9 July 2008

Welcome to a world with $500 oil

How far will the real price of oil and other carbon-based resources rise? Experts (I am not one of them) differ widely in their medium-term and long-term predictions, but my reading of the evidence suggests that there is a fair chance that the sky is the limit. In the short run (the next 2 or 3 years) a global cyclical slowdown may provide some temporary relief from rising commodity prices in general and rising oil prices in particular. This temporary cyclical energy price comfort will be deeper and longer-lived if the key emerging markets that have let inflation get out of control (effectively all of them except for Brazil) tighten monetary and fiscal policies to bring inflation down to politically tolerable levels. The resulting cyclical slowdown in emerging market growth will be bad news for economic activity in the industrial world, but will put downward pressure on commodity prices. We will be unemployed but able to afford petrol.

Once global growth returns to its underlying trend, however, say three or four years from now, I expect the relentless upward march of commodity prices, including oil, gas and agricultural commodities, to continue. The reason is simple. Global demand growth is heavily biased towards energy-intensive production and consumption in emerging markets. Even if common sense breaks out in India, China (perhaps even in the Middle East and other oil and gas producers) and domestic oil and energy use is priced at its global opportunity cost, the energy-intensity of global production and demand will be rising for quite a while. At a horizon of a decade or more, high energy costs may reduce the energy intensity of production, investment and consumption, but total energy demand is still likely to rise even if global real GDP growth averages only 3 or 4 percent per annum.

With existing technology, the supply of energy from all sources appears to be quite steeply upward-sloping. Even if relatively easily remediable bottlenecks like limited refining capacity are removed over the next 5 to ten years, the social marginal cost of conventional energy production (carbon-based, nuclear, renewable) will rise (even at existing levels of energy production) as existing non-renewable resources are depleted and as the environmental and other external costs of alternative energy sources (solar, wind, wave, tidal, biofuel) become more apparent.

Fission-based nuclear power will no doubt play a greater role in future electricity generation, but it should be recognised that this is only because the currently available alternatives have become more expensive, not because nuclear energy has become cheaper or safer. We still don't know the long-run cost of decommissioning nuclear power plants and of safely storing nuclear waste products for thousands of years. The risk of accidents, the risk of sabotage by terrorists and the risk of weapons-quality nuclear material falling into the wrong hands have not gone down. I support increased use of nuclear energy, but recognise that this is faute de mieux.

Innovation and technological change may come to the rescue and bring us infinite amounts of environmentally friendly energy at the equivalent price of $100 a barrel of oil, but counting on that to help us out over the next two or three decades seems rather Pollyanna-ish, and not a basis for policy, planning and risk management.

So how high are oil prices likely to go once we get through the cyclical global slowdown that is now under way. Arjun N Murti, a Goldman Sachs expert believes we will soon hit $200 a barrel (up from the current $146 level). The CEO of Gazprom has predicted a $250 barrel of oil before long. Dr. Robert Hirsch, a Senior Energy Advisor at MISI and a consultant in energy, technology, and managemen, says that oil will peak at $500 within the next 3 to 5 years. While your guess is as good as mine (likely better), none of these figures seem outlandish.

Fundamentally, this means that the most effective energy policy (including the most effective energy security policy) is conservation. The only way to encourage conservation is higher prices for the user, that is prices that fully reflect the long-run social marginal cost of energy. We are just beginning to see more realistic prices for energy, even in parts of the world where low-cost energy is seen as a social entitlement.

Europe is fortunate in having lived with high energy prices, especially for fuel, for decades because of high excise taxes. While Americans are groaning at the sight of petrol/gas prices of just of $4 an US gallon, equivalent UK prices are above $8 dollars. Petrol/gas reach $10 dollars per US gallon in the Netherlands. In an emerging market like Turkey they are at above $8 per US gallon.

When I hear former US Treasury Secretary Robert E. Rubin state publicly, as I did a couple of weeks ago, that the current ($146) level of oil prices is a disaster for the US economy and that even a (real) oil price of $100 is unsustainable, it is clear that the leadership of the US is in urgent need of a reality check. His statement that the increase to current levels was too quick to allow the country to adapt is also unconvincing. If the same real increase in the price of oil had been achieved over a 10-year rather than a two or three-year period, the need for a radical change in life styles and patterns of production and consumption would not have been recognised to anything like the same extent. The US, in its approach to energy use, is rather like the frog who jumps out of a pan of boiling water if dropped in it, but who allows himself to be boiled alive if put in the pan while the water is cool, wit the water subsequently brought to its boiling point gradually.

None of this means a disaster for the US or any other part of the developed world. Even a $500 barrel of oil (in real terms) would reduce US real income (as conventionally measured) by no more than 10 or 11 percent compared to where it would have been otherwise. That's 3 or 4 years of trend growth - nasty, but no disaster, if properly managed. And there would be considerable environmental benefits from a more energy-efficient lifestyle, which are not captured by conventional GDP- or consumption-based measures of real income.

Certainly, truck drivers and taxi cab drivers will be hard hit. Their industries will have to contract. Mass long-distance travel will become seriously more expensive, hurting the low-budget end of the tourism- and travel-related industries hard. The airlines will have to contract. Automobile construction will have to retool and contract (not necessarily in absolute terms, with demand in emerging markets growing rapidly despite the high fuel costs, but certainly compared to the counterfactual with constant real oil prices). All these adaptations are necessary and, in some countries, long overdue. There is no case for subsidising energy-intensive life-styles or industries through tax breaks, subsidies, selective price caps or other stratagems.

The impact on real standards of living in Europe would be much smaller - in Western Europe probably less than half the loss in real income in the US. This is both because of the lower energy-intensity of European consumption and production and because outside Russia, the accidents of geography and history have made high-density living the rule in most of Europe.

The increase in energy costs and the associated increase in transportation costs will make high-density living an economic necessity. The depopulation of the American and Canadian Mid West and part of the Far West will accelerate. Commuting by private car will give way to commuting by public transport. People will rediscover the art of wearing sweaters indoors during the winter and of opening windows in the summer. Smaller, more energy-efficient cars and appliances will become the norm.

Real oil prices between $200 and $500 would accelerate the shift in wealth, financial power, economic clout and political influence towards the energy exporting countries, especially the Middle East and Russia. Because occupying Saudi Arabia and exploiting its oil resources for the benefit of the American consumer and the Teamsters is not an option, there is really nothing that can be done to resist this shift in the financial, economic and political centre of gravity.

The real problem will be the fate of the energy-poor, those who, even at current energy prices, spend 20 percent or more of their income on energy. The way to deal with this problem is not to subsidise the energy consumption of the poor, unless there truly is no other way. In advanced countries, and wherever the government knows who the energy-poor are and knows how to reach them, the answer is cash transfers to the poor financed out of general tax revenues. Both poor and rich should, wherever possible, pay the full marginal social cost of their energy use.

If you don't know who or where the poor are, cash transfers to alleviate poverty are not an option. In that case subsidies targeted at energy sources consumed disproportionately by the poor may be the best that can be done. That would mean, in India, subsidies on kerosine used for home cooking, but not on kerosine used by airlines. It would not mean subsidies on fuel used by cabs, trucks or other vehicles. If a country has electricity or gas metering, a life-line tariff could be created, with a subsistence level of consumption provided free or at very low marginal cost, but with consumption above the subsistence level charged the full long-run marginal social cost (and possibly an extra dollop to pay the subsidy on the subsistence consumption level).

Because the increase in energy prices coincides with a large increase in food prices (and is partly responsible for it), the challenges of addressing poverty effectively will become more acute in the overdeveloped world. They will become near-overwhelming in poor developing countries. Much of the progress towards the Millennium Goal of halving extreme poverty by 2015 could be undone unless governments in developing countries and emerging markets adopt the right domestic policies to deal with this double crisis, and unless governments in the advanced industrial countries and half-emerged emerging markets create a global trading environment that allows the poorest countries to make the best use of whatever resources they have.

Increased aid from the rich countries can, in principle, help alleviate the new poverty crisis in the developing countries. In practice, aid has often done more harm than good. Sub-Saharan Africa has a near-endless list of examples of aid-gone-wrong. The political economy of the transfer of resources from the governments of rich countries to the governments of poor countries is so warped at both ends, that the poor in poor countries have frequently ended up worse off than they would have been without the aid. Aid routed through the governments of countries with a lot of very poor people is not the same as aid to poor people. When aid strengthens an unrepresentative/despotic/oppressive/corrupt/incompetent regime, the intended beneficiaries can end up the losers. ‘Do no harm' should be the first commandment for all those who see aid as a key part of the solution to the looming food and energy crisis in the developing world.

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