How low can you go? The impact of oil at $30 a barrel and falling…

Monday, 18 January 2016

How low can you go? The impact of oil at $30 a barrel and falling…

Synopsis

The price of oil keeps on falling. This blog unpicks the impacts for the UK economy, and for energy and environmental policy.

From a high of nearly $115 a barrel in July 2014, the price of Brent crude has fallen to 13-year lows of less than $30 per barrel. In the time it took to write this blog, the Brent crude futures price briefly fell even further to under $28 per barrel. UK supermarket petrol prices have dropped to around £1 per litre, which in some cases makes it cheaper than the mineral water they sell in their shops.

The world has built up a substantial glut of oil as OPEC producers refuse to limit supply, defending their market share. The over-supply is being pushed even further with sanctions being lifted in Iran, which will add 0.5 million barrels per day of production and the prospect of further increases in due course. Iran has some of the lowest oil extraction costs in the world at around $10-15 per barrel. Storage facilities in the US and China are now at unprecedented levels, and traders are even resorting to using floating tankers as temporary storage. And that’s before you even factor in the impact of China’s economic slowdown on oil demand.

Given the extent of oil-linked contracts, gas prices have followed oil to multi-year lows. The UK wholesale spot gas price has fallen from 73 pence per therm in December 2013 to a low of 33 pence per therm in the last few days, and the impact on gas futures prices has been no less severe. 

The most obvious impacts of low oil prices for the UK are economic - in terms of consumer prices and spending, the UK oil and gas industry, and on government taxes.

Falling oil and gas prices have had a significant impact on consumer prices and inflation. In the 12 months to November 2015 (the latest data available from ONS), overall Consumer Price Inflation was running at just 0.1%, and at times during 2015 the UK experienced brief periods of deflation. However if you compare energy (electricity, gas and transport fuels) against all other goods and services, the data tells a very different story. Energy prices fell by 7.2% over the last year, whilst non-energy prices rose by 1% on average. In other words, had energy prices not fallen, then CPI would have been nearly 1% higher in 2015. This represents an economic boost of nearly £6 billion per year for UK households (or more than £200 per household), which is all money they can now save or spend on other goods and services.

However, the fall in oil and gas prices has had a severe impact on the oil and gas industry. BP recently announced that it is cutting 4,000 jobs worldwide, of which 600 will be lost from its North Sea operations. In fact it is estimated that more than 5,500 jobs have already been lost in the North Sea industry, and some fear that total job losses could be three to four times that over the next few years. North Sea oil and gas production has so far been resilient to falling prices – in fact 2015 saw the first increase in production from the UK Continental Shelf for over 15 years. However, investment levels are plummeting, with companies walking away from what are now uneconomic projects. Investment in North Sea oil and gas declined significantly in 2015, and two thirds of operators in the North Sea have been forced to cancel projects. Goldman Sachs previously estimated that as much of $930 billion of oil and gas investment could be cancelled or delayed worldwide (and that was when the oil price was still hovering around $60-70 per barrel). 

The impact is also likely to undermine the UK’s emerging shale gas industry. A range of analyst reports suggest that UK shale gas would only break even at around 50-80 pence per therm. The current gas price of 33 pence per therm will make even the best projects unviable, although prospectors may continue development in the hope that prices increase significantly in the future. 

The fall in prices and North Sea investment has also fed very rapidly through to lower tax revenues for the UK government. In 2010, UK oil and gas producers were generating £11 billion in taxes (petroleum revenue tax plus offshore corporation tax). This fell to £2.2 billion in 2014-15, and is projected to be just £130 million in 2015-16. In fact the OBR’s latest forecasts show that oil and revenues over the course of this parliament are now expected to be just £0.6 billion, down more than £12 billion compared to forecasts produced as recently as 12 months ago. The petroleum revenue tax itself has become a net liability for the government, with oil and gas companies able to claw back some previously paid tax. 

As well as economic effects, the fall in oil and gas prices could have some significant implications for energy and environmental policy. All else being equal, economic  theory would suggest that the falling price of oil and gas would lead to an increase in consumption of oil and gas, with people driving their cars further, and heating their homes more. This could increase, or slow down the fall, in greenhouse gas emissions. However, the evidence suggests that it takes quite a while for people to respond to movements in energy prices and change their behaviour – energy use is relatively price inelastic, at least in the short term. There is significant inertia towards improving energy efficiency and reducing energy use in the UK – for example consumption of electricity and gas in homes has dropped by 23% over the last decade (or by 28% per person if you strip out the effect of population growth). It remains to be seen how consumers respond to the new lower energy price environment over the long term. 

Low fossil fuel prices should also in theory have a negative impact on investment in low carbon energy sources, as they become relatively more expensive compared to fossil fuels. However the evidence seems to suggest otherwise: data from Bloomberg New Energy Finance shows that global investment in clean energy hit a new record of $329 billion in 2015, up 3% on the previous year. Beneath this headline trend, there has been a massive shift in the patterns of investment, with clean energy investment reaching a new high of $110 billion in China in 2015, and Europe continuing to decline to less than $60 billion (the weakest level since 2006). But the UK clean energy sector remained resilient, with record investment levels of over $15 billion in 2015, an increase of 24% over the previous year. 

Part of the explanation for the resilience in clean energy investment may be that many projects are support by guaranteed or fixed price revenue streams, rather than market prices alone. For example, the UK is moving to the “Contract for Difference” model, under which generators are almost entirely insulated against movements in wholesale electricity prices. As we have documented previously, the implication of this, in an environment of falling fossil fuel and wholesale prices, will be an increase in the subsidies to low carbon projects. 

This is indicative of a wider shift taking place within energy companies in terms of how they generate earnings. Analysis by Moodys, looking at European regulated utilities such as the “Big 6”, shows that their earnings exposed to commodity prices declined by 26% from 2011 to 2014. At the same time, regulated and contracted earnings – which includes fixed revenues from renewables and payments for running energy networks – increased by 8%. This may explain why some major companies in the sector, such as E.On and RWE, are looking to separate their fossil fuel and non-fossil fuel operations.

In summary, the impact of low oil and gas prices is having some significant effects on the UK. Low prices are a boom to consumers, but government finances will feel the strain of reduced oil and gas related receipts, and the knock on effects of job losses. The impact on energy and environmental policy is more nuanced, and may take time to materialise fully - particularly given that clean energy investments are increasingly driven by government policy rather than market mechanisms alone. 

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how low can you go? the impact of oil at $30 a barrel and falling…