Thursday, February 4, 2016

Diminishing Profits Signal the Beginning of the End of Oil

Oil is dying. Low oil prices are erasing profits and setting into motion a death spiral from which fossil fuels will not recover. Big Oil is cutting costs, and scaling back production, this results in smaller returns and diminished investor confidence. The addition of carbon pricing schemes and the elimination of subsidies will ultimately inflate prices and reduce demand.
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The profits of the big oil companies keep falling along with the price of a barrel of crude. In 2015, the profits of oil behemoths like Shell, Chevron, Exxon Mobil and BP tumbled. Together, these big four saw profits decline by an average of 65 percent last year. These falling margins have a cascade of impacts that are hastening the demise of dirty energy.

Shell

At the beginning of 2014, Royal Dutch Shell’s quarterly earnings for the end of 2013 fell by almost half (48%). This was the third consecutive quarter of disappointing earnings. This was in part due to Shell’s failed multibillion dollar Alaskan drilling program. The situation has continued to deteriorate for the oil giant as Shell’s profits fell by 56 percent in the fourth quarter of 2015. Over the course of the entire year, Shell’s earnings fell by 80 percent compared to 2014. To make matters worse, Standard & Poor's downgraded Shell’s long term credit rating in February and further downgrades have been intimated.

Chevron

In 2015, Chevron saw its profits decline by 40 percent compared to 2014 and the company reported losses in the fourth quarter of last year. Chevron lost $588 million in the last quarter of 2015; during the same period in 2014 the company made a profit of $3.5 billion. This is the first time the company has reported quarterly losses since 2002.

Exxon Mobil

Exxon Mobil saw its quarterly profits decline by 58 percent at the end of 2015 and the company’s profits are down by half compared to the year before. Its exploration and production business lost $538 million in the U.S.

BP

British Petroleum said that its profits fell by 91 percent last year. They recorded a $3.3 billion loss in the fourth quarter of last year and $6.48 billion in losses for the year. Like Shell, the company also kicked off the new year with a long term credit downgrade from Standard & Poor’s.

Macro realities

There is no end in sight to low oil prices and falling share prices. We have not seen a commodity collapse of this magnitude in decades. However, unlike preceding oil crashes, environmental pressures and economic trends make the longer term financial forecast look bleak for fossil fuels.

Oil production continues to outpace demand and more supply is on the way now that the sanctions against Iran have been lifted. The situation is about to get even worse as storage space is nearing capacity.

While many are waiting for oil prices to rebound they may be disappointed. Driven by climate concerns and the declining price of both renewables and energy storage, we are seeing unprecedented interest in non-fossil fuel based energy production from all quarters.

In the longer term, the outcome at COP21 lends credence to the belief that fossil fuels will be subject to a host of headwinds. The fossil fuel industry is also having to deal with a rapidly expanding number of legal challenges, negative public perceptions and disruptions due to protests.

Death spiral

In addition to market pressure associated with low oil prices, producers realize that to bring oil prices up you have to decrease supply (i.e. reduce production). However, decreased production will further diminish returns and this will scare off investors.

Low oil prices have already shut down hundreds of extraction operations. Oil prices are currently about half of what they need to be to make the tar sands and shale oil viable. The exodus had begun even before oil prices fell to their current lows. At the beginning of last year, Shell announced that it was among a number of oil companies that are shelving their tar sands operations. Many are predicting that at least half of all shale oil producers will perish this year. It is not only energy intensive forms of fossil fuels that are at risk, as explained by Jesse Thompson, an economist at the Federal Reserve Bank in Dallas, “at this price range, nothing is safe.”

Big oil is responding to low oil prices and declining profits by slashing capital spending and operating expenses. For example, Exxon has said that it will cut spending by one quarter this year compared to last and BP is expected to cut spending by almost $3.6 billion this year. This translates to less production and exploration. Less exploration means lower reserves and lower reserves sends a powerful message about the future of the industry.

The linkage between lower oil prices and decreased production have set in motion a causal chain of events that does not bode well for the fossil fuel industry. As explained in a New York Times article:

"To assure their futures, oil companies need to add to their reserves to replace production, but with plunging prices, companies are delaying or canceling projects and struggling to add to their reserves."

Reduced earnings are translating to cuts in production. For Shell that means delaying a liquefied natural gas facility in Canada and a deep water oil and gas development in Nigeria.

The combination of less production and low oil prices translates to lower profits which puts downward pressure on the dividends that they can pay out to investors. This in turn, curtails investor interest. While big oil is trying to reassure investors by saying that they will continue to pay big dividends, the situation is untenable.

Maintaining investor interest will be challenging for BP and others, as explained by Biraj Borkhataria, an analyst at RBC Capital Markets in London. He is quoted as saying:

"2016 is likely to be a year of transition for BP with limited ability" to cover its dividend unless oil prices rose substantially.

Michael Hewson, an analyst at CMC Markets puts it this way:

"But with average oil prices still trading at multi-year lows so far this year the question now needs to be asked in how long can BP sustain the dividend at current levels, without an imminent pick up in oil prices."

When investor confidence evaporates, the fate of the fossil fuel industry is sealed.

The position of big oil goes from bad to worse when we factor carbon pricing and an end to subsidies. This will raise the cost of fossil fuels and reduce demand.

Although it will take decades it is clear that we can kill what Bill McKibben has called the immortal zombie of fossil fuels.

Source: Global Warming is Real

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