How will low oil prices affect renewables?

When leaders met in Davos last week to discuss the energy sector, the 2015 context they faced was a stark contrast from just a year ago. “Last year, as smart as we all were, we never talked about oil going down from a hundred [$/b] to below fifty [$/b],” said Lauren Fink, CEO of BlackRock, as he opened the World Economic Forum on the global economic outlook.

So unexpected was the drop that as recently as October you could have bought January puts to sell WTI oil today at US$70/b for 50 cents apiece. This new oil reality could mark the return to an energy context where supply exceeds demand—the historical norm of energy prices being dictated by the marginal cost of the last barrel of oil demanded—as opposed to the bidding frenzy stemming from demand outstripping supply.

One driver behind this change is the increased investment in oil production in response to high energy prices. Combined production across Algeria, Angola, Libya and Nigeria has increased by 0.9mb/d since January. Non-OPEC nations are also producing more, with the IEA expecting their oil production to increase by 1.3mb/d in 2015, on top of a 1.9mb/d increase in 2014. Most important, the US is now the world’s largest oil producer, producing 9.1mb/d today—up from just 5mb/d in 2008.

Meanwhile, the EU and Japanese economies have failed to take off and China has begun to slow, which is dragging down growth in emerging markets and, with it, oil demand. Simultaneously, the US economy has rebounded, further pushing down the price of oil—since it is priced in an appreciating US dollar. With reduced demand and increased supply, it is no wonder that price went down.

Another key determinant in today’s price level was Saudi Arabia’s (SA) November decision not to cut oil production to prop up oil prices, which effectively removed a critical floor for oil prices and sent Brent down to $49/b as of January 27. This decision was driven by SA’s belief that any cuts it made would be quickly replaced by others, thus resulting in a loss of market share and revenue only for SA. While prolonged low oil prices will hurt SA, it has plentiful reserves, $750bn, low debt and easy access to international markets—it thus believes that it can outlast all the other players in the oil game.

Other petrostates won’t be as fortunate. Venezuela is already expected to default, which would have dire implications for the Central American and Caribbean nations that have been relying on the largesse of Venezuela’s Petrocaribe programme for their oil imports. Meanwhile, Russia is coming off its worst economic period since the 1998 rouble default and facing the possibility of having to implement capital controls if its recent attempts to protect the rouble fail.

On the positive side, if sustained, the fall in oil’s price could be a powerful boon to the global economy, lifting growth rates by 0.7% in 2015 and by 0.8% in 2016, according to the IMF. With global growth weakening, the timing for such a boost is serendipitous. The biggest winners will be the world’s consumers and their disposable incomes. Of importance, low oil prices will also open a window of opportunity to cut fuel subsidies with minimal harm to citizens. The freed funds could then be spent on infrastructure, education and healthcare—building the foundation for stable growth, lowering oil demand relative to GDP and further sustaining lower oil prices. This, notes Thomas Maier, managing director for infrastructure at the European Bank for Reconstruction and Development, is precisely the approach chosen by the Indonesian government, which “has taken the oil price decline over the last few months as an opportunity to cut oil subsidies from the public budget and is now redirecting these funds to health, education and construction for infrastructure”.

The energy sector itself will also feel the effects of these changes. Upstream, investment in new oil production is expected to fall, with Goldman Sachs noting that at least $930bn of planned projects now risk being cancelled, possibly eliminating 7.5mb/d of production come 2025. Many of the projects will likely still go forward after cost-cutting measures are implemented—largely affecting oil service providers—but high-cost or risky fields like deep sea or the Arctic may only be profitable with oil near its summer highs. This could prove a challenge to Brazil’s ambitions of developing its offshore pre-salt fields. Similarly, Mexico may face demands for additional concessions in its auctions as it begins privatisation—although it is likely to resist such efforts because of the quality of its offerings, at least for the first auction round.

As for renewables, the impact should be minimal and indirect since—electric vehicles aside—there is no direct substitution with oil-derived products. In the US, where 18% of natural gas comes as a by-product of oil wells, the decline in oil production could lead to a rise in natural gas prices—positive news for renewables. In Europe, where gas prices are often indexed to oil, a drop in oil prices could also make gas become more competitive with respect to coal.

More important for renewables will be the coherence, stability and predictability of energy policies. Greater integration of electricity markets will also matter, notably in the EU, to attract the necessary investments in the electricity sector – $8trn by 2040 in OECD alone, according to the World Economic Forum.

Impact on renewables or not,  it is clear that low oil prices are a major novelty in the energy scene. And while a low prices do not imply low volatility, there is not doubt that if sustained, this new reality will shape the energy world of 2015.

This article is published in collaboration with GE Look Ahead. Publication does not imply endorsement of views by the World Economic Forum.

To keep up with the Agenda subscribe to our weekly newsletter.

Author: Drew J. Hart writes for GE Look Ahead

Image: An attendant prepares to refuel a car at a petrol station in Rome. REUTERS/Max Rossi