ORLEN ORLEN Group 2017
Integrated Report

Macroeconomic Environment

GRI INDICATORS:
Capitals:

Oil companies operate in the sector of commodities − homogeneous products such as crude oil, fuels and petrochemical products, manufactured and sold by numerous producers worldwide.

A company supplying commodities is easily replaceable with another supplier offering the same commodity for a lower price, which significantly constrains individual suppliers’ ability to control prices. Consequently, both suppliers and buyers of commodities make transactions at prices driven by the supply and demand interaction on the market.

The key external factors with a bearing on oil companies’ decisions concerning production and growth and on their financial performance are current and future:

  • Quoted crude oil prices (USD).
  • Quoted prices of fuels (USD) and petrochemical products (USD and EUR).
  • USD and EUR exchange rates.

Price path projections take into account factors that reflect changes in both supply and demand:

  • The economic growth rate in OECD countries, where oil demand has been declining since 2005, and in non-OECD countries, where peak demand is yet to be seen; the changes in demand for crude oil and petroleum products are driven to a large extent by China and India.
  • Growth of global crude output in OPEC and non-OPEC countries.
  • OECD oil inventories and OPEC oil reserves.
  • Geopolitical risks.
  • Climate change and environmental degradation risks related to power generation and transport.

The frequency and status of information about these factors vary. Prices and the USD exchange rate, i.e. hard data, change continuously and are available in real time. The economic growth rate, measured by the GDP, is an estimate published quarterly and subject to frequent corrections. In contrast, information about actual and potential supply disruptions caused by geopolitical developments emerges unexpectedly and leads to instant price changes dictated by the anticipated ramifications of such developments. The effect of price changes on supply and demand is significantly delayed if lower or higher prices continue for several quarters.

Since the time when in mid-2014 the oil market was affected by an oversupply which had gone unnoticed for a time, attention has been paid to the production structure. Among non-OPEC countries, the United States and Canada are characterised by a very short cycle of unconventional onshore oil production, a large number of oil producers, and the ability to make quick adjustments to production volumes in response to oil price changes. The strong interaction between the level of output from unconventional fields and oil price changes is attributable to the extremely short production cycle. The average time necessary to launch unconventional oil production is only 90 days vs. 3-5 years needed for the development of a shallow water oil deposit or 8 years for deep-water offshore oil production. This factor has also contributed to the fast-growing oil supply in non-OPEC countries.

Among the OPEC countries, Saudi Arabia stands out due to its immediately available significant production reserves and the control it has over the oil production policy of the cartel and the group of five countries: Saudi Arabia, Kuwait, Iraq, Iran, and United Arab Emirates, given its strong potential to produce oil at low cost.

Another important factor now in focus are exploration and production costs. These costs play a major role in long-term oil price projections (supply and demand balance). Over a long term, the price of an oil barrel may not be lower than the cost to produce one barrel of oil from the most expensive reserve, required to meet effective demand. As oil reserves are depleting, it will become necessary to drill down to more challenging resources, and the resulting higher cost of production will lead to rising oil prices.

We have decided not to include financial institutions in the list of factors affecting the macroeconomic environment of oil companies even though the value of futures contracts they execute is many times higher than the value of physical market transactions. In our view, supported by numerous studies, transactions made by financial institutions increase oil price susceptibility to changes, but do not affect price change trends. In both speculative and investment transactions, financial institutions act on the basis of the same fundamental factors as those taken into account by the participants of the physical markets, including oil companies. The upstream and financial sectors share the opinion that oil reserves are sufficient to satisfy future demand at a reasonable price in the long term. But there are serious differences in expectations about future oil demand developments. Although today the oil sector appears to believe that demand is set to plateau, such belief is not shared by the financial sector, which provides money for upstream projects.

The seed of uncertainty was planted in 2015, when the price of oil fell and it was clear that it would not rebound soon. Against this backdrop, scenarios emerged predicting a deep decline in oil demand, induced by the tightening of environmental and climate regulations and supported by technological advances and shifts in consumer behaviour. The financial sector began to show signs of worry since oil prices serve as the basis for valuation of oil companies and many financial assets. These concerns proved strong enough for the Financial Stability Board, an international body that monitors and makes recommendations about the global financial system, to set up in late 2015 the Task Force on Climate-related Financial Disclosures (TCFD). In June 2017, the TCFD issued recommendations on disclosure of exposure to climate-related risks, which are actually becoming reporting standards for companies with revenues in excess of USD 1bn.

In December 2017, 230 organisations, including 150 financial institutions with assets worth more than USD 80 trillion, many large energy companies, governments of European countries, and the London Stock Exchange, adopted these standards. According to the TCFD, the energy sector is exposed to climate risk due to changes in demand for fossil fuels, production and application technologies, emission reductions, and water availability.

Although TCFD recommendations encourage oil companies to deploy business strategies that would mitigate climate risks (sustainable development strategies), the effects of these strategies will take time to materialise due to purely technology-related reasons. Financial investors are in a very different position, with their exposure to climate risks coming from loans and bonds portfolios. They can reduce their own exposure by refusing to finance firms exposed to climate risks, such as oil exploration and production companies. The differences in the pace of adjustment between the flexible financial sector and the inflexible oil sector lead to an increased risk of a supply and demand imbalance due to a shortage of funding for upstream projects.



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