ECON 3090: Energy Econ - Chapter 4-6 HW & quizzes

Geologists predict that non-renewable fuel sources such as oil will be depleted in the near future due to overuse. Economists tend to disagree with this viewpoint. Explain the logic behind the economist's viewpoint.

Geologists base their view on absolute physical scarcity, while economists base theirs on relative scarcity, as measured by price or opportunity cost. The physical view, as typified by Hubbert, does not take price into account. Higher prices stimulate conservation, substitution, and new technologies, all of which help to alleviate relative scarcity.

Referring back to question 6, what factor makes it difficult for the cartel to stick to its agreement in the short run? What about the long run?

In the short run individual producers want to exceed their quota. In the long run new producers can enter the industry.

Provide a strength and weakness of the dominant firm price leadership model as it applies to OPEC.

Strengths are Saudi Arabia dominates OPEC decisions. Weakness are other countries don't simply follow such as Iran wants to increase production. Venezuela wants to reduce output. Restore P = $100/bl.

Explain the key FERC regulations that deregulated the natural gas industry, and which stage of the supply chain they targeted.

-436, 636 •Pipelines first given the option and then required to transport natural gas. No longer allowed to market NG. Midstream stage -If you discussed 1978 partial deregulation of NG prices at the wellhead. Upstream stage.

You own an airline that decides to buy a fuel oil contract to hedge against a possible increase in the price of jet fuel if OPEC is able to stick to its agreement in Question 12. If you are a hedger, should you buy a put or a call option?

-Call option: Right to buy underlying good at "strike" price. -Put option: Right to sell underlying good at "strike" price. •If SW Airlines expects price of jet fuel to rise. Buy call option. If strike price = $50 and oil is $60 one month from now, option will increase in value •Sell option for profit to offset higher price of jet fuel.

Describe the potential impact rising carbon costs will have on natural gas's place in the electricity sector.

-Carbon pricing will increase the price of natural gas, but by less than coal (or oil). -As nuclear and renewables do not emit carbon, their price will be unaffected, so their LCOE will be unaffected, while that of NG will increase.

You buy a NYMEX WTI Crude Oil Futures 1,000 barrel contract at a price of $70 per barrel. You decide to buy on margin where the margin requirement is 20%. In November, the price of oil rises to $77 per barrel based on expectations that OPEC will reduce oil supplies. What will be your percentage profit or loss on the contract?

-Futures contract would cost 1000*$70= $70,000. If you buy on margin, you only need to pay $14,000 (20%). -If price rises to $77, the contract has increased in value by $7000, a 50% return on your investment based on buying at a 20% margin. A profit of 50%

How does the levelized cost of natural gas compare to renewable sources of fuel used to generate electricity? What concerns do you have about this comparison?

-Levelized cost of NG is higher than for renewable fuels (solar, wind), even in the absence of subsidies for renewables (solar currently receives a subsidy). -Concerns: Renewables are intermittent. If we adjusted LCOE to take into account the high cost of backing up renewables with natural gas peaker units, as well as the costs to electric utilities of integrating those fuels, their LCOE would increase. However, if we put a price on carbon, the LCOE for NG would increase.

Provide a strength and weakness of the cartel model as it applies to OPEC.

-Strength are that it describes quota process and restrict output to raise price. -Weakness are doesn't get at outsized role of Saudi Arabia a swing producer.

U.S., EU, Japan. How do NG prices compare in these three locations, and why do they differ?

-U.S. lowest, EU middle, J highest. But EU catching up with Japan recently. •U.S. fracks, EU imports NG via pipeline (from Russia) and LNG, J needs more LNG (doesn't import from Russia; it's an island).

Provide three reasons why oil prices over time have not followed Hotelling's rule? Does the fact that prices have not followed the rule mean that the Hotelling model is not useful?

1.Technological advances. 2.Extraction costs rise over time. 3.Firms might focus on the short run (myopia)

Approximately what percentage of total energy use in the U.S. is accounted for by oil?

35%

Levelized cost can best be compared to a. Marginal cost b. Average cost c. Total cost d. Fixed cost

Average cost

What characteristic of natural gas infrastructure led to regulation of the natural gas industry in the first half of the 20th century? What type of regulation was used? What is the economic justification for this type of regulation?

Economies of scale (natural monopoly). Average-cost pricing (fair rate-of-return). -Society gains more from one large regulated company than from many small competitive companies.

In a monopoly with MC > 0:

Hotelling's Rule will not hold for a monopoly

In a monopoly with MC > 0: a. Price (P) will increase over time at the rate of interest b. P-MC will increase over time at the rate of interest c. PV (P) will increase at the rate of interest d. PV (P-MC) will increase at the rate of interest e. Hotelling's Rule will not hold for a monopoly

Hotelling's Rule will not hold for a monopoly

Referring to the numbers in question 5, suppose demand increases next year compared to this year. Will this year's output increase or decrease compared to question 5?

If next year's demand increases, next year's price will be higher. So produce less today and leave more for the future.

You think OPEC will stick to its announced plan to cut oil production. If you are an oil refiner needing oil two months from now, explain whether you should buy a put or a call option that expires in two months.

It is a call option to guarantee to have the option to buy the crude oil.

Why does Robert Howarth argue that natural gas is not preferable to coal? Why do some other analysts disagree with Howarth?

Methane emissions as bad or worse than CO2. Howarth measured over 20-year period. Others use 100-year period. Methane has greatest impact over 10 years. CO2 has greatest impact over 100 years. Also, Howarth's data on leakages was not good.

The Governor of Sunnyland is considering using her veto authority on a bill allotting $5 million in subsidies to Do Ray Me, a company that manufactures solar panels. According to the bill's supporters, the $5 million in subsidies today will generate a lump sum of $30 million in benefits in 20 years. The governor believes the bill to be risky and decides to use a discount rate of 9%. Should the Governor veto this bill based on a cost/benefit analysis?

No. The present value of the project's benefits exceed its costs.

According to the cartel model,

OPEC members work together to achieve a monopoly price

In a competitive industry with MC > 0, according to the Hotelling model of dynamic efficiency:

P-MC will increase over time at the rate of interest

The demand for a barrel of oil is P = 40 - 2Q, where Q is gallons of oil and P is $ price per gallon. 25 gallons of oil remain, to be efficiently allocated between the present and one year from now. Marginal cost of extraction is $10. The discount rate is 20%. Find the optimal allocation of Q0 and Q1, and the corresponding prices P0 and P1.

Q0= 12.72 Q1= 12.28 P0= 14.56 P1= 15.44

Assume there are ten countries of equal size in OPEC that face a demand for oil of P = 100 - 0.5Q. Marginal cost (MC) is constant and equal to $20. What will be the cartel price and quantity? How much will each country receive as a quota? What will be the deadweight loss as compared to a competitive oil industry?

Q=160, P=$20 & DWL = $1600 •Apply monopoly model to get P and Q. P = 100-0.5Q MR= 100-Q MR=MC MC=20 100-Q=20 -Q=-80 Q=80 80/ 10 countries = 8 per country plug Q=80 in P=100-0.5Q P=100-0.5(80) = $60 •Competition: P = MC 100-0.5Q = 20 -0.5Q=-80 Q=160 Q=160 & P=$20 DWL = 0.5($60-$20)*(160-80) DWL = $1600

Referring to question 5, suppose EdF has a monopoly on uranium. Given the information in question 4, how much will EdF produce in each period, and what price will they charge?

Q_0 = 19.41 tons. Q_1 = 20.59 tons. P_0=300 -10Q_0= €106/ton. P_1= 300 -10Q_1=€ 94/ton.

Electricité de France (EdF) operates nuclear plants in France. Suppose it decides to own uranium mines, a competitive industry, and faces demand P = 300 - 10 Q, where Q is tons of uranium and P is €/ton. Marginal extraction cost is €30. The discount rate is 20%. Assuming there are only 40 tons of uranium remaining in the mine, how much should EdF extract today, and how much a year from now? What will be the price of uranium today and one year from now?

Q_0 = 20.64 tons. Q_1 = 19.36 tons. P_0 = 300 -10 Q_0. P_1 = 300 -10 Q_1 P_0 = € 93.60/ton P_1 = € 106.40/ton.

Explain and provide an example of a backstop technology for the use of coal for cooking in a developing country, and how it would affect a coal producer's decision about how much to produce today as compared to when there is no backstop technology.

Solar stove. The availability of a backstop technology limits the future price of the original fuel, shifting more production to today and leaving less for the future.

Explain the 1954 U.S. Supreme Court Phillips decision. Referring back to your answer to question 2, explain whether you agree or disagree with the Court's decision

The U.S. Supreme Court regulated the price of natural gas at the wellhead. Disagree with the decision. No economies of scale at the wellhead.Competition would work.

One possible market failure in dynamic markets is that the private and social rates of discount may differ. The market failure comes about because:

The private rate exceeds the social rate, leading to the firm producing more than the efficient amount today and leaving less than the efficient amount for the future.

Provide two external costs of oil use other than emissions.

Two external cost are money & oil spills. -Money spent on national security to defend oil supplies from unfriendly foreign regimes. Currently US trying to prevent Iran from selling its oil. According to US, money is used to fund terrorist organizations (such as Hezbollah) and unfriendly regimes (such as Syria). -Oil spills now happening in Southern CA. Pipelines disturb landscape, pass through land of indigenous people.

Identify three negative externalities associated with the hydraulic fracturing (fracking) of natural gas. What impact do these externalities have on the social cost of natural gas? How does this translate into the market price vs. the socially efficient price for natural gas?

Water contamination, Low birth weights &Methane emissions. They increase social cost. Market price below socially efficient price.

You think OPEC will not stick to its announced plan to cut oil production. If you are a speculator, should you buy a put or a call option? Support the organisation of Petroleum exporting country will not stick to its announced plans to cut oil production speculator will always prefer to buy a call option because call options are the natural contract that give the option for the by your the right.

We would go with put option. If OPEC does not stick to its plan to cut production, price of oil will fall. To make a profit, you want a contract that gives you the right to sell oil at today's higher price, a put.

In what way is wood a renewable fuel? In what way can it be a non-renewable fuel? Under what conditions would you allow it to be used to meet the requirements of a renewable portfolio standard?

Wood is renewable if it grows faster than the rate at which it is harvested. Companies may operate tree plantations where they plant trees to replace the ones they have cut down. •Some trees grow slowly. Trees in old-growth forests may be 500 years old, and so cannot be replaced within one or two generations. In that case, it is best to model them as non-renewable resources. •I would allow wood to qualify for a RPS as long as it is a species that can be grown and replaced rapidly.

In a competitive industry with MC > 0, according to the Hotelling model of dynamic efficiency: a. Price (P) will increase over time at the rate of interest b. P-MC will increase over time at the rate of interest c. MC will increase at the rate of interest d. PV (P) will increase at the rate of interest e. PV (P-MC) will increase at the rate of interest

b. P-MC will increase over time at the rate of interest

A difference between forward and futures contracts is: a. Forward contracts are traded on an exchange, whereas futures contracts are traded over-the-counter. b. Forward contracts publish their prices, whereas futures contracts are not required to disclose their price. c. Both a. and b. are correct. d. Neither a. nor b. is correct.

d. Neither a. nor b. is correct.

According to the predatory pricing argument that led to the decision to break up Standard Oil, Rockefeller drove his competitors out of the oil refining business by

setting price below minimum average variable cost

Explain the argument that Rockefeller used predatory pricing to drive his competitors out of business. Then argue that Rockefeller did not use predatory pricing.

•P < min AVC. -Ordinarily, a profit-maximizing firm would not do this, as P = min AVC is shut-down point in the SR. •But John D. Rockefeller had "deep pockets." •Only works if there is a long run barrier to entry. If John D. later charges monopoly P. Will attract new entrants. John D. will not be able to recoup SR losses.

What percentage of total energy use in the U.S. is accounted for by oil? What percentage of oil is used for transportation? What percentage of carbon dioxide emissions are due to transportation?

•Percentage of total energy use accounted for by oil. -Globally one-third (33%). US is 37% in 2019, 35% in 2020 (Covid year; petroleum use dropped dramatically). •Percentage of oil used for transportation -2/3 67%, 66% in 2020 EIA stats. •Percentage of carbon dioxide emissions due to transportation 29%

Explain Saudi Arabia's role as a swing producer. Did they act as a swing producer in March 2020? Refer to Figure 5.8 in answering the question.

•Swing producer: -When P < target P, decrease production. -When P > target P, increase production. -Temporarily stopped acting as swing producer in March 2020 •P < target P, but increased production due to inability to get Russia to reduce production. -Has since cut production to try to increase oil price, with considerable success.

What is the significance of the fact that oil is fungible? In what way is it not fungible? Oil is a fungible commodity, meaning it may be traded for other commodities.

•The global oil market is rather deep, liquid and that crude oil itself is fungible. This means, stripped of the technicalities, that one barrel of oil is much like another one. This isn't entirely true: Canadian tar sands oil, Venezuelan stuff, they are both much heavier than most others and need specific refineries to treat them. But that light Arabian oil really is fungible. Refineries around the world can make use of it at least to some extent (indeed, some use it to blend with those heavier ones to make refining easier). This fungibility means is that it just doesn't matter a darn whether the US, or US companies, buy or not Saudi oil. Total oil demand around the world will be the same, total oil production around the world will be the same. All that will change will be who buys what bit of oil. So, for example, the US might buy more West African oil. But that West African oil, before it was routed to the US, might have been going to Europe. So, the US buys more West African instead of Saudi, Saudi now sells more to Europe and West Africa less.

Explain the difference between a private and a social discount rate, and which one is likely to lead to producing more today and leaving less for the future.

•The private discount rate is the cost to borrow funds in the private market. •The social discount rate is society's time preference between consuming now rather than in the future. The private discount rate discounts the future ... and leads to producing ... today and leaving ... for the future.

Japan is trying to decide if they should increase their imports of LNG. They are currently importing 10 mmBtus at a price of $17/mmBtu. If they import 11 mmBtus, they will drive the price up to $18/mmBtu, given their monopsonistic position in the LNG import market. Alternatively, they can continue to buy 10 mmBtu of LNG, and turn to a renewable backstop fuel that is available at $25/mmBtu. What do you recommend they do?

•Total cost for 110 MMBtu = 110×$7.50 = $825 •Total cost for 100 MMBtu = 100×$7 = $700 Incremental (Marginal) cost of last 10 MMBtu = $825-$700 = $125 =$12.50/MMBtu. Stay with 100 MMBtu and buy backstop for $8. •It is less expensive to stick with 10 mmBtu of LNG, and the backstop at @25 for the additional mmBtu ($195 total cost vs. $198 for 11 mmBtu of LNG).

Explain the upstream, midstream, and downstream stages of the supply chain, giving an example of each stage related to oil production.

•Upstream: Production stage -Oil exploration, extraction •Midstream: Between production and end use -Pipeline transport; possibly refining, storage •Downstream: Delivery to customer -Bulk storage, gas station