Many barrels of ink have been spilled over the OPEC deal on oil production cuts reached last November. Less attention has been paid to the deal’s impact on gas and renewable energy worldwide. But the effect will be significant: partly for the boost it gives to other energy sources, but even more for what it says about the long-term strategies of the big oil producers. The agreement requires most OPEC members to cut production from October levels by 4.4-4.5 percent, a total of about 1.4 million barrels per day (bpd). Libya and Nigeria, troubled by political unrest, are exempt. And Iran, returning from sanctions, is capped at a higher level. This accord was followed on the tenth of December by an unprecedented arrangement for Russia to reduce output by 300,000 bpd while another set of non-OPEC countries, including Oman, Kazakhstan and Mexico, cut a further 300,000 bpd. So far OPEC compliance appears to be good (almost 90%), though mostly led by Saudi Arabia, while Russia’s output is largely flat. Brent oil prices, which had climbed up from the mid-$40s per barrel as the deal was being debated, jumped to around $56 per barrel and have remained around that level since. OPEC’s stated aim in taking this action has been to reverse the heavy over-supply that triggered the price crash in mid-2014 and that had persisted since, and to drain off excess inventories. And various forecasts, such as that of the International Energy Agency, do show the market shifting into deficit this year. But the price rebound is expected to be relatively modest, at least in the short term, due to the increase in U.S. shale oil output. From a low of 8.45 million bpd in early October, U.S. crude production had already rebounded to 8.978 million bpd in early February, on figures from the U.S. Energy Information Administration.
A boon for other energy sources?
The increase in price gives some temporary relief to stressed oil producers and companies. But it also improves the situation for competitors to oil. Such competitors should be considered under three headings: natural gas; coal, renewable and nuclear power; and alternative fuel vehicles. The reduction in OPEC oil production also reduces their output of associated gas. In Saudi Arabia, associated gas amounts to about 2.4 billion cubic feet per day. Any decrease has to be met by increased oil burning. Conversely, though, higher prices for oil and by-products of gas extraction such as condensates and natural gas liquids mean more drilling in areas such as the U.S. Natural gas competes directly with oil in a few applications, such as home heating, but customers here are generally locked in to one or the other fuel. Only a few countries, notably Saudi Arabia, still use substantial amounts of oil for power generation, and here government-regulated prices mean that market fluctuations do not translate immediately into making gas more competitive. In the market for temporary and off-grid power, primarily diesel generators, higher oil prices do intensify a trend that is already underway. This is to switch to renewable energy, either with battery storage or in combination with oil-powered backup. Alternatively some locations, such as drilling rigs, are using gas where it is available. Higher oil prices have an immediate impact on gas by raising the price of oil-linked sales contracts. An oil-indexed formula is still the leading method of pricing liquefied natural gas (LNG) in Asia. Increased oil prices make gas relatively more expensive, lowering its attractiveness against gas priced on another basis (for example, U.S. LNG priced against the Henry Hub benchmark), coal, renewable energy or nuclear power. Gas is already too expensive to displace coal in many markets, such as India. So indirectly, more expensive oil will raise the share of both coal and renewables. The impact on coal is immediate, as generators switch away from gas-fired power plants. The effect on renewable energy is slower, since it takes time to build new capacity. However, in the longer-term, there is no reason for oil and gas to trade at some fixed parity level. Even oil-linked gas sales agreements will be adjusted to reflect new market realities. Gas prices are driven by their own dynamics. Indeed, a growing disconnect of gas from oil prices encourages the trend towards gas-on-gas competition, and the use of pricing points such as the U.S.’s Henry Hub, the north-west European nodes, and the new “Singapore Sling” LNG benchmark. U.S. shale gas output continues to rise strongly, the global LNG market is glutted with Australian and now U.S. supplies, and new projects from East Africa and Canada can arrive at the right price. But except perhaps in North America and for some remote stranded gas fields, the price disparity is not wide enough to encourage more gas-to-liquids projects like Shell’s giant Pearl facility in Qatar. Some major oil exporters are, of course, also big gas players: notably Qatar, the world’s largest LNG exporter, Russia, the biggest gas exporter overall, Algeria and Norway. Iran has ambitions to join them. They can be somewhat more relaxed about oil prices as long as their gas remains competitive.
Finally, more expensive oil improves the attractiveness of alternative-fuelled vehicles: running on natural gas, biofuels, hybrids or electricity, or perhaps one day hydrogen. Conventional vehicles that are smaller or more fuel-efficient also gain. And there is already a trend to switch some shipping to LNG, to comply with marine pollution controls. Battery vehicles can, of course, run on electricity from any source. Rising electricity demand would be good news for coal (if not constrained by tighter climate policies), gas, renewable and nuclear energy. Potentially all would gain market share at the expense of oil. But electric vehicles could be introduced synergistically with renewable energy. Their batteries, otherwise unused for 95 percent of the day while the driver is elsewhere, could be used to store variable solar or wind power, or indeed cheap off-peak nuclear electricity. The increase seen so far in oil prices, from around $45 to $55, will in the short-term have a relatively modest but positive impact on all of these alternatives. Whether over the next few years oil prices remain around current levels (as futures curves imply), increase further or slump again depends on the interplay of five main factors: OPEC’s discipline in adhering to current cuts and extending the deal beyond its initial six months; the strength of rebound in U.S. shale output; the pace of decline in non-OPEC output over the next few years due to the cumulative impact of underinvestment; the state of the world economy in the face of protectionist moves; and the threat of instability or conflict interrupting supplies from one or more major oil-producing countries. Oil prices at current levels will probably not greatly alter the global energy trajectory: steady gains in the share of renewable energy and electric vehicles, and improving efficiency. If OPEC continues to hold back production and non-OPEC cannot keep up with demand, a new price spike, to levels of $80, $100 or even more per barrel, would accelerate progress in converting transport to electricity and gas. It would combine with continuing climate policies to encourage government intervention favouring renewable energy and batteries. In the third case, a renewed slump in oil prices, the prospects dim for a swift transition to more efficient and hybrid or electric vehicles. Already the last two years of low oil prices have seen U.S. gasoline demand and vehicle miles travelled, which had seemed to be in terminal decline, turn upwards again. And low oil prices can also be important in guiding the trajectory of the future transport systems of the emerging Asian giants, most importantly China and India: away from small, mostly electric vehicles and public transport, and closer to an aspirational American model of large, petrol or diesel-driven cars. Almost 40% of new Chinese car sales from September to November were S.U.V.’s.
Higher oil prices have an immediate impact on gas by raising the price of oil-linked sales contracts. An oil-indexed formula is still the leading method of pricing liquefied natural gas (LNG) in Asia.
Alternative energy begins at home
At the same time as they grapple with the challenges posed to their core business by alternative energies, OPEC countries are also seeing the opportunities at home. In many of them, the legacy of years of lavish energy subsidies is high and wasteful consumption. Fiscal pressures have made subsidy reform and attempts to improve energy efficiency and productivity essential.
Falls in the cost of solar and wind power have made them highly competitive in the right localities. The UAE has taken the lead by commissioning some of the world’s cheapest solar photovoltaic plants; Saudi Arabia has recently unveiled some large-scale solar and wind plans as part of its National Transformation Plan. Solar bid prices of 2.45-2.99 US₡ per kilowatt-hour in Abu Dhabi and Dubai imply parity with gas prices around $3-3.60 per MMBtu, well below current LNG prices or the cost of developing new higher-cost domestic resources.
Some other OPEC counties are dabbling in renewable energy on a smaller scale. The UAE is also expected to start generation this year from the first reactor of its 5.6 GW civil nuclear power program. And some steps are being taken to establish electric charging networks for cars, with Tesla set to open in Dubai, its first Middle East location, shortly. Alternative energy technologies are also helping to support oil output. Oman’s Miraah solar thermal plant is due online before the end of this year, set to generate 1000 megawatts equivalent of steam for heavy oil recovery. And last November, Abu Dhabi’s Al Reyadah joint venture started delivering carbon dioxide captured from a steel plant’s exhaust for enhanced oil recovery.
The OPEC countries’ motivation is almost entirely economic rather than environmental. Renewable energy displaces more expensive oil and gas—Saudi Arabia and Kuwait being two of the few countries worldwide that still use substantial amounts of oil for power generation. Saudi Arabia’s direct burning of crude oil in the summer air-conditioning season has at times exceeded 1 million barrels per day. But, though cost-effective, it will take vast amounts of renewable energy to make a dent in consumption: one million barrels per day of crude can produce in excess of 22 gigawatts of power, more than half the installed solar capacity of Germany, and do so through night, cloud and dull winter days.
Alternative energy also holds out the hope of diversifying the economy and building a future beyond oil and gas. This was the hope of Abu Dhabi’s Masdar initiative, launched in 2006, which has built solar, wind and carbon capture plants at home and abroad, constructed a low-carbon city, and invested in renewable energy research. But beyond making use of their excellent solar potential, the major Middle East oil producers are still searching for ways to be inventors and developers of new energy technologies, rather than simply purchasers.
OPEC's Long-Term Strategy
OPEC’s debate over its long-term strategy has largely been framed in terms of three issues: the elasticity of shale production; the threat of alternative energies, particularly electric vehicles; and the pressure to phase out fossil fuels to tackle climate change. The rise of shale offers sustained growth in production at moderate oil prices, at least by recent historical standards, and weakens OPEC’s role as the arbiter of global markets. Breaking oil’s monopoly on the transport sector would rob the major oil producers of the premium value their product commands. And, while the future of climate policy is uncertain for now under the Trump administration, stricter curbs on carbon dioxide emissions are ultimately inevitable.
Shale is both a short-term and long-term problem for the major oil exporters. Electric vehicles are, so far, a longer-term threat. But together, they do pose a strategic puzzle for OPEC. The organisation could do what it did it in the 1970s and early 1980s, and repeatedly cut production to defend a price target in the face of shrinking demand and rising non-OPEC competition. This might be easier today given cooperation from some non-OPEC players, and the legacy of three years of brutal upstream spending cuts.
Alternatively, those OPEC countries with the resources and political stability to do so—essentially, Saudi Arabia, Kuwait, the UAE, and perhaps Iraq and Iran—could make a dash for growth. Expanding their production would keep prices relatively low, but they would make up some of the losses by gaining market share. This approach would also stave off competition from alternatives to oil. And the low-cost producers would sell their oil while they can, possibly leaving high-cost, high-carbon resources such as Canada’s oil sands stranded, environmentally unrecoverable within a few decades.
For a while starting in late 2014, the second strategy seemed to be the one the Saudis, at least, were adopting. Former oil minister Ali Al Naimi made it clear that his country would not again resume the burdensome role of swing producer that cost it so heavily in the 1980s.
But 2016’s return to a short-term approach of production cuts has marked the abandonment of these plans, if indeed they were ever contemplated. The short-term pain of low prices proved to be unbearable, despite the avowed scepticism of some OPEC oil ministers that the production cut strategy can succeed. Of course, the cuts so far are modest. There is still time for OPEC to change course by the time of its next scheduled meeting in May—whether the market appears to be rebalancing, or the cuts are clearly not having the desired effect. But Saudi Arabia, still the key OPEC arbiter, has made no clear moves to expanding its production capacity. Unless it does so, its ultimate weapon—the ability to overwhelm competitors with a surge of production—will remain capped at an absolute maximum of 12.5 million barrels per day, just 2 million bpd above recent output records.
OPEC's debate over its long-term strategy has largely been framed in terms of three issues: the elasticity of shale production; the threat of alternative energies, particularly electric vehicles; and the pressure to phase out fossil fuels to tackle climate change.
The OPEC agreement and the organization’s shift of tack make oil somewhat more expensive for a while. The gas market will adjust quite soon to the relative shift of pricing. And in the limited areas where they compete directly with oil, renewable and nuclear power will get a boost, as will sales of hybrid and electric vehicles.
In a world in which oil output remains the key source of revenues and exports, but is no longer the driver of growth, the major petroleum producers will gradually develop a bigger role for renewable energy. But even as some of the supermajors, notably Total, grapple with biofuels, wind, solar and battery technology, none of the big national oil companies have articulated a future beyond oil. And both they and their host countries need soon to devise a strategy for output that balances short-term revenues, long-term market share and carbon constraints. That crucial step, much-debated, remains elusive.