Diatribes of Jay

This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

08 January 2015

What Will Oil Prices Do Now?


[For comment on the puzzling paucity of natural-gas-burning cars and light trucks, click here.]

In an essay published just three weeks ago, I argued that the Saudis have no economic motive for letting oil prices plunge as they have. At just under $49 a barrel for WTI crude yesterday, oil prices have dropped by more than 50% in less than one year. That has been a huge plummet, with enormous global economic consequences, not the least for Saudi Arabia and every other petro state.

The question on everyone’s mind now is how long the low prices will last.

My reasons for calling the Saudis’ decision to let prices fall non-economic were simple and sound enough. Oil and its end-product (gasoline or petrol) are what economists call “price inelastic” commodities. In fact, they are about the most price-inelastic commodities in widespread industrial use today. I explained the reasons in an earlier essay; more about this later.

What this inelasticity means in practice is that small changes in global supply of or demand for oil can produce huge price shifts. In my recent essay, I calculated (roughly, using the behavior of gasoline prices during the Crash of 2008 as a proxy) how much the Saudis would have had to decrease their own production, unilaterally, to have kept global oil prices stable. The answer was 7.5%.

The total revenue received by any vendor selling oil equals the quantity sold times the price. By dropping their production (and hence sales) by 7.5%, the Saudis could have kept prices stable, incurring a total loss of only 7.5%, even if no other oil producer also cut production. As it happened, neither the Saudis nor anyone else cut production, so the price of oil has dropped over 50%. The result is that the total oil revenue of every petro state, including Saudi Arabia, Iran, Iraq, Russia and Venezuela, has dropped by over half. Needless to say, that’s much more than 7.5%.

That outcome, I concluded, was economically irrational for the Saudis to have caused deliberately. So I looked for political motives for the Saudis’ action. I quickly focused on a vital political goal: pressuring Iran and its patron, Russia, to make a deal to avoid Iran becoming a nuclear state.

This strategy would offer a blandishment as well as a threat: the implicit promise of a return to “normal” oil prices after success in the nuclear talks with Iran. So if that analysis is right, oil prices should bounce right back up if and when the Iran talks yield a credible and verifiable positive result. We could be back to gasoline at close to $4 a gallon in just a few months.

But in that analysis, I focused only on short-term economic motives. What if the Saudis and the other petro states have been thinking long-term?

As it turns out, there are indeed long-term business and economic motives for keeping oil prices low, which have nothing to do with politics. In failing to see and discuss them last time, I was ignoring the lessons of my own earlier posts on this blog.

To put it simply, oil now has stiff competition for its primary market, ground transportation. The best way to see why is to reproduce here my table of energy costs per mile for driving a car, for various sources of automotive energy. Following is the latest (2013) version of that table, with the current (2015) low price (highlighted) of oil’s end product, gasoline, now about $2 a gallon in many parts of the United States:

Energy Cost of Driving, in Cents per Mile,
for Various Automotive Energy Sources

Energy SourceUnderlying Price ParameterCents per Mile Driven
 March 2012Late 2013March 2012Late 2013
Gasoline$3.78 per gallon$2.00 per gallon
(early 2015)
12.66.7
(early 2015)
Natural Gas (Residential)$1.28 per gal. equiv.$1.89 per gal. equiv.4.36.3
Nuclear Electricity4.4 ¢ per kWh15 ¢ per kWh1.55.1*
Conventional Electricity
(Residential)
11.6 ¢ per kWh12.5 ¢ per kWh44.3
Conventional Electricity
(Industrial)
6.8 ¢ per kWh7.23 ¢ per kWh2.32.4
Natural Gas (Industrial)$0.55 per gal. equiv.$0.53 per gal. equiv.2.2**2.0**
Solar Photovoltaic
Electricity (Residential)
N/A4.6 ¢ per kWhN/A1.5
Solar Photovoltaic
Electricity (Commercial)
5.1 ¢ per kWh2.4 ¢ per kWh1.80.8

* For new plants
** Assuming that service station’s retail sale of industrial gas would add only 20% for operating expenses and profit.

So right now, today, oil has serious price competition from both natural gas and electricity as a source of energy for powering cars and light trucks. Not only that. For that purpose it’s now the highest-cost alternative, whether the natural gas or electricity is priced at residential retail, commercial or industrial rates.

To add to that inconvenience, oil is likely to run out before either natural gas or electricity, whether the electricity comes from natural gas, coal, or nuclear power. According to OPEC’s own global reserve figures, and present consumption rates (including their present rate of increase), global oil will run out somewhere between 18 and 43 years from now, depending upon how accurate OPEC’s figures for global reserves are.

In comparison, our Yankee natural gas reserves will last for 39 years even if we substitute natural gas for coal in making electricity and convert our entire light-transportation fleet to run on natural gas. If we use the sun, wind and nuclear power to replace coal instead, our own natural gas will last for 53 years, even if we run all our cars and light trucks on it and continue present uses.

So if you take our Yankee figures as estimates of the global longevity of natural-gas reserves, those reserves are likely to outlast global reserves of oil. In other words, the last fossil-fuel-powered car or truck will likely run on natural gas, not gasoline or petrol.

What does all this mean practically? Three things. First, the Saudis and other petro states are offering the high-priced commodity, still today, even after the recent price plunge.

Second, the commodity they offer is likely to run out before any substitute. As it runs out, all the enormous industrial infrastructure for extracting, refining, transporting, distributing and selling oil, plus burning its end product in internal combustion engines, will become useless and mostly worthless. The same sad fate will not befall solar arrays, windmills, or nuclear power plants, or (at least in the same short time frame) natural-gas vehicles or power plants. Primarily for this reason, an earlier post urged universities and pension funds to divest their investments in oil producers.

Third, as these facts dawn on producers of energy and vehicles, the economic structure of the global transportation industry will begin to shift. Because substitutes for oil offer both cheaper and longer-lived energy for driving, even now, industry will begin to make cars and trucks that use those substitutes, namely, natural gas and electricity.

As that happens, the extreme price inelasticity of oil and gasoline will begin to moderate, and with it the power of the Saudis and petro states to control the price of oil by manipulating global production. If they try to raise prices too high, more people will shift more quickly to cars and light trucks that run on natural gas and electricity.

None of this is the least bit odd. It’s all economics 1A.

When you have a unique commodity with no real substitutes—as oil has been for about a century for most ground transportation (and still is for air transportation)—you can pretty much charge what you please. When there are reasonable substitutes, your power over price decreases. It decreases even faster when your commodity is not only the highest-priced alternative, but is also not far from running out.

What’s not economics 1A, and in fact is unpredictable, is the response of global industry. Elon Musk’s new “Gigafactory” for electric cars is just one of many possible responses. Major car makers converting part or most of their fleets to run on natural gas and/or flex-fuels might be another. The economic motivation is there, but the strength and speed of the response is unknown and probably unknowable.

The price-inelasticity of oil and gasoline depends directly on how quickly car and light-truck makers offer vehicles that run on natural gas (or flex-fuels) and electricity. And that, in turn, depends somewhat on the price of oil, which the Saudis at present control. So in addition to involving imponderables, the calculation involves an unknowable feedback loop.

Saudi Arabia and other petro states could, of course, still boost the price of oil by cutting production. But that would only hasten the transition to cheaper and longer-lived alternatives. If other petro states refused to go along, but instead strove to increase their market shares, oil would run out faster. In the end, some petro states might even be left with oil to sell and no customers after fleet conversion reached completion.

Of course the Saudis’ motives, like anyone else’s, can be mixed. Pressuring Iran and Russia at this critical geopolitical moment is probably among them. After all, the Saudis were Iran’s arch-enemy before Israel existed.

But there are also other, longer-term economic motives. For the first time since oil became King (and electric cars with primitive lead-based batteries failed) a century ago, oil now has real competition.

The writing is on the wall, underlined by Elon Musk. It will be interesting to see how the petro states will read it. If Iran makes a nuclear deal, will they raise prices back up and try to make as much money as they can in the near term, thereby strengthening others’ motivation to switch to natural-gas and electric vehicles? Do they even have the collective discipline to do so? Or will they continue to try to beat the competition in the most direct and businesslike way possible, by increasing production and lowering prices?

As the great baseball catcher Yogi Berra once said, the future is one thing that’s hard to predict. But it’s now distinctly possible that oil prices will stay down, and perhaps even go lower, until the last human culture poor or stupid enough to bet its long-term future on oil pays the supreme price for a commodity still in demand but about to run out. Current global oil-reserve estimates suggest that that sad day is only a few decades away.

Footnote: Another away to estimate the Saudis’ economic power over oil prices is to consider what increases in global supply might have caused (belatedly) the recent price plunge. The two most probable sources of increased production are Iran’s increased production due to interim lessening of sanctions (less than 1.5 million barrels per day) and our Yankee increase in shale-oil production (less than one million barrels per day). The total of these two increases is less (probably a lot less) than 2.5 million barrels per day, or less than 21% of Saudi Arabia’s estimated 12 million barrels per day production. So even if these high numbers for new production are right, the Saudis could have kept their short-term revenue losses down to 21% (and could have avoided any losses at all to other petro states), rather than forcing all petro states, including their own, to endure losses over 50%.

Coda: The Natural-Gas Enigma

One of the biggest head-scratchers in modern industrial history is the failure of global auto makers to make and sell more cars and light trucks that can run on natural gas.

For several years, natural gas has enjoyed a substantial price advantage over gasoline, on an energy-equivalent basis. The recent plummet in oil prices has nearly erased that advantage, but only for residential retail prices.

Even today—and for the foreseeable future—cars and light trucks that can run on natural gas offer both drivers and vehicle makers a number of substantial advantages, including price advantages. Here they are:
    1. “Gassing up” at home. Even at residential retail prices for natural gas, which are now at rough energy-equivalent parity with gasoline, consumers have the advantage of “gassing up” at home, using the same natural-gas sources they use for heating their homes or for cooking. All they need is a compressor, which costs far, far less than any car. Businesses can enjoy similar advantages: avoiding the cost, delay and loss of employee time to find a gas station, fill up, and go there and back.

    2. Still lower prices. Due in part to the odd economics of natural-gas distribution, commercial and industrial prices for natural gas are substantially lower than residential retail prices. So consumers and businesses willing to “gas up” at a natural-gas station can still enjoy nearly a factor-of-three reduction in the per-mile energy cost of driving with vehicles that run on natural gas, as compared to gasoline.

    3. Lower energy-price volatility. A few liquified natural gas (LNG) shipping terminals and tankers exist, and more are planned. But it will be a long time, if ever, before there’s a global market in natural gas like that for oil. In many parts of the world, natural gas is priced locally. No petro state has much influence over price or supply in these markets. Europe and Japan are about the only parts of the developed world that depend heavily on foreign suppliers for natural gas. This means that other parts of the developed world, including us Yanks, could escape forever from extreme energy-price volatility—and the influence of petro states over the price of ground transportion—simply by converting our car and light-truck fleets to natural gas.

    4. Lower distribution costs. Although much crude oil and some refined products travel by pipeline, the vast majority of retail gasoline gets distributed in tanker trucks. Therefore distribution costs for gasoline are subject the same price disadvantages of oil products as gasoline and diesel fuel themselves. In contrast, virtually all natural gas travels to its final point of consumption by pipeline—a much cheaper, safer and less cost-volatile means of distribution.

    5. Lower pollution. Natural gas burns much more cleanly than even the best gasoline, let alone diesel fuel. Switching to natural gas for light vehicles would avoid the cost of afterburners and pollution-control systems, reduce car and truck pollution, and make big cities more liveable.

    6. No refining. Natural gas doesn’t require refining to power vehicles. Crude oil does. In fact, the whole purpose of the controversial proposed Keystone XL pipeline is to transport crude oil from Canadian tar sands to our Yankee refineries on the Gulf Coast (which have excess capacity) for export of the refined products. Insofar as concerns the part of our vehicle fleet that runs on natural gas, refineries are obsolete, as is all the unhealthy pollution they produce.

    7. Ease of using and converting infrastructure. Although you might get a bit better mileage, power or range by tweaking them for natural gas, the internal-combustion engines now used for gasoline work fine with natural gas. All they require is new or modified fuel-storage and fuel-injection systems. So the vast majority of the industries and supply infracture that build gasoline cars today is easily and cheaply modifiable to produce natural-gas vehicles. It likely costs less and takes less effort to convert an existing gasoline-vehicle design to natural gas than it does to make a new design for a new model year.

    8. Less environmental damage. Natural gas is a gas. In the event of a spill outdoors, it dissipates naturally. The risk of permanent damage to people, property and other species from a spill is therefor much lower than with oil or gasoline.
As against these enormous advantages of cars and light trucks that run on natural gas, I’m aware of only three disadvantages: (1) slightly higher capital cost for the vehicle, (2) possibly lower range, and (3) fewer places to fuel up.

All these “problems” have self-evident solutions. At commercial or industrial natural-gas prices—or the slightly greater prices that commercial natural-gas stations could offer—the fuel-cost savings could recoup the added capital cost of a natural-gas vehicle in a decade or less, depending on the comparison car and the yearly mileage driven. The recoupment time would drop with greater volume of and experience in manufacturing, not to mention the saving on afterburners and exhaust systems for natural-gas-only vehicles (as distinguished from flex-fuel ones that can burn gasoline, too).

The other two “problems” are trivial. Greater range requires only bigger natural-gas storage tanks. And most consumers and small businesses can “fuel up” at their homes or offices, which already have natural-gas supplies for heating and/or cooking. Small businesses in particular already enjoy lower commercial rates for natural gas.

* * *


So as a one-time engineer, I just don’t get it. Toyota and Hyundai are now offering fuel-cell cars that run on hydrogen. Their technology is exotic, untested at scale, and hideously expensive, at least for the time being. And gaseous hydrogen, to put it mildly, is hardly available in every home or small business. It’s also much more flammable and dangerous than natural gas.

Don’t get me wrong. Hydrogen-fueled cars and light trucks, powered by hydrogen taken from water electrolyzed with solar, wind or nuclear power, are a possible future solution to our species’ twin energy and climate-change crises. They could cure the intermittency of solar and wind power and create a global market for cheap stored renewable energy, in the form of compressed or even liquified hydrogen.

But any such solution is at least a decade or two away. In the meantime, car makers could convert a substantial share of their products to run on natural gas in a mere year or two.

So why aren’t Toyota and Hyundai, as well as our Yankee car makers, offering and pushing cars that run on natural gas? It beats me. Japanese and South Korean car makers at least have the plausible excuse of having headquarters in fossil-fuel-poor countries at the mercy of foreign suppliers. Maybe they just don’t understand that we Yanks produce all of our own natural gas and have enough of it to outlast today’s projections of oil reserves by a decade or two.

As for our own Yankee car makers, what can you say? Maybe—except for Tesla and Chevy with its Volt—they’re just as dumb, happy, lazy and un-innovative as they’ve been for half a century. Maybe they’e so caught up in the rush to offer vehicles at the lowest possible initial capital cost that they can’t see anything beyond their initial-price blinders. Maybe they don’t believe in the power of their own marketing to sell the substantial advantages of natural-gas vehicles listed above.

More likely, finance guys (they are virtually all guys) and the most un-imaginative engineers at work today continue to dominate American car makers, as they do our electric-power industry. To say there’s a business opportunity here for an entrepreneur with a little guts and imagination would be an understatement of Obamanian proportions. But our plodding Yankee auto “engineers” (if you can dignify them with that title) will probably just keep doin’ what they’re doin’ until the oil runs out.

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2 Comments:

  • At Wed Jan 14, 11:38:00 AM EST, Anonymous Ed Dodge said…

    Jay, I agree with most of your points, but you fail to recognize that natural gas is becoming a fuel for heavy duty vehicles.

    LNG works great in container ships, ultra heavy duty trucks like mining trucks, and will be coming soon for freight trains.

    LNG is not only cheaper than diesel, but it has virtually no emissions other than NOx. By converting to LNG, an operator effectively leap frogs all emissions rules and is basically in compliance with current and future emissions rules (to put in simplified terms). The Maritime industry is embracing LNG for exactly this reason.

    LNG is simply methane, and methane is also abundantly renewable. BioLNG is on the market today, its identical to fossil LNG and is one of the most promising biofuels.

     
  • At Fri Jan 16, 06:07:00 AM EST, Blogger Jay Dratler, Jr., Ph.D., J.D. said…

    Dear Ed,

    Thanks for your comment.

    I don’t disagree that natural gas has the potential to do all that you claim. And your generic verb “is becoming” leaves time scales ambiguous, no doubt intentionally.

    Yet at the present time, I doubt that natural gas can do much, let alone all, that you claim.

    Today LNG (or liquified natural gas) is primarily a means of storage for transport, not burning. It “works great” as a means for storage in tankers, not container ships, which are used for transporting solid commodities and manufactured products.

    Making ships’ engines burn it, let alone efficiently, would take considerable modification of the heavy diesel engines that most large ships now use. Diesel engines ignite the fuel by compressing a fuel/air mixture to the point of combustion, rather than igniting it directly, as in gasoline engines. Diesel is the least compressible of all the three fossil fuels usable in internal combustion engines, so the compression ratios of huge seagoing diesel engines would have to be changed to handle natural gas. That would require redesigning the engines.

    I agree with your last two paragraphs, the first of which I cover in point 5 of my Coda above. But I think your first two are a bit optimistic from an engineering and practical standpoint.

    Liquifying natural gas and storing it in liquified form requires massive and continuing refrigeration, as well as compression. These things are unsuitable for use in hazardous and vibration-intense environments, such as those encountered by mining trucks and freight trains. Electricity is more suitable in both applications, and diesel is for those long-haul trains for which electrical drive is impractical.

    Tanker ships already carrying LNG for trade could, of course, use some for their engines. But at the moment, this is theory. I’m not aware that any tankers’ engines have actually been modified for that purpose.

    Could you provide a link or source to substantiate your points?

    Best,

    Jay

     

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