HORIZONS

Silver linings playbook

Five reasons to be cheerful

December 2022

Prakash Sharma, Vice President, Multi-Commodity Research Kristy Kramer, Vice President, Gas & LNG Research Alan Gelder, Vice President, Refining, Chemicals & Oil Markets Kavita Jadhav, Research Director, Corporate Research Peter Osbaldstone, Research Director, Europe Power

Conclusion: reasons for optimism

Taken together, we think these developments provide solid grounds to be optimistic about the outlook for the energy and natural resources industries in 2023 and beyond. We are more confident that society is responding to the crisis in a positive way, to find solutions to the challenges of providing sustainable, reliable and affordable energy for the long term. We wish everyone a happy holiday season and a successful and prosperous new year.

Seeing the light: policymakers accept that the world needs energy stability

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Alan Gelder

Vice President, Refining, Chemicals & Oil Markets

Alan is Vice President Refining, Chemicals and Oil Markets, responsible for formulating our research outlook and integrated cross-sector perspectives on the global downstream sector. Alan joined the business as part of our Downstream Consulting Team in 2005 and later went on to lead the division. He has managed consulting assignments all over the world, focusing on major transactions (projects and M&A) and their alignment with key success factors for industry players and third parties. He then transitioned into research upon his return to London from Houston in 2011. Prior to joining Wood Mackenzie, Alan spent 10 years as an industry consultant after working for ExxonMobil in a variety of project planning and technical process design roles.

Prakash Sharma

Vice President, Multi-Commodity Research

Prakash has over 25 years’ experience in energy, metals and mining, and climate change policy developments, ranging from change management to business strategy and commodity markets. He joined Wood Mackenzie in 2006 and is currently based in London. He is responsible for global net zero emissions scenario modeling, and leads discussions on hydrogen, ammonia, CCUS, next-gen nuclear and geothermal technologies. Previously, Prakash spent two years in Beijing as head of Wood Mackenzie’s China research, guiding a team of analysts on energy and economic trends, including supply-side reforms, inter-fuel competition and commodity prices. He has also led global coal markets analysis for five years, delivering research on decarbonisation policies, the impact of renewables, alternative scenarios and evolving patterns of supply, demand and prices. Prior to joining Wood Mackenzie, Prakash had extensive experience in the natural resources sector, including export-import of bulks and ferrous commodities for an established Canadian trading firm. He has also spent nine years in the mining industry, specialising in business improvement, international sourcing and ISO 9001 certification.

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Reality came into sharp focus in 2022. Depending on natural gas as a transition fuel without security of supply will not end well. Similarly, wind and solar power alone cannot deliver a reliable zero-carbon energy system. Policymakers have acknowledged that a diverse range of low-carbon technologies beyond variable renewables is required to achieve deep decarbonisation while maintaining a secure energy supply. They have responded by laying the policy foundations in certain vital areas, including low-carbon hydrogen, carbon capture, utilisation and storage (CCUS) and advanced nuclear power. Even through the depths of the Covid-19 and Russia-Ukraine crises, announcements of new low-carbon hydrogen and CCUS projects have continued apace. We estimate that the project pipeline has grown around 25% over the past year. About 30 projects have taken final investment decisions and another 170 are aiming to by the end of 2023. On the demand side, 30 hydrogen offtake agreements have been signed this year, as buyers seek first-mover advantage. A market for green commodities, such as low-carbon ammonia, is taking shape. In the US, the Inflation Reduction Act offers US$375 billion of funding support for climate and energy over the next decade. For low-carbon hydrogen, the production tax credit is worth up to US$3/kg, significantly improving the economics of announced projects and potentially making the US a competitive exporter of hydrogen in future. For CCUS, the 45Q incentive is revised up to a maximum of US$180/t for direct air capture with storage. While this won’t fully cover current cost levels, we expect projects to be able to make up the gap with infrastructure funding and other revenue streams. These are significant incentives, akin to the feed-in tariffs offered to solar and wind projects that played a key role in driving down costs and ramping up installations in the 2010s. With expected cost declines in hydrogen and CCUS technologies and abundant low-cost energy resources, there is an opportunity for the US to become a manufacturing powerhouse. It could become a dominant producer of green commodities – hydrogen, ammonia, steel and chemicals – serving the needs of Europe, Japan and South Korea. In the European Union (EU), the REPowerEU plan signalled that carbon contracts for difference would be used to increase funding support for hydrogen and CCUS. The European Commission approved €8.4 billion to subsidise strategic hydrogen projects and the associated value chain. Japan announced its US$100 billion Green Transformation (GX) programme to support the development and adoption of zero-emission fuels and feedstocks as it seeks to retain industrial competitiveness in a rapidly changing external environment. Australia and parts of Southeast Asia have been adjusting policies to attract more capital into hydrogen and CCUS. These emerging low-carbon, stable energy technologies create new opportunities, but also new risks. We are seeing the emergence of a bifurcated world, with the US and its allies and partners competing against a group promoted by China. If every country attempts to promote its own national low-carbon industries at the expense of others, tensions could increase both between these large blocs and within them. International cooperation will be needed to accelerate the adoption of clean energy technologies and avoid excessive inefficiencies and market distortions.

Kristy Kramer

Vice President, Gas & LNG Research

Kristy brings more than a decade of energy industry experience with particular expertise in flowing gas, LNG, and the upstream oil and gas business in the Americas, Africa and the Middle East. Kristy leads Wood Mackenzie’s gas market research team, which delivers fundamental supply, demand, and pricing analysis across global and regional gas markets. Having joined Wood Mackenzie as a principal in consulting in 2016, Kristy has been involved in helping customers determine and evaluate investment opportunities, design portfolio strategy, and understand associated market responses. She later joined our research team as Head of Americas Gas Research. Before joining Wood Mackenzie, Kristy spent eight years at ExxonMobil, where she led deal evaluation and developed portfolio strategies for both proprietary flowing gas and joint venture LNG assets.

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HORIZONS

Bio-liquid gold:

How biofuel circularity could unlock the energy transition

August 2022

Alan Gelder Vice President, Refining, Chemicals & Oil Markets Gerrit Venter Director, Corporate Analysis, Head of Corporate Research Operations Gordon McManus Research Director, EMEARC Oils & Refining Guy Bailey Head of Intermediates & Applications

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Prakash Sharma Vice President, Multi-Commodity Research

CCUS and low carbon hydrogen projects: expected FID timelines

* includes projects targeting FID for the rest of 2022 ** includes unrisked view of projects targeting FID in 2023 Source: Wood Mackenzie

The past year has been defined by Russia’s war on Ukraine and a full-blown energy crisis that has taken the world to the brink of recession. Consumers in many parts of the globe are suffering from the rising cost of living, driven in no small part by surging energy costs. Only a year after the COP26 climate conference in Glasgow seemed to take real steps towards achieving the goals of the Paris Agreement, governments have been forced to revert to coal to keep the lights on and their economies ticking over. Yet this crisis may prove to be a catalyst for the policy initiatives and investment required to transform the way we power the planet. Our analysts have identified five developments that suggest that, despite the setbacks of the past year, the world is laying the foundations for a decade or more of sustained opportunity that will deliver better outcomes for the reliability, affordability and sustainability of our energy and natural resources.

Fast, flexible and available: US LNG will help keep Europe’s lights on

Disruption to Russian pipeline flows has left a massive supply gap in European gas markets. From 140 bcm of gas to the EU in 2021, Russia is now exporting only 25 bcm on an annualised basis – a reduction equivalent to one-fifth of current global liquified natural gas (LNG) supply. Faced with such a major supply shortfall, Europe looked to LNG for a saviour – and it was destination-flexible US LNG that answered the call. We now expect two-thirds of all US LNG cargoes to land in Europe this year. Regasification capacity is currently the major impediment to even more US LNG exports to Europe.

US LNG by destination

Source: Wood Mackenzie

Kristy Kramer Vice President, Gas & LNG Research

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This has been possible because of contractual flexibility. As European prices soared above Asian spot prices, US LNG off-takers were free to choose where they delivered their wares. Whereas most traditional LNG contracts strictly limit cargo diversion, off-takers of US LNG have been ideally placed to adjust deliveries in response to market conditions. US LNG has been following the money, but the commercial structure means it is primarily the off-takers rather than the developers that are getting the biggest share of the pie. More US LNG is headed Europe’s way, further loosening Russia’s energy stranglehold. Another 25 mmtpa of US LNG capacity has been sanctioned this year, with significantly more likely to come in 2023 and 2024. The abundance of low-cost gas reserves, the relatively short time to bring new volume to market and its competitive commercial structure continue to make US LNG attractive. The problem for Europe is that most of the new volumes will not start up until the second half of this decade. Uncertainty surrounding Europe’s future appetite for hydrocarbons means that it is possible the continent will be well on its way to reducing its gas demand by the time this new supply hits the water. No matter. With the role of gas still critical to Asia’s future decarbonisation, US LNG will be well placed to supply Asian markets with future growth needs as prices retreat from 2026. US LNG players need to prepare for the future, given their product’s high carbon footprint. Emissions tracking and responsibly sourced gas are a good place to start if US LNG is to service buyers’ evolving needs. For now, though, US LNG is playing a critical role in meeting European energy demand and allowing the continent to respond to the loss of Russian pipeline supply. Flexible, fast to market and available. Take a bow, US LNG.

Refining: new capacity will burst the margin bubble

3.

In 2022, refining has played a central role in the energy crisis. Over the next year or so, the sector should retreat into its usual backstage role. When consumers face high fuel prices, it is usually the result of crude oil shortages rather than a lack of refining capacity. This time, however, supplies of crude have been ample, as worst-case fears of significantly lower Russian volumes after the invasion of Ukraine proved unfounded. And as demand softened amid concerns about the unfolding global economic slowdown, the OPEC+ countries opted to cut their agreed production from November to support prices. The significance of the refining sector to this year’s soaring fuel prices was evident, for example, in the premium of road diesel to Brent crude at the refinery gate in northwest Europe. That averaged an unprecedented US$35/bbl in 2022, 2.5 times the average of the previous 10 years. The huge premium reflects the severe stress the refining system has been under as the global economy has recovered from Covid-19, only to be faced with the uncertainty surrounding Russian crude and product exports. Stress on the refining system is set to ease in 2023 as major new refinery projects in the Middle East, Africa and Asia become fully operational. China’s decision to relax restrictions on the export of refined products will also help, as government policy shifts to support near-term economic activity. Over the next 12 to 18 months, as the new capacity becomes operational, we expect refining margins to return to historical norms. There is an important caveat, however: much will depend on whether the key projects can start on time and ramp up to full capacity on schedule. The changing global profile of the refining industry will have longer-term implications for energy security. New investment in refining capacity is in developing economies where sustained growth in oil demand is expected. In contrast, refinery capacity has been reduced in the mature markets of North America and Europe, where gasoline and diesel demand are most exposed to the electrification of the vehicle fleet. Closures accelerated during the pandemic and the subsequent bounce back in oil demand has led to a steep fall in stocks in these regions this year. Rebuilding inventory in the short term and establishing energy security in crude oil and products in the longer term will increasingly rely on inter-regional trade and long-haul freight – with an associated rise in costs.

Global composite gross refining margin to ease over next 24 months

Source: Wood Mackenzie

Alan Gelder Vice President, Refining, Chemicals & Oil Markets

Lightbulb moment: investors adopt a more realistic attitude to investing in fossil fuels

4.

The current energy crisis has prompted investors to rethink finance for fossil fuels. What has emerged is a more measured approach that reflects the real-world constraints on financial institutions and corporates in making long-term financing and capital allocation decisions. The shift in approach reflects both the complexity and the necessity of securing an orderly energy transition. The past year has made abundantly clear that energy supply and demand need to move in sync for economic stability and minimal price volatility. And, crucially, immediate divestment from fossil-fuel positions would serve only to move financial-sector portfolio emissions elsewhere rather than achieve any significant real emission reductions. Previously, global financial institutions that came together through the Glasgow Financial Alliance for Net Zero (GFANZ) were required by the United Nations Race to Zero, which underpins GFANZ, to phase out all financing of unabated fossil fuels. Leading asset managers and bulge-bracket banks have pushed for a reassessment. In response, the Race to Zero has updated guidance and GFANZ has clarified that it does not require an immediate end to fossil-fuel financing. Its goals are to:

encourage lenders and investors to increase financing of climate solutions steward and engage with companies to support a transition to Paris-aligned business models finance a managed phase-out of high-emitting assets at risk of being stranded in the transition

Kavita Jadhav Research Director, Corporate Research

• • •

This emerging strategic reset does not, however, mean a return to a no-holds-barred model. GFANZ members have committed to halve portfolio emissions by 2030. With this ambitious yet balanced approach, finance can help shift the focus from 2050 goals to actions this decade. The financial sector is setting targets for the fossil-fuel sectors and will use all the levers at its disposal to work with clients to help achieve emissions reductions. In practice, this will encourage companies to progress only projects with lower and falling carbon intensity, to support gas over oil, to continue to put coal at a disadvantage and to provide support for CCUS and carbon offsets.

This nearer-term focus will give a clear advantage to companies with rigorous transition plans for their core fossil-fuel business. To reduce total portfolio emissions, lenders and investors will accelerate the financing of low-carbon projects, including to these companies. Companies without credible plans, in contrast, will face higher cost of and/or restricted access to financing. While some financial institutions will choose to exit fossil fuels, or have announced that they soon will, we expect most to follow this more nuanced approach. Finance, therefore, has the potential to set the fossil-fuel sector firmly on a pathway that is Paris aligned.

Financial institutions’ levers with fossil-fuel companies

Source: GFANZ, Wood Mackenzie

Rewiring Europe: a power-market reset

5.

Decarbonised electricity is at the heart of Europe’s energy transition. Consequently, when EU energy policy was rewritten in the aftermath of Russia’s invasion of Ukraine, the sector’s ability to deliver was put firmly in the spotlight. The REPowerEU package lifted renewable energy ambitions to new heights and added an imperative to end the region’s reliance on Russian gas. The accelerated deployment of renewables (45% of energy by 2030, needing around 70% of power from renewables) will require substantially higher levels of investment in wind and solar. The scaling up of the hydrogen industry and its need for renewable energy supplies will put even greater pressure on the industry to grow faster. Setting targets is easy; it is the implementation that will prove challenging. Indeed, several key tests have already come to the fore this year.

EU renewable energy and power supply share: actual and 2030 targets

Source: Wood Mackenzie

Peter Osbaldstone Research Director, Europe Power

The 42 GW of renewables we estimate will go online in 2022 is a record for Europe. But the project pipeline is showing signs of strain, as evidenced by the recent record of undersubscribed government auctions. Rising equipment costs are a large contributor to this slowdown. We estimate that the solar and onshore wind levelised costs of electricity (LCOEs) are, respectively, 38% and 31% higher than they were two years ago. While this is a small increase compared with changes in fuel costs and power prices, auction arrangements (including price caps) have not kept pace with market trends. The second challenge is market design. Policymakers have responded to rising power prices with a range of emergency measures, including revenue caps and retail price interventions. This has been a stark reminder to investors of the political risk of the power business. Of more consequence over the long term, however, is the enduring form and function of markets – something else that is attracting widespread attention. For instance, UK electricity market design is under review and changes there could fundamentally reshape market function and economics. Until the revision of market rules is complete, investors will contend with significant uncertainty in their decision-making. The third challenge is providing secure and reliable supplies through the transition. In this past year, Europe has struggled to adjust to the loss of Russian gas, major supply outages in French nuclear power and the reality that climate change can substantially reduce hydro output. This combination of factors is a loud wake-up call that resource diversity is essential to power-system reliability. The transition must focus on all the tools at our disposal – including hydrogen, long-duration energy storage, nuclear and CCUS. Some of these are being pursued with more vigour than others. Power-market redesign – a key enabler of the accelerated change that will drive sustained investment – cannot be undertaken lightly. The scope is wide and the stakes are high, but Europe’s policymakers have been served notice of the need to change. The wheels are in motion.

November 2022 Avoiding pand-ammonia: How to kick-start a global low-carbon ammonia industry October 2022 Red metal, green demand: Copper’s critical role in achieving net zero September 2022 Pedal to the metal: Iron and steel's US$1.4 trillion shot at decarbonisation August 2022 Bio-liquid gold: How biofuel circularity could unlock the energy transition

Missed our previous editions of Horizons?

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Announcements of new low-carbon hydrogen and CCUS projects have continued apace

More US LNG is headed Europe’s way, further loosening Russia’s energy stranglehold

The US could become a dominant producer of green commodities

Stress on the refining system is set to ease in 2023

Finance can help shift the focus from 2050 goals to actions this decade

Setting targets is easy; it is the implementation that will prove challenging

Resource diversity is essential to power-system reliability

Kavita Jadhav

Research Director, Corporate Research

Kavita is a member of the Corporate Research team, providing insight into companies’ strategies, performance and outlook, and advising clients on energy transition and sustainability. Prior to joining Wood Mackenzie in 2021, Kavita was an energy advisor with the UK Government in Westminster and at the British Deputy High Commission in India. Kavita was the corporate finance lead for the Majors and government response to insolvencies. She managed the UK Government’s India energy security program with the International Energy Agency (IEA) and was the UK-nominated expert on the IEA energy sector review team for Central Asia. Before joining the UK Government, Kavita worked with BP and BG Group (now part of Shell), largely in the upstream sector but also including roles in city gas distribution, LNG, carbon capture and storage and alternative energy. The roles with BP and BG spanned UK, Iraq, Dubai, India, Azerbaijan and Kazakhstan. Kavita has an MBA in Finance from London Business School and a Masters degree in economics from the University of Strathclyde in Glasgow.

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Peter Osbaldstone

Research Director, Europe Power

Peter is a research director with more than a decade’s experience in European power and renewables markets. Peter joined Wood Mackenzie in 2007 as a senior power markets analyst, before moving into a role as product manager for our European Gas & Power Service. He took up the role of research director in 2015. Before joining the business, Peter was at National Grid in the UK, leading the production of long-term power generation and energy demand analysis. He has also held market forecasting, transmission network planning and commercial roles in the UK gas industry.

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Finance has the potential to set the fossil-fuel sector firmly on a pathway that is Paris aligned