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Blog » Price elasticity of oil

23 Mar 2005

Price elasticity of oil

Filed under: Economics — paulcook @ 12:49 pm

A post on blogwaffe has reminded me of some of the economic implications of oil depletion, in areas like production of plastics.

As rightly pointed out there, many uses of oil have alternatives that could be pursued, such as plant-based synthesis for plastic. But many areas of oil use, particularly agriculture and some types of transport, would require huge societal shifts to move to alternatives. Unfortunately, however, the economics of oil depletion are not going to help that shift.

Oil is not going to run out suddenly; rather the rate of production growth will start to slow, as happened in the Texas oil fields in the 1960’s. New sources of supply will become available as current ones run out, but only at far higher prices. More to the point, however, is that production doesn’t need to stay at current levels, it needs to keep growing, in order to satisfy demand. The US, with 5% of the world’s population, produces about 25% of the world’s CO2 (a good measure for energy use). As places like China and India start catching up, it is clear that oil demand is going to grow rapidly.

The question is then what will happen as production growth falls behind demand growth. Clearly prices will begin to rise, at a rate determined by the price elasticity of demand. This is essentially the derivative of demand with respect to price, that is, how much a given price change affects demand. The problem is that oil has a very low price elasticity — prices have to soar to affect demand even a little.

There are two ways to demand can be reduced as prices rise: firstly, by substitution, where another, cheaper commodity is used instead of oil; and secondly, by simple reduction in use, as people cut back on using oil. The problem is that neither works well for fossil fuels.

A look at the uses of oil (there are many good websites about this, try for example this one), shows that the main uses are things like energy production, transport, plastic production, and agriculture. None of these are particularly amenably to substitution. Renewable sources of electrical energy are still not suited for replacing the vast majority of oil, gas and coal plants — with the exception of nuclear energy, which faces huge (and in my opinion massively misguided) environmental opposition. Hydrogen cars still require hydrogen to be produced, which currently uses oil; it’s hard to see aeroplanes using anything other than oil-based fuel. Plastics use petrochemicals as their basic input, and there is currently no reasonably-priced alternative. Agriculture relies on huge amounts of energy to drive tractors, and get the food in to our cities, as well as to produce fertilisers, such that feeding six billion people is currently not possible without oil.

Contrast this to, for example, platinum and paladium, produced primarily by South Africa and Russia, respectively. They are seeing massive use in, for example, catalytic converters. It is, however, relatively easy to use either one or the other for this purpose, so historically as one starts to rise in price (from growing demand or trade sanctions), car makers move to using the other, and the price changes are moderated. No such substitute for fossil fuels exists.

So what about people just using less oil? One can characterise goods as luxuries when they are essentially optional — as the price rises, people can just chose not to buy the good. Oil is not a luxury. Electricity is vital to almost everything we do. Without dramatic reorganisation of our cities, people need transport just to get to work. Plastics are used everywhere — even clothing, and it’s hard to see us getting rid of them. Agriculture is obviously going to have to happen, regardless of oil price. So essentially, almost all our current oil use will continue to happen, largely irrespective of price.

Some proof of the above arguments: the oil shocks of last century. Relatively small drops in production due to OPEC tightening or supply disruptions led to huge rises in oil prices. And it’s happening today again: even as OPEC oil supply is increased, just the fear of supply disruptions is enough to send the price up well over 100% over the last year or two.

So what? Clearly, eventually the world will have to do some dramatic reorganistation and development of technology, as oil runs out. There are any number of great ideas, but to make them happen requires huge research, and even huger changes to society. These might include building new power plants, rebuilding our petrol distribution system to use another fuel, shifting our entire plastics industry to use a different set of precursors, and so on. All of these take a long time.

Time which we may not have. When we reach the peak of oil supply growth, which may be only a few years away according to some scientists, prices will begin to rise. But due to oil’s low price elasticity, this will have little effect on demand growth. Prices will rise rapidly, and just keep on rising. We may then be faced with huge price increases in all sorts of goods, notably things like food. Not only will this have a huge effect on the poor, but energy shortages will also make any huge infrastructure changes that are required far more expensive.

Market forces are often a good way of regulating supply and use of various commodities. But in the case of oil, the combination of low price elasticity and the importance of oil to everything we do, might suggest that some other measures be taken. Now if only more of the world’s governments agreed…

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27 Comments »

  1. Paul, excellent post! Well said. An interesting way to compare previous oil shocks to this one is to look at the long term contracts on oil futures. In previous oil shocks, the long term (five years out) contracts held steady but now the prices on the long term contracts are rising faster than the short term contracts. So oil traders seem to think that the long term oil outlook is bad.

    I also like your point on food production and how its tied to oil. I read a piece once that showed the rise in oil consumption and the rise in population. Amazing how closely they’re tied together.

    Comment by Griztown — 23 Mar 2005 @ 5:14 pm

  2. A good site to check oil prices is the New York Mercantile Exchange.

    Light Sweet Crude Oil

    Comment by Griztown — 23 Mar 2005 @ 9:50 pm

  3. Ironically, the current somewhat slow rise in prices might act to speed us along with the changes I mention above. It would be extremely ironic if the “silver lining” of the mess in Iraq was that we weathered the oil crunch better!

    Good link, thanks!

    Comment by paulcook — 24 Mar 2005 @ 12:02 pm

  4. Yeah, all the conspiracy theory people on the internet are convinced that Bush and Cheney knew about the oil depletion and went into Iraq solely to horde the oil for the US. Quite a stretch but one would assume looking back that oil was the primary reason for going into Iraq.

    Comment by Griztown — 24 Mar 2005 @ 3:58 pm

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  7. Hm. Would be true, except that your statement about the price elasticity of oil is incorrect. The short-term price elasticity of oil isn’t huge - you aren’t going to switch from a Hummer to a Prius tomorrow just because gas is now $3 a gallon.

    However, 3 years from now when it’s time to switch, the gas prices will be a consideration. The long-term price elasticity of oil is actually quite high - last I looked at the latest studies, it could be as high as -0.47 over 3 years.

    Comment by Tubby Bartles — 13 May 2006 @ 9:50 pm

  8. Sorry, should have cited source. Short-term price elasticity of -0.06 for oil in the US (quite low - not much change in demand at all for oil when the price rises). Long term price elasticity of -0.4556 - not huge, but very respectable and represents a signficant cutback in oil usage - almost 50% if prices double.

    Source: http://alpha.qmul.ac.uk/~bsw019/oil.pdf
    (Simply a survey of oil price elasticities for 23 major countries)

    Comment by Tubby Bartles — 13 May 2006 @ 10:27 pm

  9. I think elasticity should depend on credit availability and primary end use:

    ie. oil use in countries where oil use is low, should have a far higher elasticity because low incomes restrict oil use to more profitable end uses…?

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