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The peak oil crisis: peak oil elasticity

Earlier this week the U.S. Department of Energy announced that the average national price for regular gasoline in the U.S. was now $3.96 a gallon. Don’t feel too bad though; last week the Kremlin banned gasoline and diesel exports from Russia to alleviate domestic shortages sending gasoline prices in Germany to a record $9.10 a gallon. Gasoline prices have been rising steadily since last October, and given that the summer driving season is still a few weeks away are likely to keep rising for at least a while longer.

One would think that with an increase in gasoline prices of over a dollar a gallon in the last year sales of gasoline would be slipping – and indeed they have, but not very much. With U.S. gasoline consumption running around 9 million b/d in last couple of years, consumption has only fallen by about 150,000 barrels a day, or 1.6 percent, compared with last year. Three years ago during a similar price spike, U.S. gasoline consumption fell by closer to 400,000 b/d. So far this year’s drop in consumption has not been enough to stem the rise in prices which in recent weeks have become more closely tied to the global supply/demand balance and the falling U.S. dollar.

Most of us can recall from Economics 101 the concept of elasticity of price demand which says that in most cases as the price of something goes up, the demand for the product or service goes down. We saw a classic example of this phenomenon in 2008 when oil prices reached $147 a barrel and global demand for oil fell by 2 million b/d, promptly sending prices down to $40 a barrel. The elasticity comes in as a theoretical measurement of just how much demand goes down when prices go up by a given amount. It turns out that studying the elasticity of gasoline prices has been very popular recently and that in the last 20 years there have been well over 100 papers written on the elasticity of gasoline prices. There are so many studies in fact that people have written papers summarizing all the papers on gasoline’s elasticity.

The general conclusion of these efforts is that gasoline demand in motorized societies such as the U.S. falls slowly. In the very short run, motorists have no choice but to spend whatever it costs to keep their automobiles and trucks running for their livelihoods depend on it. Over the course of a year or so, some can move to substitute forms of transport, cut back on discretionary travel, and, if they have a choice, use more fuel efficient vehicles. Within a year, all this should add up to an elasticity of demand of roughly -0.26 suggesting that for every 10 percent increase in gasoline prices, gasoline demand should fall by 2.6 percent. If prices remain high for several years, then the elasticity number goes to -.58 suggesting that the demand will fall by 5.8 percent for every 10 percent increase in prices. These numbers of course were derived from past experience in a simpler time before global oil production had peaked and price run-ups were mostly short-lived.

The real question is whether these numbers make any sense in today’s environment or has the situation fundamentally changed with the advent of peak oil, an anemic economy and the prospects that gasoline prices will be moving higher and higher in the months and years ahead. This question is important as many observers have taken to repeating the mantra that the solution to high gasoline prices is high gasoline prices which kill demand.

U.S. gas prices were fairly steady at around 2.60 a gallon from May 2009 to November 2010 when they started climbing and are now in the vicinity of $4. This is about a fifty percent increase in the last seven months suggesting that if the conventional wisdom about the elasticity of gasoline holds true, demand for gasoline in the US should be down by roughly a million b/d after people sort out their relationship to automobiles in their lifestyles.

In the years prior to the recession that began in roughly 2008 US summer demand for gasoline was about 9.6 million b/d and slowly increasing. For the last two summers however, demand has peaked at about 9.3 million b/d suggesting that the recession has cut about 300,000 b/d off peak driving season demand. Some of this drop in demand, of course, is from business. With the economy limping along on the federal stimulus spending and housing construction way below the highs of five years ago, the use of gasoline is down. High gasoline prices and widespread un/under-employment have forced many to reduce gasoline consumption. Anecdotal evidence suggests that driving by the large numbers of unemployed teenagers is way below what it once was. In short, the weaker hands cut their gasoline consumption over the last few years. The average U.S. personal vehicle (cars, trucks and SUVs) consumes about 700 gallons of fuel a year. At $4 a gallon this is now about $2800 a year to fuel the average passenger vehicle. Each dollar a gallon increase adds only $60 a month to the gasoline bill, an amount manageable by many given the “essential” of personal transport.

This analysis suggests that at least for the immediate future we are not likely to see much of a drop in the demand for gasoline. If the economy slows further, then commercial demand for fuels by industry, business, airlines, etc. is likely to drop. Detroit is already expressing concern that $4.50 gasoline will cut into sales of large vehicles much as $4 gasoline did three years ago. For most there is currently no ready substitute for gasoline. When it comes to food, chicken or pasta can readily be substituted for beef, and restaurants bypassed. But for the mobility which is essential to our lifestyles few have an acceptable ready substitute. While U.S. gasoline consumption may fall by hundreds of thousands of barrels due to higher prices in the next few years, it is difficult to foresee it falling by millions.

Tom Whipple is a retired government analyst and has been following the peak oil issue for several years.

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