Friday, June 13, 2008

Oil is too expensive

The reason oil is too expensive is that the current price encourages seeking out new oil that is expensive to produce. That is not the same as the reason oil is expensive.

The US Senate defeated a windfall profits tax measure that would have taxed oil companies on the high price of oil. It was defeated on a cloture vote: 51 to 43, a majority supported the closing of debate. It is getting close and one can guess that in November, this will be a deciding factor in some senate races and is already an issue in the presidential race: http://www.iht.com/articles/ap/2008/06/10/america/NA-POL-US-Congress-Oil-Profits.php.

There is not really a good reason not to capture the portion of the profits that are made on domestically produced oil since the only use for them is to reinvest in oil exploration which is becoming fruitless. But, capturing the profits does not do anything about the price of oil except to push it up a little faster since the oil exploration is not yet entirely fruitless. But, oil exploration is pointless now and for this reason it needs to be strongly discouraged. The way to discourage oil exploration is to reduce the price of oil rather than to stomp on a bunch of profit brushfires. While prices are high, some one somewhere will be exploring and finding oil that is expensive to produce even if we (in the US) manage to keep that from happening here through tax policy. Then everyone will be able to buy just as much oil as they can afford and the cancer of expensive oil will metastasize right back here where we might have stamped out incentives to find expensive oil. But, if the price of oil is reduced below the cost of producing expensive oil, then only cheap oil will be pumped from the ground and no one anywhere will bother to explore for expensive oil.

We can tell that oil is too expensive when people are working to be able to get to work or when people who have retired are choosing between heat and food. The promise of oil has been broken and it is time to give it up as a bad job. So, we need to make sure that people can get to work and keep warm while having something to eat. And, we need a good portion of the remaining cheap oil to get through to a point where these things can be done without using any oil. How do we ensure that we get that cheap oil at a price that reflects what it costs to produce rather than the scarcity of oil compared to how we use it now? We need to be sure that we are not using oil any faster than the remaining cheap oil can be pulled from the ground. If we try to go faster than that, we'll encourage people to look for more expensive oil since oil will seem scarce and thus worthy of investment.

Our policy should be focused on keeping oil inexpensive and to do that we need to aggressively phase out the use of oil. There are some sectors where we can't do this such as aviation, but in most we can move rapidly, and, more importantly, we can move rapidly enough overall. If the US alone, were to cut its per capita consumption to seven gallons a week down from nine, (think carpools and second small cars) we'd cut world consumption by about 6%. Dropping another weekly half gallon a year for fourteen years would cut world consumption by 25%. That is surely enough to keep the world on the cheap oil supplies out to 2025 or so since these supplies will be extended a bit by the reduced demand.

How to implement this policy? We might try simply restricting imports by a quarter or so. This would surely drop the world price of oil below $20/barrel. But, the domestic price of oil would likely be pretty high, $400/barrel or so, and this would encourage all sorts of foolishness in terms of looking for expensive oil domestically. We don't want to encourage that.

We could try imposing a tax, say $380/barrel, and that should solve the problem of encouraging exploration for expensive oil domestically and abroad, but is might be destabilizing for the government since the revenue would cover much more government spending than current taxes and we were warned by the chairman of the Federal Reserve at the beginning of the current administration that paying our national debt would be a bad thing. Also, since domestic oil prices would be even higher than now, we will have failed on the getting to work and keeping warm and eating portion of our problem.

Usually, when we have something serious to undertake, we ration. If we can get gasoline down to about $0.60/gallon by being careful how we use it, then our shared sense of accomplishment should help us do the rest of the transition down to using no gasoline at all. We have an existing rationing plan http://www.osti.gov/energycitations/product.biblio.jsp?osti_id=6307185 and it includes a white market in rations. This means that rations can be sold/traded, placing the cost of (rationing imposed) scarcity on the rations slips rather than the fuel. Getting to work or staying warm end up costing less though you might be making a choice on how to convert either of those two within a few years.

Just now, such an effort is doable, but if we wait for expensive oil to gain a greater share of the world total production, then controlling prices by controlling demand will be more difficult since there will be a floor price for much more of the production. In that situation, we will need to reduce our oil consumption probably just as much, but we won't gain the benefit of getting the cheap oil at a low price.


The core reason oil is too expensive is that the current price encourages exploration for expensive oil. Oil is useful when it is cheap to produce and cheap to buy, but it becomes harmful when it is expensive to buy, and even more harmful when it is expensive to produce since this places a price floor that no amount of consumption control can break. It is crucial not to spend resources on exploring for expensive oil. At present, only the US, as a single market entity, has the power to force only cheap oil to be produced and to end exploration for expensive oil. Others could, in combination, have a similar effect, but may not have the existing coordinated plan in place and thus may not be able to take such action before too much expensive (to produce) oil is on the market. The US should implement rationing as soon as possible to drive down the price of oil below $20/barrel and encourage other countries to also restrain demand. A window of perhaps 20 years of $20/barrel oil might be achieved through managed demand, plenty of time to manage a transition away from oil at low cost.

24 comments:

popmonkey said...

a very interesting point of view that is unfortunately totally unrealistic because the consumer is way too uninformed to understand what's going on. expensive oil is a constant reminder to conserve, develop alternatives, and thus pressure politicians. the moment the prices go down people will say that peak oilers were wrong again, get back to buying SUVs and the cycle starts again.

and rationing at the level that would be needed will just cause strikes and riots and push prices up anyway. there's no way that rationing + low price at the pump can coincide in a market economy.

Chris Dudley said...

I would think that the thing that keeps the SUV use down would be the fact that you can't get all that far on 7 gallons per person per week with a SUV per family. You might work it out as a shared vehicle. Smaller cars would extend the range of single or low occupancy trips.

Now, it is possible to buy rations with the sort of white market that the DOE envisions, so you might think you could go farther, but those white market rations are likely to be bid up to over $400/barrel equvilent. Once you go over your ration, things get very expensive (this is a market after all) and you also have an oportunitiy cost of not being able to sell rations you didn't use.

Again, it is a market, it is just that it works more like tiered electric rates to very stongly encourage conservation and transition.

popmonkey said...

i can totally see it working after some period of turmoil. but that period might last a long time, 5 years?

i guess i just don't see america going to a gasoline rationing existence as the norm anytime soon. not without troop deployment...

nor do i see any politicians brave enough to even suggest such a thing. not without martial law...

i may be totally wrong - and the idea is certainly intriguing...

Chris Dudley said...

I don't think we've had martial law when we have rationed in the past. The nice thing is that turmoil is avoided. We know for sure what our track off of oil will be, and we know what it will cost.

richard said...

Chris your mistaken and dreaming if you think society would put up with your idea - wake up we live in a free market driven economy - we are capitalists and to implement your idealistic views would involve much more sever forms of socialism
get a grip mate

Shaun Chamberlin said...

Hi Chris, I am the Development Director for TEQs (Tradable Energy Quotas) and I found your post via the Oil Drum.

TEQs is essentially the tradable rationing scheme you advocate, but expanded to encompass all energy use within the national economy.

This addresses popmonkey's points to some extent as it means that the scheme operates to smooth gas prices - if there is shortage gas prices go up, which means demand for gas (and thus TEQs permits) falls. As demand for permits falls the price falls, so the total cost to the consumer (fuel + permits) is stabilised to some degree.

The default alternative, where gas is simply 'rationed by price' is getting very unpopular very quickly. The reason rationing has a bad name is because people associate it with shortage, but of course it is a response to shortage, not the cause. A public education/marketing campaign could address this.

With regard to Richard's point that this is unrealistic, I imagine the US will be some way behind, but this scheme is already being taken very seriously here in the UK, as you can see here on our site.

To be honest, I think some form of rationing is not only sensible but inevitable as peak oil bites, and we are looking at half the current global production in a couple of decades time. The earlier it is introduced the better.

Chris, I'd be interested to know your thoughts on the TEQs scheme design - do come join the discussions in our forum at www.teqs.net

All the best.

Chris Dudley said...

Shaun,

Welcome. I've come to like TEQs to some extent but I've found that breaking through on the idea of tradable rations seems to work best now by quoting the US Department of Energy and saying that is our rationing plan. I think that once we get a taste of what we can accomplish with gas rationing, it will be natural to step towards carbon rationing.

David Fleming persuaded me that TEQs end up as price in anything other than direct energy purchases since it is unlikely that the carbon emissions cost of a tomato will be charged at the supermarket if the TEQs really are tradable. That was a disappointment to me because I'd hoped that tracking carbon use down to the tomato would really get everyone's creativity engaged. So, I am thinking now that TEQs should be suplemented by disclosure of carbon use involved in consumer goods.

I am not opposed to separate treatment for different sources of carbon dioxide. Gasoline rationing fits with other economic concerns while a moratorium on new coal plants seems to be gaining traction. Targeting plants to shut down might be a next step. There is nothing special about putting all fossil fuels together if we can reduce each seperately. Increased reliance on gas, as George Monbiot suggests, may even be a good thing if we can use methane to store renewable energy such as wind. The infrastructure can be reused....

TEQs don't really separate sources of emissions as worthy of individual policy decisions. When I was in West Virginia this weekend, I spoke with some anti-coal mining folks; I can see the case for ending the use of coal even if carbon capture and sequestration works. TEQs don't really decide these issues and that can be a problem just like cap-and-trade which still dumps mercury on someone somewhere even if it is less overall.

But, there are definite advantages of TEQs over cap-and-trade at the producer level or a carbon tax.

Chris Dudley said...

Richard,

Welcome. I think you need to study political theory a little more closely. Rationing is not socialism. And, as you can see, since we are discussing tradable rations, it is certainly a market.

The claim here is that expensive to produce oil is bad and we need a market method to avoid developing these non-resources. It is quite obvious that expensive to produce oil is bad. To function well, an economy needs to devote as little effort as possible to obtaining energy. This has been the promise of oil in the past but now this is no longer possible for geological reasons.

The question we face then is what market mechanism will work to avoid pointless investment in expensive to produce oil?

Taxes might work but they put too much revenue into the hands of government. Rationing does the job more effectively since it keeps the market and cash flow largely private.

Hope that helps.

Cyril R said...

There are positives and negatives about pretty much every policy instrument, but I think the idea of very restrictive rationing, as effective as it could be, is an utter political and social loser. The point at which there will be enough momentum for large scale implementation of a rationing programme, will be when there's chaos and conflict roaming about. That is to say, it will likely be too late.

Chris Dudley said...

Cyril,

Welcome back!

As I linked in the post, we have a standby gasoline rationing plan. So, it would not take all that much to implement. We have a history of rationing at difficult times so I think your social/political objections have to be set against the perception that high oil prices are actually a problem. We are rationing by price now that supply is tight in any case.

One thing that I have found out since I wrote the post is that while the Economic Regulatory Administration which is responsible for the rationing plan is required to exist in law: http://www.law.cornell.edu/uscode/42/usc_sec_42_00007136----000-.html
it has not been active for some time. Ray Madden, at the Inspector General's Office at the Department of Energy does not know how long this mandated portion of the government has been missing but he did send me a link to a Congressional Budget Office study of a proposal to eliminate the DoE in the eighties. Perhaps the ball has been dropped for that long. He is going to look in the DoE library to see if there is more information.

In any case, there is a need to appoint an adminsitrator so that the plan can be brought up-to-date. The White Market portion of the plan, foe example, discusses a ration rights checking account set up. But one might want to use a debit card these days.

Anonymous said...

Interesting ideas, but it will take some real shifts in public attitude to accept. Gasoline being $10/gallon might get people started, with oil at $300/bbl this would mean the domestic oil companies losing 7mbd*($300-$20)= $2 billion per day. How are they (and their investors) going to deal with that?

Cyril R said...

Well since we're talking serious and unrealistic policy, how about only a vanilla tax on gas? No exceptions. Easy. All petroleum derivatives costs ten cents more per gallon, escalating @ 50% nominally per year. Effective immediately. By 2020 that's around 13 bucks per gallon extra.

This would be an aggressive tax, but not so aggressive as to kill domestic industries that heavily rely on oil such as transportation, because it still gives several years for such industries to make the transition to electric transportation and efficiency and conservation. They will know what's coming make the necessary investments.

Chris Dudley said...

Cyril,

Al Gore wants a carbon tax with tax shifting, replacing payroll tax while Hansen likes cap and share where the revenue would be distributed to people directly. I've supported a carbon tax in the past, but in this case, I am arguing for the fastest means to discourage exploring for more oil. This is not how a phased in tax would work since it takes a while to curb prices and may only curb them down to $60/barrel since depletion still makes oil scarce in the future.

There are problems with carbon taxes as well beyond being poor tools for price manipulation. In Gore's version, he destabilizes Social Security funding while in Hansen's version we get too much revenue flowing through the system as I mentioned in the original post.

It is worth remembering that the first big cut in consumption is the easy one. We can just change behaviors: heat with electricity rather than oil (a savings in money now), drive less and perhaps with a smaller used car, and carpool. The subsequent cuts require new technology and come at a slower pace. But it does run in about your proposed timescale.

That link to the law concerning the Economic Regulatory Administration does not seem to be working so I'll try again.

Cyril R said...

Perfect combustion of a gallon of gasoline emits almost 9 kilograms of CO2 so a carbon tax would work just as well. It's also more equitable as it closes the coal to liquids loophole as well as coal fired generation and other coal uses.

With a carbon tax of 10 USD/metric ton to start with, that adds 9 cents USD per gallon right now. Escalating similarly that's more than 11 USD per gallon around 2020.

This should push the market nicely, don't you think?

I think the straight carbon tax is more feasible than rationing. I'll admit rationing would be more effective, but if we can't get it off the ground it has no effect at all... the disadvantages of carbon taxing are not a huge problem IMHO.

Cyril R said...

Chris, what do you think of Al Gore's plan to "tax what we burn, not what we earn"?

This seems like an excellent idea. The income taxes will be lowered by the same revenue gained from carbon taxes. As the carbon tax increases over time, income taxes decrease. This will greatly help solving both greenhouse gas and peak oil issues, while not hurting the people.

Chris Dudley said...

Cyril,

A problem with tax shifting is that it may undercut a stable funding structure. Currently, social security is payed for by future beneficiaries. Making it dependent on a sin tax that, if successful, will generate no revenue ASAP does not seem prudent.

Again, my aim is to terminate investment in new oil production because the easy oil is gone. The way to assure that through unilateral action is to cut consumption significantly now. A phased in tax is basically just price support that won't drive the price of oil down globally.

I don't see much wrong with our rationing plan aside from the need to have a functioning office to run it.

Cyril R said...

A phased in tax is basically just price support that won't drive the price of oil down globally.

It won't have to do that precisely, because such a tax would discourage demand for oil and encourage non-oil alternatives. Which will be effective enough if the tax is high enough. It's also the mass psychological effect: an increasingly strict tax that doesn't go away, ever. That means certainty of high cost of oil in the future, which will encourage investment in alternatives even more. This is one of the reasons I think there must be long term certainty of increasing taxes. With future demand essentially destroyed, there will not be much reason to invest in new (expensive) oil exploration in the first place.

Chris Dudley said...

Cyril,

A high enough tax, say $30/gallon, would be impoverishing. It seems to me that if we want to have a large effect now, you would need to start with a high tax while, with rationing, we can do the easy 20% reduction first and see the price come down so that we have less pain in the wallet. Then, we need only do the further reductions incrementally, keeping ahead of depletion, until we are off of oil.

Again, what is the incentive to get entirely off of oil with a tax?

Cyril R said...

Again, what is the incentive to get entirely off of oil with a tax?

The guarantee that a tax will be there in the future and will only get higher will ensure the brunt of investments will be diverted from oil while still giving companies and consumers time to adapt. Time they will need, because investments that have been made have inherent inertia. While getting off of oil is urgent, it is not something we have to do in a year or two. The capital destruction will be severe. And then there's the risk of civil conflict.

It's important not to trivialize the (risk of) economic damage and even social turmoil that radical short term measures entail. Oil is so pervasive in the economy, it's not just the consumer, it's all sorts of companies that run serious risks of being destroyed by rationing meausures.

Surely you don't want a large number of US companies to go bankrupt? Or risk nation wide social uproar, even civil war?

I don't think the tax will be impoverishing because it's a long term (about a decade) strategic price signal. It's like knowing for sure that oil will be very expensive over the next decade. People and companies will adjust their investments and behaviour (like moving close to work, not buying an ICE car, not investing in oil based chemical feedstock plants etc.) You don't want to do that in a year or two, it takes time.

Cyril R said...

Also Chris, I get the feeling the whole issue is a typical case of penny wise pound foolish. All the investment in expensive oil combined is only a tiny fraction of total global investments. Why try to save a penny if it comes at a significant risk of loosing a pound? No one would participate in that lottery!

Chris Dudley said...

Cyril,

I think you have missed my point. I also anticipate a decade or so transition. I just do the easy 20% first rather than impoverishing people over the next decade. Things are more gradual after the first 20%. While the US has had civil unrest in response to taxes, a revolution in fact, this has not been a problem with rationing.

Again, the tax does not end oil use.

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