And will the new green energy system remain prey to geopolitics?
Major crises have a way of often triggering pivotal changes to life and society. The energy industry was expected to be heavily affected by the geopolitical crisis over Ukraine given Russia’s might as a key source feeding global demand for resources – everything from oil, gas, and coal. Yet, more than a month on from the invasion, the extent of the impact on the energy sector is beyond the preview of any risk planning. With all sides digging in, governments have been scrambling to minimize the impact of the disruption in trade flows as consumers cope with rising pump prices and potentially, at some point in the future, even supply rationing.
Two recent events in the US have perhaps come to symbolize the hard choices lawmakers are facing. First, the heads of several oil companies were summoned to the capital and grilled by members of the House of Representatives on the surge in retail gasoline prices, which in the US are fully driven by competitive markets. Soon after, the US Congress removed Russia’s ‘most favored nation’ trade status, which is likely to eventually cause an increase in global oil prices. These moves were an attempt to balance a fragile trade-off between trying to partially insulate the US electorate from prolonged economic pain and trying to isolate and punish Russia. Yet, this backdrop also provided the conditions for two themes that before the crisis seemed distant – energy transition and energy security – to begin to converge. Indeed, if we think about it, this development was for the most part unexpected until the current crisis erupted, as in the months before the invasion the global public debate gravitated around the transition to renewables while security of supply seemingly took the back seat. Now – and this is our main point in this REview - a faster transition to renewables appears to become a necessary condition to minimize energy insecurity, at least in some countries.
As we maintained in our previous REview column, Russia’s invasion is likely to trigger the third oil crisis, with probably an even bigger impact on natural gas markets. When push comes to shove, we can expect governments around the world to react by prioritizing the “here and now” i.e., energy security, at the expense of energy transition, at least as long as the crisis rages on. Climate change is a crisis too, and we are not arguing against it, quite the opposite. We simply highlight that the low-frequency nature of the climate crisis, seemingly less immediate but punctuated with worrisome long-term trends, is likely to be overcome by the high-frequency nature of the current crisis, triggered by geopolitical disruptions and shocks, which ends up hijacking policymakers’ priorities and agendas.
Yet, a second glance shows that things do not need to be so gloomy. In fact, we do not doubt that oil & gas importers such as Europe, China, and India right now face stronger incentives than ever to accelerate their transition to green energy sources, as these sources have gained the added advantage of being an investment in energy security. This is particularly true for Europe, which so heavily depends on natural gas and oil imports from Russia and finds itself between a rock and a hard place when trying to wean itself away from those sources. This process carries a resemblance to the 1980s diversification of sources from oil to natural gas and nuclear, along with targeted policies to increase energy efficiency, which generated a structural, albeit temporary, decline in global oil demand.
As for oil and gas net exporters, the outlook is more complicated. Many democratic governments, including Canada and the United States, rose to power in part on an energy transition ticket, and are now faced with the need to walk a tightrope between their original green agenda and the need to increase oil and gas production to secure supplies. It will not be easy - and for the time being it looks like energy security is winning the tug of war. Canada seems set to increase production from its carbon-intensive oil sands sector (see box below) and the US appear ready to vastly surpass its pre-pandemic oil and gas production in 2023, thanks to price-elastic Permian wells. In Latin America, the outlook is slightly more clear-cut: Even though renewables have been playing a large role – in Brazil for instance with hydropower and ethanol – their economies are still highly reliant on oil & gas exports, which means their governments are incentivized to increase oil production.
Spotlight on Canada
Thomas Liles, Vice President, Analysis
The tug-of-war between energy security and energy transition has manifested itself in several constellations among policymakers and energy producers in Canada. Ottawa announced a ban on Russian petroleum imports on 28 February, becoming the first country to officially target Russian energy sales. Alberta Premier Jason Kenney also advocated for enhanced energy security, calling on the White House to resuscitate the 830,000-bpd Keystone XL (KXL) pipeline expansion, while Canada’s upstream producers have shown a sense of vindication since war erupted. Suncor CEO Mark Little in early March indicated that Canadian oil supply would be boosted by “a few hundred thousand barrels” in 2022. Increased supply projections have also emanated from policymakers, with Natural Resources Minister Jonathan Wilkinson announcing in late March that Canadian producers could increase oil and gas exports by a total of 300,000 boepd (66% liquids) this year.
And yet, most of these pronouncements are arguably just noise. Canada has not imported Russian crude since 2019, and imports of Russian refined products have been miniscule. Jason Kenney’s calls for the renewal of KXL were rebuffed by pipeline operator TC Energy. The question of immediate Canadian supply, too, is not without its issues. First, Canadian producers were already slated to increase supply in 2022. Even before the crisis, Rystad Energy estimated a year-over-year (y/y) increase of about 200,000 bpd in crude and condensate, as well as an annual gain in natural gas supply of approximately 150,000 bpd. Additionally, the extent to which operators will be able to achieve incremental gains above our base case production scenario is still unclear. Most major oil sands projects have been running at or near full capacity since the third quarter of 2021, and supply chain bottlenecks will likely constrain any meaningful supply increases.
Amidst the fog of war and the scramble for immediate supply, however, the federal government has given every indication that it will continue to prioritize energy transition. Canada unveiled even more ambitious GHG emissions targets in 2021, and producers are girding for a future in which they can grow production modestly while staying on track for net-zero emissions. These two seemingly contradictory goals will rely on massive investments in carbon capture and storage in Western Canada over the next three decades, thus the looming question is who ultimately foots more of the CCS bill.
Spotlight on Latin America
Daniel Leppert, Latin America Research Director
The biggest economies and gas consumers in Latin America will be affected by Europe’s attempts to balance dwindling gas storage levels with increasing LNG imports from the US. European gas prices started to rise late in the second half of last year due to below-normal gas storage levels before the winter season, ending the year with total volume that was 24% lower than the five-year average. Brazil, Chile and Argentina are the main LNG importers in LatAm, but Chile is the only one with long-term contracts, meaning the impacts from the recent crisis are far less than for the others. Colombia does not currently have high exposure, but the country has ageing gas production and could begin importing LNG to replace this supply.
Brazil is the third-largest natural gas consumer in Latin America, with state player Petrobras responsible for 70% of domestic production, and 88% of LNG imports in 2021. All of the LNG was purchased in the sport market. Since the second half of 2021, the costs for imported LNG became higher than the income from some power plants and also stronger than the price Petrobras sells to the consumer market, causing an imbalance in Petrobras’ costs to supply the market. To reduce the damage, Petrobras offered a new price policy for new four-year contracts that is 45% higher on the first year, 24% higher on the second year and an 11.6% Brent slope for the last two years. The previous price policy was an 11.6% Brent slope for a four-year contract. In the short term, we expect Petrobras to start the new Rota 3 offshore pipeline earlier to reduce LNG imports and mitigate elevated price risks. This pipeline is already built but the processing infrastructure is not ready to receive the pre-salt gas.
The Argentine gas market is strongly influenced by the government. The current supply mechanics consist of prioritizing domestic production, including through subsides, importing natural gas from neighboring countries and LNG to fulfil demand. As the 2022 winter season comes with expectations of record-high LNG prices, the government might this year pay more than $4 billion to import LNG – four times more than what was paid in 2021. The market is not convinced that Argentina can afford this cost and demand could be limited to overcome this issue. Increased imports of diesel and fuel oil are also expected to help reduce the high gas price impact, although these are currently trading at a premium.
Colombia’s state company Ecopetrol is responsible for 73% of production, with independent Canacol Energy on 20% and others the rest. The challenge for Colombia will be to handle decreasing domestic production and growing demand. Our projections show that 2022 could be the inflection point after which imports will increase in importance as a source of supply.
The above overview summarizes our expectations on how governments will react to the current crisis to address the supply gap generated by the increasing embargo on Russian exports. But how about the demand side of the equation? Can something be done to ensure we adopt the most rational solutions? Let’s start, for instance, with the extremely elevated global gasoline and diesel prices – the highest ever in the US. They are evidently a drag on consumers, significantly contribute to inflation, weigh on economic growth and are spectacularly unpopular, especially in low- and middle-income countries. What should a rational policy maker do? We believe the last thing they should do is to pursue the most frequent fallback option – and the exact one they are adopting right now: lower fuel taxes. We highlight three reasons to argue against it: 1) it’s an interference in the market rebalancing mechanism, which implies that in the absence of sufficient oil supply to satisfy demand, we must allow prices to rise enough so as to marginally cut demand until we eventually reach a new equilibrium; 2) it flies in the face of the goal to reduce fossil fuel dependency; 3) it’s also inefficient from a macroeconomic standpoint, as consumers would be better off by receiving the fuel tax reduction equivalent in cash and being free to autonomously and efficiently decide what to do with that cash.
Different considerations should be applied to the natural gas market, as some European countries have argued for the introduction of a price cap on TTF. A price cap in this case would indeed shield families and businesses from being exposed to the vagaries of the natural gas market, especially in the fall when a seasonal surge in consumption may be met with a decrease in Russian exports. Ideally, natural gas prices should be left to float freely so that demand and supply can promptly balance, while governments generate proportionate cash reimbursements when prices are exceptionally high so that families and businesses do not suffer from events that are beyond their control. In practice though, the market mechanism may produce more damage than the benefits it usually creates, as extremely high prices could end up straining family budgets and jeopardizing businesses before cash reimbursements generated by the government reach them. The price of natural gas in this fall will be a tough nut to crack given the pending embargo on Russian supplies, and a variety of solutions must be designed and put in place before the situation arises.
Meanwhile, we believe that incentives to promote the use of renewable sources of energy in the EU, China and India would go a long way in solving their energy insecurity problem, which stems from their economies’ dependency on fossil fuel imports from unstable and unreliable countries. In that sense, even outright green subsidies, which usually have a distortionary effect on efficient market mechanisms, may be temporarily justifiable as they would help accelerate the process of emancipation from negative geopolitical externalities.
Yet, we should not be naïve and think that by reducing the dependency on fossil fuels from unreliable sources produced in unstable and undependable countries, or countries ruled by belligerent regimes, we will have eliminated the geopolitical risks linked to energy. By moving away from the old fossil fuel world to an electrified future, we will have shifted the geopolitical risks from petrostates in the former Soviet Union (FSU) and Middle East to future energy-metal-states in Africa, Latin America, and China. Indeed, looking at the current revenue share of the largest producers of metals needed in batteries and solar panels, we have a foretaste of where the geopolitical risks will likely migrate to in the electric world: China is by far the largest producer of aluminum (~50%), for cobalt it is Congo (75%), for copper Chile (25%), for nickel Indonesia (~ 40%), for silver Mexico (~20%), and for lithium Australia (50%). Scrolling down to number two and three in revenue shares for the same markets show many of the same countries, with the addition of Brazil for aluminum, Russia for cobalt, Peru for copper, and Philippines for nickel. For rare earths, the current global production market share has China in top slot with 60%, followed by the US with 15%, and Myanmar with 9%. This goes to show that even the electrified global economy will depend on some crucial metal mining, producing, refining, and exporting countries, and that some of them could develop a stranglehold on the global supply chain not unlike the one that OPEC+ appears to have had on oil over the past two years, and Russia on Europe-bound natural gas for the past two decades.
Still, by being a catalyst for an acceleration towards renewables at least in some key markets such as Europe and China, this energy crisis will have eventually left a worthy legacy - a likely reduction in the risks associated to climate change.
Senior Vice President of Oil Markets, Head of Americas Research
(The data and forecasts contained in this column are Rystad Energy’s and the opinions are of the authors.)
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