Fossil industry is the subprime danger of this cycle
The cumulative blitz on energy exploration and production over the past six years has been $5.4 trillion, yet little has come of it
By Ambrose Evans-Pritchard
9:03PM BST 09 Jul 2014
The epicentre of irrational behaviour across global markets has moved to the fossil fuel complex of oil, gas and coal. This is where investors have been throwing the most good money after bad.
They are likely to be left holding a clutch of worthless projects as renewable technology sweeps in below radar, and the Washington-Beijing axis embraces a greener agenda.
Data from Bank of America show that oil and gas investment in the US has soared to $200bn a year. It has reached 20pc of total US private fixed investment, the same share as home building. This has never happened before in US history, even during the Second World War when oil production was a strategic imperative.
The International Energy Agency (IEA) says global investment in fossil fuel supply doubled in real terms to $900bn from 2000 to 2008 as the boom gathered pace. It has since stabilised at a very high plateau, near $950bn last year.
The cumulative blitz on exploration and production over the past six years has been $5.4 trillion, yet little has come of it. Output from conventional fields peaked in 2005. Not a single large project has come on stream at a break-even cost below $80 a barrel for almost three years.
"What is shocking is that upstream costs in the oil industry have risen threefold since 2000 but output is up just 14pc," said Mark Lewis, from Kepler Cheuvreux. The damage has been masked so far as big oil companies draw down on their cheap legacy reserves.
"They are having too look for oil in the deepwater fields off Africa and Brazil, or in the Arctic, where it is much more difficult. The marginal cost for many shale plays is now $85 to $90 a barrel."
A report by Carbon Tracker says companies are committing $1.1 trillion over the next decade to projects that require prices above $95 to break even. The Canadian tar sands mostly break even at $80-$100. Some of the Arctic and deepwater projects need $120. Several need $150. Petrobras, Statoil, Total, BP, BG, Exxon, Shell, Chevron and Repsol are together gambling $340bn in these hostile seas.
Martijn Rats, from Morgan Stanley, says the biggest European oil groups (BP, Shell, Total, Statoil and Eni) spent $161bn on operations and dividends last year, but generated $121bn in cash flow. They faces a $40bn deficit even though Brent crude prices were buoyant near $100, due to disruptions in Libya, Iraq and parts of Africa. "Oil development is so expensive that many projects do not make sense," he said.
There are, of course, other candidates for the bubble prize of the current economic cycle, now into its 22nd quarter and facing the headwinds of US monetary tightening. China's housing boom has echoes of the Tokyo blow-off in 1989, and is four times more stretched than US subprime in 2006, based on price-to-incomes.
The 2007-era vogue for Club Med sovereign bonds comes despite surging debt ratios, made worse by incipient deflation. This gamble is based entirely on the premise that Germany will let the European Central Bank print money a l'outrance, a political calculation that borders on wishful thinking.
Yet the sheer scale of "stranded assets" and potential write-offs in the fossil industry raises eyebrows. IHS Global Insight said the average return on oil and gas exploration in North America has fallen to 8.6pc, lower than in 2001 when oil was trading at $27 a barrel. What happens if oil falls back towards $80 as Libya ends force majeure at its oil hubs and Iran rejoins the world economy?
A large chunk of US investment is going into shale gas ventures that are either underwater or barely breaking even, victims of their own success in creating a supply glut. One chief executive acidly told the TPH Global Shale conference that the only time his shale company ever had cash-flow above zero was the day he sold it - to a gullible foreigner.
The Oxford Institute for Energy Studies says the Eagle Ford Dry Gas field, the Marcellus WC T2 and "C" Counties, Powder River, Cotton Valley, among others, are all losing money at the current Henry Hub spot price of $4.50. "The benevolence of the US capital markets cannot last forever," it said.
This does not mean shale has been a failure. Optimists still hope it will reach a "positive inflexion point" in five years or so, the typical pattern for a fledgling industry. Some drillers have switched to tight oil projects that are much more more profitable because crude is closely linked to global prices. Yet the low-hanging fruit has been picked and the costs are ratcheting up. Three Forks McKenzie in Montana has a break-even price of $91.
Nor does it mean that America has made a mistake. Shale has been a timely shot in the arm, helping the US economy achieve "escape velocity" from the Great Recession, unlike Europe, which lurched back into a double-dip recession.
It has whittled down the US current account deficit, now just 2pc of GDP. Cheap gas costs - a third of EU prices and a quarter of Asian prices - has brought US industry back from near death, perhaps for long enough to give America another two decades of superpower ascendancy. But making money out of shale is another matter.
Even if the fossil companies navigate the next global downturn more or less intact, they are in the untenable position of booking vast assets that can never be burned without violating global accords on climate change.
The IEA says that two-thirds of their reserves become fictional if there is a binding deal limit to CO2 levels to 450 particles per million (ppm), the maximum deemed necessary to stop the planet rising more than two degrees centigrade above pre-industrial levels. It crossed 400 ppm threshold this spring, the highest in more than 800,000 years.
"Under a global climate deal consistent with a two degrees centigrade world, we estimate that the fossil fuel industry would stand to lose $28 trillion of gross revenues over the next two decades, compared with business as usual," said Mr Lewis. The oil industry alone would face stranded assets of $19 trillion, concentrated on deepwater fields, tar sands and shale.
By their actions, the oil companies implicitly dismiss the solemn climate pledges of world leaders as posturing, though shareholders are starting to ask why management is sinking so much their money into projects with such political risk. This insouciance is courting fate. President Barack Obama's new Climate Action Plan aims to cut US emissions by 30pc below 2005 levels by 2030. His Clean Air Act is a drastic assault on coal-fired power plants, "industrial sabotage by regulatory means" in the words of the industry lobby.
China too is trying to break free of coal after anti-smog protests across the cities of the Eastern Seaboard. It is shutting down its coal-fired plants in Beijing this year. There is a ban on new coal plants in key regions.
The Communist Party's Five-Year Plan aims to cap demand at 3.9bn tonnes a year up to 2015. Since the country consumes half the world's coal supply, this has left Australia's coal industry high and dry, Exhibit number one of assets stranded by a sudden policy change. Peak coal demand is in sight.
In any case, staggering gains in solar power - and soon battery storage as well - threatens to undercut the oil industry with lightning speed, perhaps in a race with cheap nuclear power from a coming generation of molten salt reactors. The US National Renewable Energy Laboratory has already captured 31.1pc of the sun's energy with a solar chip, but records keep being broken.
Brokers Sanford Bernstein say we are entering an era of "global energy deflation" where gains in solar technology must relentlessly erode the viability of the fossil nexus, since it goes only in one direction. Deep sea drilling will become pointless. We can leave the Arctic alone.
Once the crossover point is reached - and photovoltaic energy already competes with oil, diesel and liquefied natural gas in much of Asia without subsidies - it must surely turn into a stampede. My guess is that the world energy landscape will already look radically different in the early 2020s.
Cheuvreux's Mr Lewis compares the big oil companies with European utilities caught off-guard 10 years ago by the switch to wind and solar, their survival in doubt, their share prices slashed by two-thirds since 2008. "The utilities told us that renewables would have no impact on their business models, and now they are facing an existential crisis," he said.
BP's Lord Browne was derided for embracing solar and rebranding his company "Beyond Petroleum" in 2000. His successors repudiated his vision, famously going back to basics. He may have his moment of sweet vindication after all.
