FUTURE OF HYDROCARBONS

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La Jol la Conference 30 th Anni versary | P O L I C Y B R I E F

FUTURE OF HYDROCARBONS

FUTURE OF HYDROCARBONS | La Jolla Conference 30 th Anniversary Policy Brief

At the end of May 2021, a series of momentous events rocked the global oil sector. Shareholder demands and climate activism altered the composition of corporate boards at Chevron and ExxonMobil, while a judicial ruling in the Netherlands took aim at Shell’s greenhouse gas emissions profile, setting legally binding reductions. Headlines screamed that it was the week that shook Big Oil. Others, even more dramatically, called it Big Oil’s bad, bad d O a n y ly . days before these developments, the International Energy Agency (IEA) released Net-Zero by 2050 – A Roadmap for the Global Energy Sector, which was arguably an even larger quake across the industry. This followed on from 2020 – a year in which both the pandemic and extreme weather events had given pause for thought – leading to widespread calls to ‘build back better; build back greener’ in the energy sector. Looking beyond the rhetorical flourishes and scenarios, the signals and trends are clear as to the climate imperative. And demands for the oil and gas industry, regulators and governments to act faster are increasing. This Policy Brief is based upon discussions that took place in May as part of the Institute of the Americas 30th La Jolla Energy Conference and a Virtual Roundtable held under Chatham House Rules. The Policy Brief summarizes and adds context to discussions held just as the oil and gas industry was being shaken up. Thought-leaders and experts discussed the issue of the future of hydrocarbons including net-zero

commitments and targets, climate action and activism, energy security and demands faced by many countries and governments in the Americas. Net-Zero – The Environment and Climate Imperative

The publication of the IEA Net-Zero report and pathway set off extensive discussion emphasizing its importance. For starters, the report shows the sheer scale of effort needed to accomplish Net-Zero. It also is very forthright with the aim to ramp up renewables quickly. The boldness of the pathway grabbed attention, specifically arguing for no new developments of oil and gas fields and coal mines as of now! However, it also shows that even in the most aggressive scenarios, fossil fuels have a role. At the same time, it is essential to note that it is a scenario but not the only way toward Net-Zero. Furthermore, the IEA scenario

FUTURE OF HYDROCARBONS | INSTITUTE OF THE AMERICAS

FUTURE OF HYDROCARBONS | La Jolla Conference 30 th Anniversary Policy Brief

makes clear that as much as we can and should electrify the value chain, there will always be areas or sub-sectors that cannot be fully electrified. In assessing the future, it is vital to look at the trends and try to spot the inflection point. The energy transition has long been touted, but now we are seeing a strong acceleration. All indicators support that we have reached the inflection point. The IEA report is perhaps best understood as part of an accumulation of signals that tells us we are entering the end of the life-cycle of the oil and gas industry. There is an ever-growing mosaic of alternative technologies to support Net-Zero pathways, but with a lack of clarity as to the ultimate winners and losers. Most notable for hydrocarbons is carbon capture utilization and storage (CCUS) and hydrogen, with the latter becoming increasingly analyzed by countries including Chile, Brazil, Argentina, Costa Rica, Panama, Peru among others. Fossil-fuel derived hydrogen is not novel in the region, but new pilot projects aimed at harnessing the region’s burgeoning – and cheap – renewable energy point toward a different chapter for the future of hydrogen – green hydrogen. Indeed, for many, hydrogen has very rapidly, in the space of just months, become the long-term solution. CCUS has been talked about for decades but has yet to take off. Several companies in the oil and gas sector have spent considerable resources to commercialize the technology. Most are now involved in large-scale field trials. It is critical for many countries in Latin America that have deep and

inextricably linked fossil fuel-led economies to embrace CCUS. As appropriate, the market will decide technological winners and losers; for the most part, policies are currently technology agnostic. However, as the world embraces climate action and companies devote time and treasure as well, we see policies that come with money, not just words. For instance, there are economic recovery packages that are focused on funding clean energy, the so-called build back greener mantra. Perhaps more importantly, emission reduction commitments by developing economies are increasingly conditioned on external financial support and ESG commitments. Indeed, as countries review and reset their climate pledges and nationally determined contributions (NDCs) on the road to Glasgow and COP 26 in November, they are arguing for increased funding. Energy Security Long defined as the driver of the world’s most contentious geopolitics, energy security is best understood as the availability of sufficient and reliable supplies at affordable prices. But beyond that it is diversification of sources and guaranteeing a key input for economic activity. It has also long been synonymous with oil. The changes in how the world approaches the energy sector is also hugely affecting decades-old consensus on energy security.

FUTURE OF HYDROCARBONS | INSTITUTE OF THE AMERICAS

FUTURE OF HYDROCARBONS | La Jolla Conference 30 th Anniversary Policy Brief

For starters, the IEA and its effort to influence the Net-Zero and energy transition debate is a major change in global governance for an institution created by major consuming nations to indeed guarantee their energy security and economies. Some now see the IEA pronouncements as politically driven. Meanwhile, the OPEC cartel and also OPEC+, as the broader producers are known, are almost resurgent. But with the transition and accelerated by the pandemic, oil demand is forecast to trend down and decline over time according to a host of industry and trade group analyses. This is important - as oil declines, there is concern that a greater share of supply – exceeding 50% by some estimates - will be placed in the hands of OPEC. In short order, this becomes an issue of how OPEC will choose to use what many feel is its increased power.

outcome. Surely, whether for energy security or rent and fiscal reasons, it is not unrealistic to expect that some countries will maintain a portion of production of oil and gas. If the precept of an irreversible global market trend away from oil and gas is accepted, debating the future of hydrocarbons in Latin America suggests that governments and the region are not harnessing the full potential. The abundance of renewable resources bears repeating. For a decade, the region has counted some of the most sought- after markets for investment in renewables and particularly wind and solar. Clean energy auctions have been hugely successful in driving diversification and reducing electricity prices. The successes have been copied far and wide. Role of Industry and IOCs Fundamental to the discussion of the future of hydrocarbons is how industry and government fit together. With the arrival of the Biden administration in the US, the advance of ESG impacting capital deployment, along with the corporate activism discussed above, there have been unmistakable changes across international oil companies (IOCs). Even before the momentous week in May, the acceptance of the need for change in oil companies has been dramatic over the last year. There is a shift to activity and action. Certainly, ESG investing has helped create this shift. To wit, companies are shifting the way they approach

While most scenarios point to OPEC taking overall control of oil supply, there will be internal pressures to counter this

FUTURE OF HYDROCARBONS | INSTITUTE OF THE AMERICAS

FUTURE OF HYDROCARBONS | La Jolla Conference 30 th Anniversary Policy Brief

partnerships, as the recent announcement from CEMEX and BP aimed at lower-emission cement production highlights. Markets have been driving the evolution of the industry more than governments. There is a role for governments but we also need to trust markets to drive change. At the same time, incumbents are incumbents. IOCs have all technical capabilities but climate leadership is not coming from within. They are being reactive to external pressures. The transition will also lead to a changing role for oil and gas companies. IOCs have a critical role to play in it. They have to think about the transition from an integrated value chain perspective. Their knowledge will be increasingly important as we integrate the value chain further in the future. They have an opportunity to play a key role in the transition, but it will require a shift in culture and thinking. The investment model will be different as well, as IOCs will want and need to protect dividends as they transition. Large profits made during past oil super cycles will be gone. But yet, IOCs will play an important role in the consolidation effort, which has already been witnessed in North America. Many IOCs have embraced the idea that there are opportunities in the transition. It extends far beyond the energy sector, as it affects any large emitter. IOCs have an opportunity to play a critical role in navigating solutions for these emitters. Arguably, the shift and trend dates back to 2019 when capital markets first started to seriously question strategies around the transition and emissions profiles, but it is now becoming a central focus of corporate strategies.

Role of Government and NOCs It is useful to distinguish between IOCs and NOCs. In select countries in Latin America, government seemingly makes state companies and their operations more reluctant toward addressing climate change. Most obvious is the current government policy framework in Mexico aimed at its state energy firms.

For IOCs and NOCs alike, there will be a change in the way partnerships are carried out and new partnerships will be formed. With the world demanding less petroleum, we can expect to see more oil companies merge. IOCs are much better prepared for the transition, but how will NOCs make this transition?

FUTURE OF HYDROCARBONS | INSTITUTE OF THE AMERICAS

FUTURE OF HYDROCARBONS | La Jolla Conference 30 th Anniversary Policy Brief

Given their government ownership and leadership structures, NOCs are more often than not tied to political cycles. Abandoning hydrocarbons is bad news for them and their transition will be delayed as much as possible, especially in oil-dependent countries like Mexico, but also Argentina, Ecuador, Venezuela, Trinidad & Tobago, and even Peru, Brazil and Bolivia. For all the talk about new technologies, there is considerably less talk about what we will leave behind. There is concern about who will take care of the remaining oil and gas infrastructure, much in need of refurbishment. Cash flows will start declining as well and it is rare to see legislation that obligates the oil and gas sector to put money aside for environmental liabilities. The cash flows from oil and gas are important for many economies and officials need to start considering this and figuring out how to manage the legacy issues. If underpinned by a longer- term vision, some of this infrastructure can also be leveraged as part of the future energy system that will emerge in the region. When we talk about stranded economies and NOCs, the transition will introduce existential problems for the future of state energy firms and their governments. Latin America has several well-run NOCs which puts them at an advantage to transition, but there may be political challenges to head down that path. The key is that there is continuity in policy goals to transition, but Latin America has a strong pendulum effect which makes policy permanence illusory.

Governments and their NOCs need to make irreversible commitments through legislation to avoid this problem. A positive example is Ecopetrol, which is doing a lot to develop clean technology. There are also private companies in Colombia that are innovating. Policymakers have to set up NOCs for success where they can have longer-term thinking about how they can transition. Beyond rent-seeking and politics, many NOCs have strong trade unions and thus elements of reskilling and considerations as to how people will be displaced from their jobs are part of the energy transition and NOC discourse. Workforce development must be part of the stakeholder management plan, or it will be a huge inhibitor for NOCs to evolve and embrace the global energy transition. Political interference and imperatives have allowed many industries to survive even as they become obsolete. Look no farther than the example of the steel industry in the US as a key example.

FUTURE OF HYDROCARBONS | INSTITUTE OF THE AMERICAS

FUTURE OF HYDROCARBONS | La Jolla Conference 30 th Anniversary Policy Brief

In sum, there are three main issues: governance around the risks of oil declining; oil and gas companies developing and seeking more granular strategies going forward; and, as climate change policies become mandatory, the pressures derived from an accelerated and faster transition. Indeed, perhaps more sorely needed than any further scenarios are actions, from government and companies alike. Natural Gas For natural gas, we need to discuss the scale of flaring. The largest amount of flaring is occurring in Russia, Iraq, Venezuela, the US, and in Mexico. A vast amount of the flaring is being done by NOCs. How does the world influence these countries and OPEC to reduce flaring? The issue of methane and emissions is also crucial. Major strides by industry and government had slowed but are clearly back in focus. These issues and climate concerns more broadly will also translate to LNG, where carbon neutral cargoes have recently been sold from the US to both Asia and Europe.

Across Latin America, natural gas has been a key to energy security and early emission reduction gains in the power sector. But it is also unmistakably a source of domestic revenue and regional tensions too. The Argentina-Chile natural gas interconnection is a world-class example. But in today’s context, the drive to develop natural gas or support its deployment demands debate: Is it a transition fuel, or is it a transition inhibitor? Take Argentina’s highly touted and government-embraced Vaca Muerta unconventional gas play. In the context of managing emissions, it is clear that the immense play cannot reach its potential without investment in CCUS. But where will this money come from? Industry? YPF or the provinces, in effect the government? Given pressure on capital, one can argue that it is much easier to raise money for large renewable energy export projects. Certainly, the subheading of natural gas in a discussion of the future of hydrocarbons leads to more questions than answers. Conclusion The axiom ascribed to Saudi Oil Minister Sheikh Yamani as to the end of the stone age and its parallels with oil is well- worn, but in this context does underscore the point of the discussion and brief: the future of hydrocarbons is shaped by environmental concerns. There is almost universal consensus as to the evolving transition. But far from agreed upon are the pace and

FUTURE OF HYDROCARBONS | INSTITUTE OF THE AMERICAS

FUTURE OF HYDROCARBONS | La Jolla Conference 30 th Anniversary Policy Brief

rhythm. Trends point to the pace, rhythm and outlook being determined by energy security and climate security. This is particularly the case in the Americas as discussed. The end of hydrocarbons is not coming yet but there will be a massive change in the years ahead. To conclude the discussion at the La Jolla Conference, the future of hydrocarbons was translated to book and movie titles with Back to the Future, Apocalypse Now, Cinema Paradiso and The Leopard set forth as the leading choices to summarize the debate. The Institute of the Americas would like to recognize Carlos De Regules , Partner, Deloitte S-LATAM, and a member of the IOA’s Energy Steering Committee, for chairing the Virtual Panel and the participation of expert presenters: Marta Jara , Non-Resident Fellow at the Institute of the Americas and former President of ANCAP (Uruguay); Chris Sladen , Non- Resident Fellow at the Institute of the Americas, long-time energy executive and author; Christoffer Mylde , Senior Vice President at Sproule and a member of the IOA’s Energy Steering Committee. We would also like to recognize Kathryn Hillis , a graduate student at UCSD’s School Global Policy and Strategy (GPS), who served as the rapporteur for the panel and assisted in drafting this Policy Brief.

About the Institute of the Americas Established in 1981, the Institute of the Americas is an independent, inter-American institution devoted to encouraging economic and social reform in the Americas, enhancing private sector collaboration and communication and strengthening political and economic relations between Latin America and the Caribbean, the United States and Canada. Located on the University of California, San Diego campus in La Jolla, 30 miles from the border with Mexico, the Institute provides a unique hemispheric perspective on the opportunities opened by economic and social reforms in Latin America and the region’s relationship with the United States and Canada. Since 1992, the Institute’s Energy & Sustainability program has played a crucial thought-leadership role in shaping policy discourse and informing policymakers and investors on the most important trends in the energy sector. The Institute continues to serve as an honest broker between the public and private sectors across the hemisphere to help forge a constructive dialogue on the issue of clean energy transitions and emerging economic opportunities derived from renewable energy deployment. For more information, visit iamericas.org @IOA_Energy

FUTURE OF HYDROCARBONS | INSTITUTE OF THE AMERICAS