Could falling oil prices benefit the climate?

Crashing oil prices are raising the specter of gas guzzlers and a dirtier world economy. However, it may not be as simple as that. Last week, we argued that falling oil prices will not likely slow the scale up of most clean energy technologies. Now, here’s another counterintuitive point: The current oil price paroxysm may well even be a boon for the global climate.

Conventional wisdom says high oil prices encourage the use of alternative fuels while lower prices will spur the consumption of conventional fuels. However, in our view the recent price crash is going to weaken the oil industry’s hold on the global energy system, thereby providing unexpected gains for the climate.

How will that happen?

The oil industry is already challenged by the rising costs of finding new oil, often in hard-to-reach places such as deep under the sea. Over the short run, therefore, low oil prices will destroy the economics of many huge investment projects, whether in the Arctic, the tar sands of Canada and Venezuela or in deep-water drilling sites including in the Gulf of Mexico. Chevron recently put its arctic drilling plans on hold indefinitely citing economic uncertainty in the industry. In addition to Chevron, oil companies around the world are pulling back and it is estimated that this year alone oil and gas exploration projects worth more than $150 billion are likely to be put on hold as dropping oil prices make those projects uneconomic. Worldwide a trillion dollars of investments in various oil and gas projects may be at risk over the next decade.

In this regard, expanded U.S. oil production, Saudi Arabia’s hesitance to cut production and a slowdown in Asian demand have depressed prices, making many production projects unjustifiable.

And yet, there is another dynamic at work that is both contributing to the new price collapse and perhaps making it more than transitory: the long-term downtrend in U.S. and European oil consumption. Not only are Americans driving less, but fuel economy standards have massively improved the efficiency of U.S. vehicles—trends that are likely to endure. The International Energy Agency, for example, has estimated that despite a projected doubling in the number of vehicles in the world by 2040 increasing efficiency will would suppress oil demand growth by 23 million barrels per day in 2040—more than the current oil production of Russia and Saudi Arabia combined.

Other factors will come into play too that could limit oil demand, including a combination of stricter regulations to control greenhouse gas emissions, the switch to clean sources and new technologies. For instance, new research suggests that one-third of oil reserves would become stranded assets if a global deal to limit increase in global temperature to 2 °C came into effect.

In short, the oil industry has reached a tipping point. Though oil prices will eventually rise, new trends will limit the rebound. That’s why a dramatic Citigroup report, “The End is Nigh,” noted that the demand for crude oil is set to fall dramatically in the coming decade due to the rise of natural gas as a substitute for oil in various sectors and ongoing improvements in fuel economy.

Bottom line: The investor community is weighing the risks of investing in fossil fuels too.