The Third Major Energy Transformation
The Expert View
Featuring Rob West
Published on: May 21st, 2019 • Duration: 33 minutesRob West, founder of Thunder Said Energy, explains that the energy markets are in transition for the third time in 200 years. New technologies are at the heart of this transition to more abundant and cleaner sources of energy. If investors continue to favor short-term returns over long-term projects, the potential for extreme spikes in future oil prices will only increase. Filmed on May 14, 2019 in London.
ROGER HIRST: During the month of May, our Tuesday trend theme has been about oil. Today, we're going to continue that theme. We're going to talk to Rob West. Rob West is an equity analyst who's moving towards consultancy, because he's really fascinated by the changes in technology and the movement to multiple energy sources that is having such a great impact on the oil market. So, it's going to be interesting to talk to him about what's happening in that space. What are the changes? And what's the timeframe that we should expect some of these changes to take place. I'm looking forward to meeting Rob, let's hear what he has to say.
ROB WEST: Our industry is going through probably its biggest ever period of change. It's all driven by technology. Technology is coming through and changing everything in energy. And really, those changes are just under-researched. There isn't enough analysis looking at those game changing technologies and what they mean for the world. So, and I run my own firm called Thunder Said Energy. What we do is we look at those game changing technologies and economic opportunities that they're creating.
What are the challenges for investment into energy?
Answer being transformed. We probably have more uncertainty in energy today than ever. And it is killing investment in our sector, killing it. So, I put yourself in the shoes of the investment community. Last year, the global energy industry spent $1.85 trillion to meet the world's energy needs. And every day, every week, you're being asked to open your wallet to this industry, when all around you, you have signs of change.
You have people out in the streets protesting saying this energy didn't exist, you have energy transition. That's a capsule word that people use to refer to this period of change. But actually, we're not having an energy transition. We're having five energy transitions all at the same time.
Let's go back to those challenges of getting capital into this industry. So, there is an obsession right now with buybacks. The number one thing that investors want from Big Oil is their money back. There's one way to make your stock price go up. And that's to do a bigger buyback. Why? What has to happen to make investors actually prefer reinvestment? And we've measured that.
Last year, I started going around asking investors, what hurdle rate would you need? What return would you require? Will you genuinely prefer this oil major? Not to do a bigger buyback but put more money back into their business? And the results really surprised me.
So, when it comes to renewables, like wind and solar, investors see 10% as good enough. When it comes to gas, people say 13%. That's what they need as a hurdle rate. Why? Well, because it's the cleanest fossil fuel. So, we feel okay about that. Many get to shale, what people say 15% is the right hurdle rate. And again, you ask why? And the answer is because it's short cycle. Within 10 years, you've got a 3X cash on cash return on your investment.
And then you get to the scary side of the chart where you get to offshore projects, these big mega projects that the oil industry is famous for. And the hurdle rate, the required return is now 20% for investors to want to do those projects. It gets even scarier when you ask about coal. They say, no, no, no, we will never fund more coal. And then if you press them, the answer comes out somewhere like 40%.
So, think about what that means. Think about the analysts' favorite concept- marginal cost, right? So, there's always analysts like me trying to figure out what is the right oil price. And when we do that as a marginal cost calculation, you say, what is the oil price have to be in order for me to go out and find, develop, produce and commercialize the margin on barrel of oil in the market? And because it's such a capital-intensive industry.
When you take that hurdle rate from 10% to 20%, you take the marginal cost of oil from $40 a barrel to $80 a barrel. So, pulling capital away from the energy industry naturally has the risk of decreasing supply. When you decrease supply of a commodity, pretty easy to guess what happens, the price goes up. And really, there's this question mark that we could be in for a period of under-supply in the 2020s because of this divestment movement.
And actually, that really worries me. Because if you think we need to have an energy transition, and it's going to take decades, what is a big spike in the price is going to do to the political will? If oil went to $100 a barrel tomorrow, would people really want energy transition, or they want cheap energy again? We need to get that balance right. And that is the hardest challenge for the market right now is to thread that needle.
What are the five energy transitions?
What are these energy transitions? And what do they look like? Well, we've got historical precedent for this. And we can go back and look at these two big energy transitions that have occurred in the past to form a view of what the future is going to look like too.
So, the first big energy transition is coal. 1750, most energy makes is at 90% burning wood, and horses and oxen pulling carts, right? It's not a particularly advanced energy system. And then over this period of 80 years, from 1830 onwards, coal really starts building into the mix. And this is the first great energy transition. It takes 80 years, as I said, and we still burn twice as much wood as coal in the 19th century as this is happening.
At the same time, coal creates all these new sources of demand, like steamboats and mechanization and railways. That's what the first one looks like. The second one looks eerily similar. So, it's oil. Oil start really building into the mix throughout 1910 onwards, oil peaks, the share of the world's energy mix in 1973. Again, a 60-year transition. And just in the same way, we burn 15% more coal and oil in the 20th century, and oil and not these unimaginable new sources of demand that nobody could have seen coming like plastics and planes and cars.
So, here we are in 2019. And it looks like we're going to have an energy transition. But actually, we're not. We're going to have five energy transitions all at the same time. These are happening right now. And I think that analogy of what the past looks like is really applicable here. I think it's also going to take 70 plus years to meaningfully shift the energy system. I think it's also going to create new sources of demand and opportunities that are just beyond imagination today.
And so, let's go into that. So, what are these five great energy transitions? Number one, renewables. The price of wind and solar has come down by 90% since the 1980s. If you go out and fill your car up with oil today, at the pump, you pay 100 cents per kilowatt hour for energy. Okay, wind and solar on average, adding kilowatt hours to the grid, at about five cents a kilowatt hour. They are the bottom of the cost curve. And they're going to scale up and reshape the entire energy landscape over the next century.
Energy transition number two, shale. So, for the first 150 years of oil, we've been getting this resource from conventional reservoirs. These are sandstones and carbonates that have porous and permeable. Now, for the last decade, we haven't been reliant on getting oil out of these reservoir rocks, we're going straight to the source rock where the oil is generated. And there's a transformation as there's 10 times more oil in the source rocks than in the reservoirs. And the technology just keeps getting better and better.
I recently went back through 300 technical papers in shale. 100 of them are going to improve productivity. On my numbers, shale is going to be capable of reaching 25, 30 million barrels a day. And to a lot of people, that's going to sound crazy, but I can take you through some of that. And these technologies coming through, they're just game changers.
Energy transition number three, electrification. So, if you are driving a fossil fuel car today, you get 18% conversion efficiency of the gasoline in the tank to useful energy you can drive with. Make that current electric car, and you're at 70%. So, the solution here is you want to electrify as much of this inefficient combustion process as possible. And again, that is going to go and apply to as many machines as possible over the next few decades. This is why you see oil majors trying to get into electricity business. This is the future.
Energy transition number four, digital. So, it's really easy to think of an oil platform as an oil platforms and oil platform. But the ones being built today, from an engineering perspective, are lightyears ahead of the platforms of the past. You go out to the North Sea today to a modern instrumented oil platform, and it has 60,000 tags on 60,000 pieces of equipment, relaying data back to shore in real time. If something is about to break, you can see that it's about to break before it breaks and stop it breaking. This is yielding up X per barrel of three to $4 on these next generation platforms. And it's sweeping through the whole industry.
Energy transition number five, the big kahuna carbon. The world is putting 35 billion tons of carbon out into the atmosphere every year. And we got to change that. And the oil companies know we got to change that. In fact, you could go so far as to say nobody is more interested in driving this energy transition than Big Oil. Because if they don't, they are not going to have a license to operate. And really, in the last few years, you've seen companies embrace that message, hook, line and sinker. These companies know they've got to change, and they want to deliver this transition.
So, let's recap. Here the five themes, renewables, shale, digital, electrification, and environmental. Really, all of these just are enormous uncertainties for investors. And that is why, without an understanding of these uncertainties, it's so hard to open your wallet to this industry. And that is the whole point of why I want to do what I'm doing, which is helping investors see the opportunities in technology. Because we need to rebuild, not the energy system that we have so far, but three or four more of these things just aren't going to do it unless the capital can go in.
So, the latest numbers from the IAEA, I mentioned, the world invested $1.85 trillion in energy last year, we'd increase that by $200, $300 billion per annum by the 2020s in order to meet the world's energy needs. There are opportunities there. Unless investors can see those opportunities, it's not going to happen. And we've got to change that.
What does it mean for oil prices?
What does this all mean for oil prices? It's one of the most wonderfully complex questions in the whole world. I always like to think about the oil market as a clock. You can choose to focus on the second hand, or the minute hand or the hour hand. And so, maybe let's have a little bit of time on each of those.
When I ran my oil supply-demand model over the last 10 years, it's one of those humbling experiences you can have. Because you spend your whole life adding up 100 million barrels a day of supply barrel by barrel by barrel, and 100 million barrels a day of demand barrel by barrel by barrel. And then some rebel attack in Libya blows up your model for reasons you could just not possibly have perceived. And that is the day by day oil market. It's driven by unknowable changes and remains incredibly humbling to try to predict.
Then it gets to the minutes. And so, I'll give you an example of next year. My own market balances over a million barrels a day oversupplied. And that's scary. I would suggest, as shale ramps up and these Permian pipelines become bottlenecked, we could see some pressure on prices. Then when you look at the hour hand and go back to that question of, are we investing enough in our industry? I see some real risk of price spikes. By the mid-2020s, I can be two to 3 million barrels a day under-supply on the path we're on. And that's coming from one of the most bullish people on shale productivity in the universe.
So, what does that mean? Well, I'm really worried about it. Do you know the story of prohibition? It doesn't always get brought up in the oil markets, but it is a chapter of history where for 60 years, the US talks about we need to get off alcohol. Alcohol is one of the big evils of the world. In 1920, they actually do. They banned the sale of alcohol. And there are people writing, we've done it, it's great, the world is now going to be wonderful.
And what happens? Nobody can sell alcohol. So, the price goes up seven times. But it turned out that people still want to consume alcohol. And so, even with the 7X price increase, demand only fell by about 20%, 30%. And then you got all these unintended consequences, like people going blind from drinking moonshine and the mob. And then you get to 1933. And people think this experiment wasn't such a good idea, back track across the 18th amendment. And, we now look back at this period of history where alcohol was illegal. And we think what a weird, weird chapter.
Well, if we get any transition wrong, we could repeat the story in fossil fuels. If we pull back too hard and under invest in fossil fuels, and have big price spikes, we're going to lose the political will to drive this multi-decade change. So, is it really a multidecade change? Right? That's the pushback you always get. Is it really going to take 70, 80 years? And this is what I just think you have to look at the numbers.
Around the world today, we consume 60,000 terawatt hours of energy per year. Around the world today we consume 60,000 terawatt hours of energy per year. If you look at wind and solar, we're investing $400 billion per annum into these new technologies. And each of them at most, has added 150 terawatt hours per year. So, growing at 150 per year, how long is it going to take to move a 60,000 terawatt hour market? And that's why you might come to the conclusion, this is going to take decades.
You can change this. If we can get better technologies into the industry, then we can really do it. But again, that's reliant on somebody finding opportunities in these technologies.
What are the opportunities for energy investors?
So, what are the opportunities for energy investors? Well, I'd like to go back to the analogy of the clock. Let's look at the second hand first. This is going to continue to be driven by who does the biggest buyback. And I think we can all be well aware that that's the biggest force grip in the market today is that desire for cash return.
Now, let's look at the minute hand, what you see there is some underperformance in the sector, it's really been quite notable because people want to rotate out of this uncertain industry into more attractive spaces like tech and industries with big future. But now, let's look at the hour hand. And this is where you can really do some analysis that shows you the opportunity. And this is the one that I'm most excited about.
I've just been through 1800 patents around the industry. It's blown me away how much technology is coming through some of these Big Oil majors. We think about them as fossil fuel companies. But really, the leading edge of technology in these big majors, wow, the leaders are doing some incredible things. And so, let's bring it back to those five big themes that we talked about, and go through them one by one.
I'll start with renewables. I'll give you my favorite example in this sphere. It'd be the area of wind. In the wind industry, there's this well-known principle that if you go higher, the winds are faster. And it's actually it's exponential.