Reliance on oil is no longer a strategy for Latin America

The world's energy system is undergoing a transformation. Last year, renewable energy became the largest source of installed capacity in the world. The latest International Energy Agency (IEA) report forecast that it will remain the fastest growing source of electricity generation, with a share growing up to 28% from 23% in 2015. Furthermore, Bloomberg Energy Finance estimates that by 2040 electric vehicles are going to account for 35% of car sales. This undoubtedly would have implications for the oil market.

This expansion of clean energy and transport is only set to ramp up following the international Paris Agreement on climate change, which entered into force last week on November 4 in record time. In this global agreement governments decided to limit global temperatures to well under 2°C, and to strive for 1.5°C, aiming for net zero global emissions of greenhouse gases (GHG) in the second half of the century.

As governments meet this month in Marrakech for the UN Climate Change Conference to advance the implementation of this agreement, we reflect on the implications of this changing energy landscape for those countries in Latin America where oil revenues represent a substantial part of their economies.

Oil producing countries in Latin America are already feeling the pinch

The drop in the oil price has already been felt by oil producing countries in Latin America, with both exports and fiscal balances being affected. And the future of the industry looks gloomy; many experts believe that the old cycle of lower prices followed by higher prices is no longer applicable. Furthermore, the CFO of Shell has stated that he expects oil demand to peak before oil supply, with this occurring within 5-15 years time. The inevitable implication is that this will lead to assets being stranded and these will be defined by their position on the oil production cost curve.

A country’s exposure to this changing oil market is a function of both the strength of its non-oil related industries and also its position on the oil production cost curve. The relative effects are determined by the level of oil dependency which varies across Latin America. Venezuela is the most vulnerable to external shocks; crude accounts for 95% of its total exports, nearly half of its total fiscal revenues and acts as a major source of foreign exchange. Whilst less vulnerable than Venezuela Ecuador, Colombia, and Mexico have not escaped unscathed from the falling oil price.

At present, the decline in oil revenues for Latin American countries has principally been a function of supply and demand in the oil markets. However, the Paris Agreement on climate change may introduce another factor into the oil price equation, which might have a disproportionate impact on Latin American oil exporters.

According to the IEA, in order to have a 50% chance to limit global temperature rise to 2°C, only zero carbon infrastructure can be allowed from 2017. Already, the IEA estimates that the role of oil in the energy intensity of the economy, or the amount of energy a country needs to generate a unit of gross domestic product, has decreased at the global level dropping 2,3% in 2014 more than double than in the last decade a result stemming from energy efficiency and structural change happening in places like China. More significantly, increasing public concern related to dangerous air pollution levels in cities across the globe and innovators such as the automaker Tesla are also accelerating development of electric vehicles. Countries like China, US and Germany are pulling ahead increasing investment on this front, whilst Norway already announced this year to completely ban petrol powered cars by 2025.

Technology innovation and increasing efforts to avoid dangerous climate change will lead to suppression of global demand for crude oil, either through taxation or regulation -including carbon price instruments-, that benefit alternative low-carbon energy sources; or from another angle, by the removal of current price distortions by including where possible the social and environmental externalities. In turn, this implies that only the oil producers with the lowest cost base will be able to continue production on an economically viable basis.

Despite the differences in oil dependency in Latin America, there is more than geography and language that these countries share. The majority of both their current oil production and their oil reserves are made of heavy crude oil. Turning heavy crude oil into usable oil products is an extremely energy intensive activity that requires huge industrial facilities and colossal investments. Any kind of carbon price regimes in individual countries and/or tighter climate regulations would likely discriminate against heavy crude – as well as other energy-intensive forms of oil extraction such as tar sands – to the benefit of lighter crude such as that found in Saudi Arabia. Indeed, even under the current regime, with no carbon pricing, Latin America’s heavy crude already lags behind other types of oil on the industry cost curves.

Technological developments are touted as being able to mitigate this effect somewhat – for example Carbon Capture and Storage (CCS) might offer a way forward to allow continued crude oil production. However, it is very unclear that even if CCS were to become a commercial reality, whether it would be sufficient to make extra heavy crude oil competitive under a carbon pricing regime.

Oil’s lack of competitiveness

Given the likely conditions for the oil market in Latin America - compounded by climate policy- stranded assets are a probability. It is therefore high time to get the right set of policies to make the transition away from reliance on oil exports. As the economic risks for oil producers rise, financing investments will be more challenging. Furthermore, the New Climate Economy report estimates that to transform the energy sector, the investment in oil, coal and gas must decrease by about one-third by 2030 to keep global average temperature rises below 2°C; under this regime it is difficult to justify further investments in heavy crude oil extraction.

The challenges will depend on the structure of the oil industry in each country and the long term vision of the government. Dependency on fossil fuels for growth represents a challenge for climate change adaptation and mitigation, which underpin the Sustainable Development Goals agreed last year under the United Nations. Furthermore it represents a risk for the public finances of oil producing countries.

In general, reliance on fossil fuels is not a sustainable engine for the economy in the 21st century. However, Latin American countries may find that production decisions are determined for them as their high costs make production uncompetitive. This has clear policy implications. Oil production and refining in many Latin American countries is dominated by state oil companies; thus the government is doubly exposed to a market where heavy crude is no longer competitive. From the standpoint of individual governments, privatising oil production to limit their fiscal exposure may make sense. What certainly is the case is that further investment in refining capacity focus on processing heavy crude would appear to be at odds with the wider thrust of the Paris Agreement.

There are many good reasons to diversify an economy away from fossil fuel exports, including those which have little to do with either climate change or the dynamics of the oil market. However, the combination of these two factors means that oil production in Latin America is likely to feel the effects of the Paris Agreement faster than the industry realises. Governments in the region should start planning for this unstoppable transition now. Long term plans should be developed to guide the structural reform required and to trigger debates on the most appealing strategies for managing risk and fostering prosperity, addressing the new challenges and opportunities of the 21st century. Delivering effective social, economic and environmental development should be at the heart of it.

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