Oil wells
“climate change needs a solution regardless of how high or low oil prices are”

Oil prices have fallen significantly in recent months and are now trading around the $60/bbl mark. In recent years they were trading at around $110/bbl. The fall started in the middle of 2014 and although we’ve seen a small rebound recently expectations are that prices will stay low for the foreseeable future.

What is the implication of a lower oil price on the wider energy system and on our necessary attempts to clean our energy system up?

To understand that we need to consider the linkages between oil, gas and coal prices and ultimately electricity prices. Electricity is at the forefront of our attempts to decarbonise. And further electrification of heating and transport, together with the decarbonisation of electricity production, is required and assumed in our targets for carbon reduction.

In many electricity markets, including the UK, it is natural gas prices that are a key driver of electricity prices. It is gas-fired power stations that are the marginal source of supply and that set prices. This is the same stuff that also heats our homes.

Natural gas prices can vary considerably across the world and although there is talk of the ‘globalisation’ of gas, this is not a reality. Natural gas prices in Japan have been four times those in the US in recent years, and double those in Europe.

The reason for these differences is that not all gas is created equal. Natural gas varies according to:

  • Method and cost of production;
  • How it’s sold;
  • How it’s transported;
  • The quality of gas and treatment required; and
  • Environmental impact.

For example, much of the gas imported into the EU is under long-term contracts that are indexed to oil prices and transported via pipelines from Russia, Algeria and Norway. But some of these contracts are based on the domestic ‘hub’ or market prices of the importer.

Gas from Qatar and Nigeria is transported on large ocean-going tankers and is referred to as LNG (Liquefied Natural Gas). The gas is liquefied at the place of origin, transported and regasified at a terminal at the point of delivery. The liquefaction, shipping and gasification uses energy and alters the environmental impact of the use of this type of gas. Some LNG is imported on long-term contracts with oil-indexed prices and some as ‘spot’ or short-term deliveries.

In the US the renaissance in domestic oil production is based on new technology and ways of accessing oil in the ground that was previously difficult to produce – the ‘tight oil’ revolution, or fracking.

Japan imports much of its gas as LNG on oil-indexed contracts.

Today with the fall in oil prices the differences have narrowed between regional gas prices and now Japanese and European prices are closer together whilst US prices have softened only a little.

Overall, the link between oil and gas prices is much debated in energy markets. Even where there is no contractual link we may expect a loose relationship between oil and gas prices for the following reasons:
Substitution of fuels – that one fuel may be substituted for another thereby impacting demand for both. This link works for some fuels, and in some uses, but not for all.

Associated gas production – some gas is produced as a by-product of oil production and this co-production links the two fuels.
The investment plans of oil and gas producers also affect prices. In most cases it’s the large international oil and gas companies that are exploring for and producing both oil and gas. As oil prices fall their financial ability to explore for more oil and gas becomes limited. This ties the cycles of oil and gas prices together.

The upshot of all of this is that lower oil prices give rise to lower gas prices, which in turn results in lower electricity prices. But what does this mean for clean (carbon-free) energy, for wind both on- and off-shore, solar, nuclear and carbon capture and storage?

Clean energy is driven by government policy. Governments have relatively short terms of office. Clean energy is also currently significantly more expensive than conventional forms of energy.

In the UK successive governments have failed to communicate the fact that cleaning up the energy system is necessary and will cost a great deal of money, and that the voting public will have to pay for it. For governments this has proved to be an uncomfortable dichotomy.

They have gambled on high oil and gas prices and said that energy costs will be lower with their policies than they otherwise would have been without their policies. The public has heard only that prices will be lower. And prices have gone higher, in part because of higher oil and gas prices but also in large part due to a growing policy cost.

Now that gas prices are moving lower we should expect to see some relief for consumers in lower prices. But this takes time to feed through as the utilities have already bought the gas a year ago that they will deliver today. In addition, the cost of cleaner electricity is placed mainly on electricity prices. So while gas prices may fall, electricity prices will fall less and may even increase, as a progressively higher proportion of the electricity supplied comes from clean sources.

It is expected then that as conventional sources become cheaper it becomes politically more difficult to invest in clean energy, as it risks alienating voters.

In the UK there is a more direct link in place in the form of what is called the Levy Control Framework. This is a limit set out to 2020 on the amount of money that can be spent on clean energy. It is a complicated system but can be considered as a pot of money that gets spent on subsidising clean energy investments. A clean energy investment negotiates a fixed price for its production – say £90/MWh and the pot is used up by the difference between this fixed price and the wholesale price of electricity in the market – say £60/MWh. As the wholesale price falls the difference grows and uses up the pot of money more quickly.

So there is a direct control by Treasury on how much clean energy will be invested in. Higher wholesale prices means the pot stretches further. All other things being equal, it doesn’t matter how expensive the clean energy investment is, only how relatively expensive it is.

In the long-term lower oil prices will mean less clean energy. In the UK there is a direct link for this through the Levy Control Framework to 2020.

The problem is that climate change needs a solution regardless of how high or low oil prices are. Indeed, if in the future demand from fossil fuels such as oil and gas fall significantly this will result in very low prices. We can’t afford to be tempted back to our dirty old ways by the lure of cheap energy. We have to stay on the clean energy wagon.

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