Lecture #8 - Energy Economics

Market Structure

1. The petroleum and energy markets are unique markets

• Petroleum companies tend to be large corporations
  • Petroleum prices influence other markets, and governments interfere or nationalize their petroleum industries.
  • The international market is important
    • Many countries like the U.S. imports a substantial amount of petroleum
      • Japan and Europe also import large amounts of petroleum
    • The last imported barrel of petroleum sets the market petroleum price.
• Petroleum companies are large conglomerate corporations.
• Petroleum companies are vertically integrated
  • They extract petroleum from the ground, transport, refine, and sell petroleum products directly to consumers.
• Petroleum corporations merged with many natural gas companies and are merging with electric companies
• Petroleum companies form international consortiums and joint ventures with other large energy corporations.
  • Partnerships develop new oil fields, construct pipelines, update and construct new refineries, and enter new markets, where countries are deregulating their energy industries.
  • Example
  • Mobil, Chevron, Murphy Oil, Petro-Canada, and the Canadian government are developing the Hibernia field.
• Electricity and natural gas networks are set up as natural monopolies
  • Reduces the cost for connecting all the buildings with pipes and wires
  • Natural monopolies tend to be regulated as public utilities
    • Government sets price that is cost plus a rate of return on investment.
    • Investment is funding for the infrastructure
      • Could encourage companies to over invest in infrastructure to get higher rates of return

2. Many governments nationalized their petroleum industries.  The reasons are:

1. Petroleum is a critical energy resource
   • National security - a supply disruption can shut down a country
2. The petroleum industry is a large source of tax revenue.
   • Example, PEMEX is Mexico’s national petroleum and natural gas company.
     • Has a complete monopoly over the Mexican economy
   • PEMEX earned a $6.9 billion loss in 2005, but paid the Mexican national government $52.8 billion in duties and taxes.
3. Petroleum companies have strong political ties with government.
   • Gazprom -The world’s largest corporation
     • Russia’s natural gas company.
   • The Russian government owns 50.002% of the shares
     • Gov. is the majority shareholder
   • Gazprom has 100% ownership in 61 companies
   • Majority shareholder in 41 companies
   • Minority shareholder in 69 companies.
     • Thus, the Kremlin indirectly controls or influences 171 companies through Gazprom.

3. Cartel - sellers organize together and make joint decisions

• Cartel tries to act like one unit, giving it monopoly power
• Example: Organization of Petroleum Exporting Countries (OPEC).
  • They control the price of oil by agreeing on how much oil each member nation will produce.
  • Formed in 1960 when five countries nationalized their petroleum industries.
  • OPEC currently has 11 oil producing countries.
    • Algeria
    • Indonesia
    • Iran
    • Iraq
    • Kuwait
    • Libya
    • Nigeria
    • Qatar
    • Saudi Arabia
    • United Arab Emirates
    • Venezuela
• Successful in increasing oil prices in 1973, early 1980s, and 2000.
  • U.S. entered into a recession a year later.
• Obstacles which prevent collusion.
  1. As the number of firms increases, collusion becomes less effective.
     • More difficult to communicate, negotiate, and reach agreements.
     • Many times OPEC could not agree on production quotas.
     • Firms have different market shares, different costs, etc
     • Firms may have trouble agreeing
  2. Strong incentive to cheat and secretly sell its product
     • Big problem with OPEC
  3. Nonprice competition (get around a fixed price)
     • Better quality & service.
     • Larger containers (more for each $)
     • Not a concern for OPEC
  4. Low entry barriers.
     • New rivals enter the market because of economic profits.
     • Economic profits decrease.
     • When oil prices are high, new oil wells are opened in Alaska, Oklahoma, Texas, etc.
     • High petroleum prices caused OPEC share of the world market to fall
       • In 1979, OPEC provided 50% of the world's oil.
       • By 1986, OPEC supplied only 30%.
       • In 2008, OPEC supplied 43% of the world's oil.
  5. Unstable demand conditions.
     • Cartels are uncertain how consumers will react.
     • In long run, consumers reduced demand for gas.
     • Bought fuel efficient cars.
     • Traveled less.
     • Moved closer to work, etc.
  6. Economy enters recession
     • Consumers lower their spending, then the cartel could breakup if they cannot sell their quotas
  7. Antitrust laws
     • It is illegal to form cartels in the United States.
     • As the threat of getting caught increases, firms are less likely to collude.
     • OPEC is outside the United States
     • OPEC was modeled after the Texas Railway Commission
       • This commission puts quotas on petroleum and natural gas production
       • Texas is depleting its petroleum so quotas have no impact, because production is decreasing each year.

4. Oil producing countries differ in extraction costs

• Middle East has the largest petroleum reserves and lowest extraction costs
  • Non-OPEC producers will not be profitable when prices are low.
• Marginal extraction cost per barrel:
  • Middle East $2
  • Venezuela $7
  • Gulf of Mexico $11
  • North Sea $11
  • Russia $14

United States Energy Consumption

The United States consumes a large share of the world's energy

• Energy consumption by sector
  • Energy comes in many forms
  • All energy sources are converted to heat units
    • Coal, petroleum, and natural gas
    • British Thermal Unit (BTUs)
    • 1 BTU = 1055 Joules
  • Graph shows units in billions of BTUs

• Energy consumption by source
  • You have to know how the U.S. economy changed to look at units
  • Example
    • Used coal to operate trains in transportation
    • No longer do that, but use coal to generate electricity
  • Electricity is not on graph because it is created from coal, natural gas, some renewable energy like hydroelectric, and nuclear
    • United States uses nuclear energy to produce electricity
      • The nuclear data has disappeared from the data set
  • Graph shows units in billions of BTUs

• The United States imports much of its petroleum needs
  • From Lecture 8, you know the United States is on the depletion portion of its petroleum production
  • OPEC also contains a large portion of the world's petroleum reserves
• Graph is in thousands of barrels

• Problems with large petroleum imports
  1. Gives OPEC indirectly lots of bargaining power.
     • Some states like Venezuela are anti-American.
  2. Large petroleum imports means U.S. dollars are flowing out into the international markets.
     • Foreign investors are leery to keep holding onto these dollars.
     • Some countries are talking about switching the price of oil to other currencies.
  3. More barges have to transport the petroleum across the ocean.
     • Loss of energy to transport more oil to the United States.
     • Indirectly, more greenhouse gases are produced.

Petroleum

1. Petroleum - companies extract thick crude oil from the ground, transport them to refineries, refine a variety of products, and then sell them to customers

• Petroleum industry is a large and critical industry
  • Diesel fuel
    • Called distillate fuel
    • Fuel for large trucks trains, and ships
    • Heating oil for furnaces
  • Gasoline
    • Fuel for cars and small trucks
• Refineries produce hundreds of other products
  • Petroleum companies may also supply natural gas (i.e. 95% methane gas)
    • Natural gas comes out of some of the wells too.
  • Uses
    • Stoves, water heaters, and heat furnaces.
  • Processing gain - as crude oil is separated into products, refineries produce more volume as output than inputs
    • A barrel of oil is 42 gallons
    • The refinery gets 44 gallons of products
    • Densities of some materials increase, causing some chemicals to occupy more volume
      • The same matter is present
• Picture shows major products

2. Economics of Petroleum

• Demands for diesel fuel and gasoline are derived demands
  • Petroleum is a large international market
  • Model a large country that influences the world price for petroleum
• Create an Excess demand function by subtracting the Demand function from the Supply Function.
  • Excess demand function becomes the international demand for petroleum
  • The amount of trade, T, has to equal the amount imported, Q _T - Q _D
• Similarly for exporting countries, you create an Excess Supply Function for exporting petroleum
• Demand for petroleum
  • Refineries – they use petroleum as an input
• Supply for petroleum
  • Oil companies – they extract and transport oil to the refineries
  • They are usually the same companies on both sides of the market

• Petroleum refinery creates gasoline for cars
  • Supply is from petroleum refineries
  • Demand is from drivers of cars and trucks

• Supply function goes vertical at Q _C
  • This is the refinery capacity
  • Refineries increase capacity about 0.37% per year
    • No body wants refineries near their homes
    • Homeowners sue the petroleum companies in court preventing construction
• Americans are increasing their demand for gasoline
  • Demand function increases and shifts right
    • Market price and quantity are higher.
  • If demand exceeds the refinery capacity, then market price shoots up dramatically.
    • Refineries do not supply more than Q _C to the market

• Higher demand causes petroleum refineries to increase their demand
  • Excess Demand function shifts to the right
    • International price for petroleum increases
      • Helps increase domestic production
    • More petroleum is traded in internationally trades
  • For the United States, more U.S. dollars flow into the international markets.

3. Malthusian idea

• Peak oil (or oil depletion) - the world is running out of petroleum
  • Modern civilization is built upon a cheap energy source
    • United States may be more vulnerable
  • Civilization could collapse as petroleum is depleted.
  • Some forecasters predict we will not have any more oil within a decade.
  • The real problem is liquid fuels for transportation - motor vehicles, aircraft, trains, and ships have no ready alternative.
• Petroleum is a critical resource
  • Used in making cheap transportation fuel, like diesel fuel and gasoline
  • Used to make fertilizers, detergents, solvents, adhesives, and most plastics
    • They become more expensive as petroleum is depleted
    • With larger populations, then more people can starve as food crop yields decline from less fertilizer
• A majority of Americans live in suburbs
  • Suburb
    • A type of low-density settlement located outside of cities
    • Usually jobs are miles away, so requires cheap gasoline and automobiles for people to travel to work.
    • Some argue that this is unsustainable.
  • Peak oil would leave many Americans unable to afford petroleum based fuel for their cars, and force them to move to higher density areas, where walking and public transportation are more viable options.
  • Suburbia may become the "slums of the future."

4. Petroleum Prices and Recessions

• The petroleum price influences all markets in an economy
  • Petroleum supply shocks impact an economy’s growth and employment.
  • For example, U.S. recessions occur approximately a year after dramatic petroleum price increases.
• Oil price shock
  • Contract supplies in the petroleum and chemical industries
  • Contract market demands for apparel, automobile, furniture household appliances, and lumber products
• Real petroleum prices may influence the economy asymmetrically.
  • If real oil price increases dramatically, then the economy grows slower.
  • However, if real oil prices increase a little or decreases, then petroleum prices have little or no impact on the economy.

5. Backstop Technology for petroleum

1. Coal liquefaction - coal is converted into liquid fuels like gasoline or diesel by several different processes.
   • Coal has a high carbon content.
   • China - invests heavily in this technology
     • China does have some petroleum reserves
       • However, China is developing into a large importer of petroleum
       • Liquefaction is a means to reduce dependence on foreign oil
     • Supposedly liquefaction is profitable with an oil barrel price of $40.
2. Tar sands and oil shale
   • The process of extracting oil from tar sands is more energy intensive.
   • Example - Canada has large reserves of tar sands and shale
     • To extract the oil from sands or shale, the oil has to be melted out of rocks.
     • Requires more energy
     • A gallon of gasoline from tar sands releases 3 times more greenhouse gases than a traditionally produced gallon.

Electricity

1. Electricity industry - provides electricity to consumers, businesses, and industries

• Electricity industry
  • World's biggest producers
    • United States
    • China
    • Japan
    • Russia
• Transmission lines connect power stations to the end users usually in urban areas
  • Called the grid
  • Transmission lines allow a maximum amount of power
    • If power is exceeded, then breakers turn the power line off
    • Causes a blackout where consumers get no electricity
  • Has a capacity constraint
    • Legal problems to upgrade lines
    • Further, lines cross states with different rules and regulations
  • Transmission lines are usually 110,000 volts
    • Three-phase power - technical term that means all the lines are "hot"
• The United States has three broad regions where the power lines are connected
  • The east, west, and Texas.
    • Texas did not allow the state to join the grid with Oklahoma
    • Then the U.S. federal government could regulate the Texas electric power companies
  • Problem
    • Cascading blackout - if everyone is using power at the maximum, then if one power station is overloaded, and shuts down, the load switches to other stations, causing them to overload and shutdown.
    • Then a whole region losses power
  • Many stations are computerized that shuts power off to some customers, preventing the system from being overloaded.
    • Either a hacker in China or Russia hacked into one of the computer stations, leaving a program that could disrupt the system on April 8, 2009.

2. Economics for electricity market is similar to the petroleum

• Economic analysis is similar, i.e. derived demand
  • Most electricity in the U.S. is produced from coal
  • Some electricity is imported/exported to neighboring countries
  • Major difference - electricity cannot be stored on a large scale
• Coal - a fossil fuel
  • Coal is extracted from the ground by mining, either underground or in open pits.
  • Note - Nuclear is another large source of electricity
• The process
  • Coal is burned in furnaces or boilers
  • Water is turned into steam
  • The steam turns the turbines
  • The turbines turn the electric generators
• Thermal efficiency
  • 30 - 35 of the heat energy is converted to electricity
  • New technology can push the efficiency to 40% and higher
  • Expensive capital upgrades
    • Remember - grandfathering of command and control regulations
    • Companies keep the old plants running, avoiding the new tougher regulations

3. Coal Reserves and Producers

Note - Coal is traded among countries. I did not put this statistic in there.

4. Environmental effects of coal

1. Largest source for greenhouse gases like carbon dioxide
   • The primary gas responsible for climate change and global warming.
   • In the United States, electricity generation accounts for nearly 40 percent of carbon dioxide emissions.
   • Transportation emissions contribute about one-third of U.S. production of carbon dioxide
     • Second largest source
2. Generates millions of tons of waste products
   • Waste products include fly ash, bottom ash, flue gas desulfurization sludge
   • Ash and sludge contain mercury, uranium, thorium, arsenic, selenium, and other heavy metals
   • These metals are harmful to human health and the environment
3. Acid rain from high sulfur coal
4. Could contaminate groundwater
5. Dust nuisance
   • Supposedly coal-fired power plants shorten nearly 24,000 lives a year in the United States
   • Supposedly 2,800 from lung cancer.