Discussion Paper for The Canadian Ditchley Foundation
The world faces huge energy challenges in the coming years. There is consensus around the broad policy objectives of providing stable, affordable and cleaner energy. Yet, according to the World Energy Council, no country is showing leadership in all three of these areas. One fundamental reason is that no form of energy satisfies all of the criteria. Fossil fuels continue to represent about half of the primary energy demand mix. This proportion has not changed over the last 20 years. According to the International Energy Agency (IEA), fossil fuels will remain dominant for the next 25 years, even if the search for alternatives will inevitably intensify.
Sound public policies with respect to hydrocarbons must look beyond the uncertainty of the current global economic environment and address how we can meet the growing demand for oil and natural gas in stable, affordable and sustainable ways. The sheer size and rapid rate of growth of major emerging economies is creating strong demand for hydrocarbons in a context where, for geological and man‐made reasons, conventional oil and gas production is declining. The point is not that we are running out of oil and natural gas but that we must increasingly turn to non‐traditional sources and more hostile environments to respond to the demand. The structural shift in the global markets is both straining existing infrastructures and requiring huge capital investments for new ones. The end result could easily be strong increases in prices, despite the recent glut in gas production. A policy framework is needed which is supportive of the huge investments required for exploration, development and transportation of hydrocarbons but which also provides a coherent and balanced approach to energy security, efficient use of resources and environmental concerns.
Sound energy policy must therefore create the conditions necessary to fit fossil fuel development to these key objectives. This means addressing the dynamics of world demand and supply peculiar to oil and gas, as well as the capacity and availability of transportation infrastructure between the production areas and the markets, while at the same time placing a strong emphasis on energy efficiency, GHG emission reduction and the environmental impact and risks associated with the production and transportation of hydrocarbons.
The Demand Outlook for Oil and Gas
Public policies obviously have a major influence on the dynamics of demand. For instance the market share of oil is affected by government initiatives to promote fuel efficiency in transportation. Conversely, the expanding share taken by natural gas is due, to a large extent, to its more environmentally favorable attributes. The IE A estimates that natural gas demand will follow an upward trajectory throughout the next 25 years.
Since the Arab Oil Embargo of 1973 and the 1979 energy crisis caused by the Iranian Revolution, the OECD countries' efforts to increase energy intensity within their economies have achieved remarkable success. The energy to GDP ratio ("E/GDP") decreased by 28% between 1973 and 1985 and by a further 26% during the 1985‐2004 period, despite low oil and gas prices. This gradual increase in energy intensity explains in part why, during the 2008‐2035 period, there is a forecast drop in demand for oil in OECD countries, representing about 7% of current global consumption. However, it is estimated that increased consumption during the same period in the rest of the world will amount to approximately 25% of total world demand for oil. This means a huge shift in the loci of demand; approximately 93% of the world increase in primary energy demand during the period should come from non‐OECD countries, with Asian economies, in particular China and India, in the lead.
Although the short‐term impact of public policies can seem marginal, the long‐term effects are structural in nature. For example, the IEA World Energy Outlook 2010 takes into account the likely impact of government commitments in the 2009 Copenhagen Accord and those taken at the G‐20 Summit in Pittsburg to "rationalize and phase out over the medium term inefficient fossil‐fuel subsidies that encourage wasteful consumption". As a result, the projected annual rate of growth in energy demand over the 2008‐2035 period is reduced from 1.4% to 1.2%. This compares to an annual rate of growth of 2% in the previous 27‐year period.
However, even when public policies are successful in increasing energy intensity, as they have been in the OECD countries since the late 1970s, rapid economic growth still means increased demand overall, albeit at a slower rate. By the end of the decade, three of the world's largest economies will be in Asia, with the region expected to account for approximately 50% of world GDP. Such rapid economic growth would, of necessity, drive world primary energy demand. Thus, in spite of policies aimed at increasing energy efficiency, eliminating wasteful usage and curtailing demand, prospects for the next quarter century call for a 140% increase in primary energy demand. How far can further changes in public policy approaches contain this growth in demand, and what changes might have some prospects of significant success?
The Supply Outlook for Oil and Gas
While demand for oil and gas during the next 25 years is expected to be buoyant, profound structural changes are occurring at the same time on the supply side. The critical assumption embodied in the IEA forecast, and the forecasts of others, is that prices of oil and gas will adjust to the market and, therefore, supply and demand will be in rough equilibrium. However the IEA World Energy Outlook 2010 provides little real reassurance on this point when suggesting that compensation for depleting conventional oil fields will come from "fields yet to be found" and "fields yet to be developed". Moreover, the assumption that OPEC countries will increase production to satisfy expected demand in the next 25 years, in part because of revitalized production in Iraq, is fraught with significant risks. OPEC will have an incentive to increase production rapidly only if it is the most profitable way forward for its members. Because of the negative impact of abundant supply on prices, it is not a foregone conclusion that constricting supply would not yield better profits. The OPEC cuts announced in December 2008 which exceeded the expected decline in oil demand are a case in point.
Meanwhile worldwide conventional oil discoveries have been less than annual production since 1980. Conventional oil supply is expected to cover only 20 percent of the expected increase in demand since nearly all additional capacity from new oil fields is offset by the declining output of mature fields. A recent study predicts that demand for oil will surpass supply as soon as 2015.1 The causes are both geological, with the gradual depletion of mature oil fields2 ‐ at least 9 of the 21 largest fields are in decline ‐ and man‐made, i.e. the result of policies such as limiting access through nationalization of oil exploration and production, the imposition of drilling rights limits and heavy tax burdens. A thorough discussion of the supply equation cannot overlook the fact that over 75% of proven oil reserves are in the hands of state‐owned enterprises, which, in several cases, are starved of capital in order to meet public finance needs.
The IEA forecasts that the shortfall in non‐OPEC conventional crude oil production will be compensated by an increase in unconventional oil: Athabasca oil sands in the Western Canadian Sedimentary Basin, extra heavy oil in the Orinoco Belt of Venezuela and oil shale from the Green River Formation in Colorado, Utah and Wyoming in the United States. However, according to the IEA, non‐conventional oil accounted for only 5 percent of the total increase in oil production over the 2000‐2008 period. The reality is that oil exploration has shifted to areas where extraction is much more difficult and expensive, characterized by very deep wells, extreme downhole temperatures, environmentally sensitive areas or a requirement for highly advanced technology. In other words, the rising demand for oil can be met but only at potentially high prices. Moreover, the environmental, social and economic obstacles to the exploitation of these oil reserves are very significant.
These evolving conditions of oil production have a direct bearing on the volatility of crude oil prices. Historically, oil prices have been made to balance by maintaining sufficient idle capacity that could be brought to market in short order to respond to demand surges and damper price volatility. The United States played the pivotal role until the mid‐seventies until it was taken over by OPEC, mainly Saudi Arabia. It is generally agreed that to be effective such spare capacity of low‐cost reserves must amount to at least five percent of global demand. It is currently estimated that the current spare capacity of Saudi Arabia is less than half of this spare capacity threshold. There is no other producer capable or willing to replace Saudi Arabia in its role of "central banker" to the oil global market. The consequences are not difficult to fathom: in the years ahead, prices of crude oil are most likely to exhibit strong volatility with its concomitant depressing effects on investments in production and transportation infrastructure and on economic growth.
On the gas front, although recoverable reserves of natural gas are estimated to be sufficient to meet demand until 2035, the political, geological and technological obstacles likely to affect international supplies in the future should not be overlooked. Over half of conventional natural gas reserves are located in three countries: Russia, Iran and Qatar. Production is also set to increase from non‐traditional sources. The IEA suggests that around 35% of the increase in gas production between now and 2035 will come from shale gas, principally in the United States, and that LNG will account for more than half of the gas trade.
However, the exploitation of shale gas has already created a glut in global supplies and significantly lowered prices. This pressure on natural gas prices is unlikely to change for a significant period of time. A major effect of the recent collapse of prices is to discourage investment in LNG, a development that does not bode well for the future. There are also environmental concerns about some of the newer gas extraction technologies. Here again, therefore, further development of non‐traditional sources of supply will most likely be constrained by environmental, social and economic considerations.
Energy Transportation Infrastructure
The transportation of hydrocarbons from extraction to consumers depends on a complex, interlinked and expensive infrastructure. In many parts of the world, the current infrastructure is aging and in need of significant refurbishment or replacement. The uproar that followed recent spills from oil and gas pipelines in North America is a warning industry and governments would be well advised to heed. At the same time, the structural shifts in the global economic center of gravity and in the location of new production zones are increasing the need for new infrastructure and a new landscape for transport routes. These developments are subject to substantial risks and uncertainties.
For example, the Caspian region, very well‐endowed in oil and natural gas resources, has the potential to make a significant contribution to energy security in the rest of the world. However, the complexities of constructing and financing transport infrastructure passing through several countries in the region are a significant constraint on the availability of these resources in world markets within a reasonable time horizon. Here, as in other regions, the geopolitics of energy exert significant influence on the range of realistic outcomes. Local constraints can also be important. For instance, in Canada, the construction of the Mackenzie Valley pipeline and the Keystone Gulf Coast Expansion project are embroiled in political or regulatory entanglements.
At present, all of the world's largest energy importers are dependent on seaborne oil and gas. The United States imports around 60 percent of the oil it consumes by tankers. Japan is almost completely dependent on maritime imports. China and India import 90% of their needs by sea. Maritime traffic is bound to increase by leaps and bounds to satisfy the rapidly growing demand of these new markets. This, in turn, will require new transport and port infrastructures to meet the new traffic pattern.
As more difficult and environmentally challenging offshore and coastal production areas, such as the Arctic, become more significant in the supply equation, the risks associated with the construction and operation of the transport infrastructure, including maritime traffic on high density or riskier shipping routes, will become increasingly prominent in policy and public debates.
The Socio-Economic Context
In addition to the changing dynamics of energy demand and resource availability, powerful socio‐economic forces will fundamentally alter the way energy is managed and used.
On the economic side, the higher cost of fossil fuels production and transportation of the new sources of oil will increasingly affect the pricing equation. In the near future, rebounding demand following the economic downturn in Europe and the United States is likely to create a price spike which may be brutal as a consequence of the reduction in investments in upstream facilities that followed the 2008 decline in oil prices. Analyses of the causes of persistent price increases during the 2007/08 period show that the determinant factors were related to growth in global activity in the presence of supply constraints. Sharp price increases and persistent high price volatility may prompt countries to adopt strong measures to reduce oil dependency. Changing market circumstances and national priorities are contributing to significant levels of variability in policy making and in the quality of policy implementation.
The greatest challenge for many policy makers is managing energy demand, although this tends to be neglected compared to issues of supply. To date, most countries' programs designed to reduce greenhouse gases focus on promoting renewable technologies. But energy efficiency programs have been proven to be the cheapest, fastest, and cleanest way for countries to meet their energy needs. Instead of incurring economic costs, countries gain immediate economic benefits and savings when businesses and individuals simply begin to conserve energy. Energy efficiency improvements should be rewarded equivalently to energy supply developments to encourage strong public and private sector cooperation. The keystone of a sound energy policy should be a commitment to energy efficiency improvements.
Any comprehensive energy policy must also address the global issue of climate change. The international community is unlikely to be successful in its quest to reduce the risks associated with climate change without an overall framework that promotes and facilitates the vigorous creation and dissemination of new technologies across the globe. The private sector has a central role to play through increased efforts in R&D, product and process innovations and their commercialization. There are also catalyst and coordination roles for government in order to accelerate the private innovation engine, help with demonstration and promote commercialization of promising technologies.
Energy is the lifeblood of every economy and society around the world. All forms of energy have some environmental impact. The challenge for industry and governments (and citizens) is to design and implement the policy trade‐offs that will render energy development and environmental stewardship mutually reinforcing objectives.
1 Nick A. Owen, Oliver R. Inderwildi, David A. King (2010). « The status of conventional world oil reserves -Hype or cause for concern? ». Energy Policy 38 (8): 4743. doi: 10.1016/j.enpol.2010.02.026.
2 IEA reported that the rate of decline in 800 of the world's largest oil fields was 5,1% per annum; World Energy Outlook 2008.
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