Monday, July 19, 2010

Who Captures Declining Net Oil Exports?

Roughly 60% of the petroleum consumed in the United States is imported from other countries. In order for one country to import petroleum or petroleum products, one or more other countries must export a corresponding amount. If available exports were somehow constrained, which countries would be able to “capture” them? Because supply constraints generally imply higher prices, the conventional wisdom has been that richer countries – developed ones – would be able to capture an increasing share of the available exports because of their greater average wealth. There are reasons, however, to believe that the conventional wisdom might be wrong.

Should we be concerned about declining oil exports? Jeffrey Brown, writing as westexas at The Oil Drum, regularly describes the Export Land Model. The ELM points out that historically, many – if not most – oil-exporting countries first satisfy domestic demand from their production and then export the surplus. Assuming that the exporting company has a growing economy, hence a growing demand for petroleum, when that country’s production begins to decline, its exports will decline at a higher rate. Indonesia provides an example that matches the model very well, as shown in the graphic history of their oil production, consumption, and exports below. Consumption continued to grow with the economy, and while production did not peak until about 1995, exports began declining in 1992 and fell at a faster rate than production was falling.

The consequences of this behavior by oil-exporting countries (or former oil-exporting countries; Indonesia has withdrawn its active membership in OPEC) suggest that global oil exports will begin to decline before global oil production peaks. Some EIA data suggests that oil exports have already peaked. How much oil will be available for importing is a very pertinent question, as is the question of who will capture how much of those exports.

More recently, the ELM 2.0 model was introduced. That model notes that during the global recession beginning in 2008, oil consumption in developed countries (the US in particular) fell. Developing countries (China and India in particular) saw either a much smaller decline in consumption, or even continuing growth in consumption. The hypothesis is that the developing countries – or at least China and India – are able to outbid the developed countries for the available exports, and that this trend will continue. This outcome should not be surprising, and could have been anticipated based on “first principles” from economics.

One of the most important developments in economic theory in the late 19th century was the so-called “marginal revolution.” This concept asserted that economic decisions are not made on the basis of average costs or benefits, but on the basis of incremental ones. For example, a decision as to whether to purchase an additional barrel of oil is not made on the basis of the average use to which oil is put, but on the basis of the incremental use. As a general rule, the marginal value of a good diminishes with the amount of that good the consumer already has. A typical US consumer would put a great deal of value on the first few gallons of gasoline that they purchase because it is an input to high-value activities, such as getting to work. By the time that consumer purchases their millionth gallon, it has essentially no value; the consumer has already used all of the gasoline they can figure out a purpose for.

Based on their wealth relative to the price of oil, US consumers have historically used a lot of oil for relatively trivial activities. I have been known to point out that oil was cheap enough that many poor people in the US purchase additional gasoline rather than carefully monitor their tire pressures. Such is not the case in a developing country. There, the incremental barrel of oil is much more likely to be used to power an activity with much value than saving the time it takes to measure tire pressure. Since the marginal benefit from that extra barrel is greater in the developing country, that country can “afford” to pay a higher price for it. Ceteris paribus (Latin for “with other things the same”, and a favorite phrase of economists), in the face of higher prices for exported oil, the decrease in demand should occur in those importing countries that derive the lowest marginal value from the oil. Generally speaking, we would expect those to be the ones with a developed, rather than developing, economy.

There are some additional complicating factors. One of those is the cost of transporting oil from exporting to importing countries. One of the regions where oil exports are expected to continue growing is in the countries around the Caspian Sea. In 2009, Kazakhstan and China completed construction of a 2,228 kilometer-long pipeline running from the Caspian Sea to western China, where it connects to China’s internal pipeline network. A 1,056 kilometer-long spur connecting Russia’s Siberia-to-Pacific pipeline to China is scheduled to be completed by the end of 2010. Kazakhstan and Russia are two of the countries that still have growing oil exports. These pipelines make it much easier for those countries to transport oil that is produced from relatively isolated regions directly to China. In contrast, two of the major suppliers to the US that are relatively close – Mexico and Venezuela – are experiencing declining export rates.

This all suggests that the United States is likely to see its oil imports decline in coming years. The pool from which the US draws its imports will decrease. Rapidly developing countries like China will be able to outbid the US for that oil at the margin. Transportation considerations will make it easier for some of the countries that still have rising exports to deliver oil to China than to the United States.