Rajan Wilcox
Fossil fuel prices are volatile and impact not only the price of energy services but also many non-energy items. Fossil fuel price volatility is expected to continue and worsen as climate-related disruptions impact infrastructure, supply, and demand. As global demand for fossil fuels declines, market responses and potential imbalances in supply and demand could increase price volatility. Transitioning to more stable, electrified, renewable energy sources will not only help to slow climate change but will also facilitate long-term price stability.
| Characteristics | Values |
|---|---|
| Fossil fuel prices impact | Price of energy services and non-energy items |
| Energy prices as a key driver | Determining inflation rate |
| Fossil fuel price volatility causes | Geopolitical conflicts, climate-related disruptions impacting supply and demand, integration of regional natural gas markets with global LNG markets |
| Fossil fuel price volatility impact | Increase in inflation, impact on consumers |
| Measures to reduce price volatility impact | Exemptions from taxes and levies, compensation for affected consumers, support for utilities and energy companies |
| Fossil fuel price stability | Requires divestment from fossil fuels and investment in renewable energy |
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What You'll Learn
Fossil fuel prices impact non-energy items
Fossil fuel prices are volatile and impact not only the price of energy services but also many non-energy items. Energy prices are a key driver in determining the inflation rate but are also the most volatile component of a country's overall inflation. From February 2021 to June 2022, energy prices accounted for a third (33%) of Canada's overall inflation. During the same period, energy price increases contributed to a third of the United States' overall 9.1% inflation.
Oil and gas price shocks are not new, and energy-driven inflation will keep occurring as long as countries continue to be dependent on fossil fuels. Fossil fuel price volatility will continue, driven by geopolitical conflicts, climate-related disruptions impacting both supply and demand, and increased integration of regional natural gas markets with global liquified natural gas (LNG) markets.
Up to 25% of non-energy items within the Consumer Price Index are sensitive to oil prices, including food, various goods and services, and costs for shelter (both owned and rented). The impact of spiking oil and gas prices goes beyond the price at the pump and heating bills. It impacts the cost of everyday needs such as food, clothing, furniture, restaurant meals, and even the buildings we live in, whether rented or owned.
Transitioning energy systems away from fossil fuels can not only insulate against volatile fossil fuel prices and energy-driven inflation but can also reduce energy use and overall emissions. Well-designed climate policy can support affordability while also building a net-zero economy. Given the importance of energy to price stability, governments should enact policies and foster investment climates that support a transition away from fossil fuel energy dependence.
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Geopolitics and supply/demand imbalances
Fossil fuel prices are highly susceptible to geopolitical tensions, which can impact prices through two main channels. Firstly, heightened geopolitical tensions can negatively affect global demand by increasing uncertainty about the economic outlook, thereby discouraging consumption and investment and disrupting international trade. This, in turn, leads to a contraction in global economic activity and a dampening of global oil demand and prices.
Secondly, geopolitical tensions can pose risks to the future supply of oil, increasing the cash value of holding oil contracts (known as the convenience yield), thereby putting upward pressure on prices. This is particularly true if the countries involved in the tensions are key producers in global oil markets, as this could generate significant upward pressure on prices.
The impact of geopolitical shocks can vary depending on the countries involved and the duration of the tensions. For instance, the recent terrorist attacks in Israel and rising tensions in the Red Sea have put upward pressure on Brent oil prices. However, this has been offset by weak demand and higher non-OPEC production.
In addition to geopolitical tensions, supply and demand imbalances can also impact fossil fuel prices. As global demand for fossil fuels declines, market responses and potential imbalances in supply and demand could increase price volatility. For example, during periods of decline, consumers can benefit from lower fossil fuel prices, but abrupt price drops can disrupt the economy and affect businesses and employment.
To address the volatility in fossil fuel prices, a transition to renewable energy sources is necessary. Government investment in a rapid transition to electrified renewable energy can help stabilize energy prices and reduce overall emissions.
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Fossil fuel divestment for price stability
Fossil fuel prices are volatile, and this volatility impacts the price of energy services and many non-energy items. Energy prices are a key driver in determining the inflation rate. Oil and gas price shocks are not new, and energy-driven inflation will continue to occur as long as there is a dependence on fossil fuels. Fossil fuel price volatility is driven by geopolitical conflicts, climate-related disruptions impacting supply and demand, and increased integration of regional natural gas markets with global liquified natural gas (LNG) markets.
Fossil fuel divestment is a movement that has gained momentum in recent years, with a social and moral impetus to combat climate change and reduce carbon emissions. As of July 2023, more than 1593 institutions with over $40 trillion in assets worldwide had committed to some form of fossil fuel divestment, making it the largest divestment movement in economic history.
Fossil fuel divestment campaigns aim to exert social, political, and economic pressure for the institutional divestment of assets, including stocks, bonds, and other financial instruments connected to companies involved in extracting fossil fuels. Divesters cite various reasons for their decisions, including aligning investments with core values, combating the fossil fuel industry, and protecting portfolios from climate-related financial risks.
Fossil fuel divestment can contribute to price stability by reducing the inherent volatility in the energy sector. A well-managed, rapid divestment from fossil fuels is necessary to address the structural deficiency at root of inflation: dependence on fossil fuels. Government investment in a swift transition to electrified, renewable energy sources is crucial for future energy price stability.
However, building renewable energy infrastructure alone will not be sufficient to eliminate price volatility related to energy prices. It must be accompanied by a simultaneous divestment from the use and production of fossil fuels. Fossil fuel divestment protects investment portfolios from financial losses as the transition to renewable energy accelerates. Trustees of long-term investment funds should consider the negative long-term financial outlook for fossil fuels and reduce or eliminate exposure to this source of risk.
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Fossil fuel subsidies during energy crises
Fossil fuel prices are volatile and impact not just the price of energy services, but also many non-energy items. Energy prices are a key driver in determining the inflation rate. Oil and gas price shocks are not new, and energy-driven inflation will continue to occur as long as there is a dependence on fossil fuels. Fossil fuel price volatility is expected to continue and worsen as climate-related disruptions impact infrastructure, supply, and demand.
Fossil fuel subsidies are intended to protect consumers by keeping prices low. However, they come at a substantial cost. Subsidies have sizable fiscal consequences, promote inefficient allocation of an economy's resources, encourage pollution, and are not well-targeted at the poor. During an energy crisis, government commitments to phasing out subsidies are overshadowed by the priority to protect consumers. As a result, government actions reduce hardship but also weaken incentives for consumers to save or switch to alternative energy sources, and they deplete public funds.
In 2022, fossil fuel consumption subsidies worldwide rose above USD 1 trillion for the first time, according to IEA estimates. The energy crisis triggered by Russia's invasion of Ukraine led to subsidy levels that were double those of 2021, which were already almost five times those of 2020. Governments took various measures to protect consumers, such as fixing end-user tariffs or capping fuel price increases. For example, the Peruvian government decided in April 2022 to temporarily include transport fuels in the State Fuel Price Stabilization Fund to curb price rises.
In 2022, global fossil fuel subsidies were $7 trillion or 7.1% of GDP, reflecting a USD 2 trillion increase since 2020 due to surging energy prices. Subsidies are expected to decline as energy price support policies are phased out and international prices fall. However, they are projected to rise to USD 8.2 trillion by 2030 as the share of fuel consumption in emerging markets increases. Underpricing for local air pollution costs and climate damage are the largest contributors to global fossil fuel subsidies, accounting for about 30% each.
Gradually removing all consumer fossil fuel subsidies by 2030 could significantly reduce greenhouse gas emissions. This policy shift can deliver substantial climate and energy security benefits. Fossil fuel subsidy removal would also reduce energy security concerns related to volatile fossil fuel supplies.
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Oil price volatility vs other commodities
Fossil fuel prices are volatile and impact the price of energy services and non-energy items. Oil and gas price shocks are not new, and energy-driven inflation will continue to occur as long as there is a dependence on fossil fuels.
Oil price volatility compared to other commodities is a complex question. Studies have shown that oil prices have been more volatile than most other commodities, with Plourde and Watkins (1998) finding that crude oil price volatility during the 1985–1994 period was higher than price volatility for nine other commodities. However, Clem (1985) noted that agricultural commodities were the most volatile during the 1975–1984 period, with crude petroleum and coal being less volatile than most crude nonfood materials. Pindyck (1999) also analyzed oil, coal, and natural gas price changes over a long period but did not compare their volatilities.
The high volatility of oil prices is due to the low responsiveness or "inelasticity" of both supply and demand to price changes. It takes time to develop new supply sources or vary production, and consumers face challenges in switching to other fuels or improving fuel efficiency when prices rise. Geopolitical events, weather-related disruptions, and market dynamics can also contribute to oil price volatility. For example, hurricanes, refinery outages, and pipeline problems can disrupt supply and drive up prices.
While oil prices are volatile, it is important to note that the volatility of energy prices, in general, is higher than that of other commodities. Natural gas, electricity, and heating oil prices are more volatile due to consumers' limited ability to substitute other fuels when prices fluctuate. Additionally, during winter, natural gas demand often surges unexpectedly, while supply has less flexibility, leading to heightened price volatility.
In summary, oil price volatility has been higher than many other commodities, but it is not unusual compared to some crude nonfood materials. The volatility of oil prices has significant implications for consumers and the economy, and it is influenced by various factors related to supply, demand, and market dynamics.
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Frequently asked questions
Fossil fuel prices are known for their volatility. This volatility is expected to continue and worsen as climate-related disruptions impact infrastructure, supply, and demand.
The cost of crude oil is the largest component of gasoline prices and the main source of price volatility. Other factors include refining costs and profits, gasoline distribution and marketing, and taxes. Market responses, geopolitical tensions, and imbalances in supply and demand can also impact price volatility.
Fossil fuel price volatility has significant economic and social costs. High prices disproportionately impact the poor, and subsidies intended to provide relief may not always reach the intended vulnerable groups. Abrupt price drops can also disrupt the economy, affecting businesses, employment, and productivity.
