For 30 years, the conventional wisdom in the energy industry has been that the price of oil will go up because it is a scarce resource with exponential demand growth. Therefore, energy companies will be profitable – at least in proportion to their oil reserves. But according to Amy Myers Jaffe, this blind belief is completely wrong because of structural changes in the energy sector.
Jaffe is a leading expert on the geopolitics of oil and gas and energy security; the executive director for energy and sustainability at the University of California-Davis; and the chair of the World Economic Forum (Davos) Global Agenda Council on the Future of Oil and Gas. She spoke on May 9 at the 69th CFA Institute Annual Conference in Montréal on trends and changes in global energy markets. A replay of and slides from her presentation are available here.
From 2003-2011, she said, institutional investors could basically “throw a dime” and make money investing in shale. “Well, that’s not going to be true anymore,” she said. “Now you’re actually going to need to know what you’re doing.”
Jaffe predicted that we will see a dramatic change in the long-term competitive outlook of the oil sector because of improvements in technology. She argued that technological innovations will have far-reaching effects on both supply and demand in the global energy market, and that this will lead to transformational structural changes “that will further decouple energy use and economic growth.”
Why energy markets are changing
Jaffe explained that recent decades were marked by exuberance in oil and gas markets because of three assumptions: reserves will eventually deplete; oil production is inherently expensive, and therefore prices need to stay high to cover costs; and there will be insatiable demand because the growing middle class in the developing world will want to live the same lifestyle enjoyed in the West.
According to Jaffe, though, these beliefs are fundamentally flawed because they fail to account for technology-driven changes.
First, Jaffe explained, countries and businesses will no longer be able to assume that an asset pulled out of the ground will be more valuable in the future. This is because there are now sophisticated techniques to extract oil from many different sources. Innovations are allowing us to expand production to a wider variety of locations, alleviating concerns that resources are being depleted.
Second, innovations that render the extraction process more effective are already pushing costs down. Jaffe confidently asserted that upstream costs will not be a driver of high oil prices in the future, contrary to conventional wisdom in the oil industry.
Third, Jaffe said, investors can no longer assume that there will be exponentially growing demand from emerging markets. Energy demand will continue to grow as emerging economies develop. However, she added, the demand from countries like China will slow in coming decades as the pace of Chinese industrial growth slows. Jaffe also posited that, although the middle class of developing economies will increasingly demand energy, their needs will be met with a lot less fuel because of efficiency gains.
Jaffe’s presentation was based upon the notion that major changes in global energy markets are going to be driven by one underlying phenomenon: “The Fourth Industrial Revolution.” The term, recently coined at The World Economic Forum, refers to the ongoing exponential gains in productivity that are being ushered in by advances in technology such as automation, big data, and transportation logistics. According to Jaffe, these developments are going to fundamentally change the competitive landscape of energy markets in the next 20-30 years.
Jaffe said that we can already see how these innovations are transforming our energy consumption. As an example, she discussed a new program at General Electric that analyzes daily weather patterns around the world to help airlines optimize their flight routes to minimize fuel consumption.
Jaffe added that our consumption of energy will also change due to social movements enabled by technology, and that we are underestimating the effect this can have on future energy demand. To illustrate her point, she said that the head of Uber’s marketing in China recently told her that the popular ride-sharing program is being used by Millennials there to meet new people. In fact, “there’s a young man who drives a Ferrari for Uber in China, and he’s obviously not doing it for the $4 a trip; he’s doing it to meet women!” Jaffe said, “So when an oil company says it’s certain about demand for China, they’re not counting on Millennials in China riding around in sharing programs because they want to meet people.”
Jaffe did concede that there are many complex issues that make it difficult to predict how technology will change our daily lives over the next several decades. However, she argued, the technology revolution is already driving down costs and facilitating economic growth, while simultaneously improving energy efficiency. According to Jaffe, this should serve as an indication that the energy sector will see structural transformations in the 30-year time horizon.
What should investors do?
Jaffe recommended that investors use a risk-management approach when taking long-term positions in global energy markets. By risk management, she means using a long-term horizon to invest in companies that have market leaders with a compelling strategy.
In contrast to previous decades, Jaffe said, investors are actually going to need knowledge to invest in this space because we now have uncertainty about future demand for oil. She emphasized that when looking at the long-term picture, “it doesn’t have to be that demand gets eliminated over time; we just have to think that it’s a possibility, then we have to change our strategy, because now it’s a game of survival.”
She explained that management in the oil industry will have to face new market realities, and that investors should consider their ability to make strategic changes. For instance, she discussed the possibility of a global climate policy emerging in coming decades, implying that firms may need to consider how long they want to hold assets such as oil reserves. She emphasized the importance of investing in companies with the ability to pivot and adapt in the face of new risks.
Jaffe predicted that the long-term trend in oil markets is not going to be inflationary, and that renewable energy is already proving to be strongly competitive. For example, she claimed that the price of solar has dropped far enough that it is already starting to compete with natural gas. She also pointed to the fact that renewables are likely to be desirable to the future generations. Essentially, she viewed renewables as a “proactive bet” that some investors are using as a hedge, and suggested that it will be a competitive sector in the long run.
She also suggested that investors watch for market signals when investing in the energy sector as the competitive landscape changes. Jaffe was not referring to technical indicators, but rather to macroeconomic signals such as the recent announcement by Saudi Arabia’s Deputy Crown Prince Muhamed in which he asserted that he intends to transfer shares of Saudi Aramco to a Public Investment Fund. Jaffe urged investors to think critically and question why we would want to invest in this public fund given that the world’s largest oil producer declared that it is betting on the end of oil.
Although Jaffe identified a number of long-term risks in oil and gas markets, she had a different short-term outlook.
“Just because we can see the technology and structural changes coming… it doesn’t mean that, in some short-term way, we couldn’t see another spike in the price of oil,” she said.
Jaffe explained that in next 2-3 years there are many things that can impact the price of oil. She cited concerns about immediate factors such as weather-related disasters like the recent forest fires in Canada, and companies defaulting on debt because of supply disruptions.
She emphasized the role of geopolitics in the boom-and-bust cycle, explaining that low oil prices tend to create pressure on the governments of oil revenue-dependent countries like Venezuela, Russia, Saudi Arabia, and Nigeria. When this happens, Jaffe said, that pressure intensifies, threatening war, violence and civil unrest – all of which could lead to a supply disruption.
Jaffe described the various uncertainties that investors with a 2-3 year horizon should consider, and concluded that in the short term “we’re going to see volatility in the commodity, but [it will be] volatility off of a declining asset value.”
Marianne Brunet is a financial markets analyst with Advisor Perspectives
Read more articles by Marianne Brunet
For 30 years, the conventional wisdom in the energy industry has been that the price of oil will go up because it is a scarce resource with exponential demand growth. Therefore, energy companies will be profitable – at least in proportion to their oil reserves. But according to Amy Myers Jaffe, this blind belief is completely wrong because of structural changes in the energy sector.
