second half of the nineteenth century,
Manaus, the capital of Brazil's
Amazonas state, was one of the wealthiest cities in the world.
"If one rubber
baron bought a vast yacht," recounted one historian,
"another would install a tame lion in his villa, and a third
would water his horse on champagne."
A magnificent,
publicly-funded opera house, like the one immortalized in the
film Fitzcarraldo, opened in 1896.
It was not to last.
By 1910 the British
had smuggled out enough rubber seeds for Malaya to become the
pre-eminent global producer, eclipsing Amazonas and driving down
prices. Between the two world wars, chemists created better and
better synthetic rubbers, and by 1945 the natural rubber
industry was in steep decline.
Today, the entire
state of Amazonas accounts for just 1.5% of Brazil's economy.
I was put in mind of Manaus this month on a visit to Calgary,
business center of Alberta, the home of Canada's oil sands
industry. Like Manaus in its prime, Calgary is brashly wealthy.
It sports more
millionaires per capita than any other Canadian province; its
annual stampede is a raucous celebration of cowboy culture; it
has a brand new $200 million National Music Centre. But can the
good times last?
Alberta certainly had a tough few years in the aftermath of the
2014 global oil price crash. Not only did it suffer a deep
recession but, due to an oddity of Canadian economics, had to
continue sending so-called "equalization payments" to other
provinces.
In January, a carbon
levy introduced by the Province's center-left NDP government
doubled to C$30 per metric ton, one of the highest carbon prices
in North America.
Now that oil prices have risen sharply from their lows,
Alberta's immediate pain has passed. Its oil and gas companies
are once again highly profitable, jobs are returning. The
dominant political narrative, however, is one of victimhood.
As many Albertans see
it, the carbon levy, which raises about C$1.4 billion ($1
billion) per year, was meant to buy the oil sands sector a
social license to operate, in the very specific form of pipeline
approvals from neighboring provinces and countries, in absence
of which Albertan crude trades at an estimated $15 billion
annual discount to international prices.
Since the carbon levy's introduction, however,
-
President
Barack Obama has blocked Keystone XL
-
Prime
Minister Justin Trudeau has killed the Northern Gateway
-
Transcanada
has been forced to drop its application for Energy East,
...all in the face of
stiff opposition from aboriginal groups and climate activists.
Even today, the
neighboring province of British Columbia is blocking
construction of the Trans-Mountain Pipeline Expansion, which
would increase export capacity of Albertan oil to Asian markets.
Albertans are furious that, while the rest of Canada is happy to
accept equalization payments generated largely by taxes and
royalties on Albertan oil sands, it nevertheless continues to
demonize its production and attempt to block its export.
The problem is that while playing the victim may make Albertans
feel good, and looks like being a winning electoral strategy for
Jason Kenny, the leader of a resurgent conservative
coalition, it will do nothing to resolve the underlying
structural weakness of Alberta's economy.
The province is a
high-cost, high-carbon producer of a commodity that is about to
enter long-term decline, being sold to a world increasingly
concerned about climate change and increasingly exposed to
viable alternatives.
These challenges are not unique to Alberta.
Every country, state,
company and investor dependent for the bulk of its wealth on
fossil fuels or internal combustion transportation should be
thinking very carefully about the accelerating transition to
clean energy and transport.
As I wrote in March, the global economy is on track towards what
I call the "Three Third World":
by 2040, one
third of global electricity will be provided by wind and
solar; one third of all vehicles on the streets will be
electric; and the global economy will be one third more
energy-efficient.
Just to be clear, the
world will have to go much further and faster than the Three
Third World if it is to mitigate the impacts of 'anthropogenic'
climate change, and there are signs of accelerating
innovation in other sectors such as industry, agriculture and
heating.
However, even the
Three Third World will have profound implications for the oil
and gas sectors.
Demand for natural gas will continue to grow, but not
precipitously, as it is outcompeted in bulk markets by
renewables and in short-term balancing markets by demand
response and power storage.
Demand for oil will
peak sometime between 2025 and 2030 and will begin a long-term
decline thereafter. Prices for oil and gas will remain moderate
- in the case of gas, depressed by the combination of cheap
shale gas and growth in LNG, and in the case of oil by the
long-term decline of demand more or less pacing the long-term
decline of known fields.
In this environment, let's look at two possible strategies for
oil and gas companies.
Option one
- "Vicar of Bray"
Under the first strategy - which we could call the Vicar of
Bray - oil and gas companies attempt to maintain leadership
of the commanding heights of the energy industry as it shifts
away from fossil fuels to clean energy, through a
perfectly-timed and elegantly-executed redirection of capital
and human capacity.
Note:
"The Vicar of Bray" is a satirical song dating back to the 18th
century, recounting the ecclesiastical contortions of a
fictional vicar living through changes to the Established Church
during the reign of six different English monarchs.
Early attempts at the Vicar of Bray include BP's famous
"Beyond Petroleum" rebranding under Lord Browne in 2000 -
which was followed by the investment of $8 billion in clean
energy, some of which was later written off.
Similarly, Shell
tried to gain a leadership position in the nascent solar sector
by buying Siemens Solar in 2002; six years later it sold the
sub-scale and failing operation.
David Crane,
former CEO of NRG, famously failed in his attempt to turn it
into a clean energy company.
Today, it looks like all the major European oil companies are
planning on some variant of Vicar of Bray.
-
Shell
(disclosure: whose New Energies Advisory Board I
recently joined) has announced its intention to invest
$2 billion per year in its New Energies division until
2020, out of its total capital spending of $25-30
billion
-
BP is
investing a more modest $0.5 billion out of its $15
billion capex budget
-
French oil
giant Total has committed to 20 percent low-carbon
businesses within 20 years (although this includes
mid-stream and down-stream gas)
-
Statoil has
been investing in floating offshore wind as well as
carbon capture and sequestration, and this year
announced its relaunch as Equinor, removing "oil" from
its name, if not from its cash flows.
While many climate
activists would like to see oil companies try to morph into
clean energy companies, it is far from clear this can be
successfully achieved.
Professor Clayton
Christensen, inventor of the term "disruptive innovation",
established his career by documenting example after example of
powerful incumbent companies, full of smart people, failing to
navigate transitions to new technologies or business models.
Great companies, he
theorized, are always highly focused on the needs of their most
demanding clients - needs which new technologies and business
models generally don't quite meet.
So while incumbents
hold back, new players stimulate demand and serve new sectors
until they have added enough performance to go after the core
market - but at lower cost.
Sounds like electric
vehicles and solar power?
In addition,
incumbents are almost always culturally biased against
disruptive innovation: their existing business franchise makes
them risk-averse, and for all the corporate rhetoric, truly
disruptive innovators have a tough time in companies politically
dominated by the very businesses they are trying to destroy.
Building a clean energy business inside an oil and gas company
presents an additional challenge in the form of resistance from
the capital markets.
Clean energy
companies can be broadly divided into,
Fossil fuel investors
understand all about exploration and development risk, sovereign
risk, even interest rate risk, but little or nothing about how
to scale a technology provider.
As for asset-based
clean energy businesses, they tend to be less risky than oil and
gas developments; however, since they generally generate lower
returns, they require a lower cost of capital.
An oil company held
by investors for its volatile but lucrative returns is not the
right owner of utility assets.
Option two
- "Sunset Ride"
The second option for an oil and gas company - let's call it the
Sunset Ride - is to accept that the fossil fuel sector is about
to enter long-term decline, and manage its business accordingly.
The sunset will be
long and slow:
the world will be
using fossil fuels and petrochemicals for many decades to
come, and companies embarking on the Sunset Ride could have
an extended and highly cash-generative future ahead of them,
even if it is ultimately a time-limited one.
Sunset Ride
does, however, come with a number of caveats.
The first is that in
a declining market, the only safe place to be is at the very low
end of the cost curve. Oil prices may be nudging $80 right now,
but to inform strategy you need a long-term view.
BP Chief Executive
Bob Dudley recently said he expected oil prices to remain on
a $50 to $65 per barrel "fairway" in coming years; I would have
plumped for $40 to $60, but in principle he's right.
A price signal below
$40 will result in a surge in demand, especially in developing
countries; a price signal above $60 will open the taps for large
amounts of unconventional oil, accelerate the growth of
substitutes, and suppress demand.
The oil price will
spike above and below the fairway, perhaps for several years at
a time - as the global economy overheats or stumbles,
geopolitics happens and animal spirits go crazy - but $40-60
looks like a safe central scenario for strategic planning
purposes.
Any oil and gas
company embarking on a Sunset Ride needs to be able to maintain
its assets and throw off cash for decades at those prices, as
well as survive dry spells of a few years at a time below
$40/barrel.
The second caveat is that any oil and gas company undertaking a
Sunset Ride must do so ethically if it is to secure its
long-term social license to operate. This is easier for natural
gas than for oil: gas is the natural partner for the very cheap
"base-cost" renewables that is set to provide more and more of
the world's electricity in coming decades.
Battery costs are
plummeting, and that will challenge gas in many of its current
bastions, but storage at seasonal scale, or even to compensate
for low-wind weeks, will still be more expensive than gas for
many, many years.
Yet, despite their
important role in the coming low-carbon power system, gas
producers cannot take societal acceptance for granted.
Global gas production
is going to rely increasingly on fracking, not just in the U.S.,
and fracking is mistrusted by the public almost everywhere -
with some justification, given the short-term and cavalier way
it has often been pursued.
There is no inherent dishonor or immorality in pursuing a Sunset
Ride. Even the most ardent climate activist is going to be a
user of fossil fuels and petrochemical products for many more
decades, and no one with integrity can demonize products whose
demand they themselves drive.
Dishonor and
immorality lie only in attempts to obfuscate or delay the global
transition to clean energy and transport, either through
lobbying and misinformation or through a failure to strive for
the highest standards within one's own operations.
Oil and gas companies
need to lead on eliminating fugitive emissions and flaring, and
to act with transparency and honor around the world.
The third caveat for proponents of Sunset Ride is that it must
be accompanied by clear shareholder communications.
It's not that
Sunset Riders can no longer grow, it's about being clear
that they will do so only within an overall market that is set
to shrink - and explaining that investors looking for exposure
to clean energy need to take their dividends and seek their own
opportunities, rather than expecting oil and gas executives to
do it for them.
So, how to
choose?
Vicar of Bray, or Sunset Ride - two strategies,
each potentially value-creating, each, if correctly executed,
societally and morally acceptable.
How do you decide
which is right for your organization?
Vicar of Bray
certainly looks harder to execute, given that it is likely to
entail retiring or selling the bulk of existing assets;
replacing old investors with new ones; and completely rebuilding
your culture and skills from the mail room to the boardroom.
There are examples of
companies that have achieved dramatic reinventions in the face
of industry upheaval - IBM, Microsoft and some telecoms
companies have done it (Nokia managed it once, but not twice),
as have some chemicals companies and retailers - but they are
the exception, as Christensen concluded.
Oil and gas companies are not the only ones facing a crucial
decision between Vicar of Bray and Sunset Ride in the face of
the transitions to clean energy and transport.
For car companies, it
looks increasingly like the decision has been taken for them:
there simply doesn't appear to be a viable route to survival for
any producer not committed to electrification.
Certainly, there is
no route to growth:
although people
will be buying petrol and diesel vehicles for a few more
decades, Bloomberg New Energy Finance's 2018 Electric
Vehicle Outlook (web
| Terminal), released last week, shows that almost all
incremental annual car sales in China will be electric, and
the rest of the world will reach peak internal combustion
sales early in the 2020s.
Vicar of Bray it must
be...
For the coal industry, by contrast, it's a forced Sunset Ride.
Investors - even
those that are not divesting - simply don't trust coal companies
to reinvest any cash generated into clean energy. Investors have
choices:
if they want to
wind down their exposure to coal, and build a position in
clean energy, they don't need the help of an embattled group
of coal executives - they can do it more quickly and with
less risk at the portfolio level.
Oil and gas companies
could go either way.
To plump for Vicar of
Bray, you have to believe that you have very significant
synergies, either in terms of assets or skills, which can be
shared across legacy oil and gas operations and any new clean
energy activities. The jury is out as to whether such synergies
really exist, and whether they will be meaningful enough to
cover frictional costs.
Many U.S. oil and gas
companies, currently insulated from some of the societal
pressures building elsewhere in the world, appear to have chosen
the Sunset Ride by default.
Smaller
organizations, like the legions of independent oil and gas
companies that throng the oil capitals of Houston and Calgary,
may realistically have no other option.
So where does all this leave Alberta? Can it realistically
translate its leadership in oil and gas into leadership in clean
energy and transportation?
Perhaps, though that
would require extraordinary leadership, hard work and a goodly
dollop of luck.
Should it instead
double down on oil and gas? Again, perhaps - but if it does, it
must aim to be the world's lowest-cost, highest-responsibility
supplier.
Look at it this way:
if oil from
Canadian oil sands could be delivered at a lower cost and
with a lower carbon footprint than Saudi crude, is there any
doubt it would be the first choice of the majority of global
consumers, including those most concerned about climate
change?
Of course Vicar of
Bray and Sunset Ride only define the book-ends of the
strategic space facing oil and gas companies.
In real life, most
companies will want to pursue some combination of the two, at
least for an initial period. The important thing is to do so as
an explicit choice, and not as a result of muddled thinking or
ill-judged compromise, and to be in no doubt as to which is your
fundamental long-term direction of travel.
Vicar of Bray, Sunset Ride or an explicit mix of the two? It's
time for every fossil fuel executive, investor and leader of an
oil-producing state or nation to make an explicit decision. No
pressure!
