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Big Oil can expect a long and profitable decline

The rise in demand for oil appears to be levelling off just as new sources of supply are appearing

23 May 2015

9:00 AM

23 May 2015

9:00 AM

It was the kind of megadeal that sets pulses racing in the City. When in early April the oil giant Royal Dutch Shell unveiled a £47 billion takeover of its British rival BG, it prompted a predictable flurry of speculation about a fresh round of megadeals in the energy sector. Independents such as Tullow Oil were immediately put in the frame. Even the mighty BP no longer looks too big to be taken out by a rival such as Chevron of the US — even if the UK government might oppose such a bid.

And yet this dealmaking fever is as much a sign of weakness as of strength. Increasingly Big Oil looks like this decade’s equivalent of Big Tobacco. A once massive industry, supplying a product that is part of everyday life, faces long-term decline, and companies are scrabbling around to find ways of cutting costs as they try to deal with that prospect. Yet, just like Big Tobacco, Big Oil can still be very profitable. Cigarette companies have made plenty of money as they retreat: energy giants can do the same.

Shell’s acquisition of BG was the largest deal in the industry for two decades. BG used to stand for British Gas, but the company had come a long way since the days when everyone was telling Sid about it as it was privatised in 1986. The arm that delivered gas into people’s homes has long since been hived off as Centrica, and the BG that Shell is buying is mainly an oil and gas exploration and production company, with the emphasis on gas. The combined group will be worth more than £200 billion, making it one of the biggest companies in the world and a rival to the American giant ExxonMobil. The deal will allow Shell to leave its traditional British rival BP behind — and perhaps even to take it out, from a position of strength, at some point in the next few years.

But this hardly compares to the last round of megamergers, when the likes of BP’s Lord Browne were buying up businesses in a race for global domination. Oil and gas is still a huge industry, of course, turning over hundreds of billions of dollars a year, powering the world’s cars and trucks, keeping electrical generators running, and heating homes. But technology is against it — and in the medium term, that is always a bad place to be.

The big problem for the oil industry is that even though the global economy is still growing, despite what some of the pessimists might tell you, and lots of new countries are joining the developed (and therefore energy-hungry) world, demand for oil seems to have started running out of steam. Take the US, for example, traditionally the biggest consumer of oil. American demand rose from 15 million barrels a day in the early 1980s to 22 million barrels a day by 2006. Since then it has steadily fallen to around 19 million barrels, even though the American economy is more than 10 per cent larger in GDP terms than it was then. The same is true of most developed economies. China and the emerging markets are still increasing their oil demand, but the developed world has stopped — and it will, of course, only be a matter of time before the rest of the world catches up.

The reason is simple. We have become more energy-efficient, and alternative energy sources are providing real competition for the first time. Anyone who has bought a car in the past couple of years (unless it was a top-of-the-range Rolls, in which case you probably don’t care) will have noticed it is far more fuel-efficient than the one it replaced. Average miles per gallon for American cars has risen by 29 per cent over the last 13 years, and since people aren’t driving much more that means they use much less fuel. The rise of electric cars is dramatic. Last year 285,000 were sold worldwide, and sales are accelerating at 20 per cent annually. Every time someone buys an electric car, they take another little chunk out of the oil and gas business.

It’s the same in other industries. Massive subsidies for wind, wave and solar power have cut the demand for oil to generate electricity. Solar power is starting to become a mainstream product, powered by massive falls in the cost of solar panels and their much greater efficiency. The moment is close when solar can be declared a viable mainstream energy source. Indeed, renewable energy is already starting to replace fossil fuels such as oil and gas. The turning point came in 2013 when, according to Bloomberg New Energy Finance, renewables overtook fossil fuels for the first time in terms of the amount of new generating capacity built. The same was true last year. There are still a lot of existing power stations, of course, and oil will be used for a while yet. But every year, slightly less.

At the same time, there is more supply. Shale gas and oil producers are under pressure as a result of the current price slump. But they have opened up vast new supplies of both commodities at a time when demand is static at best, and falling in many markets. And that’s with only the American shale producers on stream in significant scale. If we ever manage to subdue our anti-fracking protestors, the UK will be capable of producing vast quantities of hydrocarbons from shale. So will the French, the Germans and the Poles. Add in potential supplies from Iraq and Iran and suddenly there’s a glut of oil at the same time as the black stuff has hit serious competition from other power sources. The net result? The halving of the oil price over the last year is unlikely to be a short-term blip. It may well be the beginning of a long-term decline.

The transition we’re talking about here could easily take 50 years. Technologies stick around for a decades after they start to become obsolete. It will take a long time for everyone to switch to electric (and even driverless) cars. Tractors and trucks will take even longer — farmers don’t upgrade just because they want the latest model to look good next to the barn. Switching power generation, and ships and heating systems and all the other stuff that runs on oil, will take even longer. Even so, all machines become obsolete eventually — and as they are replaced, fewer of them will use fossil fuels.

That means the Shell-BG deal is unlikely to be the last. If $40-$60 is the price range of a barrel of oil for the next few years, then all the major companies are going to struggle to make money, while the smaller explorers that Robin Andrews looks at overleaf will be in deep trouble. One by one they will be taken over as the bigger boys find it simpler to buy them out and take over their fields than develop new ones of their own. If the barrel price rachets down to $20-$30, which is by no means impossible, that process will only accelerate — and Citigroup is already predicting the price will sink that low over the next few years. The oil industry will no longer be about expansion. It will be about coping with a shrinking business as best as you can.

There is a twist to the story, however — and an important one for investors. Any long-term sectoral decline is, of course, unfortunate for workers and suppliers. Jobs are lost and prices are squeezed. But it can be surprisingly good for investors. Take tobacco again, another widely disliked product that was once ubiquitous. We smoke far less than we used to — in Britain, smoking is down from 45 per cent of the population in 1974 to below 20 per cent today. But if you had invested in British American Tobacco, you’d have done pretty well. Since 1998, its shares are up 600 per cent. Not much sign of painful decline there.

Why is that? Once they stop worrying about growing and conquering new markets, managements can focus on stuff like squeezing out excess costs, raising prices where they can, and tieing up mergers that will deliver real efficiencies. It is dull, brutal work, but it is effective and it makes a lot of money for shareholders. Big Oil has a long way to fall, but paradoxically a lot of money will be made on the way down.

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