Business-as-Usual is a Dangerous Scenario

Most Oil Demand Forecasts are far too Optimistic –  Leaving Companies Unprepared for Change

For most energy companies, the drivers they use to compute energy demand are population changes and global economic development, both of which have always increased.

Companies can then point to an unbroken history of energy demand growth across decades. But all of this has only been in the aggregate: populations are ageing, and many countries and industries are now in energy demand decline, with previous projections of growth far above actual outcomes.

To create a truer picture of future energy demand firms need to think far harder, and more stringently, about existing and emerging energy policies and technology – which may cause demand to reverse, possibly in abrupt ways.

Opting to rely mainly on business-as-usual scenarios is dangerously conservative and inflexible, leaving management teams unprepared to deal with alternative outcomes, and sticking with previous expectations for far too long.

To start with though, do we need actually foresee an energy transition? Why won’t we have an evolutionary business-as-usual outcome – which is the base case scenario in many projections?

It is indeed feasible to project a world out to 2050 and beyond that looks pretty much the same as today, with most energy coming from fossil fuels, from the same producers and suppliers we have at present.

In fact, reference projections from the US advisory body the Energy Information Agency, and forecasts from ExxonMobil and BP show this: in BP’s case, their view is that primary energy from all fossil fuels (coal, oil and gas) shifts from 86% in 2014 to around 80% in 2035 – within the bounds of error, this is essentially no change over the next 20-25 years. Shell’s main scenarios perceive a world where fossil fuel demand growth is even higher.

However, several new reports highlight how dangerous, financially and literally, these business-as-usual projections might be.

At the very least, these consensus “projections” need to clearly state that, by design, they deliberately exclude many major policy initiatives or disruptive technologies.

In fact, its generally the case that industry “reference case” scenarios are in fact “best-case” ones, with legislative risks smoothed, and sensitivities under-represented or reported separately.

As a new report from Carbon Tracker (CT) indicates, adding in simple models of future downside scenarios is in fact quite straightforward, especially for highly technically literate firms such as fossil fuel companies – who do it all the time in the day-to-day contexts of operational and safety management.

Omitting to do so, sticking to fixed visions, and denying the possibility of negative change, can have dire consequences for companies, stakeholders, investors and employees.

Take coal for example, studied in depth in the CT report.

In 2010, the US coal industry as a whole bought in to the concept of a new “super-cycle” in demand, driven largely by near-term US and Chinese growth. This analysis allowed several large, quoted US coal companies to invest in major acquisitions to meet the demand projections, taking on significant debts to do so.

Fast forward to mid-2016. Of the 12 companies studied, 6 are now bankrupt (all but one of the acquiring companies), and the average share price performance since 2010 of the remainder is down more than 70%.

Most of the firms explicitly used and regularly quoted the EIA “reference case” for coal demand projections.

However, this easy-to-misapply scenario does not in fact mean a “mid-way’ or “moderate” forecast: in the EIA’s own words: “The Reference Case, which incorporates only existing laws and policies, is not intended to be a most likely prediction of the future.” And more pointedly : “it is a projection, not a prediction”.

The EIA advises that the reference case only be used in combination with management analysis and other scenarios which model known and less certain risks such as environmental legislation, and the impact of new technologies.
In fact, the agency provides ready-made downside forecasts, which model the impact of the US Clean Power Plan (CPP) – this plan is a formal piece of legislation that imposes emissions constraints on future coal production.

However, CT’s analysis suggests the EIA reference case was used very differently: its consistently positive demand outlook, unhindered by any considerations of legislative or technological downsides, was used prominently in all company reports, and most importantly in company SEC 10K filings which are required by US law to provide a comprehensive summary of company financial performance and disclose key risks.
A summary demand analysis of EIA’s Annual Energy Outlook Reference case, their CPP scenarios and actual demand outcome is shown below:

Coal DEmand Scenarios CT

Its clear that taking an off-the-shelf downside model such as the EIA’s would have almost exactly forecast actual demand, allowing any coal firm that used it for planning purposes to potentially avoid disastrous investments at the top of the cycle, and mitigate debt and bankruptcy exposures.

That all of the companies in the study avoided such disclosures is likely a case of not “talking down the industry”.

But that is different from actually putting in place real contingency plans to mitigate emerging downsides, which were clearly developing during the period. For example, there were already policy initiatives to reduce international coal demand as part of the Chinese government Five Year Plan of 2010 (FYP 2010) – their 5-year target of 17% reduction in energy carbon intensity was exceeded in 2015, with an actual decrease of 20%.

A key lesson here (and an old one at that) is that even although companies may hope for adverse new legislation and competitive technologies to fade away, or have negligible impact, they need to plan properly for these downsides. In fact, its their obligation to stakeholders to do this, and do it clearly.

As the CT report concludes quoting SEC guidelines again:

Companies must analyze “known trends, events, demands, commitments and uncertainties that are reasonably likely
 to have a material effect on financial condition or operating performance.” We would argue that increasing measures to limit emissions from power generation, and the reducing costs of alternative power generation technologies are known trends. The direction of travel of both these vectors is clear. “

More simply, energy companies need to start communicating to investors realistic scenarios of energy demand, and how they plan to manage both upsides and downsides – and avoid only focusing on single forecasts that by-pass clear risks. If that sounds a little idealistic, recall the real fate of the US coal industry.

A general point in the CT report is fundamental to all future projections of fossil fuel demand – and it should feature in any robust management analysis:

A top-down view—translating climate targets to emission budgets to implied demand reduction—may provide a clearer picture of trends than an assumption that business will continue as usual. This is because the policy/technology nexus is complex and self-reinforcing. Policy support has played a role in incentivizing the technology and driving initial cost reductions that has fuelled the coal-to-gas/ renewables switch in power.

Regulation has further facilitated the switch by increasing compliance costs for dirtier fuels and increasing uncertainties for coal- fired generation.

This has a feedback effect: as cleaner technologies become less expensive and dirtier fuels more expensive, the cost-benefit calculus for policymakers shift, allowing more significant policy action while also making the need for policy less relevant.”

In the end coal demand actually decreased between 2010-2015 by over 20% –  with the impact already discussed.

This policy / technology self-reinforcing theme is taken up again in two recent publications: firstly, in a Chatham House research paper from ex BP Strategy Advisor, John Mitchell.

Like it or not, oil and gas companies are going to have to monitor and manage the fall-out from the Paris Climate Change (COP21) discussions.

Mitchell attempts a pragmatic view, recognizing the world continues to change, and idealistic interpretations of what Paris will produce are likely just that. But he also analyses the likely future direction of the industry in the shadow of the agreement, and offers several conclusions.

The main policy point is that the pledged minimum actions from all the countries active at Paris (the INDCs, Intended Nationally Determined Contributions) will not achieve the desired 2°C goal, but land somewhere between this and the “business-as-usual” outcome of 4°C.
But note Mitchell’s assessment of what this signifies for future projections or forecasts: “this means that additional, and more stringent, measures are likely in the future
After a long analysis of the background, and INDCs of key countries such as China and India, Mitchell has the following conclusions:

For Oil, demand will be weakened by the INDCs and any future measures imposed. Already policies underway in the transport sector, such as fuel-subsidy reductions in India, will begin to have an impact in the near-term. The effect of disruptive technologies such as battery developments for electric vehicles, will exacerbate these trends in the medium term.
• He believes that this impact is relatively predictable, at least in the short term, so should be modeled and clearly managed.
For Gas, the future seems far more uncertain. Its future market at the national level is likely to be a “residual” left over after aggressive policies on renewables, strategies for nuclear, and plans for legacy coal generation. In developed countries, with flat demand, gas will need to grow at the expense of promoted renewables, or enable a managed exit for coal. In developing countries, producers will have to convince governments to invest in infrastructure enlargement as an alternative to cheaper coal resources or imports.
For Oil and Gas companies, they now have to manage two different types of business risks posed by their oil and their gas businesses:
o In oil, there should be a realistic reassessment of future oil demand, and so avoidance of over-investment in long-term at-risk projects
o In gas, the greater uncertainty should inform capital allocation decisions, as investments are at higher risk of becoming “stranded”

However, none of the analysis suggests that current policies will reach anywhere near what is required to achieve a 2°C target – many countries will attempt to do what they can get away with, rather than “what more can I do?”

That said,the trajectory, if not the pace and scale, on policy and technology is clear, and as the CT analysis points out, this tends to drive outcomes even when stated policies are only part-implemented, or not implemented at all.

Policy momentum is also coming from other directions. The intergovernmental International Energy Agency has been championing global energy initiatives for some time. It is essentially an advisory body, but has recently attempted to broaden its policy activities with participation from developing countries as well as mature economies.

Possibly sensing a growing “numbness” toward climate change in general, and antipathy from the industry in particular, in a new report issued in June it highlights the growing impact of current energy demand on public health.

The numbers are stark: the IEA, in conjunction with the UN World Health Organisation (WHO), estimate that over 6.5 million people per year die prematurely due to the effects of fuel combustion – mainly via emission of particulates and gases from industry and transportation. Over half these deaths are from outdoor pollution in urban centres, with over 1 million per annum in China, and over 600,000 in India. The overall number is larger than deaths due to TB, HIV/Aids and road traffic accidents combined.

Its an immediate and tangible human issue, with large and negative economic and political outcomes too. The IEA has therefore put forward a multi-point plan to address the issue based on two key policy pillars: avoidance of emissions via increased efficiency, use of non-emitting fuels and improved urban planning, and reduction via new fuel standards, new transport technologies such as autonomous vehicles, and more stringent emissions standards. Simple actions such as constantly monitoring and showing air quality in large cities are already quietly being adopted.

This has caused the IEA to adopt a new scenario beside its baseline New Policies Scenario – the so-called Clean Air Scenario predicts 15% less energy demand by 2040 than its base forecast, with, for example, oil demand peaking as early as 2020 with a 0.1% pa decline rate overall – indicating consumption of 89million bpd by 2040, or 5 million bpd less than today, and 15 million bpd less than its current scenario.

Policy development, it seems, never sleeps.

IEA’s new scenario, whether ultimately accurate or not, sets a new collection of initiatives in motion. And recall CT’s insight: standards and policy drive demand outcomes, even if the precise rules and regulations are not fully realised. This new scenario will likely provide self-reinforcing support to technological developments and further government initiatives, sitting alongside COP21 and other G20 national campaigns.

A further new vector for fossil fuel demand reduction is clear, even if the details are uncertain.

Forward-looking statements from energy companies should now include these independent analyses as standard risks to the business going forward. It would allow them to begin to have a discussion with investors about the true value of assets in the ground, and help all of them to choose better strategies for future investments or disinvestments in exploration, projects and operations.

As Chatham’s Mitchell cautions:

“Different managements will negotiate these changes with different levels of success; in other sectors that have gone through major transformations, companies able to be adaptive have fared better than companies with a fixed vision, or those in denial of the extent of change.”