In this August REView, we will explain why we believe this policy pitch by a high-profile leader is misguided, even though it sounds somewhat politically appealing, and may resonate well with society and consumers paying the highest prices in decades for electricity, gasoline and travel. In addition, we will look at regional energy policies being developed in Europe and Latin America and warn about their potential pitfalls as well as their expected upside.

Let’s start with the windfall taxes and explain why they are really not a good idea. The knee-jerk reaction to propose windfall taxes on oil & gas is particularly strong today for two reasons: 1) prices are up due to the war in Ukraine, which gives the impression that companies are profiting from a catastrophe; 2) the traditional point that windfall taxes will discourage future investment in oil and gas should have become weaker since the most governments around the world are actively seeking to transition away from fossil fuels. Hence, wouldn’t this be an excellent opportunity for windfall taxes to further accelerate the transition to renewables and at the same time to redistribute income to the people most affected by the war and the disruption?

We should avoid emotional knee-jerk answers and analyze the situation as rationally as possible. Energy markets are notorious for their feast and famine cycles. So much so that in 2015, 2016 and 2020 - over just the last eight years - the net operating margins of the global oil and gas industry were negative. Moreover, relative to other S&P 500 sectors, between 2018 and 2021 oil and natural gas earnings per dollar of revenue were on average below other key sectors in the S&P 500 such as finance, industrial, communication services and information technology. On top of that, these industries didn’t show nearly as high a volatility as that of the oil & gas sector. If heavy windfall taxes were to be levied on oil & gas firms now, their business could quickly become financially unsustainable. This would probably be to the joy of some environmental activists, yet it is prudent to always be careful of what you are wishing for. In the current global primary energy mix, half of the primary sources come from oil and gas (see chart). If this sector were to become financially unattractive, or we should perhaps say even less attractive than it has been in the past eight years, we would most likely undergo a deep energy crisis. In fact, renewables and nuclear sources take years to be developed, and a sudden drop in oil & gas supply would end up decreasing the total supply of energy. This would have highly damaging effects on the global economy and end up hurting the most vulnerable people in the world.

So, what should governments do? Our stance has usually been to allow market forces to fully remain at play and sort themselves out. This is no exception. High profits in the oil and gas sector right now will be redeployed into energy projects based on their expected returns and risks, and it should be the market to efficiently allocate the resources between oil and gas projects and renewable ones. Governments are unlikely to generate more efficient allocations, and windfall taxes on oil and gas would only increase uncertainty in an already highly uncertain sector.

European energy - How historic planning shortfalls have led to the crisis

European energy policies have become the driving force that will decide the fate of the region in terms of energy availability, getting to the cusp of further damaging an already broken system if policymakers do not proceed with caution. Europe has certainly been the biggest driver of global gas demand and the surge in prices, even across the entire energy landscape to some extent – hence, any wrong moves by Europe can indirectly affect the global commodities and energy market.

Every European country is now expected to prioritize energy security in the short term over their longer-term environmental commitments.

But what still isn’t clear is:

1. How this will be achieved .... and

2. When will the longer-term initiatives kick back in? In the early months of the war, European governments devised a roadmap as best they could to ensure countries would be able to wean themselves off Russian gas as efficiently as possible. The measures and their implications have been debated in our prior REView issues, along with discussions over these ambitious targets. But can Europe deliver on these targets, and will the current crisis prevent their long-term ambitions from coming to fruition? We also touched on this a few months ago, exploring the back and forth being witnessed between energy security and energy transition. But now we are in the thick of it. As the region heads towards winter – and as gas storage inventories continue to refill throughout Europe, which are quite healthy at the moment, with around 73% full, lip-biting and white-knuckles are all too present. Only time will tell if the EU gets it right.

So far this year, one could argue that Europe has not made - nor is about to make any mistakes – when it comes to its gas policies. Perhaps mistake is too strong a word to describe the effect of past policy decisions that has pushed Europe to this point, but we have to go back to the root cause to understand the situation it is in. . In retrospect, the shutting down of nuclear-powered reactors and coal plants has had severe consequences on the present. Europe became increasingly dependent on gas and thereby also on Russia. Had coal-fired capacity remained as a back-up option, it would have supported Europe’s energy security while waiting for solar and wind power to increase its footprint, or help cope with any disruptions to the European energy system such as the one triggered by Russia’s war on Ukraine. Europe currently needs to find alternatives to Russian gas and there are not that many alternatives in the short run. LNG import capacity is running at a max, and that is only supporting a replacement of about one third of Russian gas supplies. There is also not much Europe can do to boost domestic production and pipelines imports cannot ramp up similar to LNG, so finding another large supply source is not possible. The only other option is to find an alternative for gas and most other options like biogas, hydrogen and nuclear cannot ramp up quick enough. Renewables capacity is growing but that too will take time to build out adequate infrastructure to meet demand needs.

Because these other alternatives have no way of ramping up in the short-term, really the only option is to revert back to fossil fuel sources, mainly coal, but also oil for switching. However, Europe cannot simply increase the use of coal significantly to replace Russian gas because Europe gets 60-70% of its thermal coal from Russia, a source they plan to ban from 10 August. If anything, this embargo, could be considered a ’mistake’, because that would require European consumers of coal to search for an alternative. Global coal markets are not exactly sitting pretty – in fact, the tightness in coal supplies is at a record high, so this could be a dead end for consumers seeking a substitute. Additionally, Europe has decommissioned significant coal capacity over the past few years which does nothing to help bring in whatever little coal is available to European energy markets and has led to a limited possibility for large-scale gas-to-coal switching for most countries. Really, only Germany has the capability to significantly increase its coal for power generation and German coal has also helped to boost coal-powered generation in France, Italy, Spain, Netherlands and UK by over 20% in the first half of this year. Many European countries have had to boost gas-for-power generation to keep up with increasing demand, exposing them to the very high, uncompetitive price environment but alternative options are very limited.

Really, Europe only has two options here. One could be to consider reopening coal capacity that was closed in recent years. The UK, Germany, Spain, and Italy may be able to turn back on coal fired facilities that were shut down in the past few years, but all these countries are still dependent on natural gas within their total energy mix, so it likely would not be enough. Europe’s demand for LNG is causing diversion of LNG cargoes from Asia to Europe, triggering Asian buyers to switch to coal. If Europe were to compete for that coal, prices of coal and gas would increase, putting more upward pressure on consumer’s energy bills, not only in Europe but across the globe.

Clearly, alternatives to Russian gas are difficult to find in the short-term. That leads us to the only other viable option here, which has been the direction EU policy leaders have had to go –reduce gas and energy consumption. This has triggered Europe’s agreement to cut gas demand by 15% compared to the five-year average between August 2022 and March 2023. Europe must be more effective in how it uses energy and must cut non-vital use of the commodity in order to see this year (and the coming years) through. But there is still hope for the markets to balance in the long run. The distress to Europe’s energy markets this year has been a wake-up call for all global markets. While energy security will win in the short-term, it is only a matter of time before we begin to see a new wave of investments in renewable energies, particularly wind and solar sweep across Europe, and likely with much haste as Europe is now even more desperate to move away from fossil fuels.

Analyst spotlight - The opposite cases of Colombia and Guyana

Daniel Leppert, Research Director Latin America

During his first day in office, Colombia’s president Gustavo Petro introduced a new tax reform in Congress to help fund social spending. Part of this reform aims to increase taxes on oil exports, which currently represent more than 30% of the country’s total exports. An advocate of energy transition, president Petro has made bold statements on leaving behind the country’s dependence on hydrocarbons which represents approximately 12% of the country’s total income flows in 2021. These comments have gone as far as putting a complete ban on hydrocarbon exploration, new bid rounds, and fracking. With an economy and energy matrix that is highly dependent on fossil fuels, president Petro walks a fine line, increasing government income in the short term to fund social spending, which could come at the expense of deterring much needed investments into the sector that will provide the country with energy security, and perhaps be a main source of funding of the energy transition.

Colombia’s hydrocarbon sector has seen better days, and if investments are deterred, the consequence on the economy will surely be felt. Crude production has been on a steady decline since 2013, with the nation producing an average 735,000 barrels per day (bpd) in 2021, approximately 6% lower than in 2020, with production levels this year expected to mirror 2021. At current production rates, the country will be able to sustain its crude output for only another six to seven years. Gas reserves have also fallen, reaching 3.2 trillion cubic feet (Tcf) currently and are projected to last approximately eight years. All of this in the context of continued gas demand growth, which will outstrip domestic supply within this decade. Because of this, Colombia’s reliance on LNG is expected to grow, and the exposure to the highly volatile market will certainly bring added pressure to the fiscal balance. Fortunately, investments in Colombia’s offshore exploration have grown, and two new gas discoveries have been announced within the last couple of weeks by both Petrobras and Shell, respectively. It is important that the government respects the current contractual framework, so that investments needed to unlock these strategic resources move forward.

The current government’s objectives on the energy transition and renewables are commendable and necessary. However, this needs to go hand in hand with energy security, affordability, and access. With an energy matrix that is more than 60% reliant on fossil fuels, it will be difficult to implement a fast passed transition capable of reconciling affordability and security. The insertion of non-dispatchable renewable energy such as wind and solar will need backup to guarantee security and the current price of batteries will be prohibitive in terms of providing affordability. In this sense, natural gas blends well as a bridge solution and has been the fuel of choice amongst multiple countries in Latin America and globally to cope with the intermittency generated by growing renewables while lowering emissions compared to diesel, fuel oil and coal.

Early this year, Colombia launched Latin America’s first green taxonomy, showing that the country can transition its energy sector without relinquishing its rich hydrocarbon resources. Recognizing that the hydrocarbon sector plays an integral role in the economy, and that foreign investment and technology are needed to further unlock new resources, the current government needs to maintain the momentum left by the previous administration and avoid changing the rules of the game.

President Petro needs to be careful not to fall into the footsteps of other Latin American countries, such as Venezuela, which exploited its hydrocarbon sector to fund populist policies, resulting in a catastrophic collapse of the industry. In that sense, it has been encouraging thus far to see a country like Guyana implement the necessary regulation and governance to attract foreign investors. The country is speeding up the development of its offshore hydrocarbon resources to not only develop its economy but also fund the energy transition. Time will only tell whether the country enjoys the necessary long-term stability, but there is no question on whether Guyana is currently on the right track.

In summary, we have outlined how the current energy crisis could quickly become an even bigger one if governments are not careful and decide to implement the wrong set of energy policies. Surely, policy makers must avoid the temptation for windfall taxes on oil & gas anywhere in the world. Moreover, in Europe they should try to increase the stockpile of coal ahead of the winter – as unpleasant as it may sound - and temporarily postpone climate goals in the continent. In Latin America, they must also avoid the nationalization proposed by Petro in Colombia, and if anything, use Guyana as a blueprint for energy policies aiming to attract foreign investments in the region.

REView is going to take a break in the month of September. We will be back with the October edition on Tuesday, 18 October.

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Authors: 

Claudio Galimberti  

Senior Vice President of Oil Markets, Head of Americas Research 

claudio.galimberti@rystadenergy.com

Emily McClain

Vice President of North America Gas Markets Research 

emily.mcclain@rystadenergy.com 

Daniel Leppert

Research Director Latin America

daniel.leppert@rystadenergy.com

(The data and forecasts contained in this column are Rystad Energy’s and the opinions are of the authors.)