How Do Consumers Spend Engine Efficiency Advances? On Bigger, Faster Cars

Auto companies have made great strides in improving engine efficiency in recent decades. But those improvements haven’t done much to improve the fuel economy of America’s passenger car fleet. Instead, consumers have “spent” most of those efficiency improvements on bigger, faster cars.

MIT economist Christopher Knittel has carefully quantified these tradeoffs in a recent paper in the American Economic Review (pdf; earlier ungated version here). As noted by Peter Dizikes of MIT’s News Office: 

[B]etween 1980 and 2006, the average gas mileage of vehicles sold in the United States increased by slightly more than 15 percent — a relatively modest improvement. But during that time, Knittel has found, the average curb weight of those vehicles increased 26 percent, while their horsepower rose 107 percent. All factors being equal, fuel economy actually increased by 60 percent between 1980 and 2006, as Knittel shows in a new research paper, “Automobiles on Steroids,” just published in the American Economic Review.

Thus if Americans today were driving cars of the same size and power that were typical in 1980, the country’s fleet of autos would have jumped from an average of about 23 miles per gallon (mpg) to roughly 37 mpg, well above the current average of around 27 mpg. Instead, Knittel says, “Most of that technological progress has gone into [compensating for] weight and horsepower.”

This is a fine example of a very common phenomenon: consumers often “spend” technological improvements in ways that partially offset the direct effect of the improvement. If you make engines more efficient, consumers purchase heavier cars. If you increase fuel economy, consumers drive more. If you give hikers cell phones, they go to riskier places. If you make low-fat cookies, people eat more. And on and on. People really do respond to incentives.

Is Our Luck Running Out on Oil Supplies?

In an excellent new paper, Jim Hamilton asks whether the “phenomenal increase in global crude oil production over the last century and a half” reflects technological progress or good fortune in finding new reserves. The two aren’t completely distinct, of course. Better technology helps find more resources. But the heart of the question remains: have we been lucky or good?

Based on a careful reading of production patterns in the United States and around the world, Jim concludes that we’ve been both and worries that the luck part may be coming to an end:

My reading of the historical evidence is as follows. (1) For much of the history of the industry, oil has been priced essentially as if it were an inexhaustible resource. (2) Although technological progress and enhanced recovery techniques can temporarily boost production flows from mature fields, it is not reasonable to view these factors as the primary determinants of annual production rates from a given field. (3) The historical source of increasing global oil production is exploitation of new geographical areas, a process whose promise at the global level is obviously limited.

Most economists view the economic growth of the last century and a half as being fueled by ongoing technological progress. Without question, that progress has been most impressive. But there may also have been an important component of luck in terms of finding and exploiting a resource that was extremely valuable and useful but ultimately finite and exhaustible. It is not clear how easy it will be to adapt to the end of that era of good fortune.

These arguments should be familiar to anyone who’s followed the peak oil debate, but Jim brings a welcome rigor to the discussion.

He also includes some charts illustrating how various states and regions have passed their production peaks. Here, for example, are the United States, North Sea, and Mexico:

And he discusses how oil prices affect the economy. All in all, a great survey.

P.S. If you are interested in the details, Jim’s post over at Econbrowser sparked some thoughtful comments.

Taxes and Energy Policy

Last week I had the opportunity to testify before two Ways and Means subcommittees–Select Revenue Measures and Oversight–about the way our tax system is used as a tool of energy policy. Here are my opening remarks. You can find my full testimony here.

As you know, our tax system is desperately in need of reform. It’s needlessly complex, economically harmful, and often unfair. Because of a plethora of temporary tax cuts, it’s also increasingly unpredictable.

We can and should do better.

The most promising path to reform is to reexamine the many tax preferences in our code. For decades, lawmakers have used the tax system not only to raise revenues to pay for government activities, but also to pursue a broad range of social and economic policies. These policies touch many aspects of life, including health insurance, home ownership, retirement saving, and the topic of today’s hearing, energy production and use.

These preferences often support important policy goals, but they have a downside. They narrow the tax base, reduce revenues, distort economic activity, complicate the tax system, force tax rates to be higher than they otherwise would be, and are often unfair. Those concerns have prompted policymakers and analysts across the political spectrum—including, most notably, the Bowles-Simpson commission—to recommend that tax preferences be cut back. The resulting revenue could then be used to lower tax rates, reduce future deficits, or some combination of the two.

In considering such proposals, lawmakers should consider how tax reform, fiscal concerns, and energy policy interact.  Six factors are particularly important.

  • Our tax system needs a fundamental overhaul. Every tax provision, including those related to energy, deserves close scrutiny to determine whether its benefits exceed its costs. Such a review will reveal that many tax preferences should be reduced, redesigned, or eliminated.
  • The code includes numerous energy tax preferences. The Treasury Department, for example, recently identified 25 types of energy preferences worth about $16 billion in 2011. These include incentives for renewable energy sources, traditional fossil fuel sources, and energy efficiency. In addition, energy companies are also eligible for several tax preferences that are available more broadly, such as the domestic production credit.
  • Tax subsidies are an imperfect way of pursuing energy and environmental policy goals. Such subsidies do encourage greater use of targeted energy resources. But, as I discuss in greater detail in my written testimony, they do so in an economically wasteful manner. Subsidies require, for example, that the government play a substantial role in picking winners and losers among energy technologies. The associated revenue losses also require higher taxes or larger deficits.
  • A key political challenge for reform is that energy tax subsidies are often viewed as tax cuts. It makes more sense, however, to view them as spending through the tax code. Reducing such subsidies would make the government smaller even though tax revenues, as conventionally measured, would increase.
  • Tax subsidies are not created equal. Production incentives reward businesses for producing desired energy and are agnostic about what mix of capital, labor, and materials firms use to accomplish that. Investment incentives, in contrast, reward businesses merely for making qualifying investments and encourage firms to use relatively more capital than labor. For both reasons, production incentives tend to be more efficient than investment incentives.
  • Well-designed taxes can typically address the negative effects of energy use more effectively and at lower cost than can tax subsidies. I understand that higher gasoline taxes or a new carbon tax are not popular ideas in many circles, but please bear with me. As I explain at length in my written testimony, well-designed energy taxes are a much more pro-market way of addressing energy concerns than are tax subsidies. Taxes take full advantage of market forces and, in so doing, can accomplish policy goals at least cost and with minimal government intervention. Subsidies, in contrast, make much less use of market forces and inevitably require the government to pick winners and losers. Energy taxes also generate revenue that lawmakers can use to cut other taxes or to reduce deficits.

P.S. Not surprisingly, that last point wasn’t picked up by anyone else, at least during my panel (one of three at the hearing). New energy taxes would, of course, be problematic for the macroeconomy if enacted immediately. And we’d have to make some adjustment, either in the tax code or in benefit programs, to offset the impact on low-income families. In the long-run, however, I think that would be a much better way to address many energy concerns, including carbon emissions and oil dependence. But that’s not the way our system works. Instead, as noted, it’s much more popular to use tax preferences, whose benefits are visible and whose costs are obscure, to pursue energy and environmental goals. Other participants discussed the particular incentives, existing and proposed, in greater detail; their testimony is available here.

Can Natural Gas Replace Oil for Diesel?

In a series of posts (most recent here), I’ve noted that oil and natural gas prices have become unhinged from each other. Oil (denominated in $ per barrel) used to trade at 6 to 12 times the price of natural gas (denominated in $ per MMBtu). But lately that ratio has been north of 20, thanks to a surfeit of new gas in the United States (and elsewhere) and, recently, growing global demand for oil.

The wide spread between oil and natural gas prices provides a tempting incentive for any innovators who can figure out how to use natural gas, rather than oil, to make transportation fuels.

Over at the New York Times, Matthew Wald identifies one possibility, using natural gas to produce diesel:

Diesel and jet fuel are usually made from crude oil. But with oil prices rising even as a glut of natural gas keeps prices for that fuel extraordinarily cheap, a bit of expensive alchemy is suddenly starting to look financially appealing: turning natural gas into liquid fuels.

A South African firm, Sasol, announced Monday that it would spend just over 1 billion Canadian dollars to buy a half-interest in a Canadian shale gas field, so it can explore turning natural gas into diesel and other liquids. Sasol’s proprietary conversion technology was developed decades ago to help the apartheid government of South Africa survive an international oil embargo, and it is a refinement of the ones used by the Germans to make fuel for the Wehrmacht during World War II.

The technology takes “a lot of money and a lot of effort,” said Michael E. Webber, associate director of the Center for International Energy Environmental Policy at the University of Texas, Austin. “You wouldn’t do this if you could find easy oil,” he said.

But with the huge spread between oil and gas prices, and predictions of oil topping $100 a barrel next year, the conversion technology could be a “a money-maker for whoever is a first mover in that space.”

Will Budget Concerns Ever Influence Carbon Policy?

Climate change legislation died an ignominious death in the Senate earlier this year. If you’d like to understand why, check out Ryan Lizza’s autopsy of the effort in the latest New Yorker. Lizza documents how the “tripartisan” trio of John Kerry, Joe Lieberman, and Lindsey Graham came up short in their effort to craft a 60-vote coalition in the Senate. Among the bumps along the way:

  • On March 31, President Obama announced a dramatic expansion in offshore waters open for oil and natural gas drilling. In so doing, he gave away one of the sweeteners that the trio was hoping to use to attract pro-drilling senators.
  • On April 15, Fox News reported that, according to “senior administration officials”, the White House was opposing efforts by Senator Graham to increase gasoline taxes. That claim was perverse–the bill didn’t include higher gasoline taxes and Graham certainly wasn’t pushing them–but not surprisingly it created problems for Graham back home.

Lizza’s article is rich with such anecdotes, but it’s the larger picture I’d like to emphasize. Kerry, Lieberman, and Graham adopted a traditional approach to building a Senate coalition. They identified their main goal–comprehensive climate change limits–and then started negotiating with individual Senators and special interests to see how they could get to 60 votes. Nuclear power, electric utilities, oil refiners, home heating oil, even cod fisherman all make an appearance at the bargaining table. But it’s not clear that such horse-trading could ever yield 60 votes.

This failure makes me wonder whether the traditional approach will ever generate a substantive climate bill. I suppose that’s still possible, particularly if the EPA begins to implement a burdensome regulatory approach to limiting carbon emissions. That might bring affected industries running back to the table.

But I would like to suggest another strategy: Perhaps the environmental community should make common cause with the budget worrywarts. In principle, a carbon tax is a powerful two-birds-with-one-stone policy: it cuts carbon emissions and raises money to finance the government. (This is equally true of a cap-and-trade approach in which the government auctions allowances and keeps the proceeds.) Perhaps there’s a future 60-vote coalition that would favor those outcomes even if various energy interests would be opposed?

Such a coalition is unthinkable today. Opposition to energy taxes runs deep, as Senator Graham experienced. But fiscal concerns will continue to grow in coming years, and spending reductions may not be enough to get rising debts under control. If so, maybe we’ll see a day in which a partnership of the greens and the green eyeshades will take a stab at a carbon tax.

The New Normal in Oil and Natural Gas Prices

In previous posts (most recent here), I noted that oil and natural gas prices have disconnected from their usual historical relationship. For many years, oil prices (as measured in $ per barrel) tended to be 6 to 12 times natural gas prices (as measured in $ per MMBtu). That ratio blew out to more than 20 in late 2009, briefly receded toward more traditional levels, and then expanded again. At Tuesday’s close, the ratio stood at 19.4, far above its historical range:

(Note: A barrel of oil has roughly 6 times the energy content of a MMBtu of natural gas. If the fuels were perfect substitutes, oil prices would thus tend to be about 6 times natural gas prices. In practice, however, the ease of using oil for making gasoline makes oil more valuable. As a result, oil has usually traded higher.)

The unusual pricing of the last two years reflects two factors. First, there has been a dramatic–and welcome–expansion in domestic natural gas supplies. That’s driven natural gas prices down to less than $4 per MMBtu at yesterday’s close. Second, there is limited opportunity for energy users–utilities, businesses, and homeowners–to switch from oil to natural gas. Years ago, such switching linked oil and natural gas prices relatively closely. But today those prices appear largely decoupled.

All of which poses an important question for investors, forecasters, and industry planners: Will historical relationships eventually reassert themselves, perhaps by longer-term fuel switching by utilities and transportation fleets to natural gas? Or is this time really different, with old pricing relationships no longer relevant?

One way to answer that question–or, at least, to get some insight into how others are answering it–is to look at futures prices. As illustrated in dark blue above, those prices imply that the ratio of oil to natural gas prices will remain well above historical levels for at least the next eight years. The new normal, according to futures markets, will be for oil prices to average about 15 times natural gas prices.

The End of Cap and Trade?

No, not for carbon. For sulfur dioxide.

As noted by Mark Peters at the Wall Street Journal:

The original U.S. cap-and-trade market, which succeeded in slashing the power-plant emissions that cause acid rain, is in disarray following the issuance of new federal pollution rules.

The collapse in the pioneering market where power producers trade permits that allow them to emit sulfur dioxide and other pollutants that cause acid rain comes as policy makers seek to establish a similar market to curb the emissions of carbon, a cause of climate change.

The SO2 market has been one of the great successes of economic engineering, using market forces to drive down the cost of cleaning the environment. After almost twenty years of trading, however, the market ran into what may be an insurmountable hurdle: increased regulatory concern about the location of SO2 emissions.

The SO2 marketplace is national in scope, which has been great for establishing liquid trading and allowing emitters to find the cheapest way of reducing emissions. But it also meant that some SO2 emissions would end up in particularly unwelcome spots, e.g., upwind of cities, states, or entire regions that are having trouble meeting air quality standards.

Over the past couple of years, court rulings and new regulatory efforts by the Environmental Protection Agency have increased the emphasis of the location of emissions. And that means that the national market may be coming to an end.

That’s certainly what it looks like in the allowance marketplace, where prices have fallen from more than $600 per ton in mid-2007 to $5 or less today:

The price decline has been particularly sharp because utilities had been polluting less than allowed in recent years. That allowed them to build up an inventory of allowances to use in the future. With prices so low today, however, utilities have essentially no incentive to avoid sulfur emissions and no incentive to hold allowance inventories. As Gabriel Nelson puts it over at the New York Times:

With SO2 allowances trading at about $5 per ton, and little prospect of carrying over the permits into the new program, utilities have little incentive to bank allowances or add emissions controls for the time being, traders say. Because those controls have upkeep costs beyond the original investment, some plants might even find it more cost-effective to use allowances than to turn on scrubbers that have already been installed, traders said.

Rethinking Oil and Natural Gas Prices

My recent post about oil and natural gas prices elicited some very constructive responses from readers (thanks in particular to PJ, MF, and FW, in addition to public commenters on the post). As a result, I’ve rethought my discussion of the relationship between oil and natural gas prices.

I was also inspired to look at the futures markets to see what they are signaling about the relationship between oil and natural gas prices. Here’s my usual chart of the ratio of oil prices to natural gas prices, now showing both history (lighter blue) and futures markets (darker blue):

As noted in my earlier posts, oil and natural prices appear to have disconnected from their historical relationship. For many years, oil prices (as measured in $ per barrel) tended to be 6 to 12 times natural gas prices (as measured in $ per MMBtu). That ratio blew out to more than 20 in late 2009, then receded to more traditional levels, and then blew out again in recent months. At yesterday’s close, the ratio stood at 21.8, far above its historical range.

In my previous posts, I argued that this unusual pricing reflects the sudden (and welcome) increase in natural gas supplies and that we should expect oil and natural gas prices to eventually move back toward their historical relationship as markets absorb the new gas. Of course, I was careful not to say when this would happen.

As shown in the graph, the futures markets are indeed signaling some normalization in the price ratio in coming years, but not a rapid one. Moreover, even after eight years, the ratio would return only to the upper end (12) of its historical range. (Caveat: Futures markets are quite thin that far out, so we shouldn’t place too much weight on those distant prices.)

Let me offer a revised interpretation of the pricing relationship that’s consistent both with the futures data and the comments I received. This interpretation (consider it a theory, really) distinguishes four time periods:

  • Good Old Days: For many years, the electric utility industry had generating plants that ran on oil, natural gas, or both. The ability to fuel switch (either by changing the dispatch order of oil and gas plants or changing fuels at plants that could use either) limited how much oil and natural gas prices could deviate. If oil prices fell too low, utilities would move from natural gas to oil, and vice-versa. Similar fuel arbitrage occurred, to varying degrees, among other uses as well (e.g., home heating and some industrial uses).
  • More Recent Days: In recent decades, electric utilities have embraced natural gas and moved away from oil. As a result, there is much less opportunity for arbitrage between the fuels. The same has happened among other fuel consumers as well. Oil and natural gas prices nonetheless remained within their usual historical relationship. For example, oil and natural gas prices rose and fell in tandem during 2008. This suggests that the markets encountered similar shocks during those years (e.g., strong demand or, some would argue, speculation), not that they were linked via arbitrage.
  • Today: With the decline of traditional fuel arbitrage possibilities, oil and natural gas prices can now move separately if they experience distinct shocks. That appears to have happened with the increase in natural gas supply, for example.
  • Future: Looking further ahead, however, one would expect some new arbitrage relationships to develop. If we have persistently cheap natural gas and persistently expensive oil, that creates an incentive for ingenious folks to find ways to use natural gas to serve what have traditionally been oil demands. That should eventually limit the degree to which the prices can deviate (although not necessarily in the 6 to 12 ratio range). Two leading candidates for this linkage are using natural gas as a transportation fuel (directly as a fuel and perhaps indirectly as electricity) and increased international trade in liquified natural gas.

Note: The chart uses the spot price for West Texas Intermediate at Cushing and the spot price for natural gas at Henry Hub on a monthly basis through March 2010. For April 2010, I use the closing prices on April 8. The monthly futures are from the CME Group.

Oil and Natural Gas Prices Disconnect Again

Update (4/9/10): Please see my follow-up post as well.

Last summer I noted that oil and natural gas prices had diverged to an unprecedented degree. I bravely predicted that this divergence would reverse (unbravely, I didn’t predict when).

As the chart below shows, I was right: the price relationship did move sharply toward normal levels. In the last two months, however, it’s blown out again:

The chart shows the ratio of the price of oil (measured in $ per barrel) to the price of natural gas (in $ per MMBtu). Under normal circumstances, that ratio fluctuates between 6 and 12. A barrel of oil has roughly 6 times the energy content of a MMBtu of natural gas. If the fuels were perfect substitutes, oil prices would thus tend to be about 6 times natural gas prices. In practice, however, the ease of using oil for making gasoline makes oil more valuable. As a result, oil has usually traded higher.

Natural gas closed today at $4.11 per MMBtu. Under normal circumstances, that would imply an oil price of around $25 to $50. But oil actually closed above $85. As a result, the ratio of oil prices to natural gas prices is up at 20.7, well above the usual range and closing in on the peaks of last summer (on the day before I wrote my earlier piece, the ratio reached 24.5).

Where do prices go from here?

Well, history still suggests that the price gap will eventually narrow, through some combination of oil prices falling and natural gas prices rising. But there’s no guarantee that will happen in the short-run. Over the longer-term, however, I feel confident that demand for natural gas will rise to meet the new supply (the prime reason why natural gas prices have been so low recently) and that the oil vs. natural gas price relationship will eventually move back to normal. Natural gas is cleaner than coal and is available in large quantities in the U.S. and Canada. As a result, natural gas is on the short-list of potential responses to climate change and oil dependence, two concerns that aren’t going away anytime soon.

Note: The chart uses the spot price for West Texas Intermediate at Cushing and the spot price for natural gas at Henry Hub. Both series are monthly, except for the prices for today, 4/01/10.

P.S. Note that I have again obeyed the first law of forecasting: I have given a prediction (the relationship between oil and natural gas prices will normalize), but I haven’t given a date.