A paper on Keystone’s climate impacts would fail Econ 101

The claim that Keystone will lead to lower oil prices and thus higher consumptions is based on a faulty model

shannonpatrick17 / Wikimedia Commons

Photo by shannonpatrick17 / Wikimedia Commons

An article published this week in Nature Climate Change (article via Nature paywall) is making the rounds of the headlines because it makes some pretty bold claims—namely that the US State Department under-estimated the emissions impact of the Keystone XL pipeline by up to a factor of four.

The paper’s authors apply a simple model of the world oil market to reach their conclusions, which are driven by the potential for the pipeline to increase global oil supply, thus lowering oil prices and increasing consumption.  If this is true, then the increased consumption induced by the pipeline should be treated as a consequence of the project, and accounted for in a broad analysis of its costs and benefits (of course, so too should the benefits of increased oil consumption at lower prices).

This paper attempts, basically, what those of us who teach or have taught undergraduate economics often try to do—the authors take a simple model of a market, in this case oil, and apply that model using a real world example, in this case, KXL.  What’s important, however, is to get the basics of the example correct. If you miss that, you’ll reach a conclusion or generate a set of numbers, but they won’t really mean much.  It’s also, of course, important to discuss what you miss in building your simple model.  There’s a lot left out of the basic model used in this paper, but I think they also get the basic model wrong.

So, what does this paper do? The basic elements of their analysis are shown below in their Figure 1. They assume that KXL adds 800,000 barrels of new oil to global supply, at any price, and examine the degree to which this additional supply will affect global consumption.

ncc_kxl

Source: Nature Climate Change

Depending on the slopes (or elasticities) of the demand and supply curves, the impact of adding this additional supply to the market will vary, and it’s through varying these slopes that the authors derive their key table, Table 1, shown below.

ncc_kxl2

Source: Nature Climate Change

From there, they make two calculations to assess the impact of the new, KXL-carried oil sands production on global emissions.  First, there is the impact of the pipeline on total consumption, and second there is the substitution effect whereby some oil is not produced in other areas due to the KXL-induced increase in production here.  So, using their numbers above, for each barrel shipped on KXL, you’d have somewhere between 0.08 and 0.78 barrels of increase in total consumption, with between 0.22 and 0.92 barrels of oil which would have been produced elsewhere being substituted-for by oil sands production.  The authors argue that it’s the emissions associated with increased consumption of oil which lead to an estimate of the emissions impact of KXL of 100-110 Mt/yr, up to four times the upper limit derived by the State Department.

Here’s the problem with that analysis—KXL isn’t really a level shift in the supply curve, and thus the authors don’t actually make the case for there to be any global price effect associated with the pipeline.  Look back to their figure 1—somehow, by constructing an 800,000 barrel per day pipeline, the cost of at least 2 million barrels per day of oil production has been decreased by $6 per barrel.  That’s one hell of a bargain.

Let’s go back to Economics 101, and see why their analysis is incorrect and what would have been required to do it correctly.  A supply curve is an ordered list of all the oil production opportunities globally, sorted by the cost of extraction or, probably better for this example, the potential free-on-board price at a global trading hub—take every oil play in the world and ask what it would cost delivered to the US Gulf Coast as a starting point.  The construction or not of Keystone XL affects only a small share of this oil and affects it in a particular way—it makes some of this oil more expensive to get to the Gulf Coast.  The relevant question for the world oil market is whether it makes the marginal barrel more expensive to get to market – otherwise it’s just affecting profits inside the margin.

Let me give you a simple example—suppose the marginal barrel of oil globally is, in fact, an oil sands barrel, and so an increase in oil sands supply (i.e. more barrels available at a lower price) would increase world oil production and consumption.  The global supply and demand situation would look something like this, again in an Econ 101 example:

ncc_kxl3

From there, you’ve still got to break down your oil sands supply curve, which means looking at all the potential production, and the costs of getting those barrels to market.  You’d have a separate supply curve for oil sands which would tell you how oil sands production would respond to changes in oil prices and, also, how oil prices might respond to changes in oil sands production.  The impact of Keystone XL vs a case with no pipeline would have the impact of increasing the cost of some of these potential oil sands barrels, but perhaps not of increasing the cost of the marginal oil sands barrel.  If we look at the alternatives proposed today for transporting oil sands, they are all, with the exception of Northern Gateway, more expensive options to get oil sands to market than Keystone XL—that’s why KXL is so attractive.  So, consider a simple example where I have two oil sands routes—pipeline to the Gulf or rail to the Gulf—at costs of $7.50 per barrel and $15 per barrel respectively, and also different types of oil sands production at increasing costs per barrel.  The oil sands supply curve might look something like this:

ncc_kxl4

If I take Keystone XL out of the mix, in my toy model, I haven’t impacted the cost of the marginal barrel of oil sands because I haven’t changed the cost of a barrel shipped by rail, I’ve simply reduced the profit on the barrels which would be shipped via KXL by forcing them to be shipped to market in a more expensive way. I’ve shifted a portion of the supply curve, not the whole thing. I’ve increased the potential cost of some oil sands barrels by $7.50/bbl but I haven’t created a case where oil sands barrels which were previously available at any price are no longer available no matter what or a case where all oil sands barrels are necessarily more expensive.

So, is it possible that the State Department under-estimated the impact of oil sands production changes on world oil markets? Perhaps. However, it’s certainly incorrect to assume that the existence of single pipeline impacts all oil sands supply costs, or that not allowing it would render that oil supply unavailable at any price. For this analysis to hold water, you’d have to show that the barrels which would be transported by Keystone XL are, in fact, the marginal future barrels of oil sands production.  With projects like rail terminals, pipelines east and south, and other infrastructure underway to move oil sands, Keystone XL barrels would be far from marginal.

You could also make the argument that, at some point, there is a significant increase in the per barrel cost of transportation and that the cancellation of Keystone XL would shift more barrels onto that more expensive, marginal means.  It’s possible that the potential routes for pipelines, railways, and barge transport for oil are completely exhausted and that without Keystone XL, Alberta would be left to transport oil sands by Volkswagen brigade, but somehow, despite the photographic evidence below, I find that unlikely. I wish Nature Climate Change would have asked for a little higher burden of proof.

Alberta's Volkswagen Bucket Brigade. Photo Credit: Jen Gerson

Alberta’s Volkswagen Bucket Brigade. Photo Credit: Jen Gerson




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A paper on Keystone’s climate impacts would fail Econ 101

  1. Oooh, oooh. Economics 101 graphs and arguments.

    • Thanks for the clicks, as always. Much appreciated.

      • Well, I was going to add that the jump the shark bait, last photo, appeared to be part of a caravan on its way to Montana’s in the NE to pick up some diluent.

        Anything to increase costs will slow down the development of the marginal project. I also think rail has yet to face the full public backlash – especially if it causes inconvenience and delays through some main urban areas. We shall see.

        The 4x underestimation seemed on first hearing of it to be an overstatement. But then again, I always thought the Enbridge economic forecasts for NGP to be highly questionable as well (I believe it claimed to goose ALL of the AB production netbacks).

        Gaming on both sides.

        • It claimed to change a regional market, not the global market. Try reading, then commenting.

          • The global market is an aggregation of regional markets.

            And btw, go back and read Boothe’s twitter lesson on Arrow.

          • Yes, the global market is an aggregation of regional markets reflecting the value of the marginal barrel into whatever you choose as your marker for world prices. It’s not an aggregation of regional prices – horizontal not vertical summation, if you recall from the econ 101 lesson you claim to have taken. Arrow on aggregating preferences has nothing to do with this at all, but I know you’re blinded by the possibility that someone is disagreeing with me.

          • Ahhh, the what happens in Vegas, stays in Vegas argument.

            Yeah, I know the Arrow reference was not directly related. It was in direct response to your suggestion that I go back and read something. It never seems to amaze me that people can have Theorems named after them which to most of the rest of us just makes common sense. I took Boothe’s pointed comments to you to be in response to an earlier Macleans blog, but perhaps I didn’t quite have the pulse of the nation at my fingertips.

  2. Against the intuition that preventing or slowing access to markets increases supply costs, we navigate careful consideration of marginal analysis to the conclusion that the absence of KXL unlikely to have an impact on global price and therefore consumption. The real question is whether anyone, not in the oilsands choir, would be convinced by marginal analysis to abandon the view that preventing KXL will have an impact on the market. While I appreciate the lesson in economics, Mr. Leach has addressed the easier economic question, while complaining about a higher burden of proof. This is bad faith.

    • Your comment is correct, to a point – it’s in the next to last paragraph, and depends on how you view the supply of future transportation options. If you think that the supply curve for transportation is upward-sloping over the relevant region than removing one piece of that curve will change the equilibrium transport cost, although not necessarily the equilibrium supply cost. If, as the authors of the paper suggest, the oil sands barrel is the marginal global barrel (likely easier to argue that it’s marginal new production, but even there, it’s debatable), then you’d have an equilibrium price impact in the oil market as well. If not, then not. Same logic applies. I am thinking about writing this up as a follow-up. Thanks for reading.

      • Thanks for responding – I enjoyed reading your article. Is there an additional burden of proof/persuasion on an Econ prof who consistently voices dissent in favour of oilsands? Given the recent attention to the notion of rational agent – as in, maybe there isn’t such a thing – it seems as though you are using the tools of economic discourse to chalk one up for the converted.

        I think I follow your economic argument, and mostly agree, but I’m more just befuddled about the role of reason/academic discourse in this kind of discussion. For those not in the oilsands camp, I supsect the response to your article is as follows: Mr. Leach can outpace me on economic grounds, so I’m not likely to come up with a knock-down position, and since more frequently I’ve seen academics post articles in support of their corporate sponsored positions, rational argument cannot be trusted as a primary means by which these projects are decided. Moreover, there is some possible world in which Mr. Leach writes a piece contra KXL, demonstrating by the same tools of the discipline that it will increase emissions. All this to say that I’m amenable to your reasoning, but still believe that preventing KXL would be a benefit to reduced emissions. Your position is reasonable but not persuasive – hence my tongue in cheek reference to your concern about higher standards.

        Why do you think that marginal analysis is, even if successful, convincing to the undecided or anti-pipeline contingent within a Maclean’s audience?

        • As I told you in the earlier comment, it’s coming. It’s just in copy right now.

          As for writing things which are against the oil sands or pipeline interests, I don’t see myself as writing for or against – I tend to respond to what I see and find interesting/annoying. If you look back through my writing, you’ll see that I’ve challenged voices for and against pipelines, oil sands, etc. If you look at who retweets, discusses, or re-posts my writing, some get picked up by Enbridge, some by Dogwood. It is what it is.

        • Further, I don’t think my job is to convince anyone to believe in a particular thing. My job is to explain and provide people the tools to make their own decisions, hopefully with more information and critical thought.

  3. Hey, I slept on your lentils and bucket brigade arguments. And you’ve convinced me. In fact, I’m prepared to go one step further:

    Why do we even process the tonnes of sand with water and heat, and then have to deal with emissions, tailings ponds, labour shortages etc.? Just dig it up and ship it off to China unprocessed!

    Think of it as a short of Land-Lease using rail and tanker shipments of relatively benign carloads of Northern Alberta. The Chinese can use the neutered sand after processing to fill in the gap between the Mainland and Taiwan – a sort of modern Masada, if you will, in process. Viewable from space!

    I even have a clever label, like you for my program promotion – a sort of Wayne’s World for geeks (broadcast weekly from the basement of the new digs – with a regular guest flown in from Laval via Macleans – “Gripes”).

    Drink Canada Dry. Ginger – Ales.

    The pitch: Two refined coppertops discuss the weekly events – and the subtleties of two lines (slopes, intercepts) etc.

    I can check with Teneycke if you like for a timeslot.

    • You obviously don’t get either the lentils or bucket brigade arguments, but thanks for reading nonetheless.

      • Where I went to Biz school, we were able to differentiate between perishable foodstuffs, and non renewable resources. Not sure what you teach.

        • McDonald’s?

          • Or as you like to call it: That illogical place with the Au-bimodal distribution leading indicators.

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