PRICE SIGNALS FOR ENERGY TRANSITION

Andrew McKillop

Founder member, Asian Chapter, International Association of Energy Economists

Former Expert-Policy and programming, Division A-Policy, DGXVII-Energy, European Commission

(based on Sept 2003 article for STEM forecasting division, Swedish Energy Agency)

(Oct 04)

Summary

Most economic policy makers claim that cheap oil and cheap energy underpin economic growth. Very large amounts of fossil energy are certainly vital for any modern economy. The world’s most oil-intensive and energy-intensive urban societies, of the OECD economic bloc, which have so-called ‘postindustrial’ service oriented economies, in fact outplace or delocalise increasing amounts of their industrial production, together with the oil and energy demand for that production, to the fast industrialising economies. This process accelerated the already fast domestic industrial growth of the Asian Tigers in the 1970-95 period, and accelerates the very rapid industrial growth of China and India, and several other large or very large population industrialising countries today. The absence of any ‘alternate model’ for economic development ensures there is continued very strong demand growth for fossil energy, worldwide. Upward potential for national and personal consumption of fossil fuels is essentially unlimited in this context.

The role of oil and energy price rises in increasing or decreasing economic growth, changing the type of economic growth that takes place, and either increasing or decreasing oil and energy demand growth rates is not well understood. However, depending on the economic and fiscal policy context, we can state that oil price rises to high levels (probably up to US dollars 75/barrel) almost certainly increase overall or global economic growth rates, and therefore increase oil and energy demand growth rates. Only extreme oil and energy prices, and/or extreme interest rates and very deflationary economic policies can ‘abort’ this process or mechanism.

Through 2004, estimates and outlooks for world, regional and national economic growth made by the IMF, OECD secretariat and many national and regional economic forecasting institutions have been consistently revised up – at the same time as oil prices have increased. Far from ‘hurting’ economic growth, therefore, higher oil prices in 2004 have at least in the real world, real economy been associated with ever rising economic growth trends. Inside the essentially deflationary and slow growth OECD bloc, however, oil price rises to beyond about 75 USD/bbl will likely create a ‘deflation shock’, able to cause a large fall in economic growth rates.

Since about 1994-96 world energy and oil demand growth rates have increased from previous, exceptionally low annual rates. Following the 1998-99 approximate tripling of oil prices, this trend of ever increasing energy and oil demand growth has continued and amplified. This ‘demand shock’ is due to a number of resource, economic, energy-economic, social and technological reasons. In the absence of grave economic recession, which can be quickly triggered by fast and large increases of interest rates, energy and oil demand growth rates are likely to remain high. Current short-term ‘trend growth rates’ for world energy and world oil demand are about 3% for oil and about 3.5% for energy on an annual basis. The longer-term trend rate for oil is at least 2.5%/year as a median value.

The ‘cheap oil interval’ of 1986-99 was an anomaly from many perspectives and for many reasons. One key reason is physical depletion. This is however rejected or ignored by most governments and institutions as a near-term price setting factor for both oil and for natural gas. Concerning oil, and more important than physical depletion in the very short run (next 2 years) is the question of available production capacity, and producer country stability. After 2007 or 2008 the world oil market will likely enter a situation of structural undersupply due to accelerated depletion and slowed annual additions of production capacity. Before then, strong demand growth, and loss or denial of supply through accidents, strike action, natural disasters, civil war, military invasion or sabotage in exporter countries will almost certainly produce recurring and large price ‘spikes’.

Because of depletion, but in addition because of environment impacts and climate change limits, energy transition away from fossil fuels must and will start within no more than 10 years. Due to nearly inevitable and large price rises of particularly oil and gas in the near-term future, economic restructuring for lowered energy demand will become an urgent priority for the most energy-intensive societies and economies, of the OECD bloc. Price signals for this imminent and structural change are already present in the existing economic system and framework, and should be interpreted this way, if restructuring and energy transition are to start, and to build from the immediate near term. Existing and developing frameworks provide by the Kyoto Treaty offer some potential for providing frameworks and goals for the task and goals of energy transition.

Oil prices and economic growth

In 2003 it could still be considered ‘heretical’ to argue that rising oil prices, certainly to about 50 – 60 US dollars/barrel (USD/bbl) are not only almost inevitable, but will also reinforce and accelerate entirely conventional economic growth, certainly at the world or global level. Today this argument is much less easy to dismiss or ridiculise. Defenders of the unfounded, widely-repeated, official myth that “high oil prices hurt economic growth” are forced by simple economic facts, and abundant evidence of oil prices rising while economic growth also increases, to now argue that present ‘extreme’ oil prices will only ‘damage’ economic growth after about 12 months or more have passed. This is a convenient way to deny simple facts, but is rather far from ‘scientific’, or credible.

The US economy attained it highest-ever postwar growth of real GDP, achieving what today would be an impossible all-year (12 month) rate of 7.5% in the Reagan re-election year of 1984. At the time, in dollars of 2004 corrected for inflation and purchasing power parity, the oil price range for daily traded volume lighter crudes was around 53 USD - 68 USD/bbl. (See Table 1 at end of article). Despite this simple fact of economic history, Cheap Oil is still regarded by most economic and political deciders and opinion formers as a ‘passport to economic growth’.

Oil prices in the 50 - 60 USD/bbl range are unlikely to harm the world economy today, and will in fact tend to further reinforce the currently strong economic growth in nearly all countries (OECD and nonOECD) within a few months. In turn, world oil demand and gas demand will be underpinned or increased, making it ever less likely that oil or gas prices fall. Conversely, the setting of extreme interest rates could reduce oil and gas demand growth, through provoking recession and forcing down consumption, enabling lower oil prices until employment and consumption recovered. Double-digit interest rates would however certainly cause grave damage to world stock markets, failure of finance houses, runaway ‘domino effect’ bankruptcy of many major corporations, mass layoffs and unemployment, and grave difficulties for financing the structural trade deficits of especially the US and UK. The US, facing an all-time record deficit of its public finances and of its trade balance would expose itself to the risk of runaway flight from the dollar as the interest rate weapon produced stock market and economic rout in its wake. Using the interest rate ‘weapon’ as a blunt tool of energy policy, to force down oil demand through so-called ‘demand destruction’ would also cause severe national economic difficulties in all European Union countries, Japan and the fast emerging, oil importing economic superpowers of Asia (1).

Demand destruction or energy transition?

High and stable oil and energy prices underlying serious and committed energy conservation, transition to renewable energy, and economy restructuring for a low energy economy, habitat and society are the real long-term solutions to emerging energy supply limits. Inertia and inaction will only reinforce the ‘positive feed back’ of higher oil prices reinforcing oil demand, while deliberate damage to the economy, obtaining ‘demand destruction’ through economy destruction, will be a socially divisive and perhaps dangerous strategy for civil peace inside OECD countries. This leaves economic restructuring and energy transition as the sole solutions. Both are dismissed as urgent near-term needs, or rejected as utopian and unworkable, by political decision makers.

Claims are made, notably by US Federal Reserve chairman Greenspan, and ECB president Trichet that today’s economy is ‘less oil dependent than in the 1970s’ (2). This is flatly contradicted by the simple fact that world oil consumption has risen by about 50% or 23 Million barrels/day (Mbd) since 1983, and by about 20% since 1990. Natural gas consumption has increased by even larger amounts. Oil import dependence as a percentage of total oil consumption continues to rise in virtually all OECD economies, especially in the USA, China, India, and the European Union, the four-largest importer nations or groups of nations. In the case of the EU-25, oil import demand will likely increase at its fastest-ever rate in the period 2004-2010 due to a number of factors. These include “re-industrialisation” in East European member states on the demand side, and fast depletion of the North Sea on the supply side. Implementation of Kyoto Treaty requirements may slow this trend, but on current trends, and with heavily ‘reworked’ and ‘politically sweetened’ emission reduction targets for Kyoto compliance, oil import demand of the EU-25 will soon show very fast growth, which we can estimate at up to 1 Mbd per year(3). China, India and Pakistan, all of which are nuclear armed, are also experiencing record growth of their oil import demand requirements, for a total of at least 1 Mbd per year (4). Since mid-2004, economic growth trends for oil-importing Brasil, and oil-importing low income countries of Africa have dramatically rebounded from their near-recession trends of 2001-2003, raising oil demand of these large population groupings. The economies and population groupings with lowest oil- and gas-intensity have the largest potential for further demand growth.

In these circumstances and conditions it might be expected that world oil production and export supply offer would also be increasing at a high rate. This is in fact not at all the case. Current oil prices, and also gas prices will therefore almost surely continue to rapidly increase until and unless demand is limited or constrained, one way or another. Supply-side solutions are unlikely, and can be dismissed for the short-term and mid-term (and in fact also in the long-term).

The ‘price signal’

In theory the ‘price signal’ of higher oil and energy prices must be present if a range of goals stretching from intensified activity in exploration-development of conventional and depleting fossil fuels, reduced greenhouse gas emissions, and concerted moves towards ‘energy independence’ are regarded seriously. If they are not, or they are denied as being of any importance this can well explain the basic unpreparedness of large oil and gas consumer countries to accept higher and more stable oil and energy prices. Piecemeal measures, including hastily developed ‘strategic oil reserves’ will have little leverage in a context where any interruption in supplies, of more than 5% or so for under 6 months, or depletion linked failure of world production capacity to match demand growth over 2 years or less, will very certainly create an inextricable crisis.

This returns ‘demand destruction’ as the sole real option and real response available to our current economic and political deciders, when oil or gas prices exceed some ‘extreme’ limit those deciders believe is so dangerous that it must ‘not to be exceeded’. This may be around 75 - 100 USD/bbl. After the limit is exceeded, economy destruction by the interest rate weapon.will be the sole medicine available. The last time this was applied, in 1980-83, oil prices were surely reduced through cutting economic activity in general. Oil prices in today’s dollars fell from peaks of around 100 USD/barrel in late 1979 and early 1980, to around 60 USD/barrel in 1984, but the collateral economic and social damage was awesome. In the current economic and financial context, use of the ‘interest rate weapon’ would likely lead to catastrophic falls in economic confidence and provoke intense recession.

The ‘perverse effect’: higher oil prices increase world economic growth

Higher oil prices operate to stimulate first the world economy, outside the OECD countries, and then lead to increased growth inside the OECD. This is through the income or revenue effect on oil exporter countries, and then on metals, minerals and agrocommodity exporter countries, most of them Low Income (GNP per capita below 500 USD/year). Almost all such countries have very high marginal propensity to consume. That is any increase in revenues, due to prices of their export products increasing in line with the oil price, is very rapidly spent, on purchasing manufactured goods and services of all kinds. In the 1973-81 period, in which oil price rises before inflation were of 405%, the New Industrial Countries (NICs) of that period – notably Taiwan, South Korea and Singapore – which we can call ‘traditional’ NICs (see below) experienced very large and rapid increases in demand for their exports. These three countries increased their oil imports in under 8 years through the 1973-81 period, and despite the 405% price rise, by 55% to over 80% in volume terms. For the long period 1965-78 their minimum increase in national oil demand was about 700% (1600% for S Korea), in volume terms. See Table 1.

Table 1 Asian Tiger economic demand-driven, close-coupled adjustment to Oil Shock

Oil Consumption Thousand barrels/day

1975 1976 1977 1978 1979 1980 1981

Singapore 141 165 165 170 183 181 208 Increase 1975-81 : 47.5%

South Korea 278 310 371 426 480 475 497 Increase 1975-81 : 78.8%

Taiwan ROC 214 271 304 353 358 388 359 Increase 1975-81 : 67.8%

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Source// BP Statistical Review of World Energy, various edns

The macroeconomic mechanism is of higher revenues completely displacing any ‘price elastic’ impact from much higher oil prices, working between real resource exporters and the ‘traditional’ NICs, to quickly lever up world economic growth (the very simplest type of Keynesianism, but at the global level), this pro-growth mechanism being triggered by rising oil, energy and real resource prices. This flatly contradicts the arguments by certain well-known institutions that higher oil prices ‘hurt poorer countries the most’ (4). Through 2004, as noted by the IMF and World Bank, many low-income oil importing countries have experienced a strong ‘rebound’ of their economic growth relative to 2000-2003, due to higher export revenues, triggered by higher oil prices. Higher revenue earnings for many low income oil exporter countries may in fact prevent such countries from experiencing civil conflict and strife leading to civil war and the stoppage of oil exports. For the special cases of Iraq and Saudi Arabia higher revenues may be the only effective, short-term way to prevent (or limit) complete chaos in Iraq, and prevent Saudi Arabia from falling into civil strife, insurrection and takeover by hard-line Islamists.

No immediate and instant recession can occur with oil at 50 USD or 60 USD-per-barrel. Vastly higher oil prices than this price level would be needed to abort the worldwide mechanism of higher oil, energy and real resource prices driving faster economic growth. Conversely, low oil and energy prices entraining low real resources prices, combined with rising population numbers surely aggravate the ‘cycle of poverty’ in low income commodity exporter countries. Deprived of sufficient revenues, such countries have become ‘basket case’ indebted countries, subjected to draconian conditions by the Club of Paris, World Bank and IMF for debt refinancing and restructuring. Constant ethnic and civil war in Africa provides the best and most real example of what happens to countries subjected to so called ‘structural adjustment’ (5). When or if this concerns oil exporter countries there can be no surprise if this reduces or eliminates exports by the affected countries which, after the ‘price taker’ stage fall into the bottomless pit of basket case low performer economies. When they fall from that into civil and ethnic war their capacity to supply oil – whether cheap or not - will also take a hit.

Today’s ‘emerging’ New Industrial countries (NICs) include China, India, Pakistan, Brazil and Turkey. Apart from the first 3 being nuclear armed states, all have either big or immense internal or domestic markets, and large potentials for military Keynesian spending, that is safeguarding national economic growth through deficit financed and labor intensive modernization and expansion of their military systems. The relative lack of integration of these behemoth economies into the world system, particularly India and Pakistan, also provides them with some cover or shelter from the effects of world recession, when or if the OECD countries tilt to all-out recession. Conversely, whenever any increase in world solvent demand for manufactured goods occurs, these countries will very rapidly increase output. China is now and without question the world’s leading industrial power for medium- and low-value consumer manufactured goods and will soon become the world’s single biggest industrial economy. Under almost any hypothesis, therefore, fossil energy demand – particularly oil and natural gas – will increase in China and India, and in the other large population NICs. Demand growth can only run at rates at least close to, or above their rate of industrial growth. (6)

World oil demand change under regimes of rising prices

Oil remains the economic ‘swing fuel’ par excellence, and oil price increases – before reaching certain supposedly ‘extreme’ levels – will always tend to increase or restore economic growth at the world or ‘composite’ level. In addition oil shock or sudden and large price increases, as well as slower acting but large price rises that do not ease back, change the type of growth towards more energy-intense industrial and manufactured products, away from more service-based, lower energy activities (7). This ‘perverse’ factor (7a) results in increased oil intensity of world economic output and raises the ‘oil coefficient’ or percentage increase in oil demand for a percentage point growth of the economy (8). This macroeconomic change affects all economies, some faster than others, during a certain time period. Wholly unlike the stock of myths, and ‘facts’ without foundation that circulate inside the oil market trading community, these effects can be measured and have predictive value (9). In brief, a regime of higher oil and energy prices will tend to lever up world composite or global economic growth rates. This, in turn, produces the ‘perverse result’ of firm demand for much more costly oil and gas. Whether this is inflationary, or not, will depend not only on how high oil prices rise, but more certainly on the fiscal and policy environment in large consumer and importer economies.

Oil and gas demand potential, prices and ‘demographic’ demand

Insofar as potential demand is concerned, any oil supplier (whether OPEC or not) should be very concerned for their forward national security when serious analysis is given to real world oil demand structures and growth drivers. These are all, finally, due to demographic and economic growth, to conventional technology used in the economic process, and to the very slow progress in finding real, economic, and effective substitutes for oil, gas or even coal that deliver more net energy than they ‘cost’ to produce. In addition, such is the utility and facility of fossil based liquid hydrocarbon fuels and pipeline gas that sought-after substitutes must be of a type that can be utilised in the economy and society without ‘total restructuring’ of either the economy or society.

Current oil demand worldwide extends down from 25.6 barrels/capita/year (bcy) for the USA to well below 0.2 bcy in rural areas of low income developing countries (LDCs). The world average, which fell slowly for around 15 years through 1978-93, is about 4.67 bcy. World natural gas demand on a per capita average basis (measured in barrels of oil equivalent per capita – boecy) has grown more, and without periods of lowered oil intensity per capita, through the the last 30 – 40 years. As a pure projection, if the world’s current 6.3 Bn population consumed oil at current US per capita rates this would generate a demand of around 445 Million barrels/day (Mbd). At the other extreme, at 0.2 bcy world total oil demand would be telescoped to less than 3.5 Mbd. See Table 3, below. The current, real world average of 4.67 bcy is around one-third the average for European Union countries, more than 4 times that of India, and over 3 times that of China – which will soon become the world’s biggest industrial economy. Annual increase of the world’s population (which is continuing to fall as a percentage rate, and in absolute numbers) is now running at about 85 Million. At the current world average of 4.67 bcy this itself generates a ‘latent’ or potential growth in world oil demand of about 1.1 Mbd annual, assuming no change in the energy economy, no fuel substitution, and also no economic growth.

The data shown below (Tables 2 and 4, Figure 1) show an essentially low elasticity response to rising oil prices, and almost inelastic response to rising gas prices, notably because of initial, very low prices for gas in the late 1970s and early 1980s relative to oil.

Table (2) World per capita average oil demand and oil price trends 1965-2004

Year	World population Year average Millions	Average daily oil demand Mbd ‘all liquids’	Billion barrels consumed per year	Change on previous 3-year value (percent)	World per capita average (bcy) Barrels/capita per year	Year peak oil price in 2003 dollars per barrel (light volume crudes)
1965	3310	31.23	11.39	+ 17.2%	3.65	USD 9 / bbl
1968	3520	39.04	14.25	+ 25.1%	4.05	USD 9 / bbl
1971	3750	51.76	18.89	+ 32.5%	5.04	USD 15 / bbl
1974	3980	59.39	21.68	+ 14.8 %	5.44	USD 56 / bbl
1977	4200	63.66	23.23	+ 7.2%	5.53	USD 39 / bbl
1980	4410	64.14	23.41	+ 0.7%	5.31	USD 82 / bbl
1983	4650	58.05	21.18	- 9.6%	4.56	USD 59 / bbl
1986	4890	61.76	22.54	+ 6.4%	4.60	USD 32 / bbl
1989	5150	65.88	24.04	+ 6.6%	4.67	USD 32 / bbl
1992	5400	66.95	24.43	+ 1.6%	4.52	USD 29 / bbl
1995	5610	69.88	25.51	+ 4.4%	4.54	USD 25 / bbl
1998	5870	72.92	26.62	+ 4.3%	4.51	USD 18 / bbl
2001	6140	75.99	27.74	+ 4.2%	4.53	USD 31 / bbl
2004	~ 6400	~ 82	~ 29.75	+ 7.5%	~ 4.67	USD ~ 55 / bbl

(estimated 2004 outturn)

Data sources for Table 2

Population data/ UN Population Information Network (year average or « June » population estimate)

World daily average oil demand each year : BP Statistical Review of World Energy, various edns.

Peak annual oil price (2-month basis) for volume traded light crudes. World oil prices and deflators 1965-2004, and price forecast for 2004 are calculated by this author using multiple sources., including 'Oil economists handbook' Vols 1 & 2, G Jenkins, Elsevier Applied Science, various editions, Platts Oilgram, OPEC bulletin, Bloombergs, California Energy Commission ‘Delphi oil price forecasting series’, etc. See Table at end of article.

The relation of ‘demographic’ oil demand (average per capita demand) to the almost unlimited upward potential for world demand can be understood from the following table (Table 3).

Table 3. Demographic rate of oil demand, 2004

Country/Region bpy	World demand at this rate
USA 25.6	445 Mbd
Italy 12.4	215 Mbd
China 1.8	31 Mbd
India 1.2	29 Mbd
Rural areas, LDCs 0.2	3.5 Mbd
----------------------------------------	----------------------------------------
Real world 4.67	81.5 Mbd
----------------------------------------	----------------------------------------
World annual population growth	Annual ‘latent demand’ increase
85 Million	1.1 Mbd

Sources/ Population data from UN Population Information Network, Oil demand BP Amoco Statistical Review of World Energy, 2003 and 2004

Natural gas price elasticity even lower than oil

The greater inelasticity of world natural gas demand through the same period, in part due to gas prices being lower than oil prices – and less linked to oil prices by major supply contracts – can be appreciated from the table below (Table 4).

TABLE 4

World per capita average oil demand and average natural gas demand 1965-2004

Year

World population Year average Millions

Natural gas consumed M tons oil equivalent