Election Year

As we are in an election year with higher than historic fuel prices, there will be many “solutions” to high oil prices advanced by politicians, think tanks, and pundits. One of the all time favorites is conservation as a solution. Of course conservation is necessary, economically rational, and should be promoted as a part of the solution. It does not in itself offer a solution. Proponents always state that the U.S. is energy wasteful compared with Europe, and also report that we successfully improved our energy efficiency in the last oil shock of the late 1970’s. A thorough analysis though leaves questions on both these believed “truisms.”

1) Conservation through energy efficiency, with the example of Europe.

The American public will be criticized for our large homes, driving habits, and “wastefulness” -compared with Europe’s mass transit, and more ecology-friendly lifestyle.

However, there is much less here than meets the superficial eye. A comparison of U.S. oil consumption and oil consumption by the 25-member countries of the European Union (E.U.) are instructive. On the surface, 453 million residents of E.U. countries consume only 14.8 million bls/d of oil compared with 295 million Americans consuming 22 million bls/d of oil. We certainly do seem wasteful, but on a full comparison, what do we really find?

The E.U. Gross Domestic Product (GDP) according to the World Factbook is a virtual tie with the U.S. GDP, at $11.650 trillion for the E.U. and $11.750 trillion for the U.S. On a per capita basis though, the U.S. citizen enjoys $40,100 of GDP to only $26,900 for an E.U. resident. As energy consumption is fundamental to an economy, it is unlikely our populace would favor reducing oil consumption by throttling back the economy. A “beggar the poor” policy of reduced economic activity is both unworkable and unconscionable.

What about transportation though? A different story, as we all “know” of Europe’s trains, better vehicle mileage, and conservation-inducing gasoline taxes. Again, there is more to the comparison, such as the fact that even without including Alaska, the continental U.S. land mass is more than twice the land mass of all the 25 E.U. countries combined. According to the “World Factbook,” the U.S. even without Alaska is 8.15 million sq. kilometers while the total land mass of the E.U. countries is only 3.9 million sq. kilometers. Yes, the E.U. has better mass transit and better fuel mileage, but how expensive, inconvenient, or unwanted would a mass transit system stretched to the U.S. size be? Can a mass transit system that works in small countries even be “super-sized” to U.S. standards? London to Birmingham just isn’t meaningful to compare New York to Los Angeles. If a mass transit system raises questions, what about vehicle efficiency? Let us look at actual gasoline demand and other fuels and products, adjusting for economic and land mass differences.

If we break out oil demand into product categories, and per capita (adjust for population) we find the E.U. within 20% of U.S. demand through the middle distillates and fuel oil, but much lower per capita consumption in light distillates, and other products. Other products are generally lubes, tars, waxes, petrochemical feedstock, i.e. industrial usage, reflecting again our healthier economic position. Light distillates for gasoline though offer a conservation opportunity. Adjusting for consumption differences in gasoline, diesel, and space heating, with consideration given to economic growth, GDP per capita and the land mass difference, a number of ratios become surprisingly similar. Actual total oil consumption is 39.8% greater for the U.S., just as our energy growth coefficient (EGC) is also 38% greater and after adjusting for land mass and per capita GDP, the per capita oil consumption is 34.6% greater. So with those ratios lining up and matching with the economic differences, (I am assuming the U.S. doesn’t mind consuming more oil for higher growth and greater wealth) that leaves only transportation for improved oil conservation. In transportation then even after adjusting for the land mass difference there is evidence we are 30%-35% less efficient. As noted above, a U.S. super-sized mass transit may not be realistic, so I will focus on vehicle fuels. If we look at per capita adjusted gasoline demand, this would calculate to not quite 2 million bls/d of oil consumption to reduce from our roughly 9.5 million bls/d of light distillate consumption.

In conclusion, while on the surface it would appear to offer massive reduction, after a more thorough analysis, to meet E.U. “efficiency” standards without harming our economy, suggests only about 2 million bls/d of oil consumption can be reduced through mileage standards, and mass transit where applicable, roughly a 20% reduction in gasoline consumption. There still remain several questions.

2) Of course supporters of conservation will vehemently disagree with the assessment that our economy can’t become more efficient in production without damaging itself. They will point to the success of the response to the energy shocks of the 1970’s, where the U.S. energy growth coefficient (EGC) did decline meaningfully while we transitioned to a more service oriented economy.

Herein though is what former Fed Chairman Alan Greenspan would call a conundrum. While it is true that our economic growth has increased while our EGC fell, that is only part of the story. A question must be answered: Did we truly reduce our industrial & manufacturing energy consumption per unit of GDP, or merely out-source our heavy industry to lower cost developing nations? Did we really conserve oil, or just shift the energy cost to a different part of the globe where it could be offset by cheaper labor costs?

If we take the refined product history of U.S. consumption from 1965 through 2005, there are interesting comparisons. Between 1965 and 1980, light distillate demand grew 2.2% CAGR (Compound annual growth rate), but from 1980 to 2005 grew at only a 1.18% CAGR, a decline in growth rate of 46%, as would be expected. This is the period of muscle cars fading out as the popularity of Japanese vehicles with lower fuel use became popular.

However, the decline in growth rate of middle distillates on the same two period comparison was 52.75%, the decline in growth rate of other (industrial usage) declined by 67.4%, and fuel oil usage actually declined meaningfully in absolute terms. Clearly industrial oil consumption slowed more than gasoline consumption. While many will claim this is American ingenuity in energy saving technology, a review U.S. government data raises questions.

A comparison with the Federal Reserve Total Index of Industrial Production, seasonally adjusted shows a correlation with the decline in oil consumption. The U.S. industrial production index grew at a 3.65% CAGR between 1965 and 1980, but decelerated to only 2.48% CAGR between 1980 and 2005. I don’t believe anyone would argue that U.S. consumption of manufactured goods slowed dramatically while our population grew during that time frame. The U.S. simply obtained its goods from external rather than internal production. This is shown in records of the Foreign Trade Division of the U.S. Census Bureau.

In the 1960 through 1970 period, the U.S. actually ran a balance of trade surplus in goods, and not until 1984 did it cross $100 billion deficit balance of trade in goods. Since then the balance of trade deficit in goods has accelerated sharply to $1,473 Billion in 2005.

It is at least worthy of review, that the U.S. move to a service economy, our supposed aggressive improvement in energy efficiency, and our exploding balance of trade deficit are actually an interrelated result of merely off-shoring our manufacturing base. Of course, this merely shifts oil demand to a different part of the globe, not representing conservation but just movement to where cheaper labor could offset higher energy costs to mute the inflationary impact.

Indeed, a review of total oil consumption globally shows merely a transitional pause in the early 1980’s (as industry moved from the west to the developing countries and substituted labor for energy) and then resumed the upward growth in demand. This substitution of labor for energy was possible in the oil shocks of the 1970’s-1980’s as there was adequate availability of substitutable labor and spare capacity in oil production via withheld volumes from the market. The current situation, however, sees China and India rapidly industrializing, lessening the pool of available “labor at any price,” and increasing the cost structure of the energy substitute in the factors of production. More worrisome is the lack of spare capacity in oil production as we no longer have withheld volumes.

This time, we are in a true supply/demand balance situation, not artificially caused through withheld volumes. The world also is more uniformly developed and with less ability to substitute raw labor for energy.

Accordingly, faith in conservation as a solution is misguided. It is a necessary but insufficient part of the response to rising energy costs.

By Gregory J. Winneke, CFA, CMM