Best of 2016: What’s Driving Energy Prices?

gas pumpAs a speaker at this summer’s Risk Management Conference at Fairmont Tremblant, Que., (August 10 to 12), Meghan O’Sullivan, Jeane Kirkpatrick Professor of the Practice of International Affairs and director of the Geopolitics of Energy Project, Harvard Kennedy School, Harvard University will talk about the geopolitics of oil. In advance of the conference, we asked Meghan a few questions about the impact of Middle Eastern politics, renewables, and shifting Chinese demand on oil prices and energy in general.

What’s driving energy prices right now?

As is always the case, many things are affecting the price of oil right now.  Supply and demand determine price, so anything that changes those parameters impacts price. I’d highlight a couple things of particular importance.  First is that this big drop in price we have seen is the result of a supply surge, much more than a diminution of demand.  In fact, demand for oil has actually picked up since 2014, spurred on in large part by the lower prices.  The supply surge is attributable both to the new shale oil or tight oil that has rushed to markets in the last few years and to the changed strategy by Saudi Arabia and other OPEC producers to pursue market share rather than protect price.

Both the politics of OPEC and the technology that made these new advances in shale possible are likely to put downward pressure on price for the foreseeable future.

But — and here is my second point — there is much speculation about a price spike right now.

Some anticipate a spike could occur as a result of the huge cuts in investment over the last 18 months that will undoubtedly affect production in the months and years ahead. Whether this price spike materializes really depends on how quickly shale production responds to higher prices, how robust global demand is, and whether other countries (for instance, Saudi Arabia) build any new capacity in the years ahead.

How do Saudi policies – geopolitics – fit into the structure of energy prices?

Many people were quick to conclude that, because the drop in oil prices was so damaging to Saudi Arabia’s adversaries – particularly Iran, animosity must be the primary motivator of Saudi Arabia’s changed oil policy. I tend to disagree and think the shift in strategy to go to an approach prioritizing market share had a lot more to do with structural changes in the oil market – and what Saudi Arabia assessed they would mean for it.

The main issue is that the advent of shale oil or tight oil has introduced an entirely new business model into the market.

Before shale, non-OPEC supply took a long time to respond to price. When the price of oil went up, producers needed to decide whether to invest huge amounts of money in investments that would only bear fruit over years. Tight oil works very differently; it requires many small investments, which create new production very quickly. It also requires continuous investment to keep production high.

Given these new dynamics, I think the Saudis assessed that, if they cut their production to raise the price of oil, the benefits might only be short-lived because this new, tight oil resource could swoop in and very quickly take the market share that Saudi Arabia relinquished.

How much of an inroad have alternative sources of energy made?

Alternative energy, particularly renewable energy, has made an appreciable impact on the world’s energy mix. In just the last few years, the prospects for these energy sources have improved significantly, on account of costs coming down. Renewable energy makes up perhaps one-seventh of primary energy supply in the world; but if we just look at the power sectors, the position of renewables is much stronger.

It is here in the power sector that renewables will continue to make the biggest impact in the coming years.

One thing to keep in mind when talking about the impact of renewables is that, as of right now, renewables can be a great substitute for natural gas or for coal (or nuclear for that matter), but they are really not yet a substitute for oil. This is because of the lock that oil has on transportation – close to 95% of the world’s transportation runs on some oil-based fuel.

Until this changes – through a massive increase in electric car deployment or something else – renewables can grow like gangbusters and not really affect oil’s dominance.

Are we seeing a structural shift in demand?

We’re definitely moving into a period where there is lower energy demand growth and likely lower oil demand growth. Over much of the 2000s, the annual growth in energy demand was very high, in large part due to China’s incredible overall growth and its energy intensive nature. Now we’re moving into a period where the demand for energy and for oil is still positive, but it growing less robustly than it had in the previous period.

Many of the drivers of energy demand growth are still positive: urbanization, population growth, economic growth – but they’re just not growing quite as rapidly as they were, say, 10 years ago.

Again, China is a big part of this story.  Its slowdown – and its efforts to shift to a less energy intensive economy overall – will be critical in shaping overall global energy demand growth.

What are the prospects for Canada’s oil sands, given high cost structures?

I can imagine that the calculations for oil sands producers now are quite difficult. The two most important variables of course are technology and price. Will producers be able to find new ways of bringing down the cost of producing oil sands?  If so, then many projects might be viable in the new energy environment.

But if oil sands continue to be more expensive to produce than, say, American tight oil – the cost of which has already declined even in the last 18 months –  the future of oil sands will probably not be too bright.

Again, technology and efficiency is the key. We saw tremendous cost-cutting due to both in the production of American tight oil. No doubt, oil sands producers will need to work equal magic if they are to have a future over the long term.

To learn more about the Risk Management Conference, please visit the conferences section of the CIR website. If you are interested in attending this event, please email Alison Webb to be considered, as limited space available.