February 19, 2013

How high could oil prices rise?

I think prices will stay in a range of $100-125 for quite a while: Saudi Arabia would reduce production if prices were to fall below $100, and consumption would fall if prices rose above around $125. 

When oil went from $20 to $100, US oil imports dropped in half. $2/liter fuel in Europe has been the primary reason (geology and history the 2nd) that personal fuel consumption is only 18% of the US and Canada.  If fuel were properly priced in the US at, say, $7/gallon, the US would reduce fuel consumption very quickly.

Oil consumption only decreased by about 10% when prices even though prices more than tripled from 2002 to 2012 ($30 to $100). Couldn't prices triple again?

Percentage increases aren't important. What's important is absolute increases, and their level compared to the substitutes. Below about $60/bbl there are no economic substitutes for oil, but as oil gets farther and farther above $60 substitutes become more and more obvious and pressing. In other words, this is not a linear function.

But don't we normally use the percent change when looking at consumer responses to a change in prices?

Sure, and that's just fine most of the time. The problem: that assumes a constant relationship: e.g., "10% increase in price causes 3% decline in consumption". I'm arguing that doesn't apply here. A doubling in price of oil from $20 to $40 is pretty trivial. A doubling from $100 to $200 is a very big deal. A doubling from $200 to $400 just won't happen unless the Persian Gulf is in flames, and even then it wouldn't last that long.

Why the difference?

Several reasons.
1st, $40 oil is small relative to income.

2nd, $40 oil is small relative to other costs, including oil production-related costs like refining, distribution, profit and taxes; and small relative to other consumer costs, such as vehicle depreciation.

3rd, $40 oil is cheaper than substitutes such as hybrids, plug-ins, carpooling, ethanol, CNG, online shopping, etc. As long as prices are below the price of substitutes, there will be no substitution.

Now, why haven't we seen more substitution since prices rose above $60?

1st, short term elasticity is much smaller than long-term. Oil prices haven't been high for very long, and Peak-Lite is something that didn't exist in the history of the oil industry until about 2005.

2nd Many consumers, such as long-distance truckers, don't have good "visibility". Many are *still* waiting to see if, say, natural gas prices stay low, and oil prices stay high. They have good reason, given historic volatility. Others have only recently decided that high prices are here to stay, and are still in the transition - taxis, for instance, will take several years to move fully to hybrids.

3rd, the oil industry has fought viciously to confuse the public about this issue. It has succeeded pretty well. Only prices staying high for a long time will break through that, and that delays the transition.

4th, R&D, and capital investments, take a while. Plug-ins (pure and EREV), for instance, only really took off in 2012, 7 years since 2005.

5th, change has many costs, including new infrastructure, new maintenance procedures, training of everyone involved, etc. As long as the savings from substitution are small, change won't happen. As the difference between oil prices and substitutes rises, the incentive gets larger until it breaks through. That's a non-linear relationship.

Still, you have to realize that things would change quickly if prices rose above about $150. The last time prices rose above $125 things started to change very quickly. Prices were above that level for 3 or four months only, but Industrial/Commercial users starting cutting back quite sharply, which is part of why oil prices dropped to $40 briefly, before KSA could cut back on production.

For instance,  container ships started slowing down: they can reduce fuel consumption by 50% by only slowing down by 20%. For another example, when oil prices rose in the 1970's Industrial consumers switched away from oil for process heat essentially overnight. There would be many short-term changes like that. There would also be sharp medium term changes: in the 70's the US got 20% of it's electricity from oil - that went to 5% relatively quickly, and now is about .7%.

That's the nice thing about decentralized markets: they are very flexible, and they can change things around in a million ways to optimize costs. Of course, markets are inhabited by humans who can make mistakes, as noted above, but when they get moving, don't get in their way or you'll be run down.

But, Europe still uses a lot of oil, half of US levels per capita.

Yes, because European I/C users aren't taxed as much as consumers. Consumers use 18% as much, while Industrial/Commercials actually use more than the US.

As the BRIC countries and other rapidly growing countries aspire to European levels of petroleum consumption, won't much more reduction of petroleum use will be needed?

Substitutes work as well for them as they do for OECD countries. The economics of batteries, for instance, are the same. Above about $80, electric transportation starts to be cheaper.When oil prices are at $100, the difference is only $20, which isn't enough to overcome the "friction" of change. But prices at $120 double that incentive, and prices at $160 quadruple it.

Just as importantly, BRIC countries still have some price controls/subsidies for fuel consumption, and those are on the edge of bankrupting the government or quasi-government entities that bear the burden of those subsidies. Those subsidies would have to be abandoned in the face of $200 oil, which would be dramatically raise consumer and I/C fuel costs For instance, India has recently had to abandon gasoline subsidies, and is on the precipice with diesel.