February 16, 2016
In my previous two blog entries, I tried to explain why oil companies have developed the ability to view oil prices through the lens of supply and demand changes in the long-time horizon of up to several decades, and why they interpret current market developments from that perspective. As Bob Dudley, the CEO of BP, aptly stated, “In the middle of a downturn in oil and gas prices, it is important not only to adapt to the current tough conditions, but also to prepare for the next set of challenges. Energy is a long-wavelength industry and we need a long term perspective of how the energy landscape we operate in is likely to evolve.” Dudley voiced his views during the presentation of the BP Energy Outlook 2035 report, depicting what BP considers the most likely scenario for the global energy sector in 2015−2035. He believes that, despite the current decline on global energy markets and China’s economic hiccup, demand for energy will still be on the rise until 2035 and beyond. Over the next two decades, global demand for energy will grow by 34% at an average annual rate of 1.4%. With the world transitioning to a low emission economy, this trend will coincide with major changes in the energy mix.
Despite the rapid development of alternative energy sources, BP believes fossil fuels will continue to dominate the energy mix over the next 20 years. The British oil giant anticipates that fossil fuels will meet 60% of the projected increase in demand, accounting for 80% of global energy supply in 2035. Among them, natural gas will see the highest growth in consumption, projected at 1.8% annually. On the other hand, demand for crude oil will expand by a mere 0.9% annually with a gradually diminishing share in the energy mix. BP forecasts that China and India will account for as much as 50% of the forecasted global demand for crude oil (just shy of 18 mbd). As for OECD countries, demand will continue to dwindle and by 2035 their crude oil consumption will fall by 5 mbd.
Moreover, OPEC countries will play second fiddle to other players in terms of supply growth, with the latter delivering 11 mbd more oil than in 2014. It will chiefly originate from both Americas: US shale, Brazilian deep-water deposits and Canadian oil sands. In that period, OPEC countries will increase output by 7 mbd. For more information on that scenario, refer to BP’s website http://www.bp.com/en/global/corporate/energy-economics/energy-outlook-2035.html. Now I would like to discuss a factor omitted from BP’s report, namely crude oil prices.
Why did BP elect not to present the trajectory of oil prices?
Based on what Spencer Dale, BP’s chief economist, said during the follow-up Q&A session, I can see two underlying reasons. The first is related to future costs of oil production, which are currently hard to predict due to technology advances, which tend to upset the energy sector landscape now and then (by improving efficiency / lowering costs).After all, in market conditions the price of oil depends on the cost of producing the most expensive (marginal) barrel needed to satisfy demand, and so in effect it depends on efficiency. The crux is not that base-case scenarios (the most likely ones) do not factor in revolutionary innovations, or wildcards, of which we only know that they are bound to emerge in the long term. BP’s scenario is no exception here. Rather, it lies in surprises that might be in store from existing technologies. Spencer Dale pointed out that in 2007−2014 the efficiency of US shale gas production increased over five-fold, that is 30% every year for seven years! I assume that the second reason behind BP’s decision not to show price trajectories is related to the model underlying the relevant calculations. The energy sector relies heavily on general equilibrium models, which involve price relations rather than price levels. They work particularly well for analyses of economic policies, which can be incorporated into the model through factors changing the price relations of primary energy sources, such as taxes levied on fossil fuels or RES subsidies.
The fact that BP did not include oil price trajectories in their report does not mean they hold no view on how the prices could evolve in the long-time horizon. After all, the trajectories of supply and demand presented in the Outlook are underpinned by a corresponding trajectory of oil prices, which tells at least part of the story. For instance, that in BP’s analysis a growth in demand for crude oil is more pronounced than in the New Policies Scenario developed by the International Energy Agency, discussed in my previous blog entry (0.9 mbd vs 0.5 mbd). To satisfy increased demand, higher oil production is needed, which entails a higher price trajectory than that presented in the IEA report http://ffbk.orlen.com/blog/can-oil-prices-be-predicted