As we work through energy transition, market forces are poised to create asset discontinuities. They are already wreaking havoc with the oil supply chain.
Backstory
I’m about to embark on a house renovation project. It will be pretty substantial—new kitchen, two baths, new windows, new cladding. It will take some time to complete, but when finished, we’re confident the house will last us our lifetime and have solid residual value when we eventually sell it and move on.
Household energy sources and uses are part of the renovation, including a new heat pump to replace the furnace, and an upgraded electrical box for a new plug in socket in the garage. We’re now 100% confident that when we sell our current vehicle, there will be far fewer new vehicles with internal combustion engines on offer, a larger selection of battery electric vehicles (BEV) will be available, and we will purchase a new or used BEV of some description. Our local jurisdiction has banned the sale of new gasoline vehicles in 2040 or thereabouts.
We’re also toying with installing solar panels on the roof and a power wall battery in the garage to go along with the BEV. That will give us a little insulation from the local power utility.
Consumers like us are now making these calculations about how we will adjust to energy transition. It’s only prudent as we don’t want to suffer any losses of value late in life, or be stuck with a vehicle or home we can’t sell.
It should be no surprise that industry is now making the same calculations as they confront energy transition. In industry, these same questions are increasingly relevant, but for equipment and buildings:
If the useful life of the asset is longer than when the regulations ban the asset, then there’s a risk the asset will be stranded.
If a planned overhaul to an asset extends its life beyond the regulatory horizon, then there’s a risk the overhaul will not generate a return.
If there’s demand uncertainty well into the future, then long contracts become scarce, and there’s a risk to securing financing for investments.
Most at risk are those assets whose useful lives and the known regulatory horizon are now intersecting. It helps explain why there are so few new oil refineries being built in the OECD. In addition to being difficult to site, these plants take 7 years to build, last for 50 years, and between 25% and 50% of their output is liquid fuels.
Unsurprisingly this will create market discontinuities (short hand for opportunities and losses).
Energy Transition Side Effects
Today’s news from the shipping industry brings energy transition into sharp relief. An industry monitor noted a collapse in the order books for very large crude carriers (VLCCs, ships that carry two million barrels or more of crude oil). You might not think this is a big deal, but if your first name is Greta, you probably think it’s great news.
There are 910 VLCCs of all ages currently at work moving crude oil to market, and they have a useful life of 20 years, give or take. Put another way, every year, the global shippers retire (more or less) 1/20th of the fleet or five percent, which is 45 or so ships. They also order both replacements for the retirees as well as new ships for market growth. It takes 2-3 years for the ship building industry to build and commission one of these ships (among the very biggest ships in the world).
You would expect that the global ship building industry would report orders for new VLCCs for this year to be at least five percent of the global fleet capacity, if not more. Instead the orders are 2.7%. No new VLCCs will be delivered at all in 2024 and just one in 2025.
There are lots of reasons why the order books might otherwise be short:
Rules and regulations over maritime emissions and ship propulsion are still in flux, and with that uncertainty, it’s risky to make long binding decisions. Since on board carbon capture technology doesn’t exist, shippers need to explore other fuel options such as methanol, methane (as LNG), ammonia, biofuel, hydrogen, and likely many others.
Ports will have to reconfigure to accommodate different fuels (inbound supply, site tankage, bunkering services). Shippers might be waiting to see how ports will service the market before committing to a fuel that might be systemically short.
Ship builders are busy. The demand for new LNG carriers is very strong, for example. To get a new VLCC into the ship building queue, shippers will have to contend with higher construction costs, particularly if the ships have to provide dual fuel systems. Perhaps shippers are waiting for slower yards.
Financing costs are higher. One of the ways to finance a long life asset like a ship or a plane is to first sell the services of the asset on a contract basis for many years (ideally as long as the asset will be in service). That derisks the cash flows and effectively creates an annuity, which is bankable. However, if customers won’t arrange the long charter (because they’re concerned about demand), then capital markets won’t finance the asset build.
But the most likely reason is that the ship owners are concerned that their investments, which are intended to earn a return for 20 years or more, will become stranded well before their time is up. The right answer, then, is to not invest.
Which gets us to the following problem: if the capacity to move tidal crude oil to market declines by more than the demand for tidal crude oil declines, then we will eventually have a shortage of crude oil carriers. Prices for moving tidal crude to market will have to rise.
In addition to the shortfall in capacity from a lack of orders, a number of ships have gone over to the grey market, carrying sanctioned Russian oil products, effectively being withdrawn from general service.
Looming Consequences
Extend this kind of industrial thinking to all the assets in the oil industry value chain and a number of eventualities become quite real.
PRICE SHOCKS BECOME COMMONPLACE
In the same way that too few crude carriers can cause price spikes, during energy transition many other assets that are suddenly in short supply (because they haven’t been expanded or upgraded) will cause price moves. Normally the industry response to high prices is to build more assets, but in this case, those assets could be stranded. The logical move is let demand be destroyed.
SPOT MARKETS DOMINATE
With fewer and fewer long contracts on offer, most shipping assets will be directed to the spot market. It’s much harder to secure financing for an asset if its usage is driven by an uncertain spot market instead of a take-or-pay contract or a committed long term volume. Without long term financing, some market participants will withdraw entirely, reducing competition overall.
LONG LIFE ASSETS AT RISK
The assets with the longest lives are most at risk of being stranded before they’re functionally obsolete. Examples include crude oil pipelines, shipping terminals, storage facilities, and refineries. The current oil assets being built might then be the last assets ever built, which can erode the incentive to deliver them competitively (see Trans Mountain). Eventually, it won’t make sense to build assets that last 15 years, such as off shore production rigs. Next is the 10 year asset class (rail cars, storage assets, personal cars, light duty trucks, heavy haulers, prime movers).
ASSETS ARE REPRICED
How do you price an asset with such an uncertain demand outlook? How do you value such assets on your books as the risk of being stranded looms large? Capital markets have never been through such a huge, global, and permanent restructuring of balance sheets. If there ever was a playground for investor lawsuits over poor forecasting of asset devaluation, it would have to be oil and gas assets. On the other hand, if everyone else withdraws from the market while there’s still demand, and you don’t, you’ll extract very serious rents.
INSURANCE IS REPRICED OR WITHDRAWN
Many large oil companies self insure now, but down the road, with fewer and fewer market participants to syndicate risk, premiums for the industry will have to rise. For the individual car owner, insurance for personal combustion vehicle use will have to go up. BEVs will be in their own insurance class as their self driving abilities improve.
SKILLS ERODE
If there are fewer such long life assets to be built, the pipeline of talent required for such endeavours quickly atrophies. Suppliers of the engineering and fabrication skills move onto new energy. The education system trims back the faculties and facilities because the demand for such talent disappears.
NEW INDUSTRIES EMERGE
There is an enormous amount of steel tied up in the assets of the industry. A VLCC contains 40,000 tons of steel, much of which has a useful second life as recycled steel. Pipelines are also mostly made of steel, and that steel has value (along with a lot of cost for extracting the pipeline from the ground. The ship breaking yards in Turkey, India, Bangladesh and Pakistan will be busy for years, and a similar asset abandonment and recovery business will need to develop in many countries for domestic assets, such as pipelines and refineries.
NEW SOLUTIONS EMERGE
Digital innovations that help alter the emissions profile of assets will be most welcome. These include solutions that reduce standby times, increase utilization rates, optimize energy use, and predict wear and tear.
Conclusions
The signs of change are here. No new oil refineries, no new admissions to petroleum studies, and now no new VLCCs. There is no turning back.
Check out my latest book, ‘Carbon, Capital, and the Cloud: A Playbook for Digital Oil and Gas’, available on Amazon and other on-line bookshops.
You might also like my first book, Bits, Bytes, and Barrels: The Digital Transformation of Oil and Gas’, also available on Amazon.
Take Digital Oil and Gas, the one-day on-line digital oil and gas awareness course on Udemy.
Take the one-hour Digital for the Front Line Worker in Oil and Gas, on Udemy.
Biz card: Geoffrey Cann on OVOUMobile: +1(587)830-6900email: [email protected]website: geoffreycann.comLinkedIn: www.linkedin.com/in/training-digital-oil-gas
