Energy Price & Supply Projections - How Good are Your Assumptions? Part 2

Assumptions Related to Demand or, More Accurately, Consumption

NOTE: One source of confusion in these discussions is the fact that economists often use the term “demand” to describe the amount of a product that is consumed. In common usage, the term “demand” refers to what people want to consume. These two values are essentially identical when supplies are adequate, but they are different when shortages appear. In the following discussion, the term “demand” is used to represent what people would consume if sufficient supply were available at reasonable prices. The terms “supply” and “production” refer to what actually is consumed.

11. No country can grow or maintain a strong economy without large amounts of oil

We often hear about the huge variations in per capita petroleum use around the world – from less than 1 barrel per year in India and many other countries to around 25 in the US and Canada. What we seldom hear is that the variation in energy use per dollar of economic output is much smaller. As shown in Figure 8, consumption in the more developed economies varies from around 400 barrels per million dollars of gross domestic product (GDP) in the most efficient economies to 1500 in the largest developing economies – i.e., a range of around 4:1 on economic basis vs. 25:1 on the per capita basis. Measuring on an economic basis put the US is in the middle of the range rather than at the high end. Note that I have not included major exporters and most underdeveloped economies as the quality of the data and type of economic activity makes the comparison unreliable.

Economic activity consumes energy. While inefficient consumers can reduce energy intensity significantly, they can only go so far before reductions start hurting their economies. This is particularly true for transportation which is highly dependent on oil. Developing countries such as China and India cannot continue to expand their economies without significantly increasing their energy use. Since these two plan to continue their fast growth and have the ability to pay for increased oil imports, global oil demand will continue to rise rapidly.

12. Liquid fuels for transportation are absolutely essential for health and welfare in the US

The US infrastructure and lifestyle have been built on a base of cheap, abundant fuel and there is no way to quickly reduce demand. Hybrids and other efficient vehicles will help, but we need to make major changes in living patterns and infrastructure to greatly reduce transportation fuel use. These changes include improving mass transit systems, improving the rail system (passenger & freight), and most importantly, reducing commuting distances. Ultimately, people need to relocate from inefficient buildings spread across the countryside to new, efficient ones clustered near each other. Doing so will reduce both transportation and heating & cooling energy use (building energy use is another huge problem which I will address in future assessments). These changes are inevitable, but the financial and cultural challenges associated with them are immense.

13. Dramatically increasing the energy efficiency will require massive quantities of capital

Expanding public transportation, improving the railroad system, and constructing energy efficient buildings to replace our existing inefficient (and poorly located) stock will require a lot of money and time. In addition, the lack of trained personnel to develop new liquid fuel supplies and to design, construct/fabricate, maintain, and operate the new equipment and facilities presents another daunting challenge. Thanks to the petroleum industry depression, low energy prices, utility industry restructuring (and corresponding staff cutbacks), the number of people entering these fields has dropped dramatically in the last 20 years. Many of the trained personnel in these industries are getting close to retirement and there are not enough people to fill the holes that will appear, much less expand firms to meet the growing need for these services.

14. The biggest barriers to increased efficiency are behavioral, not technological

In the US, energy has been cheap and taken for granted for decades. Few people have thought about their energy use and even fewer have bothered to take the time to learn how to improve efficiency. Equipment purchase patterns and numerous surveys have shown that energy efficiency is a low priority in all sectors. Even if the resources need to improve efficiency were readily available, people will not take action until they are motivated to do so.

While many people are becoming aware and are concerned about energy, it is unlikely that the attitudes of the majority of US citizens toward energy will change until prices rise substantially and stay high for an extended period of time. Once interest increases, it still will take a long time to educate people on how to increase efficiency, train the people needed to implement the changes, and change entrenched behaviors.

Major end-use efficiency improvements can be achieved with equipment that is readily available but underutilized. The technology pipeline is clogged with efficient systems that were developed over the last 2 decades, but have not achieved significant use due to apathy (note: this comment applies more to building equipment rather than vehicles, but until recently, vehicle purchase trends clearly demonstrated lack of concern over efficiency). While R&D is needed to develop even more efficient technologies for the future, it doesn’t make any sense to stuff more in the pipeline until we break the clog.

Assumptions Related to Balancing Supply and Demand

15. Peaking of oil and/or natural gas production isn’t the problem. The gap between production and demand is the problem

Passing the point of peak oil production will mark the start of a new era, but passing the peak will not directly causes problems. Problems result from the gap between what is produced and what people want to buy – i.e., unsatisfied demand. In the past, gaps were closed by increasing production and/or reducing demand (through conservation and substitution driven by high prices). Passing the peak removes the option of increasing production, which means that the only ways to close the gap is to reduce consumption. Consumption can be reduced through conservation (e.g., drive less), energy efficiency improvements (e.g., tune up your vehicle, switch to a higher-mileage car), or substitution of alternative fuels. Losing the ability to increase production makes balancing demand and production/consumption far more difficult, but it doesn’t mean that balance cannot be achieved.

16. Small supply shortages will yield major problems

Gasoline, diesel fuel, and heating oil are essential for survival for many people in this country and reducing consumption in the short term is very difficult. Consequently, small supply shortages will lead to large price spikes. Any indication that the shortage will persist will lead to hoarding and panic. The US has not experienced extended shortages since the oil embargo and Iran crises in the 1970s and few people are prepared to deal with a true extended shortage. In our affluent society tolerance for shortages or even disruptions of our normal practices is very low, hence the reaction will be very loud.

Another factor that will make the impact of the next shortages worse is a major change in business practices that has occurred over the last few decades. When a shortage occurs, the immediate response is to deplete inventories, activate surplus production capacity, and substitute other materials. In recent years, most large industrial firms and many commercial businesses have moved toward “just in time” and “lean” business practices. This shift has led to shrinking inventories, eliminating surplus production capacity, and reducing the ability to substitute one commodity for another. Just-in-time practices are totally dependent on a stable and reliable supply chain and disruption of any stage can create major problems for everyone in the chain. As a result, our ability to accommodate shortages of any energy commodity is far lower than it was 20 years ago.

The turmoil resulting from shortages and price spikes will motivate people to change, but business disruptions, shortages of resources, and price increases for critical items will seriously complicate the task.

17. Normal supply/demand balancing mechanisms will break down when large shortage appear

The optimists place total confidence in the markets ability to balance supply and demand. I agree that the market will achieve balance as long as it functions. However, all the rules are off if a serious shortage leads to a market collapse.

Much of the population will be able to pay much higher prices for gasoline and heating oil, but some segments will be devastated. In the event of large shortages and extreme price spikes, the impact will be widespread and severe. Stories of businesses and schools shutting down, people unable to drive to get food or medical supplies, and people freezing in the dark will lead to demands for the government to “do something.” Once the Strategic Petroleum Reserve is drained, the only options available to the government will be price controls and physical rationing. The US government tried price controls, supply allocations, and rationing in response to the oil crises in the 1970s. The results were not pretty. Given our lack of preparation and the current confrontational political climate, the next rounds are not likely to be any better.

18. Raising prices is the most effective way to reduce demand, but our leaders will not take this path until all other options fail

The US government seems to be firmly committed to trying to reduce demand without increasing energy prices or forcing people to change their lifestyles. This is not an achievable long-term goal and in fact it is counterproductive. The main elements of these programs are subsidies for using more energy efficient equipment (e.g., hybrid cars) or increasing oil production. The fierce political battles over even minor tightening of current ineffective corporate average fuel economy (CAFE) standards highlights the challenge we face in trying to achieve any significant improvement.

Experience clearly shows that sustained high prices will lead to reduced consumption. In contrast, experience with electricity and natural gas markets clearly shows the futility of trying to change behavior through subsidy programs. High subsidy levels are needed to stimulate a high degree of participation, but with high subsidies the programs generally are not cost effective.

Note that this discussion intentionally is not addressing government funding of research on advanced energy technologies. While research on more advanced technologies is desirable and necessary for the long term, there is a long time lag between research and market impact. These efforts will not have a significant impact on the major near term energy problems we are facing.

19. Competition for oil and natural gas will intensify and could get very ugly

Most forecasts of the US energy future that I have seen appear to largely ignore competition for available oil supplies – they generally assume we will be able to import as much as we want. However, all major oil and gas consumers – US, Europe, Japan, China, India, etc. – are net importers who will be competing for those supplies. When supplies are inadequate, those with the largest financial resources will win the bidding wars. If the losers’ shortages and the resulting pain get too intense, military action to secure supplies will begin to look like a reasonable step. It doesn’t take much imagination to see where this could lead the world.

20. The earth cannot sustain its current population in reasonably acceptable living standards without large quantities of fossil fuels

Few people have considered how much population the earth will be able to support after fossil fuels are largely depleted. A study of sustainability that was conducted a few years ago (reference 3) concluded that in the post-fossil fuel age, the earth could support 1.5 – 2 billion people at the current worldwide average lifestyle. The current population is around 6.4 billion. Even if the estimate is off by a large margin, it is clear that we will be forced to lower the average living style and/or population to achieve sustainability. Given that a huge portion of the world currently lives at subsistence levels, it is doubtful that major reductions in the average lifestyle are acceptable or achievable. Reducing the population will not be a pleasant task. Voluntary programs such as China’s 1 child policy are one option for reducing the population in a controlled way. The alternatives are war, plague, and famine.

Conclusions – What Should We Do Now

The debate over when oil production will – or did – peak is a distraction that needs to end immediately. There is no doubt that production will peak well before demand stops growing and major lifestyle changes will be needed to bring supply and demand into balance. We will face major upheavals as we adapt to post-peak production world. While we need optimists to build the future, we need them to focus on changing unsustainable practices, not keeping people on a path that can only end in even more pain and suffering. We need to start dealing with how to achieve sustainability rather than arguing over how serious the problem is.

The optimists argue that we don’t need to worry or do anything radical to prepare for shortages and price spikes as market forces will eliminate the problems quickly. If we do nothing and they are wrong, the impact will be devastating to the world. However, following the pessimists’ recommendations – i.e., immediately implement a massive efficiency improvement and alternative fuels program – does not have any significant downside. In fact there are several major benefits to following these recommendations including job creation, energy cost savings, reduction in harmful emissions, improved balance of trade, improved industrial productivity, and improved comfort. Why is this debate still going on?

While the need to change is obvious to anyone who objectively evaluates the facts, I am a realist. The US is a crisis driven country. Today we are overwhelmed with urgent needs such as energy prices, global political turmoil, global warming, trade deficits, social security funding, etc. Each of these issues has a strong constituency demanding action. Their debates and the confusion they generate generally results in little being done to address any of the problems until one of them becomes a true crisis. Hence, it is virtually guaranteed that the US will experience multiple major energy crises. I see no reason to believe that the leaders or citizenry of this country will begin taking the uncomfortable steps – much less the painful ones – that are needed to move onto a sustainable path until they are forced to do so.

So what should those who care about the future do? The first step in solving a problem is acknowledging you have one. Most of the US refuses to accept that we have an energy problem and is in denial. The prevailing attitude seems to be that we need to drive energy prices so we can get back to business-as-usual. An aggressive education program is needed to change this attitude, generate awareness, and help the public and politicians understand the problems better.

Once awareness is raised, we need to push for higher energy prices. Experience clearly shows that sustained higher prices are a prerequisite for getting people to take serious actions – if fact, higher prices are likely to be the only (or at least most) effective way to stimulate change. One of the more promising ways to raise prices would be an energy tax that is inversely indexed to market prices. Such a tax would establish a higher floor price and provide strong incentive to invest in efficient equipment and services. Funds generated by this tax could be used to offset the effect of higher prices on low-income people and/or finance other transition tasks. (Note: I know this type of tax is not politically viable today, but we need to start pitching it now so it is seriously considered when the next crises hit.)

Most of the “do something” proposals that are flooding political circles focus on technology R&D, subsidies, or efficiency standards, but they are ignoring the most important need: EDUCATION. While technology R&D is getting most of the attention, education is a much higher priority. Technology R&D is needed, but we will not see significant benefits from new technologies for many years. Much of the efficient technologies developed in the last 20 years are underutilized due to lack of interest among decision makers. Future advances will meet the same fate if attitudes don’t change. Subsidies can affect the market as long as they last, but their impact also is fleeting if attitudes don’t change. More stringent efficiency standards are needed to eliminate detrimental options from the market, but they will meet fierce resistance if attitudes don’t change (the CAFÉ battles clearly illustrate this challenge).

Major oil shortages could appear virtually overnight (e.g., another series of hurricanes, successful attacks on key petroleum processing & export facilities) and this country needs to be better prepared to deal with them. I do not know any homeowner who questions the need for fire insurance. The threat that serious energy shortages pose to the U.S. is comparably serious but our “energy insurance” is woefully inadequate. This needs to change.

Sustainability is mandatory, not optional. Our current lifestyle is unsustainable and by definition, no one can live an unsustainable lifestyle indefinitely. The smart move is to start trying to change ASAP. The transition will not be easy or pleasant, but it will be made one way or another. Delaying action will limit options and make the task harder – you seldom have the luxury of being picky when you are in the middle of a crisis. Failure to deal with our energy problems now increases the likelihood that we will see more of these extreme crises. Procrastination that makes the problems worse – i.e., makes war or famine more likely – is not admirable, desirable, or smart.

References:

1. Estimates of biofuels potential vary significantly from analysis to analysis, but the conclusions are largely the same. The number presented here come from an analysis by John Baise of World Perspectives, Inc. (http://www.politicaloutreach.com/WorldPerspectives/ newsletter/032806biofuels.htm).

2. An Ethanol Refresher And The 60-Minute Question, May 08, 2006, available at: http://www.thewatt.com/modules.php?name=News&file=article&mode=nested&si...

3. Sustainable Population Levels Using Footprint Data, Dell Erickson, March 20, 2000.

4. Peaking of World Oil Production: Impacts, Mitigation and Risk Management, Robert L. Hirsch et al., February 2005 (available at: http://www.energybulletin.net/4638.html).