Economics of Petroleum Energy - Research Paper Example

here 08 April Economics of Petroleum Energy Table of Contents Objectives of the Study 2 Introduction 2 Literature Review 4 Methods 8 Analysis and Discussion 10 Conclusion 11 Reference 12 Abstract This is a study into the economics of petroleum energy in the United States. At the beginning of this study, both general and specific objectives are stated as they are the guide into writing this study. In the introduction section, various aspects of the energy industry are introduced. These include the nature of petroleum energy market and cartels involved in oil production and marketing. Energy market has some exceptions from other markets as there are no readily available substitutes. Changes in prices of petroleum energy are inelastic in the short run but elasticity increases in the long run. Energy security is all about being able to absorb any shocks in the market that might be caused by changes in oil prices or oil supply. Data was obtained from the United States Energy Information Administration and different economic formulae are used in the analysis. The results are then discussed with regard to the study’s objectives and conclusions made. Objectives of the Study This study has the general objective of carrying out an analysis to determine how different economic aspects affect the petroleum energy market in the United States. The study also has specific objectives of: 1. Determining how energy security affects the energy market 2. Determining how price and demand elasticity affect the petroleum market 3. Analyzing the economics of non-renewable energy Introduction Mankind heavily depends on energy for existence. Energy forms critical aspects of human lives as energy supports lives and runs economies. Energy finds its use in different forms depending on the need. Scientists and physicists have conducted researches that have proved that energy can neither be created nor destroyed; it can only be converted from one form to another. Man acquires utility from fuel by converting it from one form to another. Fossil fuels are mined in different forms which include natural gas, crude oil and coal. These are commonly referred to as non-renewable forms of energy as their rates of depletion are far greater than their rates of replacement. This paper will look into petroleum fuel and the economics involved in its exploitation and consumption. Petroleum fuels find their use in many sectors of the economy. In some countries, funds allocated for importation of petroleum fuels form a significant part of the total fiscal budget. This is common in oil-importing countries where changes in petroleum prices significantly affect economic performance. Petroleum is such an important product that its prices do not affect its consumption. According to the law of demand and supply, when the price of a commodity increases its demand decreases. When the price of a commodity increases, its supply increases as suppliers want to cash in on the high price. This is not the case with petroleum products. The measure used to determine the extent of change in demand of a product due to change in price is called price elasticity. Petroleum prices are quite inelastic as consumption remains the same or changes minimally as a result of changes in price. According to the U.S. Energy Information Administration, changes in gasoline prices do not affect automobile travel. This further illustrates the minor responsiveness of petroleum products to prices changes. This paper will also look into how oil producing countries put in efforts to manipulate the oil market to their advantage. These countries have formed an organization called Organization of Oil Producing Countries (OPEC). This organization operates like a cartel to exploit oil importing countries. However, not all oil exporting countries are in OPEC. This paper will also look into how OPEC countries relates with non-members in terms of marketing of crude oil. Hotelling is a rule commonly used in the oil industry. It describes how price of crude oil relates to time. Hotelling rule uses a form of reverse interest where oil producing countries consider the growth rate of crude oil price and then determine the best time to extract the oil. When using Hotelling rule, an assumption is made that the oil price growth rate is equal to interest growth rate. Thus in most instances, the prevailing interest rate is used to calculate the future value of existing oil reserves. It is important to consider these petroleum economics as crude oil is a non-renewable energy source. Thus, an oil producing country should make sure that it gets maximum benefit from the resource. Some of the economic concepts in this paper also assist an oil producer to determine the best time and the best cost to extract its oil. Literature Review Gasoline is a natural resource and according to taxonomy of natural resources, there are two categories of resources: exhaustible resources and inexhaustible resources. Exhaustible resources are finite in quantity as their rate of generation is much less than their rate of use. Inexhaustible resources have a high rate of generation thus cannot be easily depleted. However, there are problems in classification of natural resources. Exhaustible resources are classified as having a fixed quantity but these resources are rarely depleted. The reason for this is because some of the reserves are near the surface of the earth so there still remains more deposits deeper underground. In other cases, the high quality deposits are first extracted so the second grade is still available. The second reason for difficulty in natural resources taxonomy is that costs of mining and extraction increase over time. This cause the supply curve to shift upwards and to the left. Increase in prices cause a decrease in demand. This usually results in consumers going for substitutes. Thus the deposits of the exhaustible resources are preserved and never get depleted. The other aspect that brings confusion in natural resources classification is that inexhaustible resources sometimes get exhausted. Examples include biological resources which have a replacement rate. There occurs instances where these resources become extinct and the entire species is wiped out. There are propositions that there be a different categorization of natural resources that is purely based on their regeneration rates. This means that renewable resources will have a positive regeneration rate and non-renewable resources such as petroleum energy will have zero regeneration rate. In this way it will be easier to analyze petroleum energy as it will be considered as a renewable resource with zero regeneration rate. Price elasticity of gasoline is an important measure in understanding the gasoline market in the United States as well as other countries. Price elasticity can be considered in both the short-run and the long-run. According to the United States Energy Information Administration, there has been a twenty eight per cent fall in average gasoline prices in the year 2014. The average price of gasoline has dropped from a peak of 3.70 dollars per barrel in 23rd June to 2.68 dollars per barrel on 8th December (USEIA). This change in price did not have a significant effect on consumption as the Energy Information Administration records that motor vehicle travel statistics did not change much. Some of the reasons for this inelasticity are lack of readily available substitutes and the essential nature of functions and processes that require gasoline. Economic studies have shown that price elasticity of fuel petroleum fuel increases with consistent increase in price. This means that a continuous increase in petroleum prices over time a certain period causes a larger or equal proportion of change in consumption. According USEIA, automobile travel is inelastic but its price elasticity has decreased in the past few decades. According to estimates by USEIA, the current elasticity of motor vehicle travel ranges from -0.02 to -0.04 in the short run. This means that the price of gasoline has to change with a relatively large percentage for there to be a very small change in gasoline consumption. However, these changes in the long run since gasoline consumers will have time to change their gasoline consumption. Consumers could opt for changing the vehicle they are using, abandoning or even taking up motor vehicle travel. Data from the mid-1990s indicates that the price elasticity of gasoline was -0.08, which is higher than the current elasticity. The use of price elasticity in determining the consumption of gasoline has some challenges. This is because there are other factors that can cause a change in the elasticity. Some of these factors are change in income levels, available infrastructure, consumer / driver behavior and vehicle efficiency. The recorded decrease in price elasticity of gasoline, in the United States, in the last several decades has been attributed to some factors. Some of these factors are; reduced rate of teenage licensing, rural-urban migration, and retirement of the population which had many children and the shrinking share of household budget for gasoline. The oil industry previously experienced a perfect competition market until the formation of OPEC. In many instances, OPEC has been accused of operating like a cartel. A cartel, in this case, means an agreement among several oil producers to observe production restrictions with the aim of increasing their profits as a group. In order to achieve this, the cartel creates a monopolistic market by dividing the market into quotas. When this is achieved, it makes it possible for the cartel to control oil prices by using the law of demand and supply. Cartels will limit production of crude oil so as to create scarcity. According to the law of demand, this will push oil prices upwards and then the cartel will supply crude oil at a high price thus increasing their profits. Cartel are illegal in almost all countries but in this case, the countries themselves form the cartel. So there are minimal chances for any recourse for any member from a non-member. According to USEIA, in the early 1890s cartels were legal in the United States. In 1881, a company called Standard Oil Company created a group called The Trust that would control the oil market back then. The Trust operated using shares and a board of trustees. The shares of member companies would be placed under the management of the joint board of trustees who would then take care of the interests of the member companies. This monopoly in the United States oil industry continued until 1890 when the Sherman Antitrust Act was made. This Act made all forms of trust and collusions illegal and several years later the Standard Oil Company was broken into different oil industry players. Cartels experiencing different challenges in their operation. However, most of these challenges are unique to individual members. The most common challenges to all members is dishonesty by some members. The high marginal benefits are motivation for a member’s dishonesty. If an oil producing members cheats in the agreement by producing more than the agreed units of production, then they would realize higher marginal returns for the extra units produced (Ortigueira). Factors that make cartels least likely to succeed are the same factors that cause cheating. These factors are a market with an unstable demand, cartel members having different objectives, many product sellers and unavailability of ways to monitor prices of other members. There exists limitations in cartels as they do not have absolute control over the oil industry in the United States. Crude oil producers have not fully succeeded in creating a monopolistic market and the result has been an oligopoly market. In an oligopolistic market, it would be difficult to keep the trust as there exist numerous incentives to cheat. This, coupled with a constrained demand curve creates an unfavorable market environment. In such circumstances, members are very highly tempted to cheat but none of the members would want to risk being discovered that they are cheating. This is because upon discovery, their membership would be canceled and this would mean returning to the unfavorable conditions where supply and demand purely determine prices. Petroleum energy is prone to price changes that cause shocks across the economy of a country. Energy security refers to the ability of United States household to accommodate disruptions in petroleum energy supplies because of availability of petroleum supply at affordable prices. Absence of ready substitutes for petroleum energy and inelastic demand of petroleum products causes huge shocks due to price changes. Countries that are huge importers of petroleum energy are highly vulnerable to shocks in oil market, either as a result of reduced supply or increase in prices. The United States contributes almost twenty percent of global oil consumption thus energy security is of great importance to the country. There exists misconceptions in relation to energy security. There is no relationship between energy security and externalities such as environmental pollution. If there exists any relationship, then it is a very distant relationship. Relating energy security to the damages caused by its use has led to development of policies that reduce energy efficiency. The second misconception is relating energy consumption to energy security. This relation is based on the thinking that reducing overreliance on petroleum energy will reduce the amount of oil imported by the United States. This will assist create a favorable balance of trade for the country alongside other benefits. The assumption herein is that if a country imports less oil, the possibility it being affected by shocks in the oil market is minimal. It not entirely true that this will happen because even if a country does not import any oil, shocks in the oil market of other countries will affect the prices of commodities in this country. Methods Energy security, to a large extent, involves shocks in the energy market. The production function was used in the analysis. Y = F (K,L,E) where; Y is the total output K is the aggregate stock of physical capital used in production process L is labor E is energy According to the production formula above, when production is optimized, the production function will be; p Y= w L + r K + q E where, p is price of output w is the wage rate r is rental price of capital q is energy price Gasoline demand can be calculated as; Gj,t = β0 P β1Jj,t Y β2j,t εj εj,t Where; β0,β1 and β2 are parameters Gj,t is per capita gasoline consumption in gallons in month j and year t Pj,t is the real retail price of gasoline in month j and year t Yj,t is real per capita disposable income in month j and year t εj represents unobserved demand factors that vary at the month level. This is modeled as fixed month effects to capture the seasonality present in gasoline consumption ϵj,t is a mean zero error term Both Yj,t and Pj,t are in constant 2000 dollars Non-renewable energy sources such as petroleum energy have some certainty that they will get depleted at one time. During analyses, non-renewable energy sources are considered to be renewable resources with zero growth rate. Consequently a reverse-to-use ratio can be used to determine how long an oil reserve will last. Reverse-to-use ratio = Analysis and Discussion When the production equation is rearranged to = it gives the elasticity of output with respect to energy. This can be interpreted to mean that a change in output with respect to energy will result in an equal change in the share of energy budget. In an economy, budget share for petroleum energy can be relatively small but the effects of changes in price and quantity have large effects on economic performance. When the formula for gasoline demand is transposed to make β1 subject of formula, we have = β1. β1 is the price elasticity of demand for petroleum. In cases where a reverse-to-use ratio is used on a non-renewable resource such as petroleum energy, the time that a reserve will last is important in determining the rate of growth for the oil prices. Reverse-to-use ratio = Alongside time left, reverse-to-use ratio can also be used to calculate scarcity. This assists in determining at what rate a petroleum reserve should be extracted. Petroleum reserves should be extracted at an efficient rate so as to ensure maximum benefit from the resource. An efficient rate of extraction also assists in maximizing present discounted values of future benefits. Efficiency in extraction can be achieved using the two period model or Hotelling’s rule. Two- period theory seeks to determine the best time for mining of the product. According to the law, the best time is when the price is equal to the marginal cost involved. P= MC = MEC +MUC. This will be the efficient time to extract the petroleum energy. This is where Hotelling rule is applied as it states that prices of petroleum energy will keep growing at the current interest rate. This means that the marginal cost also keeps rising with the current interest rate. In order to have an efficient rate of extraction, the marginal user cost should be at its lowest as it represents the foregone cost for future net benefits. Conclusion Petroleum energy, as a non-renewable energy source, should be properly managed in order to ensure that maximum benefit is received. This means that extraction should be efficient and should be at the least possible cost. This study was able to determine that energy security is an important aspect in the oil industry as it determines how an economy responds to shocks in the oil industry. Poor responses could be indications of poor policies are a weak economy. The study also determined how price elasticity of oil affects its demand as well as an economy’s performance. According to this study, the short run effects of a price change are quite minimal. However, in the long run, the price elasticity of petroleum energy increases as it there are more alternatives for the user. Non-renewable energy sources usually are considered as an investment and grows in value. The study has determined that this is the basis for the Hotelling rule as it is all about determining the best time to extract the oil reserves. In conclusion, this study has achieved both its general and specific objectives. Reference Ortigueira, Salvador. Gasoline Elasticity Slides. 2013 Ortigueira, Salvador. Cartel. 2013 Ortigueira, Salvador. OPEC Slides. 2013 Ortigueira, Salvador. Energy Security Slides. 2013 Ortigueira, Salvador. Hotelling. 2013 Ortigueira, Salvador. Extraction of Non-renewable. 2013 Read More