The following article by Ali Aissaoui, Senior Consultant at the Arab Petroleum Investments Corporation (APICORP), is published concurrently in APICORP’s Economic Commentary dated February 2012. The author wishes to state that there is no conflict of interest between his being a peer-reviewer for the IEA’s WEO and the present review and discussion. The opinions expressed are his own. Comments and feedback may be sent to: aaissaoui@apicorp-arabia.com

A few months ago, in November 2011, the International Energy Agency (IEA) released its annual World Energy Outlook (WEO).¹ This 660-page report provides analyses and insights into energy demand, production, trade and investment for the next 25 years. It further highlights the implications of a possible delay in upstream investment in the Middle East and North Africa (MENA),² which is set to supply the bulk of the growth in global oil output to 2035, as well as a substantial amount of natural gas. In a way, this is a replication of a previous study conducted in the 2005 edition of the WEO. The difference is that today’s MENA context makes the underlying assumptions more likely to occur if not already occurring.

The implications of such a delay are serious enough to warrant a review and discussion of the IEA’s main findings that could help better inform the debate on policy and investment. This is done in three parts. The first explains how our review and discussion fit within the broader IEA framework analysis. The second highlights the prospects for energy demand and the necessary investments to ensure supply to the market. The third discusses the impact of a possible shortfall in MENA upstream investment, before offering some concluding remarks.

 

Putting The Scope Review Into Perspective

The IEA analyses are performed using the World Energy Model (WEM).³ This tool makes use of a wide range of econometric and simulations programs to project global energy trends and explore the environmental impact of energy use, as well as the effects of policy actions and technological change. It further derives the investment needed in the energy supply industry.

The 2011 projections have been prepared under three policy-based scenarios. The Current Policies Scenario assumes very conservatively that no new policies are implemented. The 450 Scenario assumes strong policy measures to prevent global temperatures from rising more than 2°C above pre-industrial levels. Somewhere in between is a more plausible, though still uncertain New Policies Scenario. This central scenario takes account of announced policy commitments and plans. Each scenario involves a set of non-policy assumptions. While demographic and economic assumptions are common to all scenarios, international fuel prices and technological developments differ for each.

As shown in Figure 1, in addition to the assumptions block, the model is made up of six modules: final energy demand; transformation processes (power generation, refinery, etc); fossil fuel supply; regional energy balance; CO₂ emissions; and investment. As the impact of deferred MENA upstream investment is a key focus of the 2011 WEO, specific assumptions have been fed back into the supply module. By keeping all other assumptions unchanged, several iterations have been performed to determine the new oil and gas prices that bring global supply and demand into balance.

 

Figure 1: World Energy Model Overview

Source: IEA World Energy Model 2011 (adapted from original to show reduced MENA investment feedback).

 

The impact of lower investment and output on international oil and gas prices, energy markets and energy trade between producing and consuming countries will be discussed in the third section of this review. Before that, it is worth examining, even if briefly, the IEA’s main findings of energy trends and investment.

 

Trends In Energy Demand And Supply Investment

In the New Policies Scenario (NPS), to which we restrict the rest of our review and discussion, global energy demand increases by nearly 40% between 2009 and 2035. Driven primarily by population and economic expansion, this growth is accompanied by a major shift in geographical patterns. As a result, non-OECD countries will be responsible for 90% of the growth, with China and India alone accounting for half the total increase (Figure 2).

 

Figure 2: Growth In Global Energy Demand In The NPS

Source: IEA World Energy Outlook 2011.

 

While world demand grows for all energy sources, the share of fossil fuels (coal, oil and natural gas) in global primary energy demand falls from 81% in 2009 to 75% in 2035. Despite growing faster than any other source of energy, renewables (hydro, biomass and others) remain below each of the three fossil fuels in 2035 (Figure 3). Finally, with diminishing prospects in the wake of the Fukushima disaster, nuclear power, which is mostly led by China, India and Korea, ends up with a lower level of output than previously anticipated.

 

Figure 3: World Primary Energy Demand By Fuel In The NPS

Source: IEA World Energy Outlook 2011.

 

Oil and natural gas develop distinctive outlooks. Driven by transport, oil is expected to remain the primary source of energy for the world economy. However, global oil demand increases at the lowest average annual rate of 0.6%, from 84.1mn b/d (3,987mn tons of oil equivalent – mtoe) in 2009 to 99.4mn b/d (4,645 mtoe) in 2035. Natural gas nearly catches up with coal as it ultimately wins in the competition for power generation. As a result, global gas demand increases by a rate three times higher than that of oil, from 3.07 tcm (2,539 mtoe) in 2009 to 4.75 tcm (3,928 mtoe) in 2035. MENA is expected to supply the bulk of the growth in oil output to 2035. As the increase in production from the region is put at more than 90% of the required growth, the region’s share in global production raises from 36% in 2010 to 43% in 2035. The increase in the region’s natural gas production is 29% of the required global growth, which raises only modestly the region’s share from 19% in 2010 to 22% in 2035.

 

Figure 4: Cumulative Investment In Energy Supply In The NPS

Based on the above projections, a total cumulative investment in energy infrastructure of $37.9 trillion (2010 dollars) is needed to balance supply and demand over the next 25 years. As detailed in Figure 4, investment in the oil supply chain is projected to be $10.0 trillion, representing 26% of total; the gas supply chain $9.5 trillion representing 25% of total; coal $1.2 trillion representing 3% of total; and biofuel $0.4 trillion representing 1% of total. The highest share is that of the power sector (generation, transmission and distribution), which amounts to $16.9 trillion representing 45% of total.

In compiling the regional distribution of energy investment, MENA share proved surprisingly difficult to establish. In the current WEO, MENA is an ad hoc grouping used only in the “Deferred Investment Case”, which deals exclusively with oil and gas upstream. However, additional data communicated by the WEO team put MENA cumulative energy investment at $3.9 trillion (2010 dollars), 45% of which in the oil sector, 34% in the gas sector and 21% in the power sector.

Investment in MENA oil and gas upstream amounts to $2.7 trillion (2010 dollars) for the next 25 years and translate into an average annual investment of $100bn from 2011 to 2020 and $115bn from 2021 to 2035. The medium term levels are inferred from a bottom-up approach built, inter alia, on an extensive survey of companies’ data, prior to the region’s turmoil. They are comparatively much higher than those suggested by our latest review.⁴ Yet, MENA share in global upstream investment – some 17% in the WEO – appears somewhat low in light of the region’s resource endowment. Indeed, MENA holds 59% of the ‎world’s proven reserves of crude oil and condensate, but only contributes 36% of global oil output. Similarly, while holding 43% of ‎proven natural gas reserves, it only ‎accounts for 19% of world ‎gas output. One explanation for the relatively modest investment share, compared to potential, is that MENA upstream oil and gas generally requires comparatively less capital due to lower costs of finding, developing and producing. This is still the case despite costs having soared in recent years.

Cost inflation is the most important factor driving the increase in energy investment. The WEO has established that worldwide the costs of developing oil and gas infrastructure have at least doubled during the last decade, largely due to increase in the cost of material, personnel, equipment and services. Furthermore, in the upstream sector, costs have been found to correlate closely to both oil prices and the levels of exploration and development activities (Figure 5). This trend is fairly similar to our own findings. In the context of MENA, we have found that the cost of an ‘average energy project’ has doubled since 2003. Our interpretation, however, is that the increase stems from the concurrent inflation of the main cost components of engineering, procurement and construction, including the cost of input factors, contractors’ margins, project risk premiums and the cost of what we have dubbed ‘excessive largeness’. In any case, even if it is difficult to infer a clear-cut direction from the above, it seems likely that project costs will continue rising.

 

Figure 5: IEA Upstream Investment Cost Index

Source: IEA World Energy Outlook 2011.

While projected MENA upstream investment appears low, the required production from the region, as noted earlier, is considerable. Understandably, the IEA is concerned that a shortfall in investment could limit such a production with far-reaching impacts on global energy.

 

The Impact Of A Deferred Upstream Investment

Accordingly, the ‘Deferred Investment Case’ (DIC) analyses how global markets might evolve should MENA upstream investment fall short of what is required in the New Policies Scenario (NPS) over the medium term. The key assumption is that upstream investment is reduced by one-third across MENA.

The likely causes for deferred investment include conservative depletion policies, constraints on financing, renegotiation of upstream agreements, international economic sanctions, higher perceived risks stemming from political instability; and in case of conflict, durable loss of production due to serious damage to infrastructure. On this basis, the impacts of the DIC have been measured in terms of changes in prices, demand, production and trade, as summarized next.

In terms of prices, the average IEA crude oil import price, which proxies international oil price, increases rapidly in the short to medium term, as the investment shortfall becomes apparent to the market. As shown in Figure 6, oil price peaks to $150/B (2010 dollars) in 2016-17 (equivalent to $176/B in nominal terms), before converging gradually towards that of the NPS. More complex to analyze and predict, gas prices are also expected to increase, though not to the same extent as oil.

 

Figure 6: Average Oil Price In The NPS And DIC

Source: IEA World Energy Outlook 2011.

In terms of demand, sharply higher oil prices encourage conservation and, in the longer term, a switch to alternatives, increasingly largely in the transport sector. As a result, global oil demand increases by a mere 0.9mn b/d to 88.0mn b/d in 2015, which is 3.2mn b/d lower when compared with the NPS. Thereafter, although demand rise steadily to 97.8mn b/d in 2035, it remains 1.6mn b/d below the NPS.

In terms of production, lower investment in MENA reduces global oil production by 3.8mn b/d at its 2017 peak and 1.5mn b/d in 2035, compared with the NPS. The shortfall in MENA production, of some 3.4mn b/d in 2015, peaks at around 6.2mn b/d in 2020 by which time it is partly compensated by an increase in non-MENA production of 3.2mn b/d. While MENA is expected to recover its 2010 production by 2023, it never attains the level anticipated in the NPS since production in 2035 is still 1.2mn b/d lower.

Finally, in terms of trade, the impact on MENA exporters, non-MENA exporters and non-MENA importers is uneven. Because of the limited scope for reducing domestic demand, the drop in MENA export volumes is equivalent to the decline in production. However, in the period up to 2018, MENA cash flows (export revenues above costs) are higher as a result of lower export volumes being more than offset by higher prices. But because MENA countries lose market share through the projection period, their cumulative cash flows are roughly the same: $16.7 trillion (2010 dollars) in the DIC against $17.0 trillion in the NPS (Figure 7). This means that the gain in cash flows during the period up to 2018 is virtually offset by the loss in the period after. Obviously, non-MENA exporting countries enjoy higher revenues as a result of higher prices and possibly higher production to make up for MENA shortfall. Their export cash flows reach $8.8 trillion, 60% higher than in the NPS. Finally, the impact on importing countries is mixed. On the one hand, their oil and gas import bills increase by 10% to more than $46 trillion, since oil price increases are not offset by both reduced demand and increased domestic production. On the other hand, and this should have been emphasized by the IEA, their energy security improves as a result of more diversified supplies. It should be noted that the above cash flows have not been discounted to present values. While discounting would have led to substantially different results and policy implications, the choice of a discount rate would have probably been problematic.

 

Figure 7: Export Cash Flows And Import Costs In The NPS And DIC

Source: IEA World Energy Outlook 2011.

 

Concluding remarks

In the WEO’s central scenario, required new oil and gas production from MENA to meet global demand to 2035 involves upstream investment of over $100bn per year. It is far from certain that such levels, which are comparatively higher that those resulting from our own review, will be forthcoming; neither in the medium term, as underscored in the Deferred Investment Case, nor in the longer term. In the medium term, which involves a bottom-up analysis, the listed causes for delay are all likely, when not already a reality in some parts of the region. However, the key assumption that upstream investment is reduced by the same amount in all MENA countries is arguable. This generalization, which is perhaps not required by the IEA’s WEM model, leads to an easier, but potentially misleading, interpretation of the results. The case of the core MENA producers and major contributors to global spare capacity should have been highlighted. As none of them has been affected by the region’s turmoil, this group should be able to pursue, unhindered, their planned investment programs.

In contrast to the medium term bottom-up approach, the long term surely involves a top-down process. Accordingly, the WEM model must have been led to treat MENA, or its core producers, as residual suppliers. This approach would seem analytically irrelevant as long as the IEA fails to integrate in its scenarios MENA producing countries’ own policy commitments and momentum. Otherwise, expectations of what the region should deliver would be vulnerable to the charge of being unrealistic.

1. IEA, ‘World Energy Outlook’, November 2011.
2. MENA is made up of two groupings used by the IEA’s WEM model: the Middle East (Bahrain, Iran, Iraq, Jordan, Kuwait, Lebanon, Oman, Qatar, Saudi Arabia, Syria, the UAE and Yemen) and a sub-grouping of Africa composed of Algeria, Egypt, Libya, Morocco and Tunisia.
3. IEA, ‘World Energy Model, Methodology and Assumptions’, 2011.
4. Ali Aissaoui, ‘MENA Energy Investment: Broken Momentum, Mixed Outlook’, MEES, 3 October 2011.