BP’s Chief Economist Spencer Dale discusses global oil markets, the future of LNG in Europe, EU’s energy security and decarbonisation challenges with EER’s Chief Analyst Daria Nochevnik in an exclusive interview.

Over the past months much of the attention of energy analysts has been focused on the oil price swings and short-term challenges that energy majors and governments are currently facing. However, with the oil and gas industry adapting to the new market conditions and switching to the survival mode, mid-to-long-term market projections indeed remain paramount for the sector, albeit become much harder to be refined.

To that end, such benchmark forecasts as BP’s 2035 Energy Outlook are of particular significance, as they allow us to try looking far enough ahead, outlining the expected path for the global energy landscape over the next 20 years.

Almost in parallel to the discussions at the “Davos of the energy industry” in Houston, the 2016 edition of BP’s 2035 Energy Outlook was published this February. On the occasion of Outlook’s Presentation in Brussels last week, we had the chance to discuss some of the key questions for the oil and gas industry in Europe and the world with Spencer Dale, BP’s Chief Economist in an exclusive interview.

Impact of underinvestment in upstream on the supply side and oil prices in mid-to-long term

Last year we have witnessed a 24% CAPEX cut in oil upstream globally, while this year the expected fall is about 17%. This way, it would be the first time the investments in exploration and production fall for two years consecutively since 1986. What in your view would be the impact of current underinvestment in upstream on the supply and oil prices in mid-to-long term?

What we have seen is significant reduction in CAPEX expenditure. The level of CAPEX expenditure this year could be 30-35% down on the 2014 numbers, so my numbers are similar to yours. Importantly, this will have a maximum impact on supply in 2020-2021 time period. Companies like BP do not stop a project, which is half way through. We delay projects, so they won’t come on stream for a while and this will have the main impact further out.

Will this have an impact on the speed in which we come out if the current market weakness? My current hunch is no because it comes too far down the line. Would it affect supply in 2035? Not either, because by then the market would have adjusted and we have caught up. But it would have an impact over the 5-7 year horizon.

A point worth remembering here is that we have seen very significant levels of cost deflation.

In many industries costs lead prices but in the oil and gas industry there is a great amount of evidence to the fact that prices lead costs. What we have seen is that cost fall very dramatically, IHS or Wood Mackenzie have estimates that costs have fallen 20-25% and may fall more this year.

So there is a 35% in nominal spending and 20-25% fall in costs, hence the fall in real investment is significant, but not as significant as the headline numbers would suggest as you have also seen that your costs come down. So a dollar of investments today buys you much more than it would have done two years ago.

Interpreting the oil price shocks

One cannot help comparing the present price shock to those of 1998 and 2008. While the latter were demand shocks, the one we are living today stems from the combination of demand and most importantly supply: the Asian markets are growing slower than predicted, while crude oil supply began to surge, reaching unprecedented levels. Does the new market reality change the way we perceived the pace of oil markets’ rebalancing?

I think you’re absolutely right: when trying to understand the price dynamics and how long it will last for, you have to ask what is driving this. And I think the characteristics exactly as you said: 2008-2009 and 1998-1999 were largely temporary demand shocks and we know from economics and from history the market responds more quickly to temporary demand shocks.

I think the real cause of this one is extraordinary strong supply, so it is a supply-led shock. To that extent, it is more akin to what we saw in the late to mid 1980s and we know from history that it takes a lot longer to adjust to supply shocks than it does to demand shocks.

This is one of the reasons we have signalled the area early on, so I’m not surprised that it is taking this long, because the underlying root cause of this [shock] is supply and it takes a while to work our way through.

The existence of US shale means supply can respond more quickly than conventional oil and I think the length of duration of this shock will be less than the 1980s type, partly because shale will be more responsive. But your underlying thesis I agree with – this is a supply-driven shock and it takes longer to get off than the short-run demand ones that we saw in the last two months. I think many economists would be just looking back and saying that it’s what happened last time and the time before and forgot to understand that - even if the prices fall – the underlying source of this shock is very different and you have to understand what that underlying source is.

Is the underlying source of the shocks temporary or permanent? Is it a cyclical shock that comes back out? If it is a cyclical shock, there is a role for OPEC to play in responding to that. Likewise, on the supply side, if there is a temporary supply shock (some sort of a supply disruption) then there is also the role that OPEC can play in terms of responding to that temporary shock.
What is different about this one is that it’s a structural supply shock. A new form of supply has entered the market and it’s going to stay there.

What would be the structural changes required for the industry in order to be able to re-adjust and adapt to the new market conditions?

We have seen it now and the good news is that the oil market works like all other markets: prices work. Demand growth last years was twice the average. In terms of the EU, EU oil demand has fallen every single year since 2005 until last year when it grew because oil was cheap. We have seen the demand responded strongly.

On the other side, we have seen supply come off, particularly shale (rigs are off 70% with level of shale production off almost half a million b/day from its peak levels). My guess is that [shale] will carry on falling through much of this year.
So I think the net supply will be falling this year and the market is adjusting and working its way through this process.

We don’t need anything deep and profound to happen – prices respond. Even when we get the market moving back into balance that would still leave a significant stock overhang, that’s why it’s going to take a while to work though this, but it’s clear that the market has started working its way through and so I don’t think it’s here forever – it’s here for a long time, but not forever. We can see that the price signals are working both with demand and supply.

The Iran factor in the future oil supply and demand balance

The Outlook includes a ”Stronger Shale” case, which assumes global shale resources are significantly bigger than in the base case, thus global supplies of tight oil and shale gas are much greater than in the base case. What about the Iran factor? Was a sharp increase in Iranian oil exports considered?

I certainly think it is a risk. In our Outlook as you have seen we have built in an increasing OPEC supply of about 7bb/d over the next 20 years, as it maintains its market share. Within that we have Iranian supply gradually increasing, so it gets back to its pre-sanction levels by the early 2020s. Beyond that it is very difficult to know. We pencilled some further growth in but its hard to know, because it is a function of how quickly will the international investment start going back into Iran, what is the nature of those contracts and the Iranian oil fields and how much investments will they need if they start producing increased amount.

Is it a fundamental risk to the outlook? I think over the 10-year period if one country’s supply growth grows more, there are chances of something else growing less, so I don’t think the is a risk of a fundamental shift in that sense. When we did the shale, global tight oil in the stronger supply case group rises by 20 mb/d rather than 10 mb/d in the central case, which is an enormous shift in supply. So I don’t think Iran in itself is in that scale of uncertainly.

LNG, Pipeline Gas and EU’s energy security

Last year we have seen some exciting new market dynamics with LNG spot prices converging in Europe, Asia and the US, hence EU is set to become balancing market for global LNG. At the same time, European companies have signed a number of long-term contracts to import US LNG from Cheniere Energy totalling 6 million mt/year (5% of EU’s total gas demand). Do you think there is scope for more imports of US LNG by Europe given the current fall in pipeline gas prices? Would US LNG prices be competitive in Europe?

With regards to this question, there is a short-term and a long-term perspective.

When it comes to the short-term, I agree with your description: we know that global LNG supplies are going to increase very rapidly over the next 4-5 years. We have this amazing fact that we have a new train of LNG coming on stream every 8 weeks for the next 5 years.

These volumes of LNG are coming on stream when the global gas demand in itself is not going to be rising naturally enough to meet this, so there is a sort of surplus LNG looking for a home and I think Europe is a natural market of last resort to be that home as you suggest. Because Europe has a large demand, it is located between these supplies and it has big LNG facilities.

The question is how it will play out. Question number 1: how does LNG respond to gas pipelines and how will Russian gas exports into Europe behave? In some sense you can think of two possibilities for Russian gas exports. Most of these are contracted so they can maintain their price level, but there is some degree of flexibility in those contracts so they can maintain these price levels and give up some of the market share; or alternatively they can discount their contracts and maintain their market share. My hunch based on what we observe they are doing, the commentary we hear and also in terms of economics is they will do the latter. They will reduce their price and maintain their market share. So if they do that, that’s less scope for LNG to compete.

I think then it comes down to the question, can Middle Eastern LNG be landed here more cheaply than US LNG.

Ultimately, the question is can US LNG be landed in Europe sufficiently cheaply to be able to crowd out coal in the European power sector? And we do not know. The fact that most of the US LNG exports are fully contracted means that the cost of liquefaction is sunk and it is a fixed cost.

In some sense, you can ignore that - whether they make money from it or not is another issue.

The real issue here is of pure variable cost at which you can land US LNG. You can conceivably land US LNG at the variable costs basis for about 4$mmbtu. That’s right on the edge relative to coal, which is an interesting dynamic. I think it will all come down to can US LNG be landed in Europe cheaply enough to be able to crowd out coal? If it does, then you will see Europe consuming less coal. If it cannot, I think ultimately some of these exports may not happen and that gas will have to stay and get absorbed within the US.

I think understanding that and seeing that dynamic is interesting. Europe benefits because it will have plenty of supplies of gas driving down the price.

In the Outlook we expect Europe to become even more dependent over its gas in the next 20 years. Roughly Europe imports half of the gas it consumes today – we think that is likely to increase to ¾ of the gas it consumes in 2035. Some of that because of the demand growth but largely because on the supply side lots of domestic supplies start to come off.

The energy security issue therefore becomes very significant. I think energy security has less to do with whom you buy your energy from and is more to do with your ability to switch.

At the moment in terms of its proportion of internal consumption Europe imports as much oil from Russia as it does gas from Russia – exactly the same proportions.

I do not hear anybody saying I am really worried about energy security of my oil as I import so much oil from Russia. Because they know if anything happens to the Russian supply they can switch outside, so that is where LNG can play a role. Potentially, LNG can play a role if the demand is cheap enough to compete with Russian supplies. It may be that some of this increase in imports will come from LNG. But the other thing is, you can also use LNG as an insurance and a back up plan: if you have got lots of LNG facilities in Europe and you can enjoy the benefit of having a large neighbour who has plentiful supplies of gas who can provide that gas to you via pipelines by very competitive prices with the knowledge that you do not have an energy security problem, because should you need to, you can always go to the LNG markets. Then you think of LNG as much as an insurance mechanism rather than actual source of supply.

I think for that to happen, two things would need to be the case: one is, you would need to have LNG facilities in Europe which are underutilised, because they are only utilised when you need them. The private sector won’t deliver that, so you have to have public investment, because the private sector will not build you things that you do not use.

The other thing that is very important is that the EU would need to complete the internal gas market. The EU is really good in talking about the internal markets and completing the internal markets, but there is one market that it hasn’t completed which is the internal gas market. So that way you can make sure that you can get gas to all parts of Europe.

If you do that plus LNG facilities, I think you can solve much of the energy security issue and still enjoy the benefits of the competitively priced gas from Russia.

It is beneficial for both sides – we are thinking how dependent on Gazprom we are, while if you go to Moscow you will hear people worrying how dependent they are on Europe. In some sense, it is a mutually beneficial thing, if both sides can feel comfortable about it.

How does the carbon emissions forecast look for in the next 20 years according to the BP’s Outlook? Do you think such instruments as carbon price cap introduced in the UK be considered good practices for Europe?

The central message in the BP Energy Outlook in terms of carbon emissions is that the next 20 years looks an awful lot better than the last 20 years. Carbon emissions are likely to grow less than half than they did in the last 20 years so that is the good news.

The bad news message is that based on our current view of the most likely path of policy we see that the carbon emissions are going to rise. So you get this very big gap between our central case based on what you think is the most likely path of policy with carbon emissions by 2035 being around 20% higher than the current levels.

The IEA 2050 scenario – the benchmark scenario of what you need to reach the Paris goals - suggests that it needs to be about 30% lower. So there is a 50% gap and the message there is that policymakers need to do more. I think from the economics perspective carbon pricing makes perfect sense.

The beauty about carbon pricing is in two things: one is that it has incentives for the demand side as well as for the supply side. Using energy more efficiently, as well as using lower carbon energy.

The other great thing about carbon pricing is that it doesn’t require the policymakers to pick winners and losers. Asking policymakers to pick winners and losers over a year or two is a hard thing. Over 20 or 30 years it is almost an impossible thing to do. Putting a price on something and then letting the market decide … -not that the market is perfect -, but the market can evolve and keep adapting and adjusting as we see technology improvement and behavioural change – and that’s the key thing. From that point on, how one achieves that carbon price – via carbon trade, carbon tax or floors - economically it is far less important than getting a price - that is point number one. Secondly, how individual areas on countries or regions choose to do that is ultimately a sort of domestic and political issue. All these issues are far less impotent than the issue that we need to do more.

Paris shot the starting gun and the race ahead of us looks incredibly challenging. Doable, but incredibly challenging. It is not the time to pat ourselves on the back for finishing the race – it is about doing it and getting going.

So point number one is policymakers need to get going, because they have to lead. Energy companies, consumers, investors, entrepreneurs can follow.
Secondly, it is far more efficient to lead via prices rather than via legislation. You would have seen in the ‘faster transition’ case considered in the Outlooenthat carbon emissions would have fallen by 10% by 2035. To achieve that, the carbon price in the OECD including in Europe should go up to 100. The carbon price in Europe that I looked up yesterday was 5.42 EUR.

What would be a way of reaching out to the wider audience when it comes to describing the role that natural gas can play in EU’s energy transition?

If all you really cared about was reducing carbon emissions, shifting the share from coal to gas in the power sector by 1% has the same impact on carbon emissions as 10% growth in renewables. The mathematics quite scream at you.
The other point here is that we should think of gas and renewables being complements to each other and not being substitutes, because of the intermittency problem. We could sit here with our fingers crossed and hope that at some point in the next 10 years there us going to be a technological breakthrough and we solve the storage problem. However, given what we know now, we will need to solve the intermittency issue.

Renewable energy will only continue to grow if we do find a way of turning the kettle on in the evening when the sun is not shining and natural gas provides a natural solution to that and it’s a relatively low carbon solution, so I think I would worry for those who think renewables can solve everything, because at the moment they cannot. But they can grow very significantly, hand in hand with natural gas, providing a far lower carbon alternative as to where we are now today. Whereas coal is the dominant fuel for the power sector across many parts of the world.

This article is part of the knowledge partnership between European Energy Review and the Greek Energy Forum a group of energy professionals sharing common interest in the broader energy industry in Greece and South-eastern Europe. Follow Greek Energy Forum on Twitter @GrEnergyForum

Image: Spencer Dale, Chief Economist BP. Source: BP.