IEEFA Update: The Many Risks in Rising Oil Prices

OPEC member nations alongside other oil-producing countries yesterday announced the continuation of production cuts through 2018 in a move designed to keep prices rising.

Last year, as the first wave of recent production cuts kicked in, oil prices were $45 a barrel. They have since risen 28 percent, to $58. While this upward trajectory is being hailed by oil companies and some stock analysts, rising prices come with costs and risks.

Chief among them: Prices at the pump will go up pretty much worldwide.

IEEFA is watching specifically for fallout from the following effects:

• In India, the world’s second-most populous country, inflation, trade deficits and fiscal imbalance will increase, creating headwinds for Prime Minister Narendra Modi’s reelection push in 2019 as higher oil prices burrow into India’s economic life.
• In China, higher oil prices will drive up cost of production in factories and will undermine profits and make economic growth targets harder to hit.
• In countries like Japan, the Philippines, and South Korea, higher oil prices mean higher prices more broadly and higher interest rates.
• Even producer countries are sensitive to the effect of rising price. More oil revenue will help Vladimir Putin get reelected as Russia’s budget improves as a result of high prices. But longer-term low prices benefit the Russian economy, which is why Putin has been the most hesitant of the signatories to extend production cuts. Each OPEC decision, incidentally, is an opportunity for Putin to gain political leverage.
• Rising prices will bring more production on line in the U.S. and South America. Canadian oil becomes more competitive, and non-OPEC producers in North America and South American will gain at the expense of those cutting supply—until oversupply forces prices back down again.
• While short-term price increases are supposed to result in stock price increases, that’s not what has happened recently. As the price of oil has increased this year—again, by 28 percent—Exxon-Mobil’s share price has dropped 6 percent.

GOING FORWARD, INVESTMENTS IN RENEWABLE ENERGY and electric vehicles are clearly more attractive than oil. But will this be enough during this cycle of production cuts to limit the levels and duration of price increases? Will consumers change their habits in the wake of yet another period of high gasoline prices? Will these recent production cuts return the markets to a condition of oversupply?

These are the wild cards.

One very knowledgeable player—Norway—is considering a policy shift that bodes ill for oil  : the country’s $1 trillion pension fund may soon remove oil and gas holdings from its benchmark index. Few people know oil better than the Norwegians. They see long-term low prices, regardless of recent production cuts, and significant fiscal pressure resulting. They also are concerned with market price volatility.

Norway, which balances its budget with North Sea oil revenues, is seeking budget stability, which —in the fiscal world—means cash. While private investors can fool around with short-term cash plays and gimmick-riddled valuations for a time, public budget managers cannot. So Norway is of the view now that oil stocks more closely resemble speculative investments than secure, blue chip, stable, steady, healthy stocks. Norway will still invest in oil, probably shorting oil stock more often and buying and holding more selectively, but buying less often.

Norway is not alone. Many major oil- and coal-importing countries are re-examining their energy- investment policies. IEEFA has reported, for instance, on initiatives by large fossil fuel consumer nations like India and China to integrate more renewable energy into their electricity systems, motivated by cost, public-health issues, environmental concerns and inflation. China and other countries are looking also to tighten fuel standards, as well, as markets move toward electric vehicles.

A MICROCOSM OF THE RISK IN FOSSIL FUEL OVERRELIANCE can be seen in Puerto Rico, a U.S. commonwealth of 3.5 million residents that is looking to rebuild its entire grid system. Puerto Rico’s electricity company ran on oil, gas and coal for decades, and before Hurricane Maria the Puerto Rico Electric Authority spent close to half its annual $4 billion budget on imported fossil fuels.

The island’s utility regulator supports a lower-cost fuel mix, starting with more solar energy, broader uptake of energy efficiency, and far less reliance on fossil fuels. So far, however, the powers that be in Puerto Rico, while rejecting an oil-based future, remain wedded to natural gas and coal and opposed to scaled-up renewable investment.

With Congress, the governor and fossil fuel interests aligned with oil and gas interests on Puerto Rico, the island is at danger of repeating its past, one that left it vulnerable to price volatility and high, uncompetitive and inflationary electricity prices.

As oil producers engineer price hikes, this is the stuff to watch.

Tom Sanzillo is IEEFA’s director of finance.

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