Uncertainty and Volatility in Today's Energy System: Stability, Security, and Sustainability Through Mutual Interdependence

Ivo Bozon, Director, McKinsey & Co.

Many have argued that the oil and gas industry has entered a final era of very scarce resources—a new equilibrium of bottlenecked supply, steep cost curves, continued demand growth, and, as a result, continued very high price levels (Fig. 1). It is hard to believe, however, that resources are the constraint, given the enormous potential still available, including currently known and booked reserves, the increased scope for recovery of existing fields with new technologies, further potential discoveries, and the new frontier of vast oil sands and oil shales reserves that are in the money at current oil prices. In essence, according to the majority of the industry’s research, we have enough resources left to sustain current production levels for between 40 and 60 more years.

Fig. 1—Distinct periods in the oil and gas industry’s history.

Indeed, the core challenge is not one of resources but one of putting reserves into production and delivering energy to markets. This is evident already today. The expected near-term growth in production is barely enough to meet rising demand, let alone restore the spare production capacity to historic levels of 3–5 million BOPD, which helped maintain stable price levels in the past decades.

Thanks to this tight market, the outlook for demand and supply is as uncertain and volatile as it was in 1998, when oil was U.S. $10 a barrel, the industry’s other big period of upheaval in the last quarter century. Moreover, this level of uncertainty is likely to continue in the coming decade. In particular, there are two specific time periods in which the current balance of supply and demand could shift dramatically: in the short term (over the next 3 years) and in the long term (after 2015).

Short-Term Demand

In contrast to the 1970s, when power generation was still a significant component of demand, today transportation fuels dominate. So far, high prices have not reduced consumers’ thirst for transportation fuels, and total demand has remained more robust than in the earlier periods of price increases.

However, the evidence is growing every week that demand will begin to fall in the near term. Recent increases in government-regulated fuel prices sparked large drops in demand for oil products in Indonesia (30%) and Thailand (20%). China and other countries with regulated fuel prices are considering similar moves. In the Organisation for Economic Co-operation and Development (OECD) countries, the evidence is less clear cut. Nevertheless, the transport sectors in the U.S. and Europe exhibit early signs of a slowdown in demand growth (e.g., the slowdown in U.S. sport-utility vehicle sales, the shift to lower-priced petrol grades in Germany, and the slowdown in diesel and especially gasoline sales growth in 2005 in Europe).

Turning to supply, during the 2006–2008 period, a record number of large projects will be under development (Fig. 2). These projects could add up to 6–7 million BOPD of new non-OPEC production capacity and a further 3 million BOPD of new OPEC production capacity by 2008, in part to offset a decline of mature production of about 6–7 million BOPD over this period. About 2–3 million BOPD of these potential new capacity additions by 2008 are in danger of major delay.

Fig. 2—Planned oil production capacity growth.

Of course, continued robust growth in demand combined with project delays could result in a sustained tight oil market through 2008. However, if a majority of new projects are completed on time and demand declines significantly, the result could be excess capacity of 6 million BOPD, leading to strong downward pressure on oil prices.

Looking Further Ahead

In the long term, the evolution of vehicle transport is key, because it will account for about 60% of oil demand in 2015. Most predictions of the increased ownership rates of cars and of trends in vehicle mileage appear reasonably sound. However, extensive McKinsey research concludes that the possible unexpected angle is that new high-efficiency engines and engines powered by alternative fuels could have a significant impact on demand. We identified two possible scenarios, which we named the “ICE age” (for internal combustion engine) and the “green world.”

In the ICE-age scenario, today’s best-performing internal combustion engines—with technologies such as direct injection, variable valve lift and timing, and turbocharging—become standard across the globe, leading to an average improvement in fuel efficiency of 20% (continuing on an improvement trajectory of 40% over the past 25 years). In addition, the penetration of hybrid and compressed-natural-gas engines rises to 8% from less than 0.1% today. In this scenario, oil demand in 2015 would decline by 2–3 million BOPD below the current Intl. Energy Agency (IEA) forecast.

In the second scenario, engines are further upgraded with technologies such as start/stop systems and cylinder deactivation to reach an average further 10% efficiency improvement. In addition, there is deeper penetration of hybrids and alternative-fuel engines to a total of 25%. In this world, demand would decline another 7 million BOPD to a total of 10 million BOPD below current IEA forecasts. For those who believe this is a futuristic dream scenario, consider that sales of hybrids such as Toyota’s Prius will likely hit 200,000 vehicles this year in the U.S. alone.

On the supply side, continued growth in production capacity from 2010 to 2015 will rely heavily on several key factors, all of which are uncertain: the continued growth of production capacity of the Middle East and significant growth of the former Soviet Union, continued exploration success in deepwater locations (which has seen average find sizes steadily decline), and the underlying performance of mature non-OPEC basins. Combining the demand and supply picture for 2015 offers a vast range of possible forecasts—anything from a 10 million BOPD surplus of production capacity to a shortfall of 3 million BOPD.

In addition, there is volatility. We all experience the enormous level of price volatility as a result of disruptions in supply (hurricanes Katrina, Rita), trading positions, and/or sudden demand surges. On top of that, there is always the looming threat of the big collapse. The point is not which forecast is right or wrong, but that the level of uncertainty and volatility is at a historic peak.

What is the effect of all this uncertainty and volatility on the industry (Fig. 3) First of all, take the producing countries: many see the major resource holders as the beneficiaries of high oil prices, but the flood of “petrodollars” also presents them with many long-term challenges. It inhibits the growth of other productive sectors of the economy, distorts public finances and, in some instances, the investment policies for the oil sector, as well as threatens their reputation as “reliable” suppliers. Finally, there is the long-term risk of permanently reduced oil demand, which reduces the present value of remaining hydrocarbon resources.

Fig. 3—How volatile price cycles affect oil producers and the industry.

For the producing industry, the general sentiment, as witnessed in the recent U.S. Senate hearings, is one of undeserved windfall profits. Indeed, the publicly listed petroleum companies globally earned an unprecedented $200 billion in 2005. However, the oil boom also poses significant health issues for the industry. Companies are under pressure from investors to make further investments, although they know that investing at the top of the cycle is economically imprudent. The access cost for new opportunities is high, project costs are soaring, and, as a result, these investments are likely to become lower-returning parts of their portfolio over the cycle.

The oilfield services and supply industry faces a demand for its services that magnifies the oil-price cycle. During the boom, its capabilities are stretched to the limit, and aggressive players build up capacity to levels that are unsupportable during the middle or down periods of the cycle. When the downturn arrives, a wave of layoffs, bankruptcies, and consolidation is the inevitable result, as seen after the troughs in 1986 and 1998.

Factors Driving Uncertainty

Three major factors are driving the current volatility and uncertainty at this moment in the cycle.

Obstacles to investment.
Bottlenecks in the refining system.
Talent constraints.

Investment. The IEA estimates that the global E&P industry will require capital expenditures of about U.S. $4 trillion from 2004 to 2030, an increase of 50% from the expenditure levels of just a few years ago. But reality does not reflect this yet. Over the past 2 years, expenditures have increased by only 25%, about half of which can be attributed simply to cost inflation. Moreover, most of this capital still is not flowing to the areas with the highest potential to increase production and to add reserves, such as to the major resource holders of OPEC.

In the current world of high oil revenues, there is little incentive for many major resource-holders to bring in more capital or capabilities, because it may not be in their long-term interest. This leaves currently closed countries one of two routes:

Continue to develop their domestic industry independently of international oil companies, but expecting performance to be competitive at international standards. This needs to be combined with continued funding of significant sustained investment levels, partially financed by global capital markets where necessary, to ensure continuity even in times of tight public finances.
Open up to foreign players to gain access to international capital, new technologies, and best-in-class technical capabilities to accelerate productivity, efficiency, and, most importantly, growth.
Algeria is an interesting case to watch. Recently announced reforms are pushing both solutions by opening up the sector to foreign participation and, at the same time, forcing Sonatrach to compete for new opportunities in the country.

Countries already open to foreign participation need to pursue significant growth programs and maintain a symbiotic balance with international partners. In this regard, the recent increased tensions over division of economic rents at these high oil prices are unfortunate, because this threatens to stall the pace of investment. Stability of terms over the cycle benefits all parties in the long run and encourages sound long-term development decisions.

Refining Bottlenecks. Contrary to popular belief, overall refining capacity is currently not the crucial constraint in refining because it focuses only on specific regions, such as the U.S. west coast. Global refinery utilization was 90% in 2004 and 92% in 2005, while maximum utilization is about 96%. Moreover, significant additional capacity will be brought on stream over the next 3 years. In contrast, the real issues are the regional mismatch between the quality of crude oil and the capability of refineries to process it, as well as the shift in product mix toward diesel fuel.

First, quality of crude is regionally diverging. While average global quality remains constant, the crude slate is getting heavier in the Americas and lighter in Asia, the Middle East, and Europe. New investments are required in the local refinery systems to handle the shift.

Second, diesel demand is growing relative to gasoline and other products. Existing gasoline-oriented refineries are struggling to adapt, largely relying on higher crude runs to satisfy diesel demand. The additional crude runs in simple refining configurations have resulted in additional fuel-oil production, lower fuel-oil prices relative to crude, and wider refining margins. Investment in more diesel-oriented conversion capacity would be more efficient and use less oil.

To attract the necessary investments in the refinery system is not easy; capital markets and many of the oil companies vividly remember the pain at the bottom of the cycle. Correspondingly, financial institutions are still reluctant to provide financing and/or long-term refinery margin hedges.

Therefore, there is an important role for resource-rich countries, together with major customers in large importing countries, to ensure that refineries are equipped to deal with shifts in the quality of crude. There are examples of such cooperation already, such as Latin American heavy-crude producers having discussions with European refiners to build cokers, and the Fujian joint venture involving Sinopec, ExxonMobil, and Aramco to build a new refinery in China that processes high-sulfur crude. There is also an important role for the oil companies, which will need to be responsive and consider investments to reduce the exposure to the product-mix mismatches and capture the attractive niche opportunities in the natural supply/demand envelopes.

Talent Constraints. The industry’s ability to ramp up new energy projects is severely limited by a shortage of engineers, geologists, and skilled field personnel. The core driver of this talent constraint is the fact that the industry has one of the worst demographics of any growth industry.

First of all, the industry will require significantly more capacity—about 30% more technical personnel over the next 10–20 years. The need for capacity is felt across the industry, but particularly in the service sector, where some of the engineering and construction contractors already face backlogs of 3 to 4 years.

Second, the industry has an aging workforce. About 50% of the current pool of engineers and geologists could retire over the next 15 years, and there is a missing generation of 30–40-year-olds who should have replaced them but instead left or were never attracted to the industry during the constrained period of the 1990s.

Third, there is a significant image problem with the new generation, particularly in OECD countries. Enrollment in petroleum engineering programs has declined by 85% from its peak in 1982.

Finally, there is an issue of geographic spread. Traditionally, the majority of talent at international oil companies has been sourced from the U.S. and Europe, which corresponded with the source for the majority of the production and project activity. If we roll the clock 10 to 20 years forward, international oil companies will be increasingly focusing in places such as Africa, the Middle East, and Russia, where they will need a skilled workforce attuned to working across cultures.

What should the industry do about this? The international oil companies and the service sector should:

Work with national governments and universities in OECD countries to ensure that education in petroleum-related fields once again becomes more attractive and competitive. The industry plays an important role in this through joint research centers and education exchanges with universities, as well as through special programs to attract young workers.
Access talent sources in the emerging market countries such as India, China, and Russia, where the oil industry is still attractive and has a great reputation. Indeed, China alone has 10 petroleum engineering universities and a pool of 1.6 million well-educated young engineers.
Hire talent from related industries and assimilate them into their businesses rapidly. We see this in other industries in abundance, such as high-tech and aerospace industries. It is only a matter of time before the momentum shifts to petroleum to make this happen, but the industry needs to reconsider its employee value proposition as a cyclical industry. The past severe ups and downs of the industry’s talent pool are not a very attractive proposition to an experienced 40-year-old engineer in a more stable industry.

Finally, the major resource holders should continue their emphasis on local talent development and attraction through the establishment of major capability development centers (as in Qatar), putting pressure on national oil companies to ensure that talent development and capability building is high on management’s agenda, as well as supporting growth and expansion of local service industries.

This is an edited version of a speech given 22 November 2005 at the International Petroleum Technology Conference in Doha, Qatar.

Ivo Bozon is a director in McKinsey & Co.’s Amsterdam Office. He is the global leader of the oil and gas practice of McKinsey and works with clients in Asia, Russia, Africa, Europe, and the U.S. He has extensive experience in working with international majors, national oil companies, and host governments as well as selected independents and oilfield service providers. Bozon’s major research interest is the evolution of the oil industry in the next decade. Before joining McKinsey, Bozon worked with Royal Dutch Shell, both in The Netherlands and in Singapore. He earned master's degrees in econometrics and economics.