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Climate needs less oil, how will producing nations react?

Climate needs less oil, how will producing nations react?
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“Oil demand has dropped dramatically and oil producers are feeling the squeeze.” While this description might refer to the COVID-19 crisis, it describes what oil markets could look like in the future in a world that takes serious action on climate. When government officials and climate stakeholders meet (virtually) next week in New York City for Climate Week, the oil will be an important part of the conversation because its combustion generates nearly one- third of global carbon dioxide emissions.

Consequently, any effort to limit global temperature increase will need to limit oil use. But how would traditional oil-exporting nations, such as Saudi Arabia and Russia, or the United States for that matter, react to the prospect of a shrinking market. From concerns about budget revenues, energy security and the financial health of domestic oil actors to the use of pricing, production and protectionist levers, each country faces a different configuration of interests and its distinct capacity to act. Unexpectedly, the tumult in oil markets caused by COVID-19 may provide insights into what we might expect from producing nations if oil use were to drop to meet our climate concerns. 

Global oil demand has been rising substantially over the last several decades, powered by economic growth and increasing populations. In 1990, the world consumed 67 million barrels per day (mb/d). By 2019, that figure had increased to 100 mb/d. Annual carbon dioxide emissions from oil combustion have risen in parallel and now total over 11 gigatons. Achieving the climate goals set out in the Paris Agreement will require a dramatic reduction in these emissions. How can this be achieved? The most obvious way is by substantially cutting oil combustion, as is proposed, for example, by the International Energy Agency (IEA) in its climate modeling.

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The COVID-19 crisis has significantly reduced oil demand unexpectedly, creating tumult in oil markets. After Saudi Arabia (the world’s largest oil exporter) was unable to reach an agreement in early March with Russia for coordinated cuts in production, it announced a combination of price reductions and, surprisingly, higher output targets. 

By the end of that month, oil prices had dropped to an 18-year low. Although the market stabilized later in the spring, in part as Saudi Arabia and Russia hammered out a supply reduction agreement, the pressure on production and prices, and on the finances of oil-exporting nations, has continued as demand is projected to remain depressed into next year.  

In contrast to the rapid and destabilizing (but ultimately temporary) significant drop in demand caused by COVID-19, climate models provide a gradual but deeper and permanent reduction in oil use. For example, the IEA’s climate model provides a 30 percent reduction in consumption by 2040, and even larger reductions are required to achieve net-zero emissions. 

How many producers would survive in the substantially smaller oil market necessitated by climate considerations?

Basic economics suggests that Saudi Arabia would continue as a major player, given that it is a low-cost producer with extensive reserves and delivery capacity. But would Saudi Arabia, whose annual production averaged 11.8 mb/d in 2019, remain content with its present 12 percent market share in a world of substantially reduced oil use. Would this share translate to only 8 mb/d of sales in 2040 under the IEA’s climate scenario? Saudi Arabia’s various pricing and production announcements in response to the drop in demand caused by COVID-19 might offer some insights. In any event, they provide notice to other producers about the powerful instruments the country can deploy to preserve and even expand its market share when faced with declining oil demand. These actions have also demonstrated the government’s willingness to induce low oil prices that undercut U.S. shale and other higher-cost producers, notwithstanding the strain it places on the country’s budget. Periodically lowering prices to squeeze out and discourage competitors is a tactic that Saudi Arabia might adopt in a future where the oil market permanently contracts. 

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Oil export-dependent nations are also exploring other strategies to support petroleum production and protect their economies. This includes promoting the use of oil beyond combustion, notably in the form of feedstock (for example, to produce petrochemicals, a growing source of oil demand), and supporting the development of low-carbon combustion technologies, such as carbon capture, use and storage. It is uncertain, however, that these efforts would fundamentally alter the need for substantial reductions in oil production under a hard climate constraint. Reducing economic dependence on oil revenues is another strategy countries are developing to face the prospect of diminishing demand. Economic diversification (including in renewables) and private sector development outside of oil are keys in this regard, but the challenges are daunting, and success will require strong commitment.  

And what of OPEC, which is already facing an uncertain future as it marks this week its 60th anniversary? Perpetual cuts will make it hard to keep the internal cohesion and discipline required to sustain OPEC or the more recent “OPEC Plus” arrangement (with Russia and other producers). Paradoxically, OPEC, as an organization that brings together numerous producing nations, could potentially play a role in smoothing an eventual transition by suppliers to a smaller global oil market. 

For the U.S., which operates in the market as an “oil prosumer” (i.e., simultaneously major producer and consumer, the world’s largest in both respects in 2019), the prospect of a smaller supply market dominated by a limited number of foreign oil providers (even lower-cost ones) could raise economic and even security concerns. This could prompt the U.S. to protect some domestic production capacity even under a climate policy framework that aims to lower oil demand overall. China, also an oil prosumer (the fifth largest producer and second-highest consumer), faces parallel energy security concerns that could prompt it to protect its domestic production. 

How would producing nations react to the substantially diminished oil market required to meet climate goals? Unexpectedly, the events surrounding COVID-19 may have provided some clues. However, given the currently weak state of climate negotiations, this prospect is still hypothetical at this point … but, as climate ambition grows, the possibility of a substantially and permanently smaller oil market will merit increasing consideration by producing and consuming nations. Preparing for this future might help avoid the type of tumult in oil markets that COVID-19 has produced. 

Philippe Benoit is a senior associate (non-resident) with the Energy Security and Climate Change Program at the Center for Strategic and International Studies. He worked for over 15 years as on international banker on oil and gas investments in the Middle East, Central Asia, Africa, and Europe and, more recently, on mechanisms to implement the low-carbon transition. The views expressed are the author’s.