How the shale oil revolution has affected US oil and gasoline prices

The recent expansion of US shale oil production has captured the imagination of policymakers and industry analysts. It has fuelled visions of the US becoming independent of oil imports, of cheap US gasoline, of a rebirth of US manufacturing, and of net oil exports improving the US current account. This column asks how plausible these visions are, and examines the evidence to date.

Only a few years ago, many observers expected a steadily growing global shortage of crude oil. This shortage did not materialise in part because of the rapidly growing production of shale oil in the US. The production of shale oil (also referred to as tight oil) exploits technological advances in drilling. It involves horizontal drilling and the hydraulic fracturing (or fracking) of underground rock formations containing deposits of crude oil that are trapped within the rock. This process is used to extract crude oil that would have been impossible to release by conventional drilling methods designed for extracting oil from permeable rock formations. Shale oil production relies on the availability of suitable drilling rigs and skilled labour, which is one of the reasons why the US shale oil boom so far has been difficult to replicate in other countries.

US shale oil production has grown from about 0.4 million barrels a day in 2007 to more than 4 million barrels a day in 2014. This expansion was stimulated by the high price of crude oil after 2003, which made the application of these new drilling technologies cost competitive. The expansion of US shale oil production soon captured the imagination of policymakers and industry analysts. By 2012, the International Energy Agency projected that the US would become the world’s leading crude oil producer, overtaking Saudi Arabia by the mid-2020s and evolving into a net oil exporter by 2030 (International Energy Agency 2012). Pundits envisioned the US becoming independent of oil imports, net oil exports financing the US non-oil trade deficit, and consumers enjoying an era of cheap gasoline with a resulting rebirth of US manufacturing. My recent research, however, suggests that these visions remain far removed from reality (Kilian 2014).

Uncertainty about the US shale oil boom

To gauge the importance of shale oil for the US economy it is useful to bear in mind that, as of March 2014, shale oil accounted for almost half of US oil production, but only about a quarter of the total quantity of oil used by the US economy. This magnitude is far from negligible, but to understand the excitement about shale oil one has to consider projections of future US shale oil production.

Publicly available projections of future shale oil production have to be interpreted with some caution.

• One concern is that increases in shale oil production are not permanent.

Sustained production requires ongoing investment. Projections by the US Energy Information Administration suggest that even under favourable conditions US shale oil production will peak by 2020 (at a level commensurate with US oil production in 1970) and then decline. Moreover, even the peak level would be far below what is needed to satisfy US oil demand.

• A second concern is that estimates of the stock of shale oil that can be recovered using current technology are subject to considerable error.

In the summer of 2014, for example, the Energy Information Administration was forced to lower its previous estimates of the stock of recoverable shale oil by 64%.

• A third concern is that it is not known how vulnerable the shale oil industry is to downside oil price risk.

This concern has become particularly relevant in recent months with the rapid decline in global oil prices. Shale oil production remains profitable as long as the price of oil exceeds marginal cost. There are indications that the initially high marginal cost of shale oil production has been declining substantially, as the shale oil industry has gained experience, but there are no reliable industry-level estimates of marginal cost.

In short, there is considerable uncertainty about the persistence and scope of the US shale oil boom, and there are many reasons to be skeptical of the notion that the US will soon (or indeed ever) become independent of oil imports.

Today, the US is the third-largest oil producer, slightly behind Saudi Arabia and Russia, with US crude oil accounting for about 10% of world production. Much has been made of the possibility of the US overtaking Saudi Arabia as the largest oil producer in the world, as the production of shale oil continues to surge. The implicit premise has been that being a large oil producer ensures a country’s energy security. It is easy to forget, however, that the US already was the world’s largest oil producer in 1973/1974 as well as in 1990. This fact did not protect the US economy from major foreign oil price shocks, suggesting that the focus on becoming the world’s largest oil producer is misplaced.

Imperfect substitutability between different types of crude oil

Even more importantly, the shale oil debate has largely ignored the fact that shale oil is not a perfect substitute for conventional crude oil, making comparisons across countries difficult. The quality of crude oil can be characterised mainly along two dimensions. One is the oil’s density (ranging fromlight to heavy) and is typically measured based on the American Petroleum Institute (API) gravity formula; the other is its sulphur content (with sweet referring to low-sulphur content and sour to high-sulphur content). Figure 1 provides an overview of how commonly quoted crude oil benchmarks (including West Texas Intermediate (WTI) and Brent oil in the North Sea) can be characterised along these dimensions. Shale oil consists of light sweet crude (at most 45 API), ultra-light sweet crude (about 47 API), and condensates (as high as 60API). Thus, not all shale oil is a good substitute for conventional light sweet crude oil such as the WTI or Brent benchmarks, and an aggregate analysis of the crude oil market tends to be misleading. In reality, the impact of shale has been far more complicated.

Figure 1. Classification of conventional crude oil benchmarks

Source: US Energy Information Administration.

Notes: MARS refers to an offshore drilling site in the Gulf of Mexico. WTI = West Texas Intermediate. LLS = Louisiana Light Sweet. FSU = Former Soviet Union. UAE = United Arab Emirates.

The US shale oil boom was preceded by a persistent and growing shortage of light sweet crude oil in world markets. US refiners responded to this trend by expanding their capacity to process heavy crudes that remained in abundant supply, becoming the world leader in this field. They were therefore taken by surprise when the US market was inundated with shale crude oil from the centre of the country after 2010. Not only was much of the refining structure ill-equipped to process this light sweet crude oil, but it proved difficult to ship the shale oil to those refineries on the coasts that would have been able to process it. With the development of shale oil in the interior of the country, large parts of the US oil pipeline infrastructure developed over the preceding 40 years had suddenly become obsolete, and rail and barge transport could not cope with increased demand. Moreover, exports of US shale oil that cannot be processed domestically were (and continue to be) prohibited by US law.

The resulting local excess supply of light sweet crude oil in the central US caused the WTI price of oil to fall below the Brent price. This discrepancy between domestic and global oil prices resulted from a breakdown of arbitrage between domestic and imported light sweet crude oil. There are signs that the US refining industry is gradually responding to these price differentials. Reconfiguring the US refining and transportation infrastructure, however, is a costly and slow process. For the time being, therefore, the evolution of the US price of oil is inextricably tied to improvements in the US refining, pipeline, and rail infrastructure.

In sharp contrast, US retail fuel prices have remained integrated with the world market in part because US refined products such as gasoline or diesel (unlike domestically produced crude oil) may be exported freely. As a result, the widely noted decline in US domestic oil prices relative to international benchmarks such as Brent, has not been passed on to the consumer in the interior of the country. This point is important because it removes the basis for any notion of a rebirth of US manufacturing on the basis of low-cost US gasoline and diesel fuel.

The beneficiaries of the US shale oil boom

Thus, the main beneficiary of the US shale oil revolution has been not gasoline consumers or, for that matter, domestic shale oil producers, but the US refining industry, which enjoys a competitive advantage compared to diesel and gasoline producers abroad because of its access to low-cost crude oil. In fact, refiners have every incentive to preserve the status quo and to prevent a lifting of the US ban on exports of domestically produced crude oil. An additional beneficiary of the shale oil revolution has been the transportation sector, notably the railroad industry, and the industries directly serving the oil sector. In contrast, the macroeconomic effects on real output and employment have been small, given the negligible share of the shale oil sector in the US economy. It is fair to say that there is no support for the notion that shale oil has been a game changer for the US economy. One area in which the shale oil revolution has made a difference is in reducing crude oil imports on the one hand, and increasing exports of refined products on the other, thus improving the US trade balance (and as a side-effect dampening the effect of foreign oil price shocks on the US economy). Of course, these improvements are small compared with the overall US trade deficit.

The (lack of) impact on the global price of oil

It may seem that the rapid decline in the global price of oil after mid-2014 may be attributable to sharp increases in US shale oil production, providing direct evidence of the impact of the US shale oil revolution on oil prices after all. Although shale oil is not being exported, it replaces US crude oil imports, reducing the demand for oil in global markets, as do US exports of refined products. Some observers have gone as far as suggesting that shale oil may have become a victim of its own success in that it caused a sharp drop in global oil prices. There is no credible support for this interpretation. Similar price declines also occurred in other industrial commodity markets at the same time, suggesting that the cause of the oil price decline has not been specific to the oil sector, but that it mainly reflects a weakening global economy in Asia as well as Europe, possibly amplified by the decision of many oil producers to preserve oil revenues by increasing oil production in response to falling oil prices. This view is also consistent with the comparatively small magnitude of US shale oil production on a global scale.

By : Lutz Kilian

References

International Energy Agency (2012), World Energy Outlook 2012, Paris: OECD/IEA.

Kilian, L (2014), “The Impact of the Shale Oil Revolution on U.S. Oil and Gasoline Prices”, CEPR Discussion Paper 10304.

Global carbon taxation: Intuition from a back-of-the-envelope calculation

The failure of markets to price carbon emissions appropriately leads to excessive fuel use and induces global warming. This column suggests a new, back-of-the-envelope rule for calculating the global carbon price. The authors find that fighting global warming requires a price of around $15 per ton of emitted CO₂, or $0.13 per gallon of gasoline. The rule also highlights the importance of economic indicators, such as GDP, for climate policy.

The biggest externality on the planet is the failure of markets to price carbon emissions appropriately (Stern 2007). This leads to excessive fossil fuel use which induces global warming and all the economic costs that go with it. Governments should cease the moment of plummeting oil prices and set a price of carbon equal to the optimal social cost of carbon, where the social cost of carbon is the present discounted value of all future production losses from the global warming induced by emitting one extra ton of carbon. Our calculations suggest a price of $15 per ton of emitted CO₂ or 13% per gallon gasoline. This price can be either implemented with a global tax on carbon emissions or with competitive markets for tradable emission rights and, in the absence of second-best issues, must be the same throughout the globe.

The most prominent integrated assessment model of climate and the economy is DICE (Nordhaus 2008, 2014). Such models can be used to calculate the optimal level and time path for the price of carbon. Alas, most people, including policymakers and economists, view these integrated assessment models as a ‘black box’ and consequently the resulting prescriptions for the carbon price are hard to understand and communicate to policymakers.

New rule for the global carbon price

This is why we propose a simple rule for the global carbon price, which can be calculated on the back of the envelope and approximates the correct optimal carbon price very accurately. Furthermore, this rule is robust, transparent, and easy to understand and implement. The rule depends on geophysical factors, such as dissipation rates of atmospheric carbon into oceanic sinks, and economic parameters, such as the long-run growth rate of productivity and the societal rates of time impatience and intergenerational inequality aversion. Our rule is based on the following premises.

• First, the carbon cycle is much more sluggish than the process of growth convergence. This allows us to base our calculations on trend growth rates.
• Second, a fifth of carbon emission stays permanently in the atmosphere and of the remainder 60% is absorbed by the oceans and the earth’s surface within a year and the rest has a half-time of three hundred years.
• After three decades, half of the carbon has left the atmosphere. Emitting one ton of carbon thus implies that is left in the atmosphere after t years.
• Third, marginal climate damages are roughly 2.38% of world GDP per trillion tons of extra carbon in the atmosphere.

These figures come from Golosov et al. (2014) and are based on DICE. It assumes that doubling the stock of atmospheric carbon yields a rise in global mean temperature of 3 degrees Celsius. Hence, the within-period damage of one ton of carbon after t years is

• Fourth, the social cost of carbon is the discounted sum of all future within-period damages.

The interest rate to discount these damages r  follows from the Keyes-Ramsey rule as the rate of time impatience r  plus the coefficient of relative intergenerational inequality aversion (IIA) times the per-capita growth rate in living standards g (Foley et al. 2013). Growth in living standards thus leads to wealthier future generations that require a higher interest rate, especially if the intergenerational inequality aversion is large because current generations are then less prepared to sacrifice current consumption.

• Fifth, it takes a long time to warm up the earth. We suppose that the average lag between global mean temperature and the stock of atmospheric carbon is 40 years.

We thus get the following back-of-the-envelope rule for the optimal social and price of carbon:

where r = p + (IIA – 1) x g Here the term in the first set of round brackets is the present discounted value of all future within-period damages resulting from emitting one ton of carbon, and the term in the second set of round brackets is the attenuation in the social cost of carbon due to the lag between the change in temperature and the change in the stock of atmospheric carbon.

Policy insights from the new rule

This rule gives the following policy insights:

• The global price of carbon is high if welfare of future generations is not discounted much.
• Higher growth in living standards g boosts the interest rate and thus depresses the optimal global carbon price if the intergenerational inequality aversion is larger than 1. As future generations are better off, current generations are less prepared to make sacrifices to combat global warming. However, if the aversion is less than 1, growth in living standards boosts the price of carbon.
• Higher intergenerational inequality aversion implies that current generations are less prepared to temper future climate damages if there is growth in living standards and thus the optimal global price of carbon is lower.
• The lag between temperature and atmospheric carbon and decay of atmospheric carbon depresses the price of carbon (the term in the second pair of brackets).
• The optimal price of carbon rises in proportion with world GDP which in 2014 totalled 76 trillion USD.

The rule is easy to extend to allow for marginal damages reacting less than proportionally to world GDP (Rezai and van der Ploeg 2014). For example, additive instead of multiplicative damages resulting from global warming give a lower initial price of carbon, especially if economic growth is high, and a completely flat time path for the price of carbon. In general, the lower elasticity of climate damages with respect to GDP, the flatter the time path of the carbon price.

Calculating the optimal price of carbon following the new rule

Our benchmark set of parameters for our rule is to suppose trend growth in living standards of 2% per annum and a degree of intergenerational aversion of 2, and to not discount the welfare of future generations at all (g = 2%, IIA = 2, r = 0). This gives an optimal price of carbon of $55 per ton of emitted carbon, $15 per ton of emitted CO₂, or $0.13 per gallon of gasoline, which subsequently rises in line with world GDP at a rate of 2% per annum.

Leaving ethical issues aside, our rule shows that discounting the welfare of future generations at 2% per annum (keeping g = 2% and IIA = 2) implies that the optimal global carbon price falls to $20 per ton of emitted carbon, $5.5 per ton of emitted CO₂, or $0.05 per gallon gasoline. 

If society were to be more concerned with intergenerational inequality aversion and used a higher aversion of 4 (keeping g = 2%, r = 0), current generations would have to sacrifice less current consumption to improve climate decades and centuries ahead. This is why our rule then indicates that the initial optimal carbon price falls to $10 per ton of carbon. Taking a lower intergenerational inequality aversion of 1 and a discount rate of 1.5% per annum as in Golosov et al. (2014) pushes up the initial price of carbon to $81 per ton emitted carbon.

A more pessimistic forecast of growth in living standards of 1 instead of 2% per annum (keeping IIA = 2, r = 0) boosts the initial price of carbon to $132 per ton of carbon, which subsequently grows at the rate of 1% per annum. To illustrate how accurate our back-of-the-envelope rule is, we road-test it in a sophisticated integrated assessment model of growth, savings, investment, and climate change with endogenous transitions between fossil fuel and renewable energy and forward-looking dynamics associated with scarce fossil fuel (for details see Rezai and van der Ploeg 2014). Figure 1 below shows that our rule approximates optimal policy very well.

Figure 1. Calculating the social cost of carbon over time

The table below also confirms that our rule predicts the optimal timing of energy transitions and the optimal amount of fossil fuel to be left unexploited in the earth very accurately. Business as usual leads to unacceptable degrees of global warming (4 degrees Celsius), since much more carbon is burnt (1640 Giga tons of carbon) than in the first best (955 GtC) or under our simple rule (960 GtC). Our rule also accurately predicts by how much the transition to the carbon-free era is brought forward (by about 18 years). No wonder our rule yields almost the same welfare gain as the first best while business as usual leads to significant welfare losses (3% of world GDP).

Table 1. Transition times and carbon budget

Recent findings in the IPCC’s fifth assessment report support our findings. While it is not possible to translate their estimates of the social cost of carbon into our model in a straight-forward manner, scenarios with similar levels of global warming yield similar time profiles for the price of carbon.

Our rule for the global price of carbon is easy to extend for growth damages of global warming (Dell et al. 2012). This pushes up the carbon tax and brings forward the carbon-free era to 2044, curbs the total carbon budget (to 452 GtC) and the maximum temperature (to 2.3 degrees Celsius). Allowing for prudence in face of growth uncertainty also induces a marginally more ambitious climate policy, but rather less so. On the other hand, additive damages lead to a laxer climate policy with a much bigger carbon budget (1600 GtC) and abandoning fossil fuel much later (2077).

Conclusion

In sum, our back-of-the-envelope rule calculates the optimal global price of carbon and gives an accurate prediction of the optimal carbon tax. It highlights the importance of economic primitives, such as the trend growth rate of GDP, for climate policy. We hope that as the rule is easy to understand and communicate, it might also be easier to implement.

By : Armon Rezai, Rick van der Ploeg 

References

Dell, M, Jones, B and B Olken (2012), “Temperature shocks and economic growth: Evidence from the last half century”, American Economic Journal: Macroeconomics 4, 66-95.

Foley, D, Rezai, A and L Taylor (2013), “The social cost of carbon emissions”, Economics Letters121, 90-97.

Golosov, M, J Hassler, and P Krusell (2014), “Optimal taxes on fossil fuel in general equilibrium”,Econometrica, 82, 1, 41-88.

Nordhaus, W (2008), A Question of Balance: Economic Models of Climate Change, Yale University Press, New Haven, Connecticut.

Nordhaus, W (2014), “Estimates of the social cost of carbon: concepts and results from the DICE-2013R model and alternative approaches”, Journal of the Association of Environmental and  Resource Economists, 1, 273-312.

Rezai, A and F van der Ploeg (2014), “Intergenerational Inequality Aversion, Growth and the Role of Damages: Occam’s Rule for the Global Carbon Tax”, Discussion Paper 10292, CEPR, London.

Stern, N (2007), The Economics of Climate Change: The Stern Review, Cambridge University Press, Cambridge

High Performance Polymers for Oil & Gas 2014

These proceedings cover all the presentations from the two day event which was guided by a team of industry gurus, bringing you a broad range of highly topical papers that addressed all of the different aspects to do with the latest developments and technologies that you need to know about in order to stay at the top of your game within this continuously developing market.

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