W 0 R L D 0 I L 

EMF 6 SIIMMAgY REPORT 

Draft 9 

December 1981 

Energy Modeling Forum 

Terman Engineering Center 

Stanford University 

Stanford, California 94305 

The Electric Power Research Institute and the Department of Energy sponsor the 

Energy Modeling Forum. The Gas Research Institute has provided additional 

funding for EMF 6. 

This paper incorporates results obtained by the EMF 6 working group members, 

staff, and observers. The paper has not been approved by the working group; 

all errors remain the responsibility of James L. Sweeney. 
WORHING GROIIP PARTICIPANTS 

Chairman: 

Eric Zausner 

Deputy Chairman: 

Bruce Pasternack 

Issue Group Chairmen: 

Alvin Alm 

William W. Hogan 

David Nissen 

Henry Rowen 

Members: 

Arnold B. Baker 

Charles Boykin 

Nazli Choucri 

John Ecklund 

Leif Ervik 

Dermot Gately 

Martin Greenberger 

Bart Holaday 

Henry D. Jacoby 

Jerome Karaganis 

Michael Kennedy 

Calvin Kilgore 

Jay Kopelman 

John Kyle 

S. M. Lambert 

Alan Manne 

Robert Marshalla 

U. E. Mathis 

Ken—ichi Matsui 

John Mitchell 

Theodore Moran 

Richard Nehring 

Joseph Nye, Jr. 

Stephen Peck 

James Plummer 

Frank Potter 

James Reddington 

Stephen Salant 

Tim Shaftel 

John Stanley—Miller 

David Sternlight 

William Stitt 

Robert Stobaugh 

James Sweeney 

Philip Verleger, Jr. 

John Weyant 

Mason Willrich 

Booz, Allen & Hamilton, Inc. 

Booz, Allen & Hamilton, Inc. 

Harvard University 

Harvard University 

Chase Manhattan Bank 

Stanford University 

Atlantic Richfield Co. 

U.S. Department of Energy 

Massachusetts Inst. of Technology 

Central Intelligence Agency 

The CHR. Michelsen Institute 

New York University 

Johns Hopkins University 

Gulf Oil Exploration & Prod. Co. 

Massachusetts Inst. of Technology 

Edison Electric Institute 

University of Texas 

U.S. Department of Energy 

Electric Power Research Institute 

Imperial Oil Ltd. 

Shell Oil Company 

Stanford University 

Decision Focus Incorporated 

System Fuels, Inc. 

The Institute of Energy Economics 

British Petroleum Co. Ltd. 

Georgetown University 

The RAND Corporation 

Harvard University 

Electric Power Research Institute 

Electric Power Research Institute 

U.S. House of Representatives 

U.S. Department of State 

Federal Trade Commission 

University of Arizona 

U.S. Department of Energy 

Atlantic Richfield Company 

I.C.F., Inc. 

Harvard University 

Stanford University 

Yale University 

Stanford University 

Pacific Gas & Electric Company 
ENERGY MODELIBG BORUPS 

SENIOR ADVISORY PAHEL 

The Energy Modeling Forum seeks to improve the usefulness of energy 

models by conducting comparative tests of models in the study of key energy 

issues. The success of the Forum depends upon the selection of important 

study topics, the broad involvement of policymakers, and the persistent 

attention to the goal of improved communication. The EMF is assisted in these 

matters by a Senior Advisory Panel that recommends topics for investigations, 

critiques the studies, guides the operations of the project, and helps 

communicate the results to the energy policymaking community. The role of the 

Panel is strictly advisory. The Panel is not responsible for the results of 

the individual EMF working group studies. 

Dr. Harvey Brooks, Chairman 

Dr. Morris Adelman 

The Honorable William Bradley 

Mr. Hollis Chenery 

Mr. Gordon R. Corey 

Dr. Floyd L. Culler, Jr. 

Mr. Kenneth W. Davis 

Mr. Charles DiBona 

Mr. Herman Dieckamp 

The Honorable John Dingell 

Dr. John Gibbons 

Dr. Charles J. Hitch 

Dr. William W. Hogan 

Dr. Alfred E. Kahn 

Dr. William Lewis 

Dr. Henry R. Linden 

Mr. David Sive 

Mr. Eric R. Zausner 

Professor, Harvard University 

Professor, M.I.T. 

Member, U.S. Senate 

Vice President for Development & Policy, 

International Bank for Reconstruction and 

Development 

Consultant, Commonwealth Edison Co. 

President, Electric Power Research Institute 

Deputy Secretary, U.S. Department of Energy 

President, American Petroleum Institute 

President, General Public Utilities 

Member, U.S. House of Representatives 

Director, Office of Technology Assessment 

President Emeritus, University of California 

Professor, Harvard University 

Professor, Cornell University 

President, District Heat and Power, Inc. 

President, Gas Research Institute 

Attorney, Winer, Newberger, and Sive 

Senior Vice President, Booz, Allen & 

Hamilton, Inc. 
BNIF STAFF CONTRIBIITORS 

James L. Sweeney, EMF Director 

John Weyant, EMF Deputy Director 

Tim Shaftel, Study Coordinator 

David Kline, Assistant Study Coordinator 

Stephen Powell, Assistant Study Coordinator 

Perry Beider Research Assistant 

David Braden Research Assistant 

Nancy Cimina Publications Editor 

Wendy Dintersmith Administrative Assistant 

Joseph Eschbach Research Assistant 

Janice Evans Secretary 

Elizabeth Farrow Research Assistant 

Hillard Huntington Senior Research Associate 

John Mason Research Assistant 

Eric Mathre Research Assistant 

Sean Murphy Research Assistant 

Connie Nelson Research Assistant 

Patricia Reynolds Secretary 

Pamela Rosas Secretary 

Arlene Rosenbaum Research Assistant 

Ralph Samuelson Research Assistant 

Dorothy Sheffield Research Associate 

Carlos Tellez Research Assistant 

Nezam Tooloee Research Assistant 
URPiY P, 

EXEGUTIVE SUMMARY I 

INTRODUCTION 1 

OIL MARKET TRENDS 3 

IMPACT OF POLICIES ON OIL PRICES 5 

SECURITY OF OIL SUPPLIES 6 

IMPACTS OF POLICIES ON OIL SECURITY PROBLEMS 8 

USING THE IMPORT PREMIUM IN POLICY MAKING 9 

TRANSITION TO OIL SUBSTITUTES 10 

STATE OF THE ART IN WORLD OIL MODELING 11 

THE STUDY DESIGN 13 

THE MODELS 14 

Model Types 16 

Oil Consumers 19 

Non-OPEC Oil Producers 20 

OPEC Oil Producers 21 

Summary 23 

THE SCENARIOS 24 

ISSUE GROUPS 29 

THE WORLD OIL MARKET: 1980 - 2020 31 

MARKET TRENDS 32 

World Oil Prices 32 

Oil Quantities 40 

FACTORS INFLUENCING WORLD OIL MARKETS 45 

Oi1 Demand Reduction 48 

Economic Growth 50 

Demand Elasticity for Oi1 54 

Non-OPEC Oil Supply 55 

OPEC Capacity 58 

Other Uncertainties 59 

Summary 62 
OIL SUPPLY INTERRUPTIONS 65 

UNDERSTANDING INTERRUPTIONS 65 

QUANTITATIVE ESTIDiATES 72 

Comparative Price Impacts 73 

Economic Losses 77 

REDUCING VULNERABILITY TO OIL SUPPLY INTERRUPTIONS 78 

CONCLUSION 85 

THE VALUE OF REDUCING OIL IMPORTS 86 

THE IMPORT PREMIUM 86 

Market Power Component 88 

Security Component 89 

ESTINiATES OF THE PREMIUMS 91 

SOURCES OF VARIATION IN PREMIUM ESTIMATES 94 

IMPLICATIONS FOR POLICY 96 

THE TRANSITION TO NEW ENERGY SOURCES 98 

UNDERSTANDING THE TRANSITION 99 

FUTURE UNCONVENTIONAL OIL SUPPLIES 104 

QUANTITATIVE RESULTS 105 

World Oil Price Effects 105 

Effects on Distribution of Wealth 114 

MODEL CAPABILITIES AND LIMITATIONS FOR ANALYZING TNE TRANSITION 116 

SUMMARY 118 

IN CONCLUSION 119 

FOOTNOTES 121 

APPENDIX A: NUMERICAL INPUTS AND OUTPUTS A.1 

APPENDIX B: A BRIEF GLOSSARY OF ECONOMIC TERMS B.1 
H%ECQTIVE SIIMMAEY 

INTRODUCTION 

Oil, as one of the most flexible and portable sources of energy, has 

become fundamental to the workings of industrial economies. The convenience 

and previous low cost of petroleum products led to rapid increases in their 

use for transportation, home heating, electricity generation, and industrial 

processes. To some extent, the rapid post—war economic growth of the indus— 

trialized world was fueled by a cheap and seemingly unlimited supply of oil. 

During the decades of the 1950's and 1960's, the world price of oil, 

adjusted for inflation, gradually declined. However, the relatively stable 

conditions characterizing the world oil market of the 1950's and 1960's were 

replaced with the confrontation, chaos, and apprehension of the 1970's. With 

the 1973 Arab/Israeli war and the deliberate reduction of oi1 production from 

Saudi Arabia and other Middle Eastern countries, the world oil price jumped 

from $2.50 per barrel in 1972 to $11.00 per barrel in 1974. 

The subsequent world recession and adjustments of oil demand to the higher 

prices brought a slack world oil market; the oil price declined slowly in 

inflation—adjusted U.S. dollars and more rapidly in the currencies of other 

major OECD (Organization for Economic Cooperation and Development) countries. 

Many U.S. officials, fearing that dramatic declines in the world oil price 

would inhibit development of substitutes for OPEC oil, concerned themselves 

with establishing price floors for oil. But following the 1978 Iranian 

revolution, world oil prices shot up again--this time to over $30.00 per 

barrel. 

Late in 1980 there were widespread fears that the Iran/Iraq war would 

fuel yet another price escalation, the third in seven years, but this 

escalation never materialized. Rather, by early 1981 adjustments of oil 

1 
demand to higher prices brought on another "oil glut", and with it, widespread 

speculation that world oil prices were finally about to fall. The oil price 

optimism which characterized the mid-1970's again began to dominate popular 

discussion. 

Today, a relatively large share of the world's petroleum continues to 

flow from the highly unstable Middle East, making it likely that periodic 

interruptions in the world's supply of oil -- possibly much more serious than 

those experienced in the past -- will occur. In 1980, 32% of world crude oil 

production and 42% of WOCA (World Outside Communist Areas) oil came from the 

Arab members of OPEC. Although the expenditure for oil by OECD nations 

averages only 6% of their gross domestic product, sudden reductions in oil 

availability can create havoc for national economies. Thus, the world as a 

whole is dangerously dependent upon highly insecure oil sources. 

The high cost of oil imports, the threat of sudden supply interruptions, 

and the uncertainty about future oil market conditions pose grave difficulties 

for the oil importing nations. These problems continue to provide strong 

motivation for public policy and private sector planning and policy attention. 

The importance of these issues has motivated this Energy Modeling Forum (EMF) 

study. 

In what follows we summarize conclusions reached by an EMF working group 

studying the possible future evolution of the world oil market. Members of 

our group are listed above. In conducting the study, we used ten prominent 

models of the world oil market to project the possible future evolution of 

this market under a range of plausible situations. 

Our conclusions are based to a large extent, although not entirely, upon 

results obtained through application of the models to twelve scenarios 

designed to bound the range of likely future outcomes. One, the Reference 

Scenario (also referred to as the Reference Case), is given particular atten2 
tion as a plausible median case. But it in no way should be interpreted as 

our "forecast" of the oil future: there are simply too may unknowns to accept 

any projection as a forecast. The Reference Scenario is meant to be representative of the general trends that might be expected. Many of our conclusions 

are based upon Reference Case results and upon the variations around that 

scenario. 

OIL MARRET TRENDS 

Whi1e there remains a high degree of uncertainty about future world oil 

prices, our analysis suggests that most of this uncertainty concerns not 

whether real pricestl will rise during the next several decades but rather how 

rapidly they will rise. An additional uncertainty concerns the duration and 

magnitude of a short-run decline in prices which began to manifest itself in 

1981. We expect a soft oil market during the first half of the decade unless 

another supply disruption occurs. But by 1990, real prices can be eapected to 

exceed their current high levels. While the trend of real prices will be 

upward over the next several decades, the pattern could be one either of 

steady upward price movements or of sudden price jumps followed by gradual and 

less dramatic declines. 

We eapect conventional supplies of oil to increase only slowly during the 

1980's. Our assumption of relatively constant OPEC oil production capacity 

and our projections of declining OECD oil production, balanced against 

moderate increases in oil production from the rest of the world, indicate that 

in the 1980's the conventional oil production will grow much less rapidly than 

in the recent past. 

By the end of the century we expect significant quantities of unconventional oil production (e.g., oil shale, coal liquefaction, tar sands). When 

added to conventional production, this will allow high and possibly increasing 

3 
rates of world oil consumption for many decades to come. 

The rapidly growing economies of OPEC and the oil-importing developing 

countries can be expected to consume an ever-increasing share of future world 

oil production unless their economic growth rates are radically reduced. If 

these nations do increase their oil demands while conventional crude oil 

production is growing but slowly, we can expect OECD oil consumption to remain 

roughly constant or decline. 

High oil prices will be a major motivating force behind the substitution 

of natural gas, coal, solar, biomass, and nuclear energy for oil and behind 

the increased energy conservation in all economic sectors. Industrialization 

and rapid economic expansion will be the principal factors behind a growth of 

oil consumption in the less developed countries (LDC's). 

Despite the decline in OECD oil use, we expect a continued dependency of 

the OECD countries upon OPEC oil exports well into the twenty-first century. 

However, as a fraction of all oi1 consumption or of all energy consumption by 

the OECD countries, OPEC exports can be expected to decline significantly. 

Thus, while the economic problems of vulnerability to supply disruptions may 

decline by the turn of the century, the problems of high imported energy cost 

and uncertainty about future conditions will persist. 

Lack of dependable information about major determining factors continues 

to make precise forecasting of oil market conditions impossible. Key 

uncertainties include the market response of demand and supply to higher 

prices, the degree of policy induced energy conservation, the economic growth 

rates of the LDC's and the degree to which balance-of-trade considerations 

limit their oi1 imports, the rate of development of alternative energy 

sources, and the magnitude of future conventional oi1 and gas discoveries. 

4 
IMPACT OF POLICIES ON OIL PRICES 

Policies which reduce oil import demand, whether implemented by nations 

acting alone or collectively, can significantly reduce oil price growth. This 

effect can be quantified by examining the average price reduction (from what 

prices would have been otherwise) stemming from each 1 million barrels per day 

(MMBD) reduction in the quantity of oil imports demanded by the non—OPEC 

countries. For oil import demand reductions increasing gradually over the 

next decade, by 1990 we can expect world oil prices to be reduced by between 

$0.90 and $2.40 per barrel (1981 constant dollars) for each 1 MMBD reduction 

in oii import demand. 

During the first three to five years, these import reduction policies 

generally have a far smaller price impact per barrel reduction, since price 

adjustments in non—shortage situations tend to occur slowly. Furthermore, 

over a very long time horizon in which unconventional energy resources become 

abundant (say by 2010 or 2020), import demand reductions may have little or no 

world oil price effect since world oil prices may by that time be set by the 

costs ot unconventional fuel production. On the other hand, sudden demand or 

supply shifts, particularly those temporarily creating shortages, will lead to 

rapid price changes; the price change per MMBD supply or demand shifts may be 

several times greater than the $0.90 to $2.40 per barrel figure cited above. 

Since the OECD together or even the United States alone imports large 

quantities of oil, import reductions which moderate oil price increases can 

yield significant economic benefits to these countries. Benefits of import 

reduction, when expressed on a per—barrel basis, are collectively described as 

the oil "import premium". 

One portion of the import premium is the market power component. This 

component arises because reductions in imports can be expected to reduce the 

price paid for all oil imports and, conversely, increases in imports wiil 

W, 
cause increases in the price paid for every barrel of imported oi1. Thus the 

economic cost to a country or group of countries for importing another barrel 

of oil exceeds its price. The amount in excess is called the market power 

component of the import premium. (The other premium component which we will 

consider arises from the effect of imports on vulnerability to supply 

interruptions.) 

A simple approximation to the market power component can be based upon 

the $0.90 to $2.40 price impact per MMBD import demand reduction. For a 

country importing 6 MMBD of oil, the price reduction associated with a 0.5 

MMBD demand reduction will be applied to each of the remaining 5.5 MMBD. Thus 

the market power component of the import premium would be between $4.95 and 

$13.20 per barrel (5.5 MMBD X$0.90/bbl/MMBD and 5.5 MMBD X$2.40/bbl/MMBD, 

respectively). For the entire OECD, importing more than three time as much 

oil, these figures would be more than tripled. 

A more complete analysis of the market power component, taking into 

account the time patterns of import reductions and price changes, requires the 

direct use of the models. Here again, a range of estimates has been derived. 

The median2value of the market power component estimated under our Reference 

Scenario assumptions is about $30 per barrel above the world oil price for the 

OECD as a whole and about $8 per barrel for the U.S. alone. The magnitude of 

these estimates provides strong analytical support for energy policy choices 

which go beyond exclusive reliance on free markets. 

SECURITY OF OIL SUPPLIES 

Because so much of the world's oil comes from the highly unstable Middle 

East, the specter of oil supply disruptions remains. In fact, many of us 

believe that oil supply disruptions larger than those experienced in the past 

are possible. To examine the implications of such disruptions, we applied the 

9 
models to a hypothetical reduction in OPEC production capacity. 

Under the assumptions of our Reference scenario, world oil prices 

increase on theaverageby $5 to $12 per barrel for each 1 MMBD sudden 

reduction in OPEC crude oil output 3 , for a disruption approximately twice as 

large as any experienced to date. However we can expect price jumps to be 

more than proportional to the size of the disruption: a 1 MMBD disruption 

alone will increase prices by less than the average per barrel change, an 

increase in the disruption magnitude from 9 to 10 MMBD will have an 

incremental effect larger than the average. A 8 MMBD reduction in OPEC 

production could cause world oil prices to leap upwards by $40 to $100 per 

barrel, resulting in prices exceeding $100 per barrel. Larger production 

declines, and consequently larger price explosions, are possible. 

Likewise, the economic impacts of supply disruptions could be immense. 

If the OECD were importing 25 MMBD at the time of the disruption (roughly 

current levels), the 8 MMBD reduction in OPEC output could lead to increased 

wealth transfers from the OECD nations to the oil exporting countries of 

between $300 to $1100 billion per year -- 3% to 13% of the combined OECD 

national productsl Unemployment and other macroeconomic consequences of the 

disruption could multiply these losses several—fold. And "Ratchet effects" 

which keep prices high long after a disruption imply economic losses will 

persist even after the disruption itself has subsided. 

Although most of our models project large effects of a 10 MMBD capacity 

disruption, the maximum prices and the price pattern over time vary radically 

among the various models. There seems to be no consensus among observers of 

the world oil market as to the character of the price response during a 

disruption. Too many uncertainties--e.g., stock building and release 

patterns, expectation formation, exporter behavior--have yet to be resolved. 

7 
IMPACTS OF POLICIES ON OIL SECURITY PROBLEMS 

Our analysis of price jumps during disruptions suggests that price 

escalations could be moderated significantly if oil stocks were released or 

excess capacity were placed into production during the disruption. A 1 MMBD 

stockpile release would be equivalent in many ways to a 1 MMBD reduction in 

the magnitude of the oil supply interruption. For a large disruption, price 

jumps might be moderated by around $20 per barrel if 1 MMBD of stockpiles were 

released or excess capacity were put into production. Thus, useable excess 

capacity or stockpiles could provide major benefits to the oil importing 

nations. 

Gradual import reduction programs taken in advance might also lead to 

increases in excess capacity and may thereby reduce the price escalation and 

economic costs of disruptions. Programs could include, among other options, 

oil tariffs, incentives for energy conservation or supply increases, or fuel 

switching regulations. Such import demand reductions may moderate disruption 

costs in two ways. Under a regime of OPEC administered prices, import demand 

reductions are met partially by OPEC production declines and consequent 

increases in excess capacity. To the extent this occurs, the price escalation 

during a disruption may be moderated. In addition, a reduction in the 

quantity of oil imports exposed to the price escalations further reduces the 

economic impacts. For example, a 5 MMBD demand reduction undertaken prior to 

our hypothetical 10 MMBD oil supply disruption could reduce its economic costs 

by 30% to 90%. 

When expressed on a per-MMBD basis, this disruption-related economic 

benefit is referred to as the "security component" of the import premium. In 

our estimations, the security component, although important, is generally much 

smaller than the market power component. Under our Reference Case assumptions, security component estimates range from $1 to $5 per barrel for the 

0 
U.S. These values depend upon the probability of disruption -- 5% per year -- 

we have used for the calculations. Higher probabilities, felt by many working 

group members to be more realistic, would increase the estimated security 

component. In addition, because we have been unable to include the macroeconomic losses associated with unemployment induced by oil supply interruptions, our security component estimates should be viewed as lower bounds. 

USING THE IMPORT PREMIUM IN POLICY MAKING 

Estimates of the oil import premium can be used for evaluating energy 

policy options, since the premium quantifies the value to the U.S. or to the 

OECD of reducing oil imports, or, equivalently, the cost over and above the 

world oil price of increasing oil imports. However, a given premium value 

does not imply which specific policies are the most appropriate, but only that 

there is a large value for policy measures which go beyond sole reliance upon 

free markets. 

Estimates of the import premium depend upon a number of unresolved issues 

-- OPEC nation responses to energy policy choices in the OECD, responses of 

energy users and producers to changing prices or other incentives, the 

appropriate discount rates and time horizons for the analysis, oil stockpile 

release rates and petroleum inventory patterns. Thus the actual premium may 

be somewhat higher than our best estimates, perhaps by a factor of two or 

more. Although the premium could be below the low end of our range of 

estimates, this seems unlikely. 

Our estimates of the import premium do suggest several general 

conclusions about energy policy. Any policy which can reduce imports at a 

cost less than about $8 per barrel above the world oil price is very likely to 

be economically beneficial, while one which costs more than about $20 per 

barrel above the world price is likely to result in net economic losses to the 

9 
U.S. economy. Those which lie in between cannot be evaluated with any 

confidence using our results. However, our analysis does lead to the 

unmistakable conclusion that some import reduction policies going beyond 

simple reliance upon free markets can be justified by their economically 

beneficial impacts on world oil markets. 

THE TRANSITION TO OIL SUBSTITUTES 

The preceeding discussion focuses on the next two decades or so. Beyond 

this time, far—reaching changes in the world oil market may begin to manifest 

themselves. This study has made no attempt to resolve the great controversy 

which surrounds the issue of which energy future is most desirable. Rather, 

we have focussed on the oil market effects of different assumed unconventional 

fuel supply levels (here referred to as "backstops") under plausible 

assumptions about future oil demand and conventional supply. 

Under our assumptions about cost and future supply of backstop oil (by 

definition, a perfect substitute for oil, expensive, but inexhaustible), the 

world oil price rises well above average backstop costs in most circumstances. 

Massive quantities of backstop production (perhaps as large as the current 

level of WOCA oil production) are required before world oil prices decline to 

backstop costs. Whi1e backstop technologies may not place a cap over world 

oil prices during the next thirty years, generally the greater the quantity of 

backstop production, the lower the world oil price. Similarly, the greater 

the quantities of natural gas or other oil substitutes which are available, 

the lower the world oil price. These price differences can be large. By 

2020, projected world oil price is reduced (on the average) between $1.20 and 

$3.90 per barrel for each 1 MMBD increase in backstop production rates. 

Oil prices over the medium term (to 2000) will depend upon the beliefs 

held by oil producers and consumers as to the future cost and availability of 

10 
backstop oil. If consumers expect a technological breakthrough, and with it 

lower oil prices, they will less aggressively install energy-efficient capital 

equipment. As a result oil demand and prices may be higher than otherwise. 

Conversely, if conventional oil producers expect the breakthrough, they may 

hasten oil production in search of higher profits before the breakthrough 

occurs. Lower oil prices in the medium term may result. 

No attempt was made to estimate the costs associated with increasing the 

supply of alternative fuels. Thus, our results provide no comparison of costs 

and benefits. The study does indicate, however, that changes in backstop 

availability can significantly influence the national and international 

distribution of wealth between producers and consumers. In particular, 

countries producing backstop oi1 may reap large profits, to a large extent at 

the expense of OPEC revenues. 

THE STATE OF THE ART OF WORLD OIL MODELING 

In utilizing the ten models of the world oil market, we have also 

reached a number of conclusions about the current generation of models. The 

ten models use a striking diversity of assumptions and approximations. They 

differ in their degree of product coverage and disaggregation, with some 

representing oil markets only, ignoring other energy markets, others 

representing oi1 markets within the context of all major energy commodities, 

and still others treating all energy as a single broad aggregate. 

The models differ widely in their treatment of OPEC decision making. In 

some, virtually all OPEC choices are exogenous. In others OPEC is treated as 

an optimizing monopolist while in still others, rules-of-thumb for OPEC 

decision making are simulated. The diversity of these assumptions reflects 

limitations on current scientific knowledge and suggests that additional 

research on OPEC behavior is called for. 

11 
The models differ, although less fundamentally, in their representation 

of oil demand. All but one assume that demand responds slowly to price: 

short—run price elasticitiest of demand are far smaller than long—run 

elasticities. Only four models include any effect of oil prices on 

economic activity, even though the existence of such an effect is we11 

established. Even those models which represent this feedback from oi1 prices 

to economic growth do so using simple formulations. 

None include considerations of international balance of trade or 

represent the consequences of trade imbalance for economic growth or for oil 

import demand. Finally, none include the macroeconomic losses associated with 

unemployment of labor and capital equipment during a severe disruption of oil 

supplies. 

The differences and admitted limitations of the models reflect the 

current imperfect understanding of the world oil markets. It should be 

remembered that the oil market is a highly complex, uncertain network of 

centralized and decentralized decision making processes. Decisions are made 

in OPEC member nations, in Rotterdam trading rooms, in legislative bodies of 

the oil importing countries, in oil companies, and in the homes and work 

places of individual users of oil. Political shifts, changes in weather, war 

and revolution may cause rapid, unforeseen changes in oil market conditions. 

Fundamental research into these markets remains to be done before we will be 

able to analyze world oil markets as well as we are able to analyze domestic 

markets. To the extent that domestic policy and planning decisions require 

information about world oil trends and options -- and we believe such 

information is crucial to the entire energy debate -- more research, modeling, 

and analysis should be directed toward the world oil and energy markets. 

12 
THE STODY DESIGtd 

The Energy Modeling Forum (EMF) 4 pursues two goals related to the use of 

models in energy analysis: to improve understanding of the models themselves 

and to utilize existing models to improve understanding of current energy 

issues. These goals are pursued by identifying a number of models constructed 

for similar purposes, comparing the assumptions on which they are built and 

the results they produce, and applying these models to current energy policy 

and planning issues. 

In this study we have used mathematical models as tools for predicting 

and explaining what might happen in the world oil market, but only under a 

specified set of conditions. These models require as inputs many assumptions 

about real world relationships. In addition to the specific numerical 

assumptions needed, the projections are shaped by decisions about what to 

leave out of a model. Such specific features as an endogenous determination 

of OPEC production capacity and capacity utilization, or broad considerations 

such as the international political forces and potential changes in consumer 

life style may often be omitted. The extent to which the results accurately 

predict the future behavior of the world oil market depends critically upon 

the accuracy and completeness of the assumptions included and the significance 

of those phenomena excluded. Therefore, no model results can be considered 

perfect forecasts of the future. A detailed analysis of the underlying 

assumptions, as is attempted here, is necessary to sort out the often 

contradictory projections from different models. 

Dependence upon assumptions and consequent uncertainty in projections are 

characteristics not only of the mathematical models but also of the mental 

models used by experts or groups of experts to assess future oil market 

conditions. There is no alternative in energy analysis to some form of 

rational evaluation, involving many explicit or implicit assumptions. 

13 
Mathematical modeling is often a convenient, explicit, and powerful vehicle 

for such thinking. 

This report summarizes conclusions reached by an EMF working group 

studying the possible future evolution of the world oil market. Many of the 

conclusions result from insights gained through the use of models; but they do 

not represent an uncritical acceptance of the numerical outputs from models. 

The 45 working group members, drawnfrom government agencies, private 

sector firms, consulting and research institutions, international 

organizations, and universities, included both modelers and non—modelers. The 

group as a whole met four times between early 1980 and early 1981; the EMF 

staff assisted the working group throughout the study. 

This document is a summary of our conclusions. The complete report will 

be published separately. 5 

THE MODELS 

Table 1 lists each of our ten models, the working group member 

representing that model, and the organization with which the model (or the 

modeler) is currently closely associated. With the exception of the model 

designed by Salant, which was run independently by ICF, Inc., models were run 

by or under the direction of those individuals listed in Table 1. A11 runs 

were made by people having intimate knowledge of the specific models. Most 

models were run for nearly all scenarios. 

In this section we outline the key assumptions incorporated into these 

models (as used in this study). There are essentially three sets of 

differences across the models. First, the models may be based upon different 

assumptions as to what real—world relationships are important to include in 

the model and which can be safely ignored. Second, modelers may disagree 

about the proper form for modeling the same real—world relationships. 

14 
Table 1 

The Models 

Model Representative Organization 

Gately/Kyle/Fischer Dermot Gately/John Kyle New York University/ 

Imperial Oil 

IEES/OMS Calvin Kilgore U.S. Dept. of Energy 

(International Energy 

Evaluation System/ 

Oil Market Simulation) 

IPE (International Nazli Choucri. MIT 

Petroleum Exchange) 

Salant/ICF Stephen Salant U.S. Federal Trade Commission/ 

William Stitt ICF, Inc. 

ETA-MACRO Alan Manne Stanford University 

WOIL John Stanley-Miller U.S. Dept. of Energy 

Kennedy/Nehring Michael Kennedy/ University of Texas/ 

Richard Nehring RAND Corporation 

OILTANK Leif Ervik Christian Michelson 

Institute 

Opeconomics John Mitchell British Petroleum Corp. 

OILMAR Frank Potter Energy and Power Subcommittee: U.S. House 

of Representatives 

15 
Finally, differences in the numerical parameters used within a given form are 

possible. In what follows we will discuss only the structural differences, 

i.e., the differences in the features included and in the fundamental ways 

these features are represented. 

Model Types 

A11 models of the world oil market include, at least implicitly, the 

behavior of three sectors, or sets of participants: oil (or energy) consumers, 

non—OPEC oil (or energy) producers, and OPEC oil producers. In constructing a 

model, two basic questions must be answered: (1) How does each sector behave? 

and (2) How are the choices coordinated among sectors to maintain supply—

demand balance in the market? The ten models we have used represent a range 

of different answers to these questions. The differences and similarities in 

modeling approaches are summarized in Table 2 and will be discussed briefly in 

what follows. 

The models can be divided into two broad categories: seven recursive 

simulation models--IEES/OMS, OILMAR, WOIL, Gately/Kyle/Fischer, IPE, OILTANK, 

and Opeconomics--and three intertemporal optimization model s--ETA— MACRO, 

Kennedy/Nehring, and Salant/ICF. Recursive simulation models are those in 

which decisions of the various actors are assumed to depend upon information 

only about past and current events (or information based upon simple 

extrapolations of past changes.) In the intertemporal optimization models at 

least one sector is able to take into account information about future events. 

Typically this is made possible by assuming that actors have perfect foresight 

and that they make current decisions so as to maximize explicitly a discounted 

sumt of current and future benefits. 

Although the difference between these two model types is important 

philosophically and explains a number of differences in results (as will be 

16 
Table 2 

SUMMARY DESCRIPTION OF 10 WORLD OIL 

MARKET MODELS AS IMPLEMENTED IN EMF 6 STUDY 

Features 

Models 

IEES/OKS OILMAR WOIL Gately/Ky1e/Fischer IPE 

Model Type recursive rccurcive recursive recursive recursive 

simulatlon sLUulation simulation simulation simulation 

Foresight none none none none none 

Regional all EMF OECD U.S., OPGC, and U.9., other OECD OPEC and WOCA 8 productfon and 

Aggregatlon reglons, OPEC, res[ of WOCA OPEC, Fsxico, and consump[ion regions 

and LDCs o[her LDCs 

OPEC 

Production exogenous exogenous exogenous exogenous endogenous, based on 

Capacity expec[ed fu[ure 

demand 

Pr1ce or Quanti[y price reaction l price reaction prSce reaction price reaction fune- price reaction funeDetermination funetion funetion funetion including tion including capa- tion including R/P 

expected future ci[y utilization a[ ca[So; costs, exogecapacity utiliza- [ime T-1 nous royalties 

tion; costs 

Consumecs 

Dinect 2 Price In- via crude-price via crude-pri.ce pxoduct-price via crude-price via crude-price 

fluence on elasticities elasticities nesponse via capi- elastiti[ies elasticities 

Demand tal stock 

Energy-GP:P one-parameter not included one-parameter feed- not included not included 

Feedback feedback in ONS; back with short 1ag 

othec adjustmen[s 

in econometric 

modcls 

2/3 Adjustment 5 5 10; depends on 14 5 

Time (Years) actual GNP 

Oil vs Tn[al OMS I. oil-only, oil only several energy all energy demands oil only 

Energy 3 bu[ explicit fuel forms are con- and non-OPEC suppties 

swicching occurs sidered are aGgregaced 

Sn IEES 

Non-OPEC Producers 

Price Influence via elasticities none--oil prodoc- via invesLmen[ via supply curve Sa elasticiLies 

on Conventianal Cion is exagenous (U.S.), elasticiSupply ties (RO61) 

Depletion resource cost impl.icit in exog- minimom R/P ratios; none--Lechnological depletion mulcicurves enous production resource cost curve groa[h may be con- pliers (except in 

path for U.S. sidered net of de- Egypc and Mexico) 

pletion 

Use o£ E.^1F riack- no backscop; timc upper bounds uppex bounds no backstop is ex- base projec[Lon 

stop Quantitics horizon is 1995 plicicly iden[ified 

l All price reaction functions use capacity utilization at time T as one of the 

determinants of percent price change from T to T+l; the other explanatory 

variables are as shown. 

2 Excluding Energy-GNP feedback 

3 This item applies to both the Consumer and Non-OPEC Producer Sectors. 

17 
Table 2 (cont.) 

Models 

OILTANK Opeconomicu ETA-MACRO tiennedy/Nehring Salant/ICF 

recursive recursive in[erteniporal intertcnparal Sntertemporal 

1n,ulatiol r,_fulat. o timizatlon _ o timizatlon o timization 

none none OECD consumers non-OPEC conven- OPGC and non-OPEC 

luspt,pQtic_er, tional oil prodocers pr.dueor. 

16 production and Iran, Saudi Arabia, Oti.CD and OPEC 9 production regions; a11 non-CPE EMP 

consump[ion regions othet OPEC, OECD, D.S., otlher OSCD, regions 

LDCs and CPES and ROW consumption 

re Sons 

exogenous (except exogenous exogenous exogenous exogenous 

in high price 

scenario) 

price reaction hybrid price reac- price determina- exogenous production intertemporal op- 

£uncti.on includi.ng tion fonction/ tion function of timization to 

capacicy utiliza- suPP1y funetion OECD imports maximize discounted 

tion ae time 1'-1 n»ni.mum revenue profits 

targens 

via product-price via crudc-price via inter[emporal op- via product-price via crude-price 

elasticities elasticities timizacion [o ntaxi- el.asticitics for demand curve 

mize discouneed util- old and new capical 

ity of consumpaion . 

not included one-parameter aggregate production not inaluded not include 

fcedback with function for OECD 

long lag economy 

. . . 

... ._. ._. 

10 

_ ..._.. 

approx. 2 

....... 

14 pre-2000, 16.4 10-12.3 pre-2000, 

~ 

~ 0 

post-2000; depends oni12.5-14 post-2000; I 

actual GNP varies by region I 

oil only dem.nds for __...__ several energy forms oi1 only _ oil only . 

several energy are considered 

forms arc aggregated 

via new disaoverles oil production is via intertemporal op- via lntertemporal via intercemporal 

and the recovery exogcnous; oil timization to maxi- optimization to ,optimization to 

factor; oil production occuxs at conprice affects only 

coal and natural 

mize discounted 

utility of consumpmaximize discoun[ed profits 

!maximize discounted profits 

stan[ R/P ratios gas production tion 

constant R/P ratios implicit in resource cost curves resource cost curves resource cos[ cuxves 

exoGenous produetion path " 

not used; pro- included base prqjection upper bounds upper bounds 

duction depends exogenously 

on price via 

investmcnt ~ 

1-1 
illustrated in our discussions of the transition to new energy sources), it 

does not explain all or most of the result differences. For this, a closer 

look at each of the three major sectors included in each model (non-OPEC 

producers, OPEC producers, and oil consumers) is necessary. 

Oil Consumers 

The ten models differ in their representation of oil demand: some 

explicitly consider the oil-using capital stock owned by consumers; others 

simply use demand functions. However, each can be seen as embodying an oil 

demand function which indicates at a particular time how much oil will be 

purchased at a given price; in general, demand decreases with oil price rises 

and it increases with economic growth. Most of the models include the price 

elasticities of demand for oil or for energy as exogenous inputs. For these 

models long-run primaryt oil demand elasticities were standardized at -0.6 or 

long-run primary energy demand elasticities were standardized at -0.4, values 

consistent with previous EMF work6 . 

A11 of the models except Salant/ICF assume that demand changes slowly in 

response to price changes .7 The implication of this is that short-run price 

elasticities of demand are far smaller than long-run elasticities. 

The models vary as to whether and how they represent the effect of 

increasing oil prices on the level of economic activity (GNP or GDP). A 

feedback from oil prices to economic activity tends to reduce projected price 

fluctuations and price growth rates by increasing the responsiveness of demand 

to prices: price increases not only decrease demand directly; they also 

reduce economic activity, which in turn lowers demand still further. On1y 

four models--IEES/OMS, WOIL, Opeconomics, and ETA-MACHO--explicitly include 

this feedback. This feedback helps explain the relatively low projected 

prices in these models. 

19 
Another significant demand factor, which relates not only to oil 

consumers but also to the non-OPEC suppliers, is the energy product coverage 

and disaggregation. Five represent oil markets only, ignoring other energy 

markets; WOIL, IEES/OMS, and ETA-MACRO represent oil markets within the 

context of all major energy commodities; and Gately and Opeconomics treat some 

or all energy forms as perfect substitutes for one another. If energy demand 

elasticities, rather than oil demand elasticities, are standardized among the 

models, Gately and Opeconomics approach leads to a more price-sensitive demand 

for OPEC oil, since OPEC is now the residual supplier out of a larger energy 

pool, rather than just the residual oil supplier $ 

None of the models include explicit treatment of the inventory holding 

policies of the oil consumers, in particular, the rapid build-ups of inventory 

in times of oil supply disruptions nor the inventory declines (such as are 

currently being seen) when slack oil markets are expected. Thus they tend to 

under-estimate price jumps during times of supply interruptions and to overestimate oil import demand when expectations of tight supplies are being 

replaced by expectations of slack markets. 

Non-OPEC Oil Producers 

The modeling approaches for projecting conventional oil production vary 

widely. 

IEES/OMS, WOIL, Gately, and IPE use explicit supply curves, except for 

the U.S. region in WOIL, which responds via investments in capital. All four 

incorporate slow adjustments of supply to price changes. In OILMAR and 

Opeconomics, non-OPEC conventional oil production is an input. In OILTANR, 

non-OPEC oil is produced at a constant reserve/production ratio; prices have a 

lagged impact on new discoveries. 

A11 of the intertemporal optimization models project non-OPEC supply as 

20 
the result of an intertemporal optimization problem: In Kennedy/Nehring and 

Salant/ICF, the objective is to maximize the discounted sum of profits for oil 

producers, while in ETA-MACRO, consumers decide how much to invest in oil 

production so as to maximize the discounted utility of consumption. In 

Kennedy/Nehring marginal extraction costs increase with extraction rates; the 

Salant/ICF model was run by ICF assuming constant marginal extraction cost up 

to a maximum rate of production. 9 

Those models in which non-OPEC production is set exogenously (and is 

therefore independent of price) can show high or low prices in comparison to 

other models, dependent upon the precise levels assumed. Our analysis 

indicates that these and other non-OPEC supply factors, such as resource base 

or foresight assumptions, are important contributors to the observed 

differences in price projections. 

The study design specified the production cost of backstop oil and the 

maximum quantities available in each year, but the modelers differed in how 

they interpreted those quantities. In Opeconomics, backstop quantities are 

included exogenously; in OILMAR, WOIL, Kennedy/Nehring and Salant/ICF, they 

are regarded as upper bounds, met only under favorable oil price conditions. 

In ETA-MACRO and IPE, the study design backstop quantities serve as a base 

projection, with actual production lower or higher depending on oil prices and 

profitability. OILTANK was run disregarding the limits specified in the study 

design. In OILTANK, production depends only on investment, which in turn 

depends on oil prices. No backstop is explicitly identified in the Gately 

model. IEES/OMS results extend only to 1995 and hence include no backstop. 

OPEC OilProducers 

The decision by OPEC nations as to how much oil production capacity to 

maintain is generally treated quite simply. Nine of the models are run with 

21 
OPEC production capacity specified exogenously, using quantities indicated in 

the study design. Only IPE determines capacity endogenously, with desired 

capacity a function of expected (although not necessarily realized)future 

demand. 10In each of the models, OPEC production can never exceed capacity. 

The ultimate decision for OPEC -- what quantity to sell or what price to 

set (but not both) -- is represented in various ways within the models. In 

models which treat OPEC as setting the world oil price, OPEC producers supply 

whatever quantity is demanded at that price (subject to its capacity 

constraint); in models which treat OPEC as setting a production level, some 

market clearing mechanism is used to find the price at which total supply from 

all sources is equal to demand. This difference is primarily based upon the 

technical details of the computer algorithms and makes little difference in 

the resulting projections. 

One model -- Salant/ICF -- incorporates the assumption that OPEC 

maximizes a discounted sum of profits as an omniscient monopolist. In such an 

optimizing model, production in any year depends upon expected future demand 

for oil and characteristics of the demand function. In Kennedy/Nehring, price 

is found so as to balance total supply and demand, except that in this case 

OPEC production is set exogenously as an input by the modeler, rather than as 

a result of an optimization. In ETA-MACRO, OPEC price in any year is 

determined by OECD imports during that year, with greater imports associated 

with greater pricel l . In Gately, OPEC nations are seen as groping toward some 

long-run optimal pricing policy, operating as monopolists with imperfect 

information. 

In all of the recursive simulation models, OPEC sets a price for its oi1 

in each year, supplies as much as it can at that price and then uses its 

degree of capacity utilization in setting the price for the following year. 

this procedure implies that the short-run OPEC supply is perfectly elastic up 

22 
to the capacity limit and therefore that a reduction in demand for a given 

year will have no effect on that year's price but will only result in a 

smaller increase or a greater decrease in price during the following years. 

Six of these seven recursive simulation models use "price reaction 

functions", in which the OPEC pricing policy is to attempt to maintain 

capacity utilization at a certain desired level, typically 80 to 90 percent. 

Capacity utilization above the desired level results in price increases and 

utilization below, in price decreases. Prices generally are allowed to fall 

far less rapidly than they can rise. As discussed more fully in a subsequent 

section, a consequence is that OPEC requires time to regain equilibrium after 

a disturbance and oscillatory behavior may occur while OPEC tries to regain 

its desired capacity utilization. 

Summarv 

The analytical tools we used are not primarily models of OPEC 

decisionmaking but rather models of the world oil system. Only one provides 

estimates of OPEC capacity as an output; the rest require this central OPEC 

choice variable as an input. However, most of the models do treat OPEC 

production choices. To the extent OPEC decisionmaking is represented, 

economic paradigms are used. Little attention is paid to the internal 

structure of OPEC or to the political factors impinging upon the OPEC nations. 

However, the models do allow evaluation of the influence on world oil markets 

of production or pricing decisions made by OPEC as a whole, although they do 

not allow reconciliation of the many theories of OPEC behavior. 

While the models vary greatly in their structural characteristics, they 

have very important commonalities. Each includes representations of oil 

supply and demand. Each includes some representation of the world oil price 

setting mechanisms. And each assumes that, over time, markets will tend to 

23 
adjust so as to equate oil supply and demand on a world—wide basis. But 

beyond these fundamental commonalities, the structures of the models vary 

radically. 

The variations in the model structures imply differences in the 

projections obtained with the various models, as will be apparent in what 

follows. This does not mean that their results cannot be useful to policy 

makers and analysts. As we will show in later sections of this report, even 

with the great differences in the models, we have been able to reach 

conclusions which are robust across all of the models deemed to be appropriate 

for the various issues. In addition, the process of analyzing the differences 

in results can prove useful for delineating the major issues and for focusing 

attention on the implications of alternative assumptions, alternative 

assumptions not only in the models but also in the minds of experts and 

policy—makers. 

THE SCENARIOS 

In order to address fundamental uncertainties and policy actions, the 

working group designed twelve alternative scenarios. The twelve include a 

Reference case plus eleven others, each defined by varying one or more 

assumptions from those in the Reference case. Some include changes only in 

the policy assumptions, others only in the resolution of key uncertainties 

(e.g., economic growth rates, technological progress), and still others in 

both classes of assumptions. 

Each scenario is an abstraction of a class of related issues. Hence a 

given scenario may represent many different specific situations. For example, 

many different actions may reduce the demand for oil in the United States: 

taxes, regulations, subsidies, information campaigns, or technical progress. 

Increased supply of natural gas, enhanced ability to use coal, or railroad 

24 
electrification may likewise reduce oil demand. Because each reduces import 

demand, for our purpose of estimating world oil market impacts, each could be 

examined by use of a single scenario which assumes an oil demand reduction at 

every oil price. 

Table 3 lists the scenarios and summarizes their definitions. More 

complete definitions, including numerical input assumptions, appear in 

Appendix A (See Table A-4). 

Reference Case (Scenario 1) 

The Reference (or base) Case, has two purposes: to bring the models into 

as close agreement as possible on basic assumptions and to provide a reference 

with which to compare the results of the other scenarios. A11 other scenarios 

are derived by varying one or more of the Reference Case input assumptions. 

The Reference case assumptions include a constant OPEC capacity of 34 million 

barrels per day (MMBD) and annual GNP growth rates of approximately 3% in the 

OECD and 5% in the oi1 importing LDC's through the year 2000. 

Oil Demand Reduction (Scenario 2) 

This scenario is intended to simulate the effects of a vigorous and 

successful import reduction program in the OECD. Specific policies 

represented here could include crude oil tariffs, other energy taxes, 

mandatory fuel use restrictions, fuel switching incentives, and efforts to 

increase domestic energy production. 

In the Oil Demand Reduction Scenario, the demand for oil throughout the 

OECD is lowered from the Reference Case values. Total OECD reductions in 

selected years are 5 MMBD by 1985, 10 MMBD by 2000, and 20 MMBD by 2020. 

25 
Table 3 

Scenario Descriptions 

Scenario 

1. Reference 

2. Oil Demand Reduction 

3. Low Elasticity 

4. Oil Demand Reduction/ 

Low Elasticity 

5. Low Economic Growth 

6. Restricted Backstop 

7. Disruption 

8. Technological Breakthrough 

9. Disruption/ 

Low Elasticity 

10. Optimistic 

11. Oil Demand Reduction/ 

Disruption 

12. High Price 

Description 

Base case for analyses 

Aggressive import reduction 

program in the OECD 

Reduction in demand elasticities 

to 5/8 of Reference case 

magnitudes 

Aggressive import reduction 

program in low elasticity 

world 

Reduced GNP growth rates 

throughout the world 

Reduced (by 50%) availability 

of non-conventional energy 

Sudden and indefinitely 

continuing 10 MMBD reduction 

in OPEC capacity (1985) 

Reduced cost and increased 

availability of non-conventional 

energy 

10 P4MBD OPEC capacity reduction 

in low elasticity world 

Aggressive import reduction 

program; more availability 

of non-conventional energy; 

increased OPEC capacity 

10 MMBD OPEC capacity reduction 

in presence of aggressive 

import reduction program 

Oil price set at 50% higher 

than values determined in 

Reference case. 

26 
Low Demand Elasticity (Scenario 3) 

Although the crude oil price elasticity of demand is a key determinant of 

world oil prices, no single estimate for this parameter is widely accepted. 

This scenario examines the sensitivity of model projections to changes in this 

parameter. 

The short—run and the long—run price elasticities of demand for primary 

energy12are reduced from their Reference Case values of 0.04 and 0.4, 

respectively, to five—eighths of these values. For those models which include 

only oil, crude oil price elasticities are reduced by five—eighths from their 

Reference Case values of 0.06 and 0.6. 

Oil Demand Reduction/Low Demand Elasticity (Scenario 4) 

Scenario 4 combines the assumptions of the previous two scenarios to 

esamine the effects of a vigorous energy conservation program under the lower 

elasticity assumption. 

Low Economic Growth (Scenario 5) 

Scenario 5 illustrates the oil market effects of reduced world economic 

growth. 

For the Reference Case and the Low Economic Growth case we standardized 

the economic growth rates that would occur if crude oil prices were to remain 

constant at their 1980 levels. For the Low Economic Growth Scenario, those 

growth rates are reduced to two—thirds of their Reference Case values in all 

regions of the world. Appendix A displays both sets of assumptions. 

Disruntion (Scenario 7) 

Scenario 7, which illustrates impacts of a substantial and sudden change 

in OPEC oil production capacity, was designed to allow examination both of 

long—run changes in production capacity and of sudden supply disruptions. 

27 
On January 1, 1985 and thereafter, Middle East OPEC oil production 

capacity is unexpectedly reduced by 10 MMBD from its Reference Case value of 

34 MMBD. 

Disruntion(Low Elasticitv (Scenario 9) 

Scenario 9 combines the low demand elasticity of Scenario 3 with the 

disruption of Scenario 7, to illustrate effects of suddenly reduced OPEC 

capacity in a world characterized by a low price elasticity of oil demand. 

Restricted Backstop (Scenario 6) 

Scenarios 6 and 8 examine responses to alternative assumptions about the 

cost and availability of non—conventional substitutes for oil (such as 

biomass, coal liquefaction, coal gasification, oil shale, and tar sands). 

Scenario 6 examines the implications of slow growth in the availability of 

these substitutes, or "backstop" energy sources. Maximum rates of production 

of backstop energy are one—half of those in the Reference Case. In the 

Reference Case, maximum production ratesfor backstop energy are 1 MMBD in 

1996, 5 in 2000, 10 in 2005, 20 in 2010, 27.5 in 2015, and 35 MMBD in 2020. 

(See Appendix A). In both cases, production costs are $60 per barrel (1979 

dollars), which translates to $71 per barrel in 1981 dollars. 

TechnoloQical BreakthrouQhScenario 8) 

Scenario 8 examines the impacts of a major advance in energy technology. 

A perfect substitute for crude oil becomes available in the year 1996 and 

afterwards at a cost of $40 (1979 dollars) per barrel, or $48 per barrel in 

1981 dollars. Maximum available quantities through 2010 are identical to 

those available in the Reference Case. After 2010, the maximum quantities 

increase to 40 MMBD in 2015 and 80 MMBD in 2020. 

NE 
Optimism (Scenario10 

This scenario combines Scenario 2(Oil Demand Reduction) and Scenario 8 

(Technological Breakthrough), with an assumption that OPEC expands its 

capacity by 1 MMBD in each of the years 1982-1987, a 6 MMBD increase by 1987. 

Disruption/Oil Demand Reduction (Scenario 11 

Scenario 11 allows analysis of the degree to which disruption impacts 

would be mitigated by a pre—existing oil demand reduction or other import 

reduction program. 

The disruption assumptions of Scenario 7 are combined with the oil import 

reduction assumptions of Scenario 2. 

HiQhOilPrice SScenario 12 

Scenario 12 is designed to examine how oil supply, oil demand, and OPEC 

revenues depend upon OPEC pricing policies. The results could assist in 

evaluating the degree to which the economic circumstance of the OPEC nations 

would be influenced by their pricing policies. 

The world price of oil is assumed to be 50% higher than the value 

determined in the Reference Case for 1981 and all subsequent years. 

ISSOE GHOIIPS 

Each model was run for the various scenarios using standardized inputs. 

Outputs describing world oil supply, demand, and price, disaggregated by 

regions of the world, were produced and made available to all group members. 

Interpretation of results was the responsibility of four issue groups which 

examined model outputs and developed conclusions based upon their judgment as 

to the relevant questions, methodologies, and strength and limitations of the 

29 
various models. These conclusions were reviewed and refined by the working 

group as a whole. 

The remainder of this Summary Report presents in greater depth working 

group conclusions. These are organized into four sections, corresponding to 

the four issue groups. The first, "The World Oil Market: 1980-2020", presents 

basic data on projections of oil supply, demand, imports, and price, developed 

by applying the various models to the scenarios. In addition, the impacts of 

policy choices and other uncertain events on world oil price and, to a lesser 

extent, on quantities are described. The second section, 'bil Supply 

Interruptions", focuses attention on potential oil market ramifications of 

future supply disruptions. In addition, the role of import reduction measures 

in moderating these impacts is discussed and quantified. The third section, 

"The Value of Reducing Oil Imports", draws heavily upon the results from the 

preceeding two sections to quantify the economic benefits of reducing oil 

imports, benefits stemming from reduced oil price growth in normal years and 

reduced vulnerability to the periodic supply interruptions. The final issuegroup section adopts a longer time perspective, addressing questions of "The 

Transition to New Energy Sources". The price patterns prior to large scale 

adoption of non-conventional energy sources and the impacts on price patterns 

of alternative adoption rates provides the central theme of this section. 

30 
THS WORLD OII. MARKET: 1980-2020 

Central to energy policy deliberations, to technology development 

decisions, to corporate strategic planning, and to operating decisions in 

virtually all sectors of national economies are questions of the future price 

and availability of oil. The world oil situation shapes natural gas pricing 

in domestic and international markets, limits the profitability of coal 

mining, transportation, and conversion processes, makes investments in solar 

energy, biomass, or other technologies profitable or unprofitable, determines 

the estent of economically viable energy conservation, and shapes the relative 

desirability of alternative electric generation technologies. In addition, 

changing oil prices and availability profoundly shape the airline, railroad, 

and automobile industries, and all other elements of the transportation 

system, and, through fertilizer costs and biomass energy utilization, may 

alter the global food situation. And changing oil price and availability may 

continue to radically alter the international distribution of economic and 

political power. 

Because projections are so dependent upon the accuracy and completeness 

of assumptions, we did not seek to construct any one scenario as the most 

likely course of events. Rather, we sought to capture a broad range of 

plausible future states of the world. Thus, we believe that the model projections indicate likely bounds on future movements in oil price and quantities. 

This section provides a detailed look at the price and availability 

conclusions stated previously. The basic focus will be on a non-disrupted 

world oil market. More intensive examination of oil markets during 

disruptions will appear in a subsequent section. We begin with an overview of 

projections and follow with a discussion of those factors influencing world 

oil markets. 

31 
MARRRT TREND$ 

WorldOilPrices 

The unmistakable long—run projected trend of world oil prices 13 , adjusted 

for inflation, is upward. It can be expected that, following a several year 

slack oil market, oil prices will again begin rising, perhaps sharply, before 

the end of this decade. 

Although the general trend of prices is upward, the pattern of price 

changes can be expected to vary over our time horizon. Through the early and 

middle 1980's, the world oil market may remain fairly slack with nominal 

prices increasing less rapidly than the general inflation rate or decreasing 

if no disruptions occur. This trend is already readily apparent. By July, 

1981 (at the time of this writing) average world oil prices, in constant 

dollars, were more than $2 per barrel below their early 1981 peak level. Spot 

market prices had dropped more dramatically, signalling future declines in 

price of oil sold under long—term contracts and future declines in average 

price. This slack oil market could last through the middle of the decade. 

However, beginning in the late 1980's and continuing into the first 

decade of the twenty—first century, oil prices are projected to increase, 

possibly quite rapidly. This long—run upward trend can be expected to occur 

primarily because the growth in oil supplies is projected to be slower than 

the growth in oil demand brought on by world economic expansion. 

Within the first two decades of the next century, lower assumed economic 

growth rates coupled with increases in the supply of non—conventional oi1, can 

be expected to dampen the rate of increase in oil prices, possibly halting or 

reversing the upward trend. 

Figure 1 illustrates the Reference Case oil price projections through 

the year 2000 for the various models, 14with all prices (in this and other 

32 
u, eo 

~ 

cl-- 

J 70 

CD 

Q 

.-~ 60 

OC? 

~ 

.—i 

.~ 50 

W 

U 

~ 40 

Q_ 

—' H 90 

CD 

p 20 

~ 

~ 

u 

10 

DI 

ETA-M AO 

OSL 8 KEAA INENAIA® 

en v 

D cr rDIL 

a r Ip 

Ke EDYlAEEAIN® Y Ie /CN8 

orecoNotlscA 

ETA- CAC 

M 

~, 

1980 1385 .., 1995 ,•,,, 

REFERENCE CASE PRICES 

Figure 1 
graphs) expressed in constant 1981 dollars. 15The overall trends are evident 

even with the variation among the models. 

With the exception of Kennedy/Nehring and Salant/ICF, both intertemporal 

optimizing models, Reference Case prices are projected to be relatively flat 

at least through 1984, and perhaps longer. 16For example, projected prices 

reach their lowest levels in 1985 for OILMAR and IPE and in 1986 for IEES/OMS. 

Other models generally show slight upward trends throughout the period. 

By the end of the decade, however, the upward trend in prices appears. 

In 1990, oil price projections in the Reference case range from a low of $38 

per barrel (1981 dollars) for the IPE model to a high of over $60 for OILTANK 

with a median of over $50. By the year 2000 the range is from $42 to $90 per 

barrel, with a median of $70. 

These changes can be expessed also in terms of the rates of growth of 

real prices. In the Reference Case, the median real price increases by 2% 

annually between 1980 and 1985, by 6% annually for the next five years, and by 

4% annually over the last ten years of the century. 

Although the trend of prices is projected by all of the models to be 

upward, the patterns of price variations and the overall rates of change are 

quite uncertain. As is apparent in Figure 1, even after we have standardized 

the assumed OPEC production capacity, the economic growth rates, the demand 

elasticities, and many other key factors, the variations in projected prices 

are large. As we vary these key factors in the alternate scenarios, the range 

of possible future prices grows even larger. 

The Optimistic Scenario incorporates the most favorable conditions for 

oil consumers considered realistically imaginable by the working group. The 

results, shown in Figure 2, again indicate the price of oil increasing, 

possibly doubling over the next forty years. But the early—year declines are 

more apparent. Even in this scenario, by 1995 a11 models suggest prices 

34 
~ 80 

a:~ 

CC 

~ 70 

0 

d 

.-, 60 

0~ 

t37 

~ 

.~ 50 

W c_.) 

'—' 40 rK 

n 

J H90 

CD 

o 20 

m 

rK 

~ 

10 

ON 

1980 1585 .., 1595 CL!R 

OPTIMISM CASE PRICES 

Figure 2 
higher than current levels and most project further increases before the turn 

of the century. Thus, even the Optimism scenario suggests oil prices at or 

above $45 per barrel by the year 2000, a figure roughly 40% higher than 

current levels. 

The economic forces behind these price patterns can be illustrated by 

means of a simple transparent analysis of oil demand trends, an analysis 

designed to illustrate why these broad price trends emerge from the model 

projections. In Figure 3 we have provided a projection of oil demand under 

theassumptionthat real world oil prices were to remain constant at their 

1980 levels. In addition we have plotted two possible oil supply trends. A 

comparison of anticipated supplies with the constant—price demands can 

indicate pressures to increase or to decrease prices from those prevailing in 

1980: greater supply implies prices will tend to decline while greater demand 

implies that real prices can be expected to exceed their 1980 levels. 

The projected demands are calibrated to 1980 actual levels, increase with 

economic growth, and decrease gradually in response to the pre-1981 oil price 

rises. Price elasticities, adjustment rates, and economic growth rates have 

been chosen to be consistent with the study design. 17The low supply 

projection is based upon an assumption that total oi1 supply to WOCA remains 

constant over time, while the high projection is based upon an assumption that 

the total supply increases by 0.5 MMBD each year after 1980. 

Under the assumption that real oil prices remain at their 1980 levels, 

Figure 3 shows world oil demand decreasing to 1983 and subsequently 

increasing. This pattern results from two factors which work in opposite 

directions. The price increases which occurred between 1972 and 1980, when 

taken alone, would result in a pattern of declining demand, with the greatest 

declines coming in early years. The growth of the world economy, when taken 

alone, would result in growing oil demand, with the greatest growth occurring 

36 
~ 

O 

L 

~ 

I- 

~~ 

cr-_ 

X: 

W 

0 

~ 

z 5 

~ 

~ 

J 

~ 

~ 

~ 4 

~ 

~ 

M 

1980 1985 1990 1995 p9l"T' l, rr~r~ 

FIGURE 3 

CONSTANT PRICE PATH OIL DEMAND VS SUPPLY 
in the later years. The former effect dominates in the first few years while 

the latter effect dominates subsequently. The net result (under an assumption 

that real prices remain at 1980 levels) is the illustrated pattern of early 

year demand declines and subsequent year demand growth. 

Figure 3 helps to explain the broad price conclusions derived using the 

models. If there are no oil supply interruptions, under the lower supply 

projection, Figure 3 suggests that market clearing prices would decline below 

the 1980 levels for several years. The movement of actual prices, however, is 

more uncertain since OPEC price administration inhibits price declines during 

periods of slack oil markets. But by 1987 for the lower supply projections 

and by 1993 for the higher projection, market clearing and actual prices must 

rise above 1980 levels. The simple analysis thus helps explain the model 

projections which suggest that a period of oil market slackness will be 

followed by an era of rising real oil prices. 

Several factors could lead to prices differing from the Reference Case 

levels. Supply disruptions, lower demand elasticities, lower supplies of 

energy from non—OPEC nations, lower OPEC production capacity, or faster 

economic growth could further increase prices, while higher oil demand 

elasticities, greater production of oil substitutes, expansions in OPEC 

production capacity, discoveries of large reserves of conventional oil, less 

costly non—conventional energy sources, or slower oil demand growth in the 

less developed countries (LDC's) could result in lower price. 

The influence of several of these factors is apparent already. Since the 

scenarios were defined (January 1980), world economic growth has been more 

sluggish than anticipated and hence world oil demand has been lower than 

projected. Decontrol of U.S. oil prices has further reduced oi1 demand in the 

United States. Reductions in the magnitudes of non—governmentally held 

stockpiles of oi1 has further slackened oil demand; the study design assumed 

ME, 
stocks would be increased, not decreased. The result has been a softer world 

oil market and lower world oil prices than suggested by the Reference Case 

projections. On the other hand, OPEC nations have reduced their oil 

production rates more than was anticipated at the beginning of the study and 

thus oil prices have remained more stable than would have been expected with 

the oil demand reductions seen to date. 

These net result of the unforeseen changes may be prices lower during the 

next few years than suggested by our Reference Case results. Hence our 

conclusion that real prices may continue declining over the next few years 

unless there is another oil supply disruption. These factors, however, cannot 

be expected to greatly influence our longer term price projections. U.S. oil 

price decontrol is a one-time occurrence. Recovery of the world economy can 

be expected to bring economic activity more in line with our earlier 

projections. The drawdown of oil stockpiles, motivated by an expectation of 

falling prices, cannot continue indefinitely. Furthermore, once firms again 

expect price rises or tight oil supplies, they will again build up their oi1 

inventories. Thus the longer-term price increases can still be expected. 

The increased oil prices experienced since 1973 will continue to provide a 

major motivating force for increasing oil consumption and eapanding nonconventional oil supplies and oil substitutes. Increased oil prices will 

motivate substitution of natural gas, coal, solar, biomass, and nuclear energy 

as well as energy conservation in all economic sectors. These price increases 

may also stimulate further governmental responses aimed at increasing energy 

supply, facilitating interfuel substitution, and encouraging energy 

conservation. These quantity projections will be discussed in what follows. 

39 
Oil Quantities 

We expect the world's conventional oil production to increase slowly 

until the end of the century, by which time the production of conventional oil 

is likely to begin declining. While our assumption of constant OPEC 

production capacity implies that OPEC oil production will not exceed its 

historical peak rates, declining OECD production may be offset by new supplies 

from the LDC's. Rapid discovery and development of petroleum resources in 

these countries could more than offset the depletion of OECD reserves, 

allowing total world oil production to increase slowly over the next two 

decades. 

The quantity estimates projected using the various models in the 

Reference Case are displayed in Appendix A for four years, 1980,1990,2000, and 

2020. 

Figure 4 illustrates the projections of Reference Case conventional crude 

oil production from the non—OPEC countries 18(OECD plus the LDC's). Although 

wide variations exist among the projections, with the exception of 

Salant/ICF 19 , none project non—OPEC crude oil production to reach 30 MMBD. 

Four project slowly increasing production levels over the next decade. And 

all project a post-2000 pattern of declining crude oil production. 

Significant growth in crude oil production cannot be expected within the 

OECD nations. In the Ref erence Case, no models except Salant/ICF project OECD 

crude oil production to increase by more than 2.5 MMBD above the current 

level. And most project roughly constant or declining production.20 

In contrast to the oil production prospects for the OECD nations, the 

LDC's may experience increasing oil production. Mexican oil production will 

almost certainly increase. Continued exploration and development in other 

LDC's can be expected to lead to growing production rates. 

40 
0 

~ 

m 

~ 

~ 

v 

Z 

0 

H 

U 

~ 

0 

0 

tr 

n 

—I 

H 

CD 

w 

0 

::D 

of 

U 

30 

28 

26 

24 

22 

20 

18 

16 

14 

12 

10 

8 

6 

4 

2 

IEES/ 

IPE SRL NT/ICF 

~----_ 

OPE ONICS 

~ yOIL 

.~~ 

0 

OILTHN 

KENNEDY/NEHRIN6 

1980 1985 • ~, , ~, ~, ~„ ~, ~. ~, ~. ~ 

NON-OPEC OIL PRODUCTION 

Figure 4 

~ 
Of the five models which explicitly project LDC oil production, three 

(IEES/OMS, Salant/ICF, and IPE) show Reference Case production more than 

doubling from its 6 MMBD level by the end of the Century. OILTANK and 

Opeconomics show more modest growth in LDC production. However, despite the 

compatibility of the model results with our expectations, projections of LDC 

behavior based upon the current generation of models cannot be relied upon 

because many potentially important economic, political, and geological factors 

are not we11 understood. 

Some of the differences among the model results can be explained. The 

relatively high production rates for IEES/OMS and for IPE seem to result from 

the assumption in these models of greater initially undiscovered resources. 

Moreover, IPE includes an exogenous base projection in addition to a price 

elasticity for oil production from Western Europe. OILMAR and Opeconomics 

specify all non—OPEC production exogenously. The Salant/ICF patterns stem 

from a variety of assumptions, including the instant adjustment of demand to 

price, perfect price foresight, maximization of discounted profits over time, 

and the supply constraints imposed upon the various actors. The low 

production rates in the Kennedy/Nehring model are not we11 understood. 

However, the low production rates in the Kennedy/Nehring model and the 

Salant/ICF model are consistent with the relatively high prices projected 

using these models (see Figure 1, presented previously). 

A second growing component of overall petroleum supply is oil from 

unconventional sources such as oil shale, coal liquefaction, tar sands, and so 

on. The projections of unconventional oil production generally follow the 

study assumptions of 5 MMBD by 2000, increasing to 15 MMBD in 2010 and 30 

MMBD in 2020. These projections are more nearly inputs to the models than 

outputs from the models. 

Consistent with the supply projections are the demand projections 

42 
generated using the models. Oil (deriving from both unconventional and 

conventional sources) will remain a major part of our energy consumption for 

many decades to come. In particular, the rapidly growing economies of OPEC 

and the oil deficient developing countries may consume increasing quantities 

of oil. Such an oil consumption growth, coupled with stagnant or declining 

conventional crude oil production, would mean declines in OECD oil 

consumption. 

These patterns are illustrated by Figure 5 which displays median 

Reference case oil consumption projections for three groups of nations (OECD, 

OPEC, non-OPEC LDC's) and for the WOCA total ? 1In Figure 5, solid lines have 

been used whenever outputs were available for four or more models; a broken 

line has been used when fewer than four were available. While Figure 5 

illustrates the basic trends, it tends to exaggerate the growth rates between 

2000 and 2005. This occurs because some models project consumption rates only 

up to the year 2000 and because those models which project beyond 2000 happen 

to be the same ones that produce relatively high estimates of consumption. The 

net result is an over-estimate of LDC and WOCA consumption growth rates 

between 2000 and 2005. 22 

Despite the decline in OECD oil use, we can expect a continued dependence 

of OECD countries upon oil imports. However, as a fraction of all oil 

consumption or of all energy consumption by the OECD countries, OPEC exports 

can be expected to decline significantly. Thus, while the economic problems 

of vulnerability to oil supply disruptions may decline by the turn of the 

century, the problems of costly oil imports and market uncertainty will 

persist. 

43 
~ ~ OECD 

:. 

WOCA 

. 

.-. 

O 

p~p 60 

~ 

~ 

~ 

Z 

50 

O 

H 

D_ ~ 40 

E 

~ 

tt~ 

z 30 

0 

U 

H 20 

O 

M 

LDC C N 

OPEC 

1980 1985 1990 1995 2000 2005 2010 2015 m 

MEDIAN CONSUMPTTON RATES 

Fieure 5 
FACTORS INFLIIEHCING AOBLD OII. MARKETS 

The key factors which can be expected to predominantly influence oil 

price and availability include OPEC choices of production capacity and 

capacity utilization, non-OPEC supply of conventional and unconventional 

fuels, and oil demand, particularly in the developing countries. Oil demand 

in turn is influenced strongly by economic growth rates, by opportunities to 

substitute other energy forms or other productive inputs (such as labor, 

capital, or technology) for oil, and by public policy choices. 

The sensitivity of world oil price and availability to changes in key 

market factors can be analyzed by conceptually dividing the world oil market 

into an OPEC sector which is a net exporter of oil and a non-OPEC sector which 

is a net importer. Certain market factors will have a direct influence upon 

OPEC export supply while others will have a direct influence on non-OPEC 

import demand. 

This way of looking at the world oil market emphasizes the theoretical 

point that any two market factors which influence non-OPEC import demand by 

equivalent amounts will have equivalent impacts on oil prices. In addition, 

if an OPEC supply curve can be defined, shifts of equivalent magnitude in the 

OPEC supply curve and in the non-OPEC import demand curve will also have 

equivalent price impacts. Figure 6 illustrates the analysis. The solid lines 

represent the Reference Case non-OPEC oil import demand and the Reference Case 

OPEC oil export supply. A 2 MMBD outward shift in the OPEC supply curve 

(broken line) leads to the same price impact as the 2 MMBD inward shift in the 

non-OPEC import demand curve (broken line). However, the former shift will 

reduce quantities exchanged while the latter will increase quantities. The 

inward shift in the non-OPEC import demand could be caused by a 2 MMBD 

increase in non-OPEC domestic oil supply or an energy conservation program 

which led to a 2 MMBD reduction in non-OPEC oil demand. Both would have the 

45 
0 

V 

.~ 

H 

.~ 

C 

Reference 

Import Deman 

Reduced 

Import Demand 

\ 

\~ \ 

'~Increased OPEC 

Export Supply 

Reference OPEC 

Export Supply 

I 

1' _ - _ _ _ _ - _ - - _ C B 

I I 

Q " Q* Q

, 

Oil Quantity 

Figure 6 Price and Quantity Impacts of Increased OPEC 

Export Supply or Reduced Import Demand 

46 
same impact on world oil prices and net imports from OPEC. 

The magnitude of the price change depends upon the degree to which demand 

and supply are responsive to price. If oil demand and supply elasticities are 

low and consequently the import demand elasticity is low, a demand reduction 

may greatly reduce prices. Conversely, if elasticities are high, that same 

demand reduction will lead to only small price declines. 

The simple static supply/demand framework must be expanded somewhat in 

order to describe the more complex dynamic adjustments in the world oil market 

and those in the real models. Demand and supply in each year may depend upon 

prices in previous years and upon expectations of future price changes. With 

OPEC dominating world oil supply, prices may quickly adjust upward toward 

market clearing levels but downward only slowly. Therefore, if a policy leads 

to declining prices, the actual price change over several years may be larger 

than, not smaller than, the price change during the first year. For upward 

trending prices this phenomenon may also occur, although not as noticeably. 

In addition, the equivalence of impacts between supply and demand shifts will 

be valid only if these shifts have equal magnitudes at every moment of time. 

These dynamic aspects of the markets cannot be addressed simply without use of 

the complex models. 

In what follows we will examine the potential price impacts of changing 

the key market factors which influence OPEC export supply and non-OPEC import 

demand. As already noted, the price impacts of a change in net import demand 

should be roughly equivalent on a dollar-per-barrel basis, regardless of the 

specific phenomenon responsible for the change. Therefore we will often refer 

to the price impacts per 1 MMBD import demand reduction, in order to test the 

consistency of the model results with our theorectical understanding. In 

addition, we can apply model results derived from one class of shifts to 

analysis of other factors which lead to equivalent shifts in import demand. 

47 
Oil Demand Reduction 

Deliberate policies instituted by the oil importing nations to reduce oil 

demand (or to increase domestic supply) will have direct impacts on oi1 import 

demand and consequently on price. In our Oil Demand Reduction Scenario we have 

postulated a reduction in energy demand which varies over time but which is 

independent of oil prices. This scenario variation therefore reduces oil 

import demand by precisely the same amount as oil demand is reduced. 

Table 4 displays results of this esogenous decline in oil demand. The 

top line displays the policy—induced demand reductions (measured in MMBD), 

from the Reference Case levels, for four different years. The first group of 

lines shows, for each of these models, the projected price reductions stemming 

from these demand reductions. The final group of lines shows the projected 

price changes per 1 MMBD oil demand reduction. 

Over the first five years, as oil prices slowly adjust in the slack oil 

market, prices are reduced $0.10 to $2.10 for each 1 MMBD demand reduction, 

with a median of $1.00. The projected amount depends upon the price 

adjustment speeds incorporated into the models. 

The 1990 results represent medium term impacts after most price 

adjustments have been felt. They range between $0.80 and $3.20 price reduction 

for every 1 MMBD demand reduction, with a median of about $1.20. The central 

eight of ten estimates range between $0.90 and $2.40 per barrel price decrease 

for every 1 MMBD oil import demand reduction. It is this range that we will 

use in describing the medium term price impacts of oil import reductions. 

After 1990, price reductions per 1 MMBD import demand reduction shrink 

slowly, in 2010 ranging between $0.00 and $2.30, with a median of $0.50. 

The price responses to the demand reduction grow until they reach a peak 

a number of years after the postulated demand reduction program is initiated, 

2c 
Table 4 

PRICE BEDIICTIONS DIIE 

TO OIL DEHAND R$DIICTIONS 

1985 1990 2000 2010 

Demand Reduction (MMBD) 5.0 6.67 10.0 15.0 

Price Reduction ($/bbl) 

Gately * $10.10 $15.60 $ 8.90 $ 2.30 

IEES/OMS 7.80 7.60 

IPE 0.60 8.70 16.30 

Salant/ICF 5.40 6.20 8.80 14.40 

ETA-MACRO 3.50 13.40 16.00 7.90 

WOIL 5.20 16.30 15.30 6.20 

Kennedy/Nehring 6.30 6.90 6.00 0.00 

OILTANK* 8.50 6.10 17.70 23.80 

Opeconomics" 1.60 5.40 4.90 

OILMAR* 2.60 21.70 20.30 33.90 

Price Reductions per 

MMBD Demand Reduction 

Gately * $2.10 $2.40 $0.80 $0.20 

IEES/OMS 1.60 1.10 

IPE 0.10 1.30 1.60 

Salant/ICF 1.10 0.90 0.90 1.00 

ETA-MACRO 0.70 2.00 1.60 0.50 

WOIL 1.00 2.40 1.50 0.40 

Kennedy/Nehring 1.30 1.00 0.60 0.00 

OILTANK* 1.80 1.00 1.70 1.60 

OpeconomicsA 0.30 0.80 0.50 

OILMAR* 0.50 3.20 2.00 2.30 

* For Gately, OILTANK, Opeconomics, and OILMAR, the numbers displayed are 

five year averages of model results. This averaging was needed because of 

the oscillatory nature of the results from these models. 

49 
atter which time the responses shrink. This time pattern results from a 

combination of two adjustment lags: the gradual adjustment of OPEC 

administered price to changing demand for OPEC exports and the even slower 

adjustment of that demand to price changes. As demand changes relative to 

supply, prices do not adjust instantly to the new market clearing levels. 

Rather in the OPEC—administered market, prices adjust slowly, sometimes over a 

period of years, toward these levels. Thus in a slack oi1 market, we may 

observe relatively little price change during the first few years after a 

modest demand shift, although that change may grow over time. 

Likewise, the demand adjusts only slowly in response to changing energy 

price because the capital stock of energy using equipment is replaced only 

gradually: i.e., demand and non—OPEC supply elasticities increase over time. 

Therefore the impacts on market clearing prices of a given import demand 

reduction tend to shrink as the years go by. This latter phenomenon alone 

would imply that price reductions per unit demand reduction should decrease as 

time goes on. The combination of the two adjustment processes implies that 

the largest price change per MMBD of demand shift occurs neither right away 

nor after many years, but in the mid—run, after the slow price adjustments 

have already occurred but before most of the demand adjustments in response to 

those price changes have been felt. 

After 2005, some models show no price impact whatsoever. In these 

models, unconventional oil is available in sufficient quantities to limit 

world oil price to the cost of oil from unconventional sources. For these 

models, therefore, no price reduction is felt; the only impact of the oil 

demand reduction program is a decrease in the growth of the unconventional 

fuels industry. 

50 
Economic Growth 

World economic growth patterns comprise another factor -- a particularly 

crucial and difficult to predict factor --that may influence world oil price 

through its impact on oil demand. Our models required as inputs assumptions 

about future economic growth rates. We therefore standardized the economic 

growth rates expected to occur if world oil prices were to remain constant at 

their 1980 levels. Those models which included a feedback from higher energy 

price to economic growth projected adjustments downward in the economic growth 

rates in response to higher price. These constant-oil-price growth rates are 

displayed in Table A.3 (Appendix A). Up to the turn of the century, OECD GNP 

growth rates are assumed to average slightly over 3 percent per year, OPEC 

rates 6.4 percent, and the LDC's 5.1 percent in the Reference case. Post-2000 

rates in all cases are assumed to be significantly smaller. 

The impact on world oil markets of alternative future economic activity 

levels can be quantified by comparing oil prices in the Reduced Economic 

Growth scenario to those in the Reference case. Table 5 displays, for three 

years, the median percentage reduction in WOCA GNP from the Reference case 

levels and the resultant minimum, median, and maximum reductions in price and 

in consumption. These latter changes are expressed as percentage price (or 

quantity) change per 10% GNP change. 

In most of the models, oil demand would be roughly proportional to GNP 

if prices were to remain unchanged. Thus, each 10 percent GNP decrease could 

be expected to depress consumption by 10 percent if there were no changes in 

prices. However, because prices were not held constant between the scenarios, 

in 1990 each 10 reduction in GNP yields a median consumption decrease of only 

2 percent. The 8 percent difference is accounted for by the large price 

decrease (24 percent price decrease per 10 percent GNP decline.) This pattern 

51 
Table 5 

PRICE AND QIIANTITY IMPACTS OF 

BEDIICING ECO2tOMIC GROWTH RATES 

1990 2000 2020 

Median % Reduction in GNP 10.2 19.3 30.6 

(Low Economic Growth vs Reference) 

Price Reduction per 

10% GNP Reduction 

Maximum 40% 17% 15% 

Median 24% 10% 5% 

Minimum 12% 6% -13% 

Consumption Change per 

10% GNP Reduction 

Maximum - 1% - 5% 2% 

Afedian 2% 4% 8% 

Minimum 7% 10`/, 15% 

52 
is especially true in early years: actual declines in consumption are far 

smaller than the GNP declines. 

The converse is true for price projections. During the first twenty 

years, the resulting percentage price reductions are greater that the 

percentage GNP reductions while in later years price variations are smaller 

than the GNP variations. This time pattern occurs because, in response to a 

iven oercentaQe nrice increase, supply and demand quantities adjust more in 

the long-run than they do in a shorter time period. For this reason, smaller 

price changes are required in the long-run to motivate aiQ ven chan¢e in 

ouantitv than are required in a short time period. 

These results suggest that accurate estimation of future economic 

activity (or for that matter, energy conservation actions, availability of oil 

substitutes, or any factor influencing the oi1 demand functions) is essential 

for projecting medium-run and long-run world oil price but is far less 

important if projection of future world consumption is the goal. 

In our other sensitivity tests we displayed oil price changes per MMBD of 

import demand change. Although it would have been desirable to present 

comparable data here, this objective cannot be met in a meaningful way. 

Decreases in GNP influence the demand for oil both directly and indirectly. 

The indirect effect occurs because decreases in GNP directly decrease demands 

for all other forms of energy. In turn these demand changes for electricity, 

natural gas, and coal result in price reductions and hence increase their 

relative desirability vis a vis oil. This then indirectly decreases the 

demand for oil. 

While these decreases in the demand for any energy form will tend to 

decrease world oil demand and, hence, price, the impacts vary depending upon 

the fuel whose demand was altered. For example, if coal demand were decreased 

by the energy equivalent of 1 MMBD of oil, the world oil price would be 

53 
reduced by far less than would be the case with a 1 MMBD oil demand reduction. 

A decrease in natural gas demand would have an intermediate impact on oil 

price. (Equivalently, if demand were shifted from oil to coal or from gas to 

coal, the world oil price could be expected to decline even though the demand 

for energy as an aggregate remained unchanged.) Since we did not standardize 

these substitution possibilities, we cannot say precisely what percentage 

shift in the oil demand function corresponds to a 10 percent shift in GNP. 

Thus displaying price changes either per unit of oil demand reduction or per 

unit of energy demand reduction would not have been meaningful. 

The above discussion does suggest some important differences in the 

models. A model which includes oil only cannot explicitly account for these 

substitution effects induced by changes in GNP. In these models a program 

which reduces the demand for oi1 by 1 MMBD but which leaves all other demands 

unchanged wi11 have the same projected price impact as would a reduction in 

economic growth which reduces oil demand by 1 MMBD and at the same time 

reduces the demand for all other fuels proportionately. 23At the other 

extreme, a model which treats all energy demands as a single aggregate with 

oil as the fuel of "last resort", overstates the substitution possibilities. 

Such a model would project the same price impact for a program which reduces 

oil demand alone by 1 MMBD as it would for an economic growth change which 

reduces the sum total of all energy demands by the energy equivalent of 1 

MMBD. The former class of models tends to understate the sensitivity of oil 

prices to changing economic growth rates while the latter class tends to 

overstate the sensitivity. 

TheDemand Elasticitv for Oil 

Other factors influencing demand are also known only imprecisely. One 

such parameter is the price elasticity for oil or for energy. If two demand 

54 
functions are both based upon price and quantity observations from history, 

then for prices above their historical levels, the lower the demand 

elasticity, the higher the demand at a given price. Higher demands imply 

higher market clearing prices. Thus a lower demand elasticity implies a 

higher world oil price and a higher quantity consumed. 

Table 6 shows the percentage price increase (from the Reference case) 

resulting from reducing the elasticity of demand to 5/8 of its Reference 

level. This change generally increases projected oil consumption, but by a 

relatively small percent. However, price changes may be great. Thus future 

price projections may be highly sensitive to alternative assumptions about the 

demand elasticity, but quantity projections may be relatively insensitive. 

Contrary to what may be expected, the percentage price increases vary 

radically across the models: three models show 1990 price increases of less 

than 10% while two show increases of over 120%. While we cannot be sure why 

such surprising variations occur, the high degree of variation among these 

results is cause for concern as to whether procedures for calculating the 

sensitivity of prices to changing elasticities are standardized sufficiently 

to allow any degree of comparability. 24 

Non-OPECOilSunplv 

Changes in the supply of conventional and unconventional oil can influence world oil prices and quantities, as was illustrated in Figure 6. Figure 

7 illustrates how long-run changes in non-OPEC oil production translate into 

changes in the world price of oil. On the horizontal axis are plotted changes 

(from Reference case levels) in non-OPEC oil production for two scenarios -- 

Technological Breakthrough and Restricted Backstop. On the vertical axis are 

corresponding percentage price changes. The slope of a line from the origin 

m 
Table 6 

PRICE AHD QIIANTITY IHPACTS OF 

REDIICIHG ASSUAiSD DEMAND ELASTICITY 

1990 2000 2010 

Reduction in Elasticity To 5/8 of Reference Level 

(Low Elasticity vs Reference) 

Price Increase M 

Gately *x 81% 31% 26% 

IEES/OMS 4% 

IPE 171'/, 146% 

Salant/ICF 39% 41% 54% 

ETA-MACRO ~ 9% 73% -14% 

WOIL 19% 13% 6% 

Kennedy/Nehring" 121% 131% 166% 

OILTANK 26% 60% 61% 

Opeconomics 3% 3% 

OILMAR 8% 103% 123% 

WOCA Consumption Increase (%) 

Gately ** 2% 9% 12'/, 

IEES/OMS 2% 

IPE 16% 18% 

Salant/ICF - 6% 1% 7% 

ETA-MACRO" 6% 10% 36% 

WOIL 0% 1% 3% 

Kennedy/Nehring ~ - 5% 0% 1% 

oILTANK 7% 14% 37% 

Opeconomics 1% 2% 

oILMAR 4% - 2% -2% 

* Quantities are for OECD instead of WOCA. 

*'` Consumption increase estimates are for all energy, not simply oil. 

Percentage oil consumption increases will be larger than percentage energy 

consumption increases, perhaps by a factor of 2-3. 

56 
Change in 

60% Oil Price 

Restricted 40% 

Backstop 

Scenario 

Results Reference Case 

ZM Z (all models) 

10 20 30 40 

-20 -10 

Change in 

Non-OPEC 

Production (^MBD) 

\ \ _

~

0 

K A E 

-40% Technological 

Breakthrough S 

Scenario B.esults 

Figure . 7 Cliange in ldorld Oi1 Price with Change 

in Non-OPEC Oil Production: 2020 

(changes from the Reference case) 

-20% 

57 
to a given model result indicates the price change per MMBD increase in the 

quantity of non-OPEC (conventional plus unconventional) oil production. 

For each model, on the average, a 1 MMBD increase in non-OPEC production 

from Reference Case levels reduces long-run oil price by 1% to 2%. In 

absolute terms, on the average, each 1 MMBD increase in production reduces 

world oil price by $0.70 to $2.70 per barrel. Price impacts for large 

decreases in production are greater: on the average, each 1 MMBD production 

decrease implies price increases between 1.7% and 4%, ($1.60 and $7.00 per 

barrel). 

For production increases, the range of per-barrel impacts is similar to 

that for demand reduction measures, while for production decreases, these perbarrel estimates are larger. As discussed previously, measures to reduce 

demand should have the same per barrel impacts as measures to increase supply. 

However, the similarity of the measured ranges is somewhat deceptive since 

there are differences in concepts being measured. Figure 7 shows actual 

changes in production, not changes in the supply at a given price. Sunplv 

function changes would be somewhat larger. In order to be comparable in 

concept, we would need to use in our calculations changes in supply function. 

Such a procedure would reduce the per-barrel price impacts somewhat. But even 

with the conceptual differences, these data tend to confirm our earlier 

observation about the range of price impacts per MMBD reduction in oil import 

demand. 

OPEC Canacitv 

By using the two disruption scenarios it is possible to estimate the 

effect on world oil conditions of a continued reduction in OPEC capacity. 

These effects could be illustrated by reference back to Figure 6. An increase 

in OPEC capacity would move the OPEC Export Supply curve to the right, leading 

m 
to market clearing at Point B. World oil prices would be decreased and the 

quantity of oil produced and consumed in the world would be increased by an 

amount less than the increase in OPEC capacity. The converse results occur in 

response to an OPEC capacity decrease. 

The Disruption scenarios each postulate a 10 MMBD reduction in OPEC 

production capacity occurring suddenly in 1985. In the short-run, this capacity disruption leads to a sharp jump in oil prices. The magnitude of the 

projected change depends upon the model, but prices exceeding $100 per barrel 

are generally reported. In addition, the recursive simulation models show 

prices oscillating for many years after the disruption. A more complete 

discussion of the short-run impacts of disruptions appears in the subsequent 

section of this Report, entitled "Oil Supply Interruptions". Our interest 

here is in the effects of these capacity reductions on long-run price trends. 

The model projections of long-run price impacts per MMBD capacity 

reduction appear in Table 7 for two time periods, 2000 to 2010 and 2011 to 

2020. Over this time horizon, production is reduced by 85% to 100% of the 

reduction in capacity. In the medium run (15-25 years) the reduction in OPEC 

capacity results in an average oil price increase ranging between $0.80 and 

$4.10. In the 25-35 year period, these price impacts are generally projected 

to be smaller. These results suggest a range of price impacts roughly 

consistent with our estimated impacts of import demand reduction measures. 

Other Uncertainties 

A major uncertainty concerns the ability of the oil importing developing 

countries to finance increased levels of oil consumption. If balance of 

payments problems or other financial considerations not represented in the 

models prevent the projected increases in LDC oi1 consumption from taking 

place, then our estimates of world oil prices wi11 be biased upward and our 

59 
Table 7 

LONG RIIH PEICE IHPACTS OF 

OPEC CAPACITY DECREASE 

2000-2010 2011-2020 

Reduction in OPEC Capacity 

(Disruption vs Reference) 

Price Change per 1 *MrffiD 

Capacity Reduction 

Gately $0.80 $0.80 

Salant/ICF 1.70 2.20 

ETA-14ACR0 1.00 0.60 

WOIL 3.30 0.20 

Kennedy/Nehring 1.70 1.50 

OILTANK 4.10 1.90 

OILMAR 3.50 3.00 

~ Calculations were made for only those models that project prices for the 

years 2000 to 2020. The figures are the differences between the average postdisruption price during the two periods and the average Reference price, 

divided by the 10 IMD capacity disruption. All are in 1981 dollars. 

.1 
projections of OECD oil consumption will be biased downward. On the other 

hand, the growth in LDC revenues from their oil production along with the 

financial transfers from OPEC nations and the developed countries might 

preclude this possibility. These two alternative positions were strongly 

argued by working group members; no consensus was reached. However, most 

group members felt that estimates of prices associated with low economic 

growth may adequately incorporate this uncertainty. 

Models of LDC oil demand are relatively few. Far less empirical research 

and modeling has been focused on this group of countries than on the developed 

world. Therefore, projections of LDC oil consumption and production -- 

including ours -- should be viewed with scepticism. This inherent uncertainty 

about future LDC conditions was reflected in our lack of consensus about the 

likely biases incorporated into the LDC consumption estimates. 

A second important, yet uncertain, factor concerns the production 

policies of OPEC. The OPEC nations may have considerable latitude in 

determining production policies for the purpose of achieving non-economic 

goals. This latitude therefore makes any projections of oil prices and 

availability contingent upon political developments. This uncertainty was 

reflected by the many different representations of OPEC behavior incorporated 

into our models. In addition, other theories of OPEC behavior not included in 

any of our models were supported by working group members. 

A third remaining question concerns the consumption and production 

patterns of the centrally planned economies (CPE's). Our scenarios assume 

that during the 1980's, net oil exports from the CPE's will decline to zero. 

Whether these countries may become net oil importers in the near future 

remains to be seen. But, the impact on world oil prices of such a change can 

be extrapolated from our model results. Every 1 MMBD oil import demand 

increase may increase mid-run world oil price by between $0.90 and $2.40 per 

X-1 
barrel (probably less than $2). Thus our results suggest that while the 

political implications of such a change could be great, the direct impacts on 

the world oil market of, say, 2 MMBD of net imports, would be relatively 

small. 

Several other uncertainties, including the policy environment and the 

possibility of sudden disruptions in oil supply have been addressed and are 

discussed in a subsequent section. We did not explicitly address other 

uncertainties: e.g., the growth of nuclear power, international natural gas 

trade, or coal use. 

Summarv 

The range of prices projected using the various models for the ten 

scenarios is summarized in Figure 8, which shows projected world oil price in 

or around the year 2000, for the various models and scenarios. Thisfigure 

clearly illustrates the difficulty of forecasting world oil prices. For any 

one scenario, differing beliefs about the world, as incorporated into 

differing models, result in different forecasts of future prices. For any one 

model, reasonable variations in the assumed state-of-the-world (technology, 

OPEC capacity, economic growth, demand elasticity, demand growth) lead to 

additional variations in the projections. 

This figure highlights a central conclusion. While oil prices a decade 

or two in the future are highly uncertain, we should expect prices to exceed 

the current high levels. In only a very few combinations of models and 

scenarios are year 2000 prices projected to be as low as current levels. But 

whether price increases will be modest or dramatic is not clear. Furthermore, 

while gradual, steady increases are possible, so too are the dramatic 

escalations brought on by supply interruptions. 

62 
rn 

w 

Figure 8 Scenarios and Price Results 

— --_ 

World Oil Price ca 2000 

(1981 $/bbl) 

Scenario 

20 40 60 80 100 120 140 160 180 200 220 416 

1. Reference 

B G 6 x WS A 

2. Oil Demand 

Reduction ~ ~ O I / i 

3. Low Elasticity 

W ~ 5 C E I KOI I 

4. Oil Demand Reduction/ 

Low Elasticity y K 

~— 

5. Low Economic Growth C$ C 0 E 

7. Disruption I 

C Wi 5 K A i E ~I— 

9. Disruption/ 

Low Elasticity p/ S E 0 

1. Oil Demand Reduction/ 

Disruption C W $ 

~ 

6. Restricted Backstop 

i w SIKA E 10 1 ~ 

8. Technological E 

Breakthrough W K 

~— i 

.0. Optimism S p • 

Models G- Gately, I- IEES, C- IPE, S- Salant/ICF, A- ETA-MACRO, W- WO1L, K- Kennedy/Nehring, " 

E- OTLTANK, B- Opeconomi.cs, 0- OILMAR 

Note; For all models other than IEES/OiS and IPE, the average of prices between 1995 and 2005 1.s given. 

For IEES/OMS, the 1995 price i.s presented while for IPE r averages bettveen 1995 and 2000 are presented, 
Analysis of various uncertainties allows estimation of the impact on oil 

prices of changing supply and demand conditions. Over a time horizon of 

several years, each 1 MMBD oil demand decrease or supply increase might reduce 

oi1 price by anywhere between $0.10 and $2.10 per barrel; in the longer run 

(10-20 years), the price range is tighter -- by $0.90 to $2.40 per barrel for 

every MMBD demand decrease or supply increase. 

These price increases will motivate partially offsetting demand or supply 

changes, so that consumption or production variations will be smaller than the 

initiating changes in demand or supply. Therefore price changes per 1 Mi•iBD of 

oil consumption decrease or oil production increase will be significantly 

higher than the above estimates. 

The era of oil consumption is not at an end, but we expect slower growth 

in consumption over the next forty years. Conventional oil production is 

expected to decline. Increasing consumption in the face of declining 

production depends upon our projection of increasing availability of nonconventional sources of oil substitutes. Similarly, we expect the OECD 

nations to continue to be highly dependent upon the OPEC nations for oil. 

Some consequences of this dependence will be addressed in the following 

section. 

64 
OIL SOPPLY IHTSBBIIPTIONS 

The vulnerability of the oil importing countries to disruptions in 

supplies of crude oil became front page news during the 1970's. Whether the 

result of politically motivated embargoes, internal revolutions, or political/ 

military conflicts, these disruptions have been -- and will likely continue to 

be -- very costly. And it is conceivable that control of Persian Gu1f oil 

could pass to nations whose interests are in direct conflict with those of the 

Western world. Should that occur, disruptions or threatened disruptions could 

be used to gain economic and political advantage in ways not experienced 

heretofore. 

The global interdependency of oil markets makes the effects of oil supply 

interruptions nearly inescapable. Even those who buy oil only from secure 

sources may find their supplies suddenly vanishing during a disruption as 

those who are cut off bid higher and higher prices for the remaining supplies. 

Assessment of our vulnerability and of policies designed to reduce 

vulnerability requires evaluation of the consequences of many possible 

situations. In the present study, the effects of a sudden cutback in supply 

are examined by considering a permanent, but unanticipated, reduction in OPEC 

capacity of 10 MMBD initiated in 1985 while the world oil market is projected 

to still be "soft". 

UNDEBSTAHDIHG IIITEBgIIPTIONS 

The Iranian crisis of 1979 provides a good example of effects on oil 

supply and price of a sudden reduction in oil production capacity. Prior to 

the 1978, Iran had produced more than 5.5 MMBD. In the chaos following the 

fall of the Shah, Iranian (and world) oil production capacity was reduced by 3 

to 5 MMBD between November 1978 and January 1979. This decline in capacity 

65 
initially had only a modest impact on world oil production and price because 

other countries, principally Saudi Arabia, increased their own production. 

But ultimately after Saudi Arabia announced its intention to reduce production 

there was a 75% increase in prices resulting from a disruption less than half 

the size of that considered here. 

The price and quantity effects of a reduction in oil production capacity 

can be illustrated with a simple diagram. Figure 9 includes a typical shortrun demand curve for OPEC oil exports and an upward sloping short-run oil 

supply curve, representing primarily the willingness of the OPEC producers to 

put more of their capacity into production at higher prices. Both the demand 

and the supply curves for disruption years are shown to be different from 

those in normal years. 

The cut-back during the Iranian crisis or any disruption could be 

represented as a leftward shift in the supply curve. During the Iranian 

crisis the shift was triggered by a reduction in capacity but it need not be 

tied to a capacity change. The shift may simply represent a change in the 

willingness of the OPEC producers to utilize their productive capacity. 

During disruptions the demand curve shifts outward, increasing demand at 

any given price. This shift occurs because world-wide inventories of crude 

oil and refined products are increased whenever future price or availability 

of oil becomes intensely uncertain. As a simple example, assume that in 

response to the disruption, all consumers and firms try to increase their oil 

inventories by only 5% over a 90 day period. Since world-wide petroleum 

inventories held at all levels of distribution amount to about 10 billion 

barre1s 25 , this example inventory build-up increases demand by 5.6 MMBD, a 

full 11% of WOCA consumption during those three months. 

The relative inflexibility to adjust consumption and supply of crude oil 

over a short period of time (one year or less) is a second major factor 

m 
P 2 

D 

Disruption 

Year 

Price 

Capacity 

~ Reductioc. C 

Disruptior. 

Year 

Supply 

Normal Year 

Supply 

0 

c 

s: 

®e Normal Year 

Short-Run 

Demand 

Disruption Year 

Short-Run 

Demand 

Normal Year Price 

Export _ 

Reduction 

Disruption Year 

Exports \\, 

Normal Year 

Z Exports 

OPEC Oil Exnorts 

Fi.,ure 9 -Effects of Supply Disruption on Oi1 rmport/Export 

Pfarket 

~7 
underlying the supply vulnerability problem. Under normal conditions, the 

stock of oil consuming equipment and the usage patterns of that stock are 

gradually adjusted to expected oil price and availability. During a supply 

interruption, usage patterns can be adjusted rapidly but the capital stock 

cannot. Thus, oil substitution becomes progressively more difficult as 

additional supplies are curtailed. This relative inflexibility is reflected 

in Figure 9 by the steeply sloping supply and demand curves. Because the 

short—run import demand curve is steeply sloping, a disruption can lead to 

very large price increases. The lower the short—run import demand elasticity, 

the larger the disruption price impacts. 

One factor tends to reduce the impacts of disruptions: the actual OPEC 

export reduction can be expected to be smaller than the reduction in capacity. 

This occurs because those OPEC nations not producing at their capacity prior 

to the disruption can be expected to begin producing closer to capacity during 

a disruption. The greater the excess capacity (the difference between 

production capacity and actual production) prior to the disruption, the 

smaller will be the reduction in OPEC exports during the disruption. For 

example, during the Iranian crisis, Iranian production fell suddenly by 5.2 

MMBD. At the same time other OPEC nations increased their production 

collectively by 2.7 MMBD, leaving a net decline of only 2.5 MMBD. 

Thus the amount of pre—existing excess capacity is a key variable in 

determining the impact of a given capacity loss. Excess capacity can reduce 

the impact of a disruption since some capacity could be put into production, 

compensating for the drop in production elsewhere, if nations with the capa— 

city so choose. In the absence of much unused capacity, even small disrup— 

tions may lead to very large price impacts. Therefore, the price impacts of 

disruptions are apt to be more than proportional to their magnitudes: if oil 

markets are initially soft, a 2 MMBD capacity reduction may have relatively 

,'i3 
little effect while a 4 MMBD reduction could have a profound impact on prices. 

In summary, the magnitude of the price impacts will depend significantly 

on the amount of excess production capacity available, the willingness of the 

remaining producers to use this capacity, the short-run elasticity of supply 

and demand for oil, and the degree to which inventories are accumulated at the 

initiation of the disruption. 

Figure 9 can also be used to illustrate the estimation of a lower bound 

on economic costs to oil importing nations of a supply disruption. A simple 

approximation of this lower bound is obtained by multiplying the import 

quantity by the change in price of imported oil. For example, a nation 

importing 2.5 billion barrels of oil per year loses $75 billion of wealth per 

year if the price increases by $30 per barrel. A more precise estimate is 

obtained as the area of the region ABCDE in Figure 9. 

The actual economic costs of a disruption can be expected to be larger 

than those represented by Figure 9 because sudden oil price shocks may lead to 

unemployment of labor and capital equipment. This phenomenon is not included 

within the models nor in the calculations of economic loss conducted for this 

study. However, the subsequent Energy Modeling Forum study will explicitly 

address short-run macro-economic impacts of energy shocks. 

Our analysis suggests that the cost to the oil importing countries of a 

disruption in OPEC production capacity depends primarily upon five factors: 

the magnitude of the disruption relative to the degree of pre-disruption 

excess capacity, the short-run elasticity of demand for oil imports, the predisruption quantity of oil imported, the rate of oil stock build-up or release 

during the disruption, and the willingness of OPEC nations to utilize excess 

capacity while the disruption is occurring. 

There are several additional complications which limit the degree to which 

our analysis is representative of U.S. or OECD vulnerability. 

.• 
Expectations about several factors affect consumption, inventory, and 

supply behavior during a disruption. These include expectations as to the 

length of the disruption and the magnitude of the loss in capacity, 

expectations which will be fed, not by accurate information, but by rumor, 

suspicion and conjecture. For example, during the Iran/Iraq war dependable 

information on even the size of the cut in production and capacity was never 

readily available. In the present study, it is assumed that the disruption is 

permanent, that it is known to be permanent, and that the size of the 

reduction in capacity is known with certainty to be 10 million barrels a day. 

Clearly these possibilities do not begin to bound the range of plausible 

future disruptions. 

There is also considerable uncertainty as to the dynamics of the OPEC 

price response. During the disruption in 1979, members of OPEC appear to have 

followed the Rotterdam spot market in adjusting their prices, although, as one 

may observe from Figure 10, the adjustment did not occur instantaneously. The 

models included in this study calculate prices on a yearly basis and none 

differentiates spot from contract prices; thus, details on the dynamics of 

the price response are lost. 

An additional dynamic issue cannot be addressed by the simple analysis. 

During a disruption we have seen world oil prices escalate very rapidly. But 

once the disruption was over, the price adjustments downward have come only 

slowly. This phenomenon, often referred to as a"ratchet effect", was evident 

after each previous price jump. Because of the ratchet effect, a disruption 

may have economic impacts for years after the disruption occurs; the total 

economic losses are significantly greater than those occurring during the 

disruption itself. Yet, since this ratchet effect is closely tied to pricing 

and production decisions among OPEC nations, the extent to which it will occur 

in the future is highly uncertain. 

70 
45 

~ 40 

W 

~ 

~ 35 t= 

m 

[r 30 

W 

W 

UD 25 

~ 

~ 

~ 20 

Q 

O 

~ 15 

OU 

6) 

,---' 10 

~ 

~ 

5 

1977 197$ 1979 - :l! 19$1 

FIGURE 10 

SPOT MARKET VERSUS AVERAGE OPEC OIL PRICE 
Governmental policy responses can also have significant effects. These 

responses could include imposition of taxes or tariffs, price controls, 

release of oil inventories or stockpiles, or even the payment of a bounty for 

added imports of particular products. None of these policy responses was 

specified in the scenario design nor was any implemented in the models. 

Finally, the conditions existing just prior to the disruption can also 

have a significant influence on its effects. If inventories are low or demand 

is rapidly growing, the consequence for oil prices will be dramatic. 

Conversely, if the world economy is entering a recession, or if oil stocks are 

full, then price impacts may be relatively mild. The minor world oil price 

impacts of the Iran/Iraq war provide an excellent example. 

Stock acquisitions during the early 1980s were included in the EMF 

scenario design, but no uniform policy was set for their release during the 

1985 disruption nor for any inventory accumulations at the beginning of the 

disruption. As a consequence, except for Gately, who assumed a 1 MMBD stock 

release, the modelers implemented the Disruption scenario without considering 

any stock changes at all. In consequence, the models probably underestimated 

the rapidity of the price jumps. Whether the magnitude of these jumps was 

underestimated or overestimated is not clear. 

While there clearly are significant limitations involved in applying the 

models to evaluate our vulnerability, the models can provide some rough 

estimates of the magnitude of price adjustments to be expected for the first 

few years after a large disruption and can provide lower bound estimates to 

the economic losses. 

QIIANTITATIOS ESTIMATES 

Three scenarios have been designed to examine the impacts of sudden supply 

disruptions. In each, the OPEC oil production capacity is suddenly reduced by 

72 
10 MMBD. Each scenario includes an assumption that the OPEC capacity remains 

at the reduced level indefinitely. This specification is not meant as a 

prediction of the expected characteristics of future disruptions. Rather we 

have attempted to understand the issues involved and to illustrate the 

magnitudes of those impacts which could occur during future disruptions. The 

three scenarios differ in the assumed energy demand environment. In the 

Disruption Scenario, Reference Case assumptions hold for a11 but OPEC 

capacity; in the Disruption/Low Elasticity Scenario low demand elasticity is 

postulated; in the Disruption/Oil Import Reduction Scenario an aggressive 

import reduction program is implemented well before the disruption occurs. 

Comnarative Price Imnacts 

Figure 11 displays price projections in the Disruption Scenario. Several 

features of this graph should be noted. First, while the maximum price 

impacts of the disruption vary greatly among the models, all suggest large 

price jumps. Four -- ETA-MACRO, OILMAR, OILTANK, and WOIL -- show maximum oil 

prices exceeding $160 per barrel and three -- Gately, Kennedy/Nehring, and 

IEES/OMS -- show maximum oil prices between $80 and $120 per barrel ? 6 

The model results differ in their time pattern of price changes. Since 

the 10 MMBD disruption occurs abruptly but persists for many years, one would 

expect rapid price jumps followed by gradually declining real prices as demand 

and non-OPEC supply adjust to the elevated prices. However, in one of the 

simulation models -- OILMAR -- the maximum price increase occurs several 

years after the onset of the disruption. Virtually all project decreases in 

the disruption price impacts after the maximum price is achieved. 

Since the Disruption Scenario only standardized the reduction in OPEC oil 

production capacitv, the actual uroduction rates may decline by varying 

amounts, depending on the pre-disruption excess capacity. In general, the 

73 
~ 180 

CE: 

J 

J 180 

C? 

0 

V-., 140 

OQ 

0-) 

`-' 120 

~ 

W 

u 100 

H 

~ 

a' 80 

J 

f—i 

060 

L.IJ 

0 

~ 40 

~ 

U 

~ ~, 

WA r 

OILTRNK 

ETa- n 

K DY/NEHRINO 

BRTELY 

IEe 

OR LY KENNEDY/NENRTN6 

OTL 

I 

1982 1984 1988 1988 1990 1992 

DISRUPTION CASE PRICES 

Figure 11 
short-run price impacts of the disruption are more influenced by the 

production decline than by the capacity drop. 

Table 8 displays, along with other data, the changes in production and 

price projected using the various models. World oil price increases by 

between $5 and $29 per barrel on the averaQe for each 1 MMBD sudden reduction 

in OPEC production. All but one project world oil price jumps between $5 and 

$12 per barrel for every 1 MMBD production decline. 

The production declines are influenced, to a large extent, by the degree 

of excess capacity existing at the onset of the disruption. This is 

illustrated in the first two columns of Table 8. With the exception of IEES 

and OILTANK, the greater the pre-disruption excess capacity, the smaller OPEC 

production decline. 

The approaches to analyzing disruptions differed widely among modelers 

and models27 . In results from three of the models OPEC is projected to produce 

at capacity during the disruption. If this were to occur generally, every 

MMBD of pre-disruption excess capacity would reduce the production decline 

during the disruption by 1 MMBD. Results from one model show excess capacity 

being reduced but not eliminated during the disruption. Two modelers assume 

that OPEC nations will keep their excess capacity constant during the 

disruption. For these models, the amount of pre-disruption excess capacity 

has no influence on the ultimate level of production during the disruption. 

Finally, one model shows excess capacity actually increasing during the course 

of the disruption. The actual behavior to be expected from OPEC nations 

during a disruption is central to evaluations of disruption impacts, as is 

their potential for reducing these impacts through the utilization of preexisting capacity. As seen here, different assumptions as to OPEC disruption 

behavior lead to different projections of disruption costs. 

Differences in the short-run price elasticity for oil imports can be 

75 
Table 8 

KEY CHARACTERISTICS OF THE EMF 6 OIL SUPPLY DISRDPTIOA 

OPEC Price Maximum 

Excess OPEC Observed Maxinium Increase Annual 

Capacity Production One-Year Increase per MMBD OECD 

Model in 1984 Decreasea Import in Pricea Production Cost 

(MMBD) (MMBD) Elasticity ($/bbl) Decrease ($B/yr)d 

Gatelyb 3.9c MMBD 7.3 MMBD 0.36 $ 43 $ 6 $ 310 S 

(1985) 

IEES/OMS 8.2 9.3 0.33 51 5 370 

(1986) 

ETA-P1ACR0 5.0 5.0 0.13 143 29 1010 

(1985) 

WOIL 4.3 10.4 0.21 120 12 710 

(1987) 

Kennedy/ 0.0 10.0 0.45 67 7 570 

Nehring (1985) 

OILTANK 3.5 14.7 0.36 160 11 1130 

(1987) 

OILMAR 4.2 8.7 0.27 89 10 720 

(1992) 

a All measured in the year of maximum price increase (shown in parentheses, 

column 5). A11 monetary figures in 1981 dollars. Each comparison represents 

the difference between the value in the Disruption Scenario and the 

corresponding value in the Reference Case. 

b Low elasticity disruption used for Gately to make his oil price elasticity 

comparable to all others. 

c In addition there is 1 rII9BD of stock releases assumed for the Gately runs 

in 1985. 

d Estimated as the maximum price increase multiplied by the average of 

imports in the Disruption and the Reference Scenarios. 

76 
expected to lead to further differences in the disruption price impacts. 

Table 8 displays the short-run price elasticities for OPEC exports implicit in 

the model projections of price changes. Differences in the non-OPEC oil 

supply response and the WOCA short-run demand elasticities lead to a wide 

disparity in the short-run elasticity for oil imports. For example, in the 

Kennedy/Nehring model, the entire long-run non-OPEC supply adjustment to the 

disruption is implicitly assumed to occur instantaneously. At the other 

extreme, ETA-MACRO's low short-run import demand elasticity reflects the 

postulate that there will be no increase in non-OPEC oil supply. Although the 

proposition cannot be tested with our model results, the lower the import 

demand elasticity, the greater should be the price increase. 

The longer range price implications of supply interruptions also vary 

among the models. In particular, the recursive simulation models show many 

years of price oscillations resulting from the 1985 disruption. These oscillations occur because the original price shock from the disruption motivates 

non-OPEC producers to increase their oil supply and consumers to cut back on 

demand. The net effect is a loosening of the oil market and a subsequent 

decline in prices. Over time, this price decline leads to a tapering off of 

non-OPEC supply, a resurgence in demand, and consequently, an increase in the 

demand for OPEC oil. As the market again becomes tight, a new cycle of price 

increases is initiated. A single disruption in the world oil market is 

projected by these model to lead to a longer-term pattern of turbulence. 

Economic Losses 

Economic losses to the oil importing countries can be estimated in two 

possible ways. A few of the models internally represent the impacts of energy 

prices on economic activity. For most however, such an output is not 

available. For these models we could estimate impacts only by calculating the 

77 
area ABCD in Figure 9. In order to maintain consistency, economic impacts for 

all the models were calculated using this latter procedure. 

Table 9 includes data on the estimated annualdisruption cost to the OECD 

nations in the year of maximum impact. These costs are immense; estimated 

maximum annual costs range between $300 billion and $1.1 trillion. Higher 

costs occur in the Low Elasticity/Disruption case. 

The primary causes of variations in the projected economic losses are 

variations in the projected price increases. For the two basic disruption 

scenarios, the annual economic losses range from $6 billion to $8.5 Billion 

for every $1.00 per barrel increase in the world oil price. 

These projected economic impacts are probably too small. Even those models 

that include energy-economy interactions assume that the other factors of 

production (e.g., capital and labor) will accept lower returns, and will 

therefore remain fully employed during an oil shortage. This is an assumption 

not consistent with experience during previous oil supply interruptions. 

However, we have not been able to quantify this bias. 

REDIICIHG vULftEBABILITY TO OIL SQPPLY 

The high economic costs of disruptions provide strong motivation to reduce 

vulnerability to oil supply disruptions. Three types of policies can be used 

to reduce our vulnerability to oil supply interruptions: 

- reducing interruption costs by decreasing the pre-interruption 

level of oil imports, 

- reducing imports during the crisis, and 

- reducing the probability of disruption. 

Our scenarios cast light only on those policies which reduce interruption 

costs by decreasing pre-disruption imports. 

VE3 
Table 9 

COSTS TO THE OECD OF A 1985 DISRIIPTION 

WITH AND WITHODT IHPORT REDIICTION PROGEAffi 

Reference Case Conservation Case Reductions in 

Model Disruption Costs Disruption Costs Disruption Costs 

($ Billions) ($ Billions) ($ Billions) 

Gately'' 140 80 60 

IEES/OMS 370 170 200 

ETA—MACRO 1010 310 700 

WOIL 710 180 530 

Kennedy/ 570 310 260 

Nehring 

OILTANK 1130 780 350 

OILMAR 720 210 510 

* 

In developing this table, we were not able to substitute 1ow elasticity 

scenarios for the Gately model. 

79 
Import reduction measures undertaken prior to the disruption can reduce 

the short-run import demands and thereby can reduce disruption costs. Such 

measures may include increases in the fuel efficiency of energy using capital 

equipment (e.g., automobiles), alterations in capital equipment to allow use 

of coal or natural gas rather than oil (e.g., industrial boilers), or 

increases in the domestic production of oil or oil substitutes. However, 

measures taken in advance to reduce use of energy in unchanged capital 

equipment (e.g., turning down thermostats) may have no such favorable effect 

on the short-run import demand curves if they simply preempt measures that 

could be taken during a disruption. 

Several long-run policy measures might motivate the reductions: import 

tariffs, energy use taxes, conservation programs, supply enhancement programs, 

quotas, and so forth. The study does not attempt to differentiate among these 

instruments. Rather, the Oil Demand Reduction and the Oil Demand Reduction/ 

Disruption cases postulate a uniform reduction in the long-run and short-run 

demand functions, a reduction equaling 5 MMBD at the time of the disruption. 

Figure 12 illustrates the role of ineasures which reduce the short-run 

import demand function. Besides the supply and demand curves from Figure 9, 

Figure 12 also includes a reduced import demand curve. Normal year and 

disruption year market clearing in the reduced demand case occur at points C 

and D, respectively. 

Figure 12 illustrates that the price increase occurring during the 

disruption will be smaller in the presence of the import reduction measures 

than in the Reference situation. Likewise the actual reduction in OPEC 

exports will be smaller in the former case. Both effects occur because more 

excess capacity can be expected to exist when demand is lower. 

Figure 13 displays the results of our scenarios, showing pre-disruption 

OPEC excess capacity and the maximum oil price increase during the disruption 

M-4 
~ 

U 

~ 

H 

a 

r-1 

.~ 

O 

~ 

~i 

'.+ 

O 

~ 

ar 

smand : 

>rts 

OPEC Oil Exports 

Figure 12 Effects of Import Reduction i4easures on Disruption 

Imports 

M. 
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0 

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~ 

CJ 

U 

N 

}+ 

r~ 

O 

~ 

E .% 

r i 

Figure 13 Effect of Long-run Import Reduction Program on Level 

of OPEC E>:cess Capacity Prior to the Disrupt_ion and 

the Resulting Price Increase * 

* For a statement of model names corresponding to the letters, 

see Figure 8. 

m 
both in the Conservation/Disruption case and in the Disruption case. Each 

model illustrates that the long-run import reduction program leads to 

increases in OPEC excess capacity and important reductions in disruption price 

jumps. The magnitude of this effect in some models is quite striking. For 

example, in OILMAR (the symbol "0"), the 5 MMBD oil import reduction is met by 

a decrease in OPEC production of almost 4 MMBD and, consequently, a 4 MMBD 

increase in excess capacity prior to the disruption. As a result, the price 

jump during the disruption is reduced from $90 per barrel to $20 per barrel. 

Other models show smaller, but still large, moderating influences of 

reductions in oil imports. 

Tab1e 9(shown previously) presents estimates of maximum annual disruption 

cost decreases associated with the 5 MMBD reduction in OECD oil demand. 28The 

import reduction program reduces the projected disruption costs by more than 

50 percent in most models. For some models, an even greater percentage cost 

reduction is projected. These large economic benefits of oil import reduction 

suggest the potentially high value of programs which reduce imports. 

The scenarios have incorporated an explicit assumption that reductions in 

imports will leave OPEC production capacity unchanged. An alternative view is 

that import demand reductions will be met by equal reductions in OPEC 

capacity. If this were to occur, then no excess capacity would be created. 

However, even in this situation the economic impacts of disruptions may be 

cushioned. If the disruption occurs in the same country (or countries) whose 

pre-disruption capacity was reduced, then the size of the disruption will be 

reduced by an equivalent amount, completely offsetting any effects of the predisruption capacity reduction. In this case, whether or not capacity 

reductions do occur in response to oil import reduction programs will be 

irrelevant for evaluating the benefits of such programs. Our procedure will 

systematically overestimate benefits of import reduction programs only if the 

W 
disruption occurs in countries other than those reducing their capacity. 

Thus, our scenarios can be interpreted as embodying an assumption that either 

no OPEC capacity reduction will result from a reduction in OECD imports, or 

that any such reduction will occur in the country (countries) where the 

disruption occurs. 

Encouragement of private-sector petroleum stockpiles and development of 

the Federal strategic petroleum reserve are often discussed as crucial 

policies for reducing impacts of disruptions. In our study we have not 

defined scenarios which allow us to directly examine such issues. Rowever, we 

can use the simple analysis presented previously to extrapolate the benefits 

of such changes. This point can be illustrated through use of Figure 12. The 

release of stockpiles could be represented as a shift from the Reference 

short-run demand curve before the disruption to the Reduced Import Demand 

curve during the disruption. The net result would be that markets would clear 

at point D rather than at point B: price jumps during the disruption would 

be moderated. 

The effects of increasing useable excess capacity and of releasing oil 

stocks during disruptions can be roughly quantified by reference to Figure 13. 

This figure suggests that each MMBD of additional excess capacity reduces the 

disruption price impacts by about $20 per barrel. Note that this figure is 

well above the $5 to $12 range quoted for the avera¢e impact. The difference 

comes about because the incremental price impact associated with a relatively 

small cbange in the disruption magnitude is normally larger than the average 

impact measured for the entire production decline. 

The similarity between releasing oil held in stockpiles and putting 

excess capacity into production allows us to infer that stockpile releases 

would likewise reduce disruption prices by about $20 for each MMBD of oil so 

released. For example, 730 million barrels released over the course of a year 

.~' 
would average 2 MMBD of stock releases. This action could be expected to 

reduce disruption prices by around $40 per barrel. Thus the amount of oil 

held in stockpiles and the quantity released during a disruption are extremely 

important determinants of disruption impacts. 

COHCLIISZOft 

The models were designed primarily to examine the behavior of the world 

oil market in the absence of supply disruptions; none was explicitly designed 

to study the etfects ot the precipitous decreases in oil production capacity 

such as specified in the disruption scenarios. The models do not consider a 

number of the factors that were shown during previous disruptions to be 

important. For example, full employment is implicitly assumed, private oil 

stock-building and depletion is ignored, gasoline rationing or petroleum 

product allocation schemes are excluded, and the interplay between spot 

markets and long-term contract markets is ignored. Thus, the models may 

misrepresent and many, we feel, underestimate the economic impacts of 

disruptions. However, the models generally display very high prices during a 

disruption. A11 show that long-run import reduction measures taken in advance 

of the disruption can greatly reduce disruption costs. 

The results vary greatly among the models. These differences in projections depend primarily upon the magnitude of the disruption relative to the 

degree of excess capacity, the demand elasticity for OPEC exports, oil import 

quantities before the disruption, the quantities of stock released, and the 

willingness of OPEC nations to use their excess capacity during a disruption. 

This section and the previous section have illustrated that the oil 

importing nations may benefit from import reduction programs, in both a nondisrupted and a disrupted world. This notion is an important one for policy 

purposes. Quantification of the benefits motivates the following section. 

Ml: 
THE oALIIE OF BBDIICIftG OIL IMPORTS 

While the preceding sections have painted a picture of increasing world 

oil prices and continuing vulnerability to oil supply disruptions, they have 

also suggested that measures to reduce oil imports can provide (1) reductions 

in the future world oil price; and (2) reductions in economic losses during 

supply disruptions. The consequent economic benefits stemming from import 

reduction, when expressed on a per-barrel basis are collectively referred to 

as the "import premium" for oil. 

This section discusses the nature of the import premium and provides a 

quantification based upon the model results. Considerable variation in 

premium values results from different descriptions of consumer and producer 

behavior in the world oil market. Since we are fundamentally unsure as to the 

appropriate descriptions of producers and consumers, we must also accept 

uncertainty about the exact value of the premium. Moreover, we cannot expect 

this uncertainty to be resolved in the near future. However, our 

investigation does provide us with some general policy guidance and does 

suggest a possible range of values for the premium. Opportunities for 

displacing oil imports which incur costs near the bottom of this range should 

be seriously considered if economic efficiency is the goal. On the other 

hand, projects with costs above this range cannot be justified on the basis of 

the import costs which we consider here. 29In the center of our range, there 

is a sizable grey area where other considerations must guide policy choices. 

~ i:f44I~1I*411L:_i:{.;Ilit4 

The import premium has two equivalent interpretations. It is the 

reduction in total import costs, over and above the world price of oil, caused 

by reducing oil imports by one unit. Equivalently, it is the economic cost, 

39 
over and above the world price of oil, of importing additional oil. In this 

situation an importing country can improve its well-being by reducing its 

imports to below free-market levels. 

The import premium has at least two components. The first occurs because 

the world oil price rises when oil imports are increased. Oil importing 

countries must pay this increased price on all imports, not just on the added 

imports. Thus, additional imports increase the oil import bill by more than 

their price. The difference -- the price change multiplied by the import 

level -- is known as the "market power component" of the import premium. 

In addition, the greater the level of imports, the greater the costs of a 

disruption, if it occurs. The effect of reduced imports on expected 

disruption costs gives rise to another component known as the "security 

component" of the import premium. 

These two primary effects lead to secondary effects as well. Increased 

oil imports harm the balance-of-payments, thereby leading to exchange rate 

shifts which make all other imports more costly. Some analysts have suggested 

that the greater oil imports, the greater the domestic inflationary impact of 

an oit price increase. Furthermore, sudden oil price jumps can reduce GNP via 

unemployment, leading to recessions such as occurred in 1973-1974 and in 1979- 

1980. We have not addressed these secondary effects; for this reason our 

study may tend to under-estimate the total import premium. 

The import premium tbus measures the economic benefit to a nation of 

instituting programs to reduce oil imports, if those programs themselves do 

not introduce further inefficiencies into the economy. Costs of implementing 

such a program are not included in estimates for the market power component 

and therefore such costs must be weighed against benefits when using the 

import premium for policy analysis. Thus the market power component can be 

interpreted as the maximum (marginal) cost society should be willing to incur 

E-M 
in order to reduce oil imports below the level determined by competitive 

market forces, if economic efficiency is the goal. 

Market Power Component 

Our estimates of the degree to which oil import demand reductions 

influence world oil prices allow a simple static illustration of the market 

power component. Recall that in the medium run, each 1 MMBD oil import 

demand reduction leads to world oil price reductions of between $0.90 and 

$2.40 per barrel. Suppose that the U.S. were importing 6 MMBD of oil at $35 

per barrel. Then the daily import bill would be $210 million. An import 

demand reduction of 0.5 MMBD (demand reduced to 5.5 MMBD) would reduce world 

oil price, or lessen the price increase, by between $0.45 and $1.20 per 

barrel, leading to oil prices between $33.80 and $34.55 per barrel. The 

import bill would then range between $185.90 million and $190.03 million per 

day. In this situation, the U.S. would reduce its total cost for oil imports 

by between $19.98 million and $24.10 million per day while reducing imports by 

0.5 MMBD. The saving to the economy would range between $39.95 and $48.20 for 

each barrel of oil not imported. Those individuals reducing their imports 

would save about $35.00 per barrel. The remainder -- $4.95 to $13.20 per 

barrel -- would be a savings captured by the remainder of the economy. This 

savings from import reduction not captured by the individuals reducing their 

oil consumption (or increasing their oil production) is the market power 

component, in this case $4.95 to $13.20 per barrel 3 0 An identical logic 

would apply to increases in consumption, decreases in production, or any 

changes which increased net imports. 

The market power component cannot be calculated as simply as suggested in 

the static example if the long-run demand elasticity greatly exceeds the 

short-run elasticity or if OPEC price administration slows the speed of price 

rn 
adjustment. If both these phenomena are represented, unit import increase 

which continues over time leads to price increases which are small initially, 

grow to a maximum, and then decrease in the very long run. Since this 

behavior characterizes most of the models, some method is required to 

aggregate the various changes over time to obtain a per-barrel value of import 

reduction. 

For this study we have generalized the measurement in a straight-forward 

manner. The market power component is calculated by estimating the sum of 

costs (or benefits) of the import increase, over and above the world oil 

price, discounted at the market interest rate 31(i.e., the present valuet of 

costs or benefits). This sum is then divided by the discounted sum of shifts 

in the oil demand function to obtain the estimated import premium. 

Securitv Comnonent 

The previous section (Oil Supply Interruptions) has described how a longrun program of import reductions can reduce the economic costs of a 

disruption, if it occurs. The estimates of these cost reductions can be used 

to compute a security component which can be added to the market power 

component to obtain a total premium. 

The security component depends upon the probability assigned to the 

occurrence of an interruption. If the probability is zero, we are certain 

that an interruption will not occur and the security component will be zero. 

As the probability of a disruption increases, the security component increases 

proportionately, as shown in Figure 14. 32 

We can illustrate calculation of the security premium with a simple 

example. Suppose that a disruption would cost the U.S. $200 billion in a 

single year. Suppose further that with a 1 MMBD import reduction program, 

undertaken well in advance of the disruption, the disruption costs would be 

LIU, 
E 

7 

. ~ 

~ 

N 

F+ 

G 

u 

f: 

O 

G 

E 

H 

Probability of Disruption 

Figure 14 'Iwo Components of the Import Premium 

90 
reduced to $180 billion. The 1 MMBD demand reduction implies annual import 

reductions amounting to .365 billion barrels. If we knew a disruption would 

occur in a given year, and if reducing import demand by .365 billion barrels 

would reduce costs by $20 billion, then it would be worth $55 per barrel to 

reduce imports ($20/0.365). Assume further that the market power component 

were $10 per barrel. Then if we assessed a probability of 1.0 that a 

disruption would occur during a given year (i.e., we know it will occur), then 

the security component would be $45 per barrel ($55—$10). If we assigned a 

zero probability, there would be no security component. Under an assumption 

that theannual probability of a disruption occurring were 5%, then the 

security component would be $2.25 per barrel (0.05 X$45). 

ESTIMATES OF THE PREMIIIMS 

In our study we have included one generic policy -- oil demand 

reduction -- which can be used to examine the implications of import 

reduction measures 33 

Table 10 presents the market power component, security component, and 

total import premium estimates under Reference assumptions3 4 Two sets of 

estimates are presented: the U.S. premium and the OECD premium. The U.S. 

premium is calculated by including only those benefits of oil import 

reductions received directly in the U.S. Its estimation includes an explicit 

assumption that U.S. reductions do not encourage other nations to likewise 

reduce their imports. The OECD premium includes one of two alternative 

assumptions. The U.S. or other OECD countries may be assumed to be willing to 

make their domestic policy choices based upon benefits and costs received by 

all OECD nations. Alternatively, the OECD premium can be envisioned as 

embracing an assumption that reductions in U.S. imports or imports of other 

91 
Table 10 

IMPORT PRElIIOM ESTIMATESa 

(1981 $/bbl) 

U.S. Premium OECD Premium 

Model 

Market Power Securityb Total Market Power Security Total 

Gatelyo $ 10 $ - $10+ $35 $ - $35+ 

IEES/OMS 9 1 10 31 4 3S 

IPEc 8 - 8+ 23 - 23+ 

Salant/ICF 8 Od 8 27 Od 27 

ETA-MACRO 13 5 18 45 17 62 

WOIL 7 4 11 24 14 3/ 

Kennedy/Nehring 8 2 10 30 6 35 

OILTANK 8 2 10 28 8 36 

OILMAR 15 3 18 50 11 61 

a Security premium values based on a 5% probability of disruption occurring 

in any given year. This implies a 40% probability of such a disruption 

occurring at least once in 10 years. 

b U.S. security premium estimated by taking 30% of OECD security premium. 

For models without U.S. data, the market power premium is also taken as 30% of 

the OECD market power premium. 

c It was not possible to calculate a security premium for the Gately model 

since we used low elasticity cases instead of Reference assumptions in 

interpreting results from that model. The IPE model was not run for the 

Disruption/Oil Demand Reduction Scenario and therefore a security premium 

could not be calculated. 

d Because the short-run elasticity equalled the long-run elasticity in 

this model, we believe that this estimate is not meaningful. 

92 
nations will directly lead to the same proportional reductions in imports to 

all OECD nations. 

The U.S. import premium varies between $8 and $18 per barrel (in 1981 

dollars) with a median of $10 per barrel. The largest of the two components 

is the market power component, which varies between $7 and $15 per barrel with 

a median value of $8. The U.S. security component estimates vary from 

$1 to $5 per barrel, with a median value of $2 per barrel. 

In these security component calculations, the probability of disruption 

was assumed to be 5% per year. 35Values of this component can be scaled 

upward or downward proportionately if probability assessments are different 

from our assumptions. For example, if we had assumed a 10% annual probability 

of a major disruption occurring, then the median and maximum security 

components would have been $2 and $10 per barrel respectively. 

Similarly broad ranges appear for the OECD premium. The total OECD import 

premium ranges between $23 and $62 per barrel, with a median of $35. These 

values are somewhat greater than three times the U.S. premium values because 

U.S. oil imports account for only approximately 30% of OECD imports. 

We have presented ranges of import premiums rather than single estimates, 

primarily because the calculation of a single "correct" import premium lies 

well beyond the current state-of-the-art. Other studies which have estimated 

the U.S. import premium also indicate wide ranges of possible premium values. 

For example, Stobaugh and Yergin 36have estimated a U.S. market power 

component between $10 and $35 per barrel. Hogan 37 has estimated a U.S. market 

power component between $1 and $5 per barrel and a total premium between $2 

and $40, and Blankenship et. a1. 38 , have estimated a total U.S. premium 

between $4 and $10. 

93 
SOIIRCES OF VA&IATION IN PBEMItlM ESTIMATES 

There is considerable variance in the estimates of the premium both in 

this and other studies. This variance has implications for the use of the 

premium in policy design and evaluation. 

It would be tremendously convenient to have a single value of the 

premium. An exact value would make the evaluation of potential policies more 

straighttorward from an economic efficiency perspective. Unfortunately, since 

we can make no claim to such a single value, economic evaluation of import 

reduction policies remains problematical. 

We can, however, examine some of the sources of variation in our premium 

estimates. Within this context, we can evaluate the information our analysis 

does provide regarding appropriate import management policies. 

The projected responses of OPEC nations to an import reduction program 

are crucial to the evaluation of the two components, whether these responses 

reflect normal market behavior or strategic responses designed to discourage 

import reductions. Large reductions in OPEC production in response to OECD 

demand reduction imply small reductions in price and hence a small market 

power component. However, such responses may create more excess OPEC 

production capacity and hence may lead to a larger security component. 

Conversely, if OPEC nations keep their production almost constant but reduce 

price significantly, then the market power component will be large and the 

security component small. 

In some sense, then, there may be a trade-off in the estimates of the 

security premium and the market power component. Whether projected OPEC 

production cut-backs will decrease or increase the total import premium cannot 

be ascertained aoriori 

A second aspect of OPEC behavior leads to uncertainty in the security 

component. The procedure used to calculate this component can be expected to 

94 
understate the value: although price increases occurring during the disruption 

may remain afterwards (remember the ratchet effect), the economic costs of 

these remaining price increases were excludedfrom the calculations. This 

omission implies that the security component is probably somewhat higher than 

the estimates presented here. How much higher, however, is unclear because 

the strength of the ratchet effect depends on the degree to which the OPEC 

nations successfully administer prices during a oi1 market glut. 

A second issue is whether the U.S. or the OECD premium is to be used for 

U.S. policy purposes. The U.S. benefits directly from reducing its imports. 

But, in addition, all other oil importing countries benefit. Similarly, the 

United States benefits from import reductions in Japan, Germany, or other 

countries. Thus, the magnitude of estimated premiums depends significantly 

upon whose benefits and costs are counted and upon what assumptions are made 

as to cooperation among oil importing nations. 

At first consideration it seems as if the U.S. should use the U.S. 

premium, Japan, the smaller Japanese premium, and Norway (as an exporter of 

oil) should use a negative premium. However, there are two reasons for each 

country using a larger premium, perhaps as great as the OECD premium. 

First, policy makers in each country may be willing to consider benefits 

and costs accruing to other countries as they select their domestic policy 

options. This willingness could come from pure altruism or from deep beliefs 

that international cooperation is highly beneficial to all. In addition, 

policy makers, understanding the complex mix of continually occurring 

international negotiations, may believe that benefits conferred on allies 

through energy policy choices can be recaptured through other concessions 

granted in separate negotiations. 

Second, policy makers may believe that actions by one country to reduce 

imports would lead to similar policy choices in other countries. For example, 

95 
in an extreme case one might believe that every 10% reduction in U.S. oil 

import demand would be matched by a 10% import demand reduction throughout the 

rest of the OECD. In this situation, any U.S. import reduction would be 

matched by an import reduction in other OECD nations equivalent to 2.3 times 

the U.S. reduction. Total benefits accruing to the U.S. per unit of U.S. 

import reduction will be roughly 3.3 times as great as would be the case if no 

foreign import reductions were induced. Thus, under this belief, the OECD 

premium would be appropriate even if only those benefits and costs accruing to 

the U.S. were included. 

An additional source of variation relates to the assumed degree of 

consumer response to higher energy prices. The lower the demand elasticity 

for oil imports, the higher the market power component. And with lower demand 

elasticity, it could be expected that the security component would be higher 

as well. The economic benefits of import reduction measures in the low 

elasticity world are significantly higher than (perhaps double) those in the 

reference world. 

IMPI.ICATIOHS FOR POLICY 

The import premium describes the value (above and beyond the world price 

of oil) to the U.S. or the OECD of import reduction measures. The magnitudes 

of the two components which were estimated within this study -- the market 

power component and the security component -- depend greatly upon several 

critical uncertainties. Thus, the magnitudes of these premiums remain quite 

uncertain, depending upon the models used and the specific assumptions 

included in the calculations. 

Despite these irresolvable uncertainties, this investigation of the 

premium provides some guidance for import management. The range of estimates 

suggests that import displacements which can be obtained for less than $8 per 

m 
barrel above the world price are almost certainly a net economic benefit to 

the U.S. Such measures should receive a high priority in U.S. policy. At the 

other extreme, import reductions which cost more than about $20 above the 

world price could not be economically justified using the import premium 

components examined here. 

One further qualification should be borne in mind. Information about tne 

premium, no matter how specific, cannot help us choose among specific import 

reduction policy instruments. This choice involves issues which are entirely 

separate from the evaluation of the premium. 

What we have seen in this discussion is that import reduction measures 

can indeed by valuable to the importing countries of the world. This 

deceptively simply observation suggests that we look critically at present 

policies which actually encourage or subsidize oil imports, and then develop 

additional import reduction policies going beyond reliance upon the free 

market. 

97 
THS TBANSITION TO IISW SHSHGY SOIIRCSS 

Our focus to this point has been the evolution of the world oil market 

over the medium term: the next several decades. While events beyond the year 

2000 are exceptionally difficult to predict, it is important to consider the 

longer term future, both because developments in the next two decades will 

have major impacts later, and because current decisions can be strongly 

influenced by perceptions about the distant future. In this section we are 

particularly concerned with the role that unconventional sources of energy, 

such as shale oil or biomass, will have in the oil market of the future. 

The world energy economy has become increasingly dependent on low cost 

reserves of crude oil and natural gas. However, during the next several 

decades these reserves will be substantially depleted and new reserves can be 

expected to be more and more costly. Our scenarios suggest that the prices of 

conventional fuels will continue to rise. 

The world economy can cope with these developments in a variety of ways: 

by improving the efficiency with which conventional fuels are produced, by 

developing the capability to produce unconventional fuels, and by reducing 

energy demands. An ultimate transition away from conventional fuels is an 

inevitable consequence of their depletable nature. But the timing and nature 

of the the transition remains highly uncertain. 

This uncertainty arises from two sources. We do not know what 

technologies and resources will be available in the future, for example, 

whether oil shale will ultimately provide large amounts of inexpensive 1iquid 

fuels. The future will be shaped also by the values society places on 

different styles of living and economic organization. For example, some 

people view reduced energy consumption as desirable in and of itself, 

contending that such reductions would force society to reorganize its 

M. 
acti.vities in a more humane way. Others hold that our main concern should be 

with expanding energy supplies, contending that continuing economic growth is 

dependent upon continuing growth in energy consumption. Which, if either, of 

these views comes to dominate will determine the future of energy markets at 

least as much as will the progress of technology. 

In this study we have not attempted to address either of these 

uncertainties. We cannot predict which of the several competing value systems 

will guide future choices on energy policy, nor can we predict the outcome of 

several decades of intense technological development. Our approach has been 

to investigate the consequences for the world oil market of alternative 

assumed future levels of unconventional oil supply. These alternative 

assumptions are designed to span the range from optimistic to pessimistic, 

representing the informed judgment of the working group. But it must be 

emphasized that they are assumutions, not predictions. 

JNDE&STANDING THE TBANSITION 

As we have noted, a central feature of our energy problem is the 

increasing scarcity and rising price of conventional fuels. Rising prices 

signal the potential profitability of new sources of energy and encourage 

investment in these sources. As prices rise, and as new technologies become 

proven, conventional oil will gradually be replaced by a variety of 

unconventional energy sources. Eventually, depletable energy sources will be 

replaced to a large extent by non—depletable sources, and energy scarcity will 

no longer force the price of energy to rise. 

This verbal sketch of the long—run energy future is illustrated in Figure 

15. In this highly simplified world all unconventional oil sources are 

treated as a single backstop source, with a constant production cost. Oi1 

prices pass through three distinct phases in the Figure. Early on, only 

.. 
N 

0 

U 

'O 

G 

~ 

U 

U 

.~ 

H 

Cr 

.r 

O 

C 

l - z

' uc 

C 

o ~ ~ Total 

u 

~ Production 

ti 

° 

F I.Back, top 

roduction ~ o I I 

~ 

Conventional 

~ IProduction \_ 

T1 T Z Time 

Figure 15 Transition to the Backstop 

100 
conventional oil is produced; its price rises as this resource is depleted. 

At time T I , when the price of conventional oil first reaches the backstop 

cost, backstop production begins. If, as seems likely, unconventional oil 

production capacity can increase only slowly at first (due to limited capital, 

environmental constraints, and so on) the price of oil may continue to rise 

above backstop costs 3 9If, eventually, backstop capacity grows to the point 

where it (along with conventional oil production) can meet demand at backstop 

costs, oil prices will decline to the level of those costs. This is tne third 

phase, after T2 in Figure 15, where backstop costs set the world oil price. 

While the actual evolution of the world oil market will be more complex 

than sketched here, this discussion raises several points which will become 

important when we examine the model results. In the long run, how high the 

price of oil rises relative to the cost of alternatives will depend critically 

on the rate at which "backstop" capacity expands. The backstop may eventually 

provide a ceiling for oil prices, if backstop production, when added to 

conventional production, can meet world demand at the backstop cost. In the 

meantime, world oil prices may well overshoot backstop costs. 

Under our scenario characterization of the backstop, the world oil supply 

has the form shown in Figure 16: at prices above or below the backstop cost, 

the quantity supplied responds smoothly to changes in price, while at prices 

equal to the backstop cost, a range of different supplies are possible. 

Figure 16 shows that supply and demand can intersect in two qualitatively 

different ways. In Figure 16A the limit on backstop production influences the 

world oil price, while in Figure 16B the backstop cost determines the price. 

The former case corresponds to the earlier time period (between Tl and T2) in 

Figure 15, while the former corresponds to the later period (after T z ), 

Figure 16 also illustrates the world oil market impacts of changes in the 

backstop cost or production limit, such as occur between the various 

101 
~ 

~ PB — — — — — — — — — - 

r 

.~ 

0 

Conventional Oil 

Supply 

=mand 

A) Backstop Production Limit Influences World Oil Price 

(early phases) 

U 

U 

y 

L+ 

P+ 

~ 

.~ 

O 

P B 

Oil Supply 

B) Backstop Cost Determines World Oil Price (later phases) 

Backstop 

Oil Supply 

Figure 16 Market Clearing: Two Cases 

102 
scenarios. When the backstop cost determines the world oil price (Figure 

16B), a cost decrease reduces the price, while an increase in the production 

limit has no impact. When the determining factor is the production limit 

(Figure 16A), a cost reduction has no effect on world oil price, but an 

increase in the production limit can reduce price. 

Whi1e Figure 16 illustrates the basic interaction, the models are each 

more complex than indicated by these simple diagrams. For example, the simple 

analysis does not reflect the link between the profitability of backstop 

production and the rate at which backstop capacity expands. In several of the 

models, backstop capacity expands more rapidly, the greater is its 

profitability. In these models reductions in backstop costs will not 

influence production immediately, but wi11 eventually show up in increased 

capacity and lower prices. 

Another consideration not reflected by the simple analysis is tne role of 

foresight on the part of producers or consumers. If backstop producers 

believe that backstop production will be profitable at some future time, they 

may invest in productive capacity in anticipation. If conventional oil 

producers believe that backstop costs will be reduced, they can be expected to 

shift their production plans, producing more oil currently and saving less 

reserves for the future. This shift would result in lower oil prices well 

before any backstop oil is produced. And if consumers have foresight, the 

opposite can occur: an expectation of future reductions in oil prices can 

lead consumers to invest in less energy-efficient capital, leading to 

relatively higher energy demands and prices in the near term. 

The following sections describe our assumptions about backstop supply, 

and analyze these and other aspects of the world oil market response to 

alternative levels of backstop supply. 

103 
FOTOBB IINCOHVSNTIO2iAL OIL SOPPLISS 

Several factors make it difficult to estimate the level of unconventional 

oil production for future years. First, there is a great diversity of 

potential new sources of oil, and of energy generally. Second, the production 

rate from any one source will depend on the production from all other sources, 

the current and expected prices of oil, government policies, and a host of 

other factors difficult to quantify. 

In the face of this compleaity, for the purposes of this study we chose a 

drastically simplified description of unconventional oil supplies. A11 

potential unconventional sources were aggregated into a single perfect 

substitute for oil called the "backstop." In any single year, we assume that 

the supply of backstop energy is described by two numbers: the cost of 

backstop oil, and the maximum production allowed in that year. If the current 

price of oil exceeds the cost of backstop oil, any amount up to this maximum 

could be produced. These maximum production figures were allowed to increase 

over time, so as to roughly reflect the complex evolution of the 

unconventional oil industry. 

In the Reference Scenario, backstop oil was assumed to cost $60 per 

barrel in 1979 dollars, which translates to $71/bbl in 1981 dollars. None was 

available before 1995. The maximum quantity was assumed to be 1 MMBD in 1996, 

rising to 35 MMBD by 2020. In the Restricted Backstop Scenario the backstop 

cost was still $71/bbl but the maximum production levels were half their 

Reference values. Finally, in the Technological Breakthrough Scenario, 

backstop costs were reduced to $40 per barrel in 1979 dollars, or $48/bbl in 

1981 dollars; after the year 2010, significantly greater quantities are 

available (80 MMBD by 2020). 

During the course of the study, a member of the Working Group with 

expertise in this area (Sheldon Lambert) undertook to estimate the production 

104 
potential of several specific and relatively well known unconventional energy 

sources. These include biomass, coal gasification and liquifaction, oil 

shale, and tar sands. Estimates are provided in Table 11. Table 11 

underscores the variety of potential sources, the great uncertainty as to the 

future production from any specific source, the large quantities possibly 

available in forty years, and the small quantities to be expected within the 

next fifteen years. 

These rough estimates do confirm the plausibility of our assumptions. 

Figure 17 allows us to compare the study assumptions with these estimates. 

Generally speaking, the rates set for the Reference Scenario fall near the 

upper end of that range, and those for the Restricted Backstop Scenario near 

the lower end. The optimistic assumptions of the Technological Breakthrough 

Scenario for the period after 2010 exceed the upper end of those estimates. 

From one perspective, the estimates of Table 11 could be considered 

conservative. They exclude extensions of conventional supplies: tight gas, 

heavy oils, and so on. They also exclude all energy sources that only 

generate electricity. And, perhaps most important, they make no allowance for 

major technological breakthrough in the next several decades. On the other 

hand, the levels of production cited here represent massive financial 

investments, major political commitments, and possibly important environmental 

and social effects. A backstop industry of this size would rival the world's 

conventional oil industry of today. 

QIIANTITATIVE RESQLTS 

World Oil Price Effects 

The model results confirm and allow quantification of several qualitative 

conclusions discussed above: 

-- Projected world oil prices significantly overshoot backstop costs. 

105 
Table 11 

BACKSTOP SOURCES OF CRUDE OIL: 

;< 

ESTIMATED PRODUCTION POTENTIALS FOR WOCA 

(NA1BD) 

Biomass 

Coal Gasification 

Coal Liquefaction 

Oil Shale 

Tar Sands 

Total 

1995 2000 2010 2020 

1.2-2.5 1.5-3.2 2.1-5.0 2.6-7.8 

1.0-3.5 1.3-5.1 2.0-8.0 2.8-12.3 

0.4-1.4 0.6-3.1 0.8-4.9 1.0-7.4 

0.4-1.5 0.6-2.5 1.0-4.1 1.4-6.0 

0.5-1.3 0.7-1.8 0.9-2.4 1.1-3.5 

3.5-10.2 4.7-15.7 6.0-24.4 8.9-37.0 

~ Source: Sheldon Lambert, Shell Oil Company 

106 
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40 

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r 

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20 

2000 2010 2020 

Figure 17 Backstop Production Limits: Reference, 

Restricted Backstop, and Technological 

Breakthrough Scenarios 

107 
-- Massive backstop production rates would be required to limit oil 

prices to backstop costs. 

-- Expansion of backstop production rates would reduce world oil price. 

-- Producer and consumer expectations can influence world oil prices 

even before production begins. 

The model results confirm our conclusion that the world price of oil is 

likely to rise well above backstop costs during the early part of the 

transition while oil demand (net of conventional supply) is growing faster 

than backstop production. Figure 18, which shows Reference Scenario prices to 

2020, illustrates this pattern. Each model including post-2000 projections 

shows world oil prices above backstop costs at some point. Half show prices 

~ 

sti11 climbing in the year 2020, while the rest project that prices would have 

peaked and subsequently declined to the vicinity of the backstop cost by that 

time. Thus, the mere existence of alternative energy supplies is not 

sufficient to limit world oil prices to backstop costs. Sufficient quantities 

must be available if such high prices are to be avoided. 

How large a quantity of non-conventional energy is required in order to 

limit oil prices to backstop costs? While the precise quantities are unclear, 

they may be truly massive. In the Restricted Backstop Scenario, where 17.5 

MMBD of backstop output is available in 2020, all models but one project the 

world price to continue climbing above backstop cost through 2020 and to 

exceed $100 per barrel in that year. The exception, ETA-MACRO, includes an 

endogenously determined backstop output of 28 MMBD in 2020. Year 2020 

projections of oil prices and backstop production quantities are graphed in 

Figure 19. 

Maximum available backstop output in the Reference Scenario is 35 MMBD. 

In three models this quantity is sufficient to reduce prices to $71 in 2020. 

But in three, it is not. Finally, in the Technological Breakthrough Scenario, 

am 
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Cost for the Reference Case 
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PRICE AND BACKSTOP PRODUCTION: 2020 

Figure 19 

110 
backstop costs are lowered to $48/bbl; up to 80 MMBD is available in 2020. In 

only two of the models do prices decline to backstop cost by 2020, despite 

production levels in excess of 40 MMBD. However, in all but one model prices 

are reduced below $70 per barrel, as shown in Figure 19. 

These results indicate that if an oil backstop is eventually to limit the 

world price of oil, its production must reach roughly the same magnitude as 

today's entire WOCA oil production--truly an enormous volume! 

The backstop quantity, it should be noted, is in addition to the 

conventional crude oil production. By 2020 our projections suggest that the 

world wi11 still be producing almost one—half as much conventional crude oil 

as is being produced today. Forty years from now the transition to new energy 

forms will still be ongoing. The era of oil is far from over. 

Our results suggest that for the next forty years, backstop capacity will 

influence oil prices, as was illustrated in Figure 16A. The pattern is readily 

apparent in Figure 19, which shows year 2020 backstop production rates and the 

resulting world oil prices for the three scenarios. Increasing backstop 

production by 1 MMBD reduces world oil price by roughly $1.80 to $3.60 per 

barrel. 

These results might at first seem to suggest that a 1 MMBD increase in 

backstop production rates reduce world oil price by more than would a 1 MMBD 

decrease in oil demand. This conclusion would be incorrect. We have 

estimated here the actual change in backstop production, not the change in the 

supnlv function for conventional plus backstop production. The previously 

stated estimates for price impacts of demand reductions rely upon projected 

changes in demand functions, not changes in guantities consumed. If we could 

evaluate the changes in supply function, then the price impacts of supply 

increases would be more consistent with the impacts of demand function 

changes. 

111 
The role of expectations about future price conditions is illustrated 

through the model results. Figure 20 plots world oil prices in the Restricted 

Backstop Scenario relative to prices in the Reference Scenario (the prices in 

the Reference Scenario subtracted from the prices in the Restricted Backstop 

Scenario). Three distinctly different responses to the restriction on 

backstop production are evident. 

In one group of models (OILMAR, OILTANK, WOIL), prices are essentially 

unchanged until after 1995, when backstop production begins. These models 

include an assumption that none of the actors in the energy marketplace is 

assumed to have any foresight about future conditions. Thus prices stay at 

Reference levels until backstop production begins, at which point the market 

discovers the tight restrictions on backstop supply, and prices rise above 

their Reference levels 40 

In another group of models (Salant, Kennedy) prices are increased we11 

before this date, while in ETA-MACRO prices are decreased. In the Salant 

model, all oil producers have perfect foresight about future market 

conditions, while in the Kennedy model only non-OPEC producers have such 

foresight. In both models, beliefs of producers about the future oil price 

influence their current decisions. If they expect backstop supply to be 

restricted, they will also expect future prices to be higher than otherwise. 

In this case, it is in their economic interest to postpone to the future some 

oil production planned for the present, since it will be worth more then. And 

with lower production, prices in the immediate future will be higher than 

otherwise. 

In ETA-MACRO the opposite result occurs; it is consumers who are assumed 

to possess foresight about future market conditions. Consumers select energyusing capital so as to minimize costs over time. Less future backstop 

production means higher prices. With advance warning, consumers choose more 

112 
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Pigure 20 The Effect of Restricted Backstop Production 

Capabilities on Slorld Oil Price 
energy—efficient capital than in the Reference case. More efficient capital 

leads to lower demand and lower prices, at least until the backstop supply 

restriction dominates. 

Effects on Distribution of Wealth 

While the world oil price is an important indicator of the state of the 

energy economy, it cannot reflect fully the impacts of changing production and 

consumption patterns. Taken together, production, consumption, and prices 

will have a strong influence on the distribution of wealth between oil 

importing and oil exporting regions. In this section we look at the effects 

of increased backstop supply on the distribution of wealth, particularly 

between the OPEC and the OECD, and within the OECD between producers and 

consumers. We emphasize that while we can estimate the benefits of increased 

backstop supply, we have no information on the costs of achieving these goals. 

These costs include R&D expenditures, subsidy costs, and so on. Our results 

can indicate the stakes involved for various actors in the energy picture; 

they cannot by themselves tell us whether, for example, a particular synthetic 

fuels program is economically justified. 

As we move from the Restricted Backstop to the Reference and then to the 

Technological Breakthrough Scenarios, backstop production expands, prices 

generally fall, the consumers' surplus in the OECD (and elsewhere) rises, and 

the surplus of conventional producers falls. This is illustrated in Table 12 

which compares the Restricted Backstop Scenario to the Reference Scenario 

(left half of the table) and the Reference Scenario to the Technological 

Breakthrough Scenario (right half). Consumers gain $700 billion to $5,300 

billion (present value of surplus) in moving from the Restricted Backstop 

Scenario the Reference Case, and another $100 billion to $5,700 billion from 

adding the Technological Breakthrough. The losses to conventional producers 

114 
Table 12 

t 

CHANGES IN OECD SURPLUS AND OPEC OIL REVENUES 

(Billions 1981 $) 

Reference vs. Restricted Backstop Technological Breakthrough vs. Reference 

Consumer 

Conventional Backstop Total 

OPEC Consumer 

Conventional Backstop 

Total OPEC 

Model Surplus Producer Surplus OECD 

Surplus Revenues Surplus Producer 

Surplus Surplus OECD 

Surplus Revenues 

Surplus 

Salant 3 1 700 -800 60 2,900 -1,900 3,600 -600 1,000 4,000 -1,500 

ETA-MACRO 700 -100 -200 400 - 1,800 -200 400 2,000 - 

WOIL"" 1,500 -400 -700 500 -1,500 100 - 25 1,400 1,500 - 600 

Kennedy 4,100 -900 -1,000 2,200 -5,200 1,100 -100 600 1,600 600 

OILTANK 700 - 74 500 1,100 - 700 

Oilmar

** 

5,300 -800 -200 3,900 -4,000 

5,700 -1,300 1,100 5,300 -4,200 

1,200 -100 1,500 2,500 -1,900 

Discounted present value 1980-2020; 3% discount rate. See Appendix for details. 

Computed from U.S. data by multiplying U.S. imports by 3.29 and U.S. domestic production by 1.36. 
are projected to be much smaller than consumer gains -- generally less than 

$600 billion for either change. With two exceptions, backstop producers are 

also projected to lose profits in the change from the Restricted Backstop to 

the Reference Scenario: the resulting decline in prices more than offsets the 

rise in production. The Technological Breakthrough, on the other hand, is 

unambiguously valuable to backstop producers. The drop in backstop costs from 

$71 to $48/bbl and the expansion in production more than offset any loss from 

a decline in prices. 

Table 12 also shows the change in the present value of OPEC oi1 revenues 

resulting from the expansion in backstop supply. In all cases, OPEC loses 

revenues as backstop supply expands. With but few exceptions, the loss 

sustained by OPEC is less than the increase in OECD surplus. This result 

points to the possibility that cooperation between oil producing and consuming 

nations could be in their mutual interest. 

Our projections suggest that the discounted value of OPEC oil revenues 

over the period from 1980 to 2020 may total $12 to $18 trillion (constant 1981 

dollars). Table 12 shows that a loss of about $1 to $2 trillion, or roughly 

10 to 20 percent of the total, can result from substantial increases in 

backstop supply. The effects on OPEC, on oil consuming nations and on the 

world economy of this potential wealth transfer could be significant, but are 

difficult to predict. 

MODEL CAPABILITIES AHD LIMITATIOMS FOR AHALYZIHG THII TBAMSITIOM 

With the partial exception of ETA—MACRO and Salant/ICF, none of the 

models was explicitly designed to analyze the transition to alternative energy 

sources. Each focuses on the production and consumption of conventional 

resources over the medium term. As a consequence, all the models required 

exogenous assumptions about the backstop. In most, non—conventional energy 

116 
production rates closely followed the limits specified in the study design. 

However, in OILTANK and ETA—MACRO, investment in backstop capacity is a 

function of current or anticipated backstop profits. This latter approach is 

to be preferred to an exogenous specification of the backstop supply, as it 

allows examination of the effects of basic forces governing backstop supply. 

But even these analyses are quite speculative. Thus, taken as a whole, the 

results of this study allow us to draw conclusions about the sensitivity of 

the oil market to the level of backstop supply, but give us little insight 

into the future of the backstop industries themselves. 

Another important limitation arises from the difficulty of projecting 

forty years into the future. For example, energy demand in 2020 will depend 

not only on prices, economic activity, and the relevant elasticities, but also 

on the existing capital stock and on the future organization of the economy. 

Since those underlying factors could change dramatically in the next forty 

years, historical estimates of relationships may prove terribly unreliable. 

The eatent to which other fuels may be substituted for oil is another 

important determinant of long—run oil demand. The models vary widely in their 

capability to treat this issue. One group (OILMAR, IPE, OILTANK, Kennedy) 

explicitly represents only oil and not other fuels. Interf uel substitution 

can be reflected crudely in these models by an elasticity of demand for oil 

higher than would be appropriate for all energy. But this provides at best a 

crude approximation. In a second group of models (Gately, OPECONOMICS) some 

or all forms of energy are assumed to be perfectly substitutable. This 

exaggerates the potential for substitution between fuels. Finally, a third 

group (IEES, WOIL, ETA—MACRO) include oil within the context of supply and 

demand for all energy types. In these models the possibilities for interfuel 

substitution are represented explicitly. We feel models in this last class 

show most promise for examining long—run issues. 

117 
5QMKABY 

The world economy is not running out of energy; rather, the less costly 

sources of oil are becoming scarce. We are in the midst of a transition from 

cheap depletable energy sources to renewable or non-depletable alternatives. 

During this transition period the price of oil may rise well above the 

cost of alternatives. Depending on how much alternative supply is available, 

this overshoot could be major or minor. But unless massive quantities of 

backstop energy are available, we can expect oil prices to exceed average 

production cost of these alternative energy sources. 

The availability of alternative energy sources will have a major impact 

on the economies of every region in the world. Oil-consuming nations stand to 

gain significantly from any actions that expand future supplies. Likewise, 

oil-producing nations stand to lose if technological advances increase world 

oil supply. Nations that produce alternative fuels during the transition will 

reap large profits as oil prices overshoot the cost of alternatives. The 

economic consequences of alternative choices may be great. 

118 
IN CONCLIISION 

We have attempted to apply ten of the most prominent models of the world 

oil system to a number of issues central to energy policy and planning. Zn 

this exercise we have seen that the models are particularly useful for 

examining medium—run trends in the world oi1 markets and far less useful for 

examining short—run adjustment dynamics. As a class, they are relatively weak 

for examining sudden shocks caused by supply disruptions. Thus, further 

research and modeling efforts will be required to develop tools effective for 

examining processes of sudden adjustment. 

For very long—term analysis, the models have been shown to be useful for 

evaluating the world oil consequences of alternative backstop growth paths but 

not useful for projecting these paths themselves. Most models do not examine 

all energy carriers but either include only oil or all energy as an aggregate. 

Thus, most cannot explicitly examine the role of interfuel substitution as it 

relates to very long—term world oil trends. 

For projecting medium—run trends, however, the model limitations are of 

less consequence. And the models as a class do represent those elements of the 

world oil system which seem most important for mid—range analysis, although 

differences among the models still exist, representing differences in theory 

or data about the future evolution of the world oil markets. 

Use of the models has underscored the continuing uncertainty about future 

oil market conditions. We have identified very plausible situations in which 

constant dollar world oil prices wi11 rise only slowly and other disturbingly 

plausible situations in which prices could suddenly explode, perhaps tripling 

or quadrupling within a one to two year period. 

Even with the great differences among the models, we have been able to 

reach a number of conclusions robust across the models and scenarios. These 

conclusions relate to the future trends in the world oil market, the impacts 

119 
of possible supply interruptions, the value of import reductions, and the 

transition to alternative energy sources. 

The overall conclusions are not happy ones for the oil importing nations, 

but they do suggest the importance of aggressive energy policy actions. If 

these models and scenarios do correctly represent likely world oil futures, 

then we can expect the real price of oil to decline or remain stagnant for 

several years but then to rise significantly, the era of oil to continue, the 

oil importing nations to remain dependent on OPEC for oil supplies and 

vulnerable to interruptions of those supplies, and short—run or long—run 

import reduction measures, if taken, to significantly benefit the oil 

importing countries. 

120 
'W WR ~ 

1 The real price is the price adjusted for inflation. See Appendix B for a 

definition of this concept and some other economic concepts used in the 

discussion. The first use of a word listed in Appendix B will be marked with 

the symbol t. 

2 OECD premium values ranged between above $23 and $62 per barrel. The 

central seven of nine results range between $27 and $61 per barrel (all 1981 

dollars). U.S. premium values range between $8 and $18 per barrel for both 

the set of all nine results and for the central seven. 

3 This assumes a decrease in OPEC production levels from below market 

clearing rates. Reductions in OPEC production to meet demand reductions of 

course do not have the impact of increasing prices but rather of avoiding 

price decreases. 

4 The Energy Modeling Forum is administered at Stanford University within 

the Departments of Engineering—Economic Systems and Operations Research and 

under the auspices of the Institute for Energy Studies. Funding is provided by 

the Electric Power Research Institute, the Department of Energy, and the Gas 

Research Institute. 

5 The complete report will be published by Ballinger Publishing Company 

under the title:WorldOil. 

6 The fourth EMF study, "Aggregate Elasticity of Energy Demand" extensively 

studied demand elasticities for the aggregate of all energy. Oil elasticities 

were not separately examined. 

7 In running the Salant/ICF model, ICF incorporated a non—stationary linear 

demand curve designed to "mimic" slow adjustment of demand to price changes. 

8 A more complete discussion of this issue as it applies to the Gately model 

appears in footnote 14. 

9 The Salant/ICF model need not be run under these assumptions. These 

specific assumptions were selected by ICF as they ran the model. 

10 In IPE key decisions are investments in eaploration and development. 

11 Equivalently, the Eta—Macro model can be seen as projecting OPEC exports 

to OECD as an increasing function of oil price. The relationship shifts 

exogenously over time to accommodate increased non—OECD oil consumption. 

12 The Primary Energy elasticity is calculated with prices and quantities 

measured at the port of entry, mine mouth, or wellhead. 

13 The price of oil to which we refer is neither an OPEC contract price nor 

a spot market price, but rather an average of the various prices at which 

Saudi Arabian light crude might be sold. For a detailed discussion of oil 

price definitions and historical data, see Chapter ?. 

14 In reporting results for the Gately model, a problem of consistency among 

inputs was recognized. The study design allowed modelers to choose a 

standardized oil demand elasticity or a standardized elasticity of demand for 

aggregate energy. Gately chose the latter when running his model. Since the 

121 
Gately model incorporates an implicit assumption that all forms of energy are 

always perfect substitutes for one another, a standardization of energy price 

elasticities among models implies that the oil price elasticity in the Gately 

model will be significantly higher than in models which treat the various 

energy forms as imperfect substitutes or than in the oil-only models. Running 

the Gately model with an aggregate energy demand elasticity of -0.4 implies an 

oil demand elasticity of about -1.0, a figure far higher than specified in the 

study design. The net result was that the Gately projections were judged to 

be based upon inputs not consistent with those chosen for the other models. 

Rather than discarding the Gately results or simply accepting the 

inconsistency, we have chosen to use the Gately Low Elasticity Case in place 

of the Reference Case when reporting the results for a11 Tables and Figures 

except Figure 8("Scenarios and Price Results"). This substitution results in 

an implicit oil price elasticity of about -0.7, a figure far closer to that 

used in the other models. Whenever possible, we substituted cases including a 

low elasticity of energy demand. Throughout this report, the following 

substitutions have been made for the Gately model only: 

Low Elasticity (3) for Reference (1) 

Oil Demand Reduction/Low Elasticity (4) for Oil Demand Reduction (2) 

Disruption/Low Elasticity (9) for Disruption (7) 

Unfortunately, a more complete set of substitutions was not possible. 

Mathematically: 

(elasticity of demand for oil) _ 

(energy quantity/oil quantity)*(elasticity of demand for energy) 

-(non-oil quantity/oil quantity)*(elasticity of supply of non-oil). 

For 1980, with an energy elasticity of demand of -0.4, this equation 

becomes: 

-1.0 = 2.0*(-0.4) - 1.0*(0.2) 

With an energy demand elasticity of -0.25, this becomes: 

-0.7 = 2.0*(-0.25) - 1.0*(0.2). 

The figure of 0.2 for the elasticity of supply of non-oil is based upon the 

Gately model elasticity of supply of all non-OPEC energy of 0.2. Notice that 

changes in the value of this elasticity would not change our conclusion that 

the Low Elasticity scenario incorporates an oil demand elasticity closer to 

the study design than does the Gately Reference run. 

15 In making the runs, all costs and prices were specified in 1979 dollars. 

However, all prices are reported in this summary in terms of 1981 dollars. To 

convert from 1979 dollars to 1981 dollars, all prices were scaled upward by 

the increase in the GNP implicit price deflator between the first quarter of 

1979 and the first quarter of 1981. Thus all model-reported prices were 

scaled upwards by a factor of 1.19 for this summary. 

16 The prices in Figures 1 and 2 differ from each other even for 1980, the 

year in which the runs were conducted. This occurs primarily because the 

models have been benchmarked differently. Some, such as Salant/ICF and 

Kennedy/Nehring do not use recent prices as inputs to the models. Most of the 

others do use recent price data but are benchmarked at some year prior to 

1980. 

The high prices in the Salant/ICF model seem to occur because ICF 

imposed constraints on maximum production rates of OPEC, LDC, and backstop 

oil. The frequent imposition of such flow constraints by users of this model 

is not uncommon. While in the Reference Case these exogenous constraints do 

not bind for more than a decade, their effect on price is felt much earlier 

because this model includes an assumption of perfect foresight (see footnote 

19). 

122 
17 In developing the analysis underlying Figure 3, oii demand is projected 

separately for the OECD and for the combination of OPEC and LDC's. Oi1 demand 

for each group is benchmarked at actual 1980 levels. An income elasticity of 

1.0 is used for the OECD nations and of 1.2 for OPEC and the LDC's. Average 

levels of economic activity grow at 3% annually for the OECD and at 5% 

annually for the LDC's and OPEC. The long-run price elasticity is assumed to 

be -0.6. However, demand is assumed to adjust slowly in response to price 

changes, with only 10% of the remaining long-run adjustments to price 

occurring in each year. The adjustment process is initiated in 1971 under an 

assumption that 1972 was in long-run equilibrium. 

The equations used were as follows: 

D(t)/D(1980) = [X(t)/X(1980)] [Y(t)/Y(1980)] for OECD 

D(t)/D(1980) =[X(t)/X(1980)] LY(t)/Y(1980)1 1 ' 2 for LDC and OPEC 

X(t) = X(t-1) 0 • 9 [P(t)/P(1972)] (0.1)(-0.6) 

X(1972) = 1.0 

P(t)/P(1972) = 1.13,2.67,2.59,2.71,2.62,2.36,2.87,4.00 for 1973,1974 ... 

1979,1980 respectively 

= 4.00 for 1980 and later 

where, 

t is time, D(t) is demand at time t, Y(t) is the level of economic 

activity at time t, P(t) is oil price at time t. 

The supply estimates begin with actual 1980 quantities produced. These 

were estimated to equal the 1980 consumption plus 0.6 MMBD to account for the 

increase in oil stockpiles during 1980. 

18 These graphs were derived by subtracting OPEC production from WOCA 

production. OPEC production (and hence non-OPEC production) is not available 

beyond 2000 for the Rennedy/Nehring model because of a reporting error. 

19 ln these particular runs of the Salant/ICF model, ICF assumed that firms 

face constant per unit extraction costs up to some exogenously determined 

maximum extraction rate (which cannot be exceeded). Constraints were imposed 

on production by OPEC, the LDC's, and the backstop; in particular, for 

conventional resources, the maximum ratio of production to remaining resources 

was set at 0.10. In the Reference Case these constraints begin to bind after 

fifteen years. The effects are apparent in Figure 21 (see following 

footnote). OECD extractors initially withhold oil in anticipation that the 

constraints will be binding on other producers. Once these constraints do 

begin to bind, OECD producers rapidly expand production. 

Figure 21 also displays two other peculiarities in production projections 

of the Salant/ICF model. OECD extraction (and all other extraction) drops 

suddenly after 2002; production by OECD (and a11 non-LDC) surges suddenly 

after 2015. The drop occurs when price rises above backstop cost and backstop 

production suddenly is increased from nothing to full capacity of 6 MMBD. The 

sudden surge occurs after 2015 because the inexpensive LDC oi1 is projected to 

run out by that date. 

Figure 4 shows that the irregularities in production are offsetting; no 

jumps are noted in total non-OPEC production. It is expected that the 

irregularities in production would not show such severe discontinuities if the 

ICF cost curves were replaced with assumed marginal costs which increase 

continuously with the production rate. 

123 
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1980 1985 1990 1995 2000 2005 2010 2015 2020 

OECD CRUDE OIL PRODUCTION 

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20 These conclusions about OECD production are illustrated in Figure 21 

which appears on the page following this one. 

21 Median values were taken independently for the four consumption 

estimates. Therefore the OECD, LDC, plus OPEC estimates may not add to the 

WOCA estimates. In particular for the years after 2000, WOCA estimates tend 

to be higher than the sum of the three components. 

22 The model-based projections of Figure 5 differ significantly from the 

demand estimates in Figure 3. This difference occurs because Figure 3 is 

based upon constant real prices while the Figure 5 is based upon the higher 

market clearing prices. Thus the projections of the former figure can be 

expected to be higher than those of the latter, as they are. 

23 This comparison requires estimating the oil demand reductions associated 

with the Low Economic Growth scenario, then dividing price changes by these 

estimated demand reductions to obtain the world oil price reduction per 1 MMBD 

of demand decrease. If world oil demand is 51 MMBD and the total consumption 

of energy is 120 MMBD oil equivalent, then a 10% reduction in the GNP for each 

nation can be expected to reduce world oil demand by 5.1 MMBD and world energy 

demand by 12 MMBD. 

Results appear in Table 13 (page following this one). The first column 

shows oil price reductions per 1 MMBD import demand reduction for each model. 

The second two columns show price impacts of reduced economic growth. Numbers 

in the second column (labeled "all energy") are calculated by dividing by the 

total energy demand reduction, assumed to be equivalent to a 12 MMBD demand 

reduction in 1990 and 29.0 MMBD in 2000. Numbers in the third column (labeled 

"oi1 only") are calculated by dividing price changes by the oil demand 

reduction, assumed to be 5.1 MMBD in 1990 and 10.0 MMBD in 2000. 

For the oil-only models, the price impacts per MMBD oil demand reduction 

obtained from GNP reductions are quite similar to those obtained by policies 

that directly reduce oil demand. The oil-only models are indicated by the 

asterick (*) in the column labeled "oil only". Only one model --OILTANK -- 

shows results differing by more than a factor of two. 

For most models that include all energy, the price impacts per MMBD oil 

demand reduction exceed the price impacts per MMBD reduction in all energy use 

through GNP reductions and are smaller than the price impacts per MMBD oil 

demand reduction caused by GNP reductions. Models including all energy forms 

are indicated by astericks in the column labeled "all energy". For only one 

model -- ETA-l+iACRO -- is the price impact per MMBD of GNP-driven oil reduction 

strictly smaller than the impacts of direct demand reductions. 

24 Exceptions to the expected direction of change are displayed by the 

Salant/ICF and the Kennedy models, in which reductions in the demand 

elasticity lead to consumption reductions in earlier years and increases in 

later years. This behavior is the result of the assumed intertemporal 

optimizing by oil producers, who reduce supply in early years, saving some oil 

for the future. 

The high variability may stem from differences in procedures used by the 

various modelers to calibrate the demand functions. The closer is the 

historical price used in calibration to the projected price, the smaller will 

be the price impact of reducing the assumed elasticity. Thus, those models 

calibrated based on pre-1973 data can be expected to show much larger price 

differences than those calibrated using post-1973 price data. A part of the 

variability may also stem from differences in the point in the supply chain at 

which the price elasticities are measured. Some of the models may have 

implemented a constant price elasticity in the demand for crude oil, while 

125 
TABLE 13 

OIL PBICE REDIICTIOA PEg 1 MOD 

IffiPORT DSlfAAD REDIICTION (1981 Dollars) a 

Oil Demand Reduced Economic Growth 

Models Reduction (All Ener Oil Onl 

1990 

Gately 1.10 0.80 * 1.90 

IEES/OMS 1.10 1.10 * 2.60 

IPE 1.30 0.70 1.60 * 

Salant/ICF 0.90 0.80 1.80 * 

ETA-MACRO 2.00 0.40 * 0.90 

WOIL 2.40 1.40 * 3.40 

Kennedy/Nehring 1.00 0.70 1.70 * 

OILTANK 1.00 1.40 3.40 * 

Opeconomics 0.80 0.40 * 1.00 

OILMAR 3.20 1.50 3.50 * 

2000 

Gately 0.70 0.60 * 1.90 

IPE 1.60 0.30 0.80 * 

Salant/ICF 0.90 0.50 1.30 * 

ETA-MACRO 1.60 0.60 * 1.60 

WOIL 1.50 0.60 * 1.80 

Kennedy/Nehring 0.60 0.30 0.90 * 

OILTANK 1.70 0.90 2.80 * 

Opeconomics 0.50 0.20 * 0.70 

OILMAR 2.00 1.00 2.90 * 

a For Gately, OILTANK, Opeconomics, and OILPIAR, all numbers displayed are 

five year averages of model results. For Kennedy/Nehring the Reduced Economic 

Growth numbers are five year averages. This averaging was needed because of 

the oscillatory nature of the results from these models. 

126 
others may have done so for the demand for refined oil, according to the logic 

of the particular model. These disparate procedures could, in a world where 

the markup on crude oi1 remains constant for all prices, cause divergences in 

the projections of oil prices. Finally, the result could in some way be 

related to the existence of an energy-GNP feedback mechanism in the model: 

those models with such a feedback mechanism show the four smallest price 

impacts. 

25 Estimate by Exxon Corporation. 

26 Disruption scenario results from three models--OPECONOMICS, IPE, and 

Salant/ICF--are not presented or discussed further here because: (1) results 

from OPECONOMICS for a 10 MMBD disruption were never submitted (although 

results for the previously requested 5 MMBD disruption showed almost no 

effects); (2) for IPE, the disruption was implemented so as to include 

anticipatory behavior by oil consumers, violating the study design, and (3) 

the Salant model includes a demand function in which the long-run and the 

short-run demand elasticities are identical and in these runs equal to -0.6. 

The group decided that the implementations of the disruption scenarios in 

these three systems did not adequately capture the intent of the scenario 

specifications. 

27 In addition to the differences discussed, only one model -- Gately -- 

explicitly includes releases of oil stocks during the disruption. The release 

of 1 MMBD of oil stocks, assumed for these model runs, has a price impact 

equivalent to that of increasing the pre-disruption excess capacity by 1 MMBD. 

28 The Oil Demand Reduction Scenario postulates a 5 MMBD reduction in OECD 

oil demand in 1985 when the disruption is assumed to occur. The calculating 

procedure is similar to that of Figure 8. See the complete report for the 

precise calculations. 

29 piore expensive projects might be justified on the basis of costs of oil 

imports which we did not consider in estimating the premium, such as the 

macroeconomic implications of disruption shocks. 

30 The calculation described in the text -- equivalent to multiplying the 

price change per unit of import increase ($0.90 to $2.40 per barrel/MMBD) by 

the quantity imported (5.5 MMBD), to obtain or $4.95 to $13.20 per barrel -- 

is in fact slightly incorrect. An integration under the net import demand 

curve is required. Such a theoretically correct procedure would give a market 

power premium between $5.18 and $13.80 per barrel under our Reference case 

assumptions. 

We can extend the logic of the example further. Suppose that one 

individual decided to import 0.5 million additional barrels of oil per day, 

thereby driving prices upward. The increased prices would cause all other 

users to decrease their demand for oil. Therefore, the actual import increase 

would be less than 0.5 MMBD. The new importer would have imposed "external 

costs" on all other users of oil equal to the price increase multiplied by 

their quantities of oil consumed. They face no additional net cost as they 

cut back on their use of oil, under the assumption they were initially 

optimizing. The market power premium is this external cost, the cost imposed 

on others, per unit of increased demand by the new importer. The market power 

premium is not measured by the external cost per unit of increased total 

consumotion by all users. Thus, the denominator for the premium calculations 

is the change in the import demand function, not the actual change in imports 

after price adjustments have taken place. 

127 
31 Discoust rates of 3 percent real have been used. 

32 The total import premium is computed by taking the expected value of the 

benefits per unit of import reduction -- the sum of the per unit benefits in 

the disrupted cases and in the non-disrupted cases weighted by their 

respective probabilities. The security component as we have defined it is 

just the total premium minus the market power component. 

33 The market power component is evaluated by comparisons of the Oil Demand 

Reduction Scenario to the Reference Scenario, and of the Oil Demand 

Reduction/Low Elasticity Scenario to the Low Elasticity Scenario. The 

security component is evaluated by comparing the Disruption/Oi1 Demand 

Reduction Scenario to the Disruption Scenario. 

34 In calculating the security component we have used disruption cost 

reductions from Table 9 as approximations to the effects of a 10 MMBD, oneyear interruption. This procedure can be expected to understate the component 

since it ignores the possibility that price increases occurring during the 

disruption may remain afterwards (remember the ratchet effect). Since the 

disruption occurs when the demand curve has been shifted by 5 MMBD, the 

component has been obtained by dividing the cost reductions in Table 9 by 

1.825 billion barrels per year, the import reduction expressed on an annual 

basis and subtracting the market power component. 

A more accurate estimate would be obtained if the numerator were a 

discounted sum of the cost reductions and the denominator were a discounted 

sum of demand reductions. If cost reductions and demand reductions are 

constant over time, then this procedure would be identical to that one used. 

Since this assumption does not hold precisely, inaccuracies are introduced by 

our procedure. 

35 This implies a 40 percent probability of such a disruption occurring at 

least once in the next ten years. 

36 In Energy Future: Renort of the Energy Proiect at the Harvard Business 

School, 1979, New York, Random House. 

37 In "Import Management and Oil Emergencies," Energy and Environmental 

Policy Center, John F. Kennedy School of Government, Harvard University, 1980. 

38 In "The Energy Problem: Costs and Policy Options," Office of Oil Policy, 

U.S. Department of Energy, 1980. 

39 This will occur if backstop capacity cannot grow rapidly enough to 

satisfy oil demand (net of conventional oil production) at the backstop cost. 

40 In OILTANK price projections vary before 1996 because, unlike other 

models, OILTANK allows backstop production in the 1990-1995 interval. 

41 The "1980 actuals" data in Table A5 were taken from the BP Statistical 

Review of the World Oil Industrv. 1980, except for OPEC oil consumption, from 

International Energv Statistical Review, May 26, 1981, and price, from Weekly 

Petroleum Status Renort, February 6, 1981. 

Non-OPEC LDC consumption and production are residuals. Production 

includes natural gas liquids (NGL) in both the actuals and the model 

projections. Consumption excludes U.S. processing gains (0.6 MMBD). OPEC 

production includes crude oil only. 

128 
APPENDI% A 

NIIAfEBICA7. IftPt TS AHD OIITPUTS 

Tables A1 through A4 provide numerical assumptions defining the 

scenarios. Table Al provides a schematic representation of the scenarios, 

describing them in terms of the key input variations. Table A2 shows oil 

demand reductions for those scenarios which examine such reductions. Table A3 

presents assumed maximum production rates for backstop energy in the three 

cases. Finally, assumed growth rates of GNP appear in Table A4 for the 

Reference case and the Low Economic Growth case. 

Tables A5 through A9 display quantity (and price) projections by the 

various models for the years 1980, 1990, 2000, 2010, and 2020. Oil production 

and consumption data are separately displayed for several regions: OECD, 

U.S., Europe, OPEC, non-OPEC LDC's, and WOCA total. Primary energy 

consumption and production estimates appear for OECD and WOCA totals. In 

addition, exports from OPEC and imports to the OECD are tabulated. Finally, 

the world price projections are presented. 

A.1 
table A1 

Scenario Descriptions' 

Demand 

Scenario Reductions 

Long-Run 

Primary Energy 

Demand Elasticity 

Economic OPEC 

Growth Production 

Rate Capacity 

Non-Conventional 

Energy 

Supply 

E 

E. 

1. Reference none Oil: -0.6 See 34 hLMBD $60/bb1 

energy: -0.4 Table A3 Limited 

Quantities 

(Appendix B) 

2, Oil Demand 20 2ufBD by 

Reduction 2020 

3. Low Elasticity -0.375, 

-0.25 

Oi1 Demand 

4. Reduction/ 20 I,".fBD by ~ -0.375, 

Low Elasticitv 2020 -0.25 

5. Low Economic 2/3 of 

Growth Reference 

Rates 

6. Restricted 50Z of Reference 

Bac'Kstop Limits 

7. Disruption 24 NLdBD 

from 

1985 on 

S. Technological $40/bbl;Increase 

 Breakthrough Limits 

i 

9. Disruption/ -0.375 24 r2•?BD 

Low Elasticity -0.25 from 

1985 on 

10. Optimistic 20 PIl4fBD by Gradual $40/bbl Increasf 

2020 Increase Limits 

40 rM D 

;n IO R7 

Oil Demand 

11. Reduction/ 20 PfLffiD by 24 TLMBD 

Disruption 2020 from 

Lo85 on 

12. Eigh Price 

I 

I 

Blank bo}:cs imply the reference case value is to be used Reference case values do 

not override endogenously determined values. 

A.2 
Table A2 

OII. D&MAND RHDIICTION CAS&: REDIICTIONS 

Demand Reduction 

Y ear ( MNiBD ) 

1980 0.0 

1981 1.0 

1985 5.0 

1990 6.67 

2000 10.0 

2010 15.0 

2020 and after 20.0 

Table A3 

BACRSTOP MA%IAAJM PRODIICTION LEVffi.S 

Restricted Technological 

Year Backstop Reference BreakthrouQh 

1995 0.0 0.0 0.0 

1996 0.5 1.0 1.0 

2000 2.5 5.0 5.0 

2005 5.0 10.0 10.0 

2010 10.0 20.0 20.0 

2015 13.75 27.5 40.0 

2020 17.5 35.0 80.0 

A.3 
Table A4 

ANNUAL GROWTH RATES OF GNP FOR CONSTANT WORLD OIL PRICES: 

REFERENCE AND LOw ECONOMIC GROWTH ASSUMPTIONS 

1980-2000 

Reference Low Economic 

Growth 

Post 2000 

Reference Low Fconomic 

Growth 

OECD 

U.S. 

Canada 

Asia-Oceania 

Europe 

3.1% 2.07% 2.1% 1.407 

3.5% 2.33% 2.5% 1.67% 

4.1%, 2.73% 3.1% 2.07% 

2.6% 1.73% 1.6% 1.07% 

OPEC 6.4% 4.27% 4.4% 2.93% 

LDC's 5.1% 3.40% 3.1% 2.07% 

A.4 
Tabit- A5 

1d0St11) 011, Ai,,D N',ICl? 

1906>Y T I' I' I >TA / 01 , 1: C - 

'C', ly L E S:1 1; ~ wo I 1 1, (1 () J 0 J L" 

Actim 1 li'llcilo 1 r C I "t 

C Oil Yzbdnct imi 

(vow) 

3.6 14. 5 1 15.0 1 >.7 

U. S. I 0 ° 2 10.6 Ind 2 .8 10.9 9.5 12.4 Me 

To ropa 2 . 5 2.3 2.6 0,3 2.2 

Ot l' 1, C T c I a 1 27.3 28.6 28.0 31.0 30.6 30,7 31.0 31.5 30.3 26.7 

5.8 5.9 5.7 6, 11 5.3 5.2 

WOCA 'lota 1 10.9 30.1 52.1 4p, 6 51 Zl 47 .7 51 . 51 .2 4u. 5 

L j 

;;iDO LC I 

UL , ,'Otl-,l 52.1 

Woo, Towl 96.1 MCI 101.2 

cion P) 

OD 1) PoLnl 38.0 39.8 41.2 32.1 36.7 42,3 19.2 U.S 4 0.8 

U.S. 163 17.6 17.6 14.2 18.8 17.0 20, 17. 5 

Etlrcl,c 14.0 14 .4 1 6 . /, IJ 2 14 .11-1 

OPIT votal 2.8 2. 7 2.7 7..9 2.1 2,7 2 . 2 . 

6 7.69.0 6.4 i . 5 7.3 

49.0 50 1 52 . 1 40.6 52.5 52.2 50, 

' - 1 -j 

i 

76.3 74.3 77 A 

1 N 7 A I w . 1 95.5 97.9 95.6 101.2 

I Tr, 

J;.I j 23.1. 21; 1 2', . /i i F.S 2 26.1 27.C, 25. 

i peri 25.3 241 22. 5 28.0 31 T 26.9 273 2s. i 

I y0% 31.1 32.1 31.9 35.3 43.7 32n 11.6 in 1 31.3 SCO 32. 

See Footnote 41 for sources. 

A.5 
Table A6 

WORLD OIL SUPPLY, DEMAND, AND PRICE 

REFERENCE CASE, 1990 

Gately IEES- IPE Salant 

ETA/ WOIL Kennedy OILTANK OPEC- OILMAR 

OMS MACRO ONOMICS 

Oil Production 

(MMBD) 

OECD Total 15.6 16.3 10.1 13.2 10.1 12.9 17.2 

U.S. 9.8 9.5 5.5 8.7 7.9 9.5 9.0 

Europe 3.5 4.4 2.2 3.0 

OPEC Total 30.4 28.4 22.4 32.0 29.6 31.0 29.6 27.1 34.0 

LDC (Non-OPEC) 10.5 10.9 10.0 7•3 5.8 

WOCA Total 54.4 49.6 52.1 53.5 46.8 49.8 50.1 55.7 

Primary Energy 

Production 

(MPfBDOE) 

OECD Total 62.2 

tdOCA Total 119.2 125.0 117.13, 

Oi1 Consumption (MMBD) 

OECD Tota1 39.3 36.1 36.8 35.4 38.0 36.5 34.6 39.6 

U.S. 17.3 15.5 14.0 15.9 15.8 17.1 18.9 

Europe 12.9 12.1 11.4 11.7 

OPEC Total 4.0 5.2 3.7 2.7 5.5 3.2 3.1 

LDC (?don-OPEC) 9.5 9.8 12.5 10.8 9.6 7.0 

,dOCA Total 54.4 49.6 52.1 54.4 47.4 49.7 55.7 

Primary Energy 

Consumption 

(MDIBDOE) 

OECD Total 84.3 92.1 

G70CA Total 119.2 125.0 117.3 

Oil Trade 

(MMBD) 

OECD Imports 

OPEC Exports 

Price ( 1981$/ 

SdOCA 

23.7 19.8 26.8 22.2 26.4 23.9 22.4 

23.2 18.7 29.3 24.1 31.0 26.4 23.6 34.0 

52.9 46.1 37.2 55.5 50.6 47,8 56.8 63.0 39.7 64.0 

A.6 
Table A7 

WORLD OIL SUPPLY, DEMAND, AND PRICE 

REFERENCE CASE, 2000 

IEES- ETA/ OPEC- Gately IPE Salant ~JOIL Kennedy OILTANK ONOMICS OILPIAR 

OTfS MACRO 

Oil Production 

(MNBD) 

OECD Total 10.5 18.5 10.2 13.2 11.8 17.2 

U.S. 5.1 6.9 8.3 7.6 8.7 7.0 

Europe 2.8 4.5 2.7 

OPEC Total 31.3 2 7 • 7 33.9 28.8 31.0 28.7 30.6 31.5 

LDC (Non-OPEC) 14.3 12.5 8.1 5.8 

WOCA Total 52.5 64.9 53.2 47.7 48.6 53.6 52.0 

Primary Energy 

Production 

(MMBDOE) 

OECD Total 77.9 

WOCA Total 152.2 161.0 151.7 

Oil Consumption (!-L*BD) 

OECD Tota1 34.4 40.2 36.5 35.7 35.6 30.9 40.3 

L`.S. 15.5 13.4 13.9 14.9 15.2 17.3 

EuroDe 10.8 10.9 9.9 

OPEC Total 5.9 8.6 3.9 8.1 4.6 6.1 

LDC (Non-OPEC) 11.9 20.8 14.8 11.7 7.2 

F:OCA Total 54.8 64.9 58.7 47.2 53.6 56.3 

Primary Energy 

Consumption 

(:,1MBDOE) 

OECD Total 99.3 110.0 

WOCA Total 152.2 161.0 151.7 

Oil Trade 

(MMBD) 

OECD Imports 21.5 21.7 21.3 17.4 20.1 23.1 

OPEC Exports 19.1 30.0 20.7 31.0 24.1 24.5 31.6 

Price (1981 $/b) 

WOCA 71.7 54.6 71.3 80.2 69.6 77.5 92.1 41.5 86.8 

A.7 
Table A8 

WORLD OIL SUPPLY, DEMAND, AND PRICE 

REFERENCE CASE, 2010 

IEES- ETA/ OPECGate1 

y 

IPE Salant WOIL Kennedy OILTANK OILMAR OPiS h".ACRO ONOMICS 

Oil Production 

_ (MhiBD) 

OECD Total 6.7 7.9 7.4 7.8 

U.S. 2.1 6.1 3.7 5.7 5.0 

Europe 2.0 1.8 

OPEC Total 27.9 34.0 28.1 29.3 31.0 

LDC (Non-OPEC) 12.5 7.0 

L:OCA Total 53.3 50.0 38.3 44.1 49.5 

Primary Energy 

Production 

0u*SBDOE) 

OECD Total 99.7 

WOCA Total 183.5 206.0 

Oil Consumption ( 1114 D) 

CECD ToLa1 39.2 41.7 35.8 35.2 28.5 

L~ ,S, 11.6 13.8 14.5 14.0 18.7 

Euroae 9.4 

OPEC Total 8.8 5.1 10.6 6.1 

LDC (Non-OPEC) 29.0 19.2 13.0 

410CA Total 73.3 65.5 47.6 66.9 

Primary Energy 

Consumption 

(^LSBDOE) 

OECD Total 117.7 106.0 

idOCA Total 183.5 206.0 

Oil Trade 

(MMBD) , 

GECD Imports 32.9 18.0 8.6 18.8 

OPEC Exports 28.0 17.6 31.0 23.6 31.0 

Price ( 1981 $/b ) 

',,'OCA 71.3 88.8 64.1 81.8 71.4 129.7 120.2 

A.8 
Table A9 

WORLD OIL SUPPLY, DEMAND, AND PRICE 

REFERENCE CASE, 2020 

Gately IEES- IPE Salant ETA/ idOIL Kennedy OTLTANK OPEC OILMAR 

OMS MACRO ONOMICS 

Oil Production 

(MMBD) 

OECD Total 11.3 6.1 2.7 4.4 

U.S. 4.7 2.9 1.6 3.1 3.0 

Europe 4.0 1.1 

OPEC Total 26.1 34.0 26.2 27.4 31.9 

LDC (Non-OPSC) 2.5 5.4 

WOCA Total 47.8 44.4 31.7 37.1 48.4 

Primary Energy 

Production 

(MMBDOE) 

OECD Total 124.7 

WOCA Total 222.5 262.0 

Oil Consumption (MMBD) 

OECD Tota1 38.3 49.3 40.5 38.1 27.9 

U.S. 10.6 14.6 15.6 13.6 21.4 

Europe 8.2 8.0 

OPEC Total 13.0 6.4 14.1 8.5 

LDC (Non-OPEC) 38.1 24.8 15.3 

WOCA Total 82.8 79.4 51.7 82.3 

Primary Energy 

Consumpti.on 

(MMBDOE) 

OECD Total 140.2 167.0 

WOCA Total 222.5 262.0 

Oil Trade 

(MMBD) 

OECD Imports 27.0 15.6 0.6 13.6 

OPEC Exports 27.6 12.1 31.0 20.7 31.9 

Price (1981 $/b) 

WOCA 93.8 106.1 68.9 69.1 71.4 152.3 127.3 

A.9 
APPENDI% B 

A BRIEF GLOSSABY OF ECONOMIC TERMS 

Consumers' surplus: when prices of a commodity increase, consumers of that 

commodity are made worse off while decreasing prices make consumers better 

off. Consumers' surplus is a monetary measure of how much consumers are 

harmed or benefitted. In particular, the change in consumers' surplus is an 

approximation of the amount of income or wealth a consumer would be just 

willing to forego in order to be able to buy the commodity at the lower price. 

Alternatively it is an approximation to the amount of income or wealth a 

consumer would require to be indifferent between receiving the income (or 

wealth) and facing the price reduction. 

Discounted Sum of costs or benefits: Same as Present value of costs or 

benefits. 

Externalities: an indirect consequence that is not conventionally measured 

among the economic costs or benefits or an individual project or enterprise. 

The standard illustration of this idea is provided by smokestack emissions 

during the era prior to environmental controls. 

Price elasticitv of demand for enerQV: the percentage reduction in energy 

demands associated with a one percent increase in the price of energy relative 

to other commodities, with GNP and other factors that influence energy demands 

held constant. 

Partial eauilibrium: an approximation in which is is supposed that the energy 

sector has only a minor impact upon the long-run rate of GNP growth. By 

contrast, a aeneral eauilibrium analysis allows for the indirect impacts of 

the energy sector upon the GNP--hence requires more data inputs. 

Present value of costs or benefits: a capital sum with an economic value 

equivalent todav to afuture stream of costs or benefits. Depends upon the 

discount rate employed to convert future costs and benefits to their present 

value. Whenever a high discount rate is employed, this means that distant 

future costs or benefits will have a low present value. 

Real price: the price of a commodity denominated in dollars of constant value, 

such as 1979 dollars. The real price is calculated by deflating the nominal 

price by an index (e.g., the GNP implicit price deflator of the Consumer Price 

Index) which reflects the general inflation throughout the economy. 

Primarv Elasticity: The elasticity calculated with prices and quantities 

measured at the wellhead, minemouth or point of entry. Elasticities could 

also be delivered at the secondary level (electric utility busbar or the 

refinery gate) or at the retail level. The farther down in the supply chain 

elasticities are measured, the higher is the calculated elasticity. 

B.1