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How to eat Russia's oil lunch

Apr 03,2022 - Last updated at Apr 03,2022

CAMBRIDGE  —  A funny thing happened on the way to net zero. While environmental, social and governance standards were forcing oil companies to divest from fossil fuels, and while the United States was tightening its oil production policy and cancelling the proposed Keystone XL pipeline on environmental grounds, Russia decided to invade Ukraine.

The US and Canada quickly declared an embargo on Russian oil, while the European Union, which is more dependent on Russian energy, struggled to devise a coherent policy. With energy prices skyrocketing, Western governments focused on increasing non-Russian supplies, including by recommissioning European coal plants and expanding US oil and natural gas production. Cynics could argue that this is an Augustinian case of “grant me chastity and continence, but not yet”. Clearly, a more radical rethink of energy geopolitics and decarbonisation is necessary to confront the Russian threat.

Russia’s new aggressiveness has been enabled by its oil boom. The country’s oil production declined precipitously after the breakup of the Soviet Union in 1991, reaching a nadir of 6.1 million barrels per day in 1998, five million fewer than a decade earlier. But output subsequently recovered completely, reaching a record 11.7 million barrels per day in 2019.

Increased production and long periods of high prices gave President Vladimir Putin the resources to beef up Russia’s army and throw his weight around. For example, Russia annexed Crimea in 2014, after a decade of high oil prices and rising market share had filled the Kremlin’s coffers.

In light of Putin’s current war against Ukraine, Europe has announced plans to wean itself off Russian energy. But, to a large extent, this is a fool’s errand. As the world learned during the 1973 Arab oil embargo, it does not really matter who embargoes whom in an integrated global energy market. What counts is how much of the world’s oil supply the aggressor can hold up. If this share is significant, energy will become more expensive for everyone.

If Russia is set to remain aggressive and dangerous, the strategy should be to curtail its share of the global energy market as much as possible. But how can this be done? Which countries would benefit from such a strategy, and hence help make it happen? And can the effort be compatible with de-carbonisation goals?

The answers to these questions may be somewhat surprising. To be sure, the EU and the G-7 would obtain security benefits by helping to reduce Russia’s share of the global energy market. They can do this by restricting Russia’s access to international finance and oil-production technology, and by imposing a tax on Russian energy in order to limit the country’s market access.

But OPEC also stands to gain from such a strategy. In December 2016, when oil prices were low, Russia entered into an alliance with OPEC to curtail production and prop up prices in a broader structure known as OPEC+. The deal worked to Russia’s advantage. By 2019, OPEC had cut production by 2.3 million barrels per day (with Saudi Arabia reducing output by 573,000 barrels per day), but Russia increased production by 337,000 barrels per day.

For OPEC, an alliance with Russia no longer makes sense. Instead, OPEC has an incentive to weaken an important competitor that has taken market share from its members in the past 25 years. After all, most OPEC production is in countries with large reserves. If the world is to de-carbonise, those reserves will remain underground after 2050. So, producers are competing to monetise their reserves rather than leaving them stranded. The more that Russia is constrained, the more oil OPEC members will be able to sell.

The same logic holds for the US. The country is endowed with many well-known reserves of tight oil and gas, which have a breakeven price of less than $60 per barrel. In addition, natural gas in the US currently trades at about $5.50 per million British thermal units, a small fraction of prices in Europe, justifying major investments in liquefied natural gas trains to export output to Europe and elsewhere.

From an environmental standpoint, US oil and gas projects have the advantage of being quick to execute and wind up. A tight oil or gas well produces over 85 per cent of its output in the first two years, whereas traditional oil fields can take up to a decade to develop and then run for decades, well into the period in which the world should be approaching net zero. So, a burst of US oil production aimed at reducing Russia’s global market share need not be long-lived.

Finally, the environmental movement can join the effort. Decarbonisation requires cutting global oil production. Russian oil is heavier than most OPEC or US oil, meaning that it generates more carbon dioxide per unit of energy. It is also sour, meaning that it contains a lot of sulfur, a nasty contaminant. Reducing Russia’s oil production may therefore be a good way to cut global emissions while keeping the world adequately supplied with energy until cleaner alternatives are developed.

China is likely to oppose this strategy. But in 2019, it purchased only 2.4 per cent of its natural gas, 14 per cent of its coal, 18.4 per cent of its crude oil, and 13.4 per cent of its refined products from Russia. Pursuing an uncooperative agenda with its main energy suppliers is thus not a costless strategy for China. Moreover, solving the logistical problems constraining Russian energy exports to China will be time-consuming and expensive, providing Russian producers with only partial respite.

The world will be better off if Russia is defanged. Assembling an international coalition to do this is made easier by the shared incentive to eat Russia’s oil lunch. OPEC will need to reconsider its relationship to Russia and to oil-consuming countries, which are needed to curtail Russian production. The G-7 and the rest of the EU will need to engage in fresh thinking, too. But the incentives can be aligned. And a safer world may be the result.

 

Ricardo Hausmann, a former minister of planning of Venezuela and former chief economist at the Inter-American Development Bank, is a professor at Harvard University’s John F. Kennedy School of Government and Director of the Harvard Growth Lab. Copyright: Project Syndicate, 2022. 

www.project-syndicate.org

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