With both the supply and demand for oil being reduced because of a transition from internal combustion to electrified vehicles, a surge in fuel prices should have been avoidable. The International Energy Agency estimates that as of January 2022 there are approximately 16 million electric vehicles in operation worldwide, consuming roughly 30 terawatt-hours of electricity yearly. In layman terms this is equivalent to total electricity used in Ireland in a year for example. In 2021 electric car sales more than doubled to 6.6 million units, representing nearly 9% of the global car market, or more than triple its market share in two years.
When supply declines less than demand, the equilibrium price will decline. However, many of the climate-related efforts to reduce carbon emissions focus on reducing the supply of fossil fuels by discouraging or preventing exploration and production activity and investment, by government fiat, disallowing market forces to operate effectively. These actions include restrictions on fracking in the USA; reducing or eliminating oil lease auctions; stopping or slowing pipeline construction; preventing financial institutions from lending to or investing in fossil fuel related companies; and designating many areas off-limits to exploration and drilling. Sadly, the leading presidential candidate in Colombia, Gustavo Petro, has pledged to end all oil exploration in that country. A headline in the February 20, 2022. New York Times was “Biden Administration Halts New Drilling in Legal Fight Over Climate Costs”. This action by the department of Interior now prevents both new federal oil and gas leases as well as drilling permits.
The net effect of efforts to curtail future oil production is a sharp reduction in exploration and production capital spending. This is being accentuated by an insistence from the financial markets that firms in the oil industry emphasize capital discipline versus a historical emphasis on reserves accumulation. Chart I attached shows world oil production in millions of barrels per day versus inflation adjusted capital expenditures on exploration and production. It shows that real capital spending peaked in 2014 while oil production peaked in 2019. Global spending is poised to climb by about 16% this year after about a 5.5% increase in 2021 according to Rystad Energy. This was after a sharp pandemic related decline in 2020. Nonetheless, the rebound from 2020 is much less than would have been expected and is likely the result of climate related constraints.
A proxy for real capital spending is the active rig count. Chart II attached shows the worldwide rig count and chart III attached shows the rig count for the USA. Both series also peaked in 2014. In January 2016 our report titled Will Oil Production Fall OFF A Cliff examined the outlook for industry capital spending. Spending was modeled as a function of past and projected levels of the price of west Texas intermediate crude (WTI) as determined by the crude oil futures market. The model predicted a shortfall in capital spending, but instead of falling off a cliff it is falling off a mountain top.
In that report we used $40 per barrel as a long-term equilibrium price for WTI. The model predicted that global capital investment would be about $300 billion going forward from 2020. Actual prices to date for WTI would have predicted global investment would be about $400 billion in the current period based on that model’ or about 24% more than the projected 2020-2022 average. So, the current level of crude oil and natural gas prices would be spurring much higher exploration and production spending than is occurring. A significant portion of this differential can be attributed to the concerted effort by activists and politicians to curb fossil fuel investment.
Indeed, a recent Wall Street Journal article Frackers Brace for Shale Slowdown — Limited inventory leaves the industry with little choice but to hold back growth found that major oil plays such as the Permian, the Bakken, and the Eagle Ford basins have left drillers with a limited amount of inventory of prime drilling locations to replace fast-depleting shale wells that have used enhanced recovery methods to boost production. But these companies are not only finding it difficult to get financing through traditional channels, but they are also being pressured by investors to slow exploration and return cash to shareholders.
The current projected global exploration and production spending is less than the level forecast by actual WTI prices even considering that the futures market is in backwardation as shown on Chart IV attached. (Backwardation occurs when the current price is higher than the futures price). But oil is not the only energy source where capital spending and hence future energy supply is being curtailed by climate concerns. Coal, natural gas, and nuclear are all being phased out as a matter of policy. Those advocating such policies are the same ones expecting electric vehicles to replace oil. They further expect that renewables such as wind, solar, and bioenergy will replace fossil fuel and nuclear as sources for the much greater amount of electricity that will be required to power vehicles, cook food, and heat homes. This naivete is astounding and dangerous.
Many are now focusing on the vastly higher production of many metals that will be required if electric vehicles are to replace internal combustion vehicles. Electric vehicles use about four times as much copper as similar sized traditional vehicles. Batteries, both as an energy source and for storage, will need amounts of lithium vastly higher than current production. Nickel and cobalt prices have already increased sharply as have prices for graphite and vanadium because of increased battery demand. There are also rare earth elements whose demand will increase because of electrification. These will either drive up final product prices or reduce margins. Higher production consumes energy, which is ignored by climate advocates. And of course, the primary source for these metals is from unstable and unfriendly sources.
Had the switch from fossil fuel been driven by market forces, it would be occurring more gradually and less painfully. Horses and wood were replaced by fossil fuel by market forces and the result was a deflationary rather than inflationary episode. But if the switch from fossil fuel to renewables proceeds at the rate that climate zealots insist is necessary, the inflationary implications could be serious. The extreme inelasticity of both supply and demand of oil and gas means that if supply declines slightly faster than demand, a price spike could occur. In the short run when gasoline prices increase, motorists have the choice of paying the higher price or pushing the vehicle or riding a bicycle. (Public transit is now considered to be too unsafe to be a viable substitute). Likewise, once an oil or gas well is completed, the output will be sold at the prevailing price. Low prices will curtail future exploration, but high prices will not bring on new production if nonmarket constraints to production exist.
Some climate fanatics might consider economics to be irrelevant when combating global warming (if there is such a thing). However, even putting aside the inflationary aspect of restricting fossil fuel supply such that it declines faster than demand, there may be other problems. For example, the book The Ministry for the Future by Kim Stanley Robinson has been praised by former President Obama and Ezra Klein to name a few, who said that all policymakers should read it. Robinson was a featured speaker at COP26, the Climate Summit held recently in Glasgow.
The book is one of many that warn of a coming climate catastrophe. It begins with a “wet-bulb heat wave” which is that most humans cannot survive for long in a temperature above 103 degrees if it coincides with humidity so high that sweat does not evaporate. That would be about 35 degree humidity. In the book tens of millions perish in the year 2025 from such a heat wave. In the book the electric power grid is incapable of supplying enough power for air conditioning etc. to keep people safe during such a heat wave.
In many areas of California natural gas and propane hookups are no longer being permitted in new homes and buildings. This and most other climate laws increase electricity demand. If forest fires do not get the residents, the heat surely will. Shutting coal fired, gas fired, and nuclear power plants before sufficient alternatives are in place reduces the overall supply of electricity. Thus, the very policies which purport to prevent disasters from global warming, could also reduce the availability of the very electric power that would prevent deaths from global warming.
There are other negative outcomes associated with a hasty reduction in fossil fuel. Many coal-fired power plants worldwide have been closed in favor of cheaper natural gas. But now constrained coal capacity is boosting natural gas prices with resulting geopolitical implications. Were natural gas currently below the $2 per mcf level that prevailed as recently as a few years ago, Russia for example would probably not be as confident of using gas to impact the actions of Europe and China.
Nuclear energy, which does not emit greenhouse gases, was once thought of as a panacea. However, accidents have prompted major economies such as Japan and Germany to phase out nuclear energy. In this country nuclear is also being phased out. There were 80 nuclear power plants built in the USA prior to this year. All but five started operating in the 1980s or earlier. Already 25 of these have been retired leaving 55 currently operating. The oldest is Nine Mile Point I in New York, which entered service in 1969. Its days appear numbered. The newest is Tennessee’s Watts Bar Unit 2, which began operating in 2016. The next youngest is Watts Bar Unit I which entered service in 1996. Since 1996 only one nuclear power plant commenced operation in the USA.
The Biden administration does not seem particularly concerned about inflation generally or the potential inflationary consequences of climate policy. The administration could lower gasoline prices immediately by reforming the Renewable Fuel Standard program administered by the Environmental Protection Agency. We outlined this in OILK Is A Way To Play Another Oil Boom And Bust. But revisions would be harmful to the farm economy and thus so far it is being ignored. Now intense negotiations seem to be underway to revise the Iranian nuclear agreement, making it more palatable to Iran so that an agreement would enable sanctions to be lifted, and oil to start flowing again in hopes of lowering market prices. Apparently, it is ok for others to pollute but not us even if its consequences are short term in nature.
ProShares Trust – ProShares K-1 Free Crude Oil Strategy ETF (OILK) is a fund based on an index and seeks to track the performance of three separate contract schedules for West Texas Intermediate (“WTI”) Crude Oil futures traded on NYMEX. These contract schedules are equally-weighted in the index (1/3 each) at each semi-annual reset in March and September. For many investors OILK makes more sense than trading crude oil futures themselves. This avoids margin calls and messy K-1 tax issues, while fully capturing the upward trajectory of crude oil.
Whatever, a continued fixation on climate change in the U.S. and abroad may have salutary consequences in the long run. But in the short and intermediate term it is harming the fossil fuel industry and raising the price of fuels with adverse inflationary consequences. What is worse than fixation on climate change, is that alternatives to fossil fuel are simply not rising fast enough, such that inadequate supply will harm economic growth. The supply-demand imbalance will continue driving prices higher and could ultimately force monetary policy to stamp out the resulting inflation, driving the global economy into a ditch. This is one way to reduce prices and clean the air, but not a very gratifying way.
Source: Created by Author with data from Federal Reserve Economic Data, Rystad Energy and EIA
Source: Created by Author with data from Federal Reserve Economic Data, Rystad Energy and EIA
Source: Created by Author with data from Federal Reserve Economic Data and Baker Hughes
Source: Created by Author with data from Barchart.com
Please note that this article was written by Dr. Vincent J. Malanga and Dr. Lance Brofman with sponsorship by BEACH INVESTMENT COUNSEL, INC. and is used with the permission of both.