Mapping the geopolitics of lower oil prices
IHS Quarterly sat down with IHS Senior Vice President Carlos Pascual, former US ambassador to Ukraine and Mexico and founder of the State Department's Bureau of Energy Resources, to discuss the global political and economic implications of the decline in oil prices. IHS Energy is projecting the price per barrel of Dated Brent Crude will have bottomed out in mid-2015 before starting a modest climb back to the low-$70s by the end of 2016. While these shifts bring with them new opportunities, they also bring new risks.
Q. Net energy exporters Iran, Russia, and Venezuela are seen as the economies that are perhaps the most challenged by lower oil prices. What are the geopolitical and internal risks these nations face?
Carlos Pascual: Russia, Iran, and Venezuela are three exporters that have been profoundly hit by the collapse in oil prices. For Russia and Iran, the collapse has been combined with international sanctions that preclude both countries from access to capital markets and a way to finance themselves out of their current financial crisis.
For Russia, the critical issue has been its extreme dependence on oil for export revenue. Oil constitutes 70% of export revenues, and together oil and gas make up 52% of the budget. The combination of sanctions that has deprived Russia of access to new technology and to capital markets, as well as the collapse in oil prices, has put Russia in a dire financial position. The exchange rate lost 50% of its value. People have lost 50% of their real income. Businesses have found it extremely difficult to operate because they cannot afford to bring equipment and foreign inputs into the country-and then translate those into local currency ruble costs and still have competitive products.
The issue for Russia, of course, focuses on its intervention in Eastern Ukraine, where it annexed Crimea to the Russian Federation and then supported an insurgency that has destabilized Eastern Ukraine. The critical challenge for Russia to see sanctions lifted is whether it would be willing to support decisions that would allow for stability in Ukraine and establish the grounds to allow Russia to regain access to international capital markets.
Iran has a comparable situation-it has a tremendous natural resource base, but cannot use it to gain export revenues or leverage access to international capital markets. International sanctions have been levied because of Iran's potential development of a nuclear weapons program. But the 14 July agreement between Iran and the five permanent members of the UN Security Council plus Germany (P5+1) could potentially allow Iran to gain access again to international markets.
For Iran, there is a self-interest in a settlement that would once again allow it to rejoin the international community and develop its natural resources. For the international community, there is the supreme incentive to deter and prevent an Iranian nuclear weapons program that could present a threat globally and regionally. The US Congress and Iranian parliament have two months to review the agreement. If the agreement is upheld, it will move into a preparatory stage that would see the reduction of uranium, the removal of centrifuges, the redesign of the Arak heavy water reactor (so that it cannot produce plutonium), and relief on sanctions implemented most likely in early 2016.
A critical issue for the P5+1 has been creating the rights to inspection and transparency needed to ensure that Iran would abide by an agreement. For Iran, there is pressure internally to seek concessions before taking actions to curtail its nuclear program. In the end, it will take leadership and foresight on the part of Presidents Obama and Rouhani to steer through the political constraints and secure an international solution.
Venezuela presents a different case. There are no international financial sanctions that have been imposed on Venezuela, but its own political and economic mismanagement has left it in this crisis.
Within the country there has been a collapse of the currency, skyrocketing inflation, and a scarcity of products. One of the critical byproducts has been decreased access to electricity: brownouts and blackouts have been occurring throughout the country because of Venezuela's inability to service its hydroelectric plants, and now Venezuela is burning oil to generate power. All these factors have led to an increase in demonstrations, even in those neighborhoods that have traditionally been in favor of President Nicolas Maduro.
A key issue for Venezuela will be whether it can regain the political and economic confidence of the Venezuelan people. Without that, further political instability and economic deterioration are likely. One of the impacts will presumably be the collapse of Petrocaribe, which would affect the Caribbean states: Cuba, Dominican Republic, Haiti, Jamaica, and others. This would raise the threat of increased migration to the United States as Venezuelan subsidies decline.
For the Caribbean states, low oil prices could offer the chance to transition out of dependence on Venezuela. They have the opportunity to reduce their dependence on liquid fossil fuels to generate electricity-and move to more stable and sustainable solutions.
Q. Elaborate on tension between NATO and Russia and the implications for Ukraine and other Eastern European nations? What might occur in 2015-16?
Carlos Pascual: The tension stems from Russia's violation of Ukraine's national sovereignty and territorial integrity. As indicated earlier, Russia annexed Crimea and has supported a separatist insurgency that has involved Russian troops. Any solution to the crisis has to involve the withdrawal of Russian troops and the re-establishment of a ceasefire. In February 2015, German Chancellor Angela Merkel and French President Francois Hollande brokered a ceasefire with the participation of Russian President Vladimir Putin and Ukraine President Petro Poroshenko. That agreement broke down within days as a result of intense fighting around the town of Debaltseve, which led to battles to take over the city. Since then the intensity of the fighting has diminished but the ceasefire violations continue.
Given these failures, it will take immense effort on the part all of the parties, the four leaders, and pressure from abroad to achieve a ceasefire agreement that will hold.
The core elements needed for a ceasefire are well-known. Russia needs to withdraw troops and stop supplying the insurgents. Ukraine would have to follow through on earlier measures to decentralize political powers to local authorities, consistent with the Ukrainian constitution. All sides would have to accept a massive number of observers on the ground to ensure compliance.
Among NATO allies, there have been concerns that Russia could attempt similar incursions within the Baltic states, which are part of NATO. Such an incursion would trigger Article 5 of the Treaty of Washington that underpins NATO, and would require all NATO members to defend a state that faces an external threat. It would be unwise to test NATO's commitment. The members of NATO have consistently said that they will uphold the treaty and defend its members.
The critical step that all parties can take is to recognize that the best thing for Russia, Ukraine, the European Union, and the United States is to have a ceasefire arrangement that holds; and to have a political arrangement that allows for normalized life in the Eastern and Southern parts of Ukraine. Such steps would allow Ukraine to achieve economic prosperity, and it would help Russia regain access to international capital markets that are critical to Russian economic growth.
Q. You've called for Europe, and in particular Ukraine, to diversify energy sources to reduce its reliance on Russia. And on 19 March you testified before the US Senate Committee on Energy and Natural Resources on the economic benefits to be gained by lifting the ban on US exports of crude oil. How do you see these issues unfolding?
Carlos Pascual: The diversification of fuel sources and types is a fundamental part of building energy resiliency. Europe has already taken many important steps to lay the foundation for a more diversified system.
The European Commission has put in place, through its third energy package, a series of regulations and policies that prevent any one company-in this case, Gazprom-from owning gas resources supplied to Europe, from owning transit pipelines, and from owning the distribution system. It has also lifted "destination clauses" in gas contracts, which means that once a buyer purchases the gas, it is free to trade it with any other party. These policy measures have created a foundation for competition.
Europe has also put in place significant infrastructure investments, including massive investments in regasification infrastructure for LNG (liquefied natural gas), as well as interconnecting pipelines that allow for gas to be moved from west to east, north to south, and south to north. That network, however, is not complete; there are some states, such as Bulgaria and the Baltics, that still largely depend on one source-Russia-for gas. The critical next step for Europe is to complete the internal infrastructure that allows a European gas market to include all of its members and to benefit from the greater resiliency that it has already started to build.
In addition, there are important steps that Europe can take to complete the southern corridor for gas that begins in Azerbaijan, passes through Turkey, and cuts through Greece, Albania, and Italy. The changes in political leadership in Greece have delayed completion of this network, and issues still need to be resolved on landing rights in Italy.
Europe also continues to pursue a major antitrust case against Gazprom for alleged noncompetitive practices. The conclusion of this case will have vast implications for a competitive gas market in Europe, and the ability of individual countries in Europe to secure multiple suppliers of gas. Europe can-and should-continue to purchase Russian gas, but these measures will ensure that purchases are made on a competitive basis, not simply because there are few other choices. That will help defuse the extent to which gas supplies can be used to exert geopolitical influence over European customers.
Q. Mexico recently lifted the ban on foreign direct investment in the country's energy sector. Do you see lower oil prices impacting Mexico's energy sector in any way? Perhaps an increased reliance on oil for power generation?
Carlos Pascual: It is important to recognize the historic nature of the steps that Mexico has taken to open up its hydrocarbon sector to foreign investment for the first time since 1938. In 2013, it passed a constitutional amendment that opened the path to foreign investment in the energy sector-oil and gas, as well as midstream and downstream markets, and electricity. In 2014, Mexico passed secondary legislation needed to create the legal framework for foreign investment to move forward. Now Mexico is conducting a bid round to tender shallow water, onshore, unconventional, and eventually deepwater fields within Mexico for private investment.
The first bid round began in December 2014 and will be conducted in five phases. Bids under Phase 1 were submitted on July 15, 2015. Data rooms have been opened, 39 companies have bought data packages, and 34 have prequalified. Given low oil prices, few companies bid in phase 1. This first phase will be a learning process for Mexico, to test the market and understand the competitiveness of Mexico's resources in a tight global environment. Inevitably Mexico will draw from this experience in assessing how it sets future fiscal terms.
This is the first time that Mexico has solicited private investment in the hydrocarbons sector since it was nationalized in the 1930s. The collapse of oil prices internationally, of course, affects this process. Mexico will have to demonstrate that the resources it has to offer are going to be competitive internationally. Part of the answer to that question is available in the seismic and subsoil data. Mexico also can help its own case by working with bidders to help them understand the quality of the resources available, and how they may be analogous to comparable resources that may be available in different parts of the Gulf of Mexico and shallow waters.
The opportunities that potentially exist for Mexico are huge, but we have to understand that the process may take longer than initially anticipated. It is an enormous and technically complex process that Mexico has embarked on, seeking to attract private investment in more than 160 fields over the five different types of resource areas that are on land and offshore. Even if the process is delayed and extended, there are still huge opportunities for international investors, and it will be critical for Mexico to maintain a dialogue with the investment community in order to understand their interest and concerns, and to be realistic about the fiscal environment that is affecting all investors in the hydrocarbon sector today.
Q: Lower oil prices mean a potential for an increase in the consumption of oil, primarily for transportation, but also for power generation to a lesser extent in countries such as India, Mexico, and Japan. Global GDP growth is expected to increase in the next few years, driven in part by lower oil prices. Also, cheap coal may delay investment in alternative energy and smart grid technologies. What implications do you see these factors having on the pace of CO2 emissions and climate change? Specifically, what implications may this have on national policy and on the UNFCCC COP 21/CMP 11 conferences in Paris in December?
Carlos Pascual: The crash of international oil prices has boosted economic growth in many countries. There has been concern among some that increased growth would lead to increased oil consumption, which would in turn have a negative impact on global emissions. It is important to understand the linkages between economic growth and energy consumption, but we should not forget that economic growth is a fundamental aspiration of people globally. When countries grow, they have more resources to help them make and finance tough decisions. Countries are always able to make better decisions on policies when their resource base is strong, rather when they are in a difficult economic situation.
With that kind of positive resource base, one of the questions that many countries will face is how to create greater competition among fuels to be able to achieve a lower carbon economy, to encourage investment in energy efficiency, and to lower carbon power generation and industrial fuel uses. The biggest challenges are going to be faced in Asia.
Asia is currently on a path of increased coal consumption that, unabated or without carbon capture and storage, will lead to much higher emissions. In Southeast Asia, coal as a percentage of fuel use is projected to increase to 50% by 2030 from 30% last year. Coal consumption continues to increase in India. China is taking measures to curb the use of coal as a share of total consumption, but absolute consumption continues to grow.
To reduce emissions in Asia and globally, it will be necessary to find lower carbon solutions that can compete with coal in power generation and industrial use. Outside of China, the private sector in Asia tends to drive investments in power generation and fuel choices based on projects that offer the highest rate of return. Because of the intermittency of renewables, coal investments still often offer the highest returns on investment in Asia. For gas, nuclear, and renewables to compete with coal, countries can take policy measures that put a price on the environmental impacts of coal, reduce financing costs for lower carbon fuels, invest in technologies with greater capacity factors that cut intermittency, and address other policy constraints such as land access for geothermal that affect the competitiveness of low-carbon investments.
The critical new opportunity that is offered by the UN Framework Convention on Climate Change in 2015 is the prospect to focus climate action plans around individual country realities. Rather than focus negotiations on an ideal scientific path to emissions reduction, countries will propose measures in order to create momentum on emissions reductions. Under this new framework-laid out in the UNFCCC's Lima negations in Peru in 2014 and which would ideally be completed in Paris in December 2015-individual countries would submit to the UNFCCC their projections for emissions targets based on what they can do. Eventually, these plans must be reconciled with scientific imperatives for emissions reductions, but for now they will drive action while it is still difficult to forge consensus on how countries must share a carbon budget under an ideal outcome.
A key issue is whether those plans are supported by commercially viable strategies that will lead to lower carbon investments. This is where international cooperation will be critical-among policy experts and representatives from the financial world who will assess project viability; with energy developers and development organizations; and among technical experts globally seeking to drive down costs and improve technology performance-to find country-specific solutions and develop alternative financing models that will result in commercially viable investments for lower carbon outcomes.
Here is a practical example: what kind of policy changes and financing arrangements would be necessary to encourage investment in geothermal investment, as opposed to coal? Issues such as these will have to be resolved on a case-by-case basis. The new UNFCCC framework that will be created in Paris will stimulate a new degree of activism in climate work because it demands pragmatic solutions. That will create business opportunities to look for country-specific solutions to deliver power and energy supplies with a lower carbon profile and at a competitive price. On its own, this approach will not solve the challenge of climate change, but it can create new momentum based on the kind of commercial sustainability that is needed for a sustainable environment.
Q. Are you optimistic about COP 21?
Carlos Pascual: A huge amount of work needs to be done. A challenge countries may face is that we end up with solutions that result in lower emissions over time but with no mechanism to ensure that those lower emissions will actually achieve the reductions necessary to avoid the more cataclysmic implications of climate change. I am optimistic about COP 21 because it offers a path for developing solutions that will move us to a lower-carbon economy globally, and this approach will encompass all countries. Developed and developing countries must participate in order to succeed. Whether we are going to get to the point of actually achieving the kind of cuts necessary to avoid the worst impacts of climate change will depend on leadership. The steps already taken by the United States and China set a good precedent. There is little doubt in my mind that the debates over which countries reduce emissions, how much they reduce, and the pace of reductions will be one of the biggest geopolitical challenges in the energy sector over the next decade.
Carlos Pascual is senior vice president, IHS Energy