petroleumworld

Andrew McKillop:
Whatever happened to oil price elasticity?

The facts are overwhelming. Oil prices described as ‘very high’ by many commentators have most certainly not ‘imploded’ or ‘cratered’ the world economy. In fact the economy, and oil prices, have grown together in remarkable symbiosis and interactivity since the most recent oil price low, in 1999. Today, it is incredible to think that contracts for crude changed hands at 10 USD/barrel in 1999, but this was the case. Since then, and using nominal dollars (unadjusted for inflation), prices have grown about 575%.

Anyone who wants to can claim that there are ‘delays’ amongst economic agents and economic deciders, hampering or slowing ‘price-elastic adjustment’ of demand – that is a fall in oil demand due to high prices. In any case, fall in demand will or should mostly concern final consumers more than intermediate agents, like industrialists and manufacturers, who depend on energy-intensive and oil-intensive raw materials, and also use process energy, to produce goods.

Intermediate users, at least in copybook theory, tend to ‘pass on’ the energy price rises they suffer, often ‘anticipating’ inflation by increasing their final prices more than strictly justified by their raised energy costs. This further penalizes final users, causing faster or further economic downturn.The service sector, supposedly ‘energy-lean’, and therefore less affected by energy price rises in fact has very high energy overheads or energy infrastructure requirements per employed person. Despite this reality, it is seen as a kind of ‘bulwark’ against high oil and energy prices, explaining the attraction of the ‘decoupling’ or ‘de-materialization’ myth in New Economy theory.

Continuing with classic, copybook or fairytale economic analysis, it is claimed that final consumers, as well as intermediate users of energy, will one day come to their senses and suddenly reduce their oil demand, because it is too expensive. At that time, the economy will ‘crater’, perhaps with inflation, perhaps without.

The most immediate question is why these economic agents will ‘come to their senses’ and use less oil. What will they do after? Will they take up reading, philosophizing and musicmaking, before becoming unemployed vagabonds, we could ask. The fatuous irreality of ‘classic’ economics, regarding energy, is thrown into high relief by simple facts. The real economy isnt anything like its pastiche in fairytale economics. It is composed of millions of producers and consumers, and is obligatorily locked-on to energy utilization. The proof of this comes every hour, every day and every week.

Increasing energy demand is economic growth. In the exact same way, population growth is economic growth. The almost total absence of real, efficient, convenient or cheap alternatives to oil and gas explains why economic agents, that is everybody, goes on using them. Well can supposedly informed persons talk about the ‘energy transition’ from wood to coal, and then to oil: replacing 85 Million barrels/day of oil with wood may seem vaguely feasible in theory, but producing about 11 Billion tons of firewood each year would somewhat strain the already strained biosphere.

Arguments in favor of ‘mass electrification’, in fact going back to Stalin and Lenin, and also tried out, as an ‘industrial philosophy’ in the two Mitterand presidential terms, always defaults to how the electricity is produced, distributed, and used. More technically, energy economic studies show that intense electrification of the economy rigidifies the economy, slows growth rates, and leads to faster oil and gas demand coming out of recession, or when economic growth rates move up. We can note that the so-called, and unworkable ‘hydrogen economy’ is predicated on mass electrification.

Getting back to the narrow question of why oil demand (and world gas demand now growing at around 5%-per-year) are much less than unaffected by rising prices, but are directly increased by higher oil and gas prices, we fiinally call on facts. We can use theory first, but finally we call on facts, because scientific theory is based on, and comes from facts. The other way round is called economics – that is bending facts to fit brokenback theories.

Price elasticity of anything has an uderlying notion, hard to quantify, of ‘satisfaction’, and another of ‘substitution’. Neither of these have much place for the vast majority of oil and gas users. Nobody uses oil and gas ‘for the fun of it’, or at least very few persons. Equally, the famous ‘hi-tech emerging new energy’ substitutes and alternatives simply don’t exist. They may exist on the Nasdaq or in people’s heads and PCs, and in cute business video presentations, but not in the real economy.

So the simple fact that oil and gas demand is increasing much, much faster than during the cheap energy 1990s, with much, much higher oil and gas prices should at least allow us to accept reality, and find or develop theories that fit. When we go back to economic theory notions of ‘elasticity’, as mentioned above, we soon see that they don’t apply in large measure, or any convincing way to explaning what is happening. The bottom line is however very simple: until and unless interest rates are sharply raised, to double-digit annual rates, oil and gas prices can go on crawling ever up. With the ever surer approach of Peak Oil they will in any case have no other direction to move.

Andrew McKillop is a Founder member, Asian Chapter, Internatl Assocn of Energy Economists and Former Expert-Policy and programming, Divn A-Policy, DGXVII-Energy, European Commission. Author of several books on energy, environment and development published in UK, Canada and USA.( xtran9@gmail.com ) His latest book ‘The Final Energy Crisis’ (ISBN 0745320929) is distribute by Pluto Press, London and will be on sell shortly by Petroleumworld (pwbookstore@ hotmail.com).Petroleumworld is negotiating the rights for the Spanish edition. Its views are not necessarily those of PETROLEUMWORLD.

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Petroleumworld 05/08/05