Oil bulls predict demand for oil will snap back quickly as global economic conditions improve. The International Energy Agency (IEA), on the other hand, expects a more muted recovery. Not surprisingly you can find any demand forecast needed for either the bull or bear case. And that’s just for short term price and demand forecasts. Longer term demand forecasts have to reckon with negative factors like the rise of electric vehicles including cars, trucks and buses as well as and the nudges of environmental-social-governance (ESG) investing. In addition, the industry faces risks from changes in government policies and competition from even newer technologies. But if we’re looking for positive demand surprises, economic growth in emerging economies in Africa or Asia could accelerate and suddenly require large increments of fossil fuels in the process (Remember China?).
We won’t offer our own demand forecast to compete with those from OPEC, IEA, McKinsey and many others. If the economy, particularly in the US and Europe, snaps back so should consumption of fossil fuels, at least in the short term. Based on historical demand patterns a 10% increase in GDP should produce a 5% rise in fossil fuel consumption. No econometric model required and probably none more accurate. More on that later. It should come as no surprise to readers of this website that the long term demand trends for oil and other forms of fossil fuel consumption point to an industry in long term decline. Whether this is fast or slow we have no idea.
After World War II energy consumption and economic activity grew in like fashion. Then in the 1970s, thanks to the Energy Crisis and geopolitical tensions in which oil prices rose dramatically, consumers became more conscious of energy usage and thereafter energy consumption lagged economic activity. At the same time the economy moved away from production of goods requiring large energy inputs to production of goods and services that depend on knowledge. (Large accounting and law firms for example use considerably less electricity than a steelmaker with comparable revenues.) The key takeaway here is that around the time of the Great Recession, energy consumption patterns declined once again and consumers use even less energy per unit of GDP (See Figure 1 for a simple approximation.)
World GDP grew 70% in 2000-2019 while overall energy consumption increased 46%, continuing the trend to lower energy usage per unit of GDP that began in the 1970s.
Oil demand rose only 29% in spite of low prices. Natural gas usage on the other hand grew 60% no doubt reflecting the sharp fall in prices and added availability of the resource. Coal consumption — here’s the surprise— grew 62%, although most of that growth took place early in the century thanks to higher Chinese demand which has since slowed.
Oil showed the weakest growth of the three fossil fuels over the past two decades.
Looking ahead vehicle electrification (transportation consumes more than half of oil production) will no doubt reduce future oil demand. Coal demand will likely hold on for a while as developing countries finish coal fired power stations that they will likely attempt to operate for a decade or two prior to abandonment. But that market could sag as lending institutions bow to increasing public pressure about lending to finance those projects and because renewable resources and relatively inexpensive LNG are making the projects less competitive. Growth in coal consumption started to decelerate around 2013. For that matter, the increase in electric generation has slowed throughout the world (electric generation makes up close to half the market for coal).
Natural gas is widely used in industrial processes, electric power generation and heating and on a CO2 and particulates emissions basis is less polluting than oil and coal. On a transitional basis natural gas has seemed to us the fuel likeliest to grow its markets. But even here, political opposition from environmental activists, who prefer zero carbon emissions to less carbon emissions, have targeted gas for elimination. And drillers will once again need to worry about government mandated pollution control measures that inevitably raise costs as their four year hiatus from regulatory scrutiny may end with a new administration in Washington.
Looking farther out, researchers hope to replace natural gas with gases removed from the atmosphere or with green hydrogen and “renewable” gas. As an aside we should point out that we regard hydrogen the way we regard new nuclear power plant technologies. They both produce energy. And they both do so at economically unattractive prices but remain useful in niche applications.
So this is our question: will energy demand snap back or will the work from home movement coupled with broader economic trends continue to depress energy usage? This year both world GDP and energy consumption may fall 5%. If COVID-19 is brought under control world economic activity and energy consumption should rise and perhaps sharply. Do we expect a snap back? Yes, but would it be greater than the 5% demand loss? And is that likely rebound enough to change the long term picture especially for capital allocators in the industry?
Companies that invest in capital assets and investors who buy stock make similar decisions. The only difference is that stockholders can change their minds about a stock or its industry quickly. Nor are return seeking investors wedded to a particular line of business. The oil industry executives making capital allocation decisions with respect to investments that might not produce profits for years have the opposite problem. Once committed they can’t quickly or easily change strategic direction. Our bottom line is that long term market trends look less attractive than short term trends. If this proves correct who will want these assets and at what price several years from now?
Energy industry strategies seem to fit in one of three categories. One group, notably oil companies in the US and Russia, has chosen to double down on commitment to fossil fuels. A second group, primarily European oil firms, has decided that the future for the oil business looks grim but not right away. Consequently they are limiting new development to less risky prospects and investing in a renewables business as well. The third group is divesting or selling fossil fuel assets presently and redeploying proceeds to renewable energy. In this respect the big European utilities lead the way.
As we see it, asset ambiguity will not pay off. Investors do not like companies with two competing products and strategies—especially when they are diametrically opposed businesses like renewables and fossil fuels. We suspect this tendency may apply to customers and employees as well.
Industry managements may have to decide about the future of fossil fuels sooner than many investors realize. So we would suggest investors look beyond a likely and pleasant near term energy recovery and focus on the long term. The bull case for oil probably hinges on a gradual, multi decade energy transition where demand gradually tapers off but with occasional bursts in demand belying the secular shift.
The bear case is simply that new energy investments made today will be uneconomic long before the end of their economic lives. This makes those new investments possible stranded assets from an accounting perspective that have be written off. This is akin to throwing away money.
So, back to the opening question. Snap back short term? Yes, probably, but not necessarily relevant for decision making.