Fossil Fuel Divestment: A Warning From History

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As pressure grows to accelerate reductions in carbon emissions, many in the developed world are attempting to reduce fossil fuel use by limiting supplies. But without a commensurate reduction in demand, this could lead to rapidly rising prices for fossil fuels, diminished living standards, and even potential shortages. That raises the specter of a rerun of the gasoline lines and shortages of the so-called 1973/4 Arab oil embargo, which caused enormous public fear and political upheaval. Larger volumes of world oil production will also shift to two producing centers, the Middle East and Russia. This could result in more, not less, price volatility, even more frequent price shocks, and a future where the market is more controlled by Russian President Vladimir Putin and Iran’s Supreme Leader Ayatollah Ali Khamenei. The reaction to recent energy price increases suggests the global public would not like that outcome, which should be a warning to those urging fossil fuel divestment.

For decades, the oil industry has faced a variety of outside pressures to adopt particular strategies. In the 1980s, it was diversification away from oil, followed shortly thereafter by a reversal to emphasizing the "core business." In the 1990s, the "virtual corporation" was a fad pushed by Enron, which disappeared with it. Almost always, there has been a conflict within the investment community over emphasizing production volumes or profitability, and the past few years have seen the latter win out under the rubric "capital discipline." This, compounded with environmental, social and governance and climate change politics, suggests that investments in fossil fuels could diminish sharply.

The International Energy Agency has weighed into the debate, arguing that meeting its Net-Zero 2050 Scenario targets should mean no investment in new fossil fuel projects. Aside from the fact that reducing supply doesn’t reduce demand, as the war on drugs has proven, the likelihood that only private, Western oil companies would yield to such entreaties tends to be ignored. Combined with climate change policies pushing down demand and thus oil prices, the implication is that future oil production would be increasingly concentrated in the Middle East and Russia, but also, in national oil companies (NOCs).

National Oil Companies Prevail

Using estimates of decline rates and scenarios about stopping or phasing down investment outside of Opec-plus suggests that by 2040, more than 75% of the world’s oil production will come from Opec-plus nations, and nearly all of that from NOCs. Additionally, national oil companies in China, India and other countries will be handling much of their own imports, which has serious implications for market behavior during both normal and disrupted periods.

Some NOCs behave similarly to private ones. Others, however, are more like government ministries and subject to political interference. And whereas private companies’ investments are heavily influenced by prices and cash flow, NOCs usually get their budgets from their government. NOCs like Saudi Aramco invest in capacity based on expected oil demand, but others have much more muddled motivations, often simply the need for revenue.

Lessons for Opec

Most have forgotten that from 1975 to 1985, Opec was a price-maker, announcing the price of oil it would accept, and not a price-taker. And excluding the Iranian Revolution, the oil price was quite stable. This was largely because the exporters’ market share was high, plus the Saudis agreed to be the swing producer, letting their production fluctuate with demand rather than adjusting their price. When demand for Opec oil collapsed, the Saudis abandoned that strategy and since then, Opec (and allies) have become price-takers while adjusting production.

Conceivably, Opec-plus would have so much market share in the future that it would once again be able to set prices, and reduce volatility. This would have some significant benefits for producers and even consumers, who could base capital equipment purchases on greater oil price certainty. For example, the US auto industry has been repeatedly whipsawed when volatile prices caused consumers to change preferences in auto efficiency, both up and down.

Should Opec-plus be able to set prices once again, the biggest challenge will be to set an oil price that is sustainable, the level of which has bedeviled the group (and the world’s economists) for decades. Recall that after prices tripled in 1979/80 to $100 per barrel (in 2020 dollar terms), the great consensus was that they would keep rising into the foreseeable future; conversely, the 1998 oil price crash left at least some convinced that $20/bbl was the new sustainable price. Both were obviously incorrect and illustrate the danger involved in trying to establish a target price.

Different Responses

While private oil companies are quick to alter expenditures to changing market conditions, NOCs have difficulty responding to market fluctuations because of political oversight of and/or control over their budgets. In recent years, politicians in Iraq, Kuwait, Nigeria and many other countries have delayed legislation or project approvals, often for years. This could mean that, even with greater market power, prices could be volatile as Opec-plus sees periods where capacity is a mismatch for demand.

The potential for political interference in the oil trade in an NOC-dominated world under normal market conditions is also uncertain and worrying. Recent years have seen relatively few efforts by oil exporting government to use their sales for political purposes; indeed, the US has been the most consistent imposer of economic sanctions on governments and individuals. But a future where most OECD nations are not oil importers and the demand side is dominated by China and India could mean that intergovernmental relations affect oil flows, creating uncertain expectations and triggering speculative buying or selling, as China’s recent reduction in Australian coal purchases demonstrated.

A New Supply Shock?

The problem might be worse in a new oil supply shock. During the first major oil crisis in 1973, the Western oil majors — then known as the Seven Sisters — shifted supplies around so that importers shared the shortage. However, during the Iranian Oil Crisis, control over shipments shifted to the NOCs in exporting nations, the transition creating a certain amount of chaos. The situation worsened as importing nations scrambled for scarce supplies, offering exporters bonuses and political favors in return for "access." This set up a pattern of buyers losing supplies to higher bidders, then making their own bids for scarce supplies, perpetuating the cycle.

In 1990’s Gulf War by contrast, the spot market had grown from a few percent to a large fraction of traded oil, and those companies and countries that lost supplies from Iraq and Kuwait could easily find new sources. Although prices surged briefly, the loss of 6 million barrels per day of supply from those two countries had much less impact than a similar loss during the Iranian Revolution.

However, if future exports and imports are dominated by a few NOCs, a sudden shortfall might calcify the market once again, as governments order their NOCs not to share supplies and the spot markets dry up — with the few available barrels bid up to astronomical levels. While this would not directly affect the economies that had cut oil use, soaring oil prices would hurt countries outside the OECD which could create new supply chain problems.

The price spike would also be politically destabilizing, affecting trade and the global economy. If the half of the world that still relies on oil sinks into recession, the rest of the world will almost certainly follow suit.

Michael C. Lynch is a Distinguished Fellow at the Energy Policy Research Foundation (EPRINC) and president of consultancy Strategic Energy & Economic Research. He has extensive experience in upstream policy, energy security, market forecasting and developments in the oil and gas industry.

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