Reposted from a March 31, 2003 “White Paper” at Simmons & Company International.
Matthew R. Simmons
The U.S. air waves are now filled with economic stories like: “The Dangers of High Oil Prices,” “Gouging at the Gas Pump,” “Oil Prices are Silent Price Hike.” There is a widespread concept that a fast end to the war will bring prices back to normal, thereby “jump-starting” our weak economy. That high oil prices hurt and low oil prices are wonderful are the “twins” that underpin most economists’ (including most energy economists’) view of the energy world today.
I have scoffed at this notion for years, though I have never put real numbers to my general feeling that this thesis makes no sense! We now need to look at some rough numbers and see what they tell us.
My view on the prices for all three forms of energy, the cost of oil, natural gas or electricity, is that they need to be high enough for “the piper to be paid adequately.” If prices are lower than they need to be, it leads to instability and high spikes. There is no “Fairy Godmother of Energy.” All three energy forms are extremely capital intensive. Once a new “Energy Factory” is built (an energy factory being defined as a new oil or gas field, coal mine, power plant, refinery, etc.), the incremental cost of energy becomes very low for some period of time if you ignore a return that needs to be paid to the builder of the energy factory. This return cannot be ignored as the investor needs to be “lured back” to build other energy factories and losses deter capital investment. This is capitalism 101.
For a few years after a new energy factory is built, its maintenance costs are minimal so “break-even” rents are purely the cash costs to create energy, plus the return on investment to the investor who put up the money for the “plant.”
Over time, however, even fully built “energy factories” need substantially more investment to keep operating at the factory’s original capacity. In oil and gas fields, these cash costs begin a dramatic rise once the production begins to lose pressure or encounter water, or both—a physical event know in the trade as “the decline curve” or “depletion.” Once this happens, an ever increasing amount of money needs to be spent to stem the decline and, hopefully, keep production flat.
Another key element of the cost of energy is that proven oil and gas reserves are useless in terms of usable energy. The hydrocarbons need to be extracted through costly well completion systems, transported through a complex transportation system to a collection point where gas, water and other impurities are extracted. Each step of this process requires not only investment, but also uses up energy as raw resources are turned into useable energy.
Once “pure” oil or gas is created (i.e. all its impurities removed), it then needs to be transported to where it is turned into primary energy. Up to this point, all that has been created is a raw form of energy. This transformation requires costly refineries, gas plants and power plants. Each is also remarkably intertwined. For example, remove natural gas liquids and electricity from a refinery and the process grinds to a halt almost instantly.
Look at what needs to happen for oil to become “useable oil.” Reserves first need to be discovered. Then a costly program needs to be undertaken to bring the reserves out of the earth. It finally gets to a refinery where it is transformed through a complex process into finished petroleum products. Often the refinery output needs further blending to create useable energy. Even motor gasoline needs various other blending components to meet the environmental regulations for highway fuels. These finished products then need to be distributed to every nook and cranny of the United States, as our refineries are now “few and far between.” And even individual states have different requirements for gasoline blends.
Each step in this complex chain is very costly to perform. The replacement cost of every link in the chain is very high. All the assets deteriorate physically and a maintenance investment is constantly needed. And none of this complex can operate at 100% so spare redundancy is mandatory.
Just keeping the “work in process” inventory intact to make this complex process work is also extremely expensive. In the United States, for instance, we now routinely use about 20 million barrels of oil per day. For this high level of oil demand to efficiently, effortlessly occur requires over 900 million barrels of crude and finished product inventory. Just the carrying value of this “stock” or inventory amounts to about $36 to $45 billion. If the owner of this inventory wanted a mere 12% return, after tax, for the risk of holding all this volatile stock, it would add $800 million ($40 billion x 20% pre-tax or 12% after tax) a year to our oil prices.
What these simple numbers ought to illustrate is the myriad of “hidden” costs involved in creating safe, reliable and clean energy. But is this widely understood?
The answer is a resounding “No!” Too many world-class economists believe with some passion that oil needs to be priced at $15 to $20 to make our economy ZING! These are the same wizards who believed we were in a “New Economy” that was becoming devoid of even needing energy (and the same bright gurus who endorsed a ten-fold growth in telecommunications and the internet, causing the bubble which collapsed and created our current economic stress). $30 oil had nothing to do with these two bubbles bursting. It is certainly easy to use “oil” as the whipping boy in a sloppy economic analysis, but it really did not lead to the collapse of the NASDAQ. All who preach this concept need to open their eyes to some simple economic truths.
$15 to $20 oil was a bad concept. It was pricing very expensive energy far too low. These low prices seem good to consumers, but they are ultimately very harmful to our economy. These prices produced abysmal financial returns for every step of the lengthy chain of events needed to create energy. They punished anyone dense enough to invest in any new “energy factory.”
These low prices also created a very dangerous downward spiral in per capita GDP for every large producer of exportable oil and gas—but few economists seemed to grasp that “social costs” for countries like Nigeria, Saudi Arabia and Venezuela were just as real as the need to pay the owner of $40 billion in oil inventories a fair return for shouldering the burden.
Sadly, there are no good numbers on the total investment needed to merely satiate just the United States’ thirst for 20 million barrels of oil each day, let alone the cost of our global need for over 75 million barrels of oil each day. There are no solid numbers on the investment cost to build a slew of new “energy factories” so the world can add the IEA’s conservative estimate which shows the world needing 130 million barrels of oil-equivalent energy by 2030—and this still leaves almost 2 billion people without any electricity! It might take as much as $30 to 40 trillion to make this miracle happen. The world has never spent this much money on anything.
There is no way energy prices can stay as low as they were through the 1990s. Future prices have to rise or energy supplies will not grow and will likely decline. But how dangerous are high energy prices? Our economists seem convinced that a $10 rise in oil prices costs our GDP at least 0.5%. Are these numbers real? Does it even matter? Here is my cut at the numbers for the United States (and though admittedly rough, at least they exist.)
The U.S. GDP now totals about $10 trillion a year. Our oil use is 20 million barrels per day. Half of this is highway fuel which (after adding tax) averaged $1.65 per gallon or $70 per barrel. Assume the balance at retail prices was two-thirds this amount or $45 per barrel. This totals $420 billion a year, or 4.2% of our annual GDP. (It is also just double what we spend on consumer advertising, a cost that some think is 90% wasted!) If the cost of oil suddenly rises by $10, this adds $75 billion, bringing the total to almost $500 billion a year. The increase is seven-tenths of 1% of our GDP. Thus, it is worse than a 0.5% hit to the GDP. However, the numbers might not even matter. Almost all oil price increases immediately create more income for various participants along the complex chain, converting proven reserves into raw energy which is then converted to primary energy and finally useable energy.
Virtually all of the incremental cash created as energy prices rise is then “plowed back” into spending on more maintenance and investment capital. The net effect might actually add more to our GDP. Rising oil prices also create higher i ncomes, both personal and corporate, rise and more taxes are paid. The net affect of an increase in oil prices might then actually stimulate the overall economy although it will clearly impact a shift in consumer spending.
To the extent realistic energy prices take money away from U.S. consumers’ current discretionary income, is an entirely different issue than to assume this is simply a tax that disappears into some oil baron’s bank account.
Energy prices need to be high enough to maintain our current supply chain and build new energy factories. Prices need to be high enough so the burgeoning populations within virtually every OPEC country begin to create a middle -class from the core populations in all those now poor countries. If this middle-class develops and they begin buying what U.S. consumers take for granted, this could be a boon to our economy similar to when the Marshall Plan set out guidelines to rebuild Europe—and this created the biggest boom to our economy that lasted 50 years.
Low energy prices seem like a beautiful gift to our economy. But the apparent gift is a cruel hoax if low prices cannot create sustainable energy. Energy prices that are too low are as dangerous to the economy as drugs are to the body—another consumption item which apparently makes people feel good while they are being used. It is time for Americans to grow up about the importance of clean and reliable energy and the cost that someone needs to pay to keep this economic miracle alive. The “Fairy Godmother Era” of energy is over. The sooner we wake up to this fact, the better we will all be.
Matthew Simmons is one of the leading energy advisors to President George Bush and the United States Congress.