Crude Oil Prices, Climate Change, and Global Welfare

A few weeks ago, I participated in a panel session titled, “The Remarkable Transformation of the Energy Sector: Does it Also Transform Our World.” The motivating question was: “Is the dramatic decline in oil prices a complete gift to the West because of the enormous funds being saved, or is it an unintended Trojan horse because development of renewable energy as well as new fossil-fuel sources will decline in the West, posing longer new challenges?”

The other members of the panel – from private industry – had vastly more expertise (and relevant insights) on fossil-fuel markets, but here’s what I had to say. This is hardly at the sweet spot of my professional competence, so I welcome your comments and corrections! In general, how would you answer that question?

Causes

I start (and started) from the premise that the dramatic decline in crude oil prices that took place from August, 2014 ($96/barrel), to March, 2015 ($44/barrel), was due – on the one hand – to decreased demand, a function of slow economic growth in Asia, Europe, and elsewhere, endogenous, price-driven technological change leading to greater fuel efficiency, and policy-driven technological change that also has been leading to greater fuel efficiency, such as more stringent Corporate Average Fuel Economy (CAFE) standards in the United States; and – on the other hand – was due to increased supply, partly a function of the growth of unconventional (tight) U.S. oil production (a product of the combination of two technologies – horizontal drilling and hydraulic fracturing).  And, in the presence of all of this, Saudi Arabia decided not to restrict its output to prop up prices.

[Before proceeding, I should note that since May of this year, crude oil prices have increased by about 30% from their March low, but as of May ($60/barrel) are still far below their August 2014 level.]

Consequences

When one examines virtually any significant price change from an economic perspective, there inevitably seems to be both good news and bad news. So with the fall in crude oil prices.

The Bad News

First of all, I assume that low crude oil prices are problematic for the economic and political stability of some of the oil-producing/exporting countries, including Saudi Arabia, Russia, Venezuela, and Nigeria.  (For details, see Bordoff and Losz 2015, below.)

Second, it’s frequently been asserted that low oil prices are bad news for the development of alternative forms of energy, including renewable sources. Of course, in the United States, there isn’t much effect on electricity generation from renewable (wind and solar), because in the U.S. electricity sector, renewable supplies compete with coal and natural gas, not with fuel oil (but in other countries, which use more fuel oil for electricity generation than we do, there can be a disincentive for renewable dispatch – and hence development).

Third, there can be – indeed, has been – a major impact in the U.S. motor fuels sector, where the market for biofuels (mainly ethanol) is negatively affected by low conventional gasoline prices. However, these impacts must be somewhat muted by public policies, which directly or indirectly subsidize (or, in fact, require) the use of biofuels.

Fourth, low gasoline prices have resulted in decreased demand by consumers for motor vehicles with high fuel efficiency, and SUV and pickup truck sales have rebounded from previous lows. But these effects are also muted, to some degree, by public policies, including U.S. CAFE standards.   Finally, low gasoline prices also have short-term effects in the form of more driving and fuel use by the existing fleet of motor vehicles, which is bad news in terms of emissions (and congestion).

Differences across Sectors

Before turning to the “good news” about low crude oil prices (and there surely is good news), it’s worthwhile noting that whether individual businesses find these low prices to be good or bad depends largely upon the economic sector in which they operate. For example, whereas commercial airlines are finally making profits, due to the low price of jet fuel (their most important variable operating cost), manufacturers of commercial aircraft will see lower demand for new planes if low jet fuel prices become the long-term norm. The primary factor driving the larger airlines to replace aircraft in their fleets is the lower operating costs due to the much greater fuel efficiency of new models.

And, of course, low oil prices are systematically bad news for oil producers, including the major U.S. companies.

The Good News

Finally, here is the upside of these significant changes in crude oil markets.

Low oil prices are unambiguously good for aggregate global welfare. This includes consumers in the United States, Europe, Japan, and South Korea. And, at least temporarily, OPEC seems to have lost its ability to set a price floor.

Low oil prices mean an increase in consumers’ disposable income, amounting to nearly $2,500 per U.S. household annually, according to Stephen Brown (see below).  If we subtract the income losses to U.S. oil producers, the net gain per U.S. household amounts to a bit more than $800 per year, with gains accruing disproportionately to low-income households.

Turning to the environmental realm, there is also good news, or at least the possibility of good news. An opportunity for new, sensible energy and climate change policies has emerged with these low oil prices.

First, now is the time to reduce – or better yet, phase out – costly and inefficient fuel subsidies, which exist in many parts of the world, particularly in developing countries.

Second, with gasoline prices relatively low – and natural gas supplies holding down electricity prices, at least in the United States – there has never been a better time to introduce progressive climate policies in the form of carbon-pricing, whether via carbon taxes or through carbon cap-and-trade. Unfortunately, none of us should hold our breath waiting for that to happen.

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For further reading, I recommend:

Bordoff, Jason, and Akos Losz.  “Oil Shock: Decoding the Causes and Consequences of the 2014 Oil Price Drop.”  Horizons, Spring 2015, Issue No. 3, pp. 190-206.

Brown, Stephen P. A.  “Falling Oil Prices: Implications in the United States.” Resources, Number 189.  Washington:  Resources for the Future, 2015, pp. 40-44.

Author: Robert Stavins

Robert N. Stavins is the Albert Pratt Professor of Business and Government, John F. Kennedy School of Government, Harvard University, Director of the Harvard Environmental Economics Program, Director of Graduate Studies for the Doctoral Program in Public Policy and the Doctoral Program in Political Economy and Government, Co-Chair of the Harvard Business School-Kennedy School Joint Degree Programs, and Director of the Harvard Project on Climate Agreements.

5 thoughts on “Crude Oil Prices, Climate Change, and Global Welfare”

  1. I’d say you have it broadly right. Some more points below, distinguishing electricity, heat and biofuels. Hope you find some of interest.

    Renewable Electricity

    • Less than 5% of global electricity generation is based on oil, vs. 21% on natural gas and 41% on coal. Deployment of renewable electricity is more likely to be impacted by natural gas price variations to the extent they can be linked to oil price variation, than by oil prices themselves.
    • There are exceptions, though, such as Mexico with over 20% of the electricity being generated from oil, and some Middle East countries with even higher shares.
    • In most cases, through indexation and competition on some markets, natural gas prices and oil prices change in parallel directions. However international gas prices are affected by a number of other factors including regional supply and demand trends, as illustrated by the fact that LNG prices for Asia were already dropping well before the fall in oil prices began.
    • The US offers an exception, with gas prices remaining stable. This is due to the combination of two opposite factors. Part of the shale gas exploitation is profitable thanks to associated liquids. Lower oil prices tend to slow down drilling and thereby potentially increase prices in the short term. However, so far this has been compensated by technology improvements.
    • Where conditions are favourable, renewable generation can be broadly competitive with new-built fossil fuel-fired generating plants – and with the sole fuel costs of generation from oil at current low price levels, or from gas in some cases, notably from LNG in Asian countries but Japan. In Europe, the economic advantage of renewables lies in the stability of the LCOEs, while gas remains cheaper in the US if the current prices of shale gas fuel are maintained.
    • Renewables electricity production costs have been falling rapidly in recent years (by 80% in 6 years for solar PV, by 20-25% for wind power), driven by falling system prices but also by increasing investor confidence, which has reduced the financing costs for renewables.
    • However, an appropriate regulatory and or market framework is needed to provide revenue certainty through long-term contracts to mitigate risk for capital-intensive technologies while encouraging competition and innovation. This allows combining low technology costs with low capital costs, making renewable generation competitive where the resource is good enough.
    • Land-based wind power has levelised cost of electricity (LCOE) from USD 50 to 100/MW, with a recent record low power purchase agreement (PPA) at USD 41/MWh in Egypt; utility PV has LCOE from USD 70 to 110/MWh, with a recent record low PPA at USD 58.4/MWh in Dubai.

    Heat

    • Oil, coal and gas provide about 32%, 29% and 21% of heat, respectively. Oil used for heating purposes has dropped in price in with crude oil price changes, with specific costs depending on the type of fuel, location and taxation regime.
    • Renewable sources of heat – bioenergy, solar geothermal – can also provide opportunities to replace fossil fuels, contributing to energy security and environmental goals. These opportunities are also location specific (depending on the resource). Options such as biomass heating and solar heating can be cost competitive under the right conditions.
    • Even when it is economically attractive, deployment of renewables heat is often held back by non-economic barriers. Renewable heat policies are often not given as much attention as those for electricity and only around 50 countries have renewable heat policies in place (compared to over 120 on electricity).
    • Sustained low oil prices may discourage policy action and deter investment decisions by private households as well as industry stakeholders.

    Biofuels in the transport sector

    • Biofuels currently provide some 4% of road transport fuel needs, and 80% of this is bioethanol, with production and use concentrated in Brazil, and the US. In both countries the role of bioethanol is protected in the short term by mandates.
    • Conventional biofuels supply is determined by production costs, which are determined by short-term feedstock dynamics, as well as investment in new plants and feedstock supply chains. In both Brazil and the US ethanol production is broadly competitive with gasoline even at today’s oil prices, as feedstock costs have fallen as dramatically as oil prices due to good harvests (Figure 2). Low oil prices also reduce fertiliser and harvesting and transport costs.
    • The development and production of advanced biofuels from non-edible biomass feedstock has made good progress in the last few years with a number of commercial plants beginning operation. However advanced biofuels are not yet competitive and they remain dependent on policy support to exploit economies of scale and reduce costs. A prolonged period of low oil prices could reduce the policy motivation to bring forward this family of technologies, reduce support and lead to delays or cancellation of projects.

  2. re: OPEC seems to have lost its ability to set a price floor

    i’ve been covering this with a weekly newsletter…on Thanksgiving, OPEC decided not to cut their quotas, which resulted in the precipitous price decline to $45 January and March…since, several members have seen record output – including the Saudis, Iraq, Kuwait, and Russia, exacerbating the global glut…it is clear from the statements of the middle east oil ministers that they intend to produce as much cheap oil as necessary to drive high N. American producers out of business…

  3. This is a difficult question, which requires a complicated answer, and I think you have done as good a job as anyone could possibly do with that. Here is a different, but related, question that came to my mind reading this: Are market prices losing relevance as the enormity of the externalities is increasingly becoming apparent? In other words, as the time we have to effectively address climate change contracts, do we have the luxury of simply focusing on energy market prices when making financial decisions regarding energy production and use? If so, we may get to a point in time where even carbon pricing will become irrelevant.

  4. One point about oil prices that is under appreciated (to me) – the price of oil is (kind of) set at the marginal cost of the last barrel. Therefore, the price of oil means very little for aggregate world wealth, much more who gets the wealth. Saudi Arabia doesn’t work any harder to supply $100 oil than it does to supply $40 oil.

    Implications for non-oil producers – it is definitely in their interest to invest heavily in alternatives to oil, even when oil is cheap; even when those alternatives don’t appear cost effective, they have the effect of holding down the price of oil, benefiting all who consume oil in their society.

  5. Is there a rough estimate of the proportion of these different factors? E.g. that the $52 cut in the price is about: $25 due to lower demand due to recession, $15 to efficiency, and $12 due to increased American supply? Or whatever?

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