Shale, Renewables, and the New Energy Paradigm

Cost parity with fossil fuels is arguably the Holy Grail for renewable energy technologies. It’s the tipping point at which renewable energy will be able to stand on its own against the oil & gas incumbents, without the support of government subsidies or environmental altruism. Proponents of Hubbert’s “Peak Oil” theory have argued for years that this cost parity is imminent, since society is rapidly exhausting its limited supplies of fossil fuels. However, the shale gas and tight oil revolution in the United States has upended this calculus. For wind, solar, and other utility scale electricity generation technologies, cost parity has proved to be a rapidly moving, and ever elusive, target as natural gas prices (and oil prices to the extent that they drive LNG pricing globally) continue to hover around all-time lows. The year-end 2014 collapse in commodity prices has exacerbated once again the challenge that renewable energy technologies face in a world that continues to benefit from cheap and easily available fossil fuels.

Turbulence in the Oil Patch

However, in the wake of this commodity price collapse, as the oil and gas industry now retreats from the battlefield in order to cure its own excesses, renewables may have a chance to emerge as the ultimate victor. The two sides of the industry have proven to be the proverbial tortoise and hare, and renewables, with their slow but steady progress, have the potential to pull ahead. Since OPEC decided in November 2014 not to curtail production, the crash in oil and gas prices from a high of $107 per barrel in June 2014 to lows below $30 per barrel in January 2016 has left the entire industry in shock and pain. Lower commodity prices have hit E&P companies via not only a reduction in revenues and cash flows, but also through a reduction in the value of their oil and gas reserves that remain in the ground. Given that these barrels are used to collateralize inexpensive debt in the form of revolving credit facilities, many E&P companies are expecting a reduction of borrowing capacity in 2016. In addition, continued tightness in the public debt and equity markets (investors are treading cautiously until a potential recovery becomes more tangible) means that E&P companies lack the liquidity required to finance the drilling of new wells. In such an environment, the weakest companies can very easily fall into a death spiral whereby the inability to invest in new drilling means that revenues continue to decline and further erode the company’s ability to raise new capital or find credit providers. In the midstream sector, volume risk associated with reductions in upstream drilling activity and production volumes has translated to tempered growth forecasts, lower share prices, and wider yields. In the oilfield services sector, excess capacity has resulted in reduced utilization, reduced revenues, and stacking and scrapping of equipment. In such a dire environment, many of the weakest upstream and oilfield services players will either go bankrupt or get acquired by their stronger rivals.

While the collapse in commodity prices started with oil, it quickly spread to natural gas as well. In December 2015 natural gas prices fell to nearly $1.50 per mmbtu from highs in 2014 of over $4.50 per mmbtu. As natural gas is a power generation fuel while oil is primarily a transportation fuel, the price of natural gas is more directly relevant to the health of the renewable energy industry than is the price of oil. In the United States, falling natural gas prices reflect an emerging oversupply as areas like the Marcellus and Utica prove to be more prolific than people expected even 12 months ago, and operators continue to improve drilling efficiency and drive down production costs. As one would expect, the price of natural gas has fallen to near the break-even cost of some of the best wells in the country, signaling that the market needs to curtail the drilling of new wells. However, curtailing gas production isn’t as straightforward as curtailing oil production given that a large portion of the gas supply is the result of “associated gas” production from oil wells. So even if the gas price falls to uneconomic levels, gas will continue to be produced from oil wells. The good news is that the simultaneous weakness in oil prices and subsequent reduction in oil-focused drilling activity will help mitigate this problem.

In addition to the glut in production, the demand outlook for natural gas has weakened as well. Liquefied natural gas (LNG) exports from the United States are losing momentum as demand for U.S. LNG, which is priced as a margin to the Henry Hub gas price, has weakened in comparison to demand for spot LNG cargos that are priced as a ratio (historically ~1/6) to the oil price. Now that the price of oil has come down, long-term contracts with U.S. suppliers may not look as attractive as they did in 2014 when the price of non-U.S. LNG was much higher. Large consumers of LNG, such as Japan and China, are reducing demand for the fuel as well. Japan is restarting its nuclear fleet, while China is undergoing an overall economic slowdown as its economy shifts from industry-focused to consumer-focused.


An Opportunity for Renewables

This destruction of operating capacity across the upstream and oilfield services subsectors suggests that the industry may not emerge unscathed from the commodity price downturn. While some adjustments will prove to be cyclical, and easily reversed (e.g. stacked rigs can be put back in the field), other changes have been structural and will require much more time to normalize. For example, the scrapping of oilfield services equipment (primarily dated, less efficient capital equipment such as older generation drilling rigs and hydraulic fracturing fleets), will result in a semi-permanent reduction in the capacity of the industry to drill new wells. In addition, the flight of skilled labor from the sector, driven by the approximately 250,000 layoffs to date, will be hard to correct; it takes time to train new workers and attract new college graduates back into the industry. These changes suggest that the industry may not be able to respond quickly enough if demand for oil and gas increases dramatically and unexpectedly.

Meanwhile, renewables have continued to make slow but steady progress. In December, 195 countries, including large fossil fuel consumers such as the U.S., China, and India, made historic commitments at the climate summit in Paris to reduce their total carbon emissions. Though the deal is not legally binding and falls short of the 2 degrees Celsius target that is supposed to represent the threshold of catastrophic warming, it will hopefully serve as a catalyst for unprecedented and much-needed cooperation amongst industry, policymakers, and individuals. The newfound focus on reducing global carbon emissions will accelerate development of renewable and energy efficiency technologies and thereby help push the industry further down the learning curve. In the U.S., Congress recently extended the production tax credit for wind energy and investment tax credit for solar energy for another 5 years, providing much-needed policy visibility which should boost new capacity installations. In India, solar developers are citing healthy returns driven by supportive government policy (India is pursuing a target of 100 GW of solar capacity by 2022) and a reduction in module costs. As such, in many parts of the world, renewables have already started to approach cost parity with fossil fuels as the levelized costs of wind and solar have fallen 61% and 82% (according to Lazard), respectively, over the past 6 years. IHS expects that the cost of wind will decline a further 26% by 2030, and the cost of utility-scale solar will decline another 50% through 2030. Furthermore, as more renewables are integrated into the power generation supply stack, the marginal cost of power should come down as renewables such as wind and solar have close to zero operating costs and will displace fossil fuel plants that have higher fuel and operating costs. According to an analysis by Bloomberg New Energy Finance, renewables will benefit from another tailwind inasmuch as they drive up the costs of traditional thermal plants by reducing their capacity factors. This combination of lower marginal power prices and higher operating costs for thermal plants will drive a positive feedback loop in which renewables continue to become more competitive.

Additionally, in this environment of oil and natural gas price volatility, which is expected to continue because OPEC has forsaken its balancing role, more and more homeowners, businesses, and governments are opting to increase investment in renewables as a long-term hedge against increases in the cost of fossil fuel-derived energy. At times of high commodity prices, the stability and predictability of the cost of renewables makes them an attractive alternative for consumers who want to lock in their energy spending. This realization has driven the growth of renewables especially in the commercial sector, where uncertainty in energy costs can wreak havoc on the budgets of businesses. Companies like Google and Apple have signed several gigawatts of power purchase agreements at attractive rates. At the same time, seemingly paradoxically, the fear of low commodity prices is driving oil-producing nations such as Saudi Arabia and the UAE to push towards renewables as well. The sustained low price environment of the past 18 months has dried up export revenues and strained the coffers of most oil-producing nations. Weaker members of OPEC, such as Venezuela, have repeatedly called for price floors and coordinated action to raise the price of oil, but the strongest members are intent upon driving upstart U.S. producers out of the market. But even the strongest are showing signs of fatigue. Saudi Arabia has cut government spending, is delaying payments to contractors, and issued sovereign bonds for the first time since 2007. Even for such oil-rich countries, investing in renewables is now becoming a necessity in order to diversify their economies and energy supplies.

Even if you don’t buy the argument for more renewables now, most industry participants would agree that the price of oil and natural gas will eventually begin to rise (albeit maybe not to previous highs). Oil and natural gas are not infinite resources, and extracting them from the ground will continue to get more expensive in most parts of the world. Ironically, the current period of low prices, which is reducing drilling activity and production volumes, and is placing much of the industry into irreversible duress, may be sowing the seeds for a sharp rebound in the commodity price. As production from existing wells continues to decline and non-OECD countries steadily demand more oil and gas to drive improvements in living standards, supply will soon enough be exceeded by demand. Prices will have to rebound sharply to necessitate a flurry of new drilling activity, but by that time, whenever it may come, the slow and steady progress of the renewable energy industry may have already crystallized its lead.

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