Part I: The Low-Carbon Transition and the Data Revolution
Commodity markets have evolved over hundreds of years to enable efficient transactions between producers and consumers, based on the belief that all commodities are essentially identical. This assumption results in the misperception that differentiating commodities is unnecessary, if not impossible. As a result, no one thinks about commodities as unique “products,” but rather as undifferentiated units with only a few defining characteristics.
But all commodities are not created equal.
In today’s commodity markets, value-added differentiation and high-fidelity product information are not required, because the cost of adding them are too high—in terms of changes to a physical plant or investment in data extraction—and not recoverable based on what buyers are willing to pay.
Two macro trends are poised to transform this paradigm: the transition to a low-carbon economy, and advances in data collection and processing, known as “digitization.” As markets shift to value low-carbon production, fossil producers will be rewarded for removing high greenhouse gas (GHG) sources from their production stacks, creating a new market incentive to “brand” commodities based on how they’re produced. And digitization will refine previously siloed and muddled data into coherent and actionable information, allowing producers to share highly detailed insight into production and provenance. This is nothing short of a sea change.
The low-carbon transition and data revolution will profoundly transform commodity markets.
Xpansiv sits at the convergence of these trends. Our core product, Digital Feedstock™, will enable previously undifferentiated commodities to fall into distinct product categories, so that a market increasingly hungry for low-carbon energy sources can reward best practices. The other benefit of this paradigm shift is radically improved communication of high-resolution production information. For producers, this means improved margins for responsible production, allowing for capital recovery as they move toward a low-carbon economy. It also provides the ability to communicate detailed, verifiable information about production practices across the entire ecosystem.
In the long term, Xpansiv’s platform will enable a host of ancillary applications, with benefits ranging from product differentiation traceable along an entire supply chain, to collapsing costs and timelines for processes that involve the production and transfer of commodities.
The Status Quo: Energy Markets
The value of oil and gas depends on when and where it’s produced. And in the case of crude oil, it also depends on the grade requirements of refinery buyers. But past a certain point in current market conditions, differentiation is not practical nor cost effective. Instead, because a barrel of crude oil of a particular grade can be expected to have an energy content within a relatively narrow range, a refiner should be agnostic to the exact chemical composition or provenance of that barrel. This allows the producer to sell barrels into pooled markets for the highest price, and buyers to procure barrels for the lowest price.
The standardization of oil and gas products is hugely valuable to buyers. Instead of having to rely on brands or bespoke product information to determine quality, widely accepted market standards for quality specifications prevail. It also allows for highly liquid trading in broad indices tied to those pools (in the case of crude, Brent or WTI), which creates a real-time price discovery mechanism, as well as a means to benchmark locational basis and quality differentials. In most cases, an industry-contracting framework governs bilateral transactions, and exchanges—such as the CME, ICE, and LME—facilitate near-frictionless execution. Risk management becomes possible using deeply liquid futures and forward markets keyed off product benchmarks. Thus, on the scale between precision and efficiency, energy markets prefer efficiency.
Until now, there was simply no motivation to differentiate commodities in the marketplace.
For commodities buyers, any potential value-add from differentiated products, as well as any incremental value from higher-resolution input data, is overwhelmed by the need to lower costs. Relieved of the burden of choosing among competing brands, buyers rely on standardization. As a result, it would be hugely inefficient for oil producers to attempt to “brand” barrels of oil from specific wells where they have invested capital to produce more responsibly, because for one, the market historically has not paid them for that “responsible” barrel; and two, the ability to communicate that “branding” to the market has heretofore been technologically impossible.
The Low-Carbon Transition
The transition from a fossil fuel based economy to one based on less carbon intensive energy is underway, and is motivated by well-documented concerns around climate change. This dynamic introduces new variables into the overall value proposition of any given unit of energy. While the conventional economic drivers of supply and demand—marginal cost and utility—are paramount in market formation, the social costs of externalities are now impossible to ignore.
Over the past several decades, various incentive and pricing regimes have emerged for energy-related social costs, as have voluntary efforts to establish more responsible supply chains. The systems that rely on regulatory-compliance frameworks either charge polluters for a share of finite pollution rights, or compensate producers of renewable energy for the gap between required rates of return and prevailing market prices. SOX and NOX markets in power, PTCs and RECs in renewables, RINS in biofuels, and various regional carbon-offset programs are examples of this market evolution.
On the voluntary side, some commodity producers have relied on branding efforts to market more responsible production. Examples include fair-trade coffee, deforestation-free palm oil, and recycled aluminum. By and large, however, those voluntary markets do not involve any pricing differentiation at the wholesale level, but rely on stated claims (with varying degrees of rigor) at the point of consumption, usually in retail. In neither case—regulatory or voluntary markets—is there a widespread, transparent mechanism to price externalities across an entire product class, for example in oil or natural gas. Yet the ability to differentiate responsible production will be a critical mechanism in the market transition to come.
Beyond the valuation of carbon intensity, producers are now faced with increasing calls from investors, employees, regulators, communities, and stakeholders to treat externalities as vital information.
Many producers are responding with concrete calls to action. BP has made a commitment to lower fugitive methane emissions to less than 0.2%, for example. Stakeholders are demanding transparency and accountability with respect to these commitments. Regulators in particular are inclined to mandate proscribed actions (e.g. “install vapor recovery”) as opposed to setting goals (e.g. < 1% leakage), and allowing producers to economically optimize actions to achieve those goals. This is because they’re disinclined to believe producers’ claims of performance in the absence of reliable, independent data. Producers would prefer goal-oriented policies, but the only way to get them is to guarantee transparency. Therefore, accountability will be a second bedrock tenet in the transition economy.
The New Data Economy
The emergence of computing technology has radically transformed business processes and markets in every sector of the economy. Retail, music and video, telecommunications, and the media industries (among many others) have all been re-aligned around new digital paradigms. Yet the transition to digitization is nascent in some areas, and has yet to reach its full potential. The world of physical energy is one such area. But recent advances in digital technology are poised to envelop this industry as well.
The “internet of things” (IoT) and “big data” are two trends poised to remake the energy industry. IoT is the ability to collect data, often remotely through telemetry, at innumerable nodes along a physical system. Data can include meter readouts from gauges, valves, and pressure sensors, or satellite imagery of gasses invisible to the naked eye. Much of this data has been available for years, but recent advances in cellular technology and the ability to cheaply manufacture ever-smaller sensors has created an explosion in potential data nodes. At the same time, radical advances in data science have increased the ability to process this enormous pool of data into meaningful, actionable information. Similar advances in artificial intelligence hold the potential to automate and optimize business decisions on a massive scale.
The implications in energy markets are enormous. The dual requirements of converting to a low-carbon economy—differentiating products and ensuring accountability—are within reach by combining IoT and advanced data analytics. Xpansiv will be at the heart of this remaking of the energy world. Our platform transforms energy-production data into Digital Feedstock, a new, standardized format that records deep insights—based on existing information—to more accurately value global commodities. Digital Feedstock combines data science, cryptography, and distributed-ledger technologies to securely track and transfer source data to create intelligent, impact-inclusive commodities.
For the first time, the way energy is produced and shipped will directly influence its value in the marketplace, enabling unprecedented transparency and accountability.
In Part II of this post, we’ll explore how Xpansiv creates Digital Feedstock, which will empower the new market paradigm.