Oil Markets in the Age of Energy Transition

By Adi Imsirovic

The oil market is changing in response to energy transition. What should we expect in the next few years? Adi Imsirovic explores likely changes in this article.

The future of the oil market, the biggest and most influential commodity market in the world, hinges on the pace and direction of the energy transition. But the speed and direction of this transition are not arbitrary.

A Limit to Growth

Already, more frequent extreme weather events such as hurricanes, flooding, fires, and extreme cold snaps have introduced volatility to the oil and gas markets.¹ For these and other climate-related reasons,² meeting the Paris (COP 21) goals³ is a firm boundary condition⁴ that must be met if we are to avoid decades of climate disasters.

Having accepted these goals as a boundary condition, necessary oil demand and supply paths to meet it become clearer, making it possible to discuss likely changes in the oil markets, benchmarks, and prices. This article briefly discusses these changes.

Transition Has Already Started

Ever since the 2006 Stern Review,⁵ economists have firmly argued that the costs of stabilising the climate are manageable, but delays would be very dangerous and far more costly. Twenty-two years on, the International Monetary Fund (IMF) economists are still pressing the same point: “… to achieve net carbon neutrality by 2050 requires immediate and ambitious action. By 2030, global emissions have to be reduced by at least 25 percent compared with today’s emissions…”⁶

Working backwards from our boundary condition for meeting Paris climate goals and using the best climate models that we have to date, the International Institute for Sustainable Development (IISD) estimates the global oil consumption to fall by at least 15% by 2030 and a massive 65% by 2050.⁷ It is important to emphasise that, for a smooth energy transition, we need to reduce the oil demand and not just production. All too often, environmental campaigners and policymakers focus on the need to cut supply, causing unnecessary shocks and volatility in the energy system.⁸

The transition away from oil may be starting already. In 2021, global refining capacity fell for the first time in 30 years.⁹ In their Net Zero Emissions (NZE) scenario, compatible with the Paris goals, the International Energy Agency (IEA) sees a falling oil demand at about 6% per annum, from the current 100 million barrels a day (mbd) to only 75 mbd in 2030.¹⁰ Most of this fall in demand will come from the growing share of electric vehicles (EVs) and increased recycling of plastics.¹¹ As a result, the demand for oil is likely to become more elastic. In other words, any large increase in the price of oil will simply lead to less demand and an even faster transition.

Aside from the fall in demand for oil, the flows are likely to change too. In the IEA/NZE scenario, the share of production in the Organization of the Petroleum Exporting Countries (OPEC) nations is likely to increase from 35% in 2021 to over 50% in 2050.¹² Outside the cartel, most of the supply should come from the United States, Guyana, and Brazil. In particular, US tight oil production is likely to remain resilient as the fracking technology requires only short-term investments, reducing the risk of having stranded assets as the demand eventually falls. This resilience will be further reinforced if OPEC continues with the policy of maintaining high oil prices, accelerating the transition away from oil. In such a scenario, US production should be exceeding that of Saudi Arabia by a large margin.¹³

Stranded Assets?

However, the rising of the price elasticity of demand as well as the overall consumption will eventually pressure oil prices, increasingly forcing the high-cost producers out of the market. This tension and diminished reputation of Russia as a reliable supplier will dim the OPEC+ alliance defunct. Concentration of market power could make OPEC stronger, but in a much smaller, marginalised, and more price-sensitive market.

The recent energy crisis has brought a lot of criticism against the oil companies for their financial caution and lack of investment in new oil production. New, conventional oil investments take up to 20 years to bring to the production stage,¹⁴ making them risky and likely to become stranded assets. It is no wonder that many oil companies prefer to give money back to shareholders. These are basic economics of transition at work – a high risk of investment results in high prices in the short run, accelerating the transition to cheaper and cleaner options.

For quite some time, the growth in demand and new refining capacity has been happening “East of Suez”.¹⁵ Most of the new plants have associated petrochemical units in a hope of protecting them from the expected fall in demand. These relatively new refineries will provide relief to the western markets, facing a spike in demand in the short run, but their longer-term¹⁶ viability may not be so bright, given the expected fall in demand.

Changing Flows and Pricing Power

With the centre of gravity firmly in the Middle East and Asia Pacific regions, one would expect the pricing power for oil to move to this part of the world as well. Already, there are working futures contracts for Oman (Dubai Mercantile Exchange or DME), Murban (ICE Futures Abu Dhabi or IFAD) and a basket of delivered crudes into China (at Shanghai International Exchange or INE). However, this is very unlikely to happen for quite some time. Firstly, the INE contract is a Yuan (Renminbi) – based contract in a highly regulated Chinese economy, dominated by large, state-owned firms.

The Middle East exchanges have backing from powerhouses such as Chicago Mercantile Exchange (CME) and the Intercontinental Exchange (ICE), but the oil contracts are parochial and fragmented. For example, it would make sense for these contracts to incorporate different crudes from the region for alternative delivery.¹⁷ Arab Light, Oman, and Upper Zakum could be deliverable in the same contract, increasing the liquidity and depth of the market. Similarly, the IFAD Murban contract in Abu Dhabi could include Saudi Arab Extra Light crude and even West Texas Intermediate (WTI) as they are not dissimilar.

With the US production and exports continuing to dominate global markets for the next one or two decades at least, it is hard to see the role of WTI or even North Sea Brent being challenged. Brent, the premiere global benchmark, will see the introduction of WTI as a deliverable grade into its basket of crude oils from July 2023. While there is always a possibility that the implementation of such a major change may backfire, it is likely that the sheer volume of the US-exported oil, lack of destination, and other restrictions will ensure that these contracts, in some form or another, remain relevant for many years to come. But the energy transition may force them to come in a different form, taking into account their carbon footprint.

Carbon-neutral Benchmarks?

Many governments are looking at including carbon accounting in their trade legislation. The European Commission has proposed a regulation to impose charges for high carbon imports on a range of commodities through the Carbon Border Adjustment Mechanism (CBAM).¹⁸ Initially applicable to only a few commodities (including aluminium, steel, and power), the eventual extension of CBAM to fossil fuels is likely. This will have a knock-on effect on the international oil trade. To make the mechanism work, governments and market participants need new tools, clearly indicating the carbon intensity of individual shipments and their “carbon-adjusted” value.

In June 2021, S&P Global Platts launched the first ever daily Platts Carbon Removal Credit assessment and later followed it with the launch of monthly “carbon intensity” (CI) calculations for selected global crude oil fields. Combined, the two numbers facilitate a calculation of the “carbon intensity premium” (CIP) for individual grades of oil, alongside their usual price assessment.¹⁹ Higher CI and the associated crude oil premium would indicate a greater environmental cost (estimated using voluntary carbon credits) needed to offset emissions associated with such crudes. For example, it turns out that the heavy and high sulphur Arab Heavy crude oil should trade at a premium to lighter and lower sulphur, Iraqi Kirkuk crude which had higher CI.²⁰ These premiums would vary with the changes in the carbon price used, incentivising the refiners to use crudes with lower carbon content.

These are novel ideas and need a lot more work, especially in the area of independent verification of greenhouse emissions.²¹ However, they point the way forward for the oil market to adjust to the new environmental realities and efforts to fight climate change.

Conclusion

The necessary efforts to meet COP21 goals and avoid a climate disaster will have a major impact on the biggest and most important commodity market in the world.

Policy imbalances and climate change-induced extreme events are likely to increase market volatility and risk premiums. The net-zero emission path will require a large fall in oil consumption and will reduce the importance of oil in the overall energy mix.²² The key market for oil, the transportation sector, will see EVs breaking the dominance of the internal combustion (IC) engine, resulting in an increase in the price elasticity for crude and further decoupling of the economic growth and oil demand.

Marginal demand for oil will firmly stay “East of Suez”, but this will not necessarily imply a shift in the pricing power from the existing benchmarks such as Brent and WTI. OPEC will see a substantial increase in its market share but exercising this power will only lead to a faster transition away from oil.

With its liberal trade, and no destination restrictions, the importance of the US as an oil exporter will grow further and the pricing of its flagship, WTI crude will be a key market price indicator. To facilitate the energy transition, carbon markets will be increasingly utilised in conjunction with independently verified emissions of individual crude fields, facilitating more sustainable selection and trading of crude oil.

About the Author

Adi Imsirovic is a Senior Fellow at the Oxford Institute for Energy Studies and a member of Surrey University Energy Economics Centre (SEEC). For over 25 years, he has held a number of senior positions in oil trading in London and Singapore for companies like Texaco, Sempra, and Gazprom. Also, Adi taught Resource and Environmental Economics as well as Energy Economics at the University of Surrey on a part-time basis. Adi Imsirovic has a PhD in Economics and a Master of Science in Energy Economics. He is a Fulbright Scholar and studied at the Graduate School of Arts and Sciences, Harvard University. There, he also worked as an Adjunct Research Fellow at the Energy and the Environmental Policy Centre, Kennedy School of Government, Harvard. Adi is also the author of the book “Trading and Price Discovery for Crude Oils” published by Palgrave McMillan in June 2021.

References

1. For example, see: https://www.reuters.com/business/energy/hit-oil-output-ida-overshadows-demand-impact-says-goldman-2021-09-13/
2. Climate Change 2022: Impacts, Adaptation and Vulnerability Working Group II Contribution to the Sixth Assessment Report of the Intergovernmental Panel on Climate Change
3. Key goal is to limit global warming to well below 2, preferably to 1.5 degrees Celsius, compared to pre-industrial levels. See: https://unfccc.int/process-and-meetings/the-paris-agreement/the-paris-agreement
4. Boundary condition used here is seen as a mathematical construct – a set of conditions that a system (of simultaneous equations, for example) should meet in order to find a solution or solutions for the system as a whole.
5. https://www.lse.ac.uk/granthaminstitute/publication/the-economics-of-climate-change-the-stern-review/
6. IMF World Economic Outlook, October 2022, ch3, p.71.
7. Using a median of selected IPCC scenarios and the IEA’s Net Zero Emissions by 2050 scenario. International Institute for Sustainable Development (IISD) report: Navigating Energy Transitions, Mapping the Road to 1.5°C’, October 2022.
8. For my detailed comments on this subject, see: “History Lessons for the Energy Transition”, Energy intelligence, Tue, Jan 11, 2022, https://www.energyintel.com/0000017e-49b0-df72-a97f-ebf4ae9b0000
9. International Energy Agency, World Energy Outlook 2022, p.326.
10. Ibid, p328.
11. In 2030, 60% of all new cars sold are expected to be EVs. Plastic recycling globally increases from the current 17% to 54%. Ibid, p.325.
12. 12 The highest share of production, ever. Ibid, p.52 and p.341.
13. ‘US production in 2030 is around 50% higher than in the next largest producer country (Saudi Arabia)’. Ibid, p.338.
14. Ibid, p.326.
15. ‘Asia-Pacific is set to add around 3.6 mb/d of refining capacity… The Middle East and Africa are set to expand their refining capacity by 1.6 mb/d and 1.2 mb/d, respectively… 2.6 mb/d of refining capacity is projected to be closed, mostly in developed countries.’ in the ‘World Oil Outlook 2045’ Organization of the Petroleum Exporting Countries 2022.
16. A typical life of a refinery (with maintenance and upgrading) can be well over 50 years.
17. Alternative delivery reduces the risk of market concentration and market squeeze by increasing liquidity. What is more, they add to the market depth by introducing players who would not naturally participate in the original market. Alternative delivery was pioneered by Nymex in the mid-1980s, to counter falling WTI production. Several alternative grades were included as deliverables in the WTI futures contract, including Brent.
18. https://taxation-customs.ec.europa.eu/green-taxation-0/carbon-border-adjustment-mechanism_en
19. For more details, see https://www.oxfordenergy.org/wpcms/wp-content/uploads/2022/02/New-GHG-verified-mechanisms-for-internationally-traded-crude-oil-and-possible-impact-on-oil-benchmarks.pdf
20. Ibid, Figure 3, p.7.
21. Some 70% of the oil sector emissions are Scope 3 emissions at the point of consumption in transportation, heating, or industry. Who is responsible for emissions from the end-use of refinery products?
22. Even OPEC see a fall in the share of oil in the energy mix from 31% to 29% in 2045. OPEC WOO 2022, p.7.