The Oil Market’s Achilles Heel

Oil prices have fallen back from their immediate highs following the attacks on Saudi Arabian oil processing and production facilities earlier in September. Nerves have been calmed by the promise of the release of strategic stocks, if required, and by Saudi statements that production levels are returning to normal levels relatively quickly.

Washington appears to have stepped back from direct retaliation and has chosen to tighten sanctions instead. Iran's announcement September 23 that the British-flagged oil tanker Stena Impero was free to go will also help de-escalate tensions. Given the size and potentially escalatory nature of the event, the market's reaction has been relatively sober.

Market context

The price reaction to any extreme event is governed by the context in which it occurs and how it impacts short, medium and long-term perceptions of the supply/demand balance.

Minor supply disruptions, or a combination of minor disruptions, can have an exaggerated effect in an already tight market. Even major events, like the attacks on Abqaiq and Khurais, can have only a muted impact, if the supply loss period is short, stocks are plentiful and made available, and most other factors point in a bearish direction.

Beyond the immediate event impact horizon, bearish market factors - the slowdown in the global economy and the increase in non-OPEC production both inside and outside of the US - are unaffected.

Decarbonisation ambitions rise

But longer-term perceptions are also beginning to weigh more heavily on the oil market's fortunes. Over the last 12 months many, mostly European countries, have upped their climate change ambitions. Most notably, France and the UK, both G7 economies, have adopted net zero carbon targets by 2050. There is a strong likelihood that the EU will adopt a similar goal under the tenure of the incoming European Commission.

Such long-term aims may have little impact on short-term oil market dynamics, but net zero carbon targets widen the already large gap between current policies and the policies which need to be formulated if those long-term targets are to be met.

Bans on new sales of diesel and gasoline engines, which have been mooted in a non-legally binding manner in the UK by 2040, have been seen as a form of political greenwash. Implementation and the effects of any such policy would occur far beyond the political horizons of the government of the day.

But the adoption of a net-zero carbon by 2050 target means such bans are much more likely to become a reality and are much more likely to be implemented earlier than anticipated. Indeed, they have to be, if net-zero carbon targets are to be achieved.

Net-zero carbon is impossible without broadening the decarbonization effort beyond the power sector to address transport, industrial emissions, heating and emissions from agriculture. Pressure will build to close the existing policy gap.

As a result, the oil market needs to take more seriously the timing and impact of future environmentally-targeted legislation or risk being wrong-footed.

Electrification signposts

The current and emergent technologies that might deliver net zero carbon targets largely all point in one direction - electrification. Heat and locomotion can both be delivered by electrons rather than molecules, while the electricity system can effectively be decarbonized through the continued rapid expansion of renewable energy sources and the 'greening' of gas via Carbon Capture and Storage (CCS).

Hydrogen, rather than LNG, is, in turn, necessary to deliver heavy-duty transport emissions reductions, particularly in shipping, in line with 2050 carbon targets. But this too requires either CCS or much greater low carbon electricity generation to be a genuinely low-carbon option.

The crux of the problem is increasingly less about new technological solutions and more about the ability to expand the electricity system on a low carbon basis to the required extent and at the necessary speed.

This is balanced by the fact that as the UN Environmental Report on Global Trends in Renewables Investment published in September noted, onshore wind and solar PV have become for many countries the cheapest form of energy supply.

The report said that in 2018 the amount invested in renewables capacity globally was roughly three times that invested in coal and gas-fired generation combined.

Moreover, the attack on Abqaiq and Khurais only serves to underline the volatility of the oil market and its vulnerability to conflict, in comparison with the largely domestic production of renewable energy technologies.

Pricing back in

Oil will have a much smaller role to play in a more electrified energy system. It has already progressively been squeezed out of the electricity sector in almost all countries bar those such as Saudi Arabia, where it is abundant, and even there the government has sought to increase natural gas use in power generation to maximize its oil export potential.

This reflects the higher price oil attracts in the transportation sector, but a steady long-term erosion of oil demand as transport and heat provision are electrified does not mean that oil will be priced back into power markets. It is simply too carbon-heavy to burn, will be barred by regulation and likely face as much environmental opposition as a candidate for CCS as coal.