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If oil demand were to peak globally

Investors assumed oil would be more valuable in the future, but all bets are off if demand falls

FILE- In this Wednesday, Sept. 30, 2015 file photo, an oil pump works at sunset in the desert oil fields of Sakhir, Bahrain. OPEC member states and other major oil producers are planning to meet next month to discuss a freeze in oil output levels, Qatar's top energy official said Wednesday. (AP Photo/Hasan Jamali, file)©AP

Timing is everything when it comes to investing in commodities.

It seems difficult to believe now but in 2014 oil was considered one of the safest bets around. The reasoning among large financial investors was straightforward. Regulation and technology might well crimp demand in the industrialised west but as more of the developing world’s poor moved into the middle class oil demand and prices would remain strong.

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Fast forward to 2016, and many analysts, including those in strategic planning departments of large oil companies, are starting to warm to the idea of peak oil demand globally, not just in the OECD.

In part, the exercise has been driven by shareholders and activists who say the companies are ignoring the risks to their business from a global climate accord. A number of organisations, notably the International Energy Agency, but also including oil companies such as Statoil, Shell, BP, Total and ConocoPhillips, are modelling outcomes based on a breakthrough in battery technology or that global temperatures rise by no more than 2 degrees Celsius.

These scenarios include rising solar energy and natural gas use, cheaper car batteries, urbanisation supported by millennial ride sharing and public transportation, and a plethora of advanced, digital energy saving technologies. Many of these studies project a significant fall in oil demand to 75m barrels per day by 2040, down from about 95m b/d today.

At the University of California, Davis, we have tested oil demand sensitivities and found that a combination of factors — including slower than expected growth in the developing world, improved logistics, and advances in vehicle efficiency — could, perhaps with a push from policy, see demand for oil peak, at least for a decade or two.

The implications are bigger than they might seem given the number of ifs that surround the idea that oil demand could peak. For the past three decades, investors have assumed that oil under the ground today would be more valuable in the future. That led them to seek companies best positioned to deliver growth.

But if the rise in oil demand is uncertain, all bets might be off. That means investors don’t simply want “exposure” to crude. They will need to select a management team that will be smart, nimble and adaptive, no matter whether demand rises, falls or remains flat.

Moreover, in a more competitive world where producers might have fewer opportunities to sell its product, all investable oil assets will not be equal. Investors will have to know what the production cost basis is for a company’s reserves or how well positioned their refinery network is to beat global competitors.

Location of assets will matter. Owning a refining and marketing network in California or Germany where demand will almost certainly fall off might be less attractive than in India or Malaysia.

The use of automation and other emerging technologies to drive returns will also matter. US shale darling Pioneer Natural Resources’ chief executive Scott Sheffield told an audience recently in Houston that technology advancements had lowered the company’s production costs, excluding taxes, to $2.25 a barrel for horizontal completions in the prolific Permian Basin of Texas, low enough to compete with Saudi Arabia — one of the world’s lowest-cost producers. By contrast, operating costs in Canada’s harder to develop oil sands are estimated at $37 a barrel.

For 30 years, the oil industry has operated under the principle that it will have difficulty meeting future demand. Against that backdrop, adding reserves to the balance sheet was an end unto itself, sometimes more important to management than if those reserves could be profitably produced.

The thesis was that oil would become increasingly scarce as easy to reach reserves were depleted; the value of booked, warehoused reserves would appreciate with global prices and eventually a day would come that even ridiculously expensive assets would be profitable to produce.

But if global oil demand declines before those expensive reserves are needed, then mindlessly booking reserves is not a strategy Wall Street will want to reward in the future. Instead, investors might ask more critically what a company’s revenues outlook will be this quarter or next quarter, like most other ventures. Understanding which companies can pivot best to these new realities will be key to smart investing in oil from now on.

Amy Myers Jaffe is executive director of energy and sustainability at University of California, Davis. She served as chair to the World Economic Forum (Davos) Global Agenda Council on the Future of Oil and Gas, which recently published a study on the Implications of Peak Oil Demand.

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