Liebreich: Vicar of Bray or Sunset Ride – Oil & Gas Faces a Decision

By Michael Liebreich
Senior Contributor 
Bloomberg New Energy Finance

During the second half of the nineteenth century, Manaus, the capital of Brazil’s Amazonas state, was one of the wealthiest cities in the world. “If one rubber baron bought a vast yacht,” recounted one historian, “another would install a tame lion in his villa, and a third would water his horse on champagne.” A magnificent, publicly-funded opera house, like the one immortalized in the film Fitzcarraldo, opened in 1896.

It was not to last. By 1910 the British had smuggled out enough rubber seeds for Malaya to become the pre-eminent global producer, eclipsing Amazonas and driving down prices. Between the two world wars, chemists created better and better synthetic rubbers, and by 1945 the natural rubber industry was in steep decline. Today, the entire state of Amazonas accounts for just 1.5% of Brazil’s economy.

I was put in mind of Manaus this month on a visit to Calgary, business center of Alberta, the home of Canada’s oil sands industry. Like Manaus in its prime, Calgary is brashly wealthy. It sports more millionaires per capita than any other Canadian province; its annual stampede is a raucous celebration of cowboy culture; it has a brand new $200 million National Music Centre. But can the good times last?

Alberta certainly had a tough few years in the aftermath of the 2014 global oil price crash. Not only did it suffer a deep recession but, due to an oddity of Canadian economics, had to continue sending so-called “equalization payments” to other provinces. In January, a carbon levy introduced by the Province’s center-left NDP government doubled to C$30 per metric ton, one of the highest carbon prices in North America.

Now that oil prices have risen sharply from their lows, Alberta’s immediate pain has passed. Its oil and gas companies are once again highly profitable, jobs are returning. The dominant political narrative, however, is one of victimhood. As many Albertans see it, the carbon levy, which raises about C$1.4 billion ($1 billion) per year, was meant to buy the oil sands sector a social license to operate, in the very specific form of pipeline approvals from neighboring provinces and countries, in absence of which Albertan crude trades at an estimated $15 billion annual discount to international prices.

Since the carbon levy’s introduction, however, President Barack Obama has blocked Keystone XL, Prime Minister Justin Trudeau has killed the Northern Gateway, and Transcanada has been forced to drop its application for Energy East – all in the face of stiff opposition from aboriginal groups and climate activists. Even today, the neighboring province of British Columbia is blocking construction of the Trans-Mountain Pipeline Expansion, which would increase export capacity of Albertan oil to Asian markets.

Albertans are furious that, while the rest of Canada is happy to accept equalization payments generated largely by taxes and royalties on Albertan oil sands, it nevertheless continues to demonize its production and attempt to block its export.

The problem is that while playing the victim may make Albertans feel good, and looks like being a winning electoral strategy for Jason Kenny, the leader of a resurgent conservative coalition, it will do nothing to resolve the underlying structural weakness of Alberta’s economy. The province is a high-cost, high-carbon producer of a commodity that is about to enter long-term decline, being sold to a world increasingly concerned about climate change and increasingly exposed to viable alternatives.

These challenges are not unique to Alberta. Every country, state, company and investor dependent for the bulk of its wealth on fossil fuels or internal combustion transportation should be thinking very carefully about the accelerating transition to clean energy and transport.

As I wrote in March, the global economy is on track towards what I call the “Three Third World”:  by 2040, one third of global electricity will be provided by wind and solar; one third of all vehicles on the streets will be electric; and the global economy will be one third more energy-efficient. Just to be clear, the world will have to go much further and faster than the Three Third World if it is to mitigate the impacts of anthropogenic climate change, and there are signs of accelerating innovation in other sectors such as industry, agriculture and heating. However, even the Three Third World will have profound implications for the oil and gas sectors.

Demand for natural gas will continue to grow, but not precipitously, as it is outcompeted in bulk markets by renewables and in short-term balancing markets by demand response and power storage. Demand for oil will peak sometime between 2025 and 2030 and will begin a long-term decline thereafter. Prices for oil and gas will remain moderate – in the case of gas, depressed by the combination of cheap shale gas and growth in LNG, and in the case of oil by the long-term decline of demand more or less pacing the long-term decline of known fields.

In this environment, let’s look at two possible strategies for oil and gas companies.

Option one: “Vicar of Bray”

Under the first strategy – which we could call the Vicar of Bray  – oil and gas companies attempt to maintain leadership of the commanding heights of the energy industry as it shifts away from fossil fuels to clean energy, through a perfectly-timed and elegantly-executed redirection of capital and human capacity.

Early attempts at the Vicar of Bray include BP’s famous “Beyond Petroleum” rebranding under Lord Browne in 2000 – which was followed by the investment of $8 billion in clean energy, some of which was later written off. Similarly, Shell tried to gain a leadership position in the nascent solar sector by buying Siemens Solar in 2002; six years later it sold the sub-scale and failing operation. David Crane, former CEO of NRG, famously failed in his attempt to turn it into a clean energy company.

Today, it looks like all the major European oil companies are planning on some variant of Vicar of Bray. Shell (disclosure: whose New Energies Advisory Board I recently joined) has announced its intention to invest $2 billion per year in its New Energies division until 2020, out of its total capital spending of $25-30 billion; BP is investing a more modest $0.5 billion out of its $15 billion capex budget. French oil giant Total has committed to 20 percent low-carbon businesses within 20 years (although this includes mid-stream and down-stream gas). Statoil has been investing in floating offshore wind as well as carbon capture and sequestration, and this year announced its relaunch as Equinor, removing “oil” from its name, if not from its cash flows.

While many climate activists would like to see oil companies try to morph into clean energy companies, it is far from clear this can be successfully achieved. Professor Clayton Christensen, inventor of the term “disruptive innovation”, established his career by documenting example after example of powerful incumbent companies, full of smart people, failing to navigate transitions to new technologies or business models. Great companies, he theorized, are always highly focused on the needs of their most demanding clients – needs which new technologies and business models generally don’t quite meet. So while incumbents hold back, new players stimulate demand and serve new sectors until they have added enough performance to go after the core market – but at lower cost. Sounds like electric vehicles and solar power? In addition, incumbents are almost always culturally biased against disruptive innovation: their existing business franchise makes them risk-averse, and for all the corporate rhetoric, truly disruptive innovators have a tough time in companies politically dominated by the very businesses they are trying to destroy.

Building a clean energy business inside an oil and gas company presents an additional challenge in the form of resistance from the capital markets. Clean energy companies can be broadly divided into technology providers on the one hand, and asset-based businesses on the other. Fossil fuel investors understand all about exploration and development risk, sovereign risk, even interest rate risk, but little or nothing about how to scale a technology provider. As for asset-based clean energy businesses, they tend to be less risky than oil and gas developments; however, since they generally generate lower returns, they require a lower cost of capital. An oil company held by investors for its volatile but lucrative returns is not the right owner of utility assets.

Option two: “Sunset Ride”

The second option for an oil and gas company – let’s call it the Sunset Ride – is to accept that the fossil fuel sector is about to enter long-term decline, and manage its business accordingly. The sunset will be long and slow: the world will be using fossil fuels and petrochemicals for many decades to come, and companies embarking on the Sunset Ride could have an extended and highly cash-generative future ahead of them, even if it is ultimately a time-limited one.

Sunset Ride does, however, come with a number of caveats. The first is that in a declining market, the only safe place to be is at the very low end of the cost curve.

Oil prices may be nudging $80 right now, but to inform strategy you need a long-term view. BP Chief Executive Bob Dudley recently said he expected oil prices to remain on a $50 to $65 per barrel “fairway” in coming years; I would have plumped for $40 to $60, but in principle he’s right. A price signal below $40 will result in a surge in demand, especially in developing countries; a price signal above $60 will open the taps for large amounts of unconventional oil, accelerate the growth of substitutes, and supress demand. The oil price will spike above and below the fairway, perhaps for several years at a time – as the global economy overheats or stumbles, geopolitics happens and animal spirits go crazy – but $40-60 looks like a safe central scenario for strategic planning purposes. Any oil and gas company embarking on a Sunset Ride needs to be able to maintain its assets and throw off cash for decades at those prices, as well as survive dry spells of a few years at a time below $40/barrel.

The second caveat is that any oil and gas company undertaking a Sunset Ride must do so ethically if it is to secure its long-term social license to operate. This is easier for natural gas than for oil: gas is the natural partner for the very cheap “base-cost” renewables that is set to provide more and more of the world’s electricity in coming decades. Battery costs are plummeting, and that will challenge gas in many of its current bastions, but storage at seasonal scale, or even to compensate for low-wind weeks, will still be more expensive than gas for many, many years. Yet, despite their important role in the coming low-carbon power system, gas producers cannot take societal acceptance for granted. Global gas production is going to rely increasingly on fracking, not just in the U.S., and fracking is mistrusted by the public almost everywhere – with some justification, given the short-term and cavalier way it has often been pursued.

There is no inherent dishonor or immorality in pursuing a Sunset Ride. Even the most ardent climate activist is going to be a user of fossil fuels and petrochemical products for many more decades, and no one with integrity can demonize products whose demand they themselves drive. Dishonor and immorality lie only in attempts to obfuscate or delay the global transition to clean energy and transport, either through lobbying and misinformation or through a failure to strive for the highest standards within one’s own operations. Oil and gas companies need to lead on eliminating fugitive emissions and flaring, and to act with transparency and honor around the world.

The third caveat for proponents of Sunset Ride is that it must be accompanied by clear shareholder communications. It’s not that Sunset Riders can no longer grow, it’s about being clear that they will do so only within an overall market that is set to shrink – and explaining that investors looking for exposure to clean energy need to take their dividends and seek their own opportunities, rather than expecting oil and gas executives to do it for them.

So, how to choose?

Vicar of Bray, or Sunset Ride – two strategies, each potentially value-creating, each, if correctly executed, societally and morally acceptable. How do you decide which is right for your organization? Vicar of Bray certainly looks harder to execute, given that it is likely to entail retiring or selling the bulk of existing assets; replacing old investors with new ones; and completely rebuilding your culture and skills from the mail room to the boardroom. There are examples of companies that have achieved dramatic reinventions in the face of industry upheaval – IBM, Microsoft and some telecoms companies have done it (Nokia managed it once, but not twice), as have some chemicals companies and retailers – but they are the exception, as Christensen concluded.

Oil and gas companies are not the only ones facing a crucial decision between Vicar of Bray and Sunset Ride in the face of the transitions to clean energy and transport. For car companies, it looks increasingly like the decision has been taken for them: there simply doesn’t appear to be a viable route to survival for any producer not committed to electrification. Certainly, there is no route to growth: although people will be buying petrol and diesel vehicles for a few more decades, Bloomberg New Energy Finance’s 2018 Electric Vehicle Outlook (web | Terminal), released last week, shows that almost all incremental annual car sales in China will be electric, and the rest of the world will reach peak internal combustion sales early in the 2020s. Vicar of Bray it must be.

For the coal industry, by contrast, it’s a forced Sunset Ride. Investors – even those that are not divesting – simply don’t trust coal companies to reinvest any cash generated into clean energy. Investors have choices: if they want to wind down their exposure to coal, and build a position in clean energy, they don’t need the help of an embattled group of coal executives: they can do it more quickly and with less risk at the portfolio level.

Oil and gas companies could go either way. To plump for Vicar of Bray, you have to believe that you have very significant synergies, either in terms of assets or skills, which can be shared across legacy oil and gas operations and any new clean energy activities. The jury is out as to whether such synergies really exist, and whether they will be meaningful enough to cover frictional costs.  Many U.S. oil and gas companies, currently insulated from some of the societal pressures building elsewhere in the world, appear to have chosen the Sunset Ride by default. Smaller organizations, like the legions of independent oil and gas companies that throng the oil capitals of Houston and Calgary, may realistically have no other option.

So where does all this leave Alberta? Can it realistically translate its leadership in oil and gas into leadership in clean energy and transportation? Perhaps, though that would require extraordinary leadership, hard work and a goodly dollop of luck. Should it instead double down on oil and gas? Again, perhaps – but if it does, it must aim to be the world’s lowest-cost, highest-responsibility supplier. Look at it this way: if oil from Canadian oil sands could be delivered at a lower cost and with a lower carbon footprint than Saudi crude, is there any doubt it would be the first choice of the majority of global consumers, including those most concerned about climate change?

Of course Vicar of Bray and Sunset Ride only define the book-ends of the strategic space facing oil and gas companies. In real life, most companies will want to pursue some combination of the two, at least for an initial period. The important thing is to do so as an explicit choice, and not as a result of muddled thinking or ill-judged compromise, and to be in no doubt as to which is your fundamental long-term direction of travel.

Vicar of Bray, Sunset Ride or an explicit mix of the two? It’s time for every fossil fuel executive, investor and leader of an oil-producing state or nation to make an explicit decision. No pressure!

Michael Liebreich is founder and senior contributor to Bloomberg New Energy Finance. He is also on the board of Transport for London and an advisor to Shell New Energies. He visited Calgary as part of Energy Disruptors, a forum focused on innovation, entrepreneurship and technology in the energy sector.

“The Vicar of Bray” is a satirical song dating back to the 18th century, recounting the ecclesiastical contortions of a fictional vicar living through changes to the Established Church during the reign of six different English monarchs.

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