Transition faces pressure from oil crash and COVID-19

The energy transition faces dual challenges of an oil price crash and the coronavirus pandemic, with competitive pressure and disruptions to supply chains

Publication May 2020


Introduction

Originally published by Petroleum Economist – Energy Transition Newsletter

Until recently, the so-called Opec+ arrangement had successfully managed supply to keep the oil price up in the face of a global slow-down in demand, but within a matter of months all that has changed.

Russia no longer appears willing to keep propping up prices at the expense of losing market share to the US, and its withdrawal from the arrangement at the end of March (following its refusal to agree to further cuts) brings an end to the December 2019 reduction agreement and leaves Opec members free to open the pumps.

To add to the pressure, oil producers are now addressing an unprecedented drop in demand as the economic impacts of the Coronavirus pandemic takes hold.

Not every country can ramp up production as fast as Saudi Arabia, but even if the Saudis increase production by the levels suggested over the next month or so, at what price will they be able to obtain market share?

And, at a time when the energy transition appeared to be gathering momentum, does the combination of a plummeting oil price and the Covid-19 crisis have the potential to stop it in its tracks? Will the low prices (hovering around $22-23/bl at the time of writing) see companies and governments turn their backs on the Paris Agreement and other emissions reduction obligations and seize the opportunity to reach agreement on new pricing structures for long-term supplies of fossil fuels?

Will those IOCs leading the way to a net-zero carbon future be forced to reconsider these ambitions due to a lack of funds, particularly if they become increasingly embroiled in disputes around the globe? Or could this be the catalyst which accelerates diversification of supplies, with smaller players forced to reconsider their asset base to reduce reliance on the oil price?

It is worth bearing in mind that we were already in a low commodity price era before this, with natural gas prices at historic lows.

Covid-19 effects

On top of this, the impact of the Covid-19 pandemic has now extended far beyond LNG deliveries in China, which continues to call force majeure under many of its supply agreements. With a worker on a North Sea drilling rig testing positive for the virus, the industry must brace itself for a raft of potential shutdowns interrupting supply and causing performance issues.

Contractually, this is likely to lead to a rise in termination or suspension of contracts, claims for liquidated damages for delay, demurrage costs for shippers, and a knock-on effect of delays, losses and missed milestones further down the value chain, potentially disrupting the industry on a large scale.

Whether these claims can be headed off by a declaration of force majeure, change in law or a reliance on a material adverse change (MAC) clause is likely to end up being decided in years to come by international arbitral tribunals or the courts. Defences of frustration, impossibility or hardship might be raised but the outcomes are distant and uncertain at this point, and will not address current production and solvency needs.

Transition impact

The effects of Covid-19 are not limited to the oil and gas sector. Given the scale of solar panel production in China, many solar power projects have been hit hard by the shutdown. Battery storage production has been similarly affected and there has been some interruption in supply of turbines from China, Italy and Spain.

Corporate credit lines are consequently being stretched, with lenders looking even more closely at the ability of their customers to come through the virus-induced contraction. Energy projects may be delayed with the potential for multiple breaches of financing covenants, and if those delays give rise to termination rights for off-takers who themselves are similarly struggling, then more marginal projects could face cancellation.

Rather than rowing back, however, it might make more sense for project companies to seek component parts from a more diverse range of suppliers in the future. In respect of Covid-19 at least, the same issues of delay, loss, disruption, claims for damages and disputes will be present regardless of the underlying power source.

So what can energy companies do to protect themselves? The prudent players will be assessing their risks up and down the energy value chain and looking at ways to better ensure, for example, supply chain resilience. They will also be in proactive discussions with suppliers and customers, carrying out an urgent review of force majeure, change in law, material adverse change and other protections in their key contracts, while taking refinancing and restructuring advice in respect of long term liabilities.

When the energy transition appeared to be gathering momentum, does the combination of a plummeting oil price and the Covid-19 crisis have the potential to stop it in its tracks?

Depending on attitude, some may try to pre-empt the almost inevitable disputes by calling for price re-openers in major projects involving supplies of LNG, in the hope that long-term agreements can be renegotiated to reflect current pricing.

Of course, there will be resistance from sellers. But in a buyer’s market, it may be better to try and negotiate a future home for the supply glut which is starting to build in the face of a Covid-19-related reduction in demand from China, rather than resist any price renegotiation and end up in hard-fought litigation further down the line.

Most will be looking to once again slash back office costs and perhaps headcount, but having carried out a similar exercise barely five years ago, there may not be much scope for savings. The most cautious companies, or those most exposed to litigation risk, may feel time would be well spent getting ‘litigation ready’.

But perhaps the price crash and interruption to both supply and demand will persuade some companies to accelerate or indeed implement commitments to the energy transition?

The International Energy Agency has warned that the slowdown may hinder the implementation of clean energy technologies, and has encouraged governments to ensure that their stimulus packages directly encourage the energy transition.

Several European governments have extended deadlines for renewables projects or provided flexibility in existing incentives, and the 27 EU leaders agreed during an emergency meeting last week that the bloc's coronavirus-related economic recovery plan must be consistent with the “green transition”.

The detail has yet to be worked out, but if other countries follow suit and incorporate climate considerations into their rescue packages, the energy transition could gain renewed momentum after all.



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