Wednesday, March 12, 2008

Gas Prices & Demand Destruction

Let's talk about oil.

Provided that there continues to be enough to talk about, this may become a regular Wednesday feature. And with oil hitting $110/barrel today, there should be a lot to talk about.

Just one quick point of discussion for today: gas prices.

I paid $3.09 this morning (Denver area). How much does $110/barrel work out to? Well, there are 42 gallons in a barrel. It can't all be refined into gasoline, but that's still a good divisor because the other products produced in addition to gasoline have value as well, roughly the same as gasoline when taken as a whole. So $110/42 is $2.62/gallon. Add in roughly $1 for refining margin, distribution, retail markup, and you get gas at $3.62/gallon. Using the same math, oil at $200/barrel works out to $5.76/gallon, and oil at $300/barrel works out to $8.14/gallon. That might shock the average American, but I don't personally see significant demand destruction, even at $8.14/gallon. That's what gas already costs in much of Europe, and based on my anecdotal experience of driving a thousand miles there in December, that isn't slowing European demand in any significant way. I think most Americans frame the question incorrectly. Ask yourself (and people around you) this: IF you don't already ride the bus to work, how much will a gallon have to cost to make you do so? My commute, there and back, takes about a gallon of gas. I live right next to a light rail station, but it takes a full hour longer to ride the light rail than it does to drive (provided I leave at my usual very early time). Parking down town and the light rail ticket are essentially a wash, so an hour of my time needs to be worth less than a gallon of gas in order for it to make economic sense for me to stop driving. This calculation would change a bit if I could go entirely without owning a car, but not significantly--if I value my time at $50/hour, then, even with gas at $8.14/gallon AND the cost of car ownership, it still makes significant economic sense for me to drive. This is the result of America's huge sunk cost in suburbia, and exactly the reason why I don't see any great threat to gasoline demand, even at $8.14/gallon. Most people can give up their daily Starbucks to even out the difference between current cost and that possible, future cost--and I know which one has a greater inelasticity of demand!

15 comments:

Ruben said...

Depressing Jeff. But, you are only comparing the cost of your time to a gallon of gas. If you are already cash-strapped, say by a big mortgage, then you have no liquid cash cushion to absorb gas spikes. Let's not forget that gas prices will also increase the prices of everything else that we purchase: food, consumer products, clothing etc.. This further reduces any cash cushion. It is hard to overestimate how much gas is used to maintain our society.

Jeff Vail said...

Ruben-

No doubt that oil price rises will trickle through, quite literally, every other sector of the economy. However, I think that we have a lot of much, much more discretionary expenditures to cut (maybe not the truly poor, but certainly the average American) before people will earnestly reduce how much they drive. Starbucks Latte, $4.00. That's how much more most people will pay when gas goes from $3 to $6/gallon. Just one example, but judging by the continually long line at the DRIVE THROUGH Starbucks near my house, there's still a lot of "soft" cuts for the American consumer before they need to start taking truly drastic measures like taking the bus. Those people who truly can't afford to drive their cars at $6/gallon are also most likely to be those people who already take the bus, train, etc. Just my opinion, anyway...

Jeff Wartman said...

In the end, it's all about economics.

http://www.jeffwartman.com/2008/03/oil-prices-politics-and-economics.html

Tom Konrad said...

Jeff,
You're missing many of the advantages of light rail in your calculations. Time on public transit is worth more than time in the car, because you can be productive b/c you are not driving.

I take the bus on my 4.5 mile commute to work about twice a week. During that time, I listen to the Economist on audio (now available free to subscribers) and other podcasts I follow. I can also do this while driving, but I get less out of it do to the constant distractions. It also is much safer. So although my commute takes 2x as long as when I drive (and actually costs me about $1 more per round trip), the time is not wasted.

The other point you're missing is that demand destruction will not come from people getting out of their cars and onto public transit.

1) When people move, high fuel prices will make them look for places closer to work.
2) When they buy new vehicles, high prices will cause them to buy more efficient vehicles.
3) They will take fewer inessential trips, and combine errands.
4) Those who have the choice will telecommute more often.

In fact, gas usage in teh US *is* dropping. See my Mar 4 article:
http://www.altenergystocks.com/archives/2008/03/gas_price_demand_elasticity_1.html

Jeff Vail said...

Tom-

Good points--I'm one of those who already telecommutes 4 days a week (for the moment), so my perceptions of the value of time may be skewed. Also, I agree that I can spend time on the light rail doing more productive things, but in my case, Denver's light rail is already so popular that I usually can't get a seat until the last 2 or 3 minutes of my 40+ minute return ride. That time spent standing is actually less productive, at least in my view, than time in the car, because I have a back problem that makes it very uncomfortable to stand for that long. When I do ride light rail, I find the mornings very relaxing, listening to a podcast and reading a magazine, but I find the return ride frustrating.

For me, however, the final analysis is that I have to work a certain number of hours in the office, and I want to maximize my time with my wife and 15 month-old daughter. While I may be able to spend the 60 minutes longer that the light rail takes reading or being otherwise productive (When I tried, I found it difficult to actually bill for that time, as I wasn't fully productive), one thing I can't do with that hour is spend it with my family.

In the end, I like that light rail is an option for me, and there are many non-economic reasons to use it (greenhouse gases, support transit-oriented development, etc.), but it doesn't balance out for the time being.

While I agree that the greatest demand destruction will come in the form of people moving closer to work, buying more efficient cars, etc., these all have fairly long lag-times. We need to see a lot more than a 1% or 2% drop in gasoline consumption in the US to make any real difference--this is just sucked up by consumption growth in developing nations. 1% or 2% annual decline in consumption may be fairly elastic, but the kind of decline that we need to significantly slow the rise of oil prices--perhaps 5% to 10% annual decline--starts to become highly inelastic. I do see telecommuting as a real area for potential, but I don't see moving closer to work as a highly viable option over the next 5+ years: in tight economic times, people may find it difficult to move jobs when they are barely hanging on to their existing job, and moving houses seems to be a non-starter: the cost of commuting may make the value of a suburban home decline, but this should keep the total cost of living/commuting balanced between suburbs and "urbs"...

I guess my thinking is that as long as Americans (at least the ones that I see on a daily basis) are still spending so much money on things like fast food, Starbucks, etc., there is plenty of room for gas prices to rise...

Jeff Vail said...

Interesting discussion here:
http://www.peakoil.com/fortopic37359-0-asc-0.html

Suggests that, at least per EIA data, US gasoline consumption may not actually be declining. We won't really know until the data has been revised, if necessary, several months from now...

Jeff Vail said...

Interesting page on EU gas, diesel, and electricity prices:

http://www.energy.eu/#prices

Of note: gasoline in the Netherlands averages $9.06/gallon, the most expensive in Europe.

Tom Konrad said...

Jeff,
Reading your response to my comment, I have to say that you have already exercised your avialable gas elasticity by telecommuting 4 days per week... your gas demand is inelastic because you've already taken advantage of most of the avialable flexibility you have in your commute... not because you were inflecible in the first place. Unlike you. most people telecomute 0 days per week.

I agree that people are not going to move because of higher gas prices, but people who are ALREADY moving (and this includes renters... not everyone is a homeowner) will consider thier commute distance much more seriously if Gas is at $4 than if gas is at $2. And about 1 in 6 Americans move every year.

In other words, your personal gas demand elasticity is low, but you are far from representative of the population as a whole. My gas elasticity is low, too, since I use about 1-2 gallons a week... even if I cut my consumption 100%, it will make very little difference in overall demand. Gas demand elasticity mostly lies with people who currently use a lot of gas, and do not have stable work or homes.

Rice Farmer said...

I agree with the demand inelasticity. Here in Japan, despite its famed public transit, lots of people are dependent on cars for commuting to work and school, etc. I work at home, but when I asked others who commute how they are going to cope when gas gets even more expensive, they say, "We'll buy gas, anyway. We have no choice." Which illustrates your point.

But, there are other factors to consider. If people stop buying a latte on their way to work, what happens to the coffee shops and baristas? Answer: Starbucks just closed 100 outlets. Hence, those who purvey goods and services that are deemed luxuries will be out of business and out of jobs as fuel prices rise. As a consequence, they will no longer be buying things, including gas.

You can see where this is going. The consumer economy can take only so much of this. When the American summer driving season shrinks to a certain point, all the businesses which depend on people to drive hundreds or thousands of miles will go belly-up. The more fat that consumers pare from their household budgets, the more people are out of work.

Unless this structural dependence on high consumption of cheap energy is addressed, it's all downhill from here.

To conclude, fuel just can't keep getting more expensive, because there's an absolute limit to how much people can pay, and even before that is reached, the consumer economy will collapse. In fact, it's already in bad shape.

Michael Ejercito said...

Back in 1981, Mobil had developed a process of refining gasoline from wood, estimating the cost at $2.51 a gallon. (It would be about $5.15 a gallon today.)

I have heard of other alternatives developed since then.

While oil prices will trickle to every sector of the economy, this effect will be cushioned by mass shipment. If the fuel costs of flying a 250-passenger jet from Los Angeles rises one hundred dollars, then the effect on the ticket price would be an extra four dollars per ticket. If the fuel costs of shipping 50 tons of cargo by train from New York to Chicago go up by one thousand dollars, then the cost per ton would increase by twenty dollars a ton, which translates to a penny a pound .

green with a gun said...

Jef Vail wrote, "[...] I don't personally see significant demand destruction, even at $8.14/gallon. That's what gas already costs in much of Europe, and [...] that isn't slowing European demand in any significant way."

Europeans use one-quarter to one-half the oil Americans do. For example, oil consumption in,

US, 20.59 Mbbl/day, 7.5Gbbl/year, for 300 million people is 25bbl each.
France, 1.97 Mbbl/day, 0.72Gbbl/year, for 62 million people is 11.6bbl each.

Countries with a strong cycling culture and higher tax rates on cars and fuel like Denmark and the Netherlands manage on about 7-8bbl each.

So I think the price does affect demand.

However, what matters isn't the absolute price, but the affordability. That is, compare the price with the median wage to figure out how much the average person can buy.

You can see some data on fuel affordability here; it's not perfect and up to date, but it shows you the basic trend, that in the US the median wage can buy them 70,000lt of petrol, in France 24,000lt, and so on. Petrol is only $0.67/lt in Vietnam but their median income is less than $1,000, so...

It's not price as such that affects how much fuel is used, but affordability. If a depression hits the US, then no doubt there'll be calls for petrol to be made cheaper - since people's incomes will be dropping.

The real "demand destruction" is not going to happen in Western countries, but the Third World. If the world supply drops by (say) 10%, that's not going to mean 10% less for everyone, or the West dropping consumption by 2%; it'll mean that the West changes consumption not at all, and the Third World gets zilch.

Which is already happening in some places. Senegal, for example, gets most of its electricity from oil, so now their capital is getting blackouts as they can't afford the stuff.

That's what "demand destruction" means at first - the poorest stop consuming while the rich bitch and moan.

Michael Ejercito said...


I agree that people are not going to move because of higher gas prices, but people who are ALREADY moving (and this includes renters... not everyone is a homeowner) will consider thier commute distance much more seriously if Gas is at $4 than if gas is at $2. And about 1 in 6 Americans move every year.

Being in the real estate business, I know that, in the long run, housing next to major rail or bus lines will have a higher value relative to other housing.
If people stop buying a latte on their way to work, what happens to the coffee shops and baristas? Answer: Starbucks just closed 100 outlets. Hence, those who purvey goods and services that are deemed luxuries will be out of business and out of jobs as fuel prices rise. As a consequence, they will no longer be buying things, including gas.
People will stop buying lattes on their way to work if the price is too high or it becomes too inconvenient to purchase the latte.

If the price is too high, stores will lower the price that they offer, or shut down if the market price does not cover the marginal cost of making an extra latte.

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