Average value of a function and 2nd fund thm homework

CAROL A. DAHL

2ND EDITION

UNDERSTANDING PRICING, POLICIES, AND PROFITS

INTERNATIONAL ENERGY MARKETS

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Library of Congress Cataloging-in-Publication Data

Dahl, Carol A. (Carol Ann), 1947- International energy markets : understanding pricing, policies, and profits / Carol A. Dahl. -- 2nd edition. pages cm

Includes bibliographical references and index. ISBN 978-1-59370-291-5 1. Energy industries. 2. International economic relations. I. Title. HD9502.A2D335 2014 333.79--dc23 2014029321

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With love to Jim for his patience, forbearance, and unfailing love and support.

Figures Fig. 2–1. Conventional and unconventional natural gas reserves by major

country . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Fig. 2–2. World primary energy substitution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 Fig. 2–3. Successive median forecasts by International Energy Workshop

polls. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Fig. 3–1. World historical coal production by major country. . . . . . . . . . . . . . . . . . 44 Fig. 3–2. Percent of world coal production by major producer in 2013 . . . . . . . . . 45 Fig. 3–3. US historical coal prices adjusted for inflation . . . . . . . . . . . . . . . . . . . . . . 46 Fig. 3–4. Supply and demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 Fig. 3–5. Increase in demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 Fig. 3–6. Decrease in supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 Fig. 3–7. Representative business cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 Fig. 3–8. Global gross national product with selected countries, 1913–2012 . . . . 65 Fig. 4–1. Consumer plus producer surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72 Fig. 4–2. Supply equals marginal cost in a competitive market . . . . . . . . . . . . . . . . 73 Fig. 4–3. Government price controls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 Fig. 4–4. A maximum price in a competitive market . . . . . . . . . . . . . . . . . . . . . . . . . 77 Fig. 4–5. Government share per barrel of oil, 1998–2007 . . . . . . . . . . . . . . . . . . . . . 83 Fig. 4–6. Supply and demand in an energy market . . . . . . . . . . . . . . . . . . . . . . . . . . . 86 Fig. 4–7. Supply and demand with a unit tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87 Fig. 4–8. Supply and demand with tax on the consumer . . . . . . . . . . . . . . . . . . . . . . 88 Fig. 4–9. Incidence of a unit tax under different demand elasticities . . . . . . . . . . . 89 Fig. 4–10. Deadweight loss from an energy tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90 Fig. 5–1. US and world electricity consumption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93 Fig. 5–2. Electricity energy balance in the United States, 2013. . . . . . . . . . . . . . . . . 95 Fig. 5–3. Electricity consumption and population by major world regions,

2011. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 Fig. 5–4. World (a) and US (b) electricity production by fuel type, 2011 . . . . . . . . 97 Fig. 5–5. Various cost structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Fig. 5–6. Typical daily electric load curves for Israel, Jordan, and Egypt . . . . . . . 104 Fig. 5–7. US and Canadian electricity end use by month. . . . . . . . . . . . . . . . . . . . . 105 Fig. 5–8. Inverse demand and cost curves in a decreasing cost industry . . . . . . . 107 Fig. 5–9. Monopoly production, price, and profit . . . . . . . . . . . . . . . . . . . . . . . . . . . 109 Fig. 5–10. Peak load model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121 Fig. 6–1. Double-sided bidding market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135

xxi

xxii International Energy Markets

Fig. 6–2. Peak load demand and supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145 Fig. 6–3. Electricity restructuring in the US electricity sector, 2010 . . . . . . . . . . . 148 Fig. 7–1. Social welfare in a competitive market . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154 Fig. 7–2. Monopoly producer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156 Fig. 7–3. Numerical examples of monopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158 Fig. 7–4. Competitive supply in a constant cost industry . . . . . . . . . . . . . . . . . . . . 159 Fig. 7–5. Social losses from monopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160 Fig. 7–6. Monopoly and price controls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161 Fig. 7–7. Real US oil prices to refineries, 1861–2014 and March 2015

(in 2014$) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 Fig. 7–8. OPEC’s share of world crude oil production 1960–2012 . . . . . . . . . . . . 167 Fig. 7–9. OPEC monthly production and quotas, 1982–2012 . . . . . . . . . . . . . . . . 168 Fig. 7–10. Monthly nominal prices, three marker crudes,

January 1988–April 2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170 Fig. 7–11. Marginal cost for a two-country OPEC . . . . . . . . . . . . . . . . . . . . . . . . . . 171 Fig. 7–12. Dominant firm numerical example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173 Fig. 7–13. Developing demand for OPEC’s oil . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174 Fig. 7–14. Dominant firm model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175 Fig. 7–15. Dominant firm numerical example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178 Fig. 7–16. Marginal social efficiency of investment . . . . . . . . . . . . . . . . . . . . . . . . . 180 Fig. 7–17. Target revenues and price increases for high (a) and low

(b) absorber country . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181 Fig. 7–18. Target revenue and price increase for high-absorber countries . . . . . 182 Fig. 8–1. Natural gas world consumption and production by major region,

2012. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186 Fig. 8–2. Global natural gas use by sector, 1971–2011 . . . . . . . . . . . . . . . . . . . . . . . 191 Fig. 8–3. Historical natural gas consumption in the United States by major

sector, 1930–2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203 Fig. 8–4. Monthly US natural gas consumption and Henry Hub spot prices . . . 205 Fig. 8–5. Price and quantity changes under fixed price and fixed quantity

regimes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207 Fig. 8–6. Historical natural gas price at the wellhead, 1922–2012 . . . . . . . . . . . . . 207 Fig. 8–7. Real US natural gas prices by sector, 1967–2013 . . . . . . . . . . . . . . . . . . . 210 Fig. 8–8. Natural gas net withdrawals (withdrawals [+] minus additions [–])

to storage and spot price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211 Fig. 8–9. Major North American natural gas hubs and market flows, 2009 . . . . 212 Fig. 9–1. Monopsony purchases of LNG for constant marginal product up

to generating capacity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228

Figures xxiii

Fig. 9–2. Monopsony purchases of LNG with downward sloping MRPL . . . . . . . 228 Fig. 9–3. Perfectly price-discriminating monopsonist . . . . . . . . . . . . . . . . . . . . . . . 230 Fig. 9–4. OLEC as monopoly seller of LNG . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231 Fig. 9–5. Bilateral monopoly in the Asia-Pacific LNG market . . . . . . . . . . . . . . . . 232 Fig. 9–6. Reservation prices in a bilateral monopoly. . . . . . . . . . . . . . . . . . . . . . . . . 233 Fig. 10–1. Coal and oil consumption and production, 1950–2012 (bcm) . . . . . . 241 Fig. 10–2. Energy consumption and production for natural gas and primary

electricity in Eastern Europe, Western Europe, and the former Soviet Union . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247

Fig. 10–3. Regional non-hydro electricity generation by source, 2011 . . . . . . . . . 258 Fig. 10–4. Reaction functions for a duopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266 Fig. 10–5. Competitive market with two suppliers . . . . . . . . . . . . . . . . . . . . . . . . . . 268 Fig. 10–6. Two gas producers acting as a monopolist. . . . . . . . . . . . . . . . . . . . . . . . 269 Fig. 10–7. Limit pricing model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271 Fig. 11–1. Supply and demand in a market with negative externalities . . . . . . . . 278 Fig. 11–2. Costs and benefits of pollution emissions into water . . . . . . . . . . . . . . 279 Fig. 11–3. Varying marginal costs by area . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282 Fig. 11–4. Marginal abatement costs for two firms. . . . . . . . . . . . . . . . . . . . . . . . . . 285 Fig. 11–5. SO2 emissions for 249 regulated generating units, 1985 and 2000 . . . 287 Fig. 12–1. Coastal and inland demand for CO2 abatement . . . . . . . . . . . . . . . . . . . 293 Fig. 12–2. Social optimum for CO2 abatement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294 Fig. 12–3. Social losses for private market production of public goods . . . . . . . . 294 Fig. 12–4. Social optimum for a public good . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295 Fig. 12–5. Permits issued under different abatement cost scenarios. . . . . . . . . . . 308 Fig. 13–1. Significant oil disruptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319 Fig. 13–2. Oil and product world chokepoints. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320 Fig. 13–3. Share of global electricity consumption by fuel . . . . . . . . . . . . . . . . . . . 324 Fig. 13–4. OPEC spare capacity in millions of barrels a day . . . . . . . . . . . . . . . . . . 325 Fig. 13–5. Petroleum stocks in IEA countries (millions of barrels) . . . . . . . . . . . . 326 Fig. 13–6. IEA countries’ investment in energy efficiency. . . . . . . . . . . . . . . . . . . . 327 Fig. 13–7. Optimal spending on safety precaution (X*) . . . . . . . . . . . . . . . . . . . . . . 329 Fig. 13–8. Nuclear power with (S) and without (S') government support,

case 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331 Fig. 13–9. Nuclear power with (S) and without (S') government support,

case 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332 Fig. 13–10. Optimal nuclear safety precaution with and without the

Price-Anderson Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333 Fig. 14–1. Reserves/production ratios for the United States. . . . . . . . . . . . . . . . . . 338

xxiv International Energy Markets

Fig. 14–2. Demand in the current period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341 Fig. 14–3. Demand for oil now and in the next period. . . . . . . . . . . . . . . . . . . . . . . 342 Fig. 14–4. Optimal allocation of a resource in a two-period model . . . . . . . . . . . 343 Fig. 14–5. Consumer surplus in a two-period model . . . . . . . . . . . . . . . . . . . . . . . . 345 Fig. 14–6. Dynamic competitive solution maximizes NPV of social welfare . . . 345 Fig. 14–7. Change in resource allocation over time with income growth . . . . . . 346 Fig. 14–8. Change in resource allocation over time with lower interest

rate (r') . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 347 Fig. 14–9. Two-sector model with reserves of 500 . . . . . . . . . . . . . . . . . . . . . . . . . . 348 Fig. 14–10. Allocation in a two-period dynamic model with constant

marginal cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351 Fig. 14–11. Two-period model with a backstop fuel of $70 . . . . . . . . . . . . . . . . . . 353 Fig. 14–12. A monopoly producer in a two-period model . . . . . . . . . . . . . . . . . . . 356 Fig. 15–1. Gross world primary energy consumption . . . . . . . . . . . . . . . . . . . . . . . 369 Fig. 15–2. Hydroelectric power from a dam. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376 Fig. 15–3. Geothermal power plants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 382 Fig. 15–4. Hubbert curve for oil and gas reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . 391 Fig. 16–1. World energy use by industry, 2010. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 405 Fig. 16–2. World energy consumption by type of transportation, 2010 . . . . . . . . 407 Fig. 16–3. Total US residential energy use by service, 2012. . . . . . . . . . . . . . . . . . . 407 Fig. 16–4. US commercial energy use by service, 2012 . . . . . . . . . . . . . . . . . . . . . . 408 Fig. 16–5. Budget constraint: N = Y/PN – (PE /PN)E for Y = 160 and Y = 320 . . . . 419 Fig. 16–6. Budget constraint when only energy price doubles . . . . . . . . . . . . . . . . 420 Fig. 16–7. Indifference curve representing the consumer’s preferences. . . . . . . . 421 Fig. 16–8. Highest utility on the budget constraint . . . . . . . . . . . . . . . . . . . . . . . . . . 422 Fig. 16–9. Consumption changes with changing energy price . . . . . . . . . . . . . . . . 424 Fig. 16–10. Tracing out a consumer’s expansion path and Engel curves . . . . . . . 425 Fig. 16–11. Comparing a subsidy with an equal cost cash payment . . . . . . . . . . . 426 Fig. 16–12. Marginal revenue product for a producer . . . . . . . . . . . . . . . . . . . . . . . 428 Fig. 17–1. Consumption and production of oil products by world region,

2010 (1,000 bbl/d) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 438 Fig. 17–2. Oklahoma sweet distillation curve. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 443 Fig. 17–3. Isoquants for the Leontief production function

X1 = 2.5 min(u1, u2/2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 447 Fig. 17–4. Diagram for gasoline blending problem . . . . . . . . . . . . . . . . . . . . . . . . . . 448 Fig. 17–5. Transport of fossil fuels worldwide in 2011 . . . . . . . . . . . . . . . . . . . . . . . 456 Fig. 17–6. Illustrative gas and oil transportation costs, 2011 . . . . . . . . . . . . . . . . . 460

Figures xxv

Fig. 18–1. Daily WTI crude oil and Henry Hub natural gas prices . . . . . . . . . . . . 467 Fig. 18–2. Future prices today (t = 0) by maturity date. . . . . . . . . . . . . . . . . . . . . . . 477 Fig. 18–3. One- and four-month future contract prices. . . . . . . . . . . . . . . . . . . . . . 478 Fig. 18–4. Three-month convenience yield for US light sweet crude oil,

January 1986 to June 24, 2014, and US stocks of crude oil . . . . . . . . . . . . . . . . . . 480 Fig. 18–5. How higher futures prices might influence the spot market . . . . . . . . 485 Fig. 18–6. Petroleum stocks by month. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 486 Fig. 18–7. Real WTI price and OPEC crude capacity, production, and spare

capacity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 488 Fig. 19–1. Payoff of European long call at expiration . . . . . . . . . . . . . . . . . . . . . . . . 494 Fig. 19–2. Payoff of European long put at expiration . . . . . . . . . . . . . . . . . . . . . . . . 495 Fig. 19–3. Valuing a call from an underlying asset . . . . . . . . . . . . . . . . . . . . . . . . . . 497 Fig. 19–4. Value of one-half of an asset (a) and a bond (b) in one period. . . . . . . 497 Fig. 19–5. Value of an underlying asset in a binomial lattice. . . . . . . . . . . . . . . . . . 500 Fig. 19–6. Value of a put option in a binomial lattice . . . . . . . . . . . . . . . . . . . . . . . . 500 Fig. 19–7. Lattice with the underlying asset value (Si), put value (Pi), and

probability at each node (pi) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 502 Fig. 19–8. Net value of a European long straddle at expiration . . . . . . . . . . . . . . . 506 Fig. 20–1. Energy ladder for household energy use. . . . . . . . . . . . . . . . . . . . . . . . . . 512 Fig. 20–2. World consumption of energy by source, 1850–2013 . . . . . . . . . . . . . . 512 Fig. 20–3. Sample Lorenz curves. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524 Fig. 20–4. Gini coefficient equals A/(A + B ) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524 Fig. 20–5. Allocating labor on private (LPv) and common property (LC). . . . . . . . 528 Fig. 20–6. Effect on society’s welfare in two examples of the commons. . . . . . . . 529 Fig. 20–7. Volume of biomass from a long-growing tree . . . . . . . . . . . . . . . . . . . . . 533 Fig. 21–1. Energy consumption and GDP per capita for FR countries . . . . . . . . . 548 Fig. 21–2. World primary electricity production by source, 2011 . . . . . . . . . . . . . 552 Fig. 21–3. CO2 sources and pipelines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 556 Fig. 21–4. Production possibility frontiers for Sandy and Dland at their own

and each other’s terms of trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 559 Fig. 21–5. Potential for gains from trade with comparative advantage. . . . . . . . . 561 Fig. 21–6. Dollar market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 562 Fig. 21–7. Increasing resource exports appreciate the FR country’s currency . . 563 Fig. 22–1. Cultural preferences for individualism . . . . . . . . . . . . . . . . . . . . . . . . . . . 579 Fig. 22–2. Vertical structure and orientation for four corporate structures . . . . 595

xxvi International Energy Markets

Tables Table 2–1. Cosmological and geologic milestones in energy . . . . . . . . . . . . . . .14–15 Table 2–2. The world’s largest oil fields . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 Table 2–3. Largest accumulations of estimated unconventional oil reserves . . . . 21 Table 2–4. Categories of heavy unconventional oils . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Table 2–5. Major eras of coal formation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Table 2–6. A few oil and natural gas milestones in recent human history. . . .24–26 Table 3–1. Ten largest coal companies in China in 2010 . . . . . . . . . . . . . . . . . . . . . . 50 Table 3–2. Ten largest US coal producers, 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 Table 3–3. Ten additional large world coal producers . . . . . . . . . . . . . . . . . . . . . . . . 51 Table 3–4. Energy content by coal type . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52 Table 3–5. World coal production, consumption, and reserves, 2010 . . . . . . .52–53 Table 3–6. Global coal use by major sector, 2011 (ktoe) . . . . . . . . . . . . . . . . . . . . . . 54 Table 3–7. Revenues related to elasticities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 Table 4–1. Sample feed-in tariffs for electricity renewables, 2011. . . . . . . . . . . . . . 76 Table 4–2. Some representative severance tax rates for large fossil fuel–

producing states, 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .80–81 Table 4–3. World survey of selected petroleum product prices, 2012 . . . . . . . . . . 84 Table 5–1. Share of electricity and heat generation by fuel and total

generation, 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98 Table 5–2. Financing for a representative utility . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113 Table 5–3. US average electricity prices and consumption by customer class,

2012. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119 Table 6–1. Electricity prices and taxes, $/kWh, 2013 . . . . . . . . . . . . . . . . . . . . . . . . 130 Table 7–1. Sample of oil company mergers, acquisitions, and restructuring,

1910–2012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163 Table 7–2. OPEC petroleum, income, and population statistics for 2012 . . . . . . 182 Table 8–1. World dry natural gas consumption, production, and heat

content . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187–188 Table 8–2. Rents and quasi-rents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194 Table 8–3. Likely governance structure matrix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197 Table 8–4. Top North American natural gas marketers, 2011 . . . . . . . . . . . . . . . . 201 Table 8–5. Top United States natural gas producers, 2012 . . . . . . . . . . . . . . . . . . . 202 Table 8–6. Top ten interstate pipeline companies by mileage, 2001 and 2011 . . . 204 Table 9–1. What your banker wants to know. . . . . . . . . . . . . . . . . . . . . . . . . . 219–220 Table 9–2. Natural gas: trade movements by LNG 2013 (billion cubic

meters) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222

Tables xxvii

Table 9–3. Data on global liquefaction capacity in 2013 . . . . . . . . . . . . . . . . . . . . . 223 Table 9–4. Developing marginal factor cost for LNG supply function . . . . . . . . . 226 Table 10–1. Population and energy consumption across time, region, and

source (Eastern Europe, Western Europe, and the former Soviet Union). . . . . 240 Table 10–2. Primary energy production and relative share by energy source in

Europe and Eurasia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243 Table 10–3. Outlet capacity of export pipelines at the FSU border (bcm/year) . . . 252 Table 10–4. Natural gas imports into Europe and Eurasia (LNG and pipeline),

2013 (bcm). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254 Table 10–5. Gas storage capacity in the European Union, 2012 . . . . . . . . . . . . . . 260 Table 10–6. Major gas companies in Europe . . . . . . . . . . . . . . . . . . . . . . . . . . 261–262 Table 11–1. Milestones in US and European Union vehicle emissions

restrictions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284 Table 12–1. Carbon dioxide, GDP, and population for regions . . . . . . . . . . . . . . . 299 Table 13–1. OPEC flows of crude oil, 2012 (1,000 bbl/d) . . . . . . . . . . . . . . . . . . . . 323 Table 14–1. Typical lifetime of energy-using plant, equipment, and

appliances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336 Table 14–2. Conventional coal, oil, and gas proven reserves for selected

countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337 Table 14–3. Companies with significant oil or gas production or refinery

capacity, 2011.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 358–359 Table 15–1. Example conversions of one kilowatt hour primary electricity

to Btu energy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 368 Table 15–2. Known recoverable resources and mined production of uranium

(tonnes) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372 Table 15–3. Largest uranium producers in the world, 2012 . . . . . . . . . . . . . . . . . . 372 Table 15–4. Nuclear power reactors operating and under construction for

selected countries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374 Table 15–5. Sample of the world’s largest hydro capacity dams. . . . . . . . . . . . . . . 376 Table 15–6. Estimated levelized cost of new generation resources, 2017 . . . . . . 383 Table 15–7. Oil, natural gas, and NGL reserves and resources, 2012 . . . . . . . . . . 392 Table 16–1. World energy balances, 2011 (mtoe) . . . . . . . . . . . . . . . . . . . . . . 400–401 Table 16–2. Coal and peat use in the world in 2011 (solids in

megatonnes (Mt), gases in petajoules (PJ)). . . . . . . . . . . . . . . . . . . . . . . . . . . 410–411 Table 16–3. World petroleum statistics, 2011 (million metric tonnes). . . . 412–413 Table 16–4. World natural gas statistics, 2011 (pJ) . . . . . . . . . . . . . . . . . . . . . . . . . . 415 Table 16–5. World electricity and heat statistics, 2011 . . . . . . . . . . . . . . . . . . . . . . 416 Table 17–1. Boiling ranges for petroleum products . . . . . . . . . . . . . . . . . . . . . . . . . 440 Table 17–2. Sample crude API gravities and prices, April, 2014 . . . . . . . . . . . . . . 441

xxviii International Energy Markets

Table 17–3. Assays for various crude oil streams . . . . . . . . . . . . . . . . . . . . . . . . . . . 442 Table 17–4. World refinery capacity by region, 2013 . . . . . . . . . . . . . . . . . . . . . . . . 443 Table 17–5. Reid vapor pressure blending problem . . . . . . . . . . . . . . . . . . . . . . . . . 445 Table 17–6. Summary of refinery problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450 Table 17–7. World tanker fleet by size, capacity, and freight rate, 2012. . . . . . . . 454 Table 17–8. Representative tanker distances in nautical miles. . . . . . . . . . . . . . . . 457 Table 17–9. Domestic transport of crude oil, oil products, and coal by modal

share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 458 Table 17–10. Sample oil pipeline diameters, construction costs, and

capacities, 2012. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 459 Table 17–11. Largest net exporters and importers of refined petroleum

products in 2010. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 459 Table 18–1. Sample energy futures contracts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 470 Table 18–2. Sample futures quotes for heating oil on CME . . . . . . . . . . . . . . . . . . 472 Table 18–3. Gains and losses in the spot market at various prices . . . . . . . . . . . . 474 Table 18–4. Gains and losses in the spot and forward markets at various

delivery prices. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 474 Table 18–5. Sample US refinery production and prices. . . . . . . . . . . . . . . . . . . . . . 483 Table 19–1. Sample options contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 492 Table 19–2. Energy futures options quotes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 496 Table 19–3. Variables that affect American option values before expiration . . . 505 Table 20–1. Population, primary domestic energy supply, bioenergy and

waste share, and breakdown by sectoral use, 2011. . . . . . . . . . . . . . . . . . . . . . . . . 514 Table 20–2. Domestic supply of total bioenergy and waste in terajoules and

by source share, 2011. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515 Table 20–3. Socioeconomic characteristics of high biofuel users . . . . . . . . 520–521 Table 21–1. Countries averaging more than 14% of GDP from fossil-fuel

rents from 2008–2012. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 542 Table 21–2. Reserves, energy consumption, and GDP value added by sector . . . 544 Table 21–3. Fossil-rich countries’ energy consumption shares and growth

rate by source . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 549 Table 21–4. Unit gains of trade from specialization (absolute advantage). . . . . . 558 Table 21–5. Specialization gains Baltica (R) and Pacifica (N) (comparative

advantage) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 560 Table 21–6. Development indicators for FR countries. . . . . . . . . . . . . . . . . . 564–566 Table 21–7. Sovereign wealth funds from fossil fuels in fossil-rich countries. . . 571 Table 21–8. Net investment in producible capital plus educational expenditure

minus natural capital depletion (average 2000–2010 as percent of GNI) . . . . . 574 Table 22–1. Cultural differences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 580–581

Contents Acknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .xv List of Figures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xxi List of Tables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xxvi

Chapter 1 Introduction to Our Journey . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1

Some Scientific Principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Outline of the Book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6

Chapter 2 Energy Lessons from the Past and Modeling the Future . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Energy Geological History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Natural Gas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 Unconventional Oil Resources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Coal Resources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Energy’s Human History. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Energy Modeling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

Chapter 3 Perfect Competition and the Coal Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 Perfect Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47 Energy Demand and Supply. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 Shifts in Supply and Demand. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 Demand and Supply Elasticities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 Supply Elasticities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66 Using Elasticities to Forecast Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67 Price Changes from a Supply Disruption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67 Creating Demand and Supply from Elasticities . . . . . . . . . . . . . . . . . . . . . . . . . . . 68 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69

vii

viii International Energy Markets

Chapter 4 Energy Price Controls, Taxes, Subsidies, and Social Welfare . . . . . . . . . . . . . . . . . . . . . . 71

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71 Social Welfare . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71 Government Price Controls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74 Government Taxes and Subsidies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 Types of Taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79 Modeling Taxes in a Competitive Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86 Incidence of Tax Depends on Demand and Supply Elasticities . . . . . . . . . . . . . 89 Consumer and Producer Surplus Show Deadweight Loss from a Tax . . . . . . . 90 Energy Subsidies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91

Chapter 5 Natural Monopoly and Electricity Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93 Electricity Market Evolution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 Modeling Electricity Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98 Load Cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104 Monopoly in a Decreasing Cost Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105 Government Policy for a Natural Monopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111 Rate of Return Regulation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112 Problems with Rate of Return Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112 Valuing Money across Time. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113 Utility Rate of Return on a Bond or Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115 Utility Rate Base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117 Utility Cost Allocation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 Peak-Load Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122

Chapter 6 Restructuring in the Electricity Sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125 Problems with Regulated and Government-Owned Utilities . . . . . . . . . . . . . . 125 Models for the Electricity Sector. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127 Examples of Electricity Restructuring . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128 Evaluation of Early Reforms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150

Chapter 7 Monopoly, Dominant Firm, and OPEC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153 Monopoly Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

Contents ix

Monopoly Compared to Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159 Price Controls in a Monopoly Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160 Antitrust Laws. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162 Brief History of Oil Markets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 Multiplant Monopoly Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171 OPEC’s Demand Curve and Marginal Revenue Curve. . . . . . . . . . . . . . . . . . . . 174 Price Elasticity of Demand for OPEC’s Oil . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178 Non–Profit Maximization Goals for OPEC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183

Chapter 8 Market Structure, Transaction Cost Economics, and US Natural Gas Markets . . . . . . . . . 185

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185 Natural Gas Consumption and Production Worldwide. . . . . . . . . . . . . . . . . . . 186 Natural Gas Conversions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189 Transaction Cost Economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191 Evolution of the US Natural Gas Industry. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197 Gas Consumers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202 Gas Transmission. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203 Volatility in the Natural Gas Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205 Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208 North and South of US Borders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213

Chapter 9 Monopsony: Japan and the Asia-Pacific LNG Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217 LNG Production and Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220 LNG Monopsony on Input Market, Competitor on Output Market . . . . . . . 225 Monopsony Model Compared to Competitive Model . . . . . . . . . . . . . . . . . . . . 229 Monopsony Model with Price Discrimination. . . . . . . . . . . . . . . . . . . . . . . . . . . 229 Monopoly and Bilateral Monopoly. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230 Bargaining and Negotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234

Chapter 10 Game Theory and the European Natural Gas Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237 Coal and Oil Consumption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238 Coal and Oil Production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242 Natural Gas Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245 Primary Electricity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256 European Market Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258 Cournot Duopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264

x International Energy Markets

Duopoly Compared to Competitive Market. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267 Monopoly Compared to Competitive and Duopoly Market . . . . . . . . . . . . . . . 269 Other Game Theory Models: Bertrand and Stackelberg . . . . . . . . . . . . . . . . . . 270 Limit Pricing Model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272

Chapter 11 Externalities and Energy Pollution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275 Pollution as a Negative Externality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277 Optimal Level of Pollution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278 Regional Differences in Optimal Pollution Levels . . . . . . . . . . . . . . . . . . . . . . . . 282 Evolution and International Comparison of Vehicle Emission Standards . . . 283 Abatement across Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284 Difficulties Measuring Costs and Benefits of Pollution . . . . . . . . . . . . . . . . . . . 288 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289

Chapter 12 Public Goods and Global Climate Change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291 Public Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292 Two Other Abatement Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297 Energy Conservation and Its Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300 Energy Efficiency Gap and Policy Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303 Government Failure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307 Global Carbon Policy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308 Adaptation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312

Chapter 13 Safety and Security . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315 Market Responses to Uncertainty and Disruption . . . . . . . . . . . . . . . . . . . . . . . 321 Governments and Energy Security . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325 Energy Accidents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328 US Government Promotion of Nuclear Power. . . . . . . . . . . . . . . . . . . . . . . . . . . 330 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333

Chapter 14 Allocating Fossil Fuel Production over Time and Oil Leasing . . . . . . . . . . . . . . . . . . . . . . 335

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335 Reserves and Reserves-to-Production Ratios (R/P) . . . . . . . . . . . . . . . . . . . . . . 336 Dynamic Two-Period Competitive Optimization Models without Costs . . . 339 Model One (No Costs, No Income Growth) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341

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Model Two (No Costs, Income Growth). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346 Model Three (No Costs, No Income Growth, Lower Interest Rate) . . . . . . . . 347 Model Four (No Costs, No Income Growth, Increased Reserves) . . . . . . . . . . 348 Model Five (No Income Growth, with Costs) . . . . . . . . . . . . . . . . . . . . . . . . . . . 349 Model Six (No Income Growth, No Costs, with Backstop Technology). . . . . 352 Dynamic Multiperiod Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354 Dynamic Models with Market Imperfections . . . . . . . . . . . . . . . . . . . . . . . . . . . 354 Taxing and Bidding Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357 A Foray into the Real World. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363

Chapter 15 Supply and Costs Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367 Nuclear Fuels. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371 Hydroelectricity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375 Other Renewable Energy Sources. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377 Unit or Levelized Costs of Wind Electricity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 378 Solar Energy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 379 Geothermal Energy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 381 Inground and Aboveground Costs for Gas and Oil. . . . . . . . . . . . . . . . . . . . . . . 383 Unit Costs with No Decline Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 387 Developing Cost Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 390 Estimating Total Energy Resources. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 390 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 393

Chapter 16 Energy Balances and Energy Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 397

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 397 Energy Balances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 398 Household or Consumer Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 417 Consumer Demand and a Subsidy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 425 Factor Demand for the Industrial, Commercial, and Electricity Sectors . . . . 426 Econometric Estimates of Energy Demand—Picking the Functions . . . . . . . . 429 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 433

Chapter 17 Linear Programming, Refining, and Energy Transportation . . . . . . . . . . . . . . . . . . . . . . . 437

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 437 Crude Oil Refining . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 438 Gasoline Blending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 444 Linear Programming to Optimize Refinery Profits . . . . . . . . . . . . . . . . . . . . . . . 446 Energy Transportation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 451 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 463

xii International Energy Markets

Chapter 18 Energy Futures Markets for Managing Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 465

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 465 Energy Futures Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 468 Hedging with Energy Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 473 Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 475 What Determines Energy Future Prices on Commodities?. . . . . . . . . . . . . . . . 476 Efficient Market Hypothesis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 482 Crack and Spark Spreads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 483 Speculation and High Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 484 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 488

Chapter 19 Energy Options for Managing Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 491

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 491 Pricing Options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 493 Options Quotes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 495 Valuing Options with Replicating Formulas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 496 Creating Probabilities for a Binomial Lattice Model. . . . . . . . . . . . . . . . . . . . . . 499 Variables that Affect Option Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505 Option Trading Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505 Energy Swaps. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 508

Chapter 20 Climbing the Energy/Development Ladder to Sustainability . . . . . . . . . . . . . . . . . . . . . . . 511

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511 Combustible Biomass and the World’s Poor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518 Collecting Wood from the Commons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 526 Energy and Water. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 530 Renewable Energy Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 532 Optimal Timber Rotation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 532 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 536

Chapter 21 Sustainable Wealth in Fossil Fuel–Rich Developing Countries. . . . . . . . . . . . . . . . . . . . . 541

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 541 Fossil Future for FR Countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 545 Primary Electricity and Modern Biofuels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 551 Economic Issues in Fossil Fuel–Rich Countries. . . . . . . . . . . . . . . . . . . . . . . . . . 556 Investing Fossil Rents for a Sustainable Future . . . . . . . . . . . . . . . . . . . . . . . . . . 570 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 574

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Chapter 22 Managing in the Multicultural World of Energy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 577

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 577 Culture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 578 Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 585 Universalism and Particularism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 585 Cognitive Styles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 588 Life Values . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 589 Business Protocols . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 589 Human Dimensions of Managing Technology. . . . . . . . . . . . . . . . . . . . . . . . . . . 596 Think Like an Economist . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 598 Managing on the Margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 598 Managing across Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 When Markets Fail. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 601 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 602

Appendix A Energy Conversions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 607

Appendix B Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 613

Index. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 655

Note: An online glossary for this text can be found at http://dahl.mines.edu/glossary.pdf.

1 Introduction to Our Journey

Energy economists want to get the price right. Politicians can’t define obscene energy prices but know them when they see them. Energy traders believe that everything has a price and they know it, but if you outlaw price, only outlaws will know it.

—Modified from Unknown Author

Whether you are an energy economist, a politician, an energy trader, or an energy consumer, energy and its price will be of interest to you. Energy in all its forms can help you live an easier and more comfortable life. In the 1950s, it was touted that nuclear power would introduce an era when energy would be a nonscarce resource and we would have power too cheap to meter. Thus, we would be in a bear market with perpetually decreasing prices. Unfortunately, this prediction has not yet come to pass. Useful energy is still scarce, since we need capital, labor, and technical know-how to convert abundant but heterogeneous energy resources into the forms we all use. Sometimes useful energy is scarcer than at other times, with prices rising in a bull market or falling in a bear market. These shifts happen as consumers and producers react to changes in the market, including income, expectations, depletion, costs, and technology. But whether the market is running with the bulls or hibernating with bears, we want to use our energy resources wisely.

Energy is just one of four basic factors of production, the others being nonenergy natural resources, capital, and labor. Nor is energy the largest building block by value. Labor generally claims that prize. For example, labor’s share of the gross domestic product (GDP) is somewhat greater than 60% in the United States, while energy expenditures have not exceeded 10% of US GDP since 1985 (Mutikani 2012). Nevertheless, energy is just as crucial as the other factors. It is the ability to do work, and without work, none of the other factors could be made into the products that we enjoy every day.

My goal in this text is to consider how to use this precious factor wisely. However, the principles here apply to choices for all factors and facets of our lives where scarcity is present. Life is full of choices. Economics is about making good choices in the presence of scarcity. Since we still feel the pinch of scarcity in the

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2 International Energy Markets

energy realm, I will present the economic fundamentals, along with technical and institutional knowledge needed to implement sound economic, business, and government policy decisions relating to energy industries.

Some Scientific Principles Although useful energy is scarce and, hence, is not free, it is hard to imagine truly

running out of energy (E ) any time soon, as it is all about us. Energy, as Einstein’s famous equation (E = mc2) points out, is strongly tied to another fundamental concept in the universe, mass (m). Historically, this interchangeability of mass and energy and other scientific principles has led to major technological energy breakthroughs in the generation of electricity, transistors, nuclear fission and fusion, microwaves, lasers, iPads, and more. Science and technology are likely our best hope for even more spectacular breakthroughs in the future, as we transition out of fossil fuels and into renewable, and perhaps even to an as-yet-undiscovered source of clean, abundant energy. In the process, we need the underlying science to know if the source is possible. We also need the engineering skills to produce and deliver it, the socio-cultural sensitivity to disseminate it to a global audience, and the economic savvy to do it all at a profit. We will touch on all these attributes, with a focus on the economic aspect in this text, as well as in related material that will be posted and updated at http://dahl.mines.edu.

Let’s begin with some scientific principles related to energy. Scientists refer to four fundamental forces that govern all fundamental interactions between objects: gravity, electromagnetic, weak nuclear, and strong nuclear. These forces are responsible for all the familiar forms of energy we use. Conventional notions of force can be thought of as some sort of pressure on matter that can cause matter to move. Newton discovered the first of the four fundamental forces of physics— gravity. Although this is the weakest of the forces, it has the greatest reach and is also applicable to bodies at great distances from each other, such as galaxies.

The reach of a fundamental force is referred to as its field. The force exerted by gravity between two bodies is directly related to their masses and inversely related to the distance or space between them. Thus, the bigger the body, the more force it exerts. Bodies that are further apart exert less force.

So how does gravitation relate to energy? Energy can be thought of as the potential to do work, where work can be thought of as force acting over a distance. Thus, the force of gravity has the potential to cause water to flow from a higher to a lower elevation. If the force is exercised and water flows, it is called kinetic energy. If the water is constrained and not allowed to flow, the energy is stored and is called potential kinetic energy. However, the energy will become kinetic energy once the operator of the dam opens the sluice gates and allows the water to flow. Kinetic energy is measured in joules (J) according to the international system of units (SI) and the metric system. (Energy is also measured in calories, with 1 calorie equal

Chapter 1 Introduction to Our Journey 3

to 4.1855 joules, or in nonmetric British thermal units [Btu], with 1 Btu = 1.055 thousand joules or 1 kilojoule [kJ].) Unfortunately, despite its many advantages, the metric system is not yet in popular use in the United States. Some advantages of the metric system include the following:

• The metric system is used worldwide, with the exception of the United States, Myanmar, and Burma.

• Units in multiples of tens make computations easier to learn, easier to use, and less error prone.

• Standardized prefixes make it easier to grasp related dimensions. • Not having to convert across systems or to own redundant tools

and equipment saves time and money for a seamless fit into the global economy.

Since the system was created by scientists to be logical, consistent, and easy to use, it is the worldwide standard in science. Metric equivalents and their abbreviations will be provided throughout. However, we still live in an imperfect world and have to navigate between the systems. Thus, while we are waiting and agitating for a more perfect metric world, popular US energy equivalents will be given as well.

The next unifying principle came from Maxwell, a couple of hundred years later. He discovered that electrostatics, magnetism, and light could all be explained under one unifying force and theory—the electromagnetic force and electromagnetism.

This second fundamental force is the attraction between oppositely charged particles and the repulsion between like-charged particles. Static charges create an electric field and are responsible for electricity. Moving charges create a magnetic field, and accelerating charges create electromagnetic radiation. This radiation, from the longest to the shortest wavelength, lowest to highest frequency, and lowest to higher energy, with some familiar uses, includes the following:

• Radio waves. Transmit signals for radio and television, and some radar uses.

• Microwaves. Cook food, cellular phone communication, radar, and monitor precipitation.

• Infrared waves. Medical imaging, remote controls, and night vision. • Visible light. Normal vision, communication through fiber optic cables,

and lasers. • Ultraviolet rays. Sterilize bacteria and viruses, including those on clothes

hung out to dry. • X-rays. Medical imaging, tumor destruction, and security imaging. • Gamma rays. Treatment of disease and checking pipeline welds.

In the period around 1900, Thomson, Rutherford, and others gave us a more consistent view of the atom, with a positive charge in the center and negatively charged electrons circling the nucleus. The electromagnetic force between positive

4 International Energy Markets

and negative charges holds atoms together, and the residual force between electrons in one atom and protons in another holds molecules together. When molecules are formed or break apart, electromagnetic energy may be emitted or absorbed. Thus, electromagnetism is a unifying principle for all of chemistry. It is responsible for the heat and light when we burn fossil fuels.

Electromagnetic radiation travels at the speed of light (c) and can behave like a wave, with a crest and a trough. The wavelength is the distance from one crest through a trough to the next crest. The frequency (f) of the cycle is how many wavelengths the energy travels in a second and is called a hertz. The velocity (v) of the radiation in meters per second (m/s) equals the wavelength (λ) in meters times the frequency (v = λf). Electromagnetic radiation can also be thought of as photons—similar to little energy packets. In a photovoltaic cell, when light photons hit the semiconductors, this energy causes electrons to be emitted, forming a direct current.

The weak nuclear force was formulated by Fermi. It is another of the four fundamental forces that govern radioactivity. It allows neutrons in an atom to break into a proton, an electron (beta particle), and an antineutrino. It also allows larger alpha particles (two protons and two neutrons—the equivalent of a helium nucleus) to be emitted.

At this point, we still do not know what holds these positively charged protons together in the nucleus. The electromagnetic force suggests they should repel each other. The fourth fundamental force comes to the rescue, and it keeps everything from flying apart. It is the strongest force but has a very short range. It holds all the particles in the nucleus together. It too was hypothesized to exist in the 1930s, with the discovery that protons and neutrons make up the nucleus. When the strong force is broken by breaking apart elements heavier than iron, fission energy is liberated. When this force is exploited to fuse together elements lighter than iron, fusion energy is also liberated. However, fusing heavier elements than iron and breaking apart lighter elements than iron require a net input, rather than a release, of energy.

Although the current scientific knowledge is more complicated than the discussion above, this simplified discussion gives us some intuition about the basic energy forms we use. (For more information on newer ideas relating to the physics of energy, see http:\dahl.mines.edu\b0101.pdf.)

Energy is generated from the four fundamental forces, with commercial energy coming in six familiar forms:

1. Mechanical energy is associated with motion. Falling water resulting from gravity can turn a grinder, wind resulting from temperature differentials through electromagnetism can turn a wind turbine, and human and animal power can be used to move objects fueled by the chemical reaction of food.

Chapter 1 Introduction to Our Journey 5

2. Chemical energy is released when molecular bonds are broken or changed, as in the combustion of fossil fuels, such as coal, oil, and natural gas, or with biomatter, such as dung, wood, and crop residues. Such chemical energy from the electromagnetic force may be turned into mechanical energy, as in the internal combustion engine.

3. Thermal energy is a measure of the heat in the vibrations of molecules. It may result from friction. It may also be a product of the chemical energy of combustion. Geothermal energy, which is heat from within the earth, may be heat stored from the formation of the earth, supplemented with heating from pressure and radioactive decay (Cornell Center for Materials Research 1999).

4. Radiant energy is all forms of electromagnetic radiation. Solar energy is a critical source of radiant energy, with about 40% in the infrared and longer wavelength range, about 50% in the visible range, and about 10% in the ultraviolet or shorter wavelength range (University of California Museum of Paleontology, n.d.).

5. Nuclear energy from fusion and fission results from the strong nuclear force. It is changed to mechanical and other forms of energy in nuclear submarines, the explosions of nuclear weapons, and in nuclear power plants.

6. Electrical energy is the movement of electrons caused by the electromagnetic force. If the electrons travel one way through a wire, we have direct current. If the electrons continually reverse directions flowing back and forth, we have the more common alternating current.

In any system, we can transform energy from one form into another; for example, the mechanical energy of a stream can be turned into electricity by a hydro unit. The resulting electricity can be turned into heat and light in a home or can run a machine in a factory. With these changes, the first law of thermodynamics requires that the total amount of energy in an isolated system will always remain constant. Why then is energy scarcity a problem? The reason lies in the second law of thermodynamics, which requires that when energy is converted, it is reduced in quality and in its ability to do work. Thus, with each energy conversion, we have the same total amount of energy, but we have less available energy to do work. For example, the generation of electricity using a conventional thermal plant produces both heat and electricity. Although the heat generated may be used to warm oyster beds or might even provide district heat, it is often at too low a temperature or too far from a market to be otherwise usefully captured for work (Georgescu-Roegen 1979; Hinrichs 1996).

An understanding of the economical use of energy is interdisciplinary. Hence, in this book, we will combine knowledge of economics and mathematical analysis with institutional and technical information to better understand various energy markets. A discussion of the topics covered follows.

6 International Energy Markets

Outline of the Book Since the advent of the big bang, theorized to have occurred some 13 billion

years ago, energy has remained a fundamental component of the universe. Humans, who arrived only a few million years ago, have consumed only a small portion of the vast supply of energy on just one small planet. Part of the ascent of humans has been the process of learning how to use ever more of this supply of energy to help satisfy basic needs, along with space conditioning, transportation, and entertainment.

In chapter 2, we set the stage for the book by considering energy’s geological past and the evolution of human energy use and technology. We also address methodologies for forecasting its use in the future and analyzing energy economy and environmental interactions.

In chapter 3, we consider our first market model, perfect competition. Markets consist of buyers and sellers getting together and exchanging goods or services. We can refer to a market for a particular good, such as coal, or a class of goods, such as energy. Economists often loosely refer to the market as the accumulation of all the consumers and producers buying and selling all goods and services.

Economists often favor competitive markets in a capitalist economy for allocating scarce resources. They feel that the discipline of the market helps to create efficiencies and minimize costs. The lure of profits helps attract capital away from shrinking markets to growing ones, spurs innovation, and promotes new products. With competition and decentralized decision making, capitalist economies are more flexible and personal freedom is enhanced.

Our discussion of competitive markets in a static framework is applied to the coal industry. Principles of demand and supply help us to understand how market prices are influenced and how energy industries evolve. Coal, once the linchpin of industrial economies, has been slowly surpassed, as markets have attracted resources toward oil and gas and away from coal. However, such trends can change, as we see with recent large increases in coal use in China. Demand and supply elasticities, which capture responsiveness to price and income, are developed and used to analyze such market changes. In turn, elasticities can also be used to recreate demand and supply curves.

Energy resources are often publicly owned and considered basic wealth to a society. As such, they are usually taxed, sometimes quite heavily. In chapter 4, we consider energy taxes in the context of a static model. Criteria for tax collection such as equity and fairness will be considered. Who pays, or the incidence of the tax, depends on how responsive demanders and suppliers are to market price. Measures of this price responsiveness (price elasticities), developed in chapter 3, will be used to show tax and subsidy incidence. Price controls, another way that governments interfere with markets, will also be considered.

Chapter 1 Introduction to Our Journey 7

Although economists often favor markets and private ownership for the allocation of goods and services, there are a number of cases where economists generally agree that markets fail and that room exists for the government to step in. One such case is a decreasing cost industry, in which the greater the production, the lower the unit costs. Such industries are considered natural monopolies.

For many years, the electricity industry’s huge capital costs and economies of scale had been considered a natural monopoly. In such an industry, we prefer one producer on the grounds of greater efficiency, since the biggest producer has the lowest average cost. However, one private producer would be able to monopolize the industry and make monopoly profits.

In chapter 5, we consider the electricity industry, summarize the various technologies for generating electricity, and discuss how government ownership and price regulation have been used to try to control monopoly profits.

Problems with both government ownership and regulation, along with technical change in electricity generation, have led to deregulation, privatization, and restructuring of electricity generation in numerous markets, which is discussed in chapter 6. Classic deregulation examples in New Zealand, the United Kingdom, and Scandinavia will be considered, along with the horrific problems accompanying the restructuring of regulated markets in California.

If large producers have market power and are able to set prices, they can make monopoly profits. A classic example of this market failure is the Organization of Petroleum Exporting Countries (OPEC), which we consider in chapter 7. Some history of OPEC and models to explain OPEC’s behavior are also given. Since OPEC cannot control non-OPEC production, it will be treated as a dominant firm, rather than a monopoly. Since OPEC is not a monolith but is comprised of 12 different countries, some of their differences will be noted as well.

With deregulation, the institutional arrangements or governance structures in markets are likely to evolve. Such structures include spot purchases, long-term contracts, or vertical integration. Transaction cost economics suggests that the market structure that survives is the one that minimizes transaction costs. Specificity of assets in the industry will influence market governance. For example, a pipeline is a very specific asset, transporting a specific good from one specific place to another, whereas a semi-truck is much less specific and can transport a variety of goods to and from a variety of places. Market governance is also influenced by the amount of uncertainty and the frequency of transactions, all of which influence transaction costs. In chapter 8, we consider transaction cost economics and apply it to changes in the US natural gas markets.

Market power for either buyers or sellers leads to an inefficient allocation of resources. If there is only one buyer in a market, we refer to this market structure as monopsony. One buyer is able to depress the buying price and reap monopsony profits. A multinational company with exclusive rights to buy energy resources in a small developing country with a weak government would be an example of market

8 International Energy Markets

power on the part of the buyer. With the famous Red Line agreement in 1928, the multinational oil companies of the time carved up the Middle East and agreed not to compete with each other over resources, preserving their monopsony power. We consider the monopsony model in chapter 9 and apply it to Japan’s purchases of liquefied natural gas (LNG) in the Asia-Pacific market.

A single multinational oil company dealing with a strong government in an energy-rich developing country would be an example of a bilateral monopoly, which is a monopsonist (one buyer in a market) buying from a monopolist (one seller in a market). In this case, the outcome is ambiguous and depends on the negotiation skills of the two players in the market. Chapter 9 concludes with pointers on negotiation.

A few buyers or a few sellers in a market constitute oligopsony and oligopoly, respectively. These models get more complicated, as their outcome depends on the strategies of all the players in the market. We consider these market structures in the context of game theory, with an application to the European natural gas market in chapter 10.

Energy production, transport, and consumption produce a variety of pollutants, which are summarized in chapter 11. Power plants have often polluted the air we breathe, and coal mine runoff has fouled our waters. Since private decision makers do not take into account these costs, which are external to them, private markets will not allocate energy efficiently. Policies that have been undertaken in response to externalities such as pollution are also presented and evaluated in chapter 11.

Another externality comes from public goods. A pure public good is one from which people cannot be excluded (nonexcludability), and where one person’s consumption does not reduce another person’s consumption (nonrivalrous). The classic example is a lighthouse. Anyone in the vicinity of a lighthouse can look at it, and one person looking at it does not generally restrict the ability of another to look at it. In making a private decision to produce such a good, individuals typically only take their own satisfaction or utility into account and too little of the good will likely be produced. Further, if one cannot be excluded from consumption, each consumer will want someone else to pay for the good—the free rider problem. Both effects cause a public good to be underprovided by the private market.

In poorer countries, a significant amount of biomass is consumed to provide energy. This consumption, along with the associated land clearing and timber harvest, is reducing the biodiversity on the planet, which might be considered a public good. In addition, the reduction in forest is reducing the capacity of flora to absorb CO2. At the same time, the burning of fossil fuels, historically largely from industrial countries but increasingly from rapidly emerging markets, is increasing the amount of CO2 in the atmosphere. It is generally agreed that this buildup will cause global climate change. The National Academies of Science for the G8 countries plus five other countries (Brazil, China, India, Mexico, and South Africa) in a joint statement have noted that “the need for urgent action to address climate

Chapter 1 Introduction to Our Journey 9

change is now indisputable.” They call for governments to set and implement a goal to reduce CO2 emissions 50% below 1990 levels by 2050 (US National Academies 2009).

We do not precisely know the timing, extent, or the effects of this buildup, but expectations are that the climate will generally become warmer. With the melting of the polar caps, coastal areas will flood and weather patterns will change. Since many people enjoy the benefits of biological diversity and lower levels of CO2, but the benefits are nonexcludable and nonrivalrous, they have the characteristics of public goods. In chapter 12, we consider an analysis of the provision of such public goods, as well as current policies toward global climate change.

Energy accidents cause death and destruction on a regular basis. Sovacool (2008) documents 279 major energy accidents from 1907 to 2007, which cost thousands and thousands of lives and billions of dollars of property damage. The more recent Fukushima nuclear accident in Japan and the Macondo oil spill in the Gulf of Mexico are also high-profile examples of what can go wrong. In chapter 13, we consider some of these more high-profile accidents.

Humans and technologies can always fail, especially in today’s large, complex systems that find, produce, transform, transport, and distribute energy. Thus, such accidents, though unfortunate, to some extent are probably inevitable, and they typically produce negative externalities or damages to those nearby. With proper liability laws in place, those negative externalities can, in theory, be internalized through a country’s legal system, and those who suffer the negative damages will be reimbursed. If managers can estimate the probability of an accident and the amount of damage they will have to pay, they can also spend resources on safety systems to reduce the likelihood of accidents.

However, economists think that liability laws and markets alone may not be able to get us to the optimal level of precautionary spending for a number of reasons. Managers may get the probabilities wrong and optimistically think that low probability events cannot happen, or may even be unable to imagine some events. Did anyone expect the tidal wave that led to the Fukushima power plant accident? Managers may lack information and not be familiar with safety technology. The size of damages paid after an accident by the company may also be truncated. If damages are large enough, the company may be unable or unwilling to pay and instead will go out of business.

The situation may also suffer from principal agent problems. Managers, as agents of shareholders, may share in profits when times are good, but may not suffer proportionate losses from an accident. The losses may be spread over shareholders and others in the company, or the manager may resign and go to greener, less-soiled pastures. For these reasons, governments may step in with regulations that require safety procedures and investments to reduce the likelihood of accidents. They may require funds to be put into escrow to cover damages in the event of an accident, or they may impose fines and even jail managers for safety violations. Such sanctions

10 International Energy Markets

can be imposed before (ex ante) as well as after (ex post) an accident occurs. In chapter 13, we also consider such policies and how they should be designed to get the optimal amount of precautionary spending on safety procedures.

Chapters 2 through 13 contain static economic analysis of the allocation of energy resources. However, many energy sources, such as fossil fuels and uranium, are nonrenewable, depletable resources. For such fuels, if we produce the resource today, it will not be available for tomorrow, and dynamic analysis, in which we maximize net present value of all future production, is more appropriate. In chapter 14, we will look at a basic two-period model, with applications to oil production and leasing.

Dynamic analysis also has applications in allocating capital costs over time. In a very capital-intensive industry such as energy, it is important to be able to allocate such costs across units of production or consumption, even if the resource is renewable. Capital cost allocation procedures are developed in chapter 15. These are applied to the production of depletable resources with declining production, as well as capital investments where services do not decline until the equipment wears out, such as energy transport, renewable energy production, and services from household appliances.

Such costs are important inputs to the many market models considered in this text and have implications for energy supply. For example, Shell’s blueprint scenario (2008) pegs renewables at 30% of total global energy consumption in 2050. However, which markets renewable sources penetrate and how fast they do so will be strongly influenced by not only their characteristics, but also their costs.

Economists believe that economic actors are rational and optimize given their preferences, and demanders are no exception. Demand functions representing consumer preferences are an important part of understanding energy markets and forecasting future consumption. Along with supply or costs, they are a basic building block of many energy models, both simple and complex. Chapter 16 offers a global look at energy demand by major sectors. We look behind demand curves at optimization decisions for energy use by consumers and producers and consider statistical problems encountered when estimating demand on real-world data.

The costs and demands discussed in chapter 15 and 16 can be used as components in other larger models. If such a model is composed of linear equations, it is usually easy to solve, even if the model is quite large. In linear programming, we maximize or minimize a linear objective function subject to linear constraints. We apply this technique to oil refining and energy transportation in chapter 17, as well as mention other more complicated nonlinear static and dynamic optimizing techniques.

In chapters 1 through 12 and 14 through 17, most of the analyses assume certainty. However, we face large uncertainties in most aspects of our lives, and with uncertainty comes risk, or the possibility of loss or gain. Energy, being no exception, is a risky business. Chapters 18 and 19 of the book deal with ways

Chapter 1 Introduction to Our Journey 11

to manage financial risk. Government policies, the economy, and competition influence energy prices and costs. All three can provide unpleasant surprises, threatening not only profits, but, in some instances, a company’s very survival. Should we want to hedge—for example, reduce the risk of price change—we have various choices, including organized futures markets, with standardized contracts where parties do not know who is on the other side of the trade. With futures markets, discussed in chapter 18, we can lock in future prices for energy products that we want to buy or sell in order to reduce and manage risk. Speculators who want to take on risk in hopes of a profit can also operate in futures markets. With futures contracts, a player locks in a price and has an obligation to buy or sell at this price, or what is more likely, to close out the position at the locked-in price before the contract comes due. Because delivery is rarely taken on futures contracts, such contracts on crude oil and products are sometimes referred to as paper barrels, and the market as a paper refinery.

Sometimes a player would rather provide a ceiling or a floor for the price of energy. A refinery might want to lock in a minimum price for its product and a maximum price for the crude oil it buys. To do so, it can buy or sell an option on a futures contract for these products. These standardized contracts, discussed in chapter 19, give the buyer the right, but not the obligation, to buy or sell a futures contract depending on whether a call or put option has been purchased. If it is not profitable, the option is allowed to expire. However, if the option is in the money, usually the buyer closes out an option for a cash settlement rather than taking delivery, as with futures contracts.

Modern industrial economies have grown rich and powerful with help from copious quantities of carbon fuels. As numerous emerging markets are now quickening their pace of development, they understandably seek to follow in the same path to prosperity. However, if these carbon paths are followed, we may find ruin rather than wealth at the end of the trail, for fossil fuels will not last forever. Nor does it now seem likely that the globe can absorb all the related carbon emissions and still sustain a global population that is more than 7 billion strong and growing. So how do we sustain this endless flow of energy services in the face of resource and absorptive capacity constraints?

Energy consumption is often considered to be an important input into growth and development. Both the quality and quantity of fuels can influence output and are indicators of economic well-being. For example, the World Development Indicators (World Bank, n.d.) includes consumption of commercial energy per capita, such as electricity, gasoline, and diesel fuel, as well as more traditional biocombustible fuels and waste.

Prior to the industrial revolution, households relied on renewable noncommercial energy to heat and light their homes. Wood, straw, and crop residue were prominent sources. However, as we have progressed and become richer, households have moved away from these less-efficient sources, transitioning to charcoal and kerosene, and eventually to cleaner and more convenient liquefied

12 International Energy Markets

petroleum gas (LPG) and electricity. This movement to cleaner, more convenient, and more efficient fuels has been called a movement up the energy ladder. Worldwide, more than 1 billion people do not yet have electricity, and more than 2 billion still use traditional fuels to heat their homes and water and cook their foods. In chapter 20, we consider countries that get more than 50% of their fuel from traditional biomass, as well as issues they face, including poverty, income inequality, corruption, and problems of common ownership of bioresources. We also consider policy-induced moves to modern bioenergy in richer countries, as well as models to wisely manage commercial forests.

Energy not only supplies services to consumers, it provides revenues and incomes for producers. A number of fossil-rich countries, including Venezuela, Saudi Arabia, and Russia, receive large riches from these finite resources. Sustainability, from their point of view, is a continuance of income after the last economically viable fossil fuel has been extracted from their soil. In chapter 21, we consider issues of fossil-rich countries with more than 14% of their GDP from fossil fuels. Since such resource-rich countries often perform more poorly than non-resource-rich countries, some have considered fossil and other nonrenewable resources a curse. We will consider the hypothesized causes of the resource curse, as well as the performance of fossil-rich countries, including income per capita, health, inequality, corruption, and violence. Sustainability for them will require the investment of some of the resource rents into capital. This investment may be into international financial capital in the form of sovereign wealth funds or into other forms of capital including produced capital, human capital, technology, and institutional capital. Such investment is also briefly considered in the chapter.

Energy is a global business, with many large national, multinational, and transnational companies involved in its production and distribution. The models we consider in this book are powerful tools to help us better understand and manage our energy resources in such a global environment, and they are summed up in the concluding chapter. To succeed in this highly charged atmosphere also requires companies to understand the technologies, players, market structures, and policies that we discuss in this book. Companies should also understand the culture of both their employees and customers. It is important to develop a corporate culture that is compatible with both the corporate mission and vision statements, as well as with the national cultures with which the company does business. Thus, in addition to summing up what we have learned, we will also consider aspects of both national and corporate culture. Topics include how power is earned and distributed, people’s view of themselves relative to others and to nature, and views on uncertainty and time.

2 Energy Lessons from the Past

and Modeling the Future

Those who cannot remember the past are condemned to repeat it.

—George Santayana

Introduction

Energy markets continually evolve. How they evolve in the future will be influenced by many of the factors that we will discuss in this book, including energy resources, technology, population growth, demographics, climate change, costs, preferences, government policy, regulation, and risk. In this chapter, we will consider energy in the great historical panorama, which sets the stage for coming chapters. We will also consider models that help us forecast coming events, analyze policies, make business decisions, and simulate interactions between energy and other sectors.

Energy Geological History Science suggests that the most cataclysmic energy event for the universe was at

its beginning, with the big bang and subsequent inflation of the universe some 14 billion years ago (NASA 2013). These and other geological energy milestones are shown in table 2–1.

Although there is not total agreement or understanding of how the universe began, physicists generally believe it to have proceeded as follows. Before the big bang, time, space, matter, and energy did not exist. Then an anomaly caused negative gravity and positive energy to form from nothing. The net energy was zero, but the universe had zero size and infinite temperature. The negative gravity caused an expansion, and the high temperatures caused the formation of a small amount of matter in the form of subatomic particles from energy according to Einstein’s E = mc2. With the expansion, temperatures started to drop.

13

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Table 2–1. Cosmological and geologic milestones in energy

Date Event or Time Period

Comments

13 bya Big bang 5.5 bya Sun formed 4.6 bya Earth formed 4.5 to 0.544 bya Precambrian 4.5 to 3.8 bya Hadean (Early) Earth crust solidifies 3.8 to 2.5 bya Archaeozoic

(Middle) First life forms release oxygen to atmosphere

2.5 to 0.544 bya Proterozoic (Late)

First multicelled animals, one continent called Rodinia, oxygen buildup, mass extinction

544 mya to today Phanerozoic 544 to 245 mya Paleozoic Era Invertebrates, primitive amphibians 544 to 505 mya Cambrian Age of trilobites, explosion of life, all phyla develop, extinction

of 50% of animals, continents begin to break up 505 to 440 mya Ordovician Primitive land plants and fish appear, North America covered

by shallow seas, glaciation kills many species 440 to 410 mya Silurian First fish with jaws, insects, vascular land plants 410 to 360 mya Devonian Age of fishes, first amphibians, new insects, many extinctions 360 to 286 mya Carboniferous Huge forests and many ferns reduce carbon dioxide—global

temperature cools, atmospheric moisture increases, first winged insects and reptiles

325 to 360 mya Mississippian 325 to 286 mya Pennsylvanian 286 to 245 mya Permian Age of amphibians, supercontinent Pangea, largest extinctions,

earth’s atmosphere approaches modern composition 245 to 65 mya Mesozoic Era Age of dinosaurs 245 to 208 mya Triassic First dinosaurs, true flies, and mammals, many reptiles, minor

extinctions allow dinosaurs to flourish 208 to 146 mya Jurassic Many dinosaurs, first birds, first flowering plants, minor

extinctions 146 to 65 mya Cretaceous Tectonic and volcanic activity high, first marsupials, butterflies,

bees, and ants; many dinosaurs, continents as today, large extinction from comet collision

65 mya to today Cenozoic Era Age of mammals 65 to 1.8 mya Tertiary Modern plants and invertebrates 65 to 54 mya Paleocene First large mammals and primates 54 to 38 mya Eocene Lots of mammals, first rodents, and whales 38 to 23 mya Oligocene Many new mammals, grasses common 23 to 5 mya Miocene More mammals (horses, dogs, bears), modern birds, and

monkeys 5 to 1.8 mya Pliocene First hominids, modern whales 1.8 mya to today Quaternary Age of humans 1.8 mya to 11,000 ya

Pleistocene Appearance of humans, first mastodons, saber-toothed tigers, giant sloths, mass extinction at 10,000 years ago from glaciations

Chapter 2 Energy Lessons from the Past and Modeling the Future 15

Date Event or Time Period

Comments

11,000 ya to today Holocene Human civilization—domestication of plants and animals 1.8 mya to 4,000 BCE

Stone Age Dates vary from region to region; hunters and gatherers use stones that are chipped and flaked to form tools for an increasing variety of uses—arrows, needles, axes, etc.; agriculture appears; pottery develops; humans harness fire to cook, keep warm, and scare off animals

4,000 BCE to 1,200 BCE

Bronze Age Dates vary from region to region; bronze formed by heating tin and copper used for tools, ornaments, and weapons

1,200 BCE to 500 CE

Iron Age Dates vary from region to region; more abundant iron replaces bronze for many applications

Sources: Scotese (2002); Zoom Dinosaurs (2010); GSA (2012). Notes: mya, bya, ya = million years ago, billion years ago, and years ago, respectively. BCE = before the current age or before year 1; CE = the current age or after year 1.

However, the cosmic inflation caused temperatures to shoot up again. The universe blew up and inflated by trillions of times its former size. As it got larger, it cooled down to almost absolute zero. The strong, weak, and electromagnetic forces separated, which pushed the temperature back up. During this time, electrons, quarks, and other basic particles constituting the basic mass of the universe formed. They combined into protons and neutrons. As the universe continued to expand and cool, these basic particles combined into primarily hydrogen, with some helium and small amounts of lithium.

Later, gases formed clouds that gravity and fusion turned into galaxies and stars. Fusion within stars created heavier elements up to iron, giving off energy. When a large star ran out of fuel, it exploded into a supernova, which created elements heavier than iron, including uranium. These heavier elements also formed into stars and planets. Around 5.5 billion years ago, our sun formed, which is still directly or indirectly the source of most of our usable supply of energy. Somewhat later, the earth formed, with a core of iron. After a million years or so, the crust solidified, although the interior still remains molten and is the source of our geothermal energy. After the earth’s formation, water is thought to have accumulated from comets hitting the earth’s surface and melting.

Life formed in the oceans during the Precambrian period more than half a billion years ago. Bacteria and blue-green algae used sunlight to photosynthesize carbon dioxide and water into glucose (C6H12O6), oxygen (O2), and water (H2O) through the following chemical reaction:

6CO2 + 12H2O + sunlight g C6H12O6 + 6O2 + 6H2O

Glucose, in turn, changed into polysaccharides, such as starch and cellulose. These reactions released oxygen, paving the way for oxygen-using animals by the Proterozoic period.

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Petroleum is known to have formed as early as the Precambrian, more than half a billion years ago. From the Precambrian up through the Devonian, marine organisms (mostly plants such as algae, phytoplankton, and bacteria) were deposited in the absence of oxygen, which prevented their decay. Such anaerobic conditions occurred if deposits were buried quite rapidly or if oxygen was absent for other reasons, such as deep water. Shallow marine areas had abundant plant life that got buried deeper and deeper. As sediment piled up, the material was subject to bacterial action, forming kerogen.

Heat and pressure eventually formed oil and gas from kerogen. Oil forms under pressure at temperatures of about 60°–120° Celsius (°C), or 140°–248° Fahrenheit (°F), while gas forms at temperatures of about 120°C–255°C (248°F–491°F). Such gas and oil may migrate in interconnected porous rock and accumulate in pools, when stopped by impermeable cap rock.

Supergiant oil fields are those with more than 5 billion barrels of oil initially, while giant oil fields have 1 to 5 billion barrels. However, these definitions can be a bit cloudy. Sometimes, the oil referred to is oil in place—a measure of how much oil is thought to be in the field; at other times, it is economically recoverable reserves, usually a much smaller number. Sandrea and Sandrea (2007) put a conservative measure of current average global oil recovery rate (eventually produced reserves divided by oil in place) at 22%. Better reservoir management and enhanced recovery techniques can clearly raise this average.

Although there are no universal definitions categorizing reserves, a common approach is to define economically recoverable reserves as those that have a 90% chance of being produced with current prices, technologies, and conditions. These reserves are variously called proven, P90, and 1P. Similarly, reserves with a 50% or 10% chance are often designated as probable (also P50, 2P) and possible (also P10, 3P), respectively. For companies listed on public exchanges, these definitions and reporting requirements are sometimes prescribed by law. (For more discussion of reserve definition for various countries, see Society of Petroleum Engineers [SPE 2007] and Etherington, Pollen, and Zuccolo [2005].) For national oil companies, such transparency is usually not the case, and how they define reserves is fuzzier. Thus, the huge proven reserves additions for OPEC countries in the late 1980s, after production quotas were introduced in 1984, are more likely of political than geological origin.

The Oil & Gas Journal (OGJ) publishes proven reserve estimates for oil and gas by country in its annual December worldwide issue. They find that global proven reserves of oil, including condensate from natural gas wells, and reserves for natural gas for January 1, 2014, are 1,645 billion (109) barrels of oil and 6,886 trillion (1012) cubic feet of natural gas. (One metric tonne of oil is about 7.5 barrels of oil and varies depending on the weight of the crude, and 1 cubic meter of natural gas is about 35.3 cubic feet.) OPEC is estimated to have about 75% and 50% of these reserves, respectively. Global production was fairly flat while reserves of crude oil and lease condensate increased in 2013, according to Xu and Bell (2013)

Chapter 2 Energy Lessons from the Past and Modeling the Future 17

in the annual “Worldwide Production” report of the Oil & Gas Journal. However, recalling the lack of audits for national oil company reserve estimates, the OGJ numbers likely provide an upper bound on proven reserves.

In addition to condensate, other liquids are separated from natural gas at natural gas plants. These natural gas liquids (NGLs), which include propane (C3H8), butane (C4H10), pentane (C5H12), and some heavier hydrocarbon chains, also contribute to our stock of hydrocarbons. The first two of these products (often referred to as C3 and C4) are gases at normal temperature and pressure, and pentane (C5) has a very low boiling point (36°C or 96.8°F) (Ophardt 2003). However, C3 and C4 become liquids under a moderate amount of pressure. An estimated additional 48.9 billion barrels of NGL proven reserves may also be extracted from natural gas wells. This estimate of world NGL proven reserves for the beginning of 2013 is arrived at by taking proven oil reserves from British Petroleum (2014), which include NGLs, and subtracting the proven reserves from Xu and Bell (2013).

Some of the world’s largest oil fields, and the geological time of their formation, are shown in table 2–2. The reserves shown are the amount estimated from primary recovery or oil recovered from the natural pressure of the well. The amount of reserves that can be recovered can be increased by secondary recovery, which increases well pressure by injecting water, gas, steam, or other materials.

If the proven numbers are accurate, does this then imply that when these reserves are used up, all our oil and gas will be gone? Certainly not, because reserves are an inventory that we believe can be produced economically. However, inventories are expensive. A firm producing automobiles does not want to hold extra inventories. Nor does an oil and gas company want to invest in finding and developing extra hydrocarbon inventories. A company is likely to feel comfortable with an inventory of 10 years or so. As time proceeds, companies refine their estimates of reserves in known fields with reserve additions. They search and find new fields as needed and learn better technology to produce reserves more cheaply and increase recovery rates.

The above discussion of reserves largely applies to conventional reserves of oil and gas. Such reserves, when tapped into, have low enough viscosity to move on their own accord through permeable rock to the well bore. According to Tissot and Welte (1984), the world’s conventional oil and gas reserves were formed during three geological time periods in the following proportions:

• Paleozoic: 14% of oil and 29% of natural gas • Cretaceous: 54% of oil and 44% of natural gas • Tertiary: 32% of oil and 27% of natural gas

During this time, global temperatures, except for occasional ice ages, tended to be much hotter than today (for an example, see Scotese [2002]).

Oil and gas reserves in source rock that is not very permeable or porous are typically referred to as unconventional reserves, which we will consider in the following sections.

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Table 2–2. The world’s largest oil fields

Field Year Discovered Country Age of Reservoir Primary Reserves*

(billion barrels) 1 Ghawar 1948 Saudi Arabia Jurassic 83.0 2 Burgan 1938 Kuwait Cretaceous 72.0 3 West Qurna 1973 Iraq Jurassic 43.0 4 Bolivar Coastal 1917 Venezuela Mio.a–Eoc.b 32.0 5 Safaniya-Khafji 1951 Saudi Arabia/Neutral

Zone Cretaceous 30.0

6 Rumaila 1953 Iraq Cretaceous 20.0 7 Cantarell 1976 Mexico Paleocene 18.0 8 Ahwaz 1958 Iran Oligo.c–Mio., Cret.d 17.5 9 Kirkuk 1927 Iraq Oligo.–Eoc., Cret. 16.0 10 Daqing 1959 China Cretaceous 16.0 11 Marun 1963 Iran Oligo.–Mio. 16.0 12 Kashagan 2000 Kazakhstan Devon.–Carb.e 16.0 13 Samotlor 1965 Russia Cretaceous 16.0 14 Gachsaran 1927 Iran Oligo.–Mio., Cret. 15.5 15 Shaybah 1998 Saudi Arabia Cretaceous 15.0 16 Aghajari 1937 Iran Oligo.–Mio., Cret. 14.0 17 Romashkino 1948 USSR Carb.–Devon.f 14.3 18 Prudhoe Bay 1969 United States Cret.–Trias.g , Miss.h 13.0 19 Majnoon 1975 Iraq Jurassic 12.6 20 Abqaiq 1941 Saudi Arabia Jurassic 12.5

Sources: Tiratsoo (1986, 23); OGJ (2004). Note: *Primary reserves include estimated ultimately recoverable reserves (EUR) for primary recovery only. aMiocene, bEocene, cOligocene, dCretaceous, eCarboniferous, fDevonian, gTriassic, and hMississippian

Natural Gas Three categories of gas that fall under this rubric are tight sands gas, coalbed

methane (CBM), and shale gas. In each case, the free movement of gas is inhibited by the source rock (tight sandstones, unmineable coal seams, and shale, respectively). Thus, the rock must be fractured with the use of high-pressure water and a proppant, such as sand or chemicals, or both. The fracing creates a space in the source rock, and the proppant holds it open so the gas can flow. Such gas was once uneconomic, but with changes in price and technology, such as fracing and horizontal drilling, many of these resources have become commercial (Piccolo 2008).

Global production of these unconventional gas sources provided about 13% of total global natural gas production (3,169 billion cubic meters) in 2010. North Americans have been pioneers in the development of these unconventional gas resources. The United States and Canada, the number one and number

Chapter 2 Energy Lessons from the Past and Modeling the Future 19

three global natural gas producers, are estimated to have produced almost 85% of the unconventional gas in 2010. They get an estimated 50% and 25% of their production from unconventional gas, respectively, while Australia gets 10% of its gas production from its CBM. Fledgling CBM industries are being developed in China, India, and Indonesia (IEA 2012b).

Production for the easiest source (tight sands) started in the United States in the 1970s. Indeed, it has been produced long enough that the US and Canadian governments do not tend to report them any longer in their unconventional categories. The more difficult CBM did not get a sustainable start in North America until the 1990s.

Shale gas has become a particularly hot play in the United States, increasing from 4% of domestic production in 2005 to 43% by 2012. (EIA n.d.b.) This has affected LNG projects worldwide that had been gearing up to supply the huge US market, where declining conventional gas was not thought to be able to satisfy coming demand (Economist 2012b).

Shale gas production first took off in the Barnett Shale in Texas, which still dominates with about 50% of US production. However, production is rapidly growing elsewhere, particularly in the Marcellus Shale. The Marcellus, which follows a long, wide belt along the Appalachian Mountains from northern Tennessee to mid–New York State, is thought to hold between 40% and 50% of the US reserves (National Energy Technology Laboratory 2013).

Although shale gas is largely a US phenomenon, the International Energy Agency (IEA) (2011b) reckons that unconventional reserves are now as large as conventional ones, with their relative importance by country shown in figure 2–1. China has the largest reserves, followed by the United States, Argentina, Mexico, Australia, and Canada.

Although the potential looks huge, there are some clouds on the horizon that could prevent the dramatic US speed of development from being duplicated elsewhere. In the United States, the shale gas plays are near conventional plays, so infrastructure is already well developed. Deregulation has made US pipelines open access, or accessible to new producers. Drilling rigs have been readily available. With privately held mineral property rights in many of the US shale plays, NIMBY (not in my backyard) becomes IMBY as mineral owners laugh all the way to the bank to deposit their royalty checks. Few other places in the world allow private individuals to own subsurface rights (Economist 2012b). Environmental implications for shale gas are nontrivial and could even slow the euphoric frenzy in the US production. Shale gas is estimated to emit 3.5% more methane than conventional gas wells, and more if gas is vented. There have been concerns about chemicals and methane leaking into drinking water supplies.

Fracing has been around since the late 1940s, and the leakage problem has been solved with proper cement jobs on wells to prevent pollution to drinking water supplies. But it does require vigilance to ensure that proper techniques are

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implemented. Fracing also requires huge amounts of water that must be acquired and disposed of. China’s lack of water in the west, where the bulk of reserves are located, may slow developments of its copious reserves. The fracing process and deep underground water disposal have been associated with an increased incidence of earthquakes. Although Ellsworth (2013) finds the earthquakes from the fracing process to be inconsequential, those from underground water disposal may on occasion be more damaging. Thus, more densely populated areas of the world, with no private mineral rights, may put up more resistance to shale gas. Already, France and Bulgaria have banned fracing (Economist 2012b), whereas the United Kingdom lifted a moratorium on fracing at the end of 2012 (Bakhsh 2013).

An additional unconventional gas source is methane hydrates. These combinations of methane and water in crystalline form are found in permafrost areas and in ocean sediments. Although resources are thought to be huge (by some estimates, more than twice conventional reserves), difficulty in producing them makes their costs prohibitive relative to the other unconventional sources (Pooladi-Darvish 2004).

Although these resources are too expensive to be considered reserves, they still may merit some attention. Some have expressed concern that increasing global temperatures might release some of the methane, a potent greenhouse gas (GHG), causing further climate change (Mascarelli 2009).

Russia

United States

China

Iran

Saudi

Australia

Qatar

Argentina

Mexico

Canada

Venezuela

Indonesia

Norway

Nigeria

Algeria

0 20 40 60 80 100 120 140 160

2011 Trillion Cubic Meters

Conventional Tight Shale Coalbed Methane

Fig. 2–1. Conventional and unconventional natural gas reserves by major country Source: Economist (2012c).

Chapter 2 Energy Lessons from the Past and Modeling the Future 21

Unconventional Oil Resources Oil also comes from various sources. If the source rock is relatively impermeable,

or the oil is too dense or viscous to flow through the source rock, or both, we have unconventional oil.

Two unconventional sources of oil, extra heavy oil and bitumen, are both dense and viscous.

Heavy crudes and bitumen Heavy and extra heavy crudes have typically been degraded by the loss of lighter

components and usually contain more sulfur and heavy metals than lighter crudes. Thus, they are both dirtier and much more difficult to extract. Extra heavy oils with the highest viscosity are called bitumen. The triennial report of the World Energy Council (2010) contains estimates for resources/reserves for these two unconventional oils, as shown in table 2–3. Most of the known extra heavy oil deposits (not including bitumen) are found in Venezuela. Natural bitumen that is also extra heavy but with an even higher viscosity than extra heavy oils is found in oil sands, which are a mixture of about 90% sand, clay, and water, with the remainder being bitumen. This higher viscosity oil is more expensive to produce than heavy oil, as it requires heat to be produced.

Table 2–3. Largest accumulations of estimated unconventional oil reserves

Location Billion Barrels

Type of Resource

Definition Reservoir Age†

United States 24.0 Tight Light* Technically recoverable U. Devonian–L. Miss. Canada 0.5 Tight Light* Proved and probable U. Devonian–L. Miss. Argentina 22.0 Tight Light* Prospective resources L. Cretaceous–U. Tertiary Rest of World — Tight Light* — — Venezuela 220 Heavy/X Oil Technically recoverable Oligocene–Miocene Rest of World 1,400 Heavy/X Oil Technically recoverable — Canada 170.4 Oil Sands Remaining reserves Lower Cretaceous Kazakhstan 42.4 Oil Sands Remaining reserves — Russia 28.4 Oil Sands Remaining reserves Miocene Rest of World 2.0 Oil Sands Remaining reserves — United States 3,706.8 Oil Shale In place resources Paleogene & Cretaceous China 354.0 Oil Shale In place resources Upper Permian Russia 247.9 Oil Shale In place resources Ordovician & Jurassic Rest of World 477.4 Oil Shale In place resources —

Sources: WEC (2010); Petzet (2012); Selley (1985); and Selley (1997). Note: *Tight light oil is sometimes referred to as shale oil, but care must be taken to distinguish it from the heavy oils recovered from oil shale. †Indicates age of majority of deposits; U. Devonian is Upper Devonian; L. Miss. is Lower Mississippian; L. Cretaceous is Lower Cretaceous; U. Tertiary is Upper Tertiary; — indicates unknown to author. Heavy/X is heavy and extra heavy.

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American Petroleum Institute (API) gravity is the conventional way of measuring how heavy or dense a given stream of crude is. It is related to specific gravity, which is the weight of a given volume of a compound divided by the weight of an equal volume of water, as follows:

API gravity = [(141.5/specific gravity) – 131.5]

The specific gravity of water is 1, with API gravity of 10 degrees (°). Higher values for the API gravity are associated with lighter crude oils. For example, West Texas Intermediate (WTI) is a light oil with an API gravity around 40°, but Saudi Light is a bit heavier crude, with API gravity around 34°. Bitumen, which is extracted from oil sands, typically has an API of less than 12°. Denser oils are typically harder to move through source rocks. The actual characteristic that determines how difficult it is to move a liquid through a given source rock is its viscosity. The higher the viscosity, the harder it is to move the oil through the source rock. A standard international unit to measure viscosity is the millipascal-second (mPa-s) at 15°C. The viscosity of water is about 1 mPa-s at 20°C (Elert 2013). WTI has a viscosity of less than 9 mPa-s (Wang et al. 2003).

Just as conventional crude is heterogeneous, so too, is nonconventional oil. Cupcic (2003) gives a helpful classification for these heavy unconventional oils (B, C, and D classes) as shown in table 2–4.

Table 2–4. Categories of heavy unconventional oils

Class API Density Viscosity (mPa-s) Fluid in Reservoir A Class: Medium Heavy Oil 18°–25° 10–100 Mobile B Class: Extra Heavy Oil 7°–20° 100–10,000 Mobile C Class: Tar Sands and Bitumen 7°–12° >10,000 Not mobile D Class: Oil Shales Not mobile

Source: Cupcic (2003). Notes: mPa-s = a millipascal-second, which is also equal to a centipoise (cP). Large numbers indicate higher viscosity.

Oil shale Some source rocks rich in kerogen, a precursor to oil, but which have not been

subject to enough heat and pressure, are known as oil shale (D class in table 2–4). Vast amounts of hydrocarbons are locked up in oil shale, with major deposits shown in table 2–3. The US Rocky Mountain region has the largest deposits worldwide. Although there have been shale oil industries in various countries, beginning in France in 1838, the high cost of extracting and processing oil from the shale has caused much of this extraction to be phased out. Releasing the kerogen from the shale requires even more energy than recovering bitumen from oil sands.

Chapter 2 Energy Lessons from the Past and Modeling the Future 23

Tight light oil Just as for gas, some oil has gotten trapped in shales, and fracing of the shale

can allow this oil to move to the well bore and be produced. This tight oil produced from shale is sometimes referred to as shale oil. However, such terminology is confusing, as the term shale oil has also been used to refer to oil produced from oil shale. Tight oil is not viscous, it is just trapped. It might reasonably be called tight light oil. For example, Bakken crude oil has an API gravity from 40° to 42°, with a viscosity around 2 mPa-s (Wang et al. 2011). As with shale gas, releasing this trapped oil has been a hot play in North America, and current technically recovered resources are estimated to be around 24 billion barrels (US EIA 2011b).