Eliminating Subsidies Won't Solve the Oil Demand Problem

This week's post is an article that I wrote for The Oil Drum. Also, several new links on the side column this week. Starting next week, I hope to move away from discussing oil for a few weeks and turn to discussion of rhizome as an open source platform for developing personal and community self-sufficiency, something of a "rhizome toolkit."
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Cheap gas and diesel due to government fuel subsidies has become one of the favored whipping boys of late—a convenient way to blame high oil prices on the actions of some other government or faraway people (See 1 2 3 4 5 6 7 8). But how much can subsidies really be blamed for present oil demand? Would cutting a 30% gasoline subsidy reduce demand by 30%? Why not? I’ll stake out and defend a somewhat extreme position: reducing, or even eliminating fuel subsidies will not cause a significant, long-term reduction in demand and may even cause demand to increase more quickly than with subsidies in place. More importantly, we must not fall prey to claims that cutting fuel subsidies is an easy solution to our energy problems.

A Hummer dealership in Caracas, Venezuela, where consumers pay only pennies for a gallon of gasoline as reported by the New York Times


Fuel subsidies are currently in place for nearly half the world’s population. Fuel subsidies around the world have previously been covered at The Oil Drum in Fun With Subsidies and Taxes, as well as numerous articles in the media on the topic in the past few weeks (links above). Additionally, most OECD states indirectly subsidize fuel consumption in a variety of ways. I won’t rehash this existing coverage, though I do need to point out that every article* I’ve been able to locate has argued that cutting subsidies will have a significant effect on demand, and will help to lower oil prices (*only one analyst, Benoit de Vitry of Barclay Capital, seem to agree with me). To me, this wave of media coverage of subsidies is just like the waves of media coverage past on speculators, big oil conspiracies, and the promise of oil shale: a source of false hope that a magical solution exists to our energy problems. For that reason, my intent here is to argue that the long-term effect of cutting fuel subsidies is, contrary to the reports in the media, not of much significance.

Demand Elasticity is a Marginal Matter

The first reason that cutting subsidies won't have a dramatic impact on demand is that the fuel demand elasticity of a country is the aggregate of the marginal demand elasticity of each of its consumers. For that reason, the elimination of a 30% subsidy for fuel will not result in a proportional drop in demand of 30%. For some users, price increase will completely price them out of the market, and their marginal demand will be completely eliminated. For others, either because of wealth or the value of liquid fuels to their economic activity, the elimination of the subsidy will result in no decline in consumption. The vast majority of consumers will lie somewhere in between. Therefore, right at the outset, we can say that the elimination of a 30% subsidy will not result in a 30% drop in demand. I’d love to be more precise on this point, but neither the data nor methodology currently exists to project with any confidence exactly how much demand reduction would result from the elimination of subsidies—all we can say with any certainty is that it will be smaller than the size of the subsidy eliminated.

Evaluating the Energy Intensity of the Opportunity Cost to Subsidy Expenditures

The next question—and perhaps the most important—is to evaluate the opportunity cost of a government’s expenditures on fuel subsidies. If a government does’t spend $X billion on fuel subsidies, what will it spend the money on? What is the energy intensity of that expenditure compared to the amount of demand reduced through cutting the subsidy?

Take India, for example. In India, the total cost of fuel subsidies could be as high as 2-3% of GDP. What happens to that spending if it doesn’t subsidize fuel use? There are two theories here, both of which create at least some fuel consumption that didn’t exist before. One theory is that it will be spent in a way that results in lower fuel consumption—but almost certainly not in a way that results in NO fuel consumption. The argument in favor of this position is that, because fuel subsidies distort economic calculations in favor of consuming fuel, a neutral use of the same amount of funds should result in less fuel consumption. However, there is an opposing position: because subsidies are, according to market theory, a sub-optimal allocation of resources when compared to free-market allocation, the elimination of subsidies will result in stronger economic growth (or less economic decline) than with the subsidies. This is especially true if the money saved from subsidies isn’t spent at all, but rather reduces the tax burden or lowers the rate of inflation. It remains potentially true to a lesser degree even if the money is merely spent elsewhere, since neutral spending is likely to have a less distorting effect on economic activity. Therefore, according to this theory, elimination of a fuel subsidy may actually result in greater fuel demand over the long term—and that demand may be even more inelastic because it stems from a more efficient allocation of resources. This is the argument of Benoit de Vitry of Barclay’s Capital. In the end, it may come down to this question: What’s worse (from the admittedly very skewed perspective of demand management): 100 million Indian middle class paying 40% under market for diesel with a GDP growth rate of 5%, or 200 million Indian middle class paying market for diesel with a GDP growth rate of 7%?

Cutting Subsidies Won’t Slow the “Export-Land” Effect

Finally, cutting fuel subsidies in exporting nations won’t significantly slow the grinding effect of the Export Land Model, whereby rising revenues of fuel exporting countries lead to increasing domestic consumption and declining net exports. What happens if subsidies are suddenly cut, and citizens of Venezuela or Saudi Arabia have to pay the market rate for oil? The extra money they spend on oil goes to their own government, rather than to some other nation. And that money can then be spent on other projects or programs—the opportunity cost issue noted above. However, to make the cuts in subsidies viable, they are likely to be offset by progressive spending plans that disproportionately benefit the poor. This is exactly what is currently happening in Malaysia. The result may actually increase demand: the rich, who are not the beneficiaries of these offsetting handouts, are also the least likely to reduce their demand due to price rises. The poor, who may otherwise reduce their demand, are the most directly benefited by the handouts. And, because it may be possible to prevent any demand destruction by simply handing out 1/2 or 2/3 of the money previously spent on subsidies to the poorest consumers, there is likely to be money left over to be spent elsewhere (or not taxed in the first place), which brings us right back to the previous discussion on the energy intensity of that alternative spending.

To conclude, I’m certainly not advocating the maintenance or increase of existing fuel subsidies. They are an inefficient allocation of resources, resulting in less economic activity for every barrel of oil consumed. Rather, my intent here is only to dispel the notion—increasingly popular of late—that eliminating fuel subsidies is some kind of magic bullet to derail the demand train. At best, I think the elimination of fuel subsidies will result in a minor and short-term decrease in the rate of demand growth in developing nations. It will not significantly alter the energy crisis facing humanity. Either way, the elimination of subsidies may not be politically practicable—where they have been cut there have been riots (1 2), and there are numerous movements attempting to actually increase fuel subsidies (1 2 3 4 5).

Recession or Reallocation?

I've been fairly outspoken on my opinion that the US is not in, and likely will not enter, a recession this year or next. I'll argue for that point again today, in light of oil at $137/barrel, but first I want to address an important issue in psychology. Other people (not me!) are susceptible to getting so invested in a belief that they begin to view new information that tends to either confirm or disprove that belief with what psychologists call "confirmation bias"--that is, they discount information that goes against their belief as either insignificant or biased, and see information supporting their belief as credible and weighty. Since, to the best of my ability to investigate, I seem to also be similarly wired as a human who evolved the ability to think rationally on top of (primate/human brain, mostly prefrontal cortex), not in substitute for, my ability to think reflexively (reptilian/fish brain), it seems that I may be susceptible to the same hard-wired tendency to engage in faulty reasoning! Fortunately, thanks to my awareness of my own limitations, I'm trying to review my opinions here with extra care to identify exactly that kind of bias. Take it for what you will--I think I'm presenting this information as objectively as I am capable, which may or may not be very objectively objective. Fortunately, I seem to have been modestly but consistently right with regards to my predictions to date (2006 2007 2008), but, again, I need to remind myself that correlation between my predictions and reality does not necessarily prove that I am anything more than a highly biased and highly lucky person :)

So, given my attempt to look at the situation without confirmation bias, how can I still think that we're not in for a near-term recession when so many economists are worried about the impact of high energy prices, when so many pundits think that the economy simply can't survive on $5 gas (or $6 gas or $10 gas)? First, I think that our current media/pundit complex is very, very biased--much more so than me (confirmation bias?). Second, I can remember strikingly similar calls that the economy would collapse at $3 gas, at $4 gas, at $60 oil, and at $80 oil (and even that $40 oil would have serious negative effects). The key to discounting these renewed calls is in following the money. What happens when we pay $5/gallon for gas? Where does the money go?

Well, as a net-importer of oil, much of that money goes overseas. Where it is spent. Generating economic activity. The portion of that money that goes to domestic oil producers stays in the US, where it is spent. Generating economic activity. This is the key: high energy prices alone do not lead to recession, but rather to reallocation. While the two may feel the same if you're one of the people who's money is being reallocated out of your pocket and into the hands of Exxon or ARAMCO, they're very different animals. Recession is an aggregate decrease in economic activity. It means less opportunity overall. Reallocation, on the other hand, is not an aggregate decrease, but rather a shifting of who gets the benefit and who gets burned. It means the same--or even greater--opportunity, but in different places and in different manner than in the past.

Therefore, this is my working theory: the US, along with the global economy, is not facing a recession, but rather a reallocation. I don't think that actual economic activity will decline until actual energy availability declines (something that might not be too far off). Until that begins to happen--when we're just facing increasing prices, but not yet declining availability--we will instead see reallocation. Take a look at this graph from the latest edition of BusinessWeek:



Overall, the US economy grew at an annual rate of 0.9% in the first quarter of 2008 (yes, you can legitimately dispute those numbers due to inflation, etc.--I certainly do--but I'm looking at the official numbers so that I can compare apples to apples). Excluding autos and housing--two areas on the losing side of economic reallocation--the economy grew at nearly 4%, which is higher than the optimist's expected long-term growth rate for the US.

What to do in the face of reallocation? Reallocation hurts the most those who are not expecting it. Expect it to continue, and to intensify. Don't follow the moronic investment advice offered over at CNN Money, but rather try to tease out where the money will be reallocated to, and put yourself in position to take advantage of those new opportunities ("get yourself to the non-discretionary side of the economy," get linked to the energy economy, the local food economy, etc.). Reduce your exposure to having costs reallocated to you (e.g. by reducing commute times or transport modes, by establishing partial food self-sufficiency, by generating your own electricity/growing your own woodlot, etc.). Reallocation is change, but it is not necessarily "bad." If you're assuming that you can keep driving your F250 to work 20 miles away at the Ford plant, reallocation will feel--quite convincingly--like a recession. But that won't make the pundits who proclaim that we're already in a recession correct. It will just mean that they, like you, have fallen prey to confirmation bias and are mistaking reallocation for recession. Well, at least that's my opinion, subject to all the standard disclaimers of human thought processes.

Is the Falling Dollar behind Oil Price Rises?

It's difficult to turn on CNBC, read any newspaper article on oil prices, or listen to other discussions of the topic of oil prices without hearing this theory: really, it's the decline in the dollar that's responsible for the rise in oil prices. "They" advance two reasons for this: first, dollar-denominated oil traded on the NYMEX must go up equal to the amount that the dollar goes down, or it's actually losing value. Second, the belief that the dollar is losing its footing as the world's reserve currency is causing a flight from dollars to commodities and other hedges against a falling dollar. Lots of words, but very little data is usually provided to back this up. I decided to put together a little graph that cuts right to the heart of the matter:



Figure 1: US Dollar Index (Bottom) and NYMEX Crude Oil (Top) contracts concurrent price charts

So, let's look at two periods: before about March 10, 2008, and after about March 10, 2008.

Before March 10, 2008, there was a general (though not very convincing) correlation between dollar movement and oil price movement. We need to remember that correlation does not necessarily equal causation here, even if there are rational explanations for a potential causal mechanism. This correlation extends back into 2007 (not shown--chart begins about Jan. 1st, 2008).

After March 10, 2008, there is not a correlation between dollar movement and oil price movement. The dollar has remained relatively steady and constrained within a relatively narrow trading channel. During this same time period the price of oil experienced one of the most dramatic increases in history.

Problem: How can we infer causation from the rough correlation from 2007 to March 10th, 2008 between dollar decline and oil increase if the two data sets become uncorrelated between March 10th and the present? There are possible answers to this question--possibly because there's a lag time between dollar decline and the move to oil and other commodities, possibly because there was some new countermanding force propping up the dollar since March 10th, or something else entirely. The point isn't that there's no explanation for this--the point is that the break in correlation itself defeats any rational use of correlation as the sole basis for asserting causality. At a minimum, we'd need to perform a three-factor analysis here and see if, then, we can derive a continuing correlation--say between an identifiable fed action data set, the dollar index, and crude oil. To my knowledge, no one in the media who has been bandying about the dollar-oil theory has done that. That seriously undercuts the argument that oil price rises are due to dollar decline, in whole or in part. As with any scientific experiment to determine causality, the non-correlation between March 10th and the present must be explained or the entire dollar-oil theory falls apart. I realize that it might be beyond the attention span/sound-bite requirement for most media to discuss this, but it certainly could be addressed in a newspaper or magazine article. I have seen neither. I'll keep thinking about it, but if there are any theories that people would like put to the test, please comment!

Future Scenarios

Two points for discussion tonight: David Holmgren's new Future Scenarios site and the recent Economist coverage of Peak Oil.

First, Adam Grubb of energybulletin.net tipped me off to the launch of David Holmgren's new site, futurescenarios.org. Holmgren, co-founder of the permaculture concept and still a critical proponent working to advance that field, has done an excellent job of placing the permaculture analytical framework and toolkit into the world of peak oil scenario planning. The site is still in its infancy, but is well laid out and does an excellent job of framing both peak oil and climate change in a "how can permaculture affect these problems" sense.

I think that the notion of scenario planning is a truly critical area of inquiry. This stems from the fundamental proposition that we don't know what the future will hold. I think that, with careful inquiry and investigation, we can gain a good feeling for future probabilities, but anyone who tells you that "the future WILL contain X" is most likely acting largely on faith, not reason. The closest that we can come to a "truth" is that we don't know what the future holds, but that we may be able to discern probabilities for different scenarios. In light of this probability, we must plan our course of action in light of 1) our goals and 2) the solution space of possible future scenarios.

I don't want to get bogged down in a discussion of goals, beyond the notion that it seems that we tend to get stuck on derivative goals (like increasing GDP or decreasing poverty) when these are in fact just means to achieving our actual goals--call them happiness, stability, fulfillment, etc. It's my opinion that we'd be best served by building our goals around our genetically determined requirements--in other words, to reach for fulfilled ontogeny. Once we've carefully identified our actual goals--not mere intermediary means to achieve those goals--then we can begin to approach how to achieve these goals in an unknown but probably probabilistically determinable future environment.

So what is that future solution space? Let's frame it, for the purpose of this analysis, along only one axis--future energy availability. Let's call one end of the axis "catastrophic energy cliff due to peak oil and other primary energy sources with no substantial mitigation" and the other end of the axis "unrestrained and continuing growth in energy consumption due to new reserve discoveries or the development of adequate substitutes." Or, if those labels are too lengthy, "doomer" and "cornucopian." I contend that anyone who says we "know" which way the future will go is taking an irrational, faith-based approach. Therefore, I argue that the only rational approach is to say that both scenarios (and all points in between) are possible. We can still, of course, argue about the probabilities of the various scenarios coming to pass. I think that both extreme scenarios are sufficiently possible that we must seriously plan for them, but I think that something in the general direction of the "doomer" scenario is significantly more likely over the medium to long term. This is an area that fundamentally demands individual determination, but assuming that you accept my evaluation, what is to be done about it? This is where scenario planning comes in, and it's a topic that I've discussed in the past in future planning: hedging the solution space. The basic notion--especially where it differs from conventional wisdom on planning for the future--is to evaluate options based on their composite ability to succeed in any possible future. That is, don't just pick what you think the most likely future scenario is and plan for that alone, but rather plan a solution that addresses all possible future scenarios simultaneously, prioritizing in order of probability. In particular, I think that today's conventional wisdom focuses entirely too much on how to hedge within what conventional wisdom considers to be very probable future scenarios (though I dispute their assumptions) without placing any concern on the ability of these plans to deal with outlying scenarios (such as Peak Oil, which I actually see as "probable," but which hasn't yet been fully accepted by the mainstream--more on this below).

I think that scenario planning, such as the more limited solution space proposed by Holmgren in futurescenarios.org, is a very important start in this direction. One point that Holmgren does an excellent job of addressing is the need to address this solution space on different levels. IF we could count on our national and global means of governance addressing our problems, then that could potentially be the best way to deal with the problems facing humanity. However, because human organization at that level seems unlikely to actually address our problems in any serious way due to temporary political demands and our inability to deal effectively with inherent uncertainty, it is important that Holmgren points out how it is also possible for communities and individuals to address our path into the future solution space. I take this even further--it is my opinion that we must begin to address the future solution space at the individual level, and that only once we have established a foundation of individual, resilient self-sufficiency in light of future uncertainty can we begin to build a community and then a global solution to our problems. This is because any attempt to solve problems without first addressing security at the individual level seems to leave humanity open to the lure of populist but illusory programs. Much more about this notion in The Problem of Growth.

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I'd also like to briefly address the coverage of Peak Oil in the latest edition of The Economist. The Economist asks whether current high oil prices are caused by speculators or peak oil, and concludes that the answer is "neither." Addressing speculators, The Economist concludes rightly that the theory is "plain wrong." They provide an excellent and concise explanation of why, as I've explained here previously (essentially, that oil is a deliverable commodity and prices must ultimately be set by the consumer's willingness to pay a given amount). Next, they claim that "[t]here is little evidence to support the doctrine of "peak oil" in its extreme form." This, in itself, is an important qualification from previous statements by The Economist (and most others in the mainstream) that "peak oil" is flatly wrong. Instead, they only discount the "extreme form" of the theory (conveniently, without ever defining what differentiates "extreme" peak oil from "conventional" peak oil). Of course, they then proceed to offer up two completely unfounded arguments in support of their already unclear position. First, they claim that supply should rise in the near future due to current high prices (which is much different than showing significant extant increases), and second, they discount the "above ground" factors of increasing cost of production and resource nationalism as somehow divorced from peak oil, something that I've repeatedly (and I think convincingly) linked as a direct result of peak oil. I would like to see a more rigorous analysis from The Economist, but I guess this is what I should expect from a paper with such an ideological ax to grind. That said, I still enjoy reading The Economist because at least their ideological spin is so transparent that it is always easy to adjust for.

Oil Price "Head Fake"?

Late post today as I've just returned from vacation--I try to get new posts out early Monday mornings, but at least it's still Monday...

Oil prices have certainly been in the news lately, and I've written here and elsewhere that the concept of Peak Oil has "tipped" in the mainstream media and in the markets. Many people still think that oil prices are just a bubble. Others think that the recent run-up in oil prices are just due to the declining dollar (apparently they haven't viewed a chart of oil price superimposed over the Dollar:Euro price chart lately, as that clearly can't explain the last few weeks' dramatic run-up). Others think it's all evil speculators--I won't repeat what I've said before about why that opinion does little but demonstrate a fundamental misunderstanding of the oil markets. But increasingly people are waking up to the reality that this is simply an issue of geologically and geopolitically constrained supply and rising demand. Over the long-run, we'll either develop a new substitute for oil and/or we'll reduce our demand for oil. Unless some new miracle technology (or miracle cohesive political will) moves us consciously away from oil, or unless the global economy collapses for reasons other than energy, then over the long-run these substitutes or this demand reduction will be a result of prices rising to significantly higher than they are now. The questions, to me, is whether this price rise will be relatively smooth or whether it will come in waves with serious retracements.

In other words, will oil prices make a "head fake," and decline significantly for a few years as current high prices cause a global recession, only to prevent us from mitigating the near-term onset of production declines causing truly dramatic price increases 5-10 years down the road? Charles Hugh Smith seems to think so.

Here's Smith's graphic depicting a potential "head fake" in oil prices.

Let's consider the potential for such a "head fake" more closely:

Taken in isolation, I don't see how increased oil prices cause destruction in demand sufficient to cause prices to decline, but rather only enough to prevent or slow additional price increases. The exception to this is the time-delay inherent in demand destruction. If oil prices now make everyone choose a more fuel-efficient car when they buy their next car, then current prices will cause a reduction in demand that continues over several years as we roll-over our auto fleet. Similarly, it may take oil prices staying at current levels before people are adequately convinced that they'll remain high, and therefore incorporate these prices into their decision making. That's a reasonable enough argument, but absent this time delay, I don't see how oil prices alone can cause a massive collapse in demand that isn't already present at current price levels. I do see how we could reach a wall where it would be difficult for prices to rise further because any increase is met immediately with a demand response, but that doesn't seem like a possible cause for a significant price decline--a "head fake." Why would $5 gas suddenly cause people to radically cut consumption any more than $4 gas did? I think there's a generalized perception that at some point there will be a demand response to high prices, but I think the common fallacy is assuming that this response will be digital, that at some magic number everyone will sit up and take action. Rather, demand response to high prices is extremely graduated, with a little bit happening at every rise in demand. Sure, some psychological barriers (e.g. $5 gas) may have a bit of an extra kick, but in general price increases won't cause a decrease in demand sufficient to significantly lower price. It just isn't logical--why would $4 gas cause prices to drop to $3, when people were apparently willing to consume enough gas at $3.50/gallon to sustain that price level? It's difficult to account for the time-lag issue, but I don't think that there's such a large time-lag waiting to unfold to actually decrease prices significantly.

The "head fake" scenario proposed by Smith IS, however, possible if increased oil prices merely act as a catalyst to set off a larger economic chain reaction that, in turn, destroys far more demand than the catalyst alone can account for. This is similar to what happened with the recent credit crunch--mispricing of risk in one area cause an entire risk-pricing industry to suddenly clam up, over-correct, and over-price risk for a brief period. This same thing could happen if gas prices caused a general recession that led to people postponing capital investments and other economic activity until the recession had ended--a sort of chicken and egg problem. While I do think that gas prices alone can cause economic hardship, any recession caused by high gasoline prices seems to be only a problem of the global economy evolving to a new reality, not to an inability to maintain current levels of economic growth. If $500 Billion a year is going to the Middle East, and they are in turn spending it on luxury products, then the global economy must re-tool and re-orient to produce luxury goods for Middle Eastern sheiks rather than Fords for Ohio factory workers. That might be a painful transition, but it doesn't necessarily reflect either a decrease in economic activity OR a decrease in energy consumption, just a shift in where and how it takes place. It is important to differentiate a recession caused by the market's inability to quickly re-tool for a new economic environment due to high oil prices and the very different even of a recession due to an actual decrease in economic production due to a decline in oil production (and, possibly, also total energy available to the economy). This latter event--something that I think is still a few years away--could cause a very serious recession. The former--just high prices due to tight supply/demand issues--should only cause a re-focusing, which might be painful for some, and painful in general in the short-run, but may actually be beneficial in the long-run because it could allocate energy to higher value-added tasks than in the present. I'm not sure that the more minor recession caused by mere high oil prices would be enough to cause a "head fake" in prices, but I think it is a distinct possibility due to issues of market psychology.

One think does seem certain--if we accept the assumption that oil prices will rise over the long-term, then a steady rate of increase with minimal volatility will best facilitate adaptation to a lower-energy, costlier-energy world. The "head fake" that Smith writes about is potentially very dangerous because it could cast new doubts over the very notion of Peak Oil at exactly the time when the world must address the problem with great urgency. A "head fake" would breathe new life into the abiotic oil crowd, the "markets will always provide" crowd, the Super-Hummer crowd, etc. Because I think that there is a significant possibility of a "head fake" due to market psychology (or, possibly, due to a short-term increase in supplies if the megaproject and geopolitics stars all align over the next 24 months or so), I think that our outlook and investing in the energy sector needs to incorporate a fairly long-term time horizon. I don't think that $200 oil is a sure thing this year or next (though I think it's a strong possibility). But oil under $200/barrel in 2016 seems highly, highly unlikely absent a general economic collapse (and, in that even, we have equally big problems to deal with).

Hat tip to FutureJacked.

Peak Oil Tips (Out of Backwardation)?

Has Peak Oil, as a meme, "tipped"?

One indicator of a "tipping point" for acceptance of Peak Oil may be the state of backwardation in oil futures. I first raised this idea over 2 years ago, but recent market movements, coinciding with attention in the press, may be validating it: when the markets accept Peak Oil, we will see the end of backwardation in crude oil markets, and possibly even Contango. Here's what has happened over the past 6 weeks:



UPDATE: Chart updated with 10:00 AM EST, May 19th data to reflect move into contango.

A few quick definitions: Backwardation is when prices in the future are lower than in the present. Contago is the reverse, where future prices are higher than in the present.

Normally, oil markets are in backwardation. It is conventional wisdom that oil markets will always return to backwardation for several reasons:

- The Hotelling Rule, e.g. the expectation that improved technology will lead to ever lower extraction costs (which, of course, Peak Oil theory rejects, and in fact argues for the opposite)
- The vicious cycle theory: when backwardation reaches zero, there is no incentive to hold inventory of oil, which then causes inventory to decrease, which then causes spot prices to rise, resulting in increased backwardation
- There is no incentive to fix current prices at today's price, because the time-value-of-money would actually result in you paying more than today's price for oil (which only makes sense if you accept that Peak Oil will likely lead to dramatically higher prices in the future)
- Arbitrage (discussed below)

Is contango even possible in oil markets? The conventional wisdom is no, at least not over a sustained period of time. The theory behind this is that if oil is selling for more two years in the future than it is today, then producers will use arbitrage. They'll buy a front-month oil future, sell a distant-month oil future, pocket the difference, take delivery of the front month oil and store it for delivery at the later date. This prevents oil in the future for selling for any more than the cost of storage of oil until that date, and when time-value-of-money is accounted for, that usually requires that future oil sell for less than spot oil.

Contango could exist if a few circumstances were met: present rate of oil production would need to be effectively fixed, there would need to be a consensus that future rate of production will be lower and that demand will remain highly inelastic, and there must be some impediment to storing today's oil to sell in the future. If all three of these came to pass, then the oil markets could be in significant contango and arbitrage would not be able to remedy the situation. Of course, it seems unlikely that these things (specifically the inability to store oil) will come to pass unless through some kind of political or regulatory move, but it is possible.

Because backwardation is the norm, and contango seems unlikely, I think it is highly significant that oil has gone from very large backwardation to nearly zero backwardation over just the last 6 weeks. It seems consistent to me with an emergence of Peak Oil awareness in the markets that led the market to the rejection of every reason for "normal backwardation" listed above except arbitrage (which can only maintain backwardation equal to the difference between storage cost and time-value-of-money).

It's easy to explain away the spot price of oil in isolation without resorting to some form of Peak Oil theory. It is much more difficult to explain away the dramatic decrease in backwardation.

CDSs vs. CDOs: Why the party isn't over quite yet

The Economist has an interesting article on the Credit Default Swap marketplace ("Swap Shop"). I've written about this market before, but it is one that is even more important today than it was just a 18 months ago. Credit Default Swaps are essentially bets that anyone (well, any financial institution) can place on another credit instrument (e.g. a corporate bond). You can buy or issue a CDS without being a party to the underlying credit instrument, though often the participants in the CDS market use these vehicles to hedge their risks as parties to credit issuance. CDSs are different from the current black sheep of the finance family, the Collateralized Debt Obligation (CDOs: basically a pool of mortgages or other debt that is bundled, chopped up ("securitized"), and then re-sold). While the current "Credit Crunch" is largely a result of a meltdown in the CDO market due to mispricing of risk and other negligent/reckless lending practices in home loans, the CDS market is prospering. It grew from $34.4 Trillion in 2006 to $62.2 Trillion in 2007 and continues to grow rapidly (yes, you read those numbers correctly--the CDS market is many times larger than the entire US economy, even if most people have never heard of it). Here's the rub: this vibrant CDS marketplace will actually rescue us from the "Credit Crunch," unless of course it manages to cause the entire global economy to implode in the meantime. Fortunately, that unless isn't very likely. Yet. The CDS marketplace is like a safety net. As it grows more dense, more complex, more perfectly optimized as a risk-management tool, it also becomes more rigid--losing the very flexibility that it needs to perform its function. Currently, firms use the CDS marketplace as a network of insurance policies. When something goes wrong, as long as those firms that are obligated to pay under the CDS system have the spare change to do so, the safety net functions admirably. Of course, as a largely unregulated world shrouded in the fog of murky and non-transparent accounting practices (or worse, overly rigid ones like the new Basel-II standards), it isn't really possible to tell when a firm has over-committed themselves in this CDS shadow-world. Because CDS providers make money by issuing these swaps, and because at the right price there is a virtually unlimited market to purchase said swaps, the ratio of committed reserves to actual reserves of the financial industry in aggregate is rapidly accelerating. This makes the CDS marketplace increasingly "rigid"--where rather than absorb a shock, it spreads through the network without dissipating.

At any given point--such as now--it is much more likely that the system absorbs whatever shock it receives. But, as every moment passes, the CDS system becomes more optimized, and therefore less flexible and more brittle (there are historical precedents for this). Over time it will become increasingly likely that the any given shock shatters an increasing inflexible CDS system, but, in my opinion, we're not there yet. There is still lots of room for optimization in the system--for example, this CDS-style risk-management notion really hasn't spread to the retail level. When that happens--when I can buy a CDS on my neighbors mortgage to protect myself from the decline their bankruptcy and resultant foreclosure will cause in my home value, then I'll think we've crossed the Rubicon. Coincidentally, that's a really good business idea... (note: only partial sarcasm... I've long thought that there is a huge and untapped market for retail hedging of risk exposure far beyond life, car, and home insurance: why don't more individuals hedge exposure to volatile energy costs, food costs, housing values, job markets, etc.??)

So am I just saying that, most likely, we'll recover from our current economic mess? Not quite. What I am saying is that the current economic problems are caused by a very curable problem--poor credit practices. They are, admittedly, being exacerbated by the onset of the next source of economic problems, Peak Oil, but that is not yet the underlying cause of what's happening. I must admit, the media does seem fixated on telling us how there really is a depression, right now, in America--in my opinion because they have to talk about something, and because you don't get ratings for saying "nothing particularly striking to report today, Bob." Parts of the broader media complex--blogs and websites mainly--do nothing but cherrypick news that supports their view that we're one wake-up away from a "Mad Max" apocalyptic future. All this motivates me, at times, to defend my prediction that we aren't in a recession, and that we won't see a real recession this year at all. Of course, this conflicts starkly with my other prediction that we are currently experiencing a "slow crash." Am I schizophrenic? I don't think so (who does?)--rather, I suggest that these two views are compatible provided that the differing time periods are kept in mind.

I maintain my prediction that we won't enter a recession this year. Of course, I take that narrow-minded position that a recession should actually have to conform to the definition of recession before it counts--if people are allowed to go about willy-nilly and define what a recession is and then tell me that I'm wrong when I say the current data doesn't meet the definition, more power to them. Just for completeness, US Q1 2008 GDP growth = 0.6%, and a recession is officially defined as two consecutive quarters of zero or negative GDP growth. Contrast this with the incessant ranting of the media that "7 out of 10 Americans think we're already in recession" (and the unspoken data point: 9.9 out of 10 Americans can't actually define the threshold for recession, but the media still reports their opinion... kind of like "7 out of 10 Americans think the Surge in Iraq is working" while "9.9+ out of 10 Americans don't have the data to reach an informed opinion on the topic"), the current economic figures suggest that we are NOT in a recession.

So there's nothing but smooth sailing on the horizon and I'm transitioning my oil call options into suburban homebuilders? No. There are some grey swans that could create a true recession or depression: actual and sharp decline in oil production is one of them. I don't care how high oil prices go ($300/barrel, $500/barrel), as long as it's just a bidding war for plateauing, but not yet declining supplies, this won't cause a true recession in my opinion. Our very ability to bid prices to such heights will be reflective our our economic strength. But once actual energy supplies begin to decline substantially (say, 5% from peak), then this will cause economic damage.

Net oil exports are one key data point to watch--and they may already be showing substantial declines (in the 5% range). However, to the extent that oil exporting countries are increasing domestic demand by stepping up purchases of consumables and durables from the West, this may temporarily postpone the impact of net oil export declines. No telling, yet, whether net oil export declines or actual net production declines will be the first to start to impact the global economy, but I think we'll have time for one more bout of partying before either one puts the permanent kaybash on the festivities...

Thoughts on Demand Destruction

Oil is currently well over $100/barrel. Demand is effectively holding steady in the US despite this recent run-up in price. There are some measures that suggest a decrease in demand, and the press has seized upon these to “prove” that high oil prices are causing people to drive less. I think this is cherry-picking of statistics: one commonly watched demand indicator, the one-week domestic gasoline demand figure as published by the Energy Information Agency in This Week in Petroleum actually shows a 91,000 barrel per day increase in gasoline demand for the week ending April 11, 2008 over the week ending April 13, 2007 (9.338 mbpd in ’08 vs. 9.247 mbpd in ’07). That’s a 0.98% increase year on year—so where’s the demand destruction??

This flies flat in the face of repeated statements recently in the press and blogosphere that gasoline demand is going down, so let’s look at it a bit more carefully. Here are the EIA’s full historical tables for gasoline demand, both week ending and 4-week average. Using the smoother 4-week average, the 2008 demand has been consistently lower than in 2007, but not by much. However, using the finer-resolution one week data, 2008 demand was higher than 2007 for the weeks ending 4/11/08, 3/28/08, but lower the weeks ending 4/4/08 and 3/21/08. For two of the last four weeks, demand for gasoline has been higher in 2008 than in 2007. This is hardly conclusive evidence of demand destruction, and completely ignores that the most recent demand figure shows a year-on-year increase.

Will we see significant demand destruction in the future? There is no clear answer to that at this time, but I think one thing is clear: it’s time to take a deeper look at the mechanics behind how demand destruction will work, if and when we see it (or, if we already are).

Does a lack of demand destruction when oil is well over $100/barrel mean that prices must go even higher to destroy demand? How much higher? Or is it enough that prices hold at this level for long enough to cause people to gradually make long-term purchases with this price in mind, and thereby destroy demand? How long? Finally, how much of current US demand destruction (to whatever degree it exists—even if only as a decrease in growth of demand) is due to current economic conditions, and how much can be attributed to price alone?

Figure 1: No significant demand destruction based on EIA’s gasoline demand chart… the most that can be stated definitively is that the past year has not shown appreciable US gasoline demand GROWTH over 2007.

Time-Lag in Demand Destruction: Major Purchases Drive Energy Consumption

One way that demand destruction occurs is that, when making major energy-consuming purchases such as a car or a house, people make more energy efficient choices based on the price of energy. These choices happen over time—everyone won’t (and couldn’t) rush out tomorrow to buy a more fuel efficient car, even if gas suddenly hit $10/gallon. How long is the time lag in these choices? Moody’s says that the average time between car purchases is 4.33 years. Even if we could figure out a magic number at which every consumer will pick a new car based on improved fuel efficiency, it would take at least 4 years to affect this transition. In reality, however, no one knows what percent of people would change to a more efficient car, and how much more efficient that new car would be, based on a given price of gas.

What about houses? Americans move houses on average every 5 years. Well, at least they did when they were upwardly mobile in a growing economy and sub-prime credit was easy to come by. It is yet to be seen how the current economic situation will change this figure, but it seems likely that our rate of moving will slow. In theory, when we move homes, we could choose more energy-efficient homes (better insulated, better solar design), or, possibly more importantly, homes that require less driving to commute to work. However, the massive sunk-cost in suburbia must be taken into account. While these homes may go down in value because of the commuting difference, they will likely remain largely occupied because, while the cost of commuting may skyrocket, the cost of ownership in the suburbs may decline to even this out. After all, the average American home is about 30 years old, and despite the promise of “New Urbanism” or downtown condo living to reduce gas consumption via commuting, the turnover of America’s housing infrastructure will take time.

Return on Investment Driving Demand Destruction

Demand destruction happens in other ways than buying a more efficient car or moving to a house closer to work. It is also possible to reduce demand by choosing a less convenient, less pleasurable, or slower option over another that consumer more gasoline. Take carpooling, for example. The passenger-miles-per-gallon of any car immediately doubles when a single commuter adds another commuter as a passenger. Four adults in a Honda Civic hybrid would average about 200 passenger-miles-per-gallon. Even four adults in a Hummer would get respectable mileage per passenger! If this is so simple, then why don’t we all do this? Because carpooling costs time, both in the time required daily to pick-up and drop off the additional passenger, time required to set-up the carpool system, and time in the form of inconvenience of people unexpectedly needing to work late, not being ready for pick-up on time, etc. How do we value this? There are no statistics that I’m aware of that track % of people who commute with one or more commuting passenger, or that track something similar, nor do I have any statistics for average “inconvenience time” per additional carpool passenger. At some gasoline price level, it makes sense for any given person to arrange to carpool. At $4/gallon, however, my impression is that most Americans will still value the time saved more than cutting their gasoline bill in half. The calculations for riding the bus, light rail, walking, riding a bike, etc. are essentially the same—how do you balance the money saved on gas with value of added inconvenience and additional time? For some people the decision clearly makes sense—but those are the people most likely to already carpool, ride the bus, etc. New demand destruction doesn’t occur until the price of gasoline changes the calculus, where it didn’t make sense at $3/gallon, but does makes sense at $X/gallon. How high would gas prices have to be for it to “make sense” for 50% of suburban commuters to carpool or ride the bus?

Economic Cycles and Demand Destruction

Ultimately, the kind of calculus suggested above is inextricably linked to the health of the broader economy. Rich consumers with large and growing disposable incomes are likely to value their time and potential inconveniences at a much higher rate than those struggling to buy groceries (notably, those with high disposable income are also the most able to pay now to upgrade to more efficient homes or cars, but least incentivised to do so). Another point to consider in evaluating demand destruction is the cause of economic problems. If economic problems are caused by high energy prices, then it seems accurate to consider demand destruction attributable to these economic problems as demand destruction caused by high energy prices. However, to the extent that economic problems are the result of an economic cycle, and not due to high energy prices, then the energy demand destruction that results does not seem accurately attributable to high energy prices. Our current economic troubles seem to be a function of both issues, but in my opinion more a short-term cyclical issue (inaccurate pricing of risk and the resultant correction, as I argued a few weeks ago (LINK)). At least some of the decrease in US oil demand can be attributed to economic cycles, and not to high oil prices, but we probably cannot separate these causes and isolate the portion of demand destruction caused by economic cycles. Can we even say whether or not demand would actually continue increasing at $113/barrel IF the US was in an economic boom? Does a statistic like GDP/barrel of oil consumed allow us to see through this fog? It might if we had a very accurate measure of inflation, but the CPI certainly doesn’t qualify. For that reason, comparing the 2006 GDP/barrel consumed vs. the 2007 GDP/barrel consumed is also problematic. Furthermore, it does not necessarily follow that, in a cycle-driven recession, GDP will shift to more energy efficient paths.

Conclusion

With gasoline well over $3/gallon, and oil well over $100/barrel, there does not seem to be any significant demand destruction in the US. Reasonable people can argue that demand is up about 1% or down about 1% since this time last year, but I am defining this entire range as “minimally significant.” What is the boundary of “significant” demand destruction? By significant, I mean significant impact on the supply-demand equilibrium for oil. If a low-end estimate of the decline rate for oil production post-peak is something between 2% and 5% per year, then I think that is the boundary for “significant” demand destruction. Demand destruction of 1% per year on an ongoing basis, compared with oil production decline of 5% per year, won’t have a significant impact on the supply-demand equilibrium. Conversely, a year-on-year demand destruction of 5% compared with an oil production decline of 5% has a very significant impact on the supply-demand equilibrium because it negates the impact of the production decline rate—this is a form of what Heinberg suggests in his Oil Depletion Protocol.

If this analysis tells us anything, it is that there is no easy way to calculate exactly what price point will cause demand destruction of X%. I remember when many proclaimed that $3/gallon gasoline would cause huge demand destruction. Now many of these same people proclaim that demand destruction will explode at $4/gallon or $5/gallon gasoline. Europeans, though admittedly in a very different situation, don’t seem to be driving significantly less at $8/gallon. In the end, we simply cannot know how demand destruction will unfold, and I think that is highly significant for calculating the economic impacts of rising oil prices—we have no empirical basis to either prove or disprove propositions as opposite as 1) present prices, if maintained indefinitely, will cause sufficient demand destruction to keep prices from rising significantly higher, or 2) prices will be able to at least triple before demand destruction begins to keep pace with supply declines. I know that there are nearly endless opinions on this point, but the significance of this analysis is that we cannot prove either point of view to be right or wrong. We can only wait and see what happens…

It's also worth pointing out that this analysis only considers US gasoline demand. Even if there is an ongoing demand destruction of 1% per year in the US, two significant factors overwhelm this: global demand growth remains strong, and net exports are falling precipitously (by 150,000 barrels per day in March alone). More on these items in future posts...