IEEFA Update: New Oil Price Volatility Will Help Drive Transition From Fossil Fuels

U.S. Reversal on Iran Creates Market Disruptions That Affect Consumers, Investors and Whole Countries

Oil prices were already on the rise from strong economic growth, rising demand and OPEC supply cuts when political intervention in the markets via the Trump administration’s decision last week to abandon the Iran nuclear deal sent prices to almost $80 per barrel—or a half a mile from heaven—for Saudi Arabia, Russia, the United Arab Emirates and U.S. oil producers.

Will prices crash back to earth now or continue to rise? The impact of changes in the flow of oil from Iran, and the responses of other nations to any sanctions, remains to be seen. What’s plain is that the volatility implied in this recent price spike has major implications for world markets—and for the gathering trajectory away from fossil fuels.

Who wins and who loses?

First, the short-term “winners.” With the likely reduction of Iranian oil on the global market, Saudi Arabia, Russia, the UAE, and U.S. producers are poised to sell more oil at higher prices. Public budgets and political elites in non-U.S. oil-producing nations will benefit, as will some of the smaller state-owned operations. To give a sense of proportion, an increase of $5 per barrel increases Russia’s annual oil revenues by $20 billion (and prices have gone up approximately $37 per barrel since November 2016).

When will price spikes finally become unacceptable?

U.S. oil producers will ramp up production. These increases may lower prices and undermine the current OPEC agreement, which is up for more discussion in June. Competing incentives within OPEC—increasing market share or keeping prices high—will dominate the meeting.

The short-term “losers” include India and Japan. These countries have put out recent warning signals on inflation, trade imbalances, fiscal distress and curtailed estimates of economic growth. India’s public finance leaders, eyeing the next elections, are cobbling together near-term strategies to buffer households and businesses from energy prices that are already too high.

Consumers in the U.S., who have seen a 25% price increase in the cost of retail gasoline since November 2016, will likely see $3-per-gallon gas at the pump, just in time for summer, with a noticeable impact on those who live in rural areas, who drive long distances to work, or who have modest incomes. News outlets are pointing out that for most working people, last year’s tax cuts have been essentially nullified by this year’s gas price increase. Airline ticket prices will also likely rise.

Investors—especially those in oil and gas companies—will be battered by rapid movements in the markets. Coming out of five years of oil and gas industry distress, oil stocks are now far more sensitive to cash considerations than in the past. Shareholders are demanding increased cash flows rather than distant profits from faraway oil fields.

ONE UPSHOT OF THESE TRENDS IS THAT LOWER-COST ENERGY WILL ULTIMATELY ACHIEVE DOMINANCE, replacing “price shock” in markets.  The question is when?

Consumers and investors have growing number of alternatives to coal, oil and gas—alternatives that will likely help combat the disruption caused by rising prices and volatile markets.

In the U.S., for example, coal has lost considerable market share to natural gas and renewable energy. Technological breakthroughs in solar, wind, and energy efficiency have created cost-efficient alternatives to inflationary, climate-destroying and economically disruptive fossil fuels. Technological advances in the transport sector, including electrification, are likely to curb demand for gasoline.

The question for the markets is when will lower-cost forms of energy hit a tipping point for households, business and the economy as a whole? When will oil and gas price fluctuations no longer “shock” markets and national economies, and simply be a small and manageable part of an energy- and technologically- diverse, less-polluting portfolio of choices? What benchmarks will measure this transition to a low-carbon future?

The question for national governments is when will price spikes finally become unacceptable? Cobbling together “solutions” that drive up fiscal deficits, weaken currency, increase trade imbalances and undermine growth is poor public policy. More aggressive investment in renewable energy and electric vehicles can lower costs and lift economies. The rapid rise in renewable energy in China, India, the U.S., and Brazil shows how renewables can serve as national security tools and as a bulwark against job losses during normal down cycles of fossil fuels.

The question for investors is whether they are being sufficiently rewarded for the risk of investing in a volatile market sector? Or, are their returns now dictated by presidential tweets?

DETERIORATING FUNDAMENTALS CONTINUE TO DOG THE FOSSIL FUEL INDUSTRY, and when the dust settles, the same dynamic seen in recent years will remain: a largely oversupplied market. When oil prices decline again, political organizations like OPEC, in concert with national governments including that of the U.S., will likely intercede to raise them again in service to the fossil fuel industry. These efforts will be aimed at offsetting deteriorating fundamentals—oversupply, overleverage, ongoing cost strains and competition from new technologies—with political alignments that create winners and losers.

Fossil fuel decline will not follow any formula, script or straight line. Neither will the advancement of alternatives. The winning strategy for investors is uncertain; the imperative for the climate is clear.

Tom Sanzillo is IEEFA’s director of finance. Kathy Hipple is an IEEFA guest columnist and finance professor at Bard College’s MBA program in sustainability.

 

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