Tuesday, April 08, 2008

Conservation versus outsourcing

Read "The Wonderful Curse of Natural Gas Price Volatility". It's short, just 12 pages long.

Check out the graph at the top of page 9: "U.S. Industrial Gas Demand Destruction". That's a 22% drop in industrial natural gas utilization between 1997 and 2006. That's not efficiency, that's offshoring! What's going on here?
  • Natural gas is a feedstock for the fertilizer, chemical, and plastics industries, and a fuel for the electric generation industry.
  • Electric power generators are less sensitive to the price of their fuel than fertilizer, ethanol, and plastics, since the latter three can all be shipped to us oversea, and electricity cannot.
  • The electric generation industry is sensitive to the capital necessary to build capacity, because the rent on the capital to build their plants has to be priced into the electricity sold, and different plants do compete to produce and sell electricity. Thus, more capital-intensive plants are more likely to have lower return on investment if electricity prices dip.
  • Gas turbine power plants have exceptionally low capital costs, making them very desirable to the power producers, and gas prices were low during the 1980s and 90s.
  • So, electric generators built 200 gigawatts of gas turbine powerplants during the 1990s and early 00s, so that gas turbine plants now constitude 41% of our nameplate capacity (EIA figures). These gas turbine plants are now running at a capacity factor of 21%, and produce 20% of our domestic power (once again, EIA).
  • Figure 7 of page 8 of the Ventyx report shows that between 1997 and 2006, gas consumption by the power generators rose from 11 to 17 billion cubic feet a day. That's all those gas turbines coming on line.
  • It turns out there is a limited supply of domestic natural gas. Demand rose, supply stayed constant, and thus prices rose.
  • Over the same time, industrial consumption dropped from 23 to 18 billion cubic feet a day. That's domestic fertilizer, chemical, and plastics production being moved overseas in response to higher feedstock costs.
  • U.S. consumption of fertilizer, chemicals, and plastics has not dropped, and conversion from the feedstock to the final product increases value, so offshoring has driven the jobs overseas and also increased our trade deficit by much more than the cost of the natural gas consumed by the electric generation industry.
What we have here is another example of a strong negative correlation between the performance of the U.S. power generation industry and the U.S. economy as a whole. This is a tragedy, partially responsible for our $708 billion dollar/year trade deficit. That's an unpaid $2360 bill, per man, woman, and child, per year, for everyone in the United States.

This post and the last one may lead some of you to think I'm all for a command economy. No. I'm pretty sure that if we nationalized the electric power generation industry, we'd end up running it less efficiently, which would also lead to higher domestic power costs. I do think we need to bring the measure of performance of the electric power generation industry into better alignment with the domestic economy.

The domestic economy does well with cheap energy. In this context, gas turbines are a disaster, since they redirect a feedstock away from high-value-added uses (plastics) into low-value-added uses (electric generation). We have readily available substitutes for electric generation (coal and nuclear), but not natural gas. In some sense, all a gas turbine does is convert one kind of energy into another without increasing the domestic supply.

I don't know how to make domestic power producers profit more when the US economy has cheaper energy. The benefit of marginally cheaper power is probably nonlinear, and possibly unmeasureable in any way that would allow accountants to calculate a credit to power producers. I do not want to see more coal powerplants, because of the currently externalized cost of CO2 production, even though they are a cheap source of power. Perhaps the simplest way forward is what we have now: tax credits or subsidies for the obvious answers, like wind and nuclear, and just feel our way through, year by year, guessing which subsidies will distort the electricity market to best serve the interests of our citizens.

I'm sorry to keep harping on this energy and trade stuff, but to be honest, I'm scared. I don't understand how to predict what this trade deficit will do, nor do I understand how big is too big, but $700 billion feels too big. Our trade deficit, national budget deficit, credit crisis, housing market meltdown, and war in Iraq give me the feeling that this nation has derailed and is about to make a very expensive and possibly bloody mess.

The last time we got into a World War, we had just splurged on national infrastructure. Think about this: 90% of the Allied aluminum flying over Germany was made with power from the Grand Coulee Dam, built from 1933 to 1942, i.e. just in time. I'm not saying I expect another World War, but I am saying that when times get tough it's good to have serious infrastructure in your back pocket.


  1. I very much enjoyed your post, Iain. I, too, am an engineer - retired after a 30-year career in manufacturing and engineering for a major chemical company. And I share your concern about the trade deficit.

    I didn't always, though. There was a time when I knew nothing about trade and my interest in economics went about as far as my bank account. But all of that changed in 1993 when, while visiting the St. Louis Science Center, I saw a graph of world population from 2,000 years ago to the present. I began trying to reason through where it would all end.

    The result is a book that I recently published, "Five Short Blasts: A New Economic Theory Exposes The Fatal Flaw in Globalization and Its Consequences for America." I think you'd find this book very interesting.

    How did my concern about population evolve into a book about economics and globalization? It's because my new theory pulls it all together. The theory is that, as popuation density rises beyond some optimum level, per capita consumption begins to decline. This occurs because, as people are forced to crowd together and conserve space, it becomes ever more impractical to own many products. Falling per capita consumption, in the face of rising productivity (per capita output, which always rises), inevitably yields rising unemployment and poverty.

    This theory has huge ramifications for U.S. policy toward population management (especially immigration policy) and trade. The implications for population policy may be obvious, but why trade? It's because these effects of an excessive population density - rising unemployment and poverty - are actually imported when we attempt to engage in free trade in manufactured goods with a nation that is much more densely populated. Our economies combine. The work of manufacturing is spread evenly across the combined labor force. But, while the more densely populated nation gets free access to a healthy market, all we get in return is access to a market emaciated by over-crowding and low per capita consumption. The result is an automatic, irreversible trade deficit and loss of jobs, tantamount to economic suicide.

    One need look no further than the U.S.'s trade data for proof of this effect. Using 2006 data, an in-depth analysis reveals that, of our top twenty per capita trade deficits in manufactured goods (the trade deficit divided by the population of the country in question), eighteen are with nations much more densely populated than our own. Even more revealing, if the nations of the world are divided equally around the median population density, the U.S. had a trade surplus in manufactured goods of $17 billion with the half of nations below the median population density. With the half above the median, we had a $480 billion deficit!

    Our trade deficit with China is getting all of the attention these days. But, when expressed in per capita terms, our deficit with China in manufactured goods is rather unremarkable - nineteenth on the list. Our per capita deficit with other nations such as Japan, Germany, Mexico, Korea and others (all much more densely populated than the U.S.) is worse. In fact, our largest per capita trade deficit in manufactured goods is with Ireland, a nation twice as densely populated as the U.S. Our per capita deficit with Ireland is twenty-five times worse than China's. My point is not that our deficit with China isn't a problem, but rather that it's exactly what we should have expected when we suddenly applied a trade policy that was a proven failure around the world to a country with one sixth of the world's population.

    Our enormous trade deficit is rightly of growing concern to Americans. Since leading the global drive toward trade liberalization by signing the Global Agreement on Tariffs and Trade in 1947, America has been transformed from the weathiest nation on earth - its preeminent industrial power - into a skid row bum, literally begging the rest of the world for cash to keep us afloat. It's a disgusting spectacle. Our cumulative trade deficit since 1976, financed by a sell-off of American assets, is now approaching $9 trillion. What will happen when those assets are depleted? Today's recession may be just a preview of what's to come.

    Why? The American work force is the most productive on earth. Our product quality, though it may have fallen short at one time, is now on a par with the Japanese. Our workers have labored tirelessly to improve our competitiveness. Yet our deficit continues to grow. Our median wages and net worth have declined for decades. Our debt has soared.

    Clearly, there is something amiss with "free trade." The concept of free trade is rooted in Ricardo's principle of comparative advantage. In 1817 Ricardo hypothesized that every nation benefits when it trades what it makes best for products made best by other nations. On the surface, it seems to make sense. But is it possible that this theory is flawed in some way? Is there something that Ricardo didn't consider?

    Ricardo's principle of comparative advantage is overly simplistic and flawed because it does not take into consideration this population density effect and what happens when two nations grossly disparate in population density attempt to trade freely in manufactured goods. While free trade in natural resources and free trade in manufactured goods between nations of roughly equal population density is indeed beneficial, just as Ricardo predicts, it’s a sure-fire loser when attempting to trade freely in manufactured goods with a nation with an excessive population density.

    If you‘re interested in learning more about this important new economic theory, then I invite you to visit my web site at OpenWindowPublishingCo.com where you can read the preface for free, join in the blog discussion and, of course, buy the book if you like. (It's also available at Amazon.com.)

    Please forgive me for the somewhat "spammish" nature of the previous paragraph, but I don't know how else to inject this new theory into the debate about trade without drawing attention to the book that explains the theory.

    Keep up the good work of raising concern about this critical issue!

    Pete Murphy
    Author, Five Short Blasts

  2. Pete,

    One problem with Ricardo's princple of comparative advantage is that it strongly predicts that both nations benefit from shifting production of each good to the nation that is relatively better at it, but it doesn't say anything about how that benefit is distributed among the people of each nation.

    If the overall net worth of the nation rises, but only a minority actually benefit, then the trade is a bad choice for the majority.

    Another problem with trade is that it invited regulatory arbitrage. Energy can be cheaper in China because they burn cheaper sulferous coal in cheaper powerplants that don't scrub their output, and the mine conditions aren't as safe as ours. So things like aluminum production can move from the US to China and cost less after importation.

    My bias is actually towards something like free trade, subject to auditing to prevent regulatory arbitrage. I literally mean that the power used to make aluminum in products destined for the US should come from powerplants with US-spec emissions compliance. If this seems ridiculous, consider the alternative (which we are living with now).

  3. Iain:

    Thought provoking post. Here are a couple more ideas to consider.

    1. One of the reasons that natural gas plants are so cheap and easy to finance is that state Public Utility Commissions generally allow regulated utilities to "pass through" fuel costs. In contrast, they discouraged capital intensive sources like nuclear by initiating "prudency" reviews and requiring great effort by utilities to justify investments. Like most of us, utilities are a bit lazy. In addition, "effort" for a corporation translates into "cost".

    2. Gas consumption in price insensitive electric power plants is far more profitable for gas suppliers that gas consumption by price conscious industrial users. Many gas turbine installations in the 1990s and early 2000s were built by independent power producers with financing from gas producers like Exxon, Chevron, Shell. (I attended a number of IPP conferences in the 1990s and watched this happening.) Seems like the suppliers understood what they were doing, even if the project ended up in bankruptcy.

    3. Natural gas supply companies have been known to provide generous payments to consultants with "environmental" credentials like Amory Lovins. These consultants also have a side business as anti-nuclear activists.

    4. The cheap gas producers like Dubai are loving the effects of off-shoring from the US. It would be short sighted to believe that all of the movement is accidental and just "happened".

    5. Major international oil companies are getting into the LNG business in a big way. Exxon believes that it is one of their major growth paths. The phenomenon that you described for the US industrial gas consumers has happened in Europe and Japan as well, places where gas is even more expensive and yet more frequently used in power plants.

    Engineering is a wonderful subject and worth lots of study. Economics and politics often influence engineering decisions, so it is worthwhile for engineers to study those influences as well.

  4. Some very thought provoking ideas.
    I'd like to suggest a few more aspects that I think may be worth adding to the mix. Let me first say that I cannot claim any level of expertise in economics other than that specific to my job - I am a Process Engineer in the oil industry. Occassionally I need to consider the NPV and IRR value of possible projects but my concerns are largely of a more general nature.

    The economic and technological basis for the 'western' way of life requires the ready availability of cheap, convenient supplies of energy, particularly oil. This is required for transport, steel production, plastics, fertilizer, heating & cooking etc. and till recently the supply capacity was significantly greater than the demand and energy was cheap. However, the gap is rapidly closing (check out this article from the Wall Street Journal - http://online.wsj.com/article/SB121139527250011387.html) and energy is becoming more expensive.
    I'm sure that there are many possible reasons for this but I suspect that ultimately the main one is a combination of ignorance and greed - even we had known that a particular approach would have bad long-term results, the short-term gain would have been probably too attractive. What ever the reasons, it is becoming more apparent that we cannot go on this way forever. To achieve a drop in oil price would probably require a global recession to temporarily reduce demand but this would itself have severe consequences. My concern is, what's next?

    I think that it may be prudent to start looking at engineering the technologies required to sustain localised economies where energy and the products dependant on it are no longer cheap, convenient or readily available. In many ways this could be considered 'hippy' or to be going back to the 'dark ages' but I think bringing some of these technologies upto date and making them readily available may be a useful step to take. It could reduce some of the growth in energy demand and enable countries to develop in a less energy-intensive manner. It may also enhance the recovery of areas devastated by a natural disaster.

    Such technologies should not be the quickest or easiest or produce the cheapest product but they should require minimum energy for manufacture and transport to market and be sustainable from local materials.

    I'm not expecting this to happen over-night but if my daughter is going to have to live in a time where energy is no longer cheap then I should be doing something to improve her life-style under such circumstances.