After Decades of Wrong Predictions, Oil May Finally Be Peaking
Thanks to the pandemic, demand is flattening faster than expected. In turn, the energy economy could transform sooner rather than later.
After one of the most dramatic stretches in its history, the oil industry is slowly recovering. March and April saw the toxic combination of depressed demand, excessive supply, limited storage capacity, and intense financial speculation that turned prices on one index negative. Although concerns about a second wave of coronavirus infections remain high, demand is now back on the rise, and supply is in check.
But that doesn’t mean that the industry is out of the woods. For now, though, the greatest source of uncertainty for oil producers is structural in nature, not cyclical. In fact, there is an increasing sense that peak oil—the moment when oil production reaches its point of maximum before starting a structural decline—has finally arrived. Since the 1950s, there has been plenty of speculation about an imminent shortage of crude oil. Such speculation has proved consistently wrong, as all predictions tended to underestimate both the true amount of global oil reserves and the ability of technology to overcome physical constraints.
Now, the coronavirus pandemic, which appears to be accelerating trends—greener economies and decreased mobility—that until February seemed to be at least one decade away, might finally break the mold. This time, though, peak oil could come on the demand side of the market rather than on the supply one. Such change would mark a shift from perceived oil scarcity to oil abundance that could radically transform the structure of the oil market—even more than the shale revolution itself.
Over the last 60 years, oil demand has grown almost unabated, first in advanced economies and then in emerging economies. At the moment, global oil demand is almost five times as high as it was in 1960. In the past, particularly until the U.S. shale gas revolution, the challenge was always how to satisfy a growing demand in the face of an apparently rigid supply—especially when the energy-thirsty Chinese economy started to rise to prominence 20 years ago. However, even before the coronavirus outbreak, a number of structural factors were expected to weigh down oil consumption, from energy-efficiency gains in emerging economies and the mass commercialization of electric vehicles to sociopolitical pressure to reduce carbon emissions and the retrenchment of globalization.
Nevertheless, despite the widespread consensus that such trends existed, there has always been a high degree of uncertainty about the timing and shape of the oil-demand plateau. Small changes in the assumptions about the numerous factors that determine long-term oil demand—such as population growth, economic activity, mobility, or energy efficiency—can generate very different paths.
Last year, for example, the International Energy Agency (IEA) released two possible scenarios for long-term oil demand. In its sustainable development scenario, which was predicated on a sharp tightening of climate policies, oil demand was expected to start declining substantially in the next decade and to drop by more than 30 percent by 2040, to around 70 million barrels per day. In the other scenario, which is based on current policies, oil demand keeps growing for the next 10 years, before stabilizing in the subsequent decade as a result of downward pressure on energy consumption due to electrification balanced out by higher energy consumption from the poorest regions of the world. To be sure, in this scenario, the world would still consume a significant amount of crude oil even after the plateau—around 100 million barrels per day, close to what it is currently consumed.
Given the variety of long-term demand scenarios, energy companies have typically brushed off peak-demand arguments. However, COVID-19 might change that if it permanently transforms individuals’ behavior and societal priorities.
Mobility is the No. 1 factor that could change the calculations. Although tourist activity is likely to rebound and return to pre-crisis levels in a couple of years, especially if a coronavirus vaccine is found, remote work arrangements might drastically reduce commuting mileage for millions of workers. According to some estimates, in the eurozone, over a quarter of jobs can, at least in theory, be performed from home. Similar estimates apply to the United States, too. In Europe, the average one-way work commute is just over 9 miles, whereas in the United States it is above 11 miles. Imagine the gasoline saved if millions of people stop commuting.
Moreover, COVID-19 might lead to a significant decline in business trips in favor of videoconferencing that would not only reduce operational costs but could also lead to productivity gains thanks to more time spent at the desk than in an airport. Some industrial activities might even be reshored to reduce vulnerability to shocks that affect business partners located elsewhere around the globe, particularly for the production of goods in sensitive sectors such as health or national security. The shortage of face masks, which had primarily been produced in China, during the early days of the pandemic forced governments not only to find new suppliers but also to suddenly encourage the conversion of some domestic firms into mask producers. And new digital technologies that tend to reduce reliance on low-skilled workers will lower the incentives for companies to slice and dice their production around the world. The Fourth Industrial Revolution could significantly compress the length of global value chains.
Finally, the positive impact of the lockdowns on air quality might incentivize greener behavior in the future. In April, when around 4 billion people were stuck at home, air pollution suddenly dropped across the world, suggesting to policymakers a clear direction for seriously reducing carbon dioxide emissions. Voters might strongly push in this direction. Clearly, the solution is not shutting down entire economies. But governments might introduce tax incentives to induce companies to rely more on flexible arrangements for those jobs that can be efficiently performed remotely. Moreover, the cycling routes that were built across the major cities to reduce the use of public transportation may well remain permanently.
All these behavior changes would have a big impact on oil demand. In the United States, around 80 percent of demand for crude oil is fuel-related—petroleum, diesel, or jet fuel. It would be enough to see oil demand permanently dropping by 5 million barrels per day (5 percent below the pre-coronavirus global demand), due to changed transportation habits, to force a drastic supply adjustment. Let’s not forget that Russia and Saudi Arabia fought a price war back in March over the unwillingness of OPEC+ to agree cuts of just around 2 million barrels a day, whose effect was the collapse not just of oil prices but of financial markets more generally.
Nobody knows whether peak demand is actually right around the corner. At least in the short term, the health crisis might actually boost oil consumption if people shy away from public transportation to avoid potential infections. A survey in China conducted by the market research firm Ipsos showed that the share of bus and metro rides had fallen by 57 percent but that made by private car had doubled.
Yet, unlike in the past, energy companies are taking the peak demand scenario very seriously. According to the IEA, this uncertainty, coupled with the economic losses caused by the current recession, will lead to a 30 percent contraction in global energy-related investment in 2020. American producers, in particular, are keen to downsize their investment plans as they need the benchmark West Texas Intermediate price for oil close to $50 per barrel to cover the costs of activation of new fields.
Marketwise, the price implications will be sizable. The average life of U.S. shale wells is around 18 months. With drilling activity at new fields having been partly curtailed, prices might drift upward by 2022, when production in North America is likely to have come down as a result of a lack of investment. But over the long term, the trends might go the opposite way. In an extreme case involving a rapid drop in oil demand, like the one envisaged by the IEA’s sustainable development scenario, prices will likely come down, creating a hyper-competitive environment in which only the most cost-efficient producers survive—and American shale firms will not necessarily be among them. In other words, absent major geopolitical tensions, over the next five years oil prices might follow an inverted U-shape trajectory: first up toward $60 per barrel and then down to $40. Countries will not only fiercely compete to gain shares of a shrinking market, but politics in the region could also shift as many generous welfare programs are drastically revised down.
Clearly, vast changes in the energy economy are not something that will happen overnight. But COVID-19 might speed up the process. And, as in March, when oil prices went negative, producers may discover that their biggest asset is a liability.