Oil prices have gone up and down lately due to the coronavirus crisis, difficult OPEC negotiations and not least overflowing oil inventories. Nordea’s energy expert Thina Saltvedt tells about her view on the oil industry and what will happen when the transition to renewable carbon-free energy sources picks up speed in earnest.
Why have oil prices plunged?
- There are two reasons why oil prices have collapsed. The oil market has been hit by two shocks at the same time – the coronavirus pandemic on the demand side and the price war between Saudi Arabia and Russia on the supply side.
When a market is hit on two fronts simultaneously, it’s more difficult to recover.
First, oil prices plunged following a historical collapse in demand for oil. During the coronavirus pandemic a lot of aircraft have been grounded and about 1 billion people have been affected by the travel restrictions. This more or less wiped out about 30 per cent of global demand for oil in the course of a few weeks in March. We’ve never experienced anything like it.
Will lower oil prices not trigger an increase in consumption?
- That hasn’t happened this time. Lower oil prices are normally an incentive to increase the consumption of oil products such as petrol and diesel. But as transportation accounts for 60 per cent of the world’s oil consumption and most aircraft are grounded and more than 1 billion people are affected by lockdown, quarantine and isolation, price signals have not stimulated demand. People quite simply cannot travel even though prices are lower.
However, global demand for oil is expected to pick up unless the world economy slides into a deep recession. As we gain control over the coronavirus pandemic and the economies gradually start to reopen, the need for energy will return. Activity has already increased in China, and several European countries and US states have begun to plan for the coming reopening.
But it is nevertheless being debated whether the pandemic could have more permanent consequences for global oil demand. Our travel patterns and use of digital communication may have changed for good, which could mean that global oil consumption will never return to the pre-pandemic level of about 100bn barrels per day prevailing in early 2020.
Could Russia and Saudi Arabia have a common interest in lowering the production of US shale oil, as producers of shale oil rely on comparatively high oil prices to achieve profitability? Or is it “everybody’s war against everybody” at the moment?
- While the pandemic rapidly spread from China to other major oil-consuming regions such as Europe and the US, a price war broke out between two of the world's leading oil producers – Russia and Saudi Arabia.
And the conflict seems to be rooted in a more permanent shift in the competitive situation in the oil market.
The price war started when Russia left the OPEC+ cooperation that was launched in December 2016. After the oil crisis in 2014 and the two following years, OPEC was forced to ask for outside help to cut oil production enough to restore balance in the market and secure higher prices. The coordinated production cut was successful in raising oil prices. But the problem for OPEC+ was that it prompted a rapid rise in the output of shale oil in the US. In March 2020 Russia therefore declined to participate in an additional output cut as this would strengthen US dominance in the market. Saudi Arabia responded by turning up the taps and lowering prices towards Asian customers.
Russia will not be the first to back down; that will be the US shale oil companies.
Can Saudi Arabia put pressure on Russian oil producers so they have to resume cooperating with OPEC?
- Russia will not be the first to back down; that will be the US shale oil companies. The question is how long many of these companies can survive with low oil prices before they have to stop production and in a worst-case scenario will go bankrupt? According to Bloomberg most shale oil companies need an oil price above USD 45 per barrel to break even. Shale oil companies are often small and many struggle with a stretched liquidity position. That is why we have already seen a sharp decline in oil rig leasing, oil production is starting to decrease and bankruptcy petitions have been filed against more than one company.
Saudi Arabia probably has the world’s lowest production costs and can keep going with a price below USD 10 per barrel. The country needs an oil price above USD 80 per barrel to balance the government budget but can draw on national oil funds for a period of time to starve out other producers with higher costs. Russia, on the other hand, only needs an oil price around USD 40 per barrel to balance its government budget. They have higher production costs than Saudi Arabia, but lower costs than the US.
Although a price war is raging between Saudi Arabia and Russia, both countries have, for both competitive and political reasons, an interest in punishing the US with lower oil prices and a smaller market share. The US became the world’s leading oil producer in 2014. Thanks to the production of shale oil, the US has not only become a net exporter of oil. It has also changed the political power balance. The reason why Russia and Saudi Arabia resumed negotiations on the agreement to cut production just two weeks after it came into force was not only the steep dive in demand but also considerable political pressure from the US. Comparatively low oil prices were important for former President Donald Trump in an election year, but he also had many supporters in the oil sector where jobs will now disappear due to the low oil prices. That is why it was important for the president to drive up oil prices to a level that supports the shale oil industry.
The global economy is stagnant at the moment and demand for oil has plunged dramatically. Will this be the most serious crisis that the oil industry has experienced for a very long time? And how will this affect the many jobs in the Norwegian oil industry?
- The low oil prices hit oil investment activity hard. Several oil companies have already announced scale-backs in investment activity of 30-45% in 2020 and 2021. This is also the case in Norway and it will of course have severe repercussions for the Norwegian oil industry. When oil producers scale back their investments in new projects, demand for oil services and other related supplier services also declines sharply. Demand for seismic surveys, rigs and vessels decreases and companies are forced to lay off employees temporarily or, worst case, permanently. The authorities have now introduced measures to help the oil industry through the coronavirus crisis, to counter the number of job losses and loss of knowledge and competencies.
Some predict that the end of the oil age is near. How do you view the future of the oil market in the longer term, and for how long will the world continue to rely on a growing oil industry in light of the more climate-friendly, fossil-free energy solutions of the future?
It is important to bear in mind that the oil industry was already under pressure before the coronavirus pandemic paralysed the global economy. When the global economy gradually starts to recover after the pandemic, the oil industry will be facing three major changes that will put pressure on the market and prices in the longer term. These three changes are:
- The oil market and oil prices are no longer controlled by the powerful OPEC cartel, but increasingly by three major players: Saudi Arabia, Russia and the US.
- Global oil consumption must be cut back sharply over the coming 20-30 years to counter climate changes and the climate crisis. Consequently, oil producers will have to compete harder to deliver oil to a constantly shrinking customer base.
- With climate risks high on the political agenda and three price collapses in 12 years, it will be become increasingly difficult to attract investors and capital to finance new projects. Lower oil prices also threaten the high profitability of the oil industry.
- The time when global demand for oil peaks seems to be approaching. According to my calculations, demand will peak between 2025 and 2030 and then decline. Some of the key reasons are the electrification of the transport sector, sharply decreasing prices of solar and wind energy and battery technology. Other types of fuel, such as hydrogen gas, will capture large parts of the market. This could trigger greater uncertainty and more oil price collapses also after the pandemic. Oil companies must prepare for more periods with low oil prices.
Several oil companies, particularly in Europe, have already embarked on a transition towards a broader energy portfolio. Many companies have started to invest in renewable energy sources, infrastructure or other solutions with low CO2 emission. Moreover, many companies are under pressure from banks, customers, business partners and environmental organisations to lower their CO2 emission and change their business strategy in alignment with the Paris Climate Agreement. That is why it is important that oil companies do not halt this transition due to the current crisis.
But will investments in renewable energy and green solutions not decline now that the coronavirus crisis has driven oil prices so much lower?
- I think that companies focusing on renewable energy have a much stronger position now compared with previous crises; even a better position than companies relying on oil and other fossil energy sources.
In the near future, renewable energy projects will of course be impacted by the coronavirus crisis. Many projects that were just about to be launched have been shelved or postponed as a consequence of the pandemic. Low energy and electricity prices make it more difficult to ensure sound profitability and there is a risk that countries and companies lower their climate ambitions due to the major economic challenges resulting from the pandemic. There is also a risk that the big oil companies, which now have to drastically roll back their investments, will also have to cut investments in renewable energy and green infrastructure. However, so far several big oil companies have shown that they are still working very hard to increase their portfolio of renewable energy assets.
Thina Saltvedt lists "Companies focusing on renewable energy have a much stronger position now compared with previous crises for the following reasons":
- The costs of producing solar and wind power have declined significantly. Today, renewable energy has a much stronger competitive position against coal, gas and nuclear power than in 2008. In many areas around the globe, solar and wind power is now outcompeting fossil energy as a result of low production costs and not because of subsidies.
- The costs of producing batteries have plunged since 2014 and the same goes for the costs of solar and wind power. Electric transportation is therefore much more competitive now than during the latest period of low petrol prices in 2014-15. But the future of electric transportation depends on politicians in many countries maintaining their climate ambitions.
- The general commitment to renewable energy is more widespread today compared with 2008 and 2014. The technology is more modern and well-known also among investors and financial market players.
- Renewable energy projects are often capital-intensive and thus benefit from stable low interest rates.
- We don’t know how the coronavirus crisis will affect our lives over time. Some of the changes forced upon us by the pandemic may become permanent. Maybe we will quite simply travel less in future. As transport accounts for 60 per cent of oil consumption, this could mean that demand for oil stabilises at a low level if we continue to meet digitally rather than in person in future.
- During the past 18 months the financial services industry’s interest in sustainability and climate change has increased sharply. Many banks and other financial institutions have started shifting away from fossil energy. Partly because of the risk that fossil energy companies will be overtaken and left behind, which would render their stocks and bonds worthless, and partly because of the stronger awareness of the risks and opportunities of the green transition. Companies increasingly have to answer questions about their carbon footprint on society. The stronger focus on sustainability and the climate has made many companies both inside and outside the financial sector more interested in renewable energy.
- Oil prices have collapsed three times in 12 years and uncertainties are growing about who will control the oil market and oil prices going forward. The balance of power is shifting compared with 2008 and 2014. The sharp increase in shale oil production has made the US a net exporter of oil. Russian oil production was halved after the dissolution of the Soviet Union, but is now back at the previous level. Consequently, OPEC no longer controls the market; now three major powers control the market and compete for market share: Saudi Arabia, Russia and the US. This will make the collaboration on production cuts between OPEC and the others more difficult. Moreover, global oil consumption will have to decrease over time if we are to meet the goals of the Paris Climate Agreement. And lower demand means intensified competition.
- The important climate summit, COP 26, at which the signatories to the Paris Climate Agreement must further increase their ambitions, has been postponed to next year. This gives the countries more time to hopefully gain better control over the pandemic. And to prepare for the meeting and formulate more ambitions targets for fulfilling the goals of the Paris Climate Agreement. The drawback of the postponement is of course shorter time to reach these targets.
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