Right now, global energy commodity prices remain close to long-term highs despite recent declines.
But short-term strength in the value of oil or gas should not prompt any fresh waves of investor capital allocation towards fossil fuels. Periods of cyclically high prices will arguably represent the greatest risk in the longer-term when the structural drivers of the energy transition take over again.
A good example of this is Brent crude. In October it traded at seven-year highs of above $85 per barrel and has dipped only narrowly below this mark during November trading so far.
Such periods of high prices in the oil sector may tempt some investors into believing that the days of profitable returns on investment from fossil fuel production are not quite over.
But as we have seen in the recent past, cyclical highs can quickly reverse. This, and more importantly, mistaking cyclical swings as sustainable over the long-term risk resulting in significant value destruction for investors when the backdrop of declining demand in a carbon constrained world is considered.
Brent crude prices spent the early part of the 2010s above $100 per barrel, prompting investors to pile fresh capital into the oil majors that appeared to be on course to deliver attractive returns. A price crash in late-2014 however saw crude values tumble by more than half over a six-month period, and eventually to lows of below $30 per barrel in early-2016.
This year’s rally, which has largely been driven by the sharp increase in energy demand seen in the COVID-recovery, has represented Brent’s best attempt at returning to the high prices of a decade ago.
But eventually we will return to a normalised post-COVID environment of some form, volatility will ease, and the energy transition shall begin to drive annual demand reductions and fewer projects within the oil sector once again. Investors must ensure that they are not left heavily exposed to potential value destruction when this comes.
These characteristics of the energy transition were confirmed in the IEA’s recent World Energy Outlook report which forecasts that fossil fuel demand will continue to rise from 2019 levels in only one of its three main scenarios – its Stated Policies Scenario (STEPS), which effectively represents business-as-usual. However, the world’s temperature rise from pre-industrial levels would overshoot the 1.5˚C of warming target specified in the Paris Agreement by at least 1.1˚C and reach 2.6˚C under this scenario.
By comparison, under the IEA’s updated Announced Pledges and Net Zero scenarios, the global temperature rise would be limited to 1.8˚C and 1.4˚C respectively.
Achieving net zero emissions by 2050, which is critical if the world is to avoid the most dangerous effects of global warming, means the days of investing in new fossil fuel supply are already over, with the IEA specifying that there can be no further oil or gas projects commissioned beyond those already committed for net zero alignment.
Gas price volatility highlights urgency of power sector transition
Similar to the jump in oil prices, we have a seen a surge in demand for electricity compared with last year. This has brought with it extreme supply issues for the European gas industry amid a slowdown in flows from Russia. Storage facilities are also depleted having emptied last winter and failed to fully refill over the summer months.
Lower wind power generation over the summer period has been blamed by some for meaning that more gas was required for power sector use, thereby slowing storage refill. But volatility such as this in the natural gas market is nothing new.
The political sensitivities surrounding the market have brought frequent price swings in recent years amid fears that supply may be reduced at any time. Although these movements may not have been to the extent that we have seen this year before, extreme volatility and exposure to commodity price movements is something that impacts gas generation, but not renewables.
Our recent Put Gas on Standby report finds that more than 20% of European gas plant units and more than 30% of US plants would be unprofitable to run on paper today when assuming maximum gas price levels of only around $35/MWh for Europe and $41/MWh for the US, compared with the levels of close to $80/MWh that we have seen at times this year.
In fact, we estimated that just a 50% increase in our base case fuel price assumptions would take the proportion of European gas units that are already unprofitable to operate on paper to above 70%, although we acknowledge that the effect of higher gas prices on unit margins will have been at least partially offset by this year’s rise in power prices.
The report also finds that costs for new renewables with battery storage capacity will fall below those associated with continuing to run existing gas plant capacity across Europe and the US by the end of this decade, leaving nations in a position to reduce their dependency on gas imports and exposure to international commodity price moves, creating greater price stability within the wider electricity market. New onshore wind or solar units without battery storage installed meanwhile are already cheaper investments than continuing to operate existing gas plant capacity.
The levels of risk from investment in continued fossil fuel use will only grow further over time and compare starkly with the vast opportunities from the low risk and low-cost renewables sector.