Thursday, August 19, 2004

Oil: The Logic of Exponential Demand,

Ian at BOP-news writes a spec on article about future oil demand.

It's not just Iraq, Venezuala and Russia that are roiling oil prices. The simple fact is that demand is rising fast - very fast. As China (and to a lesser extent, India) industrialize you've got more than just the energy for industry - you've got the energy needed for all those consumers to have the cars, refrigerators, air conditioning and heating they've always wanted.

It's only just that these billions of people be drawn into a world with some prosperity and modern material comforts - but it's going to have a price.

Specifically, a price in oil.

Let's look at a very simplified model of demand. Suppose that the current world energy consumption is 100% or 100 units. Let's suppose that the consumption of oil is proportional to total energy expenditure. Let's suppose that as of a few years ago mostly agrarian China effectively consumed 0% of this. That's a gross exaggeration but suppose. We do know that the USA consums about 25% according to some figures I've seen. So the USA consumes about 25 units of demand out of 100.

Suppose we have a simple additive model of demand and consumption. This suggests that if China wishes to achieve the per capita energy consumption of the USA and has approximately four times the population, they must add 100 units to the total world demand - consuming as much by themselves as the entire world does now.

Then there's India which isn't industrially advanced as China but will have more people by some projections. If they too wish to match USA standards of per capita energy expenditure, then they will add another 100 units.

The same applies to Indonesia, third most populated country in the whole world, which surely will be good for another 50 units of demand.

This is the logic of exponential demand growth - of economies both industrializing and growing in absolute size simultaneously.

Now suppose radical fuel saving technology and alternative energy fossil fuel replacement technology were to be created and disseminated universally throughout the entire world. Suppose this radical new set of technological fixes curbed per capita energy consumption by 50% of today's standards. Houses are twice as efficient at cooling or heating. Cars get twice more to the gallon - or if you live in the civlized world the liter. There is substantial reliance on hydroelectric, nuclear, solar, wind turbine, and geothermal alternative energy. The whole kit and kaboodle.

Suppose this technology is given away to the entire world, and they industrialize using it. Well we have 100+100+100+50 =350, 350/2 = 175. So we still end up using 75% more energy in the future then we are now. The story of oil is a story of demand growth, not supply constriction in the immediate future. Then when in the eventual future when oil really does start running out, then you should really watch out.

But for now the story is bad enough. Of course we haven't counted the rest of the world either. Now this is admittedly a crude additive model. It doesn't take into account several things.

For instance as demand outstrips supply growth, the price of oil may rise sufficiently high to curb and limit the penetration of industrialization in these other societies. However that's not a good thing, because that story - the story of societies on the brink of Western style consumption and lifestyles but held back only because of energy shortages - is the story of wars over oil.

However what else my model doesn't take into account is well frankly the rest of the world. There are more countries industrializing than China, India, and Indonesia. Brazil and even to a certain extent Eastern Europe will also be driving demand, as well as Africa and the Middle-east. Not that many westerners pay attention to Africa but besides their usual problems with plagues, famine, civil wars, genocides, and tin horn dictators they are also industrializing as part of globalization. More slowly to be sure, but nonetheless their energy consumption is creeping up.

Of course my model doesn't take into account the fact that India and China are not starting from scratch. So the expected per capita increase can be expected be less than from zero to American standards. This is sadly offset however because of the fact that China and India are industrializing using dirtier, less fuel efficient technology than we currently employ. The older and more well disseminated the tech, the easier and cheaper it is to implement.

China is not industrializing using Japanese hybrid-fuel technology. Neither is India. Sheer margin concerns are driving this. Even when there is money, it wants a higher ROI or bang for its buck. Even if they eventually transition to cleaner and more modern technologies, there will be the changeover costs and delay period.

So as a matter of fact, while my model is pretty crude on the whole it does give a rough idea of what the future will be like. That is a future where overall demand in oil will increase by a few multiples from what it was only a decade or two ago.

Finally, another less commented upon driver of oil prices is the dollar. As the dollar falls in value, the price of oil has risen to help compensate since oil is still denominated in dollars. Oil is almost for sure good for another 20-25% price jack up, if for no other reason than the dollar seems poised for a long term trend fall in the same range.

Last I checked oil was getting up to $47 pb lsc. In two years time, it could rise to highs of $60 pb lsc purely on the lack of strength in the dollar.

Will it all really turn out this way? Well oil demand might not rise that high, but if it doesn't the only reason is that the price will be higher. Oil at aboit $90-100 pb lsc would prevent the scenario I foresee from completely playing out. But it won't mean that demand will dip, even with optimistic technology scenarios, but just flatten. In fact that may be what will happen, that a new equilibrium may be reached at about $90 pb lsc that enables the world to keep on using fossil fuels for another century.

But the only ways that the demand model is underbid is when things turn out pretty nasty. Now I'm sure that some bright fellow out there could come up with better numbers and by showing a partial view of things, find a projection that is less. However all the more detailed models I've looked at have for every demand reducing factor a corresponding demand increasing factor or a price increasing factor.

In the end, you come up with the same conclusion. Either consumption goes up or price goes up or both, and usually in unpleasant mixes.

Now in a world like this it is not futile to try to switch to energy-saving or replacement technologis. In fact it may be the only way not to be impoverished or dragged into endless wars over oil. It is financially sound, if for no other reason than the increasing cost of oil reduces transportation margin and makes it less feasible to build a cheap trinket in Bangladore and undercut a local producer here in the States halfway around the world. Freight is not a high margin business and fuel routinely takes up half or more of its costs on runs, once you consider the energy costs of producing the transport and increased labor costs due to energy costs. Sometimes it's more than half. Increases in oil impact transport pricing significantly. This is why the Airlines are having such trouble now.

Small mass-produced durable items will see the smallest increases, but the increases there should be significant enough still to make local labor more financially viable.

But while it makes personal and local sense to conserve energy, it doesn't sufficiently impact the total price-consumption envelope growth to change the basic story of sharply increased demand, prices, and consumption. There are extremes in price where consumption doesn't grow as high, even though demand does, and there are extremes in consumption lows where price doesn't grow as high because demand is met in better ways ... but the total growth of demand is inexorable. The best case scenarios are still pretty bad.

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