The Marginal Barrel

I just read an interview with an oil industry analyst named Steve Kopits. He’s the guy who pointed out that 4 of our last 5 recessions happened just after our national expenditures on oil reached 4% of GDP.

Kopits talks about a concept that is new to me – peak oil price.

When we think about supply and demand, we generally think in terms of a simple relationship with price. All other things being equal, if supply goes down, price goes up. When price goes up, demand goes down. Of course, there is such a thing as price elasticity. That is, if you are truly dependent upon something a 10% price rise won’t result in a 10% fall in consumption.

Oil has shown itself to have a very elastic price. Oil cost $25 a barrel back in 2000. Now it costs more than four times that much (Brent price $110), but you don’t see a drastic drop in consumption.

Enter the marginal consumer, the marginal barrel, and carrying capacity. The marginal barrel is that highest priced barrel of oil that blends in with the rest of the world supply and holds up the world average price. The marginal consumer is the world’s poorest consumer, or the consumer for whom there is a less appealing but plausible alternative to oil waiting for use. Carrying capacity, in Steve Kopys’ thinking, is the maximum price that a particular country will tolerate before cutting back on consumption.

According to Kopits, the U.S., Europe, and other western industrialized nations hit carrying capacity at around $110 a barrel. China has another $10 or so to go before it starts losing its taste for the stuff. Some poorer countries have hit their limits already.

The upshot is that although supply is constrained, the price has hit a wall. Enough people, countries, and industries will grudgingly conserve or switch to prevent oil prices from rising drastically. Here in the U.S. gasoline consumption is down 3% from last year. This could be partly due to the recession, but partly because we have hit our carrying capacity.

By Kopitz’s estimation, just as world oil production has hit a bumpy plateau, so too has the price of oil. It will come to rest north of $110, but this will make more consumers retreat from the market.

Nota Bene: Increasing wealth, increasing efficiency, and inflation will all tend to raise the nominal carrying price of oil. The price will creep up along with our efforts to be more efficient, simply because a mile of driving or a day of 68F in a house will cost the same.

This is when, paradoxically, the most energy efficient economies become the greatest users of oil. (The formal term is Jevon’s Paradox) It is a huge advantage. Oil is an unparalleled commodity, as both energy and chemical feedstock. The city, state, or nation with the highest efficiency, and therefore cost tolerance for oil, will be able to take advantage of its conveniences after other entities have been forced to use lower quality compromises. The same holds true for any other energy source.

I’d like to see my home state of Vermont put more emphasis on energy efficiency. Right now we are the fifth most energy efficient state in the U.S. I’d like to see us beat out Massachusetts for the top spot. Then I’d like to see us pour it on and open up an unbeatable lead. It would put us in an enviable economic position as all energy sources approach their limits.

(Just in case you are interested, I now have a Twitter account, @MinorHeretic. Nothing serious, just photos of the natural world and minor absurdities. A break from all the grim stuff.)

Comments

[Doug Riley]

Very interesting stuff. It's comforting to observe that consumers actually will turn away from oil at some price level. Simpler models predicted that we'd buy the same amount of it no matter how high the price -- selling kidneys if necessary --because we simply could not live without it.

On that score, a pedantic definitional point: A price-elastic commodity is one for which, when the unit price goes up by a given percentage, unit sales DEcrease by more than that percentage, and when the unit price goes down by a certain percentage, unit sales increase by more than that percentage. A price-inelastic commodity is one for which unit sales decrease less than proportionally when the price goes up.

The "simpler models" I mentioned assume that oil is quite price-inelastic (people will buy just as much no matter how much it costs, presumably because they have no choice). The interview suggests that oil is more price-elastic than we thought.

Price elasticity tends to be near zero in the very short run, but to increase if the consumer has time to adjust his consumption habits and to find substitutes for the commodity whose price is rising. That may be why oil looks more price-elastic than it used to.

Wal-Mart thrives on price elasticity (drop the price on consumer goods and you make more money on the higher volume than you lose on the lower profit margin). The oil companies may not be quite as used to it. Yet.

-- Crusty Old Econ. Major