News Story

May 27, 2015

Sizing Up a New Energy Era

Oil’s dramatic price decline has rocked oil-producing nations, prompted consumer glee at the pump, and captivated the attention of economists and environmentalists alike, who view what may be the beginning of a new era of cheap energy with both
fascination and foreboding.
   Fascination comes at the brute force oil exerts in global economic and geopolitical arenas. Foreboding comes because cheap oil, perhaps not surprisingly, is bad news for climate change and for the environment broadly, putting a thumb on the economic scales that drive consumer purchase decisions and tipping them away from cleaner, though still more expensive, alternatives.
   The foreboding comes also from a sense of déjà vu. Thirty-five years ago, the oil shocks of the 1970s boosted development of cleaner alternatives, which were subsequently killed when oil prices fell over the next decade. Cheap oil means more miles driven and more gas-guzzlers on the road. It means fewer electric cars and hybrids and makes next-generation biofuels tougher to bring to market. Even in areas not touched by oil, cheap gasoline and home heating oil have a psychological impact, creating a broad sense that energy problems—and the perhaps painful action needed to solve them—are over.
   At a time of tight budgets, that psychological shift could reduce the urgency around research and development into clean alternatives, work still needed to bring prices down and make alternatives commercially viable. It is in this arena, perhaps, that the echoes of the 1980s reverberate loudest, fueling fears that promising avenues will remain unexplored and climate change-easing solutions undeveloped, resulting in increasing amounts of world-warming carbon dioxide pouring into the atmosphere.
   But the world is a different place than it was in the 1980s. Though falling oil prices will undoubtedly have an
impact, experts point out that prices have also fallen dramatically for alternatives like solar photovoltaics, which are seen as part of the future energy mix even by oil-producing nations. In addition, U.S. progress toward the adoption of renewable alternatives to fossil fuels is not solely at the mercy of consumer pocketbooks—some is baked in by relatively recent government subsidies, regulations and mandates, like California’s zero-emission vehicle program and Massachusetts’ renewable energy portfolio standard, strictures that aren’t going to be undone by cheap gas at the pump.
   And, though some predict low oil prices will last a year or more, others say low energy prices might endure and that tomorrow’s oil market may be stabilized by new unconventional sources responding rapidly to market swings. In short, we just might be stepping into a new energy future.

Consumer is (still) king
From July 2014 until early this year, the U.S. price of a gallon of gas fell from about $3.70 to around $2. The environmental impact was likely felt almost immediately, as consumers responded not just with childlike joy at the gas station, but in their driving habits.
   “The transportation question tends to be about which of the two cars in my driveway I use. I’ve got a truck, and I’ve got a sedan that gets twice the mileage of the truck,” said Professor of Government Stephen Ansolabehere.    “When the price of oil is high, I think about which car I drive, and when the price of oil is low, I don’t think about it, I take whichever one I want.”
   With low gasoline prices, drivers will also increase consumption in other ways—by going out instead of staying home or taking the car instead of the train—that together can make a big difference. “It’s plausible to think that you’ll be seeing a pretty large effect … With
lower prices, people consume more. That’s the way it works with everything,” said James Stock, Hitchings Burbank professor of political economy. “That’s a basic feature of economics, and it will be the case here.”
   If prices stay low, Stock estimated gasoline consumption will increase by about 8 percent in 2015. That would mean another 100 million tons of CO2 in the atmosphere this year, Stock said, enough to wipe out somewhere between a third and a fourth of the expected reductions from the Obama administration’s proposed regulations to clean up power plant emissions.
   “That’s a big deal. That’s a really big deal,” Stock said.
   Vehicle sales statistics, meanwhile, show that consumers aren’t just driving differently, they’re also buying less fuel-efficient vehicles. The average fuel efficiency of U.S. vehicles bought in December fell 0.7 miles per gallon from November, a significant—and surprisingly rapid—response, according to Henry Lee, the Jaidah Family director of the Harvard Kennedy School (HKS) Environment and Natural Resources Program.
   While buying a gas-guzzler may seem risky given that prices were high just a few months ago, according to Stock, consumers are sophisticated enough to discern temporary volatility from longer term trends that favor low prices.
   “My sense is that consumers are reasonably good at differentiating between more persistent versus temporary price spikes,” Stock said. “Here we’re talking about a completely new revolution in extraction technology, and that’s not going away. Whatever the geopolitics are, fracking is a reality.”

(Worried) Eyes on the future
Aside from the immediate increase in carbon dioxide emissions from American drivers burning more gasoline, cheap oil today has the potential to exacerbate harm to the environment tomorrow.
   “My first concern is the subjective view of oil prices. People use it as a bellwether for the energy situation,” Lee said. “So when prices are down, there’s no energy problems. That’s really simplistic, but I think that’s how people look at it. So why invest in alternative fuels, alternate types of cars? Why invest in renewable energy, which has nothing to do with oil?
   “I’m particularly worried about government being willing to support [research and development]. They’re going to say we don’t need R&D, we don’t have an energy problem. I think that’s a really, really big mistake for the climate. We have thirty-five years to deal with [the climate problem], and we’ve used up twenty of them. The severity of that problem is just enormous, and I do not think these prices are going to help.”
   Daniel Schrag, director of the Harvard University Center for the Environment, Hooper professor of geology, and professor of environmental science and engineering, agreed, saying neither electric cars nor biofuels are ready to replace gasoline as a transport fuel, making continued investment—by government or private industry—in research and development critical.
   “Most troubling is the question of people’s willingness to invest in alternative technology,” Schrag said. “This price drop has the potential to send a message to investors—that’s one of the most troubling aspects of this.”   
   Stock offered an example from the budding biofuels industry. After years of development, four commercial-scale plants are opening in 2014 and 2015 in Nebraska and Iowa. The plants make ethanol from agricultural waste, like stalks and leaves, a more difficult process than producing fuel from corn kernels but one that promises an 85 percent improvement in greenhouse gas emissions over petroleum.
   “They say they’re economically competitive in the $70 range,” Stock said. “Seventy dollars a few months ago looked great. Seventy today is a real problem.”
   With low gas prices shifting economic incentives away from biofuels, it’s more important than ever that the government step in and foster the transition to cleaner fuels, Stock said. “We are going to be facing more economic challenges to … your favorite technology alternative in the transport sector: cellulosic ethanol, electric vehicles, fuel cells,” Stock said. “Because of the oil price decline, their cost disadvantage has only heightened.”

It’s electric
Consumers voting with their pocketbooks are also bad news for the nation’s budding electric and gas-electric hybrid fleet, Lee said. Cheap oil makes them more expensive to drive compared with gasoline vehicles burning newly inexpensive fuel. Sales of the hybrid Chevy Volt, for example, plunged 48 percent from January to March 2015 from a year earlier. General Motors announced in April that it would suspend production for four weeks in early summer to use up existing inventory and prepare for 2016 model production.
   But all is not lost, Stock said. Even though sales may dip, the vehicles’ environmental appeal should insulate them somewhat from pure market forces. Hybrid owners paid a premium for the cars even when gasoline prices were high, and he expects a significant number to continue to do so.
   Robert Stavins, the Pratt professor of business and government at HKS and director of the Environmental Economics Program, agreed, saying the same dynamic applies to electric vehicles, particularly in California, which has an ambitious zero-emission vehicle program that will continue to foster electric car sales.
   “Is demand greater when gas prices are high? Yes, but the major change is SUVs in and out,” Stavins said. “The core constituents of hybrids will buy and drive them anyway.”
   That dynamic applies to Tesla, America’s flashiest electric vehicle, according to Eric Van den Steen, associate professor of business administration and author of a Tesla case study. Van den Steen said gasoline savings wouldn’t matter much for buyers of the $70,000 Model S, though it may make some investors in the company pause. This could crimp financing for still-needed growth, particularly in the company’s planned battery-building “Gigafactory” in Nevada.
   “My sense is that the impact on a company like Tesla would be relatively limited,” Van den Steen said. “First, the people who buy in the price range of a Tesla are unlikely to be swayed by some savings on gas, especially since the range issues imply that this would not be your first choice of car if you need to drive long distances.
   “On the downside, non-professional investors who bought Tesla stock with gas prices in mind may be less attracted to the company. So the (likely bubble) price of the stock may come down a bit. That would make it harder to find rich financing. But that would not hamper Tesla itself, but may raise more issues for the Gigafactory.”
   To Stavins, cheap oil’s most important price effect may very well be on commercial fleets. Major commercial fleets—like FedEx and airlines—log many more miles than the average commuter, he said. High oil prices encourage fleet owners to buy more fuel-efficient vehicles sooner while low prices encourage them to keep older, lower-mileage vehicles on the road.

International negotiations
Though auto-driving consumers around the world may be influenced by low oil prices, Stavins said he didn’t expect cheap oil to affect their nations’ bargaining positions in international climate talks.    
   Stavins, who leads the Harvard Project on Climate Agreements, said the agreement expected to be finalized in Paris in December won’t include limits that are likely to be upset by low oil prices, but rather “intended nationally determined contributions” that will be decided by—and give flexibility to—each nation.    
   In the U.S., that means, among other things, tougher mileage standards for vehicles and tougher clean air standards for power plants—whose proposed rules are set to be finalized this year.
   But even if additional carbon dioxide emitted by U.S. drivers isn’t a hurdle in the Paris climate talks, Michael McElroy, Butler professor of environmental studies, said it may cause a problem with China.
   Last November, President Obama announced a landmark agreement with China in which the world’s two largest carbon dioxide emitters pledged to cut greenhouse gas emissions. Low oil prices make it
tougher to comply, McElroy said.
   Obama said the U.S. would cut carbon emissions between 26 percent and 28 percent from 2005 levels by 2025. China, meanwhile, agreed to peak its carbon emissions and make non-fossil sources 20 percent of primary energy production by 2030.
   The U.S. transport sector made up 34 percent of overall emissions in 2013, meaning a significant increase in miles driven can also significantly impact national carbon emissions. McElroy said the change in driving behavior will have to be compensated for somehow, perhaps by further cuts to power sector emissions—and zeroing out coal.
   “If we’re going to meet the Beijing commitment, I don’t see it happening in the transportation section the way the White House hopes,” McElroy said. “If the best I can get is constant emissions from the transport sector, we have to double savings from the power sector. You can do it, but it’s a politically tough thing to do.”
   Cheaper oil affects China as well, McElroy said. It means lower gasoline prices to the growing number of Chinese drivers but, since the government controls who buys cars and when, unlike in the U.S., it may not have an equivalent to the U.S. SUV dynamic.

Politics and possibility
With economic incentives for cleaner, greener vehicles and fuels falling, several said now is the time for the government to step in and support their use. A carbon tax, they argue, would provide an economic incentive to lower carbon emissions and be far less painful levied in a time of low fuel prices.
   William Hogan, Plank professor of global energy policy, said a carbon tax would finally “internalize externalities” inherent in fossil fuels. In other words, a carbon tax would make fossil fuels’ price reflect their actual cost—including harm to the environment from
carbon emissions.
   “The price of oil going down makes it now important and easier to adopt the kinds of externality-internalizing taxes like carbon taxes. It doesn’t make it easy, but it makes it easier,” Hogan said. “That makes it more important because it’s not happening by itself. More consumption of oil makes it harder for substitutes to come in.”  
   In a Jan. 4 op-ed in the Washington Post, Eliot University Professor Lawrence Summers echoed Hogan’s call, saying the case for a carbon tax “has become overwhelming” with the oil price decline. Summers said a $25 per ton carbon tax would increase gasoline prices by just 25 cents a gallon, an amount that could be borne even by low income Americans, who were paying more than that just months ago. It would raise more than $1 trillion over the next decade, providing funding for infrastructure repairs, pro-work tax credits, or a reduction in the payroll tax.
   Similarly, David Keith, McKay professor of applied physics and professor of public policy, said low oil prices would make it easier to adopt a strict national low carbon standard, which would encourage low-carbon fuels in the transportation sector. “The only potential upside, which hasn’t happened, is that it makes it more politically palatable to impose a stronger low-carbon fuel standard when prices are low because the consumer won’t see it,” Keith said.    
   The problem with either idea, Keith and Hogan agree, is politics. In talking with colleagues, Hogan said the closer they are to Washington D.C., the worse chance they think a carbon tax has.
   Stavins sees the same dynamic at work. “The political forces against … are so massive that lower gas prices are not going to make that much of a difference,” Stavins said. If the politics can be overcome, low oil prices create an opportunity not just for carbon pricing but also to remove costly fuel subsidies, largely in the developing world, which keep fossil fuel prices artificially low, Stavins said.
   Though political resistance to a carbon tax may be disappointing to environmentalists, it reflects public opinion, which politicians are following, according to Ansolabehere. The bad news is that, according to polls, the time may never be right for a new tax.
   Though the public consistently supports environmental regulations, they also clearly favor regulatory approaches like EPA action or increased auto mileage standards over taxes, Ansolabehere said.
   “When asked, people will favor more regulations on coal companies, more regulations on tailpipe emissions, on fuel efficiency and things like that,” Ansolabehere said. “What they’re very reluctant to embrace is gasoline taxes or electricity surcharges.”
   And, though the public consistently favors cleaning up pollution, their concerns are focused locally. Global climate change doesn’t generate much fervor.  
   “They’re much more concerned…about smog, mercury, or particulates, than they are about global warming,” Ansolabehere said. “So, when you look at policy options that … have immediate effect on carbon emissions—such as cap and trade, energy tax, or letting the EPA just cap carbon emissions—you don’t get a clear majority in favor of cap and trade, [you get] a large opposition to a gas tax, but you get pretty much majority support for EPA regulations, straight up.”

Reliving the 1980s
Though 1980s flashbacks may not be useful in predicting clean energy’s track in the months to come, memories of that time are nonetheless relevant. In fact, they may be a major factor behind Saudi Arabia’s decision not to cut production to prop up oil prices, said Meghan O’Sullivan, who heads the Harvard Kennedy School’s Geopolitics of Energy Project.
   In the 1970s, the oil crises roiled the U.S. and demonstrated the economic muscle of OPEC, the Organization of Petroleum Exporting Countries. But by the 1980s, the global oil marketplace was changing. New supplies came online from Mexico and the North Sea, driving the price down and presenting OPEC with the choice of accepting less money for their oil or voluntarily cutting production to keep prices high.
   Most OPEC nations balked at cutting production, so Saudi Arabia decided to go it alone. Despite a production cut that eventually reached seven million barrels a day, however, prices remained stubbornly low. In the end, the Saudis lost market share and some of the shine on their reputation as the oil industry’s most important player.
   Thirty years later, the situation repeated itself. Over the last five years, the hydraulic fracturing revolution brought vast new supplies of U.S. shale oil to market. From the Saudi point of view, conditions were disturbingly similar to those of the 1980s, O’Sullivan said.    
   New U.S. oil was hitting the market as economic growth cooled in the U.S., Europe, and Asia. As prices fell, OPEC nations struggling with unrest at home or budget woes refused to cut production, leaving Saudi Arabia again faced with the choice of whether to go it alone. This time, though, it decided to keep pumping and let prices fall.
   “My sense is that the Saudis looked at the market and had uncomfortable flashbacks to the 1980s, a period when Saudi Arabia underwent enormous economic pain,” O’Sullivan said. “If the price was up, it [might] spur new investment in North Dakota, spur more American production, so why would Saudi Arabia cut production to prop up prices when it would spur more American production?”
   Though Saudi Arabia can pump oil profitably at prices as low as $10 a barrel in some fields, that course is not without pain. Its national budget is balanced on the assumption that oil averages $90 a barrel, O’Sullivan said, so prices below that—the U.S. Energy Information Administration is predicting Brent crude to average $59 a barrel in 2015—mean continuing budget deficits and tapping monetary reserves to cover them.
   While economic reasons are likely central to the Saudi inaction, O’Sullivan said, rarely in the Middle East are consequential things done for just one reason. The fact that low oil prices cause pain to nations like Russia—whose support of Syria’s Assad regime Saudi Arabia opposes—and regional rival Iran, could certainly be viewed as an added geopolitical benefit.
   In addition, the death in January of King Abdullah bin Abdulaziz Al Saud put new Saudi leaders in power, who run the risk of appearing ineffective and weak during a crucial transition if they try to prop up oil prices and fail, O’Sullivan said.
   “It would send the message that the Saudi government is not in control of the oil market. That’s probably never a good message from a Saudi perspective, particularly with a new king in power,” O’Sullivan said.

Shale in the crosshairs
But the Saudi’s action isn’t just rear-looking. It also likely has a practical, economic purpose today, according to Leonardo Maugeri, an energy expert at the Harvard Kennedy School’s Belfer Center for Science and International Affairs. The Saudis, he said, want to make life difficult for their newest rival and the cause of all the trouble: U.S. shale oil producers.
   “There’s no doubt [the Saudis’] first target is to get rid of U.S. oil production,” Maugeri said.
   Unconventional oil, like that from shale deposits and tar sands, costs more to extract than in conventional wells. It was thought that unconventional sources needed prices at least $75 a barrel to remain profitable, well above the level that conventional wells can profitably pump. It is that price differential, Maugeri said, that the Saudis have banked on. By keeping prices low, they believed they could disrupt U.S. shale oil production.
   The strategy has already had an effect. Hundreds of wells have shut down and some weaker operators have closed their doors or been bought up by stronger companies, Lee said.
   But a shakeout in the number of shale oil wells isn’t the same as crippling the industry. Unfortunately for the Saudis, U.S. shale oil production is marked by rapid technological innovation and efficiency improvements that have aggressively pushed down the prices at which the oil can be extracted.  
   “Their mistake, in a way, is that they believed that U.S. production was uneconomical at $75 a barrel. This is not true,” Maugeri said. “Eighty-eight percent of U.S. shale production breaks even at $42 a barrel. Most of the U.S. shale production is still feasible.”
   Maugeri doesn’t expect the Saudis to alter course, however. The kingdom has plenty of money to weather a price war and can wait for 18 months or longer, until supplies tighten and prices rise.
   “Once the war has started, they want to win the war,” Maugeri said.
   This particular war, however, may not be entirely winnable and John Shaw, the Dudley professor of structural and economic geology and chair of Harvard’s Department of Earth and Planetary Sciences, thinks the Saudis are savvy enough to understand that.
   “Those resources aren’t going anywhere. We know where they are. People will go for them sooner or later. It may be stretching the timeline, but it’s not really changing the long-term dynamic of the market,” Shaw said. “They [the Saudis] are not going to want to hold oil to half its market value for very long because they would lose out in that equation.”
   In addition, Shaw and Maugeri agree, the cost of extracting shale oil is only headed in one direction: down.
   New techniques to drill multiple wells from a single pad or to space wells more closely together are being developed. Producers are re-fracking existing wells and using contractors who’ve squeezed labor costs down to stay competitive. Together these factors will continue to lower prices at which shale oil can be extracted by roughly 10 percent a year, Maugeri said.
   “It changes every six months with improved knowledge, shared information, improved technology,” Maugeri said. “The breakeven is a dynamic figure, not a given forever.”
   Whatever their initial motivation, O’Sullivan said the Saudis are watching developments with great interest. “No one knows how low the price has to go before you get a reaction. We’ve seen the number of rigs go down a lot, but haven’t seen it affect production yet. But it will. [And] nobody knows how quickly they can come back on when the price goes up,” O’Sullivan said. “It’s a completely new dynamic in the market and really central to OPEC calculations. I think the Saudis were interested in finding out at what point U.S. shale production will stop. I don’t think their objective is to kill all shale production.
   “I don’t think they view shale as an unmitigated negative. It’s prevented a massive spike in the price of oil and would have saved them from investing in more capacity when they wanted to spend money on keeping their population content and not demonstrating for rights.”

A pipeline priced out?
Cheap oil, of course, impacts not just the economics of unconventional oil, it might also impact how it’s moved.
   The proposed Keystone XL pipeline, which would transport Canadian tar sands oil to U.S. refineries, is at the center of a political debate between Congressional Republicans and the White House. Supporters say it will be a jobs producer, while opponents are concerned that the risk of rupture and spoiling the lands it runs through is too high. In February, President Obama vetoed legislation authorizing the pipeline, arguing it pre-empted ongoing government evaluation of the project.
   Cheap oil may have drawn some of the steam from the debate by making tar sands oil, more expensive to extract even than shale oil, less attractive economically.
   “I think it definitely makes it easier to say no to Keystone, that’s clear,” Keith said.
   Whichever side you’re on, Stavins said, one thing does seem clear: the pipeline is not about jobs.      
   “Although it’s become a strong political-ideological issue, the proponents of it talk about massive economic benefits, that’s not really valid,” Stavins said. “There will not be many jobs created except in the construction phase. Obviously it’s a very large issue, ideologically, in the U.S, but my overall view on Keystone XL … it’s much ado about nothing.”

Impacting tomorrow’s oil today
While the world is watching for cheap oil’s impact on the U.S. unconventional oil business, future supplies of conventional oil may also take a hit. That’s because exploration for tomorrow’s conventional oil sources are also impacted by low oil prices.
   Exploratory wells in many of the most prospective areas cost upwards of $300 million to drill and several may be needed to find a resource. While conventional oil producers will continue to pump from existing wells at lower prices, it is the exploration and development that is curtailed when prices drop, and Shaw said oil companies are “moving exploration down to cruise control.”
   That can affect oil supplies five years down the road, Shaw said. More immediately, it means hundreds of millions of dollars of exploration and development have already been curtailed, sparking layoffs at oil service companies like Halliburton and Schlumberger.
   “We certainly have seen the effects of the downturn on many companies in the six months’ time frame,” Shaw said. “It’s clear these activities are being curtailed.”
   To Cox Professor of Law Jody Freeman, it is this dropoff in exploration—including that in environmentally sensitive areas—that keeps falling oil prices from being a clear loss for the environment.
   “There are always arguments on both sides regarding what lower prices mean for the environment,” said Freeman, who heads Harvard Law School’s Environmental Law Program and serves on the board of directors of ConocoPhillips. “On the one hand are arguments that low cost oil and gas will lead to more consumption and reduce incentives to invest in cleaner alternatives. On the other hand are arguments that the low prices will make it uneconomical for industry to drill in high cost and often environmentally fragile areas like ultra-deep water, the Arctic, and oil sands.”

A new energy era?
Energy economists agree we’re in the midst of a sustained period of low oil prices and that it may take one or two years until demand catches up with supply, or until production falls enough to match continued slow demand.
   During that time, Maugeri predicts that oil prices will vary between $35 and $60 per barrel, with the volatility due to geopolitical events layered over the fundamental forces of supply and demand. Events such as unrest in the Middle East due to ISIS, Saudi intervention in Yemen, tension with Russia over Ukraine, or natural disasters that affect production facilities, can cause prices to spike regardless of fundamentals.
   O’Sullivan, however, said the low prices may last even longer. “We’re probably in a new energy dynamic, with new fundamentals on the energy landscape that overall mean downward pressure on prices. It doesn’t mean prices won’t go up and down—it’s very easy to portray a geopolitical scenario with high prices in 2016. But the general trend is one where more supply abundance and slower, positive rates of demand grow together,” O’Sullivan said. “The new energy abundance, it’s a pretty big contrast from ten years ago, when it was all about scarcity, all about peak oil.”
   Though some volatility seems assured, some say that another feature of our energy future may in fact be greater price stability. Since shale oil producers can curtail and re-start operations far more quickly than conventional operators, their activity might dampen the traditional oil price swings, according to Shaw and Stock.
   “On the upside and downside, it should stabilize prices,” Stock said. “We’ll see. We’re running the experiment.”
   Cheap oil or not, Stock expressed confidence that the transition to cleaner fuels is coming. Transformational change can be slow, he said, but it does happen. Back in the early 1990s, Stock said, you would have been laughed at if you had said gay marriage would one day be legal. But change spread relatively quickly as a new generation with new sensibilities came into their own. He sees a similar transition in the offing, though perhaps still years away, for clean energy.
   “That [example] makes one optimistic, but it forces you to be patient,” Stock said. “A generational patience."

— Alvin Powell

This feature story originally appeared in Environment@Harvard, Volume 7 Issue 1.

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