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Salman Ghouri

Salman Ghouri

Dr. Salman Ghouri is an oil and gas industry advisor with expertise in long-term forecasting, macroeconomic analysis and market assessments.

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How To Mitigate The Risk Of Peak Oil Demand

Refinery

There is a lively debate in the world of oil & gas surrounding the concept of peak demand. In essence, this debate centers around the question of when oil & gas demand will reach its peak and begin to decline.

This debate has become especially heated due to three recent catalyst. Firstly, the adoptions of electric vehicles (EVs) and their potential to disrupt oil’s number one pillar of demand: gasoline. Secondly, the continued growth of renewables, which have the potential to disrupt the largest natural gas market: electricity generation. Finally, the general public’s increasing awareness of, and concern about, greenhouse gas emissions and their impact on the climate.

The subject of peak demand has raised concern among shareholders of International Oil Companies (IOCs), and some are now even trying to force their companies to study the subject. The shareholders’ concern is explained by the fact that if peak demand occurs, the oil companies might be left with “stranded assets” – assets in which billions of shareholder dollars have been invested. As a result, most IOCs have communicated their views on the subject in quite explicit terms. In the U.S., ExxonMobil and Chevron don’t see Peak Demand arriving at least until 2040 or 2050. In Europe, BP is on record stating it could happen towards the end of the 2030s, while Shell communicated it could happen as early as 2025.

However, since the lion’s share of oil existing reserves are not held by the IOCs, but by OPEC’s members (and the NOC’s that produce these resources), it would seem logical that it is the NOCs that have to worry most about peak demand and stranded assets.

How would Peak Demand impact NOCs?

If/when peak demand hits, the global oil & gas markets will change fundamentally. Not because oil and gas demand would disappear overnight – that is not a realistic assumption considering the multitude of uses of the two commodities. But peak demand would result in another major supply glut, especially as shale technology is opening up new opportunities for production, putting downward pressure on oil prices.

In the “lower forever” environment that might result from this permanent glut, profit focused organizations would look to the lowest cost basins, most of which are located in OPEC’s major oil producing nations –Venezuela, Saudi Arabia, Iran, UAE, Kuwait, and Russia. Therefore, in what seems an ironic twist of fate, the countries that seem to have most to fear from peak demand will also most likely be the ones that remain standing if / once peak demand happens. Related: EU Could Switch To Euros In Oil Trade With Iran

It is other nations with more complex geological or political realities such as Indonesia that will feel the immediate pain of peak demand. Interest in their production potential will disappear as drillers will find it too burdensome and thus too costly to explore, develop or produce at lower prices levels.

Of course, it is not that the countries that will be left standing by peak demand will not be impacted. The lower oil prices will severely affect the budgets of their governments. The ability of their NOCs to re-invest in new production would thus, most likely, be severely squeezed as their owners will put them under pressure to maximize royalty, tax and dividends payments.

What strategy options would the NOCs have for dealing with peak demand?

Is accelerated production an option? One might argue that the NOCs should start producing more now, well before peak demand, as their oil reserves are worth more now than they will be after peak demand hits. This additional money could then be invested in a ‘rainy day’ fund.

This is not a realistic option, however, and it could be argued that lowering the prices of oil and gas products would slow down the penetration of non-fossil energy and electric vehicles, and thus delay peak demand. Nonetheless, the impact of this strategy on the budgets of the major oil producing nations would be devastating. OPEC is currently supporting global oil prices, and bringing an additional 1.5 mmbd capacity back onto the market could push oil prices back down into the $50s, $40s, or even less. An accelerated production strategy would simply cause mayhem – a return to the 1st quarter of 2016 when OPEC's "market share strategy" caused the price to fall into the $20s.

In other words, accelerated production is not a solution for the risk of peak demand. If anything, it would make matters worse for the major oil producing nations.

Is decelerated production an option? Decelerated production is producing below optimum, essentially what OPEC is doing right now. This tactic supports oil prices, which of course provides some comfort to the budgets of petro states. The argument for this strategy is that it makes funds available to the governments of the major producing countries, which they can then use to diversify their economies in preparation for peak demand.

But, at least part of the benefit of OPEC’s production cut is not going to the OPEC members. U.S. producers, who have not contributed to the production cuts stand to benefit from higher oil prices, enabling them to enhance their production. It is, therefore, an expensive strategy from a NOC’ perspective.

In fact, it is similar to taking drugs in order to achieve happiness. At first, it works well, but the effect quickly tapers off as higher prices encourage increased production elsewhere. So one needs another shot in the arm, bigger than the previous one, which after a while will induce the same response from other producers, and so on and so on.

Faced with peak demand, the decelerated production strategy is thus very risky in the medium to long term. Ceteris paribus, it’ll reduce the NOCs’ market share, while subsidizing other producers to invest in technology to lower their breakeven cost, and when peak demand arrives, it could hit the reserves of the major oil producing nations and make them less economically appealing. Next to this, it would incentivize investment in non-fossil energy solutions, accelerating peak oil demand.

Natural production, then? Thinking through the implications of accelerated and decelerated production makes it clear that the best strategy option is natural production, which optimizes long-term recovery from the field. Because as the above explains, in the face of peak demand, there is no quick fix solution that will keep oil prices around $70 per barrel and ensure continued demand. Related: China Looks To Capitalize On Cheap Iranian Oil

In the past, NOCs could get away with sub-optimal efficiency because their resources were so prolific and so cheap to operate compared to the price at which oil was selling. The optimal strategy for NOCs now would be to focus on optimizing long-term recovery and lowering exploration, development and production costs. If they decide to do so, their reserves will remain the prime assets of the oil industry even after peak demand.

Indeed, in the short term this will not support the budgets of the major oil producing nations, but it needs to be understood that if peak demand will happen, there is nothing in the present that can offer a long-term solution other than reducing the budgetary dependency on oil revenues.

The best strategic hedge for the risk that peak demand represents is reducing dependence on oil revenues. This will require more than just state-run grandiose projects, as such projects will only deliver if they are accompanied by a liberalization of the wider economy, reducing red-tape, and enabling the population to follow their entrepreneurial spirit.

By Salman Ghouri for Oilprice.com

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  • Ronald C Wagner on May 22 2018 said:
    The best article I have ever seen on "Peak Oil" however it does not deal with the fact that natural gas is an option to fuel any and all internal combustion engines and is the chief and logical fuel for creating electricity. It is also IMHO, the best environmental option right now and would also be better for the economy.

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