At a recent investment conference sponsored by Royal Bank and Suncor I spoke about the likelihood that billions of dollars of carbon assets will never see the light of day. Contemplating the idea of stranded assets isn’t in either company’s interests, so both deserve credit for providing a discussion forum for a topic that’s going to become ever more important to investors.
After laying out my argument for why oil prices must fall in an emission-constrained future, I was asked a question that might seem straightforward on the surface, but in reality is anything but. Won’t falling oil prices always trigger a rebound in oil demand (and, by extension, an equally large bounce in carbon emissions)?
It’s a belief that many energy investors are likely clinging to these days. A 30 percent drop in global oil prices so far this year is stoking expectations that a big pick up in demand is just around the corner. In a world before climate change became a household term that may have been the case, but not any more.
Now, more of the world’s governments are turning their attention to how carbon emissions might be successfully managed without triggering an undue amount of negative economic fallout. To get a sense of the enormity of that task, consider calculations from the International Energy Agency that show global oil consumption will need to fall to 80 million barrels a day by 2035 if we’re to limit atmospheric carbon to 450 parts per million. That’s the threshold that the scientific consensus says we must not exceed if we’re to avoid the grimmer consequences of a warming planet.
It’s a tall order given the world currently consumes more than 90 million barrels a day and counting. Even if demand growth, currently moving ahead at more than 1 percent a year, were to stop dead in its tracks, oil consumption would still need to fall by more than 10 million barrels a day over the next two decades.
If that were to come to pass, the implications for oil prices would be dramatic. During the last recession, for instance, a drop in demand of 3.5 million barrels a day sent prices from a high of $147 a barrel to lows that dipped below $40. Regardless of where exactly crude prices would end up trading, it’s a certainty that once carbon emissions become more of a consideration the price of a barrel of oil will be heading lower.
Of course, the path from here to there isn’t exactly straightforward. Basic economics tells us that high crude prices curtail demand and induce new supply. At the same time, lower prices cause production to be shut in and encourage consumption to rise.
It’s a familiar pattern, but will it continue to hold true? Right now, there are big bets being made in both directions.
Elon Musk, the chief executive of Tesla Motors, for instance is investing $5 billion to build the Gigafactory, which will become the world’s largest production site for lithium-ion batteries. He can’t be happy to see the recent drop in oil prices already has more U.S. drivers switching back to gas-guzzlers. How many electric cars can Tesla really expect to sell if oil is $40 a barrel?
At the same time, how confident can you be if you’re Exxon and you just spent $13-billion in Alberta’s oil sands on the Kearl mine and have plans to pour another $9-billion into the project over the next few years? Can you trust that tomorrow’s rebound in demand will be lasting enough to make that investment pay off? Without higher oil prices, the Kearl mine suddenly becomes a sinkhole for shareholder capital.
And what about the global economy? Will it continue to lurch and sputter along with oil prices or will it eventually wean itself off the fuel? For that to happen, it will take more than the unfettered workings of the free market. The price of burning oil will have to reflect the cost of emissions and not simply the expense of getting the fuel out of the ground.
Is that happening yet? No, but the world is beginning to take more steps in that direction.
For the coming rebound in oil demand to be capped in a meaningful way, policy makers will have to decide it’s time to intervene. If taxes become a larger component of what motorists pay at the pumps then the world might actually have a shot at reducing demand to the 80 million barrels a day that researchers say might be sustainable for the planet.
Choosing that path would require countries shifting a good chunk of their tax base from personal and corporate income to carbon taxes collected from households and businesses. Of course, if our economies are to remain competitive while doing that it will also require the levying of carbon tariffs on goods from countries that don’t tax emissions like we do.
Those are big changes, no doubt. When faced with the alternative, however, does overhauling our tax rules really seem so daunting?