The International Energy Agency’s (IEA) annual outlook is one of the most important and comprehensive forecasts for the global energy markets. This month the IEA published World Energy Outlook 2016 (WEO), a 667-page report that delves into recent developments across the energy sector and projects trends to 2040 under a variety of scenarios.

The WEO is used by governments and corporations in policymaking and strategic planning. Those decisions impact investors. And while we pride ourselves here on not following the herd, the IEA provides a very clear view of what the herd expects in the years ahead. More than anything, the report serves as a guidepost.

The WEO projects how energy markets might evolve in response to multiple policy options. The latest report considers three distinct scenarios.

The Scenarios

The Current Policies Scenario represents a glide path for global energy based on policies in place as of mid-2016. It assumes no further change in policy and the extension of any current policies currently scheduled to sunset. For example, the U.S. solar investment tax credit currently scheduled to expire in 2021 is assumed to be extended until 2040.  

The New Policies Scenario takes into account governments’ stated aims, targets and intentions on energy policies. It factors in commitments made under the Paris Agreement on climate change, which has just gone into effect nearly a year after adoption. Many governments made climate pledges as part of the Paris Agreement that are not yet reflected in legislation, but the New Policies Scenario assumes the promises made in Paris are fulfilled.   

Finally, the report looked at a “450 Scenario,” which considers what it would take to limit carbon dioxide concentration in the atmosphere to around 450 parts per million. The report assumes that’s what it would take to give humanity a 50% chance of limiting the global temperature increase caused by greenhouse gases to 2 degrees Celsius. This scenario is quite different from the others, as it specifies a climate goal and then speculates about the required cuts that might not be economically practical or politically feasible.

Below I will present some of the demand and pricing projections for the Current Policies and New Policies scenarios. It is reasonable to assume that reality will fall somewhere in between. There will be new legislation in an attempt to address climate change, but it is likely to fall short of the pledges made in Paris.

The status quo described under the Current Policies Scenario (CPS) is more bullish for fossil fuels. New Policies Scenario (NPS) would in contrast favor renewables and electric vehicles (EVs). The 450 scenario is significantly less probable than those two. When I refer to scenarios below, I am discussing the CPS and NPS unless otherwise specified.     

Oil

Demand for oil is forecast to increase under both scenarios, which is consistent with my own expectations. The past 30 years have seen global crude oil demand grow fairly steadily by a total of about 35 million bpd.

Extrapolating the same rate of increase puts oil demand at about 120 million bpd in 2040. And in fact, the CPS estimates oil demand at 117 million bpd of oil demand by then (along with another 3.6 million bpd of biofuel demand.)

The NPS assumes slower growth in oil demand, to 103 million bpd in 2040 (along with 4.2 million bpd of biofuels.) For reference, the 450 Scenario would require oil demand to fall to 73 million bpd by 2040 — highlighting the large gap between the commitments in the Paris Agreement and actions required to meaningfully slow climate change.  

Oil demand is forecast to grow at a compounded annual rate of 0.5% in the NPS and 1% annually under current policies. Demand for biofuels is projected to more than double from current levels in either case, but demands to roll back some of the aggressive biofuel mandates of the past decade have gained some momentum. So even the lower growth scenario for biofuels may be too optimistic, conditioned as it is on continuing government support.    

Under the CPS, the global price of crude oil is projected to rise to $82 per barrel by 2020, $127/bbl by 2030, and $146/bbl by 2040. The NPS assumes policies that will cause global oil demand to be lower than in the CPS. As a result, oil prices are projected to rise to $79/barrel (bbl) by 2020, $111/bbl by 2030, and $124/bbl by 2040.

Even in the NPS — the case that is more bearish for oil — oil prices are forecast to rise 72% from current levels in the next three years. Further, the report warns that given the long lead time for oil projects, current underinvestment risks another oil price shock in the early 2020s. This is quite a bullish forecast for the oil industry over the next five years or so.

Oil demand in advanced economies is projected to fall by almost 12 million bpd by 2040, but is expected to be more than offset by increased crude consumption in developing regions. India is projected to be the largest source of future demand growth for oil (and coal), with a 6 million bpd increase under the NPS. Demand in Africa is projected to grow at the fastest rate, averaging 2.2% per year. However, the largest volume increase is projected to come from Asia, which is expected to require an extra 12.5 million bpd by 2040. Asia alone is expected to more than offset the decline in demand from advanced economies.

Natural Gas

The EIA expects natural gas to be the biggest long-term winner among the fossil fuels. Global natural gas demand grows by nearly 50% through 2040 in the NPS, and by about 60% in the CPS. The average annual growth rate of 1.5% in the NPS would make natural gas the fastest growing fossil fuel and increase its share of primary global energy demand from 21% today to 24% in 2040. Given its advantages over coal as a relatively clean and flexible fuel, gas would  gain market share even under the 450 Scenario, despite the inroads by renewables.

However, the report is skeptical that growth in U.S. shale gas production can continue at its recent rate in the long run:

“Because of the rapid decline rates of shale gas wells, producers must continuously scale up drilling activity in order to compensate for the drop in production from existing wells and expand output. Thus, even under the most optimistic resource estimate, production growth rates observed in recent years could hardly be sustained beyond the medium term. We project US shale gas production to reach a plateau in the latter half of the Outlook period, mainly due to the fact that development extends progressively into lower quality reservoirs, where initial flow rates are lower than in the past. A downbeat view on shale gas resources (14 tcm) still implies considerable growth over the medium term, but rapid decline rates would then lead to a peak in shale gas output in the early 2020s.”

U.S. natural gas prices have languished because production growth has been very strong, outpacing demand. But given the WEO forecast of strong demand growth and flattening production gains one would expect prices to head higher. Indeed, that is what the IEA forecasts. It expects U.S. natural gas prices, currently a bit above $3 per million British thermal units, to hit $7.90/MMBtu by 2040 under the CPS, and to $6.90/MMBtu under the NPS.

Natural gas prices around the world are expected to continue to vary widely, underpinning the economics of liquefied natural gas (LNG) exports.  Gas prices in the U.S., the European Union and Japan are forecast to reach $4.7/MMBtu, $9.2/MMBtu and $11.3/MMBtu respectively in 2025. In the longer term, prices climb to around $7/MMBtu in the U.S., $11.5/MMBtu in the European Union and $12.4/MMBtu in Japan. These prices are expected to spur cumulative investment of $9.4 trillion in natural gas supply by 2040.

Coal

Of all the fossil fuels, coal is going to be the most sensitive to government policies in terms of long-term demand. Coal emits more carbon dioxide than natural gas to produce the same amount of electricity, and although it is often the cheapest option there are alternatives that cause much less environmental harm. Even modest incentives could cause a large swing away from coal to natural gas, nuclear power and renewables. Oil demand, in contrast, isn’t nearly as vulnerable, because there are no quickly scalable alternatives.

As a result there is a particularly wide spread between the forecast coal consumption numbers, depending on the assumed scenario:

Even under the NPS the world’s coal use grows by 0.2% per year in the period to 2040, although high-income economies like the European Union and the U.S. slash coal demand by over 60% and 40% respectively. But India and much of Southeast Asia lack a similarly low-cost alternative for meeting surging energy demand and should offset the declines elsewhere.  

Uncertain government policies are a big risk for investors in the coal sector. That doesn’t mean we will avoid all coal exposure. We will just be very selective.   

Nuclear Power

The WEO doesn’t offer as much detail about nuclear power, but it does show nuclear energy’s market share under the various scenarios. Under the CPS, nuclear power grows at a 1.7% annual rate through 2040. Under the NPS, that growth rate increases to 2.3%, fastest among all energy sources other than wind and solar power.

But under the 450 Scenario, nuclear power is required to grow at an annual rate of 3.4% — double the expected rate under current policies. This is primarily dictated by the need to offset the massive drop in coal use required to meet the stated climate goal. In other words, the IEA sees no pathway to checking global warming that doesn’t involve a massive increase in nuclear power production. I fully agree with this assessment.  

Renewables

Renewable energy is the major growth story of the WEO. Under the CPS, “Other Renewables”, which refers primarily to wind and solar power, are forecast to grow at an average annual rate of 5.9%. Under the NPS, that jumps to 6.9%, with renewables’ market share increasing from 1% of global energy consumption in 2010 to a 6% by 2040. This would approach nuclear power’s projected 7% market share, but still trail far behind coal’s 23%.

Under the 450 Scenario, wind and solar would have to grow at a rate of 9.1% per year through 2040. That may not seem like a lot given the double-digit growth rates of the past five years, but those growth rates have been slowing. Further, even at that rate and with coal declining in the 450 Scenario, coal would still command a greater share of global energy use in 2040 than wind and solar (13% versus 12%).   

On the other hand, some countries already derive more than 12% share of their energy needs from wind and solar. Denmark (25.2%), Portugal (14.6%), and Germany (12.5%) achieved that distinction in 2015, and several other countries fell just short. For reference, renewables other than hydropower made up 3.1% of U.S. consumption, and 2.8% globally.    

Summary

The 2016 World Energy Outlook is broadly in line with our expectations for how the energy markets will evolve over the next 25 years. Natural gas will see the biggest gains among fossil fuels, but oil demand will continue to steadily grow as well. Coal won’t be obsolete, but demand for it will remain very dependent on public policies. Biofuel demand is set to double, but also remains dependent on continued government support. Should that support wane, the biofuel sector could come crashing down.

Modern renewables like wind and solar should grow strongly even without additional subsidies, as they are becoming competitive in many markets. But if governments follow through on the commitments made in that Paris Agreement on climate change, renewables should benefit. Likewise, the effort to reduce carbon emissions strongly favors increased use of natural gas (as a replacement for dirtier coal) and nuclear power.

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