COVID-19 continues to shake the global economy, and energy markets are no exception. Oil in particular finds itself caught between the devil of an unpredictable demand shock and the deep blue sea of major producing countries’ vast reserves under a breakdown of previously co-ordinated production cuts. At Carbon Tracker, our focus is on the financial effects of the energy transition; however, relatively short term events can give invaluable context and a lens through which to view longer term challenges.

Expect the unexpected

We have recently written about the difficulty of preparing for sudden market disruptions in “Handbrake Turn”. Business as usual scenarios assume fossil fuel use rising in an uninterrupted gentle trajectory for decades on end; even energy transition scenarios of structurally lower fossil fuel demand use tend to show beguilingly smooth demand pathways, lulling into a false sense of security. This is by necessity of course – some market shocks simply can’t be predicted, either in cause, effect or timing, and can only be mitigated with caution beforehand.

When thinking about the energy transition this means oil executives should be planning for a decarbonised economy and limited fossil fuel use even if they personally don’t believe it likely, although that position is becoming an increasingly hard one to take. The upshot would be a higher margin, lower cost portfolio of projects that is relatively resilient to any demand shock, whether transition related or not. A company that had committed to only sanctioning projects which fit in a low carbon world, and accordingly committed to a lower internal price deck, would currently be somewhat less panicked than peers that have approved assets that are more reliant on higher prices.

Unfortunately, in normal times incentives are often to do the opposite – a company that uses a price case of $60/barrel will find that it gets outbid for assets by companies that assume $70 and thus see greater future cash flows in their modelling. These smooth demand scenarios may then give confidence that these assumptions are safe bets – one could see a parallel in assumptions of ever-rising house prices before 2007. An upshot of the recent crisis may be to sharpen attention on the risks of lower prices and/or demand, although now later than some investors may have preferred.

The shortcomings of practice around scenario analysis are highlighted

We have long argued that expecting future oil markets to look pretty much as they have done in recent history is a dangerous game. Pricing may be influenced by the intersection of supply and demand in the long term, but short term effects can be violent and both demand and supply curves are moving parts.

For example, relying on OPEC+ to support markets with a backdrop of growing demand is one thing. Assuming that it will cut continuously as demand falls, allowing other producers to eat its lunch, is quite another, thereby removing a key pillar of oil price support over the last 6 years at a time when the market is already facing challenges. As oil prices fall, so does industry activity, meaning that service providers have to cut rates – effectively lowering the supply curve and hence the intersection with demand, and thus the equilibrium oil price needed to clear the market.

This highlights the difficulty of predicting prices even if armed with accurate picture of supply and demand. Again, scenario analysis relies on understanding the limitations of those scenarios and maintaining a healthy sense of conservatism. Oil producers often produce transition scenario analysis with price scenarios that raise an eyebrow – for example, Occidental Petroleum is one of several that has used the International Energy Agency’s transition scenario price deck, assuming that oil prices stay steady in the $60s and $70s as oil falls at around 1 mmbbl/d every year from 2020 onwards. We do not think this passes the sniff test as a proxy for structurally changing markets; indeed, the current market reaction to even a short term period of weak demand and oversupply (albeit of greater severity) illustrates this clearly.

None of us have a crystal ball, and scenario analysis remains an important tool to test thinking. However, it is important to keep an eye on the big picture and stress test assumptions, rather than using optimistic inputs to tick boxes. But what’s done is done, and the oil and gas industry now finds itself in a very difficult position.

Oil prices and project sanction

Where next for oil prices? That’s anyone’s guess. Even in the best of times, commodity markets are characterised by feedback loops, time lags/short term inelasticity of supply, and path dependency. In 2014-16, oil prices reached lows only a little higher than the levels we see in the market today, but then bounced fairly quickly – Brent rose from a low of $26/barrel to the $40s within a couple of months, and reached $50 within four months. This bounce was, however, supported by OPEC+ cuts and strong demand growth, neither of which are in evidence right now. Further, Saudi Arabia and Russia are not just failing to make cuts and allowing the market to rebalance, but also increasing output to intensify and speed up the shake out process.

While prices therefore subsequently staged something of a recovery from the last crash, they remained a long way below the heady $100+/barrel seen previously, as the supply curve readjusted with lower production costs across the industry. Costs do not have as much slack as they did in the pre-2014 investment binge having already been cut hard, so we do not expect to see the supply curve fall as far again.

If costs do not have too far to fall, recovering demand would imply a recovery in prices. Accordingly, if and when short term factors clear and the oil demand trajectory moderates (the International Energy Agency estimates that oil demand will drop by a startling 20 million barrels per day in the short term), it would not be a surprise for the oil price to again approach a longer term marginal cost level which is currently unknown but likely higher than the current mid-$20s for Brent. Presumably this is the calculation that is being made by the Saudis. The pace of recovery will be strongly influenced by the rate of demand growth as we exit the immediate shock, itself a big question mark.

The prevailing oil price then determines which projects go ahead, and the ultimate amount of oil (and associated carbon) produced. When looking at which projects fit within a particular demand scenario, we prefer to focus on the supply and demand fundamentals combined with the relative cost positioning of projects on the supply curve, rather than any implied oil price for the reasons discussed above. However, in our 2019 report “Breaking the Habit”, we estimated that depending on the scenario used[1], the International Energy Agency low-carbon oil demand pathways could be cleared by projects that generate a 15% IRR at oil prices between late $30s and late $40s based on the cost industry structure at the time.

Would a sustained low oil price therefore mean that climate change is solved? Not necessarily. As above, the marginal cost level may change, and producers may build projects that generate an IRR below 15% – either by design or inadvertently. For example, in its own climate-resilience test, BP indicated that it had sanctioned a project in 2019 that generated returns far below 15% at an oil price in the $50s[2]. Additional low cost production from Saudi Arabia and Russia would also change the shape of the curve, moving the marginal cost lower. And moreover, there is an iterative effect in reality outside of the scenarios – periods of low oil prices will have a knock on effect to the ultimate level of demand, with wider effects in the transition.

Where does this leave the energy transition?

In the near term there will now be a big hit to producers. Expect oil output declines in many countries that have producing assets in threatened portions of the cost curve, including the US  and others such as China. US production falls will reflect the high decline rates of shale production, but with additional challenges compared to the last downturn – the industry’s debt burden is more pressing, and investors are likely to be less enthusiastic about injecting fresh capital having had their fingers burnt once already. Emissions will dip in the short term. But what will be the longer lasting impacts relating to the transition that might arise from a shorter term shock? At this point we can only speculate, and much will depend on the actions of governments.

On the face of it, a lower oil price would make fossil fuel applications more competitive against alternatives such as electric vehicles, at first glance implying that it may delay the energy transition (all other things remaining equal). But again, there are many confounding and unpredictable factors that may point in the opposite direction.

It would not be a surprise to see a structurally higher cost of capital for fossil fuel producers going forward. We prefer forward looking measures of risk that help raise the alarm before value is lost, whereas many volatility measures are backward looking – but so be it. Recent volatility has now passed into the historical record, raising equity premiums, and producers’ balance sheets are sure to be stretched in a way that may be seen as portending future transition-related challenges by providers of debt capital.

Weaker balance sheets will also find less money to spend on lobbying, perhaps reducing incumbent political power.

There may also be all sorts of structural changes on the demand side. For example – aviation, long one of the mainstays of scenarios that project ever-rising oil demand, may fall well short of expectations as people get used to different and remote ways of working.

Crunch time for policy makers, in terms of subsidies/carbon policy…

The pace and extent of the transition will be affected by a multitude of factors, but even the above effects and the startling recent improvements in the cost competitiveness of alternative technologies will only take us so far under the current policy regime. Taking emissions down to net zero and achieving the Paris goals will require the hand of governments to keep going further with climate-related policy, and their reactions to the current crisis will be critical in setting the course for the next decade[3].

At a time when climate change has never been higher on the political agenda and policymakers seek to steady the ship, there is the opportunity to bring together immediate/short term need with long term strategy to mutual benefit.

Periods of low commodity pricing are the ideal opportunity to both cut subsidies for fossil fuels and reconfigure fiscal approaches to help the prices of products reflect their true costs including carbon externalities, giving a much needed boost to battered budgets and a source of funds for stimulus measures. The public will still enjoy a much cheaper tank of gasoline than it is used to, making the political cost easier to bear.

This was an argument that was made at the time of the previous oil price collapse in 2014-16, but in practice subsidies proved very hard to remove, and policy makers often sought to support domestic fossil fuel production – for example the UK government cut taxes for petroleum producers in 2015 and again in 2016. Perhaps recent net zero announcements will strengthen resolve; the recent decision to extend the freeze on fuel duty to a tenth successive year (in effect a cut, considering the effect of inflation) does not inspire confidence, but it is still early.

… and wider socio-economic strategy

Governments are rightly concerned about other economic impacts, for example job losses in the energy industry. Clearly an equitable, “just transition” that doesn’t leave people behind is going to be essential when building enduring support for action.

But policymakers have a full suite of actions available to them. They can attempt to defy gravity, using taxpayer money to keep favoured fossil fuel industries afloat in their current form. The fossil fuel industry often appears to inhabit an unusual place in the mind of policy makers – Republican senators are now of the view that not having a cartel prop up oil prices is “harmful market distortion”. China’s rumoured $7 trillion stimulus package may support the increased build out of coal generation capacity, despite the majority of the existing fleet already experiencing low utilisation and costing more to run than building new renewables.

Or they can use more imagination, look forward and think about how they might put economies on a more future-proof footing. Our research has shown that the earlier governments act on climate policy, the less value destruction in stranded assets further down the line.

Governments should prioritise investing in the development of high value-add industries that will be the engines of employment, and are more sustainable both in terms of environmental impact and longevity. COVID-19 is going to have a terrible human cost, both physically and as its effects will reverberate in the economy. Optimising stimulus plans to mitigate future disruption would be a fitting way to respond.


[1] Our analysis used the International Agency’s Sustainable Development Scenario (associated with a  1.7-1.8ºC warming outcome) and Beyond 2 Degrees Scenario (we estimated equivalent to a 1.6ºC outcome)

[2] See BP, “Annual Report and Form 20-F 2019”, March 2020 (p21)

Available at

BP does not give precise figures, but graphically indicates a project sanctioned with a profitability index of barely over 1.0x. Profitability index is calculated as (PV of future cashflows after initial investment)/(initial investment) or equivalently (NPV of future cashflows including initial investment)/(initial investment) – 1, indicating that the project has a minimal NPV at the prices and discount rates used. The discount rate used is not disclosed, but likely to be BP’s cost of capital – which will be more like half the 15% IRR we use here. The price used is $50/barrel in 2015 dollars, implying a present day price somewhere in the $50s after accounting for 5 years of inflation.

[3] The implications of climate policy are explored in the Inevitable Policy Response project.