February 21, 2007
Donald R. Byrne, Ph.D.
Edward T. Derbin, MA, MBA
Note: To print a hard copy of this newsletter, click on the following link for a PDF download…
ENERGY, ENERGY, EVERYWHERE – BUT WHY DOES IT COST SO MUCH?
One thing the world does not lack is the ability to produce lots of energy. Despite the pessimism, there are plenty of fossil fuels and non-fossil fuels; many of which are renewable and will help us to generate much more energy than we are currently producing.
The first part of the newsletter shows the plethora of fuels needed
to produce electricity, power vehicles and mechanize production, heat
buildings, and provide feedstocks for the chemical
industry, etc. We will stress the
The second aspect of this newsletter is to examine the degree and implications of the growing concentration of market power controlling supply and price in this area.
The Total Environment
– or Big E versus environmental myopia
The third part of the newsletter is to examine the overall environmental picture as opposed to the narrower view of environmental concerns. This narrower view has led to higher energy costs as well has enhancing the monopoly power of firms producing energy.
In a recent report by the U.S. Department of the Interior,
it was revealed that since 2002, a number of major oil fields have been
discovered in the Gulf of Mexico, east of
Service (US Department of The Interior)
The question is what
incentive has a domestic producer to exploit those finds when they can charge
nearly $60, without increasing production (with its consequent fall in
price). This disincentive is further strengthened by the continued
pressures from the environmental movement with their accompanying cataclysmic
fears of despoiling the “pristine”
This newsletter article is dedicated to sorting through the voluminous data and making some sense of our current energy dilemma.
Some graphs from Energy Information Administration
Annual Energy Outlook 2007 with Projections to 2030
In the following tables and other graphics from the Energy Information Administration we’re showing how the entire energy outlook appears from today through 2030. In 2005 our imported energy was 34.4% of total consumption (85% petroleum based); in 2030 that portion rises to 35.4% (81% petroleum based).
In Table A1, you’ll first notice that the presentation of the material is in QUADRILLION Btu.
2005 (Energy Picture)
1) The U.S produces 70 percent of its
2) Imports amount to 34.5 percent (85% of the imported energy is Petroleum or other liquid fuels)
3) Exported product nets out to 4.5 percent (this is then netted against the Imports)
4) Total U.S. Consumption was about 100 quadrillion Btu in 2005
5) Price levels are projected to remain fairly stable out to 2030 – yet another indication that supply is not as large of a problem as one may be led to believe.
Annual Energy Review (AER)
- Long-term historical statistics all in one place
Annual Energy Review 2005
Report No. DOE/EIA-0384(2005)
Posted: July 27, 2006
In the following flow
diagrams, we see the sources and uses of energy in the
Remember that the total energy inflow includes imported product as well as domestic. The outflow represents consumption in the various sectors of the economy (residential, commercial, industrial and transportation).
Watch that Energy Flow…
Total Energy Flow, 2005
Petroleum Flow, 2005
(Million Barrels per Day)
For petroleum, bear in mind that roughly two-thirds of its Crude Oil inflow is imported, while roughly two-thirds of its outflow goes to transportation. The majority of the Industrial use is for petrochemical feedstocks (fertilizer, etc.)
Natural Gas Flow, 2005
(Trillion Cubic Feet)
For natural gas, less than 20% of what
Coal Flow, 2005
(Million Short Tons)
Electricity Flow, 2005
Nuclear power accounts for roughly 20% of
electricity production in the
Putting it all together…
Petroleum usage is 68% dedicated to Transportation; Natural Gas is 36% to Residential and Commercial; Coal is 91% dedicated to Electricity production; Renewable is 61% dedicated to Electricity production (mostly hydroelectric); Nuclear is 100% dedicated to the production of Electricity.
In the following summary of Total Energy Consumption, along with some other statistics, it is important to keep in mind that the entire energy picture, while dynamic, is absolutely enormous and one should try to keep an eye on the ever-changing trends. While carbon dioxide emissions are slated to rise over the next several years, shifting toward “cleaner” fuels or reducing emissions associated with coal, for example, could significantly improve/lower the CO2 levels.
“Why stand we here idle? What is it that gentlemen wish? What would they have? Is life so dear, or peace so sweet, as to be purchased at the price of chains and slavery?”
Patrick Henry, Second Virginia Convention at St. John’s Church – Richmond, Virginia, March 23, 1775 http://www.ifcwtc.org/words6.html
The Price (Real Price) of Imported Petroleum???
An Inquiry into the Nature and Causes of the Wealth
(First published 1776)
“People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”
-- Adam Smith
Book 1, Chapter 10
Of Wages and Profit in the Different Employments of Labour and Stock
From the Adam Smith
(July 17, 1990)
“For Smith, government should not seek to subvert the creative process that is the market, but should establish the framework necessary to keep it alive. It should enforce competition. It should not give in to the well-argued demands of monopolists and would-be monopolists. It should punish people and authorities who conspire to fix prices, divide up markets, or restrict production. "Monopoly," wrote Smith, "is a great enemy to good management."
Michael Forsyth MP (British)
Adam Smith's Relevance for Today
Price Elasticity --- An Economics Lesson
Markets are where two forces of reality confront one another, the reality of demand and the reality of supply.
What lies behind demand?
The laws of supply and demand are the preference of the buyers, what they want, but they have to have income to back it up. It is what we call an effective demand – a demand without income is not effective.
Therefore, it is the preference of people that is backed up by their income, the more income they have, the more they can manifest their preferences. Remember, they get the income by supplying resources. They did that in what we call a resource market.
They then coming to the product market (consumer goods and services), utilizing that income to reveal their preferences and buy goods and services, hamburger and fries, gasoline, canned goods, meat to cook, or even having a haircut at the barbershop.
Behind the supply lies the scarcity of resources, technology and diminishing returns in the short run, and the need to bid resources away from other uses.
These two forces of reality (supply and demand) confront one another, and determine what will be the equilibrium price and the equilibrium quantity.
The equilibrium price is the price, which equates demand and supply. Quantity demanded equals quantity supplied; equilibrium quantity is that very quantity determined by the equilibrium price (where the supply and demand curves intersect).
It is the only price at which quantity demanded equals quantity supplied (where the market is cleared).
If the price were above the equilibrium, in terms of supply, quantity supplied would increase and the quantity demanded would decrease…the gap in between would represent a surplus.
Now if there were no power in the market, no monopoly power to control supply, the surplus in the market would drive the price down to the equilibrium where quantity demanded equals quantity supplied. …And it would do it rather quickly.
This is referred to as the Walrasian Market Adjustment Process that occurs in competitive markets.
At a price below the equilibrium, quantity demanded will be greater and the quantity supplied will be less than the equilibrium.
This is a shortage: where demand exceeds supply.
Assuming no power in the market to restrict the movements, then the existence of a deficit or shortage will drive the price back up to the equilibrium level.
The quantity demanded shrinks and the quantity of supply increases until it once again reaches equilibrium.
Equilibrium is the only price then that has neither surplus nor shortage. Again, more specifically, we call that the equilibrium price which results in the equilibrium quantity.
Scarcity still exists…
Scarcity can exist with a surplus. Scarcity is when everyone can’t have all they want of everything they want.
Shortage simply means that the quantity demanded exceeds the quantity supplied.
The surplus and/or shortage that we refer to are the disequilibrium positions of price, while scarcity simply means that a price must be paid for a product – it is not a free good.
Market Power – Price Power
If a firm acquires power in the goods and services market, energy in this case, there is harm done to society.
The firms, in this case the oil sector, can restrict supply and raise the price, pushing the price of the energy above its equilibrium level.
The end result…
When the consumer spends its income, they get less quantity at a higher price, while the firms’ productive resources (including the owners/shareholders) receive more than their opportunity costs.
In economic theory we say that the producer surplus increases (economic rent) by expropriating some of the consumer surplus.
The goal then of market power is to restrict supply in order to raise the price – as long as profits are increasing.
If the firm was pricing its product in the price inelastic portion of its demand curve, total revenue (price times quantity demanded) increases even though quantity demanded decreases.
If, however, the firm was pricing its product in the elastic or upper portion of the demand curve and they were to raise the price, total revenue would fall.
TR = P X QD
The total revenue a firm receives from selling a product depends upon the product of Price times Quantity Demanded (P X QD)…price times quantity demanded equals total revenue (P X QD = Total Revenue).
Now you have to stop and pause and think about this.
All else equal (ceteris paribus),
Profits = Revenue – Expense (cost)
When revenue rises, profits rise
When revenue falls, profits fall
…holding cost constant…
The above illustration should help you to understand the relationship of a demand curve, which is really an average revenue curve, or price curve (average revenue, meaning average revenue per unit) and total revenue, which is price times quantity demanded.
If you look at the demand curve, the total revenue is a rectangle, an area bounded by the price times its respected quantity demanded as it drops down from the demand curve. Now if we were to do this for each price, we would take the area of the price times the quantity and demand that corresponds with it and convert the area to a vertical line, you would have the height, representing total revenue. So, beneath the demand curve, we have a total revenue curve, and we try to relate it to the demand curve or the average revenue curve directly above it.
We can see that the total revenue is zero where the demand curve intersects the quantity demanded axis; which means no matter how much you sell, if price is zero…then total revenue is also zero.
Then as we raise the price, price times quantity demanded, or total revenue increases, it reaches a maximum at the midpoint of the demand curve
Note that further increases in price causes a decrease in total revenue.
So hence you see, the total revenue curve below the demand curve or average revenue curve, as an inverted “U” where the maximum total revenue corresponds to the midpoint along the diagonal of the demand curve.
This is an extremely powerful notion, in other words, if you start raising the price from zero (from the price (vertical) axis), total revenue rises, at a decreasing rate; it reaches a maximum at the midpoint on the demand curve, and further increase in prices cause the total revenue to start decreasing (at an increasing rate). Finally, at the price where the demand curve intersects the price axis, the revenue is zero once again.
No matter what the product is, they all follow the same law. If you keep raising the price, eventually revenue will fall…even for such things as cigarettes and gasoline.
In other words if we look back at the demand curve, assuming it is a straight line demand curve for ease of explanation, the upper portion – above the midpoint, is the elastic range where price increase causes revenue to fall.
The lower half is the inelastic range, where price increases causes revenue to rise. This is counterintuitive to most people.
If we go the other way, we would notice that in the elastic range, the upper half of the demand curve, as price is cut, revenue rises. However, when we get to the inelastic range or the lower half of the demand curve, as price is cut or decreased, then total revenue falls.
In other words, total revenue in the elastic range moves in the opposite direction of price changes. Alternately, in the inelastic range, in the lower half of the demand curve, price and total revenue rise and fall together.
Price Elasticity of Demand
The relationship of the price of a good to the quantity demanded of that good is normally negative or inversely related – when price rises, the quantity demanded of that good falls and price falls, quantity demanded of that good rises. The degree to which quantity demand responds to price depends upon substitution effects and income effects. Most goods are normal (as income rises, you buy more of those goods), so the income effect reinforces the substitution effect. The substitution effect simply means that when the price of a good increases, you will tend to buy less of those goods and more of the substitute goods whose price remains constant.
The percentage change in quantity demanded divided by the percentage change in the price that caused the change in the quantity demanded
(QD1 – QD2)/QD1
(P1 – P2) / P1
How market power and its accompanying price power exploits the consumer…
In the following graph, we can see how the oil industry led by OPEC finds it advantageous to restrict output in order to increase its total revenue and profits. Remember that as long as the price remains in the inelastic (lower portion of the demand curve), price increases will result in increased revenue and profits.
Enter the mind of the Monopolist:
Cartel à Monopoly Power: First, it’s OPEC’s turn…
(1) We’re only addressing the insatiable
American addiction to oil and to maintain a balance (to increase revenues and
(2) The world’s reserves are limited and we’re doing the best we can (again, to increase revenues and profits)
(30 November, 2006)
“Top oil exporter
For those of you that still think that the price of oil is driven by rising costs alone
According to International Energy Agency, in its Resources to Reserves publication from 2005 http://www.iea.org/textbase/nppdf/free/2005/oil_gas.pdf,
“Oil and gas totaling 1.5 trillion barrels of oil equivalent (boe) have been produced to date. Roughly the same amount will be needed to meet demand over the next 25 years. The world contains at least 20 trillion boe of oil and gas. Some 5 to 10 trillion boe are technically recoverable today.”
Full Text of report
(Resources to Reserves)
Interpreting the charts…
WEO (World Energy Outlook) required cumulative need to 2030: 1.5 trillion boe from 2006 – 2030
Other conventional oil sources able to produce 1
trillion boe at an economic price ranging from $10
per barrel to $25 dollars per barrel
The 1st Trillion Barrels = $10 per barrel (on average)
The 2nd Trillion Barrels = $20 per barrel (on average)
The 3rd Trillion Barrels = $26 per barrel (on average)
The 4th Trillion Barrels = $42 per barrel (on average)
Keeping in mind that all we will need are 1.5 trillion barrels through 2030…
What Characteristics the Free Market Capitalism must have to serve the Common Good…
For the market to work for the common good, it must be a competitive form of free market capitalism; a place where individual firms have no monopoly or price power – they are pure price takers, not price makers. They can do their best to maximize their self-interest, but they will end up serving the common good. When competition in a market decreases, firms begin to acquire monopoly or price power. They become price makers and no longer price takers. By restricting supply, they can control the price and increase their profits. The result is a reduction in the consumer surplus and an increase in surplus rewards (greater than opportunity costs – their just desserts) to the productive resources, including owners/shareholders, entrepreneurs/management and labor. This has been happening in the oil industry as it has become increasingly concentrated both domestically and on a global level.
On the other hand, the auto industry has become increasingly competitive and has seen a gradual shift as the surplus rewards to the productive resources have decreased, causing the consumer surplus to increase. In economic theory, we would say that in the oil industry, we would be moving away from efficiency and equity, while in the auto industry we are moving ever closer to the economic welfare goals of equity and efficiency.
Monopoly Power: Now it’s the Domestic Producers’ turn…
Domestic Oil’s side of the argument (viewpoint)…
(1) We’re victims of the world price of crude oil – “IT’S THE MARKET.” Why explore and exploit when it will only serve to reduce the price of oil? (Why decrease revenues and profits?)
(2) Environmentalists and the public refuse to allow us to build refineries. Besides, why would we attempt to increase refinery capacity when we can hold our hands up and say that there is nothing we can do about it? (Why decrease revenues and profits?)
Recall that oil prices in 2002 were around $15 per barrel for crude oil (price at the pump was around $1.15 per gallon). Since Chevron, for example, is earning $45 more per barrel at $60/bbl price levels, then what interest do they have in driving the price down by introducing more oil into the market?
The recent price levels are yielding Mobil Exxon in excess of 30% of Return on Equity to the “stockholders.” This is far above “the Fortune 500 group of companies, who in contrast, turned in a 14.9 percent return on equity in 2005.”
Be sure to revisit:
The Nature and Possible Solutions to the Current Energy Challenge
on Full-Year 2005 Results)
To provide some perspective to the Return on Equity in the following graph of the Petroleum Sector:
“The Fortune 500 group of companies, in contrast, turned in a 14.9 percent return on equity in 2005.”
Mobil Exxon financial snapshot http://money.cnn.com/magazines/fortune/fortune500/snapshots/496.html
“Of course Exxon Mobil
isn't the only oil company reporting sharply better results. The
...Myopia: Environmental lobby’s role in preserving monopoly power -unintended consequences
(1) Our role
is to safeguard the environment – period. This means a reduction in the
current 100.7 Btu quadrillion energy usage and its accompanying levels of CO2
(20 tons per American). (Since energy drives the
economy, this means that we must accept lower economic growth).
(2) We have to switch the focus from fossil fuel to renewable energy sources – nuclear is not an option. (Renewable Energy sources amount to around 6% of the total energy picture - this means that we must accept lower economic growth)
on Global Warming
The environmental movement is being used as an ever-ready and convenient excuse to delay the exploitation of our crude oil reserves. Included in environmentalists’ portfolio of complaints are all sources of energy – from fossil fuel to non-fossil fuel alternatives. Aside from oil, among the other sources mentioned are solar, wind, nuclear, etc., a hue and cry goes up citing aesthetic disdain for acre upon acre of solar panels, aviacide from wind power and the China Syndrome for nuclear power (not the fear of Chinese imports, but the nuclear meltdown fears).
End Game: environmental
concerns versus the
LET’S MAKE SOME SENSE OUT ALL THIS NOISE
(1) Fact: Our economic engine requires energy; without the energy, the result is chaos on a global scale.
(2) Why not move to some rational policy targeting a gradual reduction in greenhouse gases while promoting the research and development to achieve that end in the near-term. This would focus on the continued reduction in the emissions of fossil fuels and the gradual phasing in of non-fossil fuel energy sources (including renewables and nuclear power).
Moving a narrow view to a broader view of the environment
To quote Lou Holtz, former football coach at the University of Notre Dame, “Winning isn’t everything, but it ranks right up there with breathing.”
To paraphrase the preceding, man does not live by bread alone, but it ranks right up there with clean air. The creation of jobs and promoting economic well-being and the fight against poverty are just as much environmental issues as are the current concerns over global warming and endangered species.
One of the consequences of monopoly power and environmental myopia is the significant and rising cost of oil. A redirection of our energy toward domestic sources will allow us to reorient our economy and focus on other goods and services. This would go a long way in decreasing the piece of our nation’s budgetary pie from going to domestic and foreign oil companies.
Remember that oil is the intermediate goal in our quest for satisfying our energy needs. We are past due in terms of moving on, but we must continue to use oil into the near term – regardless. As we gradually learn to control the problems facing us in the harnessing the fossil fuel alternatives, we will move away from fossil fuels in general – the sooner the better.
In summary, we are misconstruing the nature of the environmental problem. The environment is not just the narrow focus of endangered species and global climate change, but it is the human aspect of the problem. This includes economic consideration, and peace and prosperity in the world (the elimination of terrorism, reduction of poverty and job creation) – which represent a far larger part of our environmental picture.
Consider the following:
If we exploited our own oil…
1) We could cut the
trade deficit by at least 1/3 (70% imported oil---300+ bil
/year at $55)
2) Increase GDP growth, imported oil reduces it by 1 to 2 percent
3) Defund terrorist organizations – how much would this save us in terms of treasure and life in the cost of fighting it? ($100 billion per year in the War on Terror, plus loss of life)
Sources of imports
Richard Lugar, U.S. Senator,
(Opinions expressed on
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reflect the position of