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Tuesday, November 18, 2003

Oil depletion and economics - Part III

The previous two posts presented an argument for depletion and that it would act as an exogenous component in the supply of oil. The effect would become increasingly dominant as the resource endowment was used up. But supply is only part of the picture. The structure of demand will determine the overall effects on the market. For example, if demand were extremely elastic then the overall effects of a supply limitation would be minimal.

Together, the ‘income effect’ and ‘substitution effect’ are large determinants of the elasticity of demand. The first reflects the relationship between income and consumption. The latter reflects the ease of switching to alternatives.

[The previous posts focused on oil. However, it’s difficult to talk about demand, particularly substitution, without occasionally extending the discussion to energy in general.]

The income effect

It turns out that per-capita energy usage is a pretty good indicator of overall welfare in a society. This suggests that energy consumption and income/wealth/development are related. However, this relationship isn’t linear, or even monotonic.

At low levels of development, profits are invested in relatively low energy intensity activities. Eventually, further development brings about industrialization/mechanization and with it - increased energy intensity. However, further development moves society to a point where the less-energy-intensive service sector becomes a large portion of the economy’s growth. The end result is that a plot of energy consumption vs. income would be somewhat ‘s’- shaped: It would increase slowly for a while, and then would increase rapidly until it slowed down again.

In microeconomic terms, the income elasticity is the derivative of this curve. At low levels of development, the income elasticity is relatively low but increasing. In the mid-stage, income elasticity of energy is relatively high. As service sector growth becomes more significant, the economy begins to ‘dematerialize’ and the income elasticity decreases.

It is important to note that the middle, high-elasticity, phase captures the fact that *building* the infrastructure for a modern society requires energy. So, even developing economies that focusing on rapidly growing the service sector (e.g. India) are still going to go through the middle stage.

To be accurate, there isn’t a single ‘s’-curve that applies for all countries. The exact shape will be a function of a large number of factors including taxes, subsidies and transportation mix. The general behavior, not the specifics in the height and shape of the curve, are what’s important here. For example, there’s a dramatic difference in per capita energy consumption between OECD countries. However they went through the same general trend as they developed.

The behavior of the income elasticity of energy consumption repeats with oil consumption. And the broad conclusions also apply. The declining GDP/oil consumption ratio of OECD countries is a consequence of the ‘dematerialization’ associated with the ‘top’ of the ‘s’.

The substitution effect

The income effect is only part of the picture. In general, the substitution effect is much larger. The purpose of this section is to describe why isn’t.

From an engineering perspective, oil is a great fuel. It has a high energy density, minimizing the size and weight of fuel tanks. It burns hot for good thermodynamic efficiency and as a liquid, it’s easy to distribute. These are only some of the reasons why the vast majority of the transportation industry uses oil. Other industries use oil as well. In some cases, they can switch to a substitute (typically natural gas) relatively easily. A great deal of infrastructure, and engineering, has been optimized to take advantage of oil’s attributes. This places limits on the ease of substitution, at least in the short term.

An even stronger limitation comes from the market itself. Switching away from oil entails a considerable investment of time and money. The delay between commitment and implementation means that the trigger for substitution is not the price but the *expected* price for some period in the future.

The oil market has a history of price surges, followed by spectacular collapses, and any rise in the price of oil is viewed through this lens. This means that price increases or spikes are viewed as temporary so the expected future price doesn’t change appreciably. As a result, the incentive (price signal) is largely ignored.

Another factor is that oil is less of an end product and more of a factor of production. In many cases, the price of oil is a small factor of the overall cost. As such, price swings are easily passed on. Alternatively, since the price increase is viewed as temporary the cost increase is ‘eaten’.

The end result is that the substitution effect for oil is very low.


The overall elasticity will be a combination of the income effect and the substitution effect. Given that the substitution effect is very small, it’s possible that the income effect can have a significant – even dominant – impact. Recently, between 1998 and 2000, the price of oil jumped from about $10 to more than $30, a 200+% increase. At the same time, demand didn’t decrease appreciably – on the order of a percent or two. Even if the deviation of trend, rather than the absolute change, is used the overall conclusions remain unchanged. A 200% jump in price yielded a few percent change in demand. The net elasticity (dQ/dP) << 1. Demand is virtually inelastic, at least in the short term.

It turns out that the observation mentioned above occurred under somewhat unusual circumstances. Specifically during this interval, the U.S. made up a disproportionate amount of the overall world growth. A quick summary of a few economies should highlight the significance of this.

* US – The U.S. is the largest consumer of oil, its per-capita consumption is among the highest in the world and its oil/gasoline taxes are very low relative to other OECD countries. In principle, this should make U.S. more elastic. Despite this, recent observations show that overall demand is very inelastic.

* Other OECD – They aren’t as energy intensive as the U.S. and they also have relatively high taxes on oil – suppressing the effects of price increases. Arguably, they should be less elastic than the U.S. As was the case with the U.S., the recent tripling of crude oil prices had little overall effect on demand – a low elasticity of demand.

* OPEC – Higher prices translate to increased revenue. This, along with their rapidly increasing populations, implies increasing consumption – both for oil and other products.

* China – As the lowest-cost producer of basic goods, they would be beneficiaries of OPEC’s increased income. This also contributes to a secular (as far as oil price is concerned) trend of growth in China. Although it is difficult to gauge the net effect, demand for oil is inelastic, if not positive (for secular reasons).

* Commodity Exporters (e.g. Chile, Peru, Brazil) – This is an interesting, subtle, case. Increases in oil prices cause their customers (e.g. OPEC and China) to increase demand. In turn, this increases their income. Since many of these countries are close to the steep portion of the ‘s’ curve (large income elasticity), and the large role that commodity export plays in their GDP, the income effect overrides the substitution effect. This gives rise to a *positive* elasticity of demand – demand increases with increasing oil price (a ‘Giffen good’.


To summarize; recently the price of oil jumped dramatically. Despite this, the decrease in overall demand was negligible. Furthermore, this occurred when the U.S. made up a very large portion of world income growth. The U.S. has a relatively low income elasticity compared to other countries. Arguably, if world growth had been more evenly distributed, the overall elasticity would have been smaller, if not positive. This would have been particularly true if growth was focused in rapidly industrializing countries. This past Friday, the WSJ had an article on Friday about how China made up a very large percentage of the growth in world oil demand this year.

The short-term elasticity for oil is very low. If depletion starts to dominate oil supply, there’s no reason to believe that the demand side will be able to mitigate the effects mentioned in the previous posts – at least in the short-term. Clearly, elasticity is not fixed for all prices but there is little evidence that elasticity will suddenly jump either.


The long-term effects are difficult to untangle. Perhaps the biggest single hurdle is the ‘price-expectation’ issue: Alternatives will take time to implement. If the price expectation doesn’t take depletion into account, the market signal could be delayed to the point that alternatives will not be ready in time.

The absence of alternatives will present us with some harsh decisions. Some of which involve developing countries. In order for developing countries to obtain a ‘modern’ infrastructure, they will have to go through a higher energy/oil utilization phase. In the absence of alternatives, depletion implies one of two choices: Either developing countries halt their advancement, or developed economies reduce their oil consumption to free up oil for the developing countries to advance. In the latter case, the relatively high GDP/unit of oil consumption of is something of a ‘curse’: A developed country must sacrifice many dollars of output to free up a unit of oil. The recipient, a developing country, uses this oil to advance but produces relatively fewer dollars of output. The economically optimal solution allocates oil to the country with the highest marginal output per unit of oil, so it’s clear which choice the market would favor.


The next (hopefully last) section will cover international flows and investment in both oil and alternatives.


Disclosure: The last few posts, this one included, rely on the works of others that I’ve been too lazy to cite properly. Please do not interpret this as entirely original work. If there is sufficient interest, I will write this up in a formal format with proper citations. Otherwise, if you have questions where something came from, ask me.

- Chris Anderson

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