Most people seem to believe that oil prices will go down in the long run because of climate policies and the growth of electric cars. Friedbert Pflüger, Director of the European Centre for Energy and Resource Security (EUCERS), argues that this view is far too simplistic. The only constant in energy markets, he writes, is that they are cyclical – and we seem to be poised for a sharp downturn right now.
Following the Paris climate accord of 2016, voices have been getting louder that the world is getting ready to phase out fossil fuels, particularly oil and coal, in the coming years. Amongst major oil producing countries and oil majors, talk of “peak oil demand” is making the rounds.
For example, a recent Financial Times piece pointed out that the industry is “facing a mountain of writedowns as the world weans itself off fossil fuels” and that there may be “systemic overstatement of capital and performance due to the use of overly optimistic long-term energy price assumptions.”
The suggested solution is to assume more modest price assumptions in the calculations by taking the risks of de-carbonization efforts and a resulting lower demand for oil into account.
De-carbonization is by no means a certainty
However, there are several reasons why things are not that simple.
Firstly, no one can accurately predict the long-term price of oil. There are too many variables at play. The best and most accurate price projections we can hope for are the prices in the futures markets, which in themselves are far from perfect.
Secondly, we should not forget that lower demand does not necessarily translate to lower prices. The stagflation of the 1970s demonstrated that clearly. Moreover, OPEC recently demonstrated that they are fully capable of working together with other major producers like Russia to curb production to put upward pressure on prices.
Thirdly, de-carbonization is by no means a certainty. Global leaders have promised the world a low-carbon world following the Paris agreement. To what extent they are willing – or able – to keep their promises is another matter. Two years after the accord, nearly half of the G20 countries – which in total account for some 75 percent of the world’s energy consumption – are among the worst performers of the 2018 Climate Change Performance Index. This includes huge energy consumers like the US, which famously withdrew from the accord altogether, China, Russia, Japan and South Korea.
Fourthly, a brief excursion into energy history teaches us that few things are absolute. In 1981, the World Bank reported that oil production would plateau by the end of the century. Now, some 37 years later, production seems ever increasing and new barrels are continually being discovered. Hardly anyone talks about peak oil production any more.
The Federal Reserve is signaling that it intends to continue to raise interest rates, which is putting pressure on many economies around the world with high debt levels denominated in dollars
The same dynamic applies to other forms of energy. Germany will shut down the last of its 17 nuclear plants for good by 2022. At the same time, there are 35 nuclear power plants under construction in Asia and another 70-80 planned. There will be times where one form of energy is used more at one period in time or in a certain region, and another form less.
The one constant in energy markets throughout the decades has been that energy demand and production are cyclical. This is only a general trend, but it can nevertheless be helpful in making future investment decisions.
So, what is the general trend when it comes to the supply and demand dynamics of oil going forward? Well, let us briefly examine the peak demand debate. Current proponents of peak oil demand argue that stricter climate policies like the Paris agreement, newer market disruptors like solar and wind power, as well as gas-powered vehicles and electric vehicles will decrease the demand for oil over the medium to long-term.
However, it seems that these disruptors have not had a significant impact on the commodity as of yet. Global oil demand has steadily increased since 1965, with three notable exceptions: the economic downturn in 1974/75 (oil demand usually lags economic crises, so it really started in 1973), the economic downturn in the 1980s, and of course the Great Recession of 2008/09.
The IEA’s Outlook fails to take into account what would happen [to demand for EVs] if there were a sudden cut in subsidies resulting from an economic slowdown or recession
As of yet, there has been no indication that de-carbonization efforts and the aforementioned “disruptors” have made a real dent in global oil demand. While electric, hybrid and natural gas vehicles have only recently gained traction, renewables around the globe have been heavily promoted for over a decade now, without any discernible impact on oil demand.
Of course, it is the transport sector that consumes the most oil. Therefore, the jury is still out on whether fuel-switching in the transport sector will impact oil demand down the line. However, thus far, the evidence suggests that the impact is minimal at best. In its Global Electric Vehicle Outlook 2017, the IEA predicts that “the electric car stock may range between 9 million and 20 million by 2020 and between 40 million and 70 million by 2025.” It makes this optimistic projection based on country targets, announcements from carmakers and scenarios on electric car deployments.
Yet, currently there are about 2 million electric and plug-in hybrid vehicles on the road globally, which comprises a 0.16% market share of the world’s automotive vehicle stock of approximately 1.2 billion. This means that the world’s electric vehicle stock will have to at least quadruple in two years just to reach the IEA’s lower range 2020 projection. This is highly unlikely if not impossible.
Moreover, growth is not always linear. Subsidies have played a crucial role in sustaining the electric vehicle market thus far. Tesla, for instance, has received billions in subsidies following its IPO around 8 years ago, which has helped the company stay afloat even as it struggles to become profitable. The IEA’s Outlook fails to take into account what would happen if there were a sudden cut in subsidies resulting from an economic slowdown or recession.
The growth in electric vehicles is heavily concentrated in high-subsidy markets like Europe, China, Japan and the US, all countries that incidentally also have heavy debt loads that pose significant economic risks. A potential liquidity crunch resulting from a potential economic slowdown in these markets is thus not out of the question. This would, in turn, reduce the amount of available subsidies – and thus impact the growth of electric vehicles.
What we do know for sure is that the risk of lower oil demand is much higher during major and prolonged economic downturns, and the probability that we may have another is increasing daily.
There are also strong indications that the stock market may be nearing a top
President Trump seems intent on escalating a global trade war, pushing protectionist policies, and weaponizing the Treasury Department to impose sanctions on other countries, including major oil exporters Russia and Iran.
There are also strong indications that the stock market may be nearing a top. For instance, since the beginning of 2018, only a handful of stocks (Apple, Amazon, Microsoft, Netflix) account for half of the S&P 500’s gains. This rather top-heavy concentration of strong performers and lack of breadth in the markets is usually indicative of a market top.
And the Federal Reserve is signaling that it intends to continue to raise interest rates, which is putting pressure on many economies around the world with high debt levels denominated in dollars. Just since August 2018, the currency values of Turkey, Argentina, South Africa and Brazil have significantly lost value vis-à-vis the US dollar. All signs point to more challenges ahead for these countries, which has also raised the risk of contagion.
Yes, there are indeed risks to lower oil demand, but – at least for the foreseeable future – they are more likely to stem from a major economic slowdown caused by one or more of the aforementioned factors rather than current global de-carbonization efforts.
Friedbert Pflüger, German State Secretary of Defense (ret.), is director of the European Centre for Energy and Resource Security (EUCERS) at King‘s College London, senior fellow with the Atlantic Council’s Global Energy Center and managing director of Pflüger International GmbH.