August 13th, 2020 by George Harvey
The fossil fuels sector used to face questions about how soon we would be running out of oil, gas, or coal. They always assured us that they had hundreds of years worth of supplies. And though the supplies might be harder to extract, as shale oil is tight, the industry has believed prices could just be raised, because everybody needs the product.
Now, stranded assets are the worry. After helping sink the coal industry, the oil & gas sector is itself failing, because of competition from renewables and batteries. Believe it or not, Exxon Mobil stock is down nearly 50% from where it was when Trump became president.
After spending a lot of time refining my thoughts on this, I have come to believe that the end of oil & gas could look very different than what people expect. In ways it could appear even to defy the accepted law of supply and demand. If I am right, loss of demand in the face of continued availability of the resources could drive retail prices up instead of down. And once this process has begun, the consequences could quickly become disruptive.
What I foresee is a situation where the price of oil and gas at the wellhead could be so low that companies are going broke, at the same time that the price of gasoline at the pump reaches unprecedented highs. And in the entire supply line, from the wellhead to the gas pump, nobody is making money. The cause would be insufficient demand to keep alive an industry that is burdened with debt and assets it cannot put to use.
I realize that this scenario seems very much out of keeping with the law of supply and demand that most people seem to take for granted. Under that paradigm, the price would go down with the demand. But that “law” of economics tracks prices and availability in times like those we have seen in the past. It does not address the possibility of an ongoing reduction in demand in the face of continuous supply, which seems to be exactly the situation we have before us.
I think this is pretty clear. But many people find it hard to understand that in the face of reduced demand, there could actually be an increase in the retail price, and this could drive the demand down even more. I will try to explain.
The problem for the industry arises from fixed costs. For example, for a gas station, the rent, long-term debt, and a large portion of the electricity bill will have to be paid regardless of the amount of product sold. As sales of gasoline decline, the markup on the wholesale price due to such fixed costs has to be increased. The retail price per gallon has to go up, or the station will lose a lot of money.
This, however, is not just a problem for the retailer. Gasoline deliveries will be reduced, but the delivery fleet owners will still have their fixed costs. Refiners will have a reduced flow of product, but they have their own fixed costs. The same is true of storage facilities, pipelines, and other types of transportation. Each step in the way, with a reduced flow of fossil fuels, the fixed costs will have to be covered by increases in the charge per unit of the product.
This would imply that in such a time, the company extracting fossil fuels might suffer from low prices of their products because of low demand, companies could barely make ends meet every step of the way to the customers, and the customers could still be charged prices they consider outrageous. And, not understanding why this has happened, they will cook up conspiracy theories.
There are examples in the real world of somewhat similar things happening. We can use the price of sugar to see this.
Simply put, processing cane sugar starts with extracting and filtering juice from the cane. The juice is then centrifuged. After that, it might or might not be filtered again to produce a highly pure product. Finally, it is dried as crystals.
If we go through the entire sequence of steps, including the final filtration, what we wind up with is white, refined sugar. On the other hand, if we don’t bother with the last filtration, we wind up with turbinado sugar. Turbinado sugar is easier and cheaper to make, because an important step is eliminated from the process, but nevertheless, turbinado sugar costs more than refined sugar at the retail level. Packaging, transporting, and selling all take up greater portions of the final cost of turbinado sugar. With reduced demand, efficiencies of scale are lost, and so the retail price has to be increased.
Turbinado sugar is cheaper to make, but it is more expensive because the demand for it is lower.
If prices of oil and gas go up as demand goes down, the probability of rapid disruption in the market could increase. Reduced demand, caused by higher prices, would wind up driving further reduction in demand, increasing prices even more. Market behavior could become what an environmentalist might term a “virtuous cycle.” A fossil fuel glutton might have a different name for it.
Standard thinking seems to be that the last 10% or 20% of fossil fuel use would be very difficult to reduce, resulting in a long, slow tapering off of sales. In my way of thinking, the last 20% of most uses of fossil fuels might go fastest. And this would mean that fossil fuel use would not taper off to 2050 or later. Instead, I think it might crash altogether long before that.
I am not an economist. I could easily be wrong. My advice is to choose wisely before you place your bet.
Image: Tarot card by Lauron William De Laurence, 1918. Public Domain. Wikimedia Commons.
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