14 July 2006

Colorado And Oil Prices: A Big Picture View.

For those of you who aren't paying attention, Israel and Lebanon are in the midst of a war right now. Israel has blown up Lebanon's airport, bombed its major highway, blockaded its ports and lobbed artillery shells into Lebanon. Lebanese guerillas have sent hundreds of rockets flying into Israel. The result, on top of the ongoing Iraq War, military saber rattling from the Bush administration directed at Iran (one of the financial backers of the guerilla group attacking Israel), unrest in Nigeria, and various other geopolitical tensions is that oil is selling at $78 a barrel. This is the story of what that means to Colorado.

A Brief History of Oil Prices



Chart from here.

What does $78 dollar a barrel oil mean? Consider some historical context. In inflation adjusted dollars, the price of a barrel of oil hovered for about three decades (1946-1974) between $15 and $25, actually showing a slight declining trend.

Then, the energy crisis associated with the Carter Administration, although it actually started two years earlier, hit. Between 1974 and 1976, oil prices (again in inflation adjusted dollars) lept to just under $50 a barrel and stayed there for a couple of years. From 1976 to a peak in December of 1979, oil prices shot up again, steadily, to $99.83 a barrel in May 2006 dollars. When the Iranian hostage crisis ended in 1980, shortly after President Reagan took office, oil prices started to return to normal, reaching a pre-energy crisis level of $20 a barrel, in inflation adjusted dollars, by 1986.

The energy crisis was a major cause of the stagflation (i.e. combination of stagnant economic growth and inflation) of the late 1970s and early 1980s. Unlike many periods of high inflation, the problem was not simply poor management of the money supply and interest rates, but a genuine shortage of a key factor of production in the American economy which increased the real cost of goods, rather than merely increasing their nominal prices, in an economy which, at the time, was far more manufacturing centered and far less energy efficient than it is today.

The 1970s energy crisis coincided peak oil in the lower 48 states of the United States (i.e. the point at which new discoveries were no longer keeping pace with consumption of existing reserves), which took place in 1971. Oil production in the lower 48 states has fallen steadily since then and has now reached 1940s levels. Of course, the 1970s energy crisis itself was artifical. It was a form of retaliation by OPEC countries for U.S. support for Israel in the Middle Eastern wars with Syria and Egypt that it was engaged in at the time. The problem then was not that there was not enough oil, but that a cartel was not willing to sell it to the U.S. at a reasonable price.

Nevertheless, the 1970s energy crisis had consequences, in addition to the immediate economic impact. It produced dire predictions that there would be no oil left in a matter of decades, which proved premature and have hampered the credibility of peak oil scholars looking at peak oil in the relevant world market, rather than simply the United States. It was pivotal in developing an awareness that help lead to the modern environmental movement, to new legislation mandating energy conservation measures (such as the CAFE fuel efficiency mandates for car makers), and an increased awareness that our nation's reliance on foreign oil was an issue that had national security implications. The intensity of these concerns gradually waned as high oil prices subsided, but they never died and have returned with a vegenance to the public debate as oil prices have returned to record high levels.

This drop in oil prices in the early 1980s is what precipitated the oil bust that devistated Colorado's oil industry, and with it towns like Grand Junction, Rifle and the then much more oil economy based Denver. As Wikipedia notes:

Denver's position near the mineral-rich Rocky Mountains, encouraged mining and energy companies to spring up in the area. In the early days of the city, gold and silver booms and busts played a large role in the economic success of the city. In the 1970s and early '80s, the energy crisis in America created an energy boom in Denver captured in the soap opera Dynasty. During this time, Denver was built up considerably, with many new downtown skyscrapers built during this time. Eventually the oil prices dropped from $34 a barrel in 1981 to $9 a barrel in 1986, and the Denver economy dropped with it, leaving almost 15,000 oil industry workers in the area unemployed (including mayor John Hickenlooper, a former geologist), and the highest office vacancy rate in the nation (30%)[15]. Energy and mining are still important in Denver's economy today, with companies such as Newmont Mining, Patina Oil and Gas, and Western Gas Resources.


The period from 1986 to 1999 was marked by volatility. For most of that thirteen year period, oil prices shot back in forth in a wide range between about $20 a barrel and $33 a barrel (in inflation adjusted dollars). There was a brief spike in 1991, associated the one of the few brief recessions in the long period of economic growth that made up most of the 1980s and 1990s, where oil prices topped $50 in inflation adjusted terms. This period ended with a steady decline in oil prices from 1997 to 1999 from $30 a barrel to $10 a barrel (in inflation adjusted dollars).

The story from 1999 to the present has been a relentless increase in oil prices, briefly interrupted by the demand reducing technology bust in 2000 and 2001, from $10 a barrel in inflation adjusted terms, to today's $78 a barrel. In terms more familiar to most people, each $25 a barrel in oil prices translates roughly into $1 gallon for gasoline. Prices have been at energy crisis levels in the $40 a barrel plus range since roughly around the time the Iraq War began in 2003.

Colorado's Oil Resources and Industry

According to the Energy Information Administration, Colorado ranks 11th among the states in petroleum production. Texas, Alaska, California, Louisiana, New Mexico, Oklahoma, Wyoming, Kansas, North Dakota and Montana all produce more.

While Colorado has significant oil resources, many, like Western Slope oil shale deposits, are relative expensive to exploit. Unlike Alaska, Texas, the Persian Gulf, the North Sea, and the Gulf of Mexico, much of Colorado's oil supply doesn't come in vast underground reservoirs of oil that you can simply put a glorified straw into and let it burst out of its own accord or remove with a simple pump.

[Map deleted for technical reasons. Some nice person cleaned up the problem in the cross-post at Colorado Confidential.]

Map of Colorado oil operations from the Colorado Department of Natural Resources.

In times of high oil prices, Colorado is an attractive place for a burgeoning oil extraction economy. In times of low prices, Colorado's oil industry is little more that a minor sideline for farmers lucky enough to have oil deposits on their land. The future of the oil industry in Colorado will depend to a great extent on how sustained current high oil prices remain. If they remain high, the current oil driven boom in places like Rifle will be effectively permanent. If they collapse as conflicts like the Iraq War and the current Lebanon-Israel conflict are resolved (if ever), Colorado could easily see a repeat of the 1980s oil bust, although it would likely be more localized because Colorado's economy, which was largely oil driven in the 1980s, has since diversified.

Higher oil prices may also, ironically, impact the Eastern Plains of Colorado for a very different reason. One major agricultural product these days is ethanol, a renewable alternative to gasoline made from a variety of grains, such as corn. Because it is a substitute, its prices move in lockstep with those of gasoline, which in turn move in lockstep with the price of oil. Higher oil prices encourage farmers in the Eastern Plains to grew fuel crops. Right now, this is pretty much a sideline for Colorado farmers. But, if sustained high oil prices continue, this could change.

On the other hand, many Colorado farmers also rely on petroleum based fertilizers to make it possible to farm at all. The price of these fertilizers also rises with the price of oil, and this factor has the potential to drive Colorado farmers who rely on enriching poor soils artificially out of business. Thus, high oil prices encourage organic farming.

Oil Price Prospects For The Future

Further oil price increases are well within the range of possibility.

This could come from increased international tensions. If there are military strikes on major oil supplier Iran, for example, a surge in oil prices is almost inevitable. U.S. support for Israel in its current conflict with Lebanon (and indirectly with the Syrian and Iranian backers of the guerilla group behind most of the rocket attacks) could trigger an OPEC oil embargo like response from Arab nations sympathetic to Lebanon's plight. Another shoe could drop in oil industry regulation in Venezula where Hugo Chavez has expressed an interest in not making Venezulan oil available to a United States whose government has openly opposed his regime, not that this, in isolation, matters much when oil prices are set in a world market. Political uncertainty after the close Presidential election in Mexico could spook oil traders. A full fledged civil war between the North and the South, or regionally, could break out in Nigeria, another major oil producing nation. The list goes on.

But, the bigger concern is that there could be a fundamental, long term shift in oil prices based upon factors less transitory than the international conflicts of the moment and domestic turmoil in oil producing nations.

World demand for oil is rising. China is rapidly industrializing and increasing its demand for oil with it. India has similar ambitions. Those countries alone make up more than a third of the world's population. As more countries that historically used little oil because they were undeveloped and lacked the industry and transportation infrastructure that consumed it, industrialize, worldwide demand for oil is growing faster than already industrialized countries can retool themselves to produce economic output with less oil through greater efficiencies.

Industrialized countries have already been working to wean themselves from oil, slowly but steadily, at least since the energy crisis of the 1970s. For example, oil based electricity production has virtually disappeared from the American economy outside Alaska and Hawaii (and from most of Europe), and industrial processes are increasingly being converted to natural gas from petroleum, in part, to ease compliance with Clean Air Act, and in part out of concerns about the rising price of petroleum. Europe has used very high gas taxes, urban planning, investment in high speed rail infrastructure, and a push to get the auto industry to produce fuel efficient small cars for their market to reduce transportation industry consumption of oil, and Japan has taken similar steps. The United States has lagged behind in these efforts. The trouble is, that weaning the nation from its addition to oil is a slow process (although rising oil prices will certainly speed up conservation efforts), while the foreign economic development driving an increased demand for oil is a more rapid process.

Increased production can also ease the squeeze. But, even the biggest unexploited oil deposits in the United States, such as those in the Artic National Wildlife Reserve (ANWR), would be largely a drop in the bucket of the larger world market, where the United States is a player, but only one of many big players. Blogger NewMexiKen lists the countries that now have oil reserves [correction, current production] of, at least, two million barrels (see also here):

*Saudi Arabia 10.37 Million
*Russia 9.27 Million
*United States 8.69 Million
*Iran 4.09 Million
*Mexico 3.83 Million
*China 3.62 Million
*Norway 3.18 Million
*Canada 3.14 Million
*Venezuela 2.86 Million
*United Arab Emirates 2.76 Million
*Kuwait 2.51 Million
*Nigeria 2.51 Million
*United Kingdom 2.08 Million
*Iraq 2.03 Million


The United States is number three on the list, but already consumes far more than it produces. About 60% of U.S. oil consumption is imported.

More promising, but still pie in the sky at this point, are Montana Governor Brian Schweitzer's ambitions to convert its ample coal supplies into diesel for transporation uses, something that was been done in Germany and Japan (in World War II) and in South Africa.

Many of the participants at the Denver World Oil Conference held last November, think that there is more to the 21st century's oil price surge than international mayhem.

Still, at the global level there is strong evidence that new discoveries and production, while continuing, are declining in volume, while demand continues to surge. When production fails to keep up with rising demand, you have peak oil. Some experts think that global peak oil may either have already arrived in the mid-2000s, or may be on the verge of happening around 2010. This would imply that, even in the absence of international tensions, we can expect a steady and relentless increase in oil prices in the future. This would flow from basic principals of supply and demand driven by fundamental factors like increasing industrialization of the world economy and finite oil supplies.

Of course, major technological advances in the production side or on the consumption side could makes these predictions obsolete. But, the peak oil hypothesis is based largely on empirical, statistical trends that have held steady for long periods of time, which makes it a robust model. While the "black box" empirical nature of the peak oil model means that it may work due to hidden assumptions that could turn out to be false in the future, this also means that the model is not dependent upon detailed and technical assessments of particular technologies and oil finds, which are individually more easily subject to dispute and interpretation.

Only fringe scientists believe that material quantities of mineral petroleum are still being created. Everyone else agrees that the global oil supply is effectively fixed. There is likewise widespread consensus among informed observers that the cost of exploiting existing reserves varies from deposit to deposit. The cheaper oil is being exploited first, while the more expensive to exploit oil is remains in the ground. The size of the true world oil supply is a function of the price one is willing to pay to get it. We will never use all of the oil on earth. Some of it will always be too expensive to exploit. The real disputes among informed observers is over how fast prices will rise, and how much technology advances in oil exploitation technologies can mitigate this trend.

Reasonable optimists believe that new technologies will allow oil prices to retreat considerably for a sustained period of many years once international tensions in the Middle East and elsewhere subside, much as they did after the 1970s oil crisis. Reasonable pessimists think that while international tensions are contributing to current $78 a barrel oil prices, that, unlike the 1970s energy crisis, which took place well before global peak oil, that any retreat in oil prices will be modest and fleeting. Just about all reasonable observers believe that in the long term we will eventually reach a peak oil threshold leading to higher oil prices driven by the fundamentals described above. But, whether this is happening now, will happen in the next few years, or is decades away, is a matter of considerably dispute that keeps commodity traders in business.

Demand Side Impacts in Colorado

When and if Colorado faces sustained period of higher and higher petroleum prices, this will impact both the Colorado economy and the national and world economies. In a summer when gasoline is costing $3 a gallon, this may end up happening sooner, rather than later.

While the industry can respond to pressure on the supply of oil by looking at new production options, the rest of the economy has just two choices to address rising oil prices: use less or spend more. So far, the U.S. economy has largely opted to spend more. As economists would decribe it, demand for gasoline is inelastic in the short term.

Why?

Transportation is far and away the predominant use of oil in Colorado. There are also forms of oil consumption outside the transportation sector. Oil is used for fertilizers, plastics, and industrial processes. Particularly in the Northeast, it is often used to heat homes. But, in 2002, in Colorado, about 83% of oil consumption went to the transportation sector. Another 12% of the total in Colorado is used in the industrial sector. Only about 0.1% is used to make electricity. The remain 5% or so is split a little more than two-thirds in the residential sector and one-third in the commercial sector, mostly doing things like providing heat in isolated rural areas, oiling squeaky hinges and running lawn mowers.

Oil consumption in the transporation sector is driven by decisions made in the long and medium term like where you live, where you work, and what vehicles you purchase, to a much greater extent than it is by day to day decision making. Some people can decide in the short term to bike or ride a bus to work, instead of driving, but most cannot. A household can consolidate the number of shopping trips it makes, and can curtail vacation and recreation driving, but this is a relatively small share of most family's driving, and at the very least, households need to drive enough to have groceries and clothe themselves. Once you make decisions about where you live and where you work, the amount of driving you do is inflexible. For most people unwilling to change their address or their job, the only way to change the amount of gasoline consumed is to buy a more fuel efficient vehicle, and this only makes sense, in most cases, if their existing vehicle is old enough to need replacing.

People can choose to live closer to work and shopping, and they can buy more fuel efficient vehicles. But, these decisions are made on time frames of multiple years and decades, rather than months or days. These decisions also depend on their individual guestimates about how important fuel costs will be in the coming decade or so.

Thus, we are likely to see lower income Coloradans, who don't have excess funds to spend on rising gasoline prices, face an economic squeeze before conservation measures can kick in over the longer term. And, in the medium term, more compact urban areas (as suburbs and exurbs grow less popular due to fuel costs) are likely to develop. Also, fuel efficiency, both through more fuel efficient vehicle choices, and by putting more people in the same vehicle with either car pools or public transportation, is a natural medium term responses. For commercial transportation, there is also likely to be a shift from trucks to far less fuel price sensitive freight rail, for intercity shipping. Eventually, in the long term, we may have to return to a society parallel to that of a century ago, before oil became the lifeblood of our economy.

Cross Posted at Colorado Confidential.

4 comments:

Dex said...

i've been a peak oil geek since i made the mistake of buying james howard kunstler's bordering-on-the-sociopathic screed, "the long emergency" a year or two ago, at the start of grad school.

my own panic around peak oil has changed some - i now see it as a tremendous opportunity to apply all of the scientific skill and technical acumen of the worldwide community to radically change how we live, environmentally, politically, all that, if - IF - there's sufficient political leadership and enough noise from the scientific community. that's a big IF, though, and things seem to be in a one-step-up-two-steps back kind of place.

a solid and well-researched post. i'd like to see more about yr estimation of options via other forward-looking persons (and you may want to resize and repost that big map, too).

Andrew Oh-Willeke said...

Gah! I wish I was better at the html part.

Randy Park said...

Here's another way of looking at the price inelasticity...
As a specialist in how people make decisions and a commentator on energy issues I'm often asked by the media about gas prices, and I was curious myself about the economics.
My new Gas Price Calculator, on the basis of numbers people choose for themselves, calculates how much they will pay for gas for the convenience, time savings, and comfort of their own vehicle. Try it at www.EnergyPredicament.com and see how much you will pay.
People who have tried the Calculator are surprised at how much it indicates they will pay for gas, with many results in the range of tens of dollars per gallon or more. And since many people will pay a lot, gas prices will continue to rise if supplies get tighter.

Randy Park

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