December 3, 2015

The Price of Oil and the Price of Carbon

“The human influence on the climate system is clear and is evident from the increasing greenhouse gas concentrations in the atmosphere, positive radiative forcing, observed warming, and understanding of the climate system.” —Intergovernmental Panel on Climate Change, Fifth Assessment Report

Fossil fuel prices are likely to stay “low for long.” Notwithstanding important recent progress in developing renewable fuel sources, low fossil fuel prices could discourage further innovation in and adoption of cleaner energy technologies. The result would be higher emissions of carbon dioxide and other greenhouse gases.

Policymakers should not allow low energy prices to derail the clean energy transition. Action to restore appropriate price incentives, notably through corrective carbon pricing, is urgently needed to lower the risk of irreversible and potentially devastating effects of climate change. That approach also offers fiscal benefits.

Low for long

Oil prices have dropped by over 60 percent since June 2014 (see Chart 1). A commonly held view in the oil industry is that “the best cure for low oil prices is low oil prices.” The reasoning behind this adage is that low oil prices discourage investment in new production capacity, eventually shifting the oil supply curve backward and bringing prices back up as existing oil fields—which can be tapped at relatively low marginal cost— are depleted. In fact, in line with past experience, capital expenditure in the oil sector has dropped sharply in many producing countries, including the United States. The dynamic adjustment to low oil prices may, however, be different this time around.

Oil prices are expected to remain lower for longer. The advent of shale oil production, made possible by hydraulic fracturing (“fracking”) and horizontal drilling technologies, has added about 4.2 million barrels per day to the crude oil market, contributing to a global supply glut. Shale oil will lead to shorter and more limited oil-price cycles. Indeed, shale requires a lower level of sunk costs than conventional oil, and the lag between first investment and production is much shorter. Furthermore, shale is still at a relatively early stage of its industry life cycle, where the scope for learning is substantial, as shown by production levels that have proven resilient thanks to phenomenal efficiency gains forced by the big drop in oil prices.

In addition, other factors are putting downward pressure on oil prices: change in the strategic behavior of the Organization of Petroleum Exporting Countries, the projected increase in Iranian exports, the scaling down of global demand (especially from emerging markets), the secular drop in petroleum consumption in the United States, and some displacement of oil by substitutes. These likely persistent forces, like the growth of shale, point to a “low for long” scenario, even after the supply legacy left by the high-price era of the 2000s has dissipated. Futures markets, which show only a modest recovery of prices to around $60 a barrel by 2019, support this view.

Natural gas and coal—also fossil fuels—have similarly seen price declines that look to be long-lived. Coal and natural gas are mainly inputs to electricity generation, whereas oil is used mostly to power transportation, yet the prices of all these energy sources are linked, including through oil-indexed contract prices. The North American shale gas boom has resulted in record low prices there. The recent discovery of the giant Zohr gas field off the Egyptian coast will eventually have repercussions on pricing in the Mediterranean region and Europe, and there is significant development potential in many other locales, notably Argentina. Coal prices also are low, owing to oversupply and the scaling down of demand, especially from China, which burns half of the world’s coal.

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