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The Prognosis for the United States

Dave Cohen
Wednesday, 25 June 2008

Procrastination is the art of keeping up with yesterday
     —the late George Carlin

The oil crisis is upon us. I hope to convince you that sharply curtailing our oil demand is the only and best way for Americans to negotiate the coming decade (2008-2018). To that end, I will construct three scenarios for you to consider in contemplating your future energy consumption.

High oil prices are starting to work the way economists think they should. A recent CERA report argues that U.S. gasoline demand peaked in 2007. It appears that vehicle miles traveled has also peaked. Despite these welcome trends, changes forced upon us by the unavoidable workings of the dismal science are likely to be inadequate to the task ahead. The Econ 101 solution becomes harsher as time goes on as the phrase "demand destruction" implies.

The simple scenarios laid out below might persuade you that taking the initiative to reduce your liquid fuels use will be necessary to maintain our collective prosperity. Early adapters of measures that reduce their oil consumption will be rewarded, for the race is to the swift. Vulnerable Americans who do nothing will pay the piper as the coming decade unfolds. (See NPR's More Workers Telecommuting, Seeking Closer Jobs, June 18, 2008).

Some Assumptions About the Oil Market

The downward "corrections" in world oil demand that accompanied the supply shocks of 1973-75 and 1979-83 (graph left) are unlikely to be repeated this time around. Back in 1970, demand in the more advanced OECD economies made up an astonishing 74% of global oil demand. In 2007, OCED consumption made up only 57% of the total. This rebalancing trend is set to continue.

Slow or no growth in the oil supply has combined with a demand shock from outside the OECD (Russia, China, India, Brazil, Venezuela, the Persian Gulf countries) to create soaring oil prices over the last 5 years. This demand shock will not abate any time soon, or at least not in time to save our bacon unless we take immediate remedial actions. New oil production will provide only limited relief. It is thus incumbent upon consumers in the OECD countries to be very aggressive in cutting their demand for refined products made from oil to reduce global competition for this precious resource.

The scenarios laid out below depend on three assumptions about future oil market fundamentals. I think these assumptions are reasonable although some pollyannas will disagree.

1. Oil consumption outside the OECD grew by 5.42 million barrels per day (b/d) in the period 2003-2007 (graph left). I assume that this trend will continue, with demand rising approximately 1 million b/d per year over the next five years. Growth may slow after that. If you look upon this assumption as overly aggressive, I would argue that fuel subsidies, especially in the oil exporters (Russia, the Middle East), will continue to drive this phenomenal growth. It is always wise to err on the side of caution. Subsidies never pay off in the long term, but I am not talking about the long term (a decade of more). Every country wants a large share of what promises to be a diminishing oil pie in the long run.

2. China is the main driver of non-OECD demand growth, so I want to emphasize that our expectations about their consumption should be in line with point #1. I assume the steep upward trend (graph left) will continue, despite China's recent move that raised state-controlled gasoline prices by 15.8% and diesel prices by 17.8%. The Chinese leadership is very worried about the country's 8% inflation rate, which will no doubt be exacerbated by partially lifting fuel subsidies. To tame inflation, China will continue to subsidize its oil demand.

3. I will make a "peak oil" assumption which goes as follows: oil (crude + condensate only) will top out at about 76.5 million b/d within the next 5 years. (The latest EIA March number puts it at 74.494 million b/d before the lastest Saudi increases.) This assumption, which may turn out to be generous, results in an average increase of 285,000 b/d per year over 7 years, but the supply growth likely won't gradual. The oil supply, when it can rise at all, tends to go up by fits and spurts, as it has this year after being flat for 3 years, and as it did in 2004. Addition assumptions are made concerning other liquids, not just crude + condensate.

   • Natural gas liquids are plentiful, but do not affect the transportation or industrial sectors (outside petrochemicals) where most oil consumption occurs.
   • So-called "1st Generation" biofuels production—made from the corn, not the stalk—peaks within a few years. I am including biodiesel from palm oil or other feedstocks and ethanol made outside of Brazil.  The competition with food that is driving up food costs is the primary driver of slowing biofuels production.
     

   We are mainly interested in the global supply of middle distillates (diesel, heating oils, jet fuels) and gasoline i.e. the high quality products made from crude oil. I am agnostic about whether the oil supply starts to decline or remains in a plateau after it peaks, at least for the purposes of this analysis. Supply will be tight in any case. My supply-side assumptions depend on the probable OPEC production scenarios discussed in Sleepwalking Toward the Oil Precipice (ASPO-USA, April 30, 2008).

Three Simple Scenarios

Conceptually, each of the 7-year scenarios below is very simple. It is a matter of making compensatory demand decreases. For example, if non-OECD demand rises 1 million barrels per day in a year's time, and the crude + condensate oil supply increases 285,000 barrels per day, then OECD demand must fall by 715,000 barrels per day during that year to keep the oil market in approximately the same balance it is in today.

It is the ability or failure to achieve the necessary offsets that makes for relative reward or punishment in the OECD economies. It will take 7 to 10 years (or more) to make significant structural changes that decrease OECD (and America's) oil demand. Such changes include significant market penetration for gas-electric hybrids or plug-in hybrids, some "2nd generation" biofuels from cellulosic feedstocks, more ultra-deepwater oil production, building extensive light-rail transit systems, expanding the railroad system (in the U.S.), and restructuring the geography of work & living patterns to encourage fuel conservation.

American oil demand makes up 40.6% of total OECD demand (EIA data, two-month average for 2008). I will assume that U.S. oil consumption stays constant as a percentage of OECD demand in future years. The price elasticity of demand measures the sensitivity of consumption to price. Low elasticity implies that demand does not decrease much as the price rises.

• Scenario 1 — Buy Some Time
  Yellow Alert

  This scenario assumes a high price elasticity of OECD oil demand. Americans, Europeans, the Japanese, the Koreans and others are highly motivated to cut their demand sharply in the medium-term. The OECD countries achieve a 10% consumption cut over 7 years while keeping the economic performance stable at current GDP levels. The decreased consumption offsets non-OECD demand growth and sluggish oil supply growth, thus buying us some of the time necessary to implement significant structural changes. OECD consumers adapt well to high oil prices, which remain more or less at their current level. After 7 years, American oil demand comes in just below 18 million barrels per day. This is the "best case" scenario.

• Scenario 2 — Close But No Cigar
  Orange Alert

  This scenario assumes a medium-to-low price elasticity of OECD oil demand. The developed economies achieve only a 5% consumption cut after 7 years. Competition for oil (exports) goes up because non-OECD demand growth is not offset, resulting in an ever-rising floor price for crude oil. Americans are slow to make adjustments, or find it too difficult to do in an anemic economy with sharply declining home prices. The real price of oil (in 2008 dollars) rises above $150, a price level which is sustained for years at a time. The housing market never recovers.The economy is slowly strangled by an ever-tightening stagflation noose. The economy is intact, but just barely. School districts, city & county services, businesses, et. al. are hit hard but do not shut down.

• Scenario 3 — It's All Over Now, Baby Blue
  Red Alert

  This scenario assumes a very low price elasticity of OECD oil demand. The OECD nations achieve only a minuscule consumption cut in the next few years. Non-OECD demand growth and inadequate global supply are only slightly offset. Actually, a much larger consumption cut is "achieved" after 2011 because the economy is in a tailspin. Sustained prices of $200/barrel lead to the economic collapse. Demand takes a nosedive as duress causes the loss of many jobs when businesses (or public services) are forced to shut down. Home mortgage defaults are common. Driving becomes a luxury for many. Conditions are akin to the Great Depression for many Americans. Our quality of life deteriorates rapidly. This is the worst case.

Can We Buy Some Time?

I'd like to think we can buy some time, but my money is on Close But No Cigar. I'd also like to think that I'm the Answer Man, but I'm not. We're in terra incognita in 2008 and beyond. I've got a pretty good track record up to now, but prediction is notoriously difficult, especially if it's about the future (Niels Bohr).

The scenarios outlined here are not black or white. Instead, they are meant to delimit the range of possibilities as we think about the coming decade. The prognosis for the United States likely lies somewhere in this range but let's face it, all sorts of bad stuff could happen in the next five years in places like the Gulf of Mexico or the Middle East. Conversely, miracles are rare.

There are signs that the early adapters are busy making changes right now. Here's a partial list.

• looking for housing closer to work
• telecommuting and 4-day work weeks
• buying more fuel efficient cars or riding the bus
• shipping goods by rail

I would urge all Americans to start making changes now. Even if you are not feeling the pinch of higher fuel costs yet, there is no guarantee that you are immune to future price hikes. You must think in terms of $5-6/gallon for gasoline or $6-7/gallon for diesel. The danger is that complacency will settle in if prices fall for a few months.

A major problem is that the structure of American society makes it difficult for everyone to make the necessary changes. There are just so many houses near useful public transit to go around. Inevitably, not all people will succeed. Those who are slow to move or unfortunate will be left behind.

The warning signs are there for everyone to see. It is hard to miss the stress in the trucking industry, the airlines, suburban school districts and other enterprises that are heavily dependent on liquid fuels. I have argued that cutting our oil consumption is the only sensible thing to do. If we achieve a 10% cut in the next 7 years, we'll buy some time to implement the structural changes necessary to meet the crisis.

On the other hand, if we insist on having senseless arguments about opening up ANWR and the outer continental shelves for oil exploration, then perhaps It's All Over Now, Baby Blue.

Contact the author at dave.aspo@gmail.com