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Thursday, December 31, 2015

Cheap Oil Forever? – Disaster for the (Auto) Industry!

Mike Smitka, Economics Dept, Washington and Lee University

The global auto industry is placing very large bets on the value of lightweighting and vehicle electrification. They may lose these bets.

...the industry may lose its expensive bet on new technologies...

In a previous post from April 2014 I argued that we were seeing "peak oil" in economic terms, as extraction costs (and hence the base price for petroleum) were rising. Again, this was an economic definition, because improvements in exploration technology has led to a steady increase in known "physical" reserves. To reiterate: my main point-cum-assumption was that, whether or not the level of reserves continued to rise, the cost of extracting those reserves would. Energy prices will remain cyclical, affected by swings in demand and the impact of short-run surges in drilling. But the underlying trend would be for each peak (and trough) to be higher than the last. That was overall good news for the auto industry: regulators in the main markets were pushing for a combination of higher fuel efficiency, lower emissions and enhances safety, for none of which had consumers in the past been willing to pay. So absent high prices, the industry was headed to producing a mix of cars (and, in the US, light trucks) that consumers would be reluctant to purchase.

But I may have been wrong on my key assumption. Nick Butler, an energy expert who blogs at the Financial Times, argues that in fact the cost of extracting hydrocarbons is falling, and will continue to do so. (See his Dec 27, 2015 post, The oil price in 2016. How low is the ceiling?.) As evidence, he notes the failure of production from "tight" formations to fall, stemming from rapid improvements in the technology of locating oil and horizontal drilling. Now Butler's focus was on the new producers, and not on the costs of extraction in the (Persian) Gulf, where my (limited) understanding of the physics of secondary production is that getting petroleum out of the ground will only become more difficult. But offsetting that is the spread of "fracking" outside the US; tight formations aren't unique to North Dakota and Oklahoma.

Cyclical components make discerning the empirical magnitude of these new exploration and extraction technologies difficult. Saudi Arabia is desperate for cash and needs to keep pumping. (See my previous post debunking the conspiracy theory that Saudi Arabia is trying to destroy fracking.) Sanctions on Iran are likely to ease. Demand growth in China is slowing. And, on the margin, solar and wind power are shifting the economics of power generation – on the margin because the substitution of renewables for petroleum is small and price effects indirect. Since these factors depressing energy prices aren't set to ease for several years, even if Butler is wrong, the strategic position of the auto industry is not enviable. In order to remain profitable, it will be dependent on policy to keep energy prices high and to close off the options for consumers to buy old-technology vehicles. Oh, and reversing mandates won't help; the parameters for model year 2018 vehicles are already locked in place.

...the next several years will see a costly mismatch between the vehicles under development and demand...

My own hunch is that the politics are driven in part by concerns over pollution, road safety and global warming, but that a bigger factor has been strategic concerns driven by high market prices for energy. As those concerns ease, I expect policy to backtrack. Perhaps I'm unduly US-centric, because these initiatives have a lot of momentum in the EU. How consistent China will be in pushing electrification will be critical. (Japan's domestic market is less and less relevant for global vehicle strategies.) Still, the next several years will see a costly mismatch between the type of vehicles already under development and the structure of demand they face post-start-of-production.

I just put midgrade gas in my 1988 pickup truck at $2.05 a gallon...filling the tank is no longer so expensive as to make driving it unreasonable. On the other hand, it's not fun on the hilly, winding roads I take into town, and then there's the challenge of parallel parking, so I normally opt for my car. But I provide that personal example because it is not only me who's being less careful about saving gas: US light truck sales are booming. Meeting CAFE standards will be hard, as pointed out in a recent Bloomberg article. What I've yet to investigate are the implications for the industry of failing to hit legislated targets. That's important because I believe the US market is likely to be more important for global industry profits than in the past few years – the decline of China as a profit center is the topic for a pending post.