Navigating the tricky path to net-zero
The year 2020 may be remembered as a tipping point for the oil and natural gas industry. In the middle of a global pandemic and economic lockdown that are expected to wipe out more than 8 million barrels per day of oil demand, producers have slashed capital spending to the lowest level in 15 years.
In almost any other year, these cuts to capital spending and output could be attributed to supply-demand cycles and price responsiveness. But the legacy of the coronavirus pandemic could change consumer and business behavior permanently.
The downside pressure to longterm oil consumption in a post-pandemic world has weakened the demand outlook for nearly every major oil product category, with the exception of plastics.
There is an emerging conversation about the extent to which the pandemic has shifted the world into a low-demand and therefore a low-carbon trajectory. Whether in terms of the drop in fossil fuel consumption or in terms of the expected fall in carbon dioxide emissions, S&P Global Platts Analytics expects near-term decreases to exceed those required in a low-carbon world.
Some of the world’s most prominent oil producers have announced major cuts to capital spending, as well as asset writedowns and dividend cuts, while redoubling their commitment to long-term net zero targets.
The more ambitious of these aspire to be “net-zero” by 2050, but all companies have some form of commitment to reduce the greenhouse gas intensity of existing operations and some form of pledge to expand activity related to low-carbon energy carriers such as renewable power, biofuels and even hydrogen.
Concurrent with this, the reduced long-term oil demand outlook has caused many producers to adopt lower pricing guidance.
Demand destruction
The collective share of fossil fuels in final energy consumption in 2050 is projected to decline from nearly 45 percent to under 30 percent if the world succeeds in limiting the rise in average global temperatures to no more than 2 degrees Celsius, as set in the Paris climate accords. For oil, this equates to 50 million barrels a day of demand destruction compared to business-as-usual over the long term.
Most significantly, refined petroleum products are almost entirely displaced from on-road transport (passenger cars and commercial road transport). Fossil fuel’s share of on-road transport demand is expected to fall from 91 percent to 10 percent if the Paris climate goals are met.
This would necessitate a massive buildout in the electric power grid. Strictly in terms of absolute demand levels, new lowcarbon electricity demand would be nearly equal to the reduction in fossil fuel supply for on-road use in 2050.
This implies that oil and gas companies should seek to transform their business model fundamentally. Oil demand is projected to fall by 1.9 percent a year.
Our long-term average oil price outlook has been lowered by around $10 a barrel due to the impact of the pandemic. If the world follows the low-carbon pathway of the Paris agreement, that would result in an additional $10 barrel reduction in average oil prices over the period between 2020 and 2050.
Recognizing that a weaker demand outlook will not bolster long-term prices, some oil producers and major lenders have announced that they will no longer seek to develop higher cost supplies such as Canadian oil sands or Russian Arctic offshore deposits.
Staggering ambition
Any additional demand-side risk could cause other basins to fall out of favor as producers continue to adjust their long-term price view.
The energy transition ambition is staggering. Meeting the 2 degrees Celsius threshold requires a 50 percent reduction in carbon dioxide emissions by 2050 as well as a 50 million barrels a day reduction in oil demand.
Companies’ long-term net zero targets come with a diverse set of energy transition strategies, ranging from procuring emissions offsets and improving operational efficiencies to pursuing a full-scale business model transformation.
Overall, the story might be told through capital reallocation: energy transition would imply $14 trillion in new capital spent in low-carbon electricity against a $6 trillion reduction in spending on oil exploration and production, leaving $8 trillion that has to come from somewhere.
That is a huge gap to fill, but if investments in low-carbon alternatives are profitable, the capital markets should be able to link a wide range of investors with these opportunities, given enough time and appropriate policy incentives.