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Outlook 2017+


Prepared in April 2017

From an empirical point of view related to oil market scenarios, our Outlook 2017+ remains broadly unchanged what we presented last year. In response to the latest news and developments that surprised the market (like OPEC’s intervention or the effective date of a cap on marine fuel sulfur content accelerated by five years), we have slightly adjusted our projections of oil pricing trends over the next five years.

We expect oil prices to average about USD 55 per barrel in 2017 and 2018. In the following years, we believe that prices may accelerate upward in the wake of cuts in spending increases in conventional upstream projects seen in 2015−2017. As the size of the cuts remains unknown, we will not speculate on how fast oil prices are likely to rise in 2019−2021.

No new factors have emerged that we would have missed a year ago and that could impact on oil supply and demand over the next 20 years. Today we better understand the factors that we were only aware of before and to some of them − specifically the advances in electric mobility and digitisation − we now attach a greater weight.   Digitisation means electrification, therefore we expect this factor to spur demand for electricity as consumers take on new habits and voice new needs. The digitisation and electrification of public and private transport will add up to a weakening demand for oil. Demand for reliable electricity at stable prices will boost the appeal of solar and nuclear energy sources, while the digital revolution and progress achieved in the energy storage sector will pave the way for further developments in these primary energy sources.

What has changed the most over the past year is how we view the oil market. Attention has shifted to the future of oil demand (which may shrink), pushing price issues to the sidelines. Since the effects of oil being phased out from the global energy mix are not clear to see 20 years from now, the time horizon of scenario analyses has been extended by 15 years, to 2050. But the horizon of strategic thinking extends even further. Strategic decisions are increasingly dictated by change scenarios, with the ‘business as usual’ approach generally viewed as outdated. Businesses still use it to communicate to the market their estimates of future returns on existing assets over a 20-year horizon.

Our Outlook 2017+ differs from prior editions in that it contains no in-house scenarios. This is for two principal reasons. No major revisions have been made to the possible scenarios until 2020, which we discussed last year, or to the underlying price path assumptions. We refrain from disclosing the numbers assumed in the change scenarios used to develop our strategy, which is a common practice. Further on in Outlook 2017+, instead of numbers, we will discuss qualitative changes in our approach to planning strategies and allocation decisions for the oil sector.

Oil market: change of perspective

From price paths to demand paths
The oil market can be viewed from various angles. Until recently oil price paths were the focus of attention, with movements in supply and demand seen through the lens of their impact on prices. With China’s accession to the WTO in late 2001, the sharp growth in demand became the most powerful force driving the oil market, and the lagging supply put upward pressure on prices. China needed more and more oil to power its booming industry, to fuel ships carrying growing cargo volumes, etc. It was a time of prosperity for refiners, with profit margins rising. When the financial crisis struck, the deep recession that followed, compounded by high oil prices, stifled demand temporarily. Refining margins shrank, and many refiners went bankrupt. But skyrocketing oil prices, that had continued in an uptrend for years, provided an incentive to increase production potential, something that the world failed to notice on time. The potential of ground-breaking innovations was once again underestimated. At this point in history, new technologies opened up oil deposits that no one had expected could ever be accessed, including shale and deepwater reserves. As recently as 2010, it was widely believed that the oil supply would soon run out again. Much more recently, in mid-2014, it turned out that there were still ample oil reserves. Since then the market has been driven by the supply side. The prices went down, the short-cycle production sources have quickly adapted to the low price environment, and crude stocks have been built. These adjustments have brought the market back to a state of balance and raised the  question of what will happen next to oil prices.

There was no doubt that the price of USD 30−40 per barrel of oil was unsustainable and prices would rebound. But predicting future price paths proved more controversial, for two reasons: the ample global supply and the prospects of shrinking demand. Global oil reserves have been growing faster than output. In 1980, global oil production totalled 23 billion barrels. Oil reserves of 683 billion barrels would have lasted the world for 30 years in those circumstances. But in the 32 years between 1980 and 2012 global reserves reached 852 billion barrels. 2012 alone witnessed an output of 31.5 billion barrels. Under these conditions oil deposits holding 1,668 billion barrels of oil would last for 53 years.  The total output in 1980−2015 reached 1,300 billion barrels of oil. In 2016, production totalled 30 billion barrels, with reserves estimated at 2,092 billion barrels, enough to supply the world for the next 70 years.  Zaki Yamani, Saudi Arabia’s oil minister from 1962−1986, noted: “The Stone Age came to an end but not from a lack of stones and the oil age will end, but not from a lack of oil”. Indeed, demand for oil and liquid fuels from OECD member countries has been in decline since 2005. When will oil demand start to shrink globally? There are two opposing views on that. According to one of them, prevalent until recently, the rumours of global demand peaking soon are exaggerated. The abundance of oil and the progress in extraction technologies support low prices, but in the long term prices cannot be lower than the marginal cost of extraction, or the break-even cost of producing three to four million barrels of the most expensive crude per day required to cover demand. Oil prices remaining low for some time would raise demand. Slightly more expensive oil reserves would have to be tapped, and the industry would be back to business as usual. In those scenarios, oil prices would be set by the marginal cost of production of approximately USD 70−80 per barrel (in constant US dollars) in the long term, generally assumed to be 20 years. Three years ago it was believed that the price of oil would reach USD 100 per barrel in the long term, but the price expectations were revised downward year by year, reflecting improved production efficiency.

The other view, which has received much attention of late, predicts the end of the dominant role of oil in transport and the end of oil as a power generation fuel (outside the OECD, as OECD countries already went through this process after the oil shocks of the 1970s and 1980s). Although more oil will be consumed as feedstock by the petrochemical and chemical industries, by 2050 overall global demand for crude oil and liquid fuels could shrink by as much as one-third relative to current levels.  Shrinking demand means no need to extract more expensive oil and the balance price would drop far below the level assumed in the scenarios of rising demand.

A central feature of publications and scenarios envisaging shrinking oil demand is not the prices but demand and negative demand drivers. Electric mobility is coming to the fore, but looming in the background is a much more powerful force − the progressing and all-pervasive digital revolution, which has been hailed as the fourth industrial revolution although its impact will reach far beyond traditional industry. In those scenarios, oil prices have a big question mark hovering over them as the only available metric is the marginal cost of production, which itself depends on the geology of deposits and the extraction technology available.  Considering geological factors and E&P costs, declining oil demand could bring down the price per barrel of oil to a level as low as USD 40 in the long term. The problem is that other factors also come into play – some oil reserves that would be the cheapest to produce cannot be accessed for geopolitical reasons. More importantly, the shrinking-demand and low-price scenarios have price cycles embedded in them. The mechanics are described below. The life cycle of production and refining assets runs into decades, typically multiplied by digits above five.  The mere prospect of oil demand falling in the wake of a technological revolution means that some of the existing assets will become stranded, weighing on the market value and spending capabilities of oil companies, and affecting their propensity to invest in production and refining assets. This trend is further compounded by production lost as a result of some upstream projects being postponed in the last two years due to depressed prices, with the scale of output reduction as yet unknown. When we confront reduced supply with projected demand expected to rise sharply over the next five years (by an average of 1.3 mmbd a year) before it starts to fall, this can be read as a signal that oil prices could rebound in two to three years. If prices increase, production will become profitable, so upstream project spending assumptions in ‘business as usual’ scenarios should be raised. But upstream firms know that demand will slow down over the next 20 to 30 years. Where will the oil price go then? Will companies in the upstream industry still be ready to invest despite the prospects of shrinking demand? Or will they make do with profits from high oil prices for as long as there is demand? No wonder scenarios predicting a shift away from oil in the transport industry are silent about future oil price paths. The scenarios envisaging a decline of the oil industry have departed from prices as the key driver of capital allocation decisions anyway.

Extending the horizon
Economists define a horizon based on the time required for the production potential to change. In services, this takes months, but in heavy industry the shift could take over a decade. In the case of the fuel and energy sectors, the short-term horizon is up to five years. Defining the long term is much more complex.  If we focus on changes in production potential resulting from the investment in available technologies, the long-term horizon would range from between 15 to 20 years. This is long enough for additional fuel and energy output from new projects (e.g. power stations) to reach the market and for consumers to replace old systems and equipment (heating systems, vehicles, etc.). However, twenty years is much too short a period to apply nascent innovations on a mass scale and change the rules of the game in the industry (efficient energy storage systems, electric cars, etc.). It is precisely this overly short time perspective, which is insufficient to capture the effects of revolutionary shifts in the fuel and energy sectors, that explains

Scenarios for the oil business
The purpose of scenarios developed by oil companies is twofold: to provide a basis for estimating future earnings in terms of spending capacity (these are shared with the market) and to set the direction of capital allocation (these remain a business secret until a project is sanctioned). The latter requires a much longer time horizon that the former, given the life cycle of production, refining, petrochemical, and power assets. For reasons including the uncertainty of the future, accelerating technology advancement and the emergence of various game changers, allocation scenarios are intended as a safeguard against grave mistakes (such as investing in assets which will have to be written off after two to four decades) rather than as a tool to optimise decision-making. Allocation scenarios materially differ in the assessment of future price and demand paths. Some scenarios are viewed as more viable than others. Companies indirectly use the knowledge of allocation scenarios when communicating with the market, by disclosing demand and price projections determined on the basis of the paths assumed in the considered scenarios, weighted by the probability of their being met within the next 20 years. Averaging out the demand and price paths mitigates the projection error.

Market communication underpinned by ‘business as usual’ scenarios
Typically, a time horizon of 15 to 20 years is long enough for fuel and energy companies to estimate future returns on assets in operation today and on new investment in existing technologies, particularly after accounting for the time value of money. Knowing that companies are reluctant to share details of their investment strategies before any go-ahead decisions are made, no wonder that long-term outlook reports of global fuel and energy majors do not go beyond the 15- to 20-year horizon, and show smooth continuation of price and demand paths for energy commodities. For instance, the latest BP Energy Outlook, which “presents the most likely path for energy demand and the evolution of the fuel mix over the next 20 years” and “shines a light on the key trends and forces that are likely to shape global energy markets over the next 20 years”, does not mention an oil demand peak. What it does say is that “a simple extrapolation of these trends beyond 2035 would suggest that oil demand may start to decline during the mid-2040s”. ExxonMobil takes a similar stance in its Outlook for Energy: Journey to 2040. Even though its time horizon is five years longer, the Outlook predicts that “oil will continue to play a leading role in the energy mix, driven by demand in transportation and feedstock for the chemical industry”.

The quoted Outlook reports are multifaceted and discuss the risks and uncertainties surrounding the base-case trend paths. They examine mega-trends and touch upon structural shifts which are taking place across the global energy sector but are too gradual and too moderate to change the rules of the game. But it would be a mistake to think that the picture of the future of the fuel and energy sectors painted in BP and ExxonMobil’s Outlook reports is used by the companies to guide their capital allocation decisions.

Strategic decisions underpinned by change scenarios
The situation looks very different when it comes to capital allocation. Given the long life cycle of oil assets, the time horizon adopted in setting the directions of long-term growth must extend far beyond the next two or three decades. Only then is it possible to discern the risks associated with the continued use of the existing business models, and gain the time required to make the necessary adjustments.

The tightening of the climate change regime (like the recent decision of the International Marine Organisation to shorten the time allowed to implement the cap reduction on the content of sulfur in marine fuel from 3.5% to 0.5%) is by no means the most powerful driver of the structural transformation of the global energy sector − the progress in digitisation is, further reinforced by technological improvements and new business models that go with the process. The combination of technological, social and economic changes brought on by digitisation has been dubbed the Fourth Industrial Revolution, although it is reaching far beyond the industrial sector. Since anything digital is also electric, the Fourth Industrial Revolution is an electric revolution as well, with far-reaching implications for the energy and transport sectors. The pace of transition may suddenly accelerate as the revolution is also having an impact on the demand side of the market, determining which primary energy sources we choose and how we use energy. To illustrate this point, Google consumes five terawatt hours of electricity annually to power its data centres, an equivalent of the electricity used by all of San Francisco in a year. Over 80% of the electricity consumed by Google comes from renewable sources. The use of renewables is driven by business rationale − the cost per unit of energy is easy to predict and, consisting mainly of depreciation charges, it is insensitive to cyclical fluctuations. And since electricity is the largest cost item, this helps to keep overall operating costs down. Therefore, a critical factor considered by Google before choosing a site for a new data centre facility is the accessibility of renewable energy sources.

Non-business scenarios bring change to the fore
Research organisations from outside the business community take an entirely different approach to energy transition and scenario analysis. The world’s most respected energy think-thank is the International Energy Agency (IEA), bringing together OECD member countries. Its annual World Energy Outlook is an extensive report containing alternative scenarios for the global energy sector. One of them is the rigid 450 Scenario, setting out a pathway to limit global warming to 2°C above pre-industrial levels by 2040. In the 450 Scenario, global oil demand peaks in 2020, and then moves into a decline out to 2040, when it reaches 70% of the current consumption levels. Few assumptions made in the Scenario have actually been met, and the IAE itself treats it as a point of departure for developing other scenarios, which assume a very slow decline in oil demand.

The role of passenger cars in shaping oil demand
The running theme of the international and domestic debate on the future of oil and liquid fuels last year was electric mobility, and with good reason. The future of oil largely depends on how long it will retain its dominant position as the primary fuel source for transport. The world today consumes 96 mmbd of crude oil and liquid fuels, with the transport sector accounting for 56 percent of that, equivalent to 54 mmbd. Demand from the industrial sector as the second largest consumer is three times lower, at just above 18 mmbd (19 percent of global demand). Secondly, transport relies heavily  on oil, with 90 percent of the energy that fuels the sector derived from petroleum. Central to electric mobility are light-duty vehicles (LDV), which consume 63 percent of the total crude oil and liquid fuels used in transport (34 mmbd). Heavy vehicles account for slightly less than 10 mmbd (18 percent), with the other 10 mmbd is consumed outside the road transport sector: 10 percent by air transport, 6 percent by maritime transport, 1.5 percent by rail transport, and 3.5 percent by other modes of transport. The largest proportion of light vehicles are passenger cars, consuming 19 mmbd of fuels (35 percent of total consumption in the transport sector). This category of vehicles is most heavily influenced by consumers and their transport choices, thus being the most likely electrification and digitisation target. Electrification is the replacement of cars with traditional combustion engines by vehicles powered by an electric power train. Digitisation may reinforce the process, for instance through car sharing (electric cars will be less expensive for users, transport demand will rise, vehicle numbers will remain unchanged or rise, and the driving range will double). In the period of transition, hybrid vehicles are gaining prominence, fitting well into the world of combustion-engine vehicles. Some use an electric motor in addition to a traditional engine, others use a combustion engine as a back-up range extender in vehicles with electric drive systems. But the true breakthrough comes with battery electric vehicles (BEVs), popular particularly with technology enthusiasts and devoted environmentalists. Norway is an example that electric cars can be deployed on a mass scale if appropriately dense charging and maintenance infrastructure is available and incentives, both financial and non-financial, are put in place to encourage electric car adoption. Unfortunately, the Norwegian system is extremely costly and therefore cannot be easily replicated in other countries. So, when can we expect a revolution in car transport that will dethrone crude oil as the main fuel? As it turns out, a lot depends on the car makers who, like American Tesla, have taken matters into their own hands and are planning to build a network of fast-charging stations along Europe’s motorways. The global car fleet totalled 0.9 billion vehicles in 2015, including 1.2 million hybrids and EVs, and 680,000 pure electric cars (BEVs). Due to the long service life of a passenger vehicle, averaging 20 years, roughly 5 percent of the fleet is replaced every year. Considering the pace of growth in global fleet numbers and EV penetration, the share of electric cars in the global fleet by 2035 is all but impressive. BP’s Outlook puts the number at 6 percent, with the related reduction in oil demand not exceeding 1.2 mmbd. Nothing to worry about. But the latest scenarios of academic centres researching changes in the energy and transport sectors predict that by 2050 electric vehicles will account for 70 percent of the global passenger car fleet, with the world’s demand for oil expected to shrink by over 24 mmbd. It is interesting to note that according to the same scenarios, by 2030 electric cars will account for 5 to 9 percent of the global fleet. If we do not look far enough ahead, we may fail to notice a potential threat. A growing share of solar and nuclear sources in the global power mix (30 percent and 25 percent respectively) will significantly contribute to reducing carbon emissions. Dieter Helm, a British economist and specialist on changes in the global energy sector, in his latest book under a telling title ‘Burn Out - The Endgame for Fossil Fuels’, argues that the key drivers of change will be technological innovations and business, rather than governments or regulations aimed at combating climate change. Economic policies may keep these processes under control, but innovation support tools will play a greater role than instruments for environmental and climate protection.

ORLEN Group’s scenarios

Projections for crude prices and product and refining margins are just one of a number of deliverables of scenario analyses, and not even the most important one. The scenarios are not meant to foresee the actual course of events, but rather to prepare the Company for building sustainable growth strategies which will stay up-to-date regardless of the actual developments. A well-organised scenario analysis will help avoid the four ‘deadly sins’ of strategic planning, namely: (i) a tendency to hold on to earlier assumptions no matter what, (ii) optimism dominating over realism, (iii) illusion of control over the course of events, and (iv) attaching too much weight to recent information. Therefore, it is very important to identify the differentiating factors between the scenarios. Each scenario tells a logical story about the crude oil market, which may come true in the future. Taking a purely mathematical approach we may come to a conclusion that those stories are countless. However, building alternative scenarios only makes sense when we can tell several very different stories, which may potentially come to life in the future and change the course of events in the oil market; and their number is much smaller. The key to building such scenarios are the most relevant problems which will determine the future of the global oil market and generate alternative solutions, depending on how they are addressed.

During the last strategic review, we examined threats and opportunities that may come with the Fourth Industrial Revolution. Strategic analyses of this sort focus on identifying ‘black swans’, understood as a confluence of factors that may precipitate technological and social change affecting our current areas of activity to the extent that this may derail our business. Black swans are events with a low probability and high impact. New technologies to produce and use energy are black swans. Or the shale revolution, which caused oil price falls, sidelined OPEC’s control over prices and is now effectively keeping prices down. Once the relevant areas have been identified, a change strategy is analysed to clarify the direction we should adopt to exploit the shifts to our advantage and to verify our ability to do so at the right scale and time. Strategic analysis, investigating more and less probable scenarios, results in a road map for growth, identifying the areas we should exit and the directions we should follow. No company will divulge the findings of its strategic analyses. What the official strategy brings to light are the expected returns under analysed scenarios of change occurring in the external environment, or in other words the probability-weighted average of returns. This approach makes Outlook reports published by companies similar to ‘business as usual’ scenarios and is safe as a method of estimating expected returns on assets, as weighting eliminates extreme scenarios and mitigates the risk of error in price path projections.

The next five years: waiting for oil prices to rise
Since we worked on our first Outlook in March 2015, the oil market has rebalanced. OPEC is also back with interventions intended to prevent prices from falling again. Recovering prices prompted growth in unconventional production in the US which is characterised by price elasticity, curbing the potential for further increases over the next year or two. Accordingly, we expect oil prices to hover around USD 55 per barrel in 2017 and 2018. Current market developments are being closely watched by OPEC, considering the viability of further interventions. The cartel wants to see the price of crude at above USD 50 per barrel, but below USD 60, a level which would trigger a rise in new conventional upstream projects, leading to price drops in the longer run. As global economic growth is accelerating and oil demand is expected to rise at a fast pace of around 1.6−1.7 mmbd in 2017−2018 and 1.3−1.4 mmbd in 2017−2021 on average, the International Energy Agency predicts oil prices are likely to grow more in three to four years. This view is supported by the large scale of conventional upstream projects planned for launch in 2015 and 2016 but cancelled or postponed as a result of low oil prices. The mismatch between supply and growing demand was mentioned in our previous Outlook reports as a risk factor potentially speeding up growth in oil prices. Even today it is difficult to predict the pace of that growth, so we decided not to publish any price assumptions for 2019−2021 in our Strategy.

Over the past two years, oil market movements have been in line with expectations, although market adjustments have been slower than we had expected. No new factors have emerged outside the realm of policy (which is always relevant as a risk factor) that would have come as a surprise and prompted major revisions to expectations for the next five years due to a high degree of uncertainty. We will not even try to guess what oil prices are going to be in the future, because in the commodities sector like ours what matters more is the position on the refining and petrochemical cost curve in the region and globally, and an adequate financial buffer, as these factors determine our resilience to unexpected movements in prices and margins.

In this context, the regulatory change to marine fuel specification requirements will significantly impact oil prices and product margins over the next five years. The International Maritime Organisation resolved to accelerate the implementation of new bunker fuel quality rules by five years. As of January 1st 2020, the sulfur content of marine fuels used worldwide will be capped at 0.5% instead of the current 3.5%. The change itself is no surprise, but it was originally planned for 2025. The unexpected decision to implement the new rules five years earlier is bound to have major implications for shipowners and refiners, with strong volatility of oil and petroleum product prices (margins) expected around the implementation date. It is difficult to predict how shippers and refiners will adapt to the new regime.

The long term: look far ahead and expect the unexpected
Moving on to the long-term horizon, worthy of note are major revisions to growth prospects for the energy and oil sectors that were made during the year − the outlook horizon has been extended to provide sufficient time for the outcomes of global economic and social mega-trends and new energy technologies to materialise. As the energy sector stands out from other industries for the long service life of its supply-side assets (power stations, refineries) and energy-consuming systems and equipment (vehicles, home heating systems), as well as for high equipment replacement costs, the global consequences of even far-sweeping changes are impossible to see within a 20-year time horizon. At least 30 or 40 years are needed for that. Extending the time horizon is nothing new, as this is the time horizon commonly adopted by energy companies when calculating returns on key investment projects. Anyone who has ever had to deal with large-scale capital projects knows that energy price paths are an input to a project’s economic analysis. But where to look for energy price projections when we are dealing with scenarios involving technological breakthroughs?

Intuition has proven a much better decision-making tool than rational calculation models for many business processes, for instance in setting the direction of capital investment allocation, which should factor in the far-reaching effects of today’s innovations that are bound to drive change in the long term. Moving your business on new tracks of innovation is a big task that cannot be accomplished if you do not trust expert intuition. As data on innovation projects is incomplete, it is impossible to perform economic analysis and estimate project costs or future revenue streams. New business projects are so unique that they cannot be subject to rational evaluation as the basis for the selection process. The project owner can only rely on its ‘gut feeling’. In the world of conventional projects, basing your decision on intuition alone would be considered a manifestation of economic irrationality and mismanagement. But innovation projects belong to a world where relying on your intuition is the norm. Simply because there is no other choice.

Author of Outlook 2017+:
Adam Czyżewski, Ph.D.
Chief Economist, PKN ORLEN


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