The following are demand related aspects of Carbon Asset Risk. The influences of capital expenditures, oversupply and demand destruction are outlined below.
“Cap-Ex Crisis” in Oil
In 2014, analysts at Kepler Cheuvreux coined the term “Cap-Ex Crisis” to describe the risks that oil majors were facing as the costs of producing oil had risen “astronomically” while production growth had been minimal. This crisis is most clearly illustrated in the graphic below taken from Kepler Cheuvreux’s “Toil for Oil Spells Danger for Majors,” (September 2014):
This meant that although capital expenditures were on the rise, especially for unconventional reserves, the capital efficiencies were declining rapidly. Investors emphasized the dangers that these high capital costs presented for companies especially if demand or price were to shift rapidly in shareholder resolutions filed in late 2014. The “Cap-Ex Crisis” is just one of the aspects that increases Carbon Asset Risk. Close scrutiny of a particular company’s capital costs and trends by reserve type is key to understanding how it is managing this risk.
The rise in new technologies for producing oil in the U.S. and Canada shifted the global balance of production and created a situation where supply was growing faster than global demand. When oil prices first began to fall in late 2014/early 2015, one of the key factors was oversupply. According to the EIA, U.S. production rose 45% from 2010 to 2014 while total world demand grew about 4%. Generally, when supply outstrips demand, OPEC has been willing to cut production, but with the new global dynamic at play created by hydraulic fracturing and North American growth, Saudi Arabia and other OPEC nations were unwilling to lose market share. As a result, oversupply has persisted even while prices have dropped dramatically. Many OPEC nations can continue to produce because their capital costs are lower than the capital costs incurred by many North American producers in developing unconventional reserves.
Demand for oil has also been changing as fuel efficiency standards and rapidly falling prices for renewable energy change impact markets. As one analyst put it, demand destruction is real. That is, carbon intensity is declining as the economy becomes more efficient, and oil companies are overestimating demand growth as countries like China begin to change their consumption patterns.
Finally, and crucially, oil’s competition is getting cheaper. Wind, solar and battery technology costs have been dropping more rapidly than anyone had predicted, putting quite a dent in the demand for oil for power generation. If battery costs continue to drop, that’s likely to begin to edge oil out in the transportation sector as well.