Oil Price Shocks and Recessions

(chart source: page 4 of PDF)

A welcome shout out for Oil 101 today from economist James Hamilton of the University of California, San Diego. Hamilton's blog (along with co-blogger Menzie Chinn) is the excellent and widely followed econbrowser. Hamilton has carried out extensive and widely quoted research on the economic consequences of oil price shocks. For example, the chart above is one of Hamilton's from a recent presentation given by US Energy Secretary Steven Chu.

Oil 101 Review

A great review of Oil 101 was posted by Robert Rapier of theoildrum and r-squared blogs today. Previously on his r-squared blog, Robert has addressed our collectively low energy IQ and I hope that Oil 101 goes some way to improving the situation. Here is a quote from the review:

"if you want to understand the oil industry, Oil 101 will tell you what you need to know. In fact, "Oil 101" will be my stock answer from now on for anyone who wants to learn more - whether you know nothing or already feel like you are well-informed..."

OPEC's Next Cut: Fake it?

OPEC members meet next on May 28, 2009. Although varied OPEC members create a lot of media noise, this is usually for consumption by their domestic news markets. OPEC decision making is effectively Saudi Arabian decision making. The Saudis speak softly but carry a big spigot.

Today's WTI price is around $50/bbl. Every day we spend below the Saudi's 2009 governement budget balancing number of around $60 per barrel the more likely an additional token cut of up to 1 million barrels per day will be announced with no intention of ever implimenting it.

Since Q4 2008, OPEC have taken more than enough oil (3.5 million barrels per day) from the market to clean up global inventories (2009 global demand is only expected to be down 1.5 to 2.5million barrels per day - my models are around the 1.75mark) and so this OPEC token cut would simply be to change sentiment.

The Wall Street Journal quoted my opinion a few days ago.

"If oil is not above $60 by May 28, OPEC will announce a one-million-barrel-a-day cut with no intention of implementing it," said Morgan Downey....."They're going to have to give the market a kick in the butt to get it positive again."

Why Crude Oil Prices Rose to $150 in 2008

One of my pet peeves is when someone says that the rally in oil prices close to $150 in July 2008 was due to a temporary speculative bubble. Blaming high oil prices on bubbles is dangerous because it is so inaccurate.

Between September 2005 (see story) and July 2008 the global oil market had run out of spare production capacity for the first time since it began in 1859. Oil prices rose to slow down demand growth and incentivize new marginal supply. The first annual fall in oil demand since the early 1980s began to take place (see story). This created spare capacity once again.

The reason this is an annoyance of mine is that casually dismissing the rally in oil prices as a speculative bubble ignores the huge underlying physical supply issues we are facing and which are being temporarily masked by the current recession.

EIA Presentations

The EIA has placed presentation materials from its recent conference on its web site. The materials are a little dry without the commentary from those presenting. For example, an excellent presentation given by Robert Weiner of George Washington University would be much improved if the superb live talk he gave were superimposed over the slides. Weiner's analysis of non-public CFTC data shows that large groups acting independently but in similar patterns ("herding" and "flocking") is not significant in oil markets. In other words, the analysis clearly shows that speculation is not a driver of oil prices. Fundamental physical supply and demand drive prices. The EIA recorded the presentations. Hopefully the recordings will be posted online.

Economic Pinch to a Crunch

IEA Sees Oil-Supply Crunch by 2013 on Slow Investment (bloomberg)

“I can’t rule out the possibility of an oil supply constraint in 2013 and 2014,” Nobuo Tanaka, Paris-based IEA’s executive director, said in an interview in Tokyo today. “Investments have dropped, and if this continues, an oil crunch would emerge.”

Oil Markets and Economic Recovery

Two interesting monthly oil numbers which came out today are US vehicles miles travelled (upper chart) for February and Chinese oil demand numbers for March (lower chart - with US data superimposed). Chinese new vehicle sales were up 10% year on year in March 2009 and so the resumption of strong positive Chinese oil demand growth is likely soon. The question is, will oil demand in the US and the rest of the world turn positive soon also. The trend, at least in US vehicle miles traveled, would indicate so.

Great Books on Energy

A new book I highly recommend is 'Sustainable Energy - Without the Hot Air' by David MacKay, a physicist at Cambridge University. You can download it for free or buy a hardcopy. Reviews from The Economist and Boing Boing echo my feelings. MacKay's book is entertaining, insightful. witty, accessible, educational and no nonsense.

In his book, MacKay mentions a book by another physicist, Caltech professor David Goodstein's 'Out of Gas', which I also recommend.

Electric Vehicles: Solution?

(Oil 101 Pag 7, Fig 1-3, data source: EIA and IEA)

Electric cars have been touted as the next big thing for over 100 years. Current proponents say they are green as they will run on solar and wind energy. They also say that the metals required for batteries are available in sufficient quantities.

Sceptics point out that electric cars simply offer a feel-good factor by shifting the consumption of fossil fuels out of sight (most electricity comes from coal - see chart above) and that solar and wind are not scalable to the level required to offset a meaningful amount of oil. Currently only 2% of electrical power globally is produced from solar, wind and other such fuels.

Still others ask why are we wasting resources producing electric vehicles when a fuel used to generate electrical power, such as natural gas, should itself be used directly in automotive engines. Natural gas is currently successfully used as a fuel by many city bus and taxi fleets around the world.

Alternatively, we could use hydrogen as a store of energy (once the significant kinks have been worked out) and generate the electricity with nuclear power.

We are not short of choices. The real question is if you sum the outcomes of all the choices and their probability of success, do they get us where we want to go? Maybe the easier solution is changing our transportation need itself rather than its fuel?

Modeling Oil Demand

(chart: vehicles per capita)

When building oil supply and demand (S&D) models, demand is especially challenging to model when there are rapid large price movements.

When oil prices are relatively stable, consumers in developing countries increase their oil demand steadily with income until they reach European (high population density) or US (low population density) levels. Once consumers reach European or US demand levels then, in a stable oil price environment, oil demand in such countries becomes much less sensitive to income growth and changes only with population size.

However, in the face of rapid price increases such as that experienced in 2008, there is little historical data available describing how any oil consumer behaves. Data for the oil shocks of 1973-1974 and 1980-1983 are useful, but the world economy and transportation vehicle ownership patterns looked quite different back then.

Comparing patterns of vehicle ownership in different parts of the world today, I find it useful to have three model touchstones : 1. the US, 2. Europe (representing the developed world outside the US) and 3. the developing world.

1. The US has a high rate of vehicle ownership at 2.28 vehicles per household according to a recent survey. From the same survey, “'The most common pairing of vehicles in American households with two to four cars is a full-sized pickup truck and a standard, mid-range vehicle.” The average efficiency of the US vehicle fleet is in the low 20 mpg range.

2. Europe has slightly smaller levels of vehicle ownership per household compared with the US. Average European fuel efficiency is much higher than the US. Public mass transit is also more readily available in Europe than in the US.

3. In the developing world there is usually less than one vehicle per household and these vehicles are very efficient (such as a motorcycle/tiny car). Public mass transit is often much less available than in Europe and the US.

When oil prices rise rapidly, households in the US have capacity for immediate efficiency gains as they can drive the more efficient of their two vehicles more and if they buy a new vehicle they can buy a much more efficient vehicle. There is a certain amount of discretionary oil spending in the US (especially vacations involving air travel) which can also be cut back rapidly.

Europeans are already driving relatively efficient vehicles and so they have less capacity for immediate oil consumption efficiency apart from using public transportation more heavily. Europeans have less discretionary oil spending (as GDP per capita is lower) compared to the US - but what discretionary oil spending exists is still oil price sensitive.

In the developing world, there is less public transportation available and vehicle owners are already driving one very efficient vehicle. This vehicle is usually essential to getting to and from a good job and there is little oil spent on vacations (jet travel, and so on). Developing country oil consumers, therefore, have the least ability to cut back on consumption when oil prices rise.

In summary, when oil prices rise, households in the US can (to a certain extent) quickly decide to buy less oil, followed closely by Europe – but for slightly different reasons. In the developing world, households cannot as easily avoid buying oil when prices rise quickly.

This demand model was clearly evident in the rapid increase in oil prices during 2008 when US oil demand collapsed first and most severely (almost 13% year/year decline at its nadir in October 2008), followed by Europe. Developing world oil demand fell only very slightly, but quickly recovered.

Why Europeans Pay Higher Gasoline Taxes

(chart: population density)

There are fundamental differences between Europe and the US that make the European gasoline and diesel retail tax model unsuitable to the US.

First, there are major differences in population density. High European population density and the clumping of European populations makes public transportation a convenient alternative. US population density is much less than a third that of France, Germany, Italy and the UK. The less dense US population is also less clumped. Thus, public transportation is not an option for a large portion of the the US population.

Second, North America’s geography dictates far different commercial transportation patterns. The EU has seven times more coastline for its landmass than the US. European commercial seaports are in close proximity to consumer centers and less road trucking is required. In the U.S., two large coastlines require commercial oil powered trucking to haul goods inland.

Third, car ownership is spread more widely across the wealth spectrum in the US compared to Europe. Higher gasoline taxes would therefore impact a much larger portion of the US electorate versus Europe.

Given these fundamental differences, European governments have had an easier time implimenting high retail taxes on gasoline compared with US governments.

The US should look for solutions appropriate to US circumstances, rather than adopting ill-fitting models. The US could instead use a simple Vehicle Efficiency Market rather than a retail gasoline or diesel tax to increase efficiency.

The Evolution of Oil Demand

In Oil 101 I describe how oil demand evolves. As you can see from the chart below (from Chapter 1 - Oil 101), oil demand is initially strongly correlated with GDP. Then when oil demand gets to a certain level it tends to level off in per capita terms. In 1985, 24.45 barrels were consumed by the average US person. In 2008, the US average was 23.3 barrels even though population size and the economy had changed significantly.

Page 18, Fig. 1-13, Morgan Downey, 2009, Oil 101

Let's be Realistic

There are a lack of realistic and a lot of conceptual solutions to energy issues with little honest distinction made between them. Many proposed solutions are vested interests lining their pockets at the expense of the gullible. Spending taxpayers' or investors' monies on something unrealistic creates the false appearance of leadership and progress and is dishonest.

I am all about simplicity and pragmatism. Following is a simple test which every energy solution should pass:

1. No new technological discoveries are required.
2. Government subsidies are not required.
3. Solution is scalable without distorting other markets.
4. The solution is politically acceptable.

This is not to say that we should not invest in new technology, provide occasional subsidies or encourage small scale alternatives. However, the more tests a solution does not pass the more it should be treated as a conceptual solution and discounted far more severely compared with realistic solutions. Apologies if it seems like I am stating the obvious, but I get the feeling that many energy "solutions", no matter how theoretical, are treated as if they have an equal chance of success.

Gasoline Taxes - The Future of Transport

(The future for many? A photo I took in 2005 near Jaipur, India)

A Simple Alternative to Gasoline Taxes
The reason I am proposing a Vehicle Efficiency Market is that gasoline taxes are not politically viable in the US. Here is a good summary from the New York Times today of the recent failed attempts by several individual US states to raise gasoline taxes.

The Future of Transportation
At the EIA conference in Washington D.C. earlier this week I thought that one of more thought provoking and entertaining presentations was that given by Lee Schipper (Precourt Institute, Stanford University). Here is a site he posts to.

The reason I thought Schipper's comments were so interesting is that he paints a fairly credible picture of the future of transportation by pulling together images from his travels. In a future where we must do more with less, Schipper envisions a world in which transportation involves many people (even in the developed world) riding motorcycles (as in India/China) rather than cars, bus rapid transit (such as the Metrobus in Mexico City and Bogotá's TransMilenio) and more sidewalks (even along highways) ensuring walkable roads.

At the conference, Schipper also made an observation that one of the primary infrastructure gaps discouraging push bicycle transportation is not a lack of cycling lanes, but that there are few safe places to store cycles at office buildings or rail stations.