The Oil Security Metrics Model

1. The Oil SecurityMetrics Model David L. Greene Paul N. Leiby Oak Ridge National Laboratory A presentation to the IWG GPRA USDOE March 6, 2005 Washington, DC

2. OSMM estimates oil security benefits of changes in the U.S. oil market. • Based on the NAS Committee’s framework that distinguishes energy security benefits from normal market benefits. • Includes uncertainty about future oil market conditions via up to four alternative AEO projections. • Simulates supply disruptions calibrated to historical deviations of OPEC supply from AEO projections. • Technologies change both the level of demand & its response to oil prices. Both are estimated. • Security benefits, are estimated as the difference between normal market (AEO Reference Case) benefits and benefits in alternative futures that allow supply disruptions.

3. The OSMM does not: • Predict technological or market success of DOE’s R&D programs or how technology would change w/o DOE R&D efforts. • Predict impact on U.S. petroleum consumption (the VISION Model is used for this). • Estimate impacts of DOE R&D on the probability, size or timing of oil market disruptions. It should. • Estimate defense or foreign policy costs in dollars. • Incorporate a global demand response to DOE’s R&D achievements.

4. The NRC (2005) made a distinction between normal and disrupted market benefits. • “Economic net benefits are based on changes in the total value of goods and services that can be produced in the U.S. economy under normal market conditions,…” (NRC, 2005, p. 29) • “Security net benefits are based on changes in the probability or severity of abnormal energy-related events that would adversely impact the overall economy, public health and safety, or the environment.” (NRC, 2005, p. 29) • At present, the OSMM does not estimate the changes in the probability of supply disruptions. • The definition appears to omit “insurance costs” of oil security (e.g. SPR, defense costs) during undisrupted periods.

5. The cartelized, volatile oil market produces three direct costs to the U.S. economy. • Loss of potential GDP due to greater economic scarcity of oil. • Transfer of wealth due to monopoly pricing and price shocks. • Dislocation losses of GDP due to oil price shocks. Transfer of wealth is not a loss of GDP but a change in the ownership of GDP. It can occur in disrupted and undisrupted markets and occurs whether or not OPEC is the cause of the disruption.

6. The direct economic costs of oil dependence have been greatest during supply “disruptions”.

7. Implementing as a spreadsheet model with Monte Carlo simulation software allows price shocks, OPEC reaction & parameter uncertainty to be represented. • Economic net benefits in normal market are obtained by using the undisrupted AEO cases (or Reference Case), with and without DOE program impacts. • Economic + Security benefits are obtained by running Monte Carlo simulations, with and without DOE programs, using probability distributions for: • Occurrence of a disruption • Timing of a disruption • Size of a disruption • Security net benefits = (Economic + Security benefits) – Economic net benefits

8. The impacts are tested in 10,000 futures. • Randomly Choose • Oil Market Scenario • & Calibrate WOM • High Oil Price • Reference Oil Price • Low Oil Price • Parameters • Adjust for Technology Impacts • Reduced oil demand • Increased oil supply • Changes in price elasticities Generate Stochastic Oil Supply Disruption Iterate to 10,000 • Compute Oil Dependence Costs • Transfer of Wealth • Reduced Potential GDP • Disruption Costs Select OPEC Strategy & Solve New Oil Market Equilibrium Distribution of Oil Dependence Costs by Year

9. The impacts of reducing US oil use, on imports and oil prices can be bounded. The key question is, “What will OPEC do?” • Maintain production: • World oil price falls • US imports depend on elasticities • OPEC market share increases • Maintain the price of oil • US supply unchanged • US imports fall • OPEC market share decreases • Increase production? • Decrease production more than enough to maintain the previous price?

10. The supply shock simulation model creates projections more consistent with recent history. Supply shocks are deviations from AEO projected OPEC supply.

11. Each oil market future chooses an AEO Case in which there may be oil supply disruptions that generate price shocks.

12. Expected hybrid vehicle benefits alone = $191B PV, assuming OPEC maintains its production plan (Ref. Proj. = $137 direct oil savings). By NAS definition, security benefits are $191B - $137B = $54B.

13. If OPEC maintains the price path, expected benefits are $120B PV, versus Ref. Proj. $71B direct oil savings. Security benefits are $120B - $71B = $49B. (Versus $54B)

14. In addition to monetary benefits, a number of non-monetary metrics are calculated.

15. The OSMM rigorously estimates the prospective oil security benefits of EERE R&D programs. • Using the NAS definition of security benefits. • Reflecting key uncertainties. • Oil market conditions via AEO Cases • Supply disruptions • Parametric uncertainties, too. • Includes price elasticity as well as demand reduction impacts. • Vehicle technology elasticity impacts included • Biofuel supply impacts to come.

16. THANK YOU.

17. U.S. oil imports in the base case, supply shock and EERE impacted cases.

18. The impact of EERE technology on world oil price.

19. The impact on OPEC’s market share.

20. The impacts on OPEC gross revenues.

21. The impacts on U.S. oil consumption.

22. The impact on U.S. wealth transfer.

23. The impact on the size of the SPR.

24. And, the impact on the price elasticity of U.S. oil demand.

25. One can measure how advanced technologies expand the fuel economy-cost envelope and increase the price elasticity of oil demand.

26. Technology changes the price elasticity of MPG, which changes the price elasticity of gasoline demand. Energy Efficient technology clearly affects the long-run price elasticity of demand. The short-run impact must be carefully considered.

27. The impacts of alternative and replacement fuels on price elasticity can be similarly estimated. • Given VISION program impact estimates of alternative fuel market shares, elasticity changes over time can be calculated. • The time trend in elasticities can be entered into the oil market simulation model by modifying the price slope of the US oil demand equation. β’s are price elasticities, b’s price slopes, s’s are market shares, g, r, and f indicate gasoline, replacement fuels, and all motor fuel.

28. Each direct cost component can be estimated by a relatively simple equation. • Total costs • Wealth Transfer • Loss of potential GDP (dynamic) • Disruption losses (dynamic)

29. SPR benefits are readily monetizable either as a reduction in costs or an increase in insurance value.(Leiby & Bowman, 2000)

30. Reduced costs of an SPR sized to replace 57 days of imports are expected to be $2.4B, PV.

31. The proposed method doesn’t include dollar estimates for defense or foreign policy costs. • It should. • Instead, the model can provide indicators: • OPEC revenues • OPEC market share • US petroleum imports • US petroleum consumption • When used in simulation mode, these would be probability distributions.

32. OPEC oil revenues are an indicator of monopoly rents to oil producers.

33. Net US imports are an output of the oil market model. OPEC or Persian Gulf imports are not.

34. The world oil market changed profoundly in 1973.

35. OPEC is an imperfect, partial market monopoly cartel. • It influences oil markets via decisions on: • Long-run: production capacity • Short-run: production • Its ability to collude is limited. • Its control of markets is limited. • It has a strong incentive to price above MC P = monopoly price C = competitive price β = demand price elasticity σ = OPEC mkt. share q = ROW supply Qo = OPEC supply r = rate of demand growth δ = rate of ROW supply decline

36. Short- and long-run elasticities bound the region in which OPEC can operate. Key Assumptions: Linear lagged adj. Supply Elasticities: L.R. = 0.60 S.R. = 0.06 1-lambda = 0.90 Demand Elasticities: L.R. = -0.70 S.R. = -0.10 1-lambda = 0.85 Competitive price = $13/bbl.

37. It is not likely that the problem of OPEC market power will go away soon. (3/11/04).

38. Dermot Gately has convincingly argued that OPEC will not expand its capacity to meet the world’s demands at a low price.

39. If Middle East producers do not increase output by 80%, unconventional oil production may have to expand rapidly. The M.E. can retain a third of the market as the lowest cost producer through 2050.

40. Security benefits can also be estimated for a portfolio of EERE technologies, but this has not yet been done.

41. Expected oil dependence costs under BAU = 2% of GEP with a 90% C.I. of 0.8-3.5% of GDP.(Interior interval = +/- 1 std. dev., exterior interval = 5% to 95% C.I.) % of GDP % of GDP

42. A one-time single-focus policy is insufficient: Raising LDV fuel economy to 35 MPG by 2017, then stopping, lowers the cost range to 0.5% to 3.0%. % of GDP % of GDP

43. The result is nearly unchanged if OPEC chooses to maintain output. % of GDP % of GDP

44. The NCEP strategy falls just short of the independence goal. More is needed, and progress must be sustained beyond 2030.

45. Oil independence works regardless of OPEC’s response strategy.

46. A simple oil market model that can be calibrated to any AEO scenario can be constructed with four linear equations. • US Demand • ROW (incl. OPEC) Demand • US Supply • ROW (excl. OPEC) Supply • OPEC Supply assumed exogenous.

47. National defense and foreign policy costs are controversial, difficult to measure, but not zero. • Two wars since 1990 not entirely unrelated to oil security. • Protection of oil supplies has some impact on US military expenditures. • Transfer of wealth • Provides surplus that can be spent on military build-up but also support for terrorism. • A blessing or a curse? • Assuming these costs to be zero is not defensible but, at present, OSMM does not estimate national security costs.

48. The OSMM does estimate the effects of EERE’s R&D programs on the: • Economic costs of oil supply disruptions, • Wealth transfer • Potential GDP losses • GDP dislocation costs • Potential GDP and wealth transfer costs during normal market periods, • Levels of US oil imports, • World oil prices, • OPEC market share and market power and • SPR costs or benefits.