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Oil Is Far Too Interesting: How Volatility Threatens Its Supremacy and Drives Innovation

Posted by Brent Giles on Aug 10, 2015 12:10:49 PM

It is easy to attribute today’s low oil prices to specific causes, like the OPEC’s competition with the U.S. shale industry, but current low oil prices are just a symptom of a larger dynamic in the energy space: high volatility. Studies show that crude oil is significantly more volatile than more than 90% of other commodities, and becoming more so (see Figure below). Oil volatility has far-reaching implications. Low oil prices have led to a string of layoffs in the oil industry and has impacted alternative energies that still struggle to compete with traditional fuel. It also forces energy-intensive industries to operate conservatively, slowing their expansion and keeping cash on hand in case of another oil shock. The sheer scale of the oil industry creates severe repercussions for the economy as a whole: even small fluctuations in the price can increase unemployment and decrease output as the market hedges its bets against higher prices.

In the short-term, the alternative energy industry stands to lose from low oil prices, forcing still premium products to rely even more heavily on regulation as they struggle to compete with established commodities. Yet volatility encourages adoption of new energy sources, since a predictable resource, even if currently relatively high priced, commands a premium. For investors looking at the mid- to long-term, the short-term stress of low oil prices presents an excellent opportunity to find value beyond traditional production.

The most successful scalable alternative energies, wind and solar, are electricity generators and only indirect competitors to oil. While French oil giant Total has made serious investments in the space, most of its rivals have yet to follow suit. However, the gradual growth of electric vehicles will pit oil directly against solar, wind, nuclear, and coal. Despite the recent downturn in oil prices, nascent EV demand is likely to remain strong, keeping pressure on traditional transportation fuels.

Direct competitors to oil and gas are also on the horizon. While traditional alternative fuels such as ethanol and biodiesel face strict blend wall limits because they are not fully compatible with engines built for traditional fuels, some next generation fuels have no such limitations. Global capacity for these novel fuels is projected to grow annually by 17.2%, reaching 2.3 BGY in 2018. Renewable diesel, a true drop-in replacement to diesel, leads novel fuels growth with an expected 1.6 BGY capacity by 2018, driven by major players Neste and Diamond Green Diesel. Additionally, waste feedstocks for next-generation fuels are still largely untapped, and more exotic non-food feedstocks like waste oils, municipal solid waste, and lignocellulosic biomass could make biofuels a significant part of the energy mix in coming years.

Within the oil and gas industry, spending tracks closely with oil price, but even here technology is working against volatility by broadening the geographic and play-specific reach of resource recovery. In the short-term, improvements in operational efficiency can keep marginal wells producing and rigs drilling. Non-productive time accounts for 20% of all rig time onshore, and 32% offshore. Improved data analysis, as well as failsafe tools that eliminate the need for time-consuming workovers, are rapidly improving those numbers. For the long term, technology continues to unlock previously inaccessible plays. The combination of horizontal drilling and hydraulic fracturing has opened up a vast new resource in the U.S. and, increasingly, South America and beyond, while advances in heavy oil recovery have made Canadian oil sands viable. From 1998 to 2013, the global reserve to production ratio, a key measure of proven reserves relative to production, defied peak oil prognosticators and grew from 40 years to 53 years on the strength of these two resources.

The emerging energy mix will balance cost, volatility, and environmental concerns, and it will undoubtedly be far more diverse than the existing market. The good news is that the top technology companies working now are likely to be foundations of that mix. A moment of low oil prices is an ideal time to invest in what comes next.

 

For more on Lux’s research on corporate venturing, contact Brent at brent.giles@luxresearchinc.com.