Toil for Oil Spells Danger for Majors Unsustainable Dynamics Mean Oil Majors Need to Become “Energy Majors”

15 September 2014 Energy transition & climate change Toil for oil spells danger for majors Unsustainable dynamics mean oil majors need to become “energy majors” Oil and stranded assets: gauging the risk from higher long-term prices Until now, concern over new high-cost oil projects potentially becoming stranded in future has focused on the downside risk to oil prices, a concern that will only increase if oil prices – already down by nearly USD20/bbl since June on demand worries – fall further near term. However, there is another dimension to stranded-asset risk, largely ignored in this debate so far, namely the risk posed by a scenario of sustained higher oil prices over the longer term. And when looking at the risk of stranded assets it is the long term – i.e. beyond 2025 – that counts. Dynamics of oil majors’ upstream capex increasingly unsustainable Despite oil prices averaging close to USD110/bbl since mid-2011, the majors have seen their capital productivity decline sharply in recent years, prompting them to announce cuts to future capex in Q1 of this year. This is a clear sign they need higher prices for their higher-cost new projects. For this and many other reasons, we think that whatever happens in the near term, sustained higher prices will ultimately be necessary to bring on the supply projected in the IEA’s base-case scenario out to 2035. But with our Energy Return on Capital Invested (EROCI) analysis suggesting that renewables are already surprisingly competitive with marginal new oil projects, and with renewables set to see further cost reductions over the next two decades, higher long-term oil prices will be no guarantee against asset-stranding beyond 2025 for marginal new projects. EVs are a risk to long-term oil demand growth, with China the key The IEA sees global oil demand 14mbd higher in 2035, with c.4mbd of this for light vehicles in Asia. If the improving economics of renewables versus oil spurs a faster take-up of EVs in China than the IEA is assuming, this could threaten the viability of the marginal barrels beyond 2025. Higher long-term oil prices could thus create asset-stranding risk for new projects undertaken today at the higher end of the cost curve, a risk the majors should take seriously. Indeed, we think the oil majors now need to re-think their business model and become energy majors. Sustainability research team Oil & Gas research Mark C. Lewis (author) Samuel Mary Peter Oppitzhauser (head) [email protected] [email protected] [email protected] +33 1 7081 5760 +44 20 7621 5190 +41 43 333 6002 Stéphane Voisin (coord.) Robert Walker [email protected] [email protected] +33 1 7081 5762 +44 20 7621 5186 Sudip Hazra [email protected] +33 1 7081 5762 IMPORTANT. Please refer to the last page of this report for “Important disclosures” and analyst(s) certifications keplercheuvreux.com ESG research Contents Executive summary ............................................. 3 Risks to our view 16 With a model in crisis oil majors must become “energy majors” 18 Glossary of terms used throughout this report 18 Toil for oil: a much harder game since 2005 22 Declining conventional crude output since 2005 23 The rise of unconventional crude: intensive and expensive 31 Global exports of crude oil in decline since 2005 45 Conclusion: toil for oil triggers rising capital intensity 64 Oil and the IEA’s NPS: A Critique .................... 69 The key macro assumptions underlying the NPS 70 Non-OECD countries drive increase in oil demand out to 2035 72 IEA assumes huge improvement in energy and oil intensity 74 Where will the supply to satisfy this demand come from? 77 Outlook for upstream oil capex to 2035 91 What will the IEA’s oil-supply projections cost to bring in? 93 Conclusion: higher oil prices needed, but can the world afford it? 98 Pricing scenarios and future capex risk ........ 99 The high-price scenario: not a panacea for the majors 101 The flat-price scenario: what if prices remain stagnant? 110 The low-price scenario: the biggest risk for the oil majors 111 Conclusion on pricing scenarios 112 Future capex at risk of stranding even with higher oil prices 113 Conclusion: oil majors need to become “energy majors” 129 Research ratings and important disclosures 130 Legal and disclosure information .................... 132 2 keplercheuvreux.com ESG research Executive summary Toil for oil: market’s structural changes entail higher long-term prices The global oil market has undergone profound structural changes in the last decade that have now culminated in a capex crisis for the industry, particularly the oil majors. The structural changes that have precipitated this crisis are as follows: The fact that conventional crude-oil output has fallen since 2005, with overall supply ever more dependent since on (i) unconventional crude (more expensive and capital intensive than conventional crude), and (ii) natural-gas liquids and bio- fuels (of lower quality and less versatile than conventional crude); The fact that net global exports of crude oil have been declining since 2005 owing to sharply higher consumption in exporting countries – especially the OPEC countries with their very rapid population growth and highly subsidized domestic oil prices; The fact that the upstream oil industry’s capital intensity has increased astronomically over the last decade owing to the massive annual investments now required in order (i) to replace declining output in ageing conventional fields, (ii) to counter the phenomenally high decline rates in US shale-oil plays, and (iii) to add supply over and above replacement levels so as to meet growing global demand; The fact that record recent levels of upstream capex since 2005 have fed through into only very modest increases in the total oil supply (and have not been able to prevent a decline in the supply of conventional crude oil); The fact that the rising costs associated with the industry’s increasing capital intensity have run ahead of prices since 2011, and thus led to a fall in the oil majors’ capital productivity and hence to cuts in their capex budgets since the beginning of this year; The fact that the always troubling geo-politics of oil seem to have become even more complicated recently, especially with regard to Iraq, Russia, and Libya. Moreover, the base-case scenario of the International Energy Agency (IEA) over 2013-35 (known as the New Policies Scenario, or NPS) projects a further decline in the annual output of conventional crude oil over the next two decades and hence an accentuation of the increasing dependence on unconventional crude oil and other petroleum liquids observable since 2005. Despite this, the IEA projects only a modest increase in real oil prices out to 2035, although in our view some of its key assumptions look very optimistic. In this respect, we would highlight the following: The fact that the IEA projects that such growth as there will be in the supply of conventional crude oil will come from three countries – Iraq, Brazil, and Kazakhstan – whose ability to deliver on expectations is open to serious question. This means that the fall in conventional crude output over the next two decades could be much steeper than the IEA is projecting. The fact that the IEA’s projections for growth in the aggregate supply of crude oil (i.e. conventional and unconventional combined) are highly dependent on continuing rapid growth in US unconventional oil, known as shale oil or light-tight oil (LTO). 3 keplercheuvreux.com ESG research Again, this means that if the IEA’s projections for growth in US LTO output prove to be too optimistic, the increase in overall crude oil-production will be significantly lower over the next two decades than the IEA is projecting. The fact that the IEA is actually projecting an increase in net exports of crude oil out to 2035, even though net crude exports have been falling since 2005. Again, however, this increase in crude exports depends overwhelmingly on Iraq, Brazil, and Kazakhstan (with higher Canadian oil-sands production also boosting exports of unconventional crude). This means that if any or all of these countries sees slippage against the IEA’s projections, global exports of crude oil could fall much more precipitously over the next two decades than they have over the last decade. The fact that the IEA sees a broadly flat annual capex requirement for the upstream oil industry over the next two decades despite the sharp year-on-year increases experienced over the last decade, and despite the increasing importance of unconventional crude oil – with its much higher capital intensity – in the IEA’s projections out to 2035. Significantly, though, the IEA does acknowledge that its base-case projections for the future oil supply depend on timely investments being made across the forecast period in order to bring on new supply to compensate for the ongoing decline in ageing oilfields. And in this respect, the main risk highlighted by the IEA to its future supply projections is that the increases in investment in the Middle East OPEC countries necessary to raise their output through the 2020s and beyond might not be forthcoming in a timely manner towards the end of this decade and the beginning of the next. However, we think that the capex crisis of the oil majors – as signalled by their announcements earlier this year that they will reduce their upstream investments over their updated capital-budgeting horizons – means that the risk of insufficient investment is already here today. In turn, this means that the impact on supply is likely to be felt long before the early 2020s.

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