The $100 A Barrel Solution

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The high and sustained price of crude oil is having unintended consequences. 

Global consumption of crude oil rose by 14% between 2000 and 2010, about equal to the increase in population.  Almost all of the increase was in Asian countries, especially China and India, and, surprisingly, the Middle East and other oil-exporting countries.  The Middle East as a whole increased oil consumption by 56%, led by Saudi Arabia with a 78% increase.  Heavily subsidized and inefficiently used, domestic consumption of oil accounts for about one-fourth of Saudi Arabia’s huge oil output, about 2.5 million barrels a day. 

In contrast, the U.S. and Europe decreased oil consumption by a small amount, less than 1% in the U.S, over the same period.  Some of this is due to the recession, but there are longer-term trends that might lead to continued decreases in total oil consumption.

It is important to remember that crude oil is an input; people and companies like airlines consume refined products.

Good for U.S. 

The high and sustained price of crude oil has made it profitable to develop huge deposits of shale oil and shale natural gas.  I remember reading a few years ago that developing shale oil in the U.S. and Canada would be profitable if the price of crude oil stayed above $80 a barrel.  Since then, improved extraction technology has lowered the breakeven price.

The U.S. also has huge reserves of natural gas in shale.  A current estimate is that the U.S. has the second largest natural gas reserves in the world.  Some of it is extracted as a by-product of shale oil drilling.

The low price of natural gas will continue the trend of substituting it for oil and coal.  One advantage is fewer carbon emissions into the atmosphere.  This has already started in the U.S. as natural gas accounts for all of the growth in power generation.  Low natural gas prices have led to a large substitution of gas for coal in generating electricity so far this year. 

The Obama administration has just announced strict coal emission standards.  About 43% of electricity is generated by coal.  The percent has been declining but substitution of cleaner natural gas for coal will probably accelerate if the standards remain.  They could be weakened or reversed by a Republican administration.

There is no net reduction in carbon emissions if electric and hybrid cars are powered by electricity generated from coal. 

The boom in shale natural gas spurred by the high cost of oil has slowed down; prices have fallen and the number of operating wells has declined.  But even a moderate increase in the price of natural gas still gives it a huge price advantage over $100 a barrel oil.
           
Gasoline consumption has been going down.  Besides the recession and the higher cost of gasoline, other factors are the mandate to use ethanol, and the subsidized adoption of electric and hybrid cars.  In addition, the Obama administration has announced higher long-run mpg requirements for cars.  Higher mpg requirements could be reversed by a Republican Congress and president.

Total fossil fuel energy inputs may go down.  This is almost certain to happen under Obama’s comprehensive “cap and trade” plan for all energy.  This will further reduce imports of oil and increase demand for domestically-produced natural gas.  Even though originally a Republican idea, it is opposed by Republicans and some conservative Democrats, especially from coal-mining states.

A higher percent of U.S. oil and gas imports will come from Canada.  This will make us less dependent on hostile or unstable suppliers.

But the big change is that the U.S. has become a major exporter of refined oil products.  Besides crude, the U.S. has been a large imported of refined oil products, mostly from Europe. U.S. exports have risen very rapidly in the last few years to almost $100 billion a year in refined oil products.  In 2011, the U.S. exported more gasoline, heating oil and diesel oil than it imported for the first time since 1949.

Domestic production reached an eight year high in 2011.  The number of new wells drilled per year continues to rise.

This has dramatically changed America’s net imports of oil products.    The peak in 2005 was over 12 million barrels a day; last year our net imports were 8.4 million barrels a day, which was 11% lower than in 2010.  Net imports are expected to fall again in 2012.

The underlying trends – increased domestic production of oil and natural gas, slowly declining consumption, increased exports – should continue the trend of reducing net imports.

If the U.S. expands its oil refining capacity and approves the XL pipeline, there will be long-term increase in U.S. exports of refined oil products, making the U.S a dominant exporter of refined oil products.  Higher crude oil prices can be passed on as higher prices of exported refined oil products.  As more imports and domestic production of crude are exported, this should also help our balance of payments deficit. 

Bad for China and Japan (at least in the short run)

In the short run, high crude oil prices are bad news for China and Japan.  Chinese imports of crude and refined oil are rising rapidly due to a huge increase in car and truck production.  This year China may surpass the U.S. as the world’s largest net importer of oil products.  You might also take some comfort that the price of gasoline in China is $5 a gallon.

China has huge untapped natural gas reserves.  As these are developed, they will be used as a substitute for the massive amount of coal that is burned to generate electricity.  China is the world’s largest producer and consumer of coal; its coal-burning plants are inefficient and dirty.

Japan has virtually no domestic oil production, importing all of its crude oil needs.
Japanese imports of natural gas are also way up as all of its nuclear power plants have been shut down.  Many, maybe most, will never be restarted.  There is a movement in Japan to permanently close all nuclear plants.

One consequence of all this is that the U.S. seems to have a widening cost advantage in energy inputs, especially in manufacturing.  Combined with other trends, the U.S. may become more price competitive in many areas of manufacturing.  A few global companies have already brought some manufacturing back to the U.S. from China.


Bad for Iran

This is counterintuitive.  How can high crude oil prices be bad for the world’s third largest crude oil exporter?

Iran is also a big importer of refined oil products like gasoline.  Domestic consumption of refined oil products increased 38% between 2000 and 2010.  The domestic price of gasoline, starting at $1.30 a gallon and rising to about $2 a gallon, is heavily subsidized by the government,.  Iran is selling crude oil at about $2 a gallon and is buying gasoline at about a little under $3 a gallon.  The regime is using crude oil revenue to heavily subsidize gasoline and other basic consumption items, and also giving cash allowances to the poor.  The regime is scared that an increase in gasoline prices might spark protests, as it has in other countries, and will increase subsidies to the poor to pay for the higher prices.

These policies buy support for the regime but at a cost of using much of their oil export revenue.  The result is a corrupt and inefficient economy.

The longer-term problem for Iran is that total crude oil production is going down while domestic consumption and imports of refined products is going up.  Iran could increase domestic production of oil and natural gas but the economic embargo and the use of oil revenue for subsidies and nuclear power (and probably nuclear weapons development) has meant little increase in domestic refining capacity.  Unless there is a change of policies and use of oil revenues, Iran may cease to be a net oil exporter.

The U.S. generates more revenue from exporting refined oil products than Iran does exporting crude oil.

Iran is the latest example of the oil curse.


Conclusion

For the foreseeable future, natural gas will be substituted for both oil and coal.  U.S. imports of crude oil will continue but probably at the same or lower level than now.  More of imported crude will be used as the input to produce refined manufactured products that are exported. This is the reason for building the XL pipeline. We will still run a trade deficit in energy but it will be a declining percent of GDP.

It is in the U.S. national interest for crude oil prices to remain above $80 a barrel for a sustained length of time so that investment in shale oil and shale natural gas production and distribution continues.

Public energy policies, or lack of, will be crucial in determining the speed at which these changes occur. 
______________________________________________________________________________

Related Post:  The Oil Curse

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