The Axis of Energy
Understanding the connection between energy, the economy and the environment.
Summary of a Presentation by
James L. Sweeney
Professor, Management Science and Engineering, Stanford University; Senior Fellow, Stanford Institute for Economic Policy Research
"The United States must attain energy independence and end its dependence on imports from the Middle East.”
"We can achieve energy independence by switching to a hydrogen economy.”
"Drilling in the Alaska National Wildlife Refuge will bring the U.S. toward energy independence.”
These are just a few of the spins and misleading claims floating around in public discourse regarding the economics of oil and energy.
"Energy independence is a meaningless statement when we hear it from some political leaders,” Sweeney said. “You need to come into this conversation with a big saltshaker.”
The sheer magnitude of U.S. energy demand makes ending oil imports unrealistic. The U.S. consumes about 100 quads of energy annually. (See the glossary of energy measurements below.) Of the total 100 quads, about 85 are derived from oil, gas and coal. Less than one quad comes from renewable energy sources. The inescapable fact is that the U.S. economy is a fossil-fuel based economy.
In addition, geologic realities make ending oil imports physically impossible. Domestic oil production in the U.S. reached its peak 30 years ago, and most of the world’s remaining oil reserves are in the Middle East. The U.S. now imports about 30 percent of all of its energy and 50 percent of its oil. These numbers have been increasing steadily for the past 30 years.
Short of a major technological breakthrough, no amount of alternative energy sources or conservation can fundamentally alter these trends. But if energy independence cannot be achieved, energy dependence can be lessened and energy security increased through good policy.
"Domestic oil production is declining, and it will continue to do so no matter what policy actions we take. But we can influence the rate of decline if we create substitutes for oil in large enough quantities that slow the growth of oil demand. This would not achieve energy independence, but it would contribute to energy security,” Sweeney said.
The Axis of Energy
The critical points of energy issues form a triangle: economic efficiency and equity at the top point; energy security at another point; and the environment at the third point. Energy policy involves a tradeoff between these three elements.
"Almost all energy issues involve these three issues, and there is interplay between them,” Sweeney said. “Good energy policy choices are supportive of all three goals. We need to understand what tradeoffs we are willing to make.”
Connected to these three main issues are gas prices, profits, cost and social equity – who has to bear the costs and who doesn’t. Costs that are not borne at the gas pump or anywhere else along the line are known as externalities. Examples of externalities are environmental damage, congestion and pollution caused by the consumption and production of oil. When costs of externalities are not incorporated into energy prices, this leads to inefficiency and the overuse of energy.
The energy triangle therefore incorporates conservation, fuel efficiency, and environmental protection, all of which are connected to national security. “There are many options for increasing energy efficiency,” Sweeney said. “Using less energy and reducing the environmental impacts of energy use makes us more secure.”
Good energy policy must take all of these elements on the axis into consideration. “The essential thing is to understand the linkages between energy, the environment and the economy. All energy policy is connected to those linkages and can change the relation of those linkages. Policy makers and the media need to understand that,” Sweeney said.
The Interdependent World
The world oil market is like a big bathtub: Oil produced anywhere in the world is pumped into the tub. In other words, countries don’t produce oil solely for their own domestic consumption and horde the rest. Oil is sold on one world oil market. A disruption in prices anywhere impacts oil prices everywhere.
"The world economy is interconnected, and oil prices move together,” Sweeney said. “It almost doesn’t matter where you import the oil from. The price of gasoline will go up just the same whether it’s produced in Texas or Saudi Arabia. Oil will command the same price wherever it is produced around the world, minus the transportation differential, which is small.”
The United States produces about 8.9 million barrels of crude oil per day, but it consumes about 20 million. Over the past 30 years, domestic production has been decreasing, while consumption is increasing. The 11 million barrel-per-day deficit has to come from somewhere.
"There is no way of getting around the fact that we live in an interdependent world, and there is no way of getting around imports,” Sweeney said. “We are not alone in the world. The world is tightly interconnected. How our economy functions depends on our trading partners. If there is a recession elsewhere in the world, and they can’t buy our goods and services, then we have a recession.
"If we continue to consume more oil, and the reduction of world oil supply leads to the world oil market skyrocketing, there will be economic consequences to the United States,” Sweeney said.
Rapid increases in oil prices lead to reductions in economic output, which lead to recessions. This rule follows an asymmetric pattern: Sudden price increases harm the economy, but sudden price decreases don’t benefit the economy as much as price increases harm it. In other words, the economy is harmed more when oil prices go up sharply than it is helped when the prices go down.
"When you talk about reductions in the overall magnitude of the economy and increased unemployment, that’s a security issue. When you talk about oil as a political weapon against the United States, as what happened in 1973, that’s an energy security issue,” Sweeney said.
In 1973, in response to Western support of Israel during the Yom Kippur War, oil-exporting Arab nations imposed an embargo on all nations supporting Israel, resulting in severe economic repercussions. The Iranian Revolution in 1979 sparked the second oil crisis, which caused widespread panic and sent the U.S. economy into a tailspin.
In response to first Arab oil embargo, the United States created the Strategic Petroleum Reserve to hedge against future shocks in the oil supply.
"With the Strategic Petroleum Reserve, we have the ability to increase the supply of oil in the event that prices go up rapidly or in response to a sudden reduction in supply,” Sweeney said. “Energy security may be creating these ‘shock absorbers’ in the system ... if we can figure out how to release the oil at the right time, and that’s a big ‘if.’”
The recent run up in stock market correlates with a decline in energy prices. Some economists believe the U.S. dipped too much into reserves for fear of running out of supply, and that created this bubble in the market.
Addicted to Oil
To the astonishment of many, in his 2006 State of the Union address, President George W. Bush declared that the United States is “addicted to oil, which is often imported from unstable parts of the world.”
In 1970, the U.S. had no troops in the Middle East. Then came the First Gulf War, the establishment of military bases in Saudi Arabia, and now the second Iraq War and Afghanistan. Military conflict with Iran looms over the horizon.
Many economists now consider the costs of national security and international diplomacy external costs of oil and gasoline consumption, similar to the external costs caused by pollution, congestion and the health care necessitated by environmental degradation.
"The more oil we import, the more energy security issues we have,” Sweeney said. “The more oil we import, the more our hands are tied in diplomatic negotiations with oil-exporting countries that we count on, particularly in the Middle East and Venezuela.”
The bottom line is that U.S. energy demand and consumption have real effects – both positive and negative; and as is the case with the international drug trade, the underlying driver of the trade is demand, not supply. In other words, the ultimate “blame” lies not with Afghanistan because poppies grow well there, or with Saudi Arabia because it possesses oil reserves, but with the individuals and nations that demand opium and crude oil.
“It is important to realize the underlying issue of oil dependence is demand, not supply,” Sweeney said. “The impact of oil price increases on the economy has to do with how much oil we use, and not how much we import. It’s not imports, it’s use.”
Up Like a Rocket, Down Like Feather
Gas prices rose precipitously during the first half of 2006, followed by a slow evening out and decline. This trend follows a typical pattern: Spikes in crude oil prices tend to cause rapid increases in price, but decreases are slower to be reflected in the price at the pump.
Gas prices follow the pattern, “up like a rocket, down like a feather,” Sweeney said. “The energy system adjusts slowly, but it adjusts.”
Many people blame high gas prices on the big oil companies. Following the devastating hurricanes of 2005, gas prices spiked when refineries on the Gulf Coast were knocked out of operation. Corresponding record profits reported by energy companies caused an outcry for increased regulation and taxation on windfall profits.
Some believe the problem of high gasoline prices is tied to a lack of refining capacity in the United States and the fact that no refineries have been built in the U.S. for 30 years. However, oil companies have increased the output of existing refineries by expanding and retrofitting them. The refining capacity has been sufficient to meet demand.
Oil companies could potentially manipulate prices decreasing refining for short periods of time, but they would not be able sustain it. In the long term, gas prices are driven by the world crude oil market, not by refiners.
In the short term, gas prices are affected by events such as hurricanes and pipeline shutdowns, which reduce supply and thus cause price spikes.
Gas prices are also determined by local conditions, such as the number of station operators in an area and who owns them. If one person owns all of the gas stations in town, prices will likely be high. However, prices at gas stations are not a conspiracy of big oil companies, since most gas stations are owned by independent operators.
The best predictor of retail gas prices is the New York Harbor spot price. Prices at the pump lag behind wholesale prices on the futures market. The Department of Energy’s Energy Information Administration web site is also a good source of information
A Special Commodity
Energy commodities such as gasoline, natural gas and electricity are unique in the world economy. They make motor vehicle transportation and commercial aviation possible; they heat homes; they are the lifeblood of the modern economy.
"In physical science, energy is the ability to do work – lifting, accelerating, heating, producing electricity. In economic terminology, energy is embodied in the commodities – gasoline, natural gas, coal, etc. – that can be used to perform physical work. Because energy involves the ability to do work, it is a special commodity,” Sweeney said.
Sweeney covers the basics of energy economics in his primer, “The Economics of Energy.” Some key points:
"A fundamental property of energy is expressed by the first law of thermodynamics: Energy can neither be created nor destroyed (except through nuclear reactions transforming matter to energy). Energy comes from the physical environment and ultimately is released back into the physical environment. Thus, energy economics is the study of human activities using energy resources from naturally available forms, through often complex conversion processes, to forms providing energy services,” he wrote.
Energy is often described as an “essential good” because human activity would be impossible absent use of energy: living requires food embodying chemical energy. In economics, an essential good is one for which the demand remains positive no matter high its price becomes.
"Although energy is essential to humans, neither particular energy commodities nor any purchased energy commodities are essential goods. Particular energy commodities are not essential because consumers can convert one form of energy into another,” Sweeney wrote.
"Energy commodities – e.g., gasoline, diesel fuel, natural gas, propane, coal and electricity – can be used to provide energy services for human activities, such as lighting, space heating, water heating, cooking, motive power and electronic activity. Energy resources – e.g., crude oil, natural gas, coal, biomass, hydro, uranium, wind, sunlight or geothermal deposits – can be harvested to produce energy commodities.
"Based on the speed of natural processes, one can classify primary energy resources as depletable or renewable. Depletable resources are those whose renewal speeds are so slow that it is appropriate to view them as made available once and only once by nature. Crude oil, natural gas, coal and uranium all fall into this category.”
When people talk about moving to a hydrogen economy, they often confuse hydrogen as a primary energy source rather than an energy commodity. Based on present technology, hydrogen can be extracted from coal or natural gas. It cannot be extracted from water in an efficient manner or on a scale large enough to support the economy.
"Hydrogen is a carrier of energy, but it’s not a primary source of energy,” Sweeney said.
Getting the Numbers
Sweeney said understanding the math and the economics of oil markets is crucial to cutting through spin. “Knowing what’s big and what’s small makes a fundamental difference as to what’s important and what’s not,” he said.
Here are some basic energy measurements defined:
Joule: the amount of energy it takes to move an approximately quarter-pound object one meter.
Exajoule (EJ): A measurement of energy equal to 1018 joules.
Watt: A rate at which energy is expended. One watt is equal to a power rate of one joule of work per second of time.
Terawatt (TW): a metric unit of power equal to one trillion (1012) watts.
Quad: A unit of energy equal to about 1.055 exajoules (EJ) or 293.07 terawatt hours (TWh). One million barrels of oil is the equivalent of 2.17 quads.
Energy Security Fallacies
Sweeney addressed several related misconceptions regarding oil markets and energy security, including:
ASSERTION: The United States must end its addiction to foreign oil and become energy independent.
CORRECTION: The United States produces about 8.9 million barrels of crude oil per day, but it consumes about 20 million. Domestic production is decreasing, while consumption is increasing. The 11 million barrel-per-day deficit has to come from somewhere
“When people talk about energy independence, no way,” Sweeney said.
ASSERTION: Most oil consumed in the United States comes from the Middle East and Saudi Arabia.”
CORRECTION: The United States imports about 3 million barrels per day from Arab OPEC nations, about 15 percent of the total 20 million barrels. Of that 15 percent, about 8 percent comes from Saudi Arabia. About 4 percent was imported from Iraq before the second Iraq war.
Supporting graphs and statistics can be found in the Annual Energy Review.
ASSERTION: If we stopped purchasing oil from Saudi Arabia, we would no longer be vulnerable to oil market disruptions.
CORRECTION: Disruptions in supply from Venezuela, Nigeria or elsewhere could still disrupt the market. Individual companies that have contracts with Saudi Arabia are the most vulnerable to disruptions in supply from that country, but the nation as a whole is not hostage to the Saudi oil supply.
ASSERTION: Developing the Arctic National Wildlife Refuge (ANWR) for oil production will eliminate U.S. vulnerability and put the country on the track toward energy independence.
CORRECTION: ANWR would produce less than 1 million barrels per day, and the oil would most be sold on the world market – most likely the closest market, Japan.
“In terms of reality, this is an overplayed issue. In terms of symbolism, it is very important,” Sweeney said.
ASSERTION: If we increase the corporate average fuel efficiency standards (CAFE) for automobiles and ban SUVs, we will eliminate our vulnerability to the world oil market disruptions.
CORRECTION: Americans consume about 8 million barrels of oil per day on gasoline transportation. If automobile fuel efficiency increased 50 percent, that would mark a significant reduction in consumption, but it would be a long-run change – in the area of five to 10 years – since most people do not buy a new car every year. Sweeney calculated that a 50 percent increase in fuel efficiency could reduce consumption by 1.25 million barrels per day over a 12- to 15-year period.
Written and reported by Bruce Murray.
Orignally posted September 29, 2006.