Business
2. Energy
2.1 Demand for energy
Chapter 5
Energy Economics and Trade
Michael Tamvakis*
1. Introduction
It is a well known fact that the international maritime industry is driven by the movement of goods and people. Maritime economists have long established that the demand for shipping services is derived from the demand for international trade and awareness of what drives the latter is the aim of this chapter.
Within the space and scope of the next few pages, it is impossible to cover all trades and factors that affect demand for maritime services. We will focus, instead, on the economics and major trade patterns of the most important commodity group, energy, which encompasses three very important commodities: crude oil and products, gas and coal.
Figure 1: World primary energy production
Source: BP Statistical Review of World Energy, 2009
looking at the development of industrial production and primary energy consumption in OECD countries since 1973. Notice the fundamental change in the relationship between the two indices after 1980. For comparison, the price of oil is also plotted on the same chart, and highlights the effect it has had on energy consumption.
The notion of a straightforward relationship between energy consumption and GDP is quite appealing, but rather simplistic. One has to look at the disaggregated picture of energy consumption to get a more accurate idea of the underlying demand parameters. Primary energy consumption is usually classified into four broad categories: industrial; transport; other (incl. residential and agriculture); and a fourth residual category encompassing all non-energy uses. Figure 3 shows the OECD estimate of energy usage in the world, by fuel, in 2007.
2.1.1 Residential consumption
Like for any other good, demand for energy depends on the price of the commodity and the total disposable income of households. Any change in the price of the commodity will affect the quantity purchased by consumers. For example, if the price of oil falls, its consumption is expected to increase ceteris paribus. The total change in consumption is usually split between the income
and the substitution effects. The first is attributed to the fact that with the new, lower price the same amount of income will buy more units of the commodity;
the second effect is due to the switch from other, more expensive substitutes to the lower-priced commodity.
Figure 2: Industrial production and energy consumption in OECD
Source: OECD Key Economic Indicators, BP Statistical Review of World Energy; Datastream
When analysing the demand for specific energy commodities, it is always useful to know their responsiveness to changes in their own price, changes in disposable income and changes in the price of substitutes. This responsiveness is measured by the own price – or demand – elasticity, the income elasticity, and the cross-price elasticity. The usefulness of these three parameters was eminently demonstrated during the two oil price shocks in 1973 and 1979. While the first shock put pressure on household incomes, which had to accommodate a larger expenditure for energy, it did not tamper demand for oil substantially. This was not the case with the second oil price shock, however, when income and price elasticities of oil experienced a structural change and led to a dramatically reduced demand for oil. In yet another demonstration of the change in these fundamental relationships, demand for energy in recent years seems to grow unabated despite the persistent ascent of oil prices.
2.1.2 Industrial consumption
The production cost of an industrial process depends – in the short to medium term – on the cost of its inputs and a set of fixed costs; in the long term, of course, all costs are variable. The production cost function can be formally written as C = ƒ(X1... Xn, E, FC), where X1...Xn are production inputs, E is energy and FC is fixed cost. This function
Figure 3: World energy consumption by fuel and sector, 2007 Source: IEA Key World Energy Statistics, 2009
represents a slight deviation from the usual norm of depicting production costs as a function of capital and labour, and is more suitable for our purposes.
The total demand for industrial energy can be viewed as an aggregation of all production cost functions like the one given above. The effects of price changes on energy demand will depend on the rate of technical substitution, which represents the rate at which one input of production can be replaced by another, in order to achieve the same cost.
In practical terms the rate of technical substitution shows how easily energy can be replaced by other input factors, and how easily different sources of energy can substitute one another in the same production process. Once again, a suitable example can be taken from the two oil price crises. The first price shock took industry by surprise, as no cost-effective alternatives to oil were available. The second shock, however, came after considerable restructuring in energy usage and efficiency had been implemented, with the result that total energy requirements were reduced and alternative sources of energy – predominantly
coal, but also natural gas and nuclear power – replaced oil.
2.1.3 Transport consumption
Energy consumption in transport is dominated by oil, which displaced coal earlier or later in the history of different transport means. In the car industry, for example, gasoline was used since the very beginning, as it was the most appropriate fuel for the internal combustion engine. At sea, coal was dominant until after the end of the World War I, but was rapidly replaced by oil afterwards.
On land, coal persisted slightly more
Figure 4: US car efficiency development
Source: Energy Information Administration, US Department of Energy, 2006 as a source of energy for locomotives, but eventually had to give in to oil’s undisputed superiority.
Today, oil is used in transport almost exclusively; perhaps the only notable exception is that of Brazil, which has promoted the extensive use of sugar- derived biofuel in the 1970s and, again, in current times. Setting aside the past and possible future use of biofuels, very few other oil substitutes have been used in transport; notably natural gas and liquid petroleum gas (propane).
Because oil has virtually no – commercially viable – substitutes in transport, demand for it depends very much on income and efficiency of use. The latter is probably more important, as is shown in Figure 4, which graphs the development of car efficiency in the United States. Two indicators are used: the rate of fuel
consumption expressed in miles per gallon; and the car usage expressed in average miles per car. Two types of vehicle are also shown: passenger cars and vans and SUVs (sports utility vehicles). As one can see, mileage was not affected substantially, despite the oil price hikes in 1973 and 1979. The rapid increase in car fuel efficiency, assisted by the mass introduction of Japanese cars in the American market, helped sustain the great love affair of US consumers with the automotive industry and provide endless material for ‘road movies’ to Hollywood scriptwriters.
Transportation is not of course limited to road only. The other two major consumers are air and seaborne transportation. The former has risen to prominence, due to the general increase in passenger and cargo air-miles travelled and due to the fact that the fuel used (aviation turbine fuel or jet kerosene) is one of the most valuable refined petroleum products. However, the importance of shipping fuel consumption (in the form of either heavy fuel oil of marine diesel) cannot be underestimated, given that an estimated 75% of the world merchandise trade is seaborne.
2.1.4 Other consumption
This category encompasses all the remaining sectors of the economy, primarily energy consumption for agricultural use and commercial buildings. Parameters affecting this segment of consumption include fuel efficiency and the degree of mechanisation of agriculture.