FAQ on EU Response to High Oil Prices

June 23, 2008 // Published as a news service by IHS

Tools for Engineers IHS sells standards collections and regulatory information for the oil & gas, petrochemical and utilities industries. For more information and a price quote, please complete the form below. API Collections ASME BPVC ASTM Collections CyberRegs - Compliance library IHS Standards Expert - Standards DB IEEE Collections NEMA Collections AWS D1.1 Welding Code First Name: Last Name: Email address:

This document contains answers from the European Union (EU) to frequently asked questions about rising oil prices.

Will growing energy prices affect EU's energy policy goals?
The impact that high oil prices and our growing dependency on foreign oil imports have on the competitiveness of the European economy has been one of the drivers for European energy policy: curbing demand through more efficient technologies and the promotion of renewable energy sources can compensate for the decline in our indigenous oil production (dropping from 133 million tons in 2005 to about 50 million tons in 2020).

Therefore, the EU should vigorously pursue its energy policy targets - namely, reducing its energy consumption by 20% compared with a business-as-usual development through an aggressive program of energy efficiency measures, the EU Emissions Trading Scheme and increasing the share of renewables in our final energy consumption to 20% by 2020.

In this context, and given the dependence of the transport sector on petroleum products, the European Commission (EC) proposals for a 10% share of renewable energy (including biofuels) in transport have an especially important part to play.

In turn, considerations about biofuels' sustainability reinforce the importance of the development of more advanced "second-generation" biofuels. EU has already in place instruments to encourage and support such development efforts.

What role do biofuels play in the current situation?
Biofuels can help to lessen the pressure on the transport sector by offering an alternative to oil. According to the Organisation for Economic Co-operation and Development (OECD), biofuels accounted for 1.8% of total transport fuel consumption in 2007. Biofuels are estimated to have met about a third of the increased demand for transport fuel in 2007.

Biofuels need to meet strict sustainability standards. As far as biofuels consumption in the EU is concerned, such standards form part of the EC's recent proposal for a renewable energy directive. The EC intends to use them as the basis to encourage biofuel producers and consumers worldwide to adopt a similar approach.

The fact that the EU biofuels target is also conditional on the commercial availability of second-generation biofuels will also help to limit the risk that biofuels use up land that could be used to increase food production.

Are any special actions envisaged in the transport sector?
The EC strategy to fight climate change in transport and, at the same time, to reduce its dependency on oil comprises a wide variety of measures that go from the vehicle level, towards equipment, modal choice and policies to influence transport decision makers.

Those measures are in the pipeline or being implemented. Discussion by European institutions and implementation by EU member states and industry need to be taken forward.

Thus, in the transport sector, the EC intends to promote energy savings through improving vehicle technologies (such as with engines, fuels and tires) and favoring more energy-efficient transport solutions (such as shifting to rail and waterways, better logistics and navigation, and smart charging).

How can energy efficiency be improved for vehicles and fuels?
Energy efficiency gains, such as those that have already taken place in aviation and with respect to the private car, are the ideal solution, as they allow reductions in both internal and external costs. However, some energy efficiency gains have long lead times, since they require investments and research upstream.

To improve the efficiency of cars, which are the biggest oil consumers, the EC has proposed tightening standards on CO2 emissions from cars. The EU has set the ambitious objective of limiting to 120 grams the CO2 emissions per kilometer for passenger cars by 2012.

The EC has also proposed that fuel suppliers reduce greenhouse gas emissions from fuel across its life cycle by 10% by 2020; it will also propose reducing the CO2 emissions from new vans by the end of 2008.

In addition, the EC is preparing a proposal on tire labeling, which is likely to cover at least car and van tires and include a system to grade tires according to their rolling resistance, at the same time satisfying safety standards.

The swift implementation of the strategic European energy technology plan, together with the creation of European industrial initiatives with industries, will allow the development of new systems of green propulsion - in particular, in the field of alternative fuels, hydrogen fuel, on-board computer systems and aviation "clean skies."

What is the impact of increasing prices on transport costs?
Transport services play a central role in modern society and economy; in the EU, they account for about 4.3% of all value added. But the real importance of transport goes further beyond this figure, as transport allows the division of labor plus it supports and interconnects markets.

But as things stand, there is no transport without oil, as it depends almost totally on oil products (97%). The transport sector is the biggest user of oil products (53% of oil for all uses, 72% of oil as a fuel).

Transport is also the sector where increases in oil prices become immediately visible. Such increases are relayed to the rest of the economy, mostly through the transport modes, which are most energy-intensive: road transport (83% of total transport energy consumption comprising both passengers and freight) and aviation (14%).

Transport costs are a relatively small part of the cost structure of industry and may range from 1% to 10% of final product value. For instance, transport costs amount to 5% to 10% of production costs for processed food, 1% to 3% in the textile sector and slightly under 4% for automotive.

Thus, if transport costs increase by 30% for sectors not subject to excises, this could mean for the automotive industry an increase of 1.2% in the total cost of production and for processed food an increase of up to 3%. In the case these products were transported by road, due to the fixed character of the excises, the increase would be slightly over half of that.

Households spend 13.6% of their total final consumption in transport and half of this amount (6.7%) corresponds to the operation of personal transport equipment, which means mostly fuel costs. A doubling of crude oil prices in this sector subject to excises for about 30% of pump prices - and where energy costs represent about 25% to 30% of transport costs - would imply an increase of almost 20% in the cost of transport, which could amount to over 1.3% of the final consumption of households.

Should the EC investigate the level of competition in the oil sector?
The EU also needs to monitor the competitive situation in the markets for petroleum, including the sectors involved in the processing, production and sale of oil and petroleum products. It is ever more important during times of high and rising prices to make sure that consumers are treated fairly.

Therefore, the EC is continuously monitoring the situation on these markets and examining any complaints received. A special study on competitiveness is being prepared to further map and clarify the level of competition in the sector.

What are the structural factors behind the rising oil prices?
Global energy supplies have recently failed to keep pace with constantly rising global demand for energy. The driving forces of global demand are mainly found in Asia's emerging economies (China and India).

Demand is also rising fast in many producing countries themselves (Middle East), sometimes helped by internal subsidies on fuels (such as in Indonesia, India, Iran), which shield the local population from the impact of global price increases and thus do not allow consumption patterns to adjust.

On the supply side, future availability of oil will be determined by new exploration and production. Given the time lag in this investment-intensive industry, availability of oil for the global market several years into the future is being decided by moves taken now.

New exploration and development of new production capacities have been lagging behind expected demand growth. The International Energy Agency (IEA) has recently warned of the possibility of an oil crunch as early as 2012.

Structural imbalances also exist in the downstream parts of the global oil sector. The global refinery capacity has not increased in recent years. Refining bottlenecks have global consequences, making supply and demand patterns in the global economy more intertwined and complex - and thus less predictable.

Why is there not enough investment to bring oil onto the market?
The reasons for lagging investments are multiple. First, with most easily accessible reserves being already in production, and sometimes already in decline, finding and producing new oil reservoirs becomes increasingly costly and technically demanding.

This puts a natural constraint on new developments. Furthermore, a commodities boom affecting steel prices, amongst other things, has pushed the cost of the investments up, making some of the upstream projects more expensive.

In addition, a number of producing countries have started to nationalize their oil industries, a tendency generally not favoring new investments in the oil industry's upstream activities, which is badly needed.

For example, Russia's overall production has recently started to decline as existing fields come to maturity, and new reserves are not being explored and/or prepared for production at necessary rates.

Badly needed new investment decisions are sometimes also held back by geopolitical uncertainties affecting major sources of oil (such as in Iran and Iraq).

Another disincentive for upstream investments has been high mineral extraction tax rates or export tariffs in many producing countries. The Russian government started to address the issue and increased the tax-free threshold for mineral extraction tax from $9 to $15. The opportunity that rising prices offer for increased taxation has to be balanced with the need for new investment.

Finally, an important structural impediment lies in the limited availability of engineering skills in recent years at global level. National and international oil companies have difficulties in satisfying their demand for a new work force, further hindering their investments.

What are the temporary factors fueling prices to rise further?
Overall expectations of generally growing oil prices have been recently exacerbated by short-term developments. The geopolitical situation persistently makes full production in some areas of the world impossible, difficult or at least intermittent.

Furthermore, the global oil market is part of the overall commodities business, which in general has been seeing upward price trends. Oil is a global commodity and one for which the global market is huge in volume and diversified in available and sophisticated financial instruments.

This results in an active presence in the global oil market of institutional investors not directly concerned with oil. Most recently the subprime loans crisis inspired a search for alternative investments, further increasing demand for oil contracts. This tends to increase the risk of sharp swings in market sentiment.

Are the oil prices rising because of speculation?
Rising oil prices are largely the result of major structural shifts in the global economy. We are moving away from the era of cheap and easily available oil; this trend is inevitable and globally applicable. Some analysts predict prices up to $200/barrel by the year's end).

The market is driven largely by expectations and, specifically, expectations of future further tightening of supply and demand. After a year-long period of "backwardation" in the oil futures market (contracts on oil for nearby delivery more expensive than those for delivery further forward), we seem to be returning to a "contango" market (contracts on oil for delivery further in the future are more expensive than those for delivery closer to the date).

How is the rising oil price affecting the price of other fuels?
Long-term gas contracts negotiated in the wholesale markets are indexed to a certain extent on heating fuels (and ultimately on crude). Decoupling of oil and gas price mechanisms is therefore an option of avoiding spill-over effects from one market into another. The decoupling has some potential of reducing market volatility.

On the other hand, because of the fact that much of the gas consumed in Europe is transported by pipelines, it is unclear how the price for piped gas would evolve in case the indexation formulae were no longer used.

Coal prices remain at record levels, having followed the rising oil and gas prices, even if they continue to evolve in line with the particular conditions of the international coal market and not only as by-products of oil.

What will the EC do to encourage producers to bring more oil onto the market?
The EC needs to promote a dialogue with key producers, like Russia, Norway and the OPEC. For example, Andris Piebalgs, EC energy commissioner, plans to attend an important meeting at Jeddah on June 22. The EC's work should continue to open new opportunities for investment and production development, as well as to help markets become more efficient and transparent on both the supply and demand sides.

How should the public authorities react to current trends?
Rising oil prices are largely the result of major structural shifts in the global economy. We are moving away from the era of cheap and easily available oil and this trend is inevitable and generally applicable.

This calls for a clear distinction between short-term measures to alleviate the hardship on vulnerable sectors of society, and longer-term measures to accompany and promote the transition to a low-carbon economy.

Governments in consumer countries, and increasingly in producer countries, have little influence on prices in global oil markets in the short term. Political pressure from citizens and companies, therefore, focuses on the tax component of the price they pay "at the pump," or subsidies to help the needy to afford energy at a time of rising prices.

A balance is needed to ensure that targeted, time-limited support to the vulnerable does not send the signal to suppliers that taxpayers are prepared to absorb price rises, rather than pass these on to the consumer.

In any event, the EU has agreed to reduce oil dependency by stimulating the development of a low-carbon economy where the EU is less vulnerable to price variations.

What can governments do to alleviate the pain for those most vulnerable?
National governments can adopt measures to alleviate the burden for the most vulnerable members of society. There are a range of measures member states can take that fall within national competence, linked to both taxation and social security. Countries like Belgium and the United Kingdom already make targeted payments to help those most in need.

At their recent meeting, the ministers of the Economic and Financial Affairs Council (ECOFIN) stressed that such measures should remain short-term and targeted at those sections of the population most in need of help, to alleviate distress as well as to encourage energy saving. The ministers said this was in accord with the "Manchester Agreement" of September 2005, when the world was confronted with an equally sharp increase in oil prices.

Their concern was to avoid sending the wrong signal to consumers and to the oil-producing countries: the signal that it does not matter how much prices increase because we will continue consuming the same levels of energy, rather than stressing the need to consume less oil and gas to force prices down and reduce our dependency on fossil fuels and imported energy.

What is the role of speculation in the current price increases?
Although financial markets have recently become more active in the commodities markets - and this may make prices more volatile - there is no conclusive evidence of a speculative impact on prices. Stocks are stable around their normal level, and there are currently no signs of high inventories or of hoarding.

Other factors can explain the ongoing price rises, in particular, the strong increase in demand from emerging economies, including the oil-producing countries themselves, which has not been matched by an increase in supply.

Given very low elasticity of supply and demand to price changes in the short run, small disturbances can lead to sharp fluctuations in prices. The EC will continue to closely monitor developments in commodity-related financial markets.

Can the EC's climate change and energy policies help in times of high oil prices?
Yes, the high oil prices make the case for the climate and renewable energy package even stronger. The package will bring important economic benefits in the short and long term. If the greenhouse gas emissions and renewables targets are met, oil and gas imports will fall by some 0.3% of GDP, which translates into import savings of €50 billion by 2020.

These savings are based on a conservative estimate of an oil price of around $60 per barrel. If the oil prices remain at the current or even higher level, these benefits will also be considerably higher.

Overall, reducing greenhouse gas emissions and increasing renewable energy in line with the targets agreed to by the heads of state will make the EU considerably less dependent on imports of oil and gas. As well as bringing positive trade balances, this will reduce the EU's exposure to rising and volatile energy prices, inflation, geopolitical risks and the risks inherent to supply chains that fail to match the global demand for growth.

Aren't the EU targets of reducing emissions by 20% in 2020 too ambitious?
The EU's climate policy is aimed at avoiding dangerous climate change and to limiting global warming to 2 degrees Celsius compared to pre-industrial levels. This is what science tells us is required in order to avoid a drastic increase in negative effects from global warming. We need to get started on this reduction path in the next 10 years or so.

We need to this first in developed countries and later also in other countries, including large emitters in the developing world, such as China and India. That's why it is so important that we get an international agreement in Copenhagen 2009 that sets the rules for long-term action. So the targets are an essential step.

There is much at stake, with the prosperity of the European economy reliant on finding the right way forward. There is compelling evidence now available that the costs of inaction would be crippling for the world economy: 5% to 20% of global GDP, according to the Stern Report.

Minimizing the overall costs of the package has been a key principle in the design of the package of proposals. The impact assessment shows that these costs can be kept to under 0.5% of GDP a year by 2020. Therefore, also from an economic perspective, the targets cannot be regarded as too ambitious.

Why has the fishing sector been hit so hard by the rise in fuel costs?
The underlying cause of the crisis in the fishing sector is the combination of depleted stocks, which have been overexploited for many decades, and overcapacity in the fleet that fishes them. The result is a vicious circle, in which chronic low profitability drives even greater fishing pressure at a time when stocks need to rest and recover.

In this context, the rise in the price for marine fuel (which has gone beyond €0.7 per liter in most European harbors, an increase of around 240% since 2004) adds to the pressure on a sector already under great strain - in particular, because with marine fuel untaxed, the proportion of the price facing an increase is higher than for most consumers.

What short-term support for the fishing sector is available from the EU?
The EC has agreed, in principle, on the content of an emergency package, which should presented to the Council of Fisheries Ministers in Luxembourg on June 24. The EC plans to adopt a formal proposal on this subject early in July. The goal is to put in place measures that provide swift help, but also encourage the trend to restructuring, which is the only viable future for the industry.

The main measures will consist of temporary derogations to the rules of the European Fisheries Fund so as to support faster adaptation of the EU fleet to the present situation and provide temporary relief during the transitional phase. The EC believes it is vital to focus aid on the fleets that are most dependent on fuel, and thus most affected by the current overcapacity.

Therefore, key measures will include fleet adaptation schemes to provide more, and more flexible, decommissioning aid for fleets that accept substantial restructuring, aid to encourage switching to more energy-efficient and environmentally friendly fishing methods, emergency aid for temporary cessation of activities and market measures to increase the value of fish.

Possible modifications to the de minimis regime for fisheries are also being considered, so that the ceiling of €30,000 per three years would be applied per vessel, rather than per firm (though with an overall cap of €100,000 per firm).

A number of specific initiatives to promote the value of fish at the first point of sale are also envisaged, and the EC is planning to set aside an additional €20 to €25 million from the CFP budget to fund ad hoc projects in this area, in addition to the funds available under the EFF.

Further measures are planned to encourage the shift to energy-saving technologies, cushion the socio-economic impact of the crisis and facilitate the reprogramming and disbursement of EFF funds.

Source: European Commission.