The future of oil: The economics of energy transition

As global energy transitions progress, oil-producing countries are embarking on a journey of economic and energy policy transformation. Seeking to diversify their economies, these nations face a daunting challenge: navigating a future shrouded in uncertainty. With fluctuating oil prices and a host of unknowns about future oil demand, choosing the right investment projects is complex and calls for careful evaluation.

“The economies of oil-dependent countries are going through a transformative journey, and there is a need to measure the costs and benefits of public investment projects in these countries,” says Fatih Karanfil, an economist based at KAPSARC. 

To help major oil-exporting countries make better-informed investment decisions, Karanfil and Axel Pierru, Vice President of Knowledge and Analysis at KAPSARC, published a study that focuses on assessing public discount rates. Key to any cost-benefit analysis is accurately calculating public discount rates, Karanfil says. This involves evaluating future economic benefits and risks and comparing them with present-day values. 

“Due to their reliance on oil, special treatment is needed when you compute a public discount rate in oil-dependent countries,” he explains. “By exploring how oil price volatility and the relationship between oil prices and gross consumption (all goods and services) in the country affect public discount rates, we aimed to provide clearer guidance for policymakers in these countries.”

Karanfil and Pierru looked at 18 oil-reliant countries, considering economic uncertainties and risks associated with oil price volatility. The study is the first to examine how oil dependence can affect the public discount rate and notes that oil-dependent countries face unique challenges when considering energy transition projects. For example, increasing energy efficiency could result in reduced domestic demand, freeing up more oil for exports. “These dynamics, which do not exist for non-oil-dependent countries, are an additional risk factor for oil-dependent countries,” Karanfil says. 

“If oil revenues are the engines of your economy and your investment impacts domestic demand for oil and alters oil exports, then you are introducing an oil-related risk into your project’s evaluation,” Karanfil says. “We aim to increase understanding of how to account for this risk, especially considering how dependent their economy is on oil prices. This helps ensure policymakers are making informed investments that will be beneficial in the long run.”

Calculating a risk premium

To address the unique risks faced by oil-producing countries, the economists calculated a ‘risk premium’ for projects that impact domestic oil consumption or use oil as an input. Assuming the per-capita gross consumption growth would continue at its historical pace for these 18 countries, they determined the risk premium—the difference between the risk-free discount rate—for cash flows not correlated with gross consumption, and the risk-adjusted discount rate, for oil-related cash flows. 

For each of the oil-dependent nations, ranging from OPEC and major oil-exporting countries, Karanfil and Pierru analyzed the economic uncertainty created by dependence on oil, including the volatility of oil prices. 

“For all the countries we analyzed, except one small oil producer, we find that the risk premium is positive. This is not surprising, as higher oil prices lead to increased consumption of goods and services in the country,” Karanfil explains. 

The average risk premium was 1.4%, according to the team’s analysis. Qatar had the highest risk premium, followed by the United Arab Emirates, Chad, Russia and Kuwait. At the lower end were several African oil-dependent countries, including Algeria, Cameroon and Gabon. Sudan was the only country whose risk premium was negative. 

These positive risk premiums offer a helpful resource for government officials and private entities looking to make sound economic decisions about which projects to invest in as the energy transition accelerates, Karanfil says. “A positive risk premium means a higher public discount rate. As a result, this premium acts like a safety buffer, ensuring that only projects truly worth the risk are undertaken.”

The team also found that the more a country diversifies its exports, the higher the public discount rate. Most oil-exporting countries still only export a small number of other products, despite efforts by some, such as Saudi Arabia, to diversify their economies in recent years.