Stranding Equitably in the Current Market and Geopolitical Context

By Albert Bressand
October 13, 2016

CCSI’s conference of early November 2016 will consider, notably, how world production of oil and gas could be significantly reduced in manners protecting the interests of lower-income producing countries, given that staying on carbon budget will require leaving two thirds of our fossil fuel reserves unburnt. The question I consider in my own research is not about the desirability or modalities of doing so, but about the market and geopolitical context in which such proposals need to be implemented. In other words, to what countries and companies would the idea of declaring some resources ‘stranded’ and other still open for production, in a way that is equitable for lower-income countries, need to be proposed (hereafter “the proposal”)? Of course, convincing as the climate argument is, economic and political considerations will nonetheless play a role in assessments of the proposal. Unless one believes in massive conversion through the sheer power of persuasion, issues concerning who would need to implement hydrocarbon production curtailment and which interests such actors would take into consideration are not mere footnote considerations.

One way to frame an exploration of our question is to consider the ‘merit-order’ supply curves for oil and natural gas. Just like the carbon-abatement cost curve that shows how much can be achieved through each type of decarbonization measure and at what cost, the merit-order curve for oil supply shows how much oil can be produced where and at what cost over the next decade(s) under a certain price assumption, with the price being just high enough to cover the cost of the last (marginal) barrel of oil on this curve. Curtailing world oil production can then be analyzed in concrete terms by identifying the segments in the merit-order curve that would be curtailed and those that would not. Doing so informs the interests at stake and opportunity costs incurred. The additional (redistributive) objective of keeping lower-income countries in the production game, while closing down production in ‘the rest of the world,’ can then be compared to lower cost alternatives. The additional cost of the redistributive approach can then be measured, leading to a discussion of compensation and burden sharing.

Back in the high-oil-price decade of 2004-2014, the merit-order supply curve for world oil production could be described as consisting of: a constrained low-cost segment (OPEC oil); a mid-range cost segment that included a large number of countries whose production was already naturally declining (notably OECD oil basins, including the U.S. where production had been declining regularly since the late 1970s); and a high-cost, ‘tough-oil’ segment located largely in developing countries, which was rendered profitable at the time by high prices. While low-cost and mid-range-cost oil was being produced by a variety of national companies, ’tough-oil’ required a combination of technology and risk-capital that the oil majors (now referred to as the International Oil Companies—IOCs) were best able to provide. As a result, implementing the proposal during the high-oil-price decade would have created losers in OPEC ranks (higher-income OPEC countries) and in OECD countries. With respect to the latter, the argument could have been made that the proposal merely accelerated ongoing production decline. Winners by contrast would have been the low-income producers of tough oil, as well as the IOCs that would develop such oil.

The situation today is radically different. Drawing on public research programs initiated by the Carter Administration, entrepreneurs such as George P. Michell were able to ‘crack the code’ and find ways to economically produce hydrocarbon molecules dispersed in mother rocks such as shales.  Peak-oil theory is still right as far as ’peak’ is concerned—it is agreed that the production of conventional oil did peak in the 2000s, more or less as expected—but peak oil theory has been proven wrong in terms of what can be considered ‘oil’. A whole new class of molecules has suddenly become available for production, the term ‘unconventional’ merely reminding us that this production was not part of accepted conventions previously. Leaving aside the reasons why, in my view, similar breakthroughs will continue to occur and to change what ‘oil’ is, it is now widely accepted that demand for oil will peak before supply peaks. One can no longer argue therefore that declaring assets stranded is merely an anticipation of what Mother Nature will nonetheless impose upon us.

In addition, the new merit-order curve will make for a very different political economy of asset-stranding, on that may be even more challenging to work with than the previous one.

First, the middle-range cost part of the new merit-order curve is a revitalized one, centered on what we call the U.S. Unconventional Gas and Oil industry (U.S. UGO). Once believed to be on an inevitable decline, U.S. oil production zoomed from 5million barrel days (mbd) at the start of the decade to 9.7 mbd in late 2014. In effect, the U.S. UGO replaced tough-oil developing countries as the producer of the marginal barrel and price setter. Second, as a result, low-cost producers can no longer count on the price set by tough-oil barrels to generate massive returns from their own constrained oil production. Saudi Arabia has therefore opted to compete on volumes, as a lower cost producer would do in any ‘normal’ market. In addition, both Iraq and Iran are on their way to increasing their own low-cost production as a result of gradual stabilization in Iraq and the lifting of UN sanctions against Iran.

This transformation of the merit-order oil-supply curve is bound to last irrespective of whether OPEC reduces its production as was agreed at its Algiers meeting at end of September. The U.S. UGO (granting that it could not have developed without the high natural gas and oil prices of the past) has embarked on a learning curve that bestows gains in productivity not unlike those transforming the wind and solar industries. In addition, the U.S. UGO follows models far more flexible than those that preside over the development of tough-oil in developing countries. Unconventional oil and gas production can be compared to subterranean forestry: massive land areas are needed, hundreds of wells must be drilled, production declines rapidly for the first three years but then stabilizes for a decade or more. As a result, a portfolio of wells created over half a dozen years exhibits strong resilience and can be ramped up or down with a flexibility unheard of in the tough-oil world.

This transformation in the supply-curve’s merit order profoundly transforms the political economy of the proposal discussed in this blog. Not only can ‘peak-oil’ not be invoked to alleviate regrets about resources left in the ground, but the tough-oil producers in developing countries are no longer the more dynamic part of the global oil system. To some extent, they need not just to be kept in business, but to be resuscitated in the wake of a massive transformation in oil-and-gas exploration capital-allocation patterns—at a significant added cost.

Three changes are worth noting in the context of the proposal.

First, with OPEC having felt the wind of the bullet from U.S. UGO, and provided that both Iraq and Iran do not become paralyzed again, lower-cost production is available in far greater volumes from OPEC countries and Russia. Implementing the proposal assumes that these countries can be convinced, incentivized, or coerced into giving up their production. Not discussing which type of convincing, incentivizing, or coercion would work—beyond the good faith of climate change mitigation advocacy—would be akin to calling for the end of war in Syria without any plans regarding how some alignment of interests could take place.

Second, the U.S. UGO will not disappear; it will restructure and keep pushing the productivity frontier. Unlike almost anywhere else on the globe, asset holders in this case are not governments but private land owners, notably farmers and ranchers. How they would be brought into the deal that would seek to strand equitably under a Clinton or Trump Administration is an essential question.

Third, many of the recommendations in proposals such as those to be considered at the CCSI conference are really addressed to large multinational companies—in this case IOCs. Large MNCs from Western countries are exposed to reputational risk and regulatory oversight that makes them open (if not hospitable) to campaigns such as an ‘equitably stranding assets’ campaign. The asset-management industry can further add to this willingness to listen by endorsing recommendations of the ’divest’ campaign that affect share prices. In this light, the bad news for the proposal is that IOCs are considerably weakened by the transformation in the merit-order curve. Their skills are no longer essential to keeping world oil production on the increase. It is true that Exxon, Shell, and others are doing their best to move into the U.S. UGO, but it remains to be seen whether they can win the contest. By contrast, the often privately held and, in any case, smaller and less reputation-concerned companies of the U.S. UGO will be less receptive to requests asking them to limit production to countries where, unlike IOCs, they do not operate. As for the Russian and Middle-Eastern state-owned companies that are at the center of the low-cost oil game, their openness to equitability arguments is often less than sufficient.

The transformation in global oil and gas supply patterns adds a further layer of complexity to the challenge of delivering on the Paris Agreement. Taking account of current geopolitical and market forces, CCSI’s Conference, titled “Climate Change and Sustainable Investment in Natural Resources: From Consensus to Action,” will explore the type of innovative policy and international governance system that can be implemented in order for the world to stand a 50% chance of keeping the global average temperature increase below 1.5oC relative to pre-industrial levels.

Albert Bressand is professor, international strategic management in energy, at Rijksuniversiteit Groningen in the Netherlands, and a senior fellow at the Columbia Center on Sustainable Investment.