Energy economics

Energy is needed by modern society to refine ores, manufacture products, transport people and goods, heat buildings, and power appliances. Various forms of energy, from simple combustion to nuclear and solar power, all have economic advantages and disadvantages, and changes in energy economics, society, and international politics are interrelated.

Background

The manufacture of any product requires energy inputs. Producing a book, for example, requires sawing and trucking lumber; pulping and processing the pulp into paper; transporting the paper; composing, printing, and delivering the book; and finally, providing lighting and space conditioning in the buildings in which it is written, made, and sold.

The economics of energy influence decisions in a wide range of industries. Rising petroleum prices in the 1970s caused tens of billions of dollars to be invested in more efficient automobiles, thicker walls, more insulation, and better furnaces. They also led to increases in coal mining and research in other energy technologies. Increased natural gas prices caused farmers to increase their use of nitrogen-fixing crops (such as alfalfa and soybeans) in attempts to reduce reliance on synthetic nitrogen fertilizer. Energy choices help shape societies. Although many energy technologies have been used through time, the dynamics of the changes have remained the same, and those dynamics will continue to determine future energy changes.

Elasticity of Energy Demand

Economists agree that, normally, increasing price causes people to buy less of a product and eventually to find substitutes. During much of the twentieth century, however, it was believed that market forces did not apply to energy: Energy use, it was thought, would rise or fall in a straight line with the economy. Real energy prices drifted downward until the early 1970s, and demand did move according to the strength of the economy, including a drop during the Great Depression in the 1930s. During the Arab-Israeli War (the Yom Kippur War) in 1973, Arab petroleum-exporting countries declared an oil embargo against governments supporting Israel. Besides not selling directly to targeted countries, participating producers lowered production to agreed-upon quota levels so that large supplies of petroleum would not be available for resale to target countries.

This action demonstrated the market power available to a production cartel of dominant producers. The Organization of Petroleum Exporting Countries (OPEC), of which Arab producers are a part, used that power to increase petroleum prices from $2.90 per barrel in mid-1973 to $11.65 by December of that year. Six years later, the 1979 Islamic Revolution in Iran disrupted production and pushed prices toward $39 per barrel. Nonetheless, these higher prices at the pump brought about changes in patterns of energy production and consumption. Petroleum vendors found less expensive and more reliable production sources. The higher price of oil spurred drilling in new areas, which eventually generated competition. Also, consumers reduced their dependency on oil by finding substitutes such as coal, reducing consumption by lowering thermostats, and shifting to more energy-efficient homes. In addition to reducing their driving habits, automobile drivers shifted their purchases to smaller, more fuel-efficient automobiles. Even the demand for electricity was reduced, something particularly impactful for the nuclear power industry. The net impact of this change in consumption patterns was a reduction in demand for petroleum, followed by a drop in the price of oil.

As demand began to slip below production capacity, Saudi Arabia reduced production to maintain low supplies. By 1985, however, Saudi sales were moving rapidly toward zero, while other OPEC members were producing more than their quotas and being enriched. Finally, Saudi Arabia increased its oil production, and the cost per barrel plummeted to nearly $10 before drifting upward again over several years to a market-set range of the high teens to low twenties. With inflation factored in, petroleum prices had returned to the levels of the mid-twentieth century.

By the summer of 2008, oil prices had risen to $147 a barrel, driven up by world events, concern over shrinking reserves, and lack of stability in the Middle East. The recession of 2008 caused consumption and, therefore, prices to decline. While developed countries encouraged substitution of oil consumption with renewable energy sources, developing countries such as China and India increased their demand for oil.

The decades of 2010 and 2020 have seen both upward and downward fluctuations in the price and production of petroleum. The first half of the 2010s showed oil prices back at elevated levels, consistently selling in the range of one hundred twenty dollars a barrel. Production surged to take advantage of these higher prices. In the latter half of the 2010s, a production technique known as hydraulic fracturing or "fracking" became widespread. Fracking allowed the profitable recovery of oil deposits in previously unproductive rock formations. On the positive side, this allowed the United States to raise production and reduce its dependence on foreign oil. Fracking, however, contributed to an excessive supply of oil in the global market. A steep drop in oil price soon followed. Major oil-producing countries such as Saudi Arabia countered by increasing production and adding to the global market supply. An objective was to drive down the price of petroleum where fracking was no longer profitable. This action, combined with a drop in demand resulting from the Covid-19 pandemic, led to a freefall in oil prices at the beginning of the 2020s. In January 2020, a barrel of petroleum had fallen to sixty dollars, and then nose-dived again to twenty dollars by April 2020. So steep was the drop that the price of oil turned negative. This meant that energy companies were producing oil at a financial loss. These enterprises found insufficient markets and had to pay buyers to retrieve and store oil supplies.

In February 2022, Russia invaded Ukraine. The subsequent economic sanctions issued by European countries and the United States included bans on purchases of Russian-produced petroleum. This soon caused a drop in the availability of supply and a sharp rise in the price of oil. By the summer of 2022, the price of oil had risen to levels not seen in a decade. Nonetheless, declining global demand soon led to a fall in oil prices which continued into the spring of 2023.

Combustion and Energy Efficiency

A basic rule is that the simplest and cheapest energy sources are the first to be exploited. Slavery and animal power were the prime movers for ancient industry. Only a declining population near the end of the Roman Empire contributed to an increased use of waterwheels for grinding grain. Once such mechanisms were developed, they proved more cost-effective than intensive human or animal labor because waterwheels do not have to be fed, as animals and human workers do. However, centuries had passed before society was driven to experiment with waterwheels and mills.

Likewise, combustion energy came into use long before nuclear energy or solar energy from photovoltaic cells because it was easier to develop. In the industrialized world the age of wood fuel has passed, but there are still large reserves of coal, petroleum, and natural gas to be exploited. Therefore, competition from new reserves and better mining techniques may keep clean energy sources minor for decades or even centuries to come. Sources of petroleum and natural gas that have yet to be exploited include deposits beneath deep ocean waters. Considerable investment has been made in accessing the oil found in tar sands in Canada, and coal use continues to increase—including the manufacture of synthetic liquid fuels from coal. Finally, according to some theorists, methane hydrates (methane frozen together with ice) may prove to contain more energy than all other fossil fuels combined.

The advantages of combustion energy can be seen in the differences between heating a house with oil and heating with an electric heat pump. Installing an oil furnace is not a major part of the house construction, and oil may be bought as needed. A heat pump (warming the indoors by cooling air from outside the house) may deliver more heat than even an extremely efficient burner. However, a heat pump is more complex than a furnace, so it costs more to buy and maintain. Moreover, electricity from a power plant is usually only about one-third efficient, with two-thirds lost as waste heat, so a heat pump must produce three times the heat of the burner just to equal the burner’s heat efficiency. Electrical resistance heating uses three times the fuel of a furnace.

Amory Lovins used this reasoning in his Soft Energy Paths: Toward a Durable Peace (1977) to argue that most tasks using only low-grade heat could be best served by combustion. He continued the argument by saying that if efficiency could be improved, energy use could decrease. People do not need energy per se: they need the services that energy provides. Thus, if end-use efficiency can be doubled, energy production can be cut in half. Improved energy efficiency can produce the same results as new mines, oil wells, and electric utilities, and energy conservation is often much cheaper than obtaining new energy.

However, improving efficiency presents a number of difficulties. Rather than several major solutions, energy conservation involves hundreds of minor “fixes.” The companies developing and marketing technology for such relatively small tasks are often small companies with less access to expertise and capital than the large energy-producing companies and utilities. End users, especially individuals, have even fewer resources available. Finally, the many minor (and often obscure) improvements in energy efficiency are often too complex and too diffuse for their developers to build a political constituency that could lobby for government subsidies. For all these reasons, only a fraction of the vast potential savings available from increased energy efficiency has been realized.

The comparisons of combustion with more exotic technologies also apply at the level of generating electrical power. Natural gas (mostly methane, CH₄) is expensive fuel compared with coal, but it burns cleanly in a simple burner. Oil burns almost as cleanly, and as a liquid fuel, it is convenient to store and use. Coal is cheapest, but as a solid it is inconvenient, and it has dirty waste products.

Nuclear Energy Economics

Nuclear fission offers vast amounts of energy. However, nuclear reactors require expensive materials and safeguards. Moreover, reactors cannot sustain the temperatures of combustion chambers. Lower temperatures mean lower efficiency, so a reactor must use proportionately more energy; it also emits more waste heat per unit of electricity generated than other sources. Finally, radiation eventually damages the structure, so reactors have a limited service life. These factors result in a high overall cost, even with subsidized fuel production and government-provided nuclear waste disposal.

Meanwhile, combustion plants have options not available to nuclear plants for increasing efficiency and thus decreasing costs. Waste heat from natural gas-fired turbines can run a steam turbine “bottoming cycle” to approach efficiencies of 50 percent and more. Coal-fired plants can pretreat the coal with heat and steam to generate methane and carbon monoxide (CO) for burning in a gas turbine. Spent steam from steam turbines can be used for industrial heating (a process known as cogeneration). Fission reactors, although they produce steam, miss this opportunity because they are usually sited away from other facilities for security and safety reasons. Lacking these options, fission reactor designers increased the size of plants in the 1970s to improve efficiency. However, costs, complexity, and risk increased more than proportionately. The accident involving a partial meltdown at the Three Mile Island, Pennsylvania, nuclear plant in 1979 demonstrated the hazards involved.

More important, the complexity and perceived risk of fission reactors caused financial meltdowns. A number of utilities had contracted for construction of fission reactors in the 1960s and 1970s to fill projected electrical needs. When rising prices slowed growth in electrical demand in the 1980s, many generator projects under construction had insufficient markets and were abandoned. Reactor projects that had stretched over many years were particularly expensive to abandon. Billions of dollars were lost, and plans to build fission reactors in the United States virtually came to a halt. Globally, the construction of nuclear power plants continues to decline.

Solar Energy Economics

Solar energy has economic problems as well. The resource is vast and free, but it is thinly spread energy, and the equipment to capture it is expensive. As with nuclear fission, most of the cost comes “up front,” before power—and revenue—are received. However, with increased investment in solar technology and a commitment by many states and countries to increase generation of energy from renewable sources, the cost of solar energy will become competitive with that of combustion generated energy. However, solar energy stops at night and is undependable because of clouds. The use of solar energy close to the point where it is captured—especially in solar water heaters—can be economically effective. It appears that the cost of solar-generated energy on a larger scale will become competitive with combustion-generated electricity in regions with optimal solar conditions in the next decade. Commitments in California and Hawaii, as well as Germany and Spain, are driving innovation in the solar-energy industry. An interesting historical footnote is that a budding solar-engine industry at the beginning of the twentieth century was destroyed by competition from combustion engines.

The production of electricity by arrays of photovoltaic cells cannot compete economically in areas served by the “electrical grid,” which has cheaper power cabled from large generating plants. However, photovoltaics are cheaper at the fringes of the grids (where power costs include electricity plus extensive cabling and poles) and for some small uses. They are also useful in isolated areas not served by utilities. These somewhat limited markets allow photovoltaic production to continue. Continued production allows photovoltaic producers to move down the “learning curve” toward lower costs that may yet allow photovoltaics to work from the fringe toward the center of the grid.

Photovoltaic prices started in the thousands of dollars per installed watt for spacecraft in the 1960s. As with other electronic devices, prices have dropped steeply. However, as opposed to most electronics, photovoltaic cells must be large so as to cover a large sunlight-collecting area. Even if photovoltaic prices drop to inconsequential levels, the underlying structure supporting the cells will still keep photovoltaic arrays expensive. Thus, for solar energy to compete as a major part of electrical supply, cell efficiency must increase or the arrays must be integrated into other structures, such as roofs and exterior walls of buildings.

Transportation Economics

In the transportation industry, the advantages of simplicity and cost are multiplied for certain fossil fuels. Hydrocarbons, such as gasoline and some slightly heavier petroleum fuels, have more energy by both weight and volume than coal does. For this reason, ships, which used coal-fired boilers at the beginning of the twentieth century, were being powered by oil-fired boilers by the second half of the century. For smaller vehicles, another crucial advantage of liquid hydrocarbons is that they can be simply and easily pumped into an engine. The complexity of feeding coal to a boiler adds to the cost of running a steam railroad locomotive and is prohibitively expensive for automobiles and trucks.

When hydrocarbon fuels from petroleum eventually become very expensive because of diminishing reserves, there will undoubtedly be replacement fuels, but all potential replacements currently known have expensive disadvantages. Synthetic fuels produced from coal have proved economically unfeasible except in emergencies. Production of ethyl alcohol from agricultural products involves energy losses from farming, from energy used by yeasts to make alcohol, and from the energy required to concentrate the alcohol. Electric automobiles involve two-thirds waste from electrical generating plants plus the cost of buying and moving massive batteries. A revolution in battery technology is changing those economics.

Energy Resource Bell Curves and Energy Crises

Geologist Marion King Hubbert noted a bell-shaped curve in the use of resources, now commonly called the “Hubbert curve” and often used in estimates of resource use and reserves. (Hubbert first applied his curve to petroleum in the late 1940s and subsequently reviewed and amended his prediction a number of times.) According to the Hubbert curve, a resource is used experimentally at first. Then, use increases rapidly until the resource begins nearing a point of half exhaustion. At that point, difficulty in obtaining diminishing supplies begins driving up costs, so demand growth begins to slow. As prices continue rising, competing energy sources emerge, and production of them increases. Use of the first resource declines in a mirror image of its earlier rise, and it gradually fades away. Hubbert noticed this pattern in the production of onshore petroleum in the forty-eight contiguous states of the United States. In 1948, he correctly predicted that production in this region would peak in the early 1970s. He noted that such energy curves had already occurred for other major energy sources in the United States, including firewood, whale oil, anthracite coal, and bituminous coal. Extension of such analyses to world energy production suggested that there would be a worldwide energy crisis after production of oil and gas peaked. Worries about such a crisis encouraged price increases, stockpiling, and government actions that helped create the energy crises of the 1970s.

The discovery of new reserves and the development of new energy sources can cause different kinds of crises that are as damaging economically as shortages are. In the 1930s, a Texas oil boom combined with the Great Depression to reduce petroleum prices to ten cents a barrel, nearly bankrupting the industry. The response was a group of state oil regulatory commissions that limited petroleum production.

Energy economics can have a wide range of ramifications. A by-product of the cheap energy of the mid-twentieth century was the growing problem of waste materials, from junked automobiles to tin cans and, later, aluminum and plastic containers. The seriousness of the problem was recognized in the 1960s, but not until the rise in energy prices of the 1970s was recycling of materials widely adopted, slowly reducing the volume of waste. Perhaps most notably, energy-intensive aluminum was recycled, and waste cans grew more scarce.

The 1970s energy crises resulted in two major economic reforms that will help ameliorate future crises. First, as noted, price increases led to increased efficiency. Second, a major energy source was reborn when the price of natural gas was released from government price controls. At twenty cents per 5.7 cubic meters, gas had been so cheap that it was often not even reported in drilling logs, so supplies were vastly underrated. The possibility exists that in the twenty-first century more energy will come from gas than from petroleum. In addition, those crises spurred research that may eventually yield viable new energy solutions.

In the 1970s, some observers saw the energy crises as an indication that petroleum reserves would be imminently sliding down the diminishing side of Hubbert’s bell-shaped curve. Such predictions were premature, but his analyses nevertheless show that energy production must continue evolving. As noted earlier, combustion processes will probably be cheaper than other energy sources for some time, at least in the United States. Nonetheless, if history is an indication, fossil fuels may eventually be supplanted. In 1850, “rock oil” (petroleum) was used only in small amounts, natural gas was a curiosity, and nuclear reactions and the electronic interactions that make solar cells work were entirely unknown. Nonetheless, all these have become important energy sources.

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