The future of energy: stability or volatility?

Short-term, long-term views of demand, supply, and price

THE FABRICATOR® NOVEMBER 2006

November 7, 2006

By:

Senior Editor Eric Lundin looks at changes in supply and demand for energy, and how they have affected the prices for crude oil, gasoline, natural gas, and electricity. He also digests a few predictions to see what fabricators can expect for future energy prices.

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Petroleum. Natural gas. Coal. Propane. Kerosene. Fuel oil. Liquid petroleum gas. Uranium. Hydroelectric. Biomass. Geothermal. Solar. Wind. All provide power in some way or another to run the myriad appliances, machines, tools, and vehicles we use every day.

Our reliance on technological conveniences and necessities—whether residential, commercial, or industrial—drives our energy needs, or demand. Supply is the other fundamental factor. Understanding energy sources' origins is the key to understanding supply dynamics.

Mapping the territory where supply and demand meet reveals the third component in our energy environment: price. As long as supply and demand change gradually and

predictably, prices tend to change gradually and predictably also. However, supply and demand for energy don't always change gradually— they can and do change abruptly, leading to price disruptions. Tracing the history of supply and demand for energy provides explanations for past price changes; looking to the future provides a glimpse of what the future holds.

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Energy Consumption

Although petroleum grabs most of the headlines, it is just one of many energy sources we rely on every day. Other significant sources are coal and natural gas. Nuclear energy and renewables fill out the U.S. energy picture.

The U.S. consumes approximately 100 quadrillion British thermal units (BTUs) of energy annually. Petroleum provides approximately 40 percent of U.S. energy needs; natural gas and coal each supply 23 percent; nuclear provides 8 percent; and renewable energy sources provide approximately 6 percent (see Figure 1).

Petroleum is used mainly for transportation after it is processed into gasoline, diesel, or aircraft fuel. In 2004 the U.S. produced 8.7 million barrels of oil per day and consumed 20.73 million barrels of oil per day (58 percent of U.S oil was imported). In 2004 the world produced 83 million barrels of oil per day and consumed 82.45 million barrels per day (BPD).

Among the dozens of uses for petroleum, the top four in the U.S. are gasoline (44.2 percent), fuel oil (19.9 percent), liquefied petroleum gases (9.8 percent), and jet fuel (7.88 percent).

Coal, which is known for providing a significant number of mining jobs from Pennsylvania to Kentucky and in a handful of Western states, actually is mined in substantial quantities in 25 of the 50 states. In 2004 the U.S produced 1,112.1 million tons of coal; it consumed 1,107.3 million tons. In the same year the world mined 6,078.6 million tons and consumed 6,098.8 million tons.

Although the U.S. has been a coal exporter for many years, net exports of coal have dwindled from 28.9 million tons in 2001 to 19.5 million tons in 2005, falling at an average rate of 2.35 million tons per year. At this rate, the U.S. is likely to become a coal importer in less than 10 years.

The three top uses for coal are electric power plants (92 percent), combined heat-and-power plants (2.6 percent), and coke plants (2.1 percent).

Natural gas is used for heating, industrial processes, and generating electricity. In 2004 the U.S. produced 18.8 trillion cubic feet (cu. ft.) of natural gas; it consumed 22.4 trillion cu. ft. of natural gas (16 percent of the total was imported). In 2004 the world produced 98.6 trillion cu. ft. of natural gas and consumed 99.7 trillion cu. ft.

Residential use accounts for 22.1 percent of the demand for natural gas. Other users are industrial (29.9 percent), power generation (26.5 percent), and commercial (14 percent).

Nuclear power generation for electricity in the U.S. has increased from 621 megawatts in 1969 to 99,210 megawatts in 1996. U.S. nuclear powers plant operators purchased 65.7 million pounds of uranium in 2005. Imports consisted of 54.7 million pounds, or 83 percent.

Although nuclear power is one of the most efficient methods of generating electricity (see Efficiency in Generating Electricity sidebar), no new nuclear power plants have been commissioned in the U.S. since 1996. No new nuclear plants are planned.

Renewables. Solar, hydroelectric, and wind power are among the most cost-effective ways of generating electricity. They also are the least utilized, providing just 9 percent of U.S. electricity (see Figure 2), likely because they have the lowest operational efficiency. Solar and wind, because they are subject to weather conditions, have a capacity utilization that is half that of fossil fuel-powered plants and, at best, one-third that of nuclear-powered plants.

Supply, Demand, and Price—A Brief History

The history of fuel prices is meaningless without an understanding of the supply and demand dynamics. The three main fuels—coal, petroleum, and natural gas—are fossil fuels mined or pumped from the ground. Beyond that, they have little in common.

Coal. In 1981 the U.S. consumed 732.6 million tons of coal; China consumed 679.9 million tons. In 1982 China's consumption of coal surpassed the U.S.'s, and its appetite for coal has continued more or less unabated since then. From 1982 to 2004, the world's coal demand grew 32.5 percent. Demand by the top three coal-consuming countries, China, the U.S., and India, grew 136.9 percent, 54.9 percent, and 204.9 percent, respectively.

Changes in coal demand and coal production usually are gradual and they tend to go hand-in-hand (see Figure 3). Coal production exceeded demand in 11 of the 25 years from 1980 to 2004. Despite coal shortfalls in 14 of the 25 years, the price of coal fell throughout much of the 1980s and 1990s (see Figure 4).

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Demand grew suddenly in 2003. China, the world's largest coal consumer, increased its year-to-year coal consumption 21.8 percent in 2003, and 19.9 percent in 2004. India's demand reinforced this trend. However, India's impact is much smaller than China's. In 2004 India's consumption was just 23 percent of that of China (478 million tons to China's 2,062 million tons).

The price reacted predictably, shooting up 28 percent from 2003 to 2005 (using inflation-adjusted dollars).

Petroleum. Much of the world focuses on the supply, demand, and price of crude oil. While many factors affect the price of oil, two enduring factors are the concentration and location of the world's largest oil supplies. Abundant oil supplies are concentrated in the hands of just a few countries in the world, so it is prone to monopoly behavior. Political activity in the main oil-supplying regions—the Middle East and western Africa—leads to price volatility.

For decades oil demand and supply changed gradually, with the notable exceptions of 1973 (the Arab oil embargo) and 1979-1980 (OPEC production cuts, the Iranian revolution and hostage crisis, and start of the Iran-Iraq War). These upsets in the supply, while drastic, were temporary, and supply volatility gradually subsided. Prices followed.

The recent round of trouble started during the middle 1990s, as production exceeded demand by a growing margin (see Figure 5). The 1997-1998 Asian financial crisis upset many Pacific Rim economies, and demand for energy products fell throughout much of the region. Oil markets were awash in excess supply, and the price reacted predictably, plummeting to less than $11 per barrel in 1998 (see Figure 6). Gleeful U.S. consumers found themselves paying less than $1.00 per gallon for regular-grade gasoline, but such low prices wouldn't last long. The ensuing price hikes would be swift and steep.

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Prices headed north in 1999. From 1999 to 2004, world oil demand increased an average of 1.53 percent per year. That doesn't sound like much, but compared with the historical average (1.02 percent per year since 1980), it's 50 percent faster than normal. While the oil market has not been upset by any single, large-scale supply disruption like the embargo of 1973, numerous events have repeatedly disrupted the oil supply, including a crude oil workers' strike in Venezuela (2002-2003); the U.S. military invasion of Iraq (spring 2003); Hurricanes Katrina and Rita (fall 2005); militant activities in Nigeria (2006); infrastructure damage in Iraq (2003-2006); fighting in Lebanon (2006); and the Prudhoe Bay pipeline shutdown (2006).

The lack of shortages is evidence that supply has been able to keep pace with demand. However, supply and demand are not the only two significant components. The amount of spare production capacity, which is a buffer that protects the market from sudden supply disruptions, influences crude oil prices. The Energy Information Administration estimates that OPEC's spare capacity was approximately 6.75 million BPD in 2002 (8.8 percent of the world's supply, which was 76.9 million BPD at that time). It estimates that by the end of 2004, OPEC's spare capacity was just 1 million BPD, which was 1.2 percent of the world's production (83 million BPD).

Natural Gas. Like oil and coal, natural gas is a fossil fuel. Found in oil fields, natural gas fields, and coal beds, it is the cleanest-burning of the fossil fuels. For many years it was a nuisance in oil drilling operations and it was simply vented or flared (burned). Because it is now economically viable to compress and ship natural gas, much less natural gas is wasted these days than in years past.

World demand for natural gas increased 85.8 percent from 1982-2004; supply increased 80.8 percent. The U.S. is the largest consumer of natural gas (it consumed 22.4 trillion cu. ft. in 2004), followed by Russia (16 trillion cu. ft.). After that, demand by country drops considerably; Germany, the third-largest consumer of natural gas, used 3.6 trillion cu. ft. in 2004. The U.K. consumed 3.5 trillion cu. ft. in 2004.

The price of natural gas follows a predictable seasonal pattern, peaking usually in August and hitting a trough in March, in a range less than $5.00 from trough to peak. Based on inflation-adjusted dollars, natural gas peaked in August 1984 at $13.45 per thousand cu. ft., then spent two decades in hibernation. The peaks and troughs suddenly grew in 2000, and the price finally broke the 1984 record in July 2004 when it hit $13.56 per thousand cu. ft. The hurricanes of 2005 damaged a substantial amount of natural gas processing equipment in the U.S., causing the residential price to hit an all-time high of $16.66 in September 2005. The latest price available at press time, from June 2006, was $14.95 (see Figure 7). This was $1.07 higher than the June 2005 price, which suggests that the 2006 peak might break the 2005 record.

Energy Prices and Inflation

Nothing drives inflation through an economy like energy prices do. Because energy is used in many activities—manufacturing and shipping goods; heating and lighting factories and offices; and powering nearly every mode of transportation—increases in energy prices generally drive increases in all other prices.

As prices increase, or inflate, the dollar's value falls. These aren't two separate developments—they're two sides of the same coin. The oil supply disruptions of 1973-1974 and 1979-1980 did exactly this, and inflation wreaked havoc on the U.S. economy throughout much of the 1970s and the early 1980s.

The dollar, like all other commodities, obeys the law of supply: as the supply increases, the value decreases. The dollar's value, then, is related to the quantity of dollars in circulation. The Federal Reserve Board of Governors keeps an eye on inflation and acts through the Federal Open Market Committee (FOMC) to conduct open market operations, buying and selling Treasury bills to change the amount of currency in circulation.

Under the leadership of former Federal Reserve Board Chairman Paul Volcker, the FOMC took drastic action in 1982 to remove a substantial number of dollars from circulation. The results were predictable: sky-high interest rates, a recession, and a spike in the unemployment rate. For all the economic pain it caused, the upside was that this action crushed inflation. It remained subdued for much of the next two decades.

Now, as then, fuel prices are a significant economic concern. However, the recent oil price increases are not likely to cause years of high inflation as they did in the 1970s or the deep recession as they did in the early 1980s for three reasons: The recent price changes have been relatively gradual; inflation has been restrained; and the U.S. economy is less reliant on petroleum than before.

Gradual Changes. Although a long series of disruptions have interfered with the crude oil supply, the recent run-up in price largely is a result of increasing demand rather than decreasing supply (which caused the price spikes in 1973 and 1979). The recent price increases have been relatively gradual.

The supply shock of 1973 caused the oil price to jump 135 percent in one month, when it increased from $4.31 per barrel in December 1973 to $10.11 per barrel in January 1974. The increase at the end of the decade was a little more gradual when it went from $15.85 in April 1979 to $39.50 in July 1980, a 149 percent increase in 15 months (an average increase of 10 percent per month). The recent increase simply doesn't compare. Although the change has been more significant, it has been much more gradual, increasing from $19.67 in January 2002 to $74.41 in July 2006, or 278 percent over 54 months (an average of 5 percent per month).

The federal government raised the federal funds rate, which determines all other interest rates, from 6 percent to 13 percent in 18 months at the time of the first oil crisis, an average of 0.38 percent per month. It raised the federal funds rate from 10.5 percent to 19 percent over 18 months at the time of the second oil crisis, an average of 0.47 percent per month. This time around the federal funds rate went from 1 percent to 5.25 percent over 26 months, an average of 0.16 percent per month. In addition, the current federal funds rate, after increasing steadily for two years, is still quite low relative to historical levels.

Inflation. Price inflation changed from a manageable 2.6 percent per year in 1972 to 7.45 percent in 1973, then to 9.45 percent in 1974. It fell to about 4 percent in 1976, then started climbing again, hitting 10.5 percent in 1979. Throughout the 1980s it varied between 3 percent and 3.5 percent; in the 1990s it generally was even lower, averaging 2.5 percent. The recent run-up in oil prices hasn't caused rampant inflation; in 2005 inflation was less than 3 percent.

The FOMC might continue to pull money out of the economy and interest rates might rise accordingly, but these moves are likely to be gradual, so the threat of a recession is much lower than it was in the early 1970s and the early 1980s.

Fuel Intensity. Over the years the U.S. economy has become less fuel-intensive. This reflects the changing nature of the U.S. economy. Fuel-intensive activities (such as manufacturing) have diminished as a share of gross domestic product (GDP).

From 1970 to 2000 the U.S. GDP grew from $3.78 trillion per year to $9.82 trillion per year, an increase of 160 percent. During the same time, U.S. petroleum consumption increased much less, from 14.7 to 19.7 million BPD, an increase of 34 percent.

The Forecast

Where the future of energy is concerned, the focus is largely on petroleum, and for many solid reasons. It is the largest energy source used in the U.S.; the U.S. imports it in vast quantities; the largest reserves are concentrated in just a few politically unstable regions; and price spikes are known for preceding recessions.

Forecasts generally try to look beyond the horizon and predict long-term trends in supply, demand, and price. The Prudhoe Bay fiasco and the threat of tropical storm Ernesto, which both occurred in August, proved that small disruptions and threats of disruptions continue to influence the petroleum price. However, such changes tend to be small in magnitude and short in duration. The spot price of West Texas Intermediate oil increased from $74.93 on Aug. 1 to $77.05 on Aug. 4, then fell to less than $70 per barrel before the month ended. Energy forecasts look past these small, temporary disruptions and attempt to piece together a longer-term view.

12-month Outlook. The petroleum supply is expected to continue growing as the necessary infrastructure expands. The Baker Hughes monthly rig count shows that the number of rotary rigs in the world increased from 581 to 921 (58.5 percent) from July 1999 to July 2006. According to the Pipeline & Gas Journal's 2006 International Pipeline Construction Report, new and planned pipelines increased from 15,650 miles to 70,421 miles—a 29 percent jump—from 2005 to 2006.

Barring any extreme event such as a damaging hurricane or a long, cold winter, the prevailing opinion is that the price of crude oil is likely to float in a range between $60 and $75 per barrel for the next 12 months or so.

An article titled "Scant relief on gas prices after summer," posted on www.kiplingerforecasts.com on Aug. 22, predicted that oil would go as low as $68 per barrel by the end of 2006. A subsequent update posted Sept. 7 at the same site, "Cheaper gas coming by year end" predicts that oil will drop even lower, to $60 per barrel, during 2006.

The Short-term Energy Outlook (STEO), published in August by the Energy Information Administration (EIA), goes into more detail, making a distinction between imported oil ($64.36 per barrel by the year's end) and West Texas Intermediate ($72.17 by year-end). The EIA estimates that regular-grade gasoline will average $2.70 per gallon at the end of 2006. Further, according to the report, the price of WTI is expected to vary between $67.33 and $70.67 throughout 2007, with regular-grade gasoline fluctuating between $2.53 and $2.84 per gallon in 2007.

Crucially, the STEO forecasts the world's petroleum demand to rise from 84.8 million BPD in 2006Q3 to 87.1 million BPD in 2006Q4; then fall to 85.1 million BPD by 2007Q2; then resume climbing, finishing the year at 89.0 million BPD. Supply is expected to exceed demand in 2007Q2 and 2007Q3, then fall behind in 2007Q4.

According to the EIA's Annual Energy Outlook 2006, the U.S. produced 18.46 trillion cu. ft. of natural gas in 2004. This fell to 18.14 trillion in 2005, largely because of the hurricane damage. It expects U.S. production to climb and the combination of demand, inventories, domestic production, and imports to put downward pressure on the price; it expects the residential price, which averaged $12.68 per thousand cu. ft. in 2005, to fall to $12.12 in 2006 and $11.55 in 2007.

The EIA bases its estimates on a large number of macroeconomic factors, such as trends or changes in personal income, manufacturing output, weather, business inventory, producer and consumer prices, employment rates, vehicle fuel efficiency and the number of miles traveled, aircraft utilization, airline ticket prices, and raw steel production.

Its projections for 2006 and 2007 predict economic growth between 2.2 percent and 3.2 percent (annualized); a continued expansion in manufacturing, employment, and industrial production; and continued increases in consumer prices.

Long-term Outlook. Increasing demand tends to lead to increasing price, which encourages suppliers to increase output, and the EIA predicts that this simple economic scenario will increase the supplies of fuels over the next couple of decades.

The Annual Energy Outlook 2006 predicts demand for petroleum to increase from 82.46 million BPD in 2004 to 117.80 in 2030. While production growth is likely to be somewhat uneven—growing faster than demand in some years and slower in others—the EIA expects that production growth will keep pace with demand, also growing to 117.80 million BPD by 2030.

Cambridge Energy Research Associates (CERA®) sees production going much higher than the EIA does. A CERA report titled "Expansion set to continue—global liquids capacity to 2015," which predicts the world's petroleum-processing capacity will expand from 88.74 million BPD today to 110 million BPD in 2015, an increase of 24 percent.

The EIA estimates that, in 2004 dollars, the annual average price of crude oil is expected to fall to less than $50 per barrel in 2010 and not break through $50 again until 2020. Note that this is an annual average. On some days the crude oil price is likely to be much higher or lower. From 2020 to 2030, the price is expected to drift upward to approximately $57 per barrel. The retail price of gasoline is expected to drop from $2.24 in 2007 to $1.99 in 2014, then climb to $2.19 by 2030.

The price of natural gas is expected to moderate between now and 2030. The EIA estimates that the residential price will average $11.55 per thousand cu. ft. in 2007, fall to $10.07 in 2016, then climb to $11.67 in 2030.

Finally, residential electricity is expected to be even less volatile than the price of natural gas: starting at 8.9 cents per kilowatt-hour in 2007, fall to 8.5 cents per kWh in 2009, then remain within a band of 8.3 to 8.5 cents per kWh until 2030.



FMA Communications Inc.

Eric Lundin

Editor
FMA Communications Inc.
833 Featherstone Road
Rockford, IL 61107
Phone: 815-227-8262

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