Thursday, June 29, 2006

The Future of Oil

Graph 1. A forecast of oil prices, courtesy of the World Bank.

Graph 2. The price of oil by year in constant 2004 US$ since 1970. (Source, BP Statistical Review of World Energy June 2006).

Right now the price of crude oil is close to historic highs, and is fueling inflation. A swirling group of related issues, long ignored, have come to the fore. They are all related but not the same. They include energy independence, CO2 emissions, and the effect on the economy of high energy prices. I’m wary of wading into this topic, but I have an insight that I haven’t seen expressed anywhere else. (That probably means that I’m wrong, but I’ll toss it out there and let the world decide.)

One of the issues that has been discussed is that the price of gasoline is affected by the fact that refineries in the U.S. are running at full capacity. Any hiccup in that production capacity, such as a hurricane, will cause gasoline prices to spike. No new refineries have been built in decades, and the excuse offered by oil companies is the cost of environmental regulation and NIMBY attitudes. Obviously regulation has cost, but this seems disingenuous to me. The way to look at a refinery is to consider what it takes to build one. It takes a huge amount of capital and many years worth of time. That, I propose, is the main reason why oil companies don’t want to build refineries.

Let’s say it takes 10 years to build a refinery and costs billions. An oil company starts building now—why not? They have lots of cash, and right now a new refinery could generate a lot of income. But what about 10 years from now? Well, let’s look at what the World Bank says will happen to the price of oil in 10 years. (See Graph 1 above) This is from a report prepared April 28 of this year.

You can see the problem. In 10 years, the price of oil will be significantly lower than it is now. The investment that looked great suddenly looks like a loser. Now the World Bank is just making a forecast, and they have some smart economists, but forecasts are inherently unreliable. They depend on knowledge of future events that no one has.

On the other hand, knowledge of the past is absolute. If we can expect oil prices in the future to behave as they have in the past, it makes any plan based on long-term high oil prices seem fairly foolish. This is because the price of oil has been very volatile since 1970. (See Graph 2 above.)

Some say that the price of oil will never drop again, at least not significantly. They point to Hubbert Peak, the idea that we may be near the peak of oil production for the world as current fields are depleted and new fields become more difficult to find. They point to the oil-hungry-economies of India and China, both of which are growing rapidly. These two factors, as well as political instability in oil-producing nations and other factors, will push the price of oil up. But there will be downward pressures as well. After the 70s, vehicle efficiency improved markedly in response to high oil prices, and other efficiency measures also helped. (Conservation has a bad rap—Cheney famously dismissed it—but in my mind, conservation is efficiency.) Also, high oil prices encourage additional exploration and production of oil, as well as additional energy production from non-oil sources.

So oil prices will continue to be pushed up and down at the same time. The World Bank believes that downward pressures will outweigh upward pressures in the near future.

So we come back to the refinery problem. I used refineries as an example, but the principle is the same. Let’s say instead of refineries, we want to discuss hydrogen fuel cells. The cost of developing a useful hydrogen fuel cell and bringing fuel cell vehicles to market, along with the infrastructure to support them, will be enormous. And it will take a long time. So investors in this technology are faced with the same problem that oil companies are faced with when they consider building a refinery. What happens to our multi-billion dollar investment if the price of oil is $15 per barrel when the hydrogen fuel cell car factory goes on-line? The same issue faces almost all alternative energy schemes, as well as the production of oil from exotic sources like oil shale.

In other words, the volatility of oil prices prevents the capital investment in projects that could—in the future—mitigate oil consumption. That guarantees that oil shocks will continue to happen and have negative effects on the world economy (not to mention the environmental consequences).

So how can we break out of this cycle?

There are two ways, and both require direct government intervention. First is for the government to directly invest in these capital projects. The idea of a refinery owned by the government is pretty laughable, but governments do own power plants and dams, so there is a precedent for the government being in the energy business. Still, it’s hard to imagine this flying in today’s market-worshipping climate. Government could spend more on pure research, though.

The other kind of intervention would be through government policies that encourage private investors to make these capital investments. This could be achieved by subsidy, taxation, and/or regulation. For example, if CAFE requirements were ratcheted up, auto manufacturers would be forced to create more efficient cars, or cars that didn’t require gasoline to run. Or if a tax were placed on gasoline that would keep it at a minimum price of $4/gallon (inflation adjusted) indefinitely, the hydrogen fuel cell entrepreneurs and their moneymen might feel confident in investing in the hydrogen R&D, plants, and infrastructure. Even though it would take years to make a profit, with a guaranteed floor on the price of gasoline, they could at least be certain that the rug wouldn’t be pulled out from under them.

But taxes, regulation, and government spending aren’t popular. The oil industry—which is politically powerful—would scream bloody murder if gas taxes were increased. But I believe they are necessary to create an economic environment where more efficient use of fuels and development of energy alternatives can be encouraged.

In the 70s, Brazil—hit very hard by OPEC—launched a program of ethanol production from sugarcane. After the price of oil declined in the mid80s, Brazil had to endure ridicule for their super-expensive, government-subsidized sugar-fuel. The Economist, as I recall, was especially derisive. They believed—correctly—that the problem of high oil prices would be solved by the market, and they were. For a while.

But now Brazil seems especially farsighted. They subsidized ethanol during the years when oil was cheap, which allowed the industry to mature there. Now, when they really need it, it’s there. The research has been done and the infrastructure has been built. And, amazingly, Brazil has become a net exporter of oil.

We need this kind of long term approach to energy in this country. When the price of oil drops, as I believe it will, we can’t just sit back and say, “Problem solved.” That’s what we did from 1986 until now, and we’ve been caught with our pants down. Again.



Blogger Richard said...

Givcen that refineries buy oil as an input, and then sell refined product (like petroleum etc), why doesn't a lower cost of oil just increase their profit margin?

8:40 AM  
Blogger  Robert Boyd said...

Hi Richard. Not in a competitive gasoline market. Of course, in a competitive gasoline market, margins will be low even when the price of oil is high. But there will be more liquidity for oil companies in that circumstance, as well as more opportunities to profit in other aspects of the oil biz (especially upstream). At least that's what seems to be happening now.
Still, I don't want to focus too much on refineries--they were just an example of the kind of long-term, capital-intensive project that is discouraged by the volatility of oil prices.
Thanks for replying.

11:53 AM  

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