March 07, 2018
Author: James Neale, Equity Research Analyst
At the midpoint of the last energy cycle, analysts, scientists and op-ed writers fretted over the concept of "peak oil," a theoretical point in time when the world would reach the apex of hydrocarbon extraction and experience a long, steady decline in supply. Toward the end of that cycle, however, the tune changed, as US shale and alternative energy supply flooded the market and energy producers were instead left with a glut of product and falling demand for it. This is why energy companies are now more concerned with peak oil demand than peak oil supply, as they were just a decade ago.
The rise of emerging markets, new demand for alternative energy sources and US shale technology have all disrupted the energy sector significantly over the last few decades — and will continue to do so in the next cycle. At MFS®, we monitor disruption across sectors and the potential implications that these themes have on the underlying fundamentals of the securities we invest in.
Disruption to traditional business models from new demand/supply drivers and technological innovation offers both risks and opportunities for investors. We believe security selection is crucial in this sector and that these disruptive supply/demand themes will continue to impact how we invest through the next energy cycle.
Transitioning to a new cycle
The energy sector recently completed a full investment cycle that began around 2000. During this period, oil prices moved from less than $20 per barrel to more than $140 before falling back below $30 by February 2016. The cycle began with a demand shock from emerging markets (primarily China), as shown in the left chart of Exhibit 1, and ended with a supply disruption from shale and alternative/unconventional sources of energy supply (right chart on Exhibit 1). Oil prices rose to a level where disruption from shale and alternative energy became a permanent feature of the supply mix. Today, the sector is increasingly challenged by the demand side, through a politically-supported move toward mass electrification of transportation and the desire in some pockets for greater use of alternative sources.
The electric vehicle revolution
The transition to the current energy cycle began with disruption in the demand for battery-powered electric vehicles (BEVs), which was underpinned by growing political support and the regulatory scrutiny of diesel manufacturers. Recent diesel emission rigging scandals at Volkswagen and others have placed additional pressure on manufacturers of conventional combustion vehicles. In July 2017, the United Kingdom and France both announced a ban on gasoline and diesel automobile sales by 2040, while Volvo announced that every new car model manufactured after 2019 would have an electric motor. Exhibit 2 shows estimated electric vehicle (EV) market penetration, which is currently less than 5% but is expected to move above 80% by 2050, as automobile manufacturers shift production and ride-sharing and autonomous vehicles become mainstream.
Mass electrification of the transportation fleet would have a significant impact on demand, as passenger cars currently account for approximately 30% of global oil demand. Greater than 530 million EVs are expected to be on the road by 2040, which would displace up to eight million barrels of transportation fuel per day. 1
Rising EV demand does have a downside — it requires increased electricity supply and improved storage capacity. Based on forecasted EV uptake, incremental global electricity demand will be 15% to 20% higher by 2050 to meet this demand.2 Meeting this increased demand requires improvement to grid capacity, storage innovation and peak demand management, all of which are currently proving challenging for the sector as a whole.
Seeking a good return on energy investment
Simply meeting energy demand with new supply is only part of the energy solution. We think about energy as a chemical equation: An amount of energy goes in to get an amount of energy out. Conventional hydrocarbons require very little energy input to get a large energy output, thus producing a surplus. However, the world is replacing efficient conventional energy sources with less efficient unconventional sources and alternatives that have lower volume output, lower thermal energy value and higher relative energy input costs. In other words, newer, unconventional energy requires more energy to make less energy than conventional hydrocarbons.
Alternative energy sources have benefited from government subsidies and tax breaks, as well as supportive capital markets providing low-cost capital. However, they will need to significantly increase production efficiency to improve inferior relative energy production, as approximately 33% of the energy is being consumed in the energy production process and another 17% lost in storage and delivery.3 Producers are left with only half of the primary energy available for consumption after this process.
On a positive note, the cost of lithium-ion battery packs has dropped nearly 80% in the past six years, to $227/kWh, and is expected to fall to $100/kWh by 2030.4 Cost-effective storage is needed to enable better grid capacity management, to make energy available at peak times. The risk remains that lower energy surpluses end up pushing costs higher, as it would be unusual to see a mass transition to new technology before it is cost competitive. Until then, we would argue that conventional energy players still have a significant role in the energy supply mix, and fundamental characteristics such as balance sheet strength, quality of geological assets and management's ability to navigate the changing landscape will determine winners and losers.
The global energy sector continues to evolve in response to powerful disruptive technological, governmental, economic and environmental forces. We are witnessing a growth shift from developed to emerging economies and a transition from conventional fossil fuels toward clean energy technologies. This transference is largely in response to greater supply, targeted green energy standards and economic development goals in many countries. While conventional hydrocarbons will remain the backbone of the energy supply for many years, changes at the margins may have major implications for investors in the years ahead. We believe security selection and risk management will remain crucial components of any investment strategy with exposure to the energy sector over the next cycle.
1Bloomberg New Energy Finance, Electric Vehicle Outlook 2017.
2MFS estimate based on BP Statistical Review of World Energy June 2015.
3IEA, BP Statistical Review of World Energy June 2015.
4Bloomberg New Energy Finance, Electric Vehicle Outlook 2017.
The views expressed in this commentary are those of James Neale and are subject to change at any time. These views should not be relied upon as investment advice, as securities recommendations, or as an indication of trading intent on behalf of any other MFS investment product.