The Post-Everything Energy Market

One of the most puzzling aspects of oil market analysis (and policy making more generally) concerns the frequent tendency to assume that short-term and transient developments represent the ‘new normal’ or a phase change. Neo-Malthusians tend to argue that permanent global starvation has set in every time there’s a bad harvest, and when an oil price spike causes demand to dip, the final peak is acclaimed to have arrived. Peak oil supply advocates repeatedly perceived an impending collapse in Saudi production whenever weak markets lead them to cut production.

The combined crisis of the pandemic and the war in Ukraine are having a similar impact on perceptions about energy markets, especially oil and natural gas. Many expect that European gas supplies will never again be adequate to allow gas used for power and industrial consumption to reach pre-war levels, based on the assumption that sanctions on Russia will continue indefinitely or that countries will eschew their supplies even with the cessation of hostilities. A surge in renewables is projected as the wartime high gas prices made their economics more attractive, and accelerated investment in renewables is assumed even as some nations embrace coal. Russian oil supplies are expected to be constrained, even postwar, because of a reluctance of foreign companies to provide investment and/or technology.

But as the impact of pandemic eases and given the potential for an end to the Ukrainian war, energy markets could once again defy expectations. Indeed, warm winter in Europe has seen gas prices retreat, although not all the way to pre-pandemic levels. So, what will energy markets look like when the pandemic eases, the Ukrainian war ebbs, and inflation recedes?

First and foremost, there is a misperception (often repeated in the press) that German and European industry have thrived on cheap Russian gas. The reality is that Russian gas is not discounted compared to other sources and tends to be quite expensive, especially compared to gas in the United States. So, now that European gas prices have approached pre-war levels, the move overseas by heavy industry will be delayed, if it occurs at all. European governments have long allowed unions to protect energy-intensive industries, including refining. As the figure below shows, capacity utilization in the European refining sector was long below that of the U.S., which rose rapidly after President Reagan decontrolled the sector.

And while Russian gas is now perceived as being politically insecure and granted pariah status, even should the Ukrainian war end, there is every possibility that a post-war and especially a post-Putin Russia will find ready customers. In the early 1980s, numerous governments sought to replace their oil purchases from the Middle East and production there plummeted, with the region’s oil exporters becoming the ‘residual’ suppliers: everyone else sold out their supplies, and the Middle Eastern producers were left with whatever demand remained. As the Figure below shows, their production plummeted—until the oil price crash of 1986.

At present, the IEA projects a drop in Russian oil production of over 1 mb/d in 2023 from last year’s level, which was already slightly depressed by sanctions. Some of that no doubt reflects the impact of the exodus of Western service companies but so far, sanctions seem to have made only a small effect and the price cap appears unlikely to as well. Should Russian exports next year not decline, the likelihood of triple digit oil prices will recede.

Would a post-war and/or post-Putin Russia be able to attract Western companies to return? Bearing in mind that, as one oil executive said years ago, “Political risk is the mother’s milk of the oil industry,” oil companies have often shown short memories—if the price is right. Countries like Iran and Iraq, with a history of nationalizing foreign oil companies’ assets, have nonetheless still managed to attract foreign investment, even with unchanged leadership. If Willie Sutton had been a wildcatter he would have said, “Because that’s where the oil is.” The short-term loss of production in Russia remains unclear, but after the war, the prospects for recovery are good.

Finally, the inability of renewable power to scale up to meet the demand needs during the crisis highlights two of the biggest shortcomings of that energy source: high cost of storage and near-impossible transportation. Solar power was not loaded onto Europe-bound tankers, the way LNG was nor did wind and solar ramp up as coal did in a number of nations, admittedly because of existing, idle capacity. Still, in the future, there will presumably never be idle renewable power plants and the likelihood of a 21^st century SPR—Strategic Power Reserve, being created with banks of batteries or uninstalled solar panels waiting for a new supply disruption seems remote.

More likely, the richer European nations (France, Germany especially) will increase their gas storage capacity, possibly through the use of LNG tanks as well as buying options on Floating Regasification and Storage Units (FRSU), which can be utilized in other markets according to relative prices, but then recalled on (relatively) short notice should new supply problems or extreme cold occur.

More spending on the power sector can certainly be expected, including upgrades to infrastructure to improve resilience. Support for investments in renewable and batteries will probably increase, but the cost could easily reach levels that spark public resistance. Demonstrations against fossil fuel burning have been dwarfed last year by those angered at higher costs, and while mandates and subsidies will go far towards disguising the true costs of renewables, that could change as oil, gas and coal prices decline.