A price band for oil? Why not just do a global deal on climate?

As oil continues its crazy gyrations (yesterday’s price – $48), news is proliferating that investment in new exploration and production is falling off a cliff.  Monday’s NYT, for example, had this:

From the plains of North Dakota to the deep waters of Brazil, dozens of major oil and gas projects have been suspended or canceled in recent weeks as companies scramble to adjust to the collapse in energy markets.

Oil markets have had their sharpest-ever spikes and their steepest drops this year, all within a few months. Now, with a global recession at hand and oil consumption falling, the market’s extreme volatility is making it harder for energy executives to plan ahead. As a result, exploration spending, which had risen to a record this year, is being slashed.

The precipitous drop in oil prices since the summer, coming on the heels of a dizzying seven-year rise, was a reminder that the oil business, like those of most commodities, is cyclical. When demand drops and prices fall, companies curb their investments, leading to lower supplies. When demand recovers, prices rise again and companies start to invest in new production, starting another cycle.

Now for Dan Drezner, all this poses a question:

So, let me see if I have this right:

If oil prices are sky-high, the energy sector explains that it will be slow to develop new fields, because exploration requires massive fixed investments and no one knows what the price of energy will be 5-10 years from now;

If oil prices are low, the energy sector explains that it is unprofitable to develop new fields because… energy prices are low.

Well, actually that is more or less the long and the short of it; as I argued back in July, the oil price is set to continue its recent yo-yoing for as long as we continue without a clear ‘signal from the future’ about the long term demand outlook for oil. After all, if you were an investor considering ploughing money into oil fields that were only profitable above $60 or $70 a barrel, and which would take many years to recoup the capital cost, wouldn’t you apply a pretty big risk premium if you saw prices collapsing to below $50 from a high of $147 less than six months earlier, with the potential in the background for future climate policy to cause demand to plummet?

Problem is, though, that without that new investment, we’re on track for a serious price crunch at some stage, as both the IEA and Chatham House have argued.  So how to square the circle?  Well, Nick Butler – who was John Browne’s chief of staff at BP and now heads the chairman of the Centre for Energy Studies at Cambridge’s Judge Business School -has a proposal in the FT yesterday. He writes:

If the energy ministers want to stabilise the market they should begin by commissioning a detailed, independent analysis of what went wrong. They should then develop the stabilising mechanisms that would limit the possibility of any repetition of 2008.

The most effective mechanism would be agreement on a broad target range for prices – say, between $50 and $75 a barrel – backed by a strategic stock holding to be augmented or deployed when prices diverged from the range. To support such an agreement trading would be limited to those with a direct physical interest in the market.

From a new base of relative stability ministers could consider the longer-term issues that will shape the energy market: the huge need for infrastructure investment ($350bn a year according to the International Energy Agency) and climate change.

This idea of a price band is clearly starting to gain ground in the energy think tank world – I heard a very similar idea mooted by an attendee at a Shell / Economist energy breakfast in London last month. But I’m not so sure.  While Nick Butler’s clearly right to refer to the need to integrate energy security with climate change, why not go one step further – and use a comprehensive climate framework to provide the long term oil price stability that’s needed to bring the right amount of new investment on stream?

Think about it.  Imagine a climate regime in which the emission targets are sufficiently long term (i.e. multi-decade rather than in 5-yearly increments as under Kyoto), and which is based on a quantified stabilisation target, which therefore means that all major emitters have binding caps. (You can argue about political feasibility in the current political climate, but the fact remains that a global deal on climate that actually solves the problem will have to satisfy these conditions anyway – and sooner rather than later if we’re to limit warming to two degrees C.)

What such a regime would also achieve, with no extra work needed, is to provide long term predictability on how much fossil fuel will be being consumed – for decades ahead.  True, it wouldn’t tell you exactly which fossil fuels – coal versus oil, for instance – but since they’re used in different markets (oil mainly for transport, coal and gas mainly for power generation and heat), you could make a pretty good guess.

And now imagine again that you’re the potential energy investor we met earlier.  All of a sudden, you can invest with much more confidence – and what’s more, knowing the level of demand will enable you to watch what other investors are doing too, so that more or less the right amount of new oil is brought on stream to meet projected demand, within the context of a global deal for climate.

Oh, and there’s one other advantage: given that a global deal on emissions is primarily an agreement between energy consumers, you can worry just a little bit less about OPEC’s congenital inability to stop itself from cheating

Update: meanwhile, “OPEC oil ministers meet on Wednesday to remove a record 2 million barrels per day from oil markets as they race to balance supply with the world’s collapsing demand for fuel … Saudi Arabia, the world’s biggest oil exporter, has led by example — reducing supplies to customers even before a cut has been agreed to help push prices back toward the $75 level Saudi King Abdullah has identified as “fair.””