It seems to me that most policymakers have missed some basic issues with respect to our energy problem. One of these is that world oil supply is very inelastic–that is, even with high price, it doesn’t rise much, if at all. Another issue is that free international trade makes world-wide impacts of policies fairly different from what the effects seem to be, when measured within the boundaries of the country. It seems to me that the combination of these issues is contributing to one of our current problems–rising world CO2 emissions, even as countries struggle to contain CO2 within their own borders.
Furthermore, the policies being designed today are being selected primarily from a CO2 perspective. These policies aren’t being designed to address the problems that inelastic oil supplies bring, which include recession when there is even a small imbalance between supply and demand. Unless policymakers understand the broader picture and develop policies that consider all of the issues (that is, (1) inelastic oil supply, (2) CO2 impacts, and (3) spill-over effects to Emerging Markets), they cannot make optimal decisions.
Inelastic Oil Supply
The usual assumption with most resources is that supply is elastic–that is, with a higher price, more will be produced. But with oil, oil production doesn’t rise much regardless of price. Back in April, I showed this graph:
Figure 1 above is on an “all liquids” basis, so includes biofuels, natural gas liquids, and almost anything else that might act to extend oil supply. Even on this broad basis, liquids aren’t rising much at all.
On an annual basis, world crude oil production has been close to flat. There was a dip in production in 2009 when oil prices dropped too low (also note Figure 1), but when prices spike, high oil prices do virtually nothing to add more.
Economists talk about inelastic supply, or about a vertical supply curve, when higher price doesn’t result in more production.
When there is a nearly vertical supply curve, even a small increase in demand results in a sharp upward price spike, and even a small decrease in demand results in a sharp drop in prices. Doesn’t this sound a whole lot like what we have been seeing with oil supply recently? Everyone assumes “speculators must be causing the increase” because the increases and decreases are so sharp, but even a small out-of-balance between supply and demand could be causing these fluctuations, if supply and demand are balanced very tightly, as they are with a nearly vertical supply curve.
Substitutes Can’t Rise Much, Very Quickly, Compared to Current Oil Consumption
There are a few products that are “sort of” substitutes for oil, with biofuels coming closest. Even biobuels are pretty inadequate, however. Biofuels, at least as they are made today, are not chemically equivalent to oil, so can be added only as a small percentage of the fuel (recently raised to 15% for ethanol). It also takes a lot of cropland for biofuels. The Wall Street Journal recently showed this graph, when talking about corn used for ethanol in the United States.
It is pretty clear that if ethanol currently requires over 40% of our corn supply to produce a liquid that replaces 3% of our petroleum consumption (on an energy basis–comparing Btus of the two fuel sources for 2010), then we are not going to be able to replace much of our petroleum supply with corn ethanol. There are other types of biofuels that researchers are working on, but so far they are very small–nothing we can count on replacing any sizable percentage of oil with, on a short-term basis.
How Inelastic Oil Prices Result in Recession and Falling Home Prices
What happens when oil prices rise greatly, because of even a small increase in demand? Oil is refined and used to make products of all sorts–for example, gasoline, diesel, jet fuel, home heating oil, asphalt for roads, shingles for roofs, fabric for clothing, herbicides, and pesticides. It is also used in farming, in construction, in making all kinds of disposable medical products, and, of course, for transporting goods of all types.
So when the price of oil rises, the price of all of the products that are affected by the oil price theoretically needs to rise at least a little. This rise in price does not provide any improvement in the products from the customer’s point of view. The buyers don’t have any more money to buy these higher priced products, at least in oil importing nations. (In oil exporting nations, there are ways around some of these problems. Prices of the oil-related products can be subsidized. Also, some of the higher profits from the state-run oil companies can be used to increase subsidies for food. )
If we think of
demand = amount people can afford,
then demand falls for a very broad range of products, because of the rising prices of goods with oil-related price increases. This drop in demand leads to employment cut backs, and even further drop in demand, because the newly unemployed cannot afford as much. With price increases on oil-related products and employment cutbacks, more people default on loans. Businesses take out fewer new loans, because they have no reason to expand their businesses. Home prices are likely to fall, because people without jobs may default on their loans, and because people who are spending more on oil-related goods are likely to cut back on their expectations regarding buying a more expensive home.
Impacts of Nearly Vertical World Oil Supply Curve on Policies
In the face of a nearly vertical oil supply curve, programs to reduce oil supply use, such as carbon taxes, more efficient vehicles, and cap-and-trade programs are likely to work differently than originally intended. Since world oil consumption remains essentially constant regardless of price, these programs don’t reduce world oil consumption, or world CO2 emissions related to oil, since any oil saved will be quickly used by someone else, perhaps at a bit lower price. These programs may still have some oil-related benefits–allowing more people to share in the oil that is available, and reducing oil imports to a particular country. But the impact on world oil production / consumption is minimal, if the total world oil supply is virtually fixed, and there is free trade among nations.
What effect these programs have depends on what happens to the demand that is “saved” by the tax or the greater efficiency. In the case of energy efficiency, this might be the money the buyer of a more fuel-efficient car has left over to spend on other things because of lower fuel use. In the case of a carbon tax, this might be the fuel use that is transferred to a lower CO2 source such as natural gas or wind.
In the case of energy efficiency, suppose that the buyer with money left because of lesser fuel use uses this left-over money to buy goods that are manufactured in Emerging Markets. The net impact, at least from a CO2 perspective, may be negative, because of the large amount of coal these countries use both in manufacturing goods and in the way the workers spend their salaries.
In the case of a carbon tax or cap-and-trade, the effect may be to transfer fuel use to another type of fuel more quickly than otherwise would have been the case. If the fuel is natural gas, one could argue that the policy results in a more-rapid rise in use of natural gas, and leaves world oil usage virtually the same, so that there is a net increase in CO2 emissions. In the case of a transfer to wind, wind turbines take fossil fuel energy to create. If there is no savings in world oil consumption, but an increase in fossil fuel use for wind production, the effect is still an increase in world CO2, but a smaller one than with natural gas.
As a practical matter, OECD Fuel consumption (Figure 6) has shifted far more to natural gas than to renewables, such as wind, in the past 20 years. (In the BP data shown above, biofuels are “buried” in oil. Renewables are wind, solar, geothermal, biomass, and waste.)
Of course, if there really isn’t enough oil, maybe what is important is to transfer oil usage to another fuel source to prevent oil prices from spiking even worse than in the past, and causing even more recession. So from this point of view, maybe CO2 policies are working better from a “transfer to other usage perspective” than from a CO2 perspective, or from a “savings of fossil fuels” perspective.
Policymakers Need a Broader View
My concern in all of this is that the scientists and regulators looking at these questions seem to have blinders on. They seem not to have figured out that world oil supply is extremely inelastic and that there is a real problem with oil prices spiking and recession following. Because of this issue, policy-makers need to adjust their focus to consider more than just CO2.
Furthermore, with free international trade, it is very important where money from a country is being spent. Obviously, products produced in many Emerging Markets use coal-fired electricity in their production. But equally as important, the salaries that the workers in these countries receive allow them to have air conditioning and other products that use coal fired electricity. This means that even services, like computer programming outsourced to India, can have a negative impact on world CO2 emissions.
I think the time has come to start thinking seriously about which goods and services we produce at home, and which ones we purchase abroad. When we purchase goods and services abroad, we basically abdicate control to local authorities. If we are not paying any attention to this, and just focusing on what happens within our own borders, we are likely to see a rerun of what has happened recently–a rapid shift to coal viewed from a world-wide perspective, with most of the growth coming from Emerging Markets. We also lose the jobs and wages that get transferred to Emerging Markets, making our struggle with recession even worse.
If we need to be using coal, maybe we need to be doing it at home, and making certain efficiency of manufacturing operations is high, and pollution controls are optimal. Or maybe we need to be figuring out how to do without these goods and services all together. But I don’t think that blindly wandering along, assuming CO2 programs for individual countries will fix world oil supply issues, makes sense any longer.
If we don’t understand the problem fully and we don’t look at all of the indirect ramifications on a world-wide basis, we cannot possibly figure out a rational energy policy. We really need to look at the whole picture, and think about options we have never considered in the past.