Forecasting the future

Mark Spelman, Accenture’s Global Head of Strategy, looks at the outlook for the global energy industry in 2008.

At the start of this year, crude oil prices passed the US$100 per barrel (pb) watershed. The actual peak price was the result of a trader willing to pay a premium for the prestige of the first US$100 ticket. However, the underlying economic forces pushing oil prices beyond this barrier are real and will play a big part in shaping the course of the oil and gas industry in 2008 and beyond.

In a multi-polar world, with new emerging economies developing rapidly, demand for commodities – and especially oil and gas – is growing fast. This increased demand comes at a time of political uncertainty and increased resource nationalism in many producer countries; these trends are both the cause and the consequence of higher oil and gas prices. Consumer countries are concerned over the stability of their supply as producer countries increase their geopolitical power and economic clout. Increasing concern over the effects of climate change and uncertainly over what measures might be appropriate or feasible to tackle this challenge will also influence the long term prospects for the industry.

The outlook for the oil market remains strong
US$100 oil in early January has so far been a blip – actual crude prices for 2007 averaged the significantly lower figure of US$72pb. Prices in 2008 will depend partly on the global economic outlook – something economists currently seem to be revising on a weekly basis – and also by any supply side shocks. Despite ongoing uncertainty, there is consensus to be found in one important area: emerging-market demand is unlikely to grow faster than demand shrinks in the developed world this year; this should take the edge off current prices.

In the short-term, prices are being driven up by the financial sector: as of mid-January this year, open interest in NYMEX crude oil options stood at 3.93 million contracts, up 27 percent from January 2007 and 82 percent higher than January 2006. Investors are increasingly moving into commodities, both in response to concerns over other types of investments following the credit crunch, and as a hedge against exposure to the weakening dollar.

However, medium-term demand will be driven by growth in emerging economies, led by China and India who look set to have GDP growth of 11 percent per annum and eight percent per annum respectively in 2008. The International Energy Agency (IEA) currently forecasts world oil demand growth at 1.98 million barrels per day, and the MENA region is the only region expected to grow faster this year than last. High prices may not dent demand very much, as many emerging consumers of oil and gas are partly insulated from high prices due to government intervention – at least a dozen have some form of price controls in place. Governments are taking the hit to avoid social unrest, and in doing so, they are also supporting underlying demand.

Prices will stay high because the current balance between supply and demand remains very tight. Although there are some bright spots in production, noticeably in Iraq where latest output figures suggest the country is getting back to its 2003 levels, ongoing political tensions around the world will exacerbate worries over the reliability of oil supply. In addition, energy demand is growing fast in many exporting countries, shrinking quantities available for exports.

In parallel, inventory levels are falling. According to the US Energy Information Administration (EIA), as of the turn of the year, total motor gasoline inventories were an estimated 208.2 million barrels, down 3.6 million barrels from the end of 2006 and 2.6 million barrels below the previous five-year average at that time of year. Asian levels are also below normal, though in the rest of the OECD countries inventory levels are flat.

As Lord Browne, ex-president of BP, pointed out recently, an often underestimated contributor to recent high prices is the increase in oil production costs: the HIS-CERA Upstream Capital Costs Index indicates that equipment costs have roughly doubled over the last five years. This, combined with the increasing technical difficulty of accessing non-OPEC oil (with easier fields depleted), will underpin oil prices for the medium to long-term.

The upshot is that oil prices may edge down as economic growth slows, but the fundamentals are in place to ensure high prices for the foreseeable future.

Gas demand is up, prices have recently trended down
In contrast to oil, gas prices are now broadly trending down, though they may average slightly higher in 2008 than in 2007. Henry Hub natural gas prices averaged 7.2 dollars per mmBtu in 2007, well off their 2005 peak when the average was 8.8 per mmBtu. Two consecutive mild winters have left storage inventories well above normal and growing LNG imports have pushed supply up by 2.5 percent in 2007. Some gas market leaders in the United States are already cutting drilling plans and even shutting production. In the United Kingdom, gas prices are also trending down as warmer weather and new supplies kick in.

Gas demand is growing in most MENA countries due to growth in power generation and petrochemicals. Production, however, is not rising as quickly as many expected, partly because some major producers, among them Iran and Algeria, have struggled to implement new projects. In addition, the escalation in project costs that has taken place over the past two to three years has exacerbated difficulties.

Proven reserves of gas have also not risen as quickly as expected in some countries. One example is Egypt, a relatively new exporter of LNG and pipeline gas that is now struggling to find enough gas to ramp up its exports. Meanwhile, Libya announced it had approved more than 50 oil and gas companies, including some of the world’s biggest multinationals, to bid on its first gas-only licensing round. European countries are increasingly turning to North Africa as a natural gas supplier, but competition will increase as companies from the Americas and Asia become more interested in the region.

Global LNG trade continues to grow, and a global gas price may be on the way
LNG continues to drive gas market growth with global LNG trade expected to triple over the next 12 years to reach up to one third of international gas trade by 2020. Qatar has consolidated its position as the world’s largest exporter. The fifth train at its RasGas plant, which loaded its first cargo in December 2006, added to its output, which was running at an annual rate of 29mt in the first half of last year. Abu Dhabi and Oman also registered significant gains in production benefiting from its geographic location and ability to serve both the Pacific as well as for the Atlantic basins.

According to Cambridge Energy Research Associates (CERA), we are likely to see the emergence of a more integrated global market for gas as the industry grows and LNG capacity comes online.

Main industry trends in 2008
With demand levels and oil prices set to stay high and a new, large market for LNG opening up much of the industry focus will be on supply-side growth. International oil companies (IOCs) are finding it increasingly difficulty to replace annual reserve growth due to resource constraints around rigs, personnel shortages, rising costs and resource nationalism. The following six trends will be pivotal in 2008.

Increasing levels of capital expenditure
Resource constraints will continue to cause project delays and cancellations affecting a number of oil companies. Capacity constraints in the market are the biggest factor behind cost increases, with equipment and services suppliers struggling to meet demand. The shortage of experienced personnel will remain a significant problem.

Coupled with these constraints, rising commodity costs will also affect the level of required capital expenditure. KNPC in Kuwait recently upped its budget for a planned fourth refinery from US$6.5 billion to around US$14 billion. Project capital costs continued to rise in 2007, but cost inflation was down compared with 2006. The forecast is for a deceleration trend, with a possible cost plateau to be reached this year. In the meantime high costs will continue to cause project delays and cancellations.

More investment in new technologies and renewables
IOCs are increasing investment in technology to support their growth plans in an industry now dominated by their state-owned rivals. Royal Dutch Shell has raised its technology research and development budget 50 percent over the past three years to US$1.2 billion in 2006. The rise in R&D spending at ExxonMobil, the world’s biggest international oil company, is less dramatic, up from US$631 million in 2002 to US$733 million in 2006. 2008 will be an important year for the industry’s R&D; it is likely to increase, closer to levels in other industries such as IT, pharmaceuticals and the automotive industries as innovation in both exploration and production and downstream activity intensifies.

The decreasing ability of the IOCs to get access to reserves will necessitate more investment in technology – as operations become increasingly complex, especially in deepwater, heavy oil and remote locations. 20 percent of ExxonMobil’s production in 2010 will be from deepwater projects and Canada’s oil sand production capacity is expected to double by 2015.

Alternative energy solutions will continue to attract attention, notably around biofuels and carbon capture. Biofuels companies performed poorly in 2007 due to high volatility of feedstock prices and uncertainties around market development. The outlook will improve with capacity growth in the biofuels sector likely to run at 20 percent per year up to 2010.

Rising concerns about infrastructure security
Infrastructure security will remain a constant concern for the industry. The Assam region in India produces 45,000 gallons of oil from 18 fields, transported through a 1000km, 16-inch diameter trunk-line. This line is highly vulnerable to attack as its mostly above ground and runs through many isolated regions. Pipelines will continue to be vulnerable and attacks can be expected with some frequency in Algeria, Colombia, Iraq, Nigeria and Yemen.

Continued resource nationalism
Re-investment rates will remain limited by lack of opportunities as resource nationalism in countries such as Venezuela, Ecuador and Russia surges. Some companies will move out of these countries and others will try to renegotiate their contracts.

This trend in oil and gas-rich countries impacts output as international firms are forced to pull out of their operations and production drops while the transition to new domestic ownership occurs. The power of oil and gas will continue to be used as a way of exerting more influence on the developed world and the international community in 2008.

Competing with national oil companies (NOCs)
NOC priorities differ according to their strategic aims. Resource-poor NOCs, mostly from India and China, are particularly active, creating partnerships in many parts of the world. They are bidding aggressively on deals in West African and the Caspian and often negotiating deals that go further than the typical IOC; offering to build infrastructure or refineries or power plants. Those who control the majority of reserves, such as Saudi Aramco, Nigeria’s NNPC, Iran’s INOC and Gazprom are looking to balance their upstream portfolios by securing more downstream markets through asset swaps or equity positions.

The majority of IOC growth will be increasingly dependent upon relationships with NOCs. They hold over 75 percent of today’s proven reserves – amounting to over 880 billion barrels – and they also dominate current production: of the top 20 oil producing companies 14 are NOCs. They are competing more and more with IOCs outside of their domestic bases and increasingly rely on their own expertise and service companies. NOCs are becoming ever more effective integrated operations but they will continue to look for specialist skills from some IOCs, particularly in downstream activity, technical capability (especially around gas) and in local content.

Increased focus on refining capacity
Downstream, margins continue to be strong. There are signs that there will be more focus on capital expenditure in downstream especially refineries. BP, Chevron and ConocoPhillips, among others, have indicated that they will be looking to squeeze more capacity out of facilities rather than spend on maturing fields that offer diminishing returns. In 2006, a 45 percent increase in capital expenditure across the oil and gas industry – most of it in upstream – was met with just a two percent increase in reserves.

Priorities for the oil and gas industry in 2008
Challenges for the oil and gas industry in 2008 fall into three distinct categories: shoring up investment, responding to the pressures of climate change and dealing with risk.

IOCs need capital to address rising costs of skills and equipment, as well as R&D. Access to skills and equipment will remain a constant challenge in the short term for all companies. Loss of knowledgeable and experienced people will reduce innovation and limit the ability to execute growth. Training programmes will need to be championed to tackle the chronic shortage of technical upstream staff, currently exacerbated by an aging workforce and severe competition for talent between IOCs, NOCs and service companies. Schlumberger, for example, is using its executives as company ‘ambassadors’ to 44 engineering programs around the world, including MIT, Kazakhstan’s Kazakh National Technical University, Peking University and Universidad Nacional Autonoma de Mexico (UNAM).

In 2008, countries will attempt to make good their promises in Bali to negotiate a successor to the Kyoto Protocol. This may provide the opportunity for the oil and gas industry to position itself as an indispensable partner to governments wanting to navigate a carbon-controlled climate.

The focus for many key oil nations and IOCs is now on biofuels to meet demand for clean fuels and climate change targets. Biofuels’ share of the world energy market is set to increase substantially with the share of biofuels in global road transportation expected to grow significantly. All major oil companies are now aiming to increase their production of biofuels.

In a capital-constrained environment decisions need to be made whether to focus on oil and gas while prices are high, or to look to diversify into new business areas and technologies. Downstream capabilities will become key differentiators, not just in terms of clean fuel, but through taking the industry further into the territory of utility companies where the industry can leverage its knowledge of hydrocarbons further down the value chain

Risk – both in geopolitical and economic terms – will be a watchword for 2008. The changing structure of the industry, with NOCs dominating upstream production and increasingly moving into downstream too, will create more challenges for IOCs. IOCs may want to change the nature of the deals they propose to closer match those of their NOC rivals, offering more investment in infrastructure and the social fabric of the locality, perhaps even going so far as to leverage their understanding of managing a carbon sensitive environment to become partners in countries’ climate change strategies.

The outlook for 2008 is lower world economic growth, and ongoing geopolitical tensions; we can expect ongoing short-term volatility in the oil and gas markets whilst energy companies try to stay focussed on the delivery of their major long-term investment projects.

Mark Spelman is an international businessman with considerable knowledge and experience of the global energy and utility markets. He leads Accenture’s Global Strategy practice and runs Accenture’s global macro economic and political think-tank and the Institute for High Performance. He is responsible for the firm’s strategic relationship with the World Economic Forum (WEF) and is a regular participant and session leader at Davos and the WEF regional summits.