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Energy is plentiful. Well before anyone had heard of Coronavirus it was clear that the world had more available oil and gas than it needed. The International Energy Agency described the situation in the gas market as a “glut”. OPEC and the United States were in a fight for shares of the oil market. The economic downturn which has followed the pandemic has only made the situation worse. Energy supplies are sufficient – but that does not mean that energy security is assured.
Oil prices, after a roller coaster year, have stabilised at around $ 40 per barrel – a price lower in real terms than it was 50 years ago. Even that price has only been achieved by the removal from the market of billion barrels of supply under the quota system agreed by OPEC, Russia and other suppliers. At peak in the spring the cuts amounted to as much as 9.6 mbd. Alongside these managed reductions production from Iran, Venezuela and Libya remains well below potential for political reasons.
European gas prices have recovered from the depths of the trough seen in the second quarter but remain more than 20 per cent below the levels of a year ago. Global natural gas demand is predicted by the IEA to fall by 4 per cent year on year in 2020.
At the same time new supplies of electricity produced from ever cheaper renewables, such as solar and wind, continue to be brought on stream, adding a new challenge to an already fiercely competitive power generation sector.
The response to the spread of Coronavirus has reduced demand around the world – on current estimates oil demand will be down 8 million barrels a day year on year in 2020 – but the ending of the pandemic will not in itself remove the excess of available supplies over effective demand. The excess of supply seen at the beginning of this year will still be evident.
The old fears for energy security are therefore largely outdated. From the 1970s onwards the prospect appeared to be one of finite resources being exhausted as demand rose, of ever increasing prices as the industry moved to areas with high production costs such as the deep waters of the Atlantic and the Far Northern North Sea, and of the use of oil and gas as political weapons as dependence on supplies the Gulf States and Russia grew.
Those fears have been overtaken by technology. The advances in hydraulic fracturing has led to the creation of the shale industry in the US. The growth in production from shale rocks has made the US self sufficient in both oil and gas and has therefore transformed a global market in which large scale US imports had become the expected norm.
Technology also reduced costs across the industry. Less than a decade ago the common assumption was that a price of $100 was needed to sustain production in most areas other than in the large-scale onshore fields of the Middle East. Now, even at current prices, the industry has managed to cope even if margins are thin. Very little production in the North Sea or in the onshore of the Lower 48 states in the US has been closed down. Technology has allowed existing fields to remain viable and has enabled the industry to take on new products for instance in the deep waters offshore Brazil which would have been uneconomic a decade.
At the same time different technologies have transformed the ways in which we use energy, improving efficiency and limiting demand growth. In 2019 Europe, the United States and Japan all used less energy than they had twenty years earlier despite two decades of economic growth. The UK remarkably used less energy in 2019 than in 1965.
By enhancing supply and limiting demand technology has rebalanced the market at lower level of prices despite the growth in energy use which is driven by continuing population growth and the spread of prosperity particularly in Asia.
The old definition of energy security is outdated but the security of energy supplies remains a critical concern. The concept has been redefined against a new set of insecurities.
The first two of these insecurities come as a result of the continuing surplus of potential supply over demand. Technology, in particular the shale revolution, has already increased supply and looks set to add more in the US and elsewhere. Other technical advances – in drilling, reservoir management and the extensive use of digitisation – will increase the productivity and production potential of existing fields. Technology will also increase the capacity for substitution away from oil. Predictions that we are at the point of “peak demand” or even past that point are profoundly destabilising for those who have become dependent on oil for their national income. The perception that oil demand is set to decline could encourage some producers to maximise output in the short term in an attempt to get ahead of a falling price, a move which however logical for an individual producer can only add to the downward pressure on the market as a whole.
Falling prices will hurt those who have become dependent on oil revenue and in particular those who have failed to diversify their economies. Many have growing populations, large parts of which are dependent on public spending in one form or another. The latest published estimates suggest that many producers need prices well above current levels to maintain their fiscal balances of income against expenditure. According to the most recent estimates the breakeven price required by most exporters is well above the current level of $40 per barrel.
A study produced at the beginning of this year by the IMF argues that on the basis of their current policies and fiscal stance the existing financial wealth of the Gulf region could be depleted away within the next fifteen years. The dramatic fall in prices earlier this year makes that prediction all the more credible.
The risk is that countries which are already unstable will become even more so. The shift in the overall energy mix will not be instant and oil demand will not collapse overnight. Given the entrenched demand, particularly in the transport sector, a long plateau with demand between 90 and 100 million barrels a day is much more likely than a sudden decline. In a well-managed world there should be time for adjustment but neither the world, nor many of the countries concerned are well managed. Financial instability would further weaken already fragile governments raising the possibility of serious social instability and even state failure.
Oil and gas exporting countries are not the only potential victims of the age of plenty and not the only cause of insecurity in the energy market.
The private sector, especially the international oil companies, is also suffering from the deflationary impact of over supply.
The graph below shows the stock market performance of the oil and gas sector against the wider market index over the last year. Although there have been exceptions (most notably Equinor) the valuation of the energy sector as measured by FTSE Oil and Gas 350 index has fallen by almost 60 per cent.
The loss of value in the sector has been partly driven by the impact of CV19 on profits and dividends. But it also reflects a longer-term structural shift in sentiment.
The next graph shows the decline of energy stocks against the S and P 500 index in the US over the last decade.
The energy security risk arising from these trends is that investors might be unwilling to fund the huge long-term investments needed to maintain supplies not just of oil and gas but also nuclear power and renewables. Nuclear has already been forced back into reliance on state support of one form or another. Renewables, although continuing to grow in volume, have fallen in cost to the point where through price subsidies or market shares guaranteed by Governments are no longer necessary. Energy markets are crowded with suppliers competing by pushing prices down. The result may be good for consumers in the short term but for potential investors the market is characterised by risk and low returns.
The scale of investment in energy required over the next decade has been estimated by the International Energy Agency on the basis of existing policies at some $2.4 trillion, a figure which rises if the commitments to sustainability are to be met by an $300 bn.
Energy demand will recover from the recession of 2020 and in aggregate will continue to grow even if there are further significant efficiency gains. The world gains close to a quarter of a million new citizens a day. Most of them can now afford to buy least basic levels of commercial energy.
For investors the challenge is that however strong the prospects for demand might be the sector is both fiercely competitive and rapidly changing. No specific technology is a safe bet for the future. Advances in science and engineering offer the prospect of more disruptive technologies including hydrogen and energy storage, both of which stand to benefit from financial support under public policies such as the European Union’s Green Deal. Both have the potential to transform and in some cases destroy the business models of existing companies working in the sector.In technical terms the energy sector, having been largely stable for the last hundred years, is set to be reshaped beyond recognition. For the winners there will be great prizes. The problem, and the source of insecurity, is that investors cannot know who those winners will be and may therefore hold back their funds.
The other crucial dimension of instability and risk is the looming threat of climate change. Despite almost 25 years of serious scientific and economic debate since the Kyoto meeting in 1997, emissions have continued to rise as does the level of atmospheric carbon concentration. 2020, because of the economic recession, has brought a limited fall in emissions – most recently estimated at around 4 per cent year on year. But as the graph below shows the history of recessions is that such blips do not disrupt the trend line for long.
The absence of a fundamental and lasting shift following the Paris agreement of 2015 has raised the political salience of the issues. Campaigners have declared a climate emergency and Governments of all shades have adopted green agendas. The EU has developed a Green New Deal and many countries across Europe have committed themselves to an energy transition designed to result in zero net carbon economies by 2050. France, Denmark, Sweden and the UK have already enshrined these commitments in law.
The geopolitical dimension of the energy transition arises from the absence of any unified view on how to deal with the ultimate global challenge. The EU can no doubt achieve something close to zero net carbon over the next thirty years through a mixture of regulations and fiscal measures. The transformation of the existing capital stock of vehicles, industrial plant and buildings designed to be powered and heated by fossil fuels – will be expensive but is not impossible. Reducing the use of coal in Eastern Europe will require extensive compensation but again can be achieved if the political will is sustained.
But creating a clean Europe in a dirty world will not solve climate change. European emissions account for less than 10 per cent of the global total and even that figure will decline as the emerging economies of Asia, Africa and Latin America grow.
China, India, Indonesia and numerous other economies continue to depend on coal, often produced locally and therefore a source of both jobs and energy security. China’s recent long-term commitment to reduce emissions has been welcomed but the key indicator to watch will be the decision on how that is translated into actions driving China’s energy use over the next decade.
The source of the potential geopolitical challenge focuses on trade. As part of its Green Deal the European Union is already considering the erection of trade barriers to ensure that the costs being imposed on European companies and individuals do not lead to an exodus of businesses for which energy costs are significant.
The policy of border tariff adjustments is undeveloped but is considered necessary to sustain public support for the policies necessary to reduce emissions on the timetable required. The risks are considerable, particularly in terms of retaliation. European prosperity depends on access to the growing markets of the emerging economies. New tariff barriers could limit the development of open international trade and investment flows. They could also threaten the close links between Europe and the United States if the two sides of the Atlantic adopt materially different approaches to the climate agenda.Beyond trade policy, climate change could pose a more immediate set of political challenges. According to several authoritative studies the impact of climate change is likely to be concentrated in areas which are already vulnerable to shortages of water and the consequential risk of crop failure and famine. A band of risk stretching across North Africa and into the Middle East could result in large areas becoming close to uninhabitable. Many are already unstable. The risk is that significant numbers of individuals are forced to move under the pressure of necessity.
Europe already faces the challenge of migration driven by political instability and conflict. The risk of further, more substantial migration driven by the consequences of climate change are real, and given the unknown and unknowable time scale of extreme weather events could occur much sooner than expected.
The final element of insecurity arises from a further fundamental shift which has taken place in the energy market over the last 20 years – the dramatic change in the pattern of trade.
Energy consumption in the developed world – consisting of Europe, the US and Japan has plateaued thanks to efficiency gains. In addition, over the last decade the development of the shale industry has transformed the US from being reliant on international supplies into an exporter of both oil and gas.
Little more than a decade ago the consensus of opinion within the oil industry and within independent institutions, such as the US Energy Information Administration and the IEA, was that the development of the resources known to exist in shale rocks was never likely to be commercial. As late as 2008 the IEA’s World Energy Outlook said that “oil shakes are not projected to make a significant contribution to world oil supply before 2030” and put much greater emphasis on the prospects for heavy oil and supplies from the Arctic.
Since then in defiance of the conventional wisdom the technology of fracking has produced steadily increasing volumes of supply. From less than 1 billion cubic feet per day a decade ago US shale gas production had risen to 8 bn by the beginning of 2020. Over the same period US tight oil production rose from less than 1 million barrels per day to 7.7 mbd. Over the period the estimate of recoverable reserves has risen, and costs have fallen dramatically. Once believed to require prices of $100 the consensus of predictions at the end of 2019 was that with oil prices of around $50 a barrel, production of tight oil in the United States will continue to rise to over 11 million barrels per day by the mid 2030s. The collapse in prices caused by CV19 has tested the resilience of the industry. Some developments have stalled, companies have failed, and some supplies will undoubtedly be shut in while producers wait for prices to rise again. The potential, however, remains in place and will continue to set a ceiling on global prices. Additional production from Argentina, China or one of the other countries where a base of shale resources has been identified, is just beginning and could add material volumes to supply over the next decade.
At current levels of production, the United States can maintain net self- sufficiency in both oil and gas for the next two decades and possibly longer. Imports, which a decade ago were forecast to rise to more than 12 mbd by 2030, will not be needed. Instead the US has become an exporter. This swing is transforming the pattern of global trade and has forced OPEC back into an uncomfortable position as the swing supplier, sacrificing export volumes and revenue.
Energy security has not disappeared, but the risks and concerns have moved eastwards. More then half of the world’s daily consumption of almost 100 million barrels a day is traded internationally. Europe and Japan are still major importers. But the major shift in geography of trade is the result of growing Asian demand. China alone now consumes a quarter of all the energy used across the world each day. Energy insecurity is now a challenge not for Washington but for Beijing. Chinese oil imports have grown from almost nothing in 1980 to over 10 mbd by the beginning of 2020. The reduction in Chinese demand caused by the CV19 crisis and subsequent economic downturn earlier this year is likely to be strictly temporary. The signs of an upturn in demand were evident by the late summer. The underlying factors driving growth are extremely strong. Indian demand is more limited, with imports of just 3.7 mbd last year but there too the pressures of urbanisation and the expansion of personal mobility are set to push demand and therefore oil imports up to 7 mbd or more over the next decade.
Most of the oil exported from the Persian Gulf through the Straits of Hormuz now turns East rather than to the US or Europe. Iraq, said by some to have been the subject of a war for oil, is now a key supplier to Asia rather than America.
How China and other Asian economies deal with their new levels of dependence will be one of the key geopolitical questions of the next decade. China alone now imports almost 5 mbd from the states around the Persian Gulf. China has developed in different ways its diplomatic presence in the region and has assisted attempts by the West to limit conflicts in areas such as Syria. Beijing is clearly aware of its growing stake in the integrated global economy. There is no obvious appetite for military intervention to maintain “stability”. More likely perhaps is engagement through investment – something already evident in Iran and Iraq and through bilateral deals as evidenced by the extensive loans provided over the last decade to Venezuela in return for oil supplies. If instability does return to the market it is perfectly imaginable that China will seek to ring fence its own supplies – a logical strategic move but a step which can only increase the risk of volatility for other buyers.
Energy supplies are more than sufficient and are cheap relative to the prices which have prevailed over the last half century. But an age of plenty is not automatically a time of stability and security.
The events of the last few months have demonstrated how reliant the world is on continuous supplies not just of oil, gas and coal but also now of electricity. The communications which have allowed the economies to remain operational could not run without power. Energy is as essential as ever and the linkages from production to processing to distribution and finally to the consumer are if anything more complex and more interdependent. Energy carries a cost which is not just financial. The environmental costs are not factored into the prices we are accustomed to paying but they exist and the need to deal with them is beginning to reshape the whole sector. Maintaining supplies requires investment on a dramatic scale, but for investors the risks are more evident than the returns.
The definition and the details may have changed but energy security is as important and as vulnerable as ever.