Demand-Side Economics

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Howard Roark

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Demand-Side Economics
Mark P. Mills 08.17.07, 1:06 PM ET

It seems inevitable when Congress returns that there will be new energy legislation. Understandable. Civilizations cannot survive much less thrive without abundant, reliable energy supplies. The bellwether energy commodity, oil, is at prices at or near record levels, and turmoil continues in the Middle East, from which the world gets over one-third of its petroleum.

But having Congress patch together sweeping legislation from the cacophony of demands to fuel the national economy in this environment is like going grocery shopping when you're hungry.

Worse yet, you could say, with all due respect, it's more like sending a pack of hungry 10-year-old kids with fistfuls of money to the grocery store. You know what they'll bring back. I'm not criticizing any specific proposals, but to coin the phrase made popular by HBO's The Sopranos, "I'm just sayin'."

The reality is that governments, corporations and individuals necessarily make bets, invest time and political and fiscal capital in energy solutions. Like everything else, this domain divides pretty nicely into two parts--demand and supply. Most of the discussion, from cocktail parties to Congressional caucuses, centers on supply.

But "demand" is the horse that comes before the "supply" cart. There wasn't an electric utility industry before Edison started manufacturing light bulbs and electric motors, nor an oil industry before Ford (nyse: F - news - people ) and Lycoming started manufacturing internal combustion engines for cars and aircraft. Demand drives the supply market.

There are plenty of studies and books out there that purport to unravel the character of energy supply and demand, when in fact most of what's out there focuses on the supply issues. Last month, the Department of Energy released "Facing the Hard Truths about Energy," a study commissioned by the National Petroleum Council. The fruit of a year-plus of the labors of 350 experts convened in special panels yielded 422 pages, which certainly passes the heft test, but hardly clarified the matter nor, unsurprisingly, provided any dramatic insights. It is chock full of graphs and facts, and predictably has been roundly criticized by political opponents.
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The last time the nation was in a similar geopolitical and domestic stew over energy was when Jimmy Carter was president. Those who know me know I'm not necessarily one to quote President Carter, much less from his infamous energy speech of the Summer of 1979, known as his "moral equivalent of war," or MEW (as opposed to, "roar") speech. But President Carter did have a point when he asked, early in his remarks that last summer of oil discontent: "Why have we not been able to get together as a nation to resolve our serious energy problem?"

Good question. Maybe because, aside from the politicization of subjects one might otherwise think are unavoidable realities, we've avoided starting from a common recognition of the fundamentals of energy demand.

Herein then, a summary (highly compressed) of the seven basic principals of energy demand--recognition and understanding of which are necessary for effective investment.

Principal No. 1: It's about technology, not fuel. It's never really about the raw resources, whether tons, barrels, fields of corn, hours of sunlight or ridgelines of wind. People drive cars, take vacations, turn on computers, factories mold, weld and stitch, buildings are cooled and illuminated--all of these activities are performed with various technologies that serve a purpose. It is of course those purposes that people seek, and it is the use of technologies and tools wherein those purposes are sated.

And it is an a priori reality that all technologies consume energy, but importantly, this is a consequential not an intentional outcome of the pursuit of food, light, information, comfort and entertainment. For millennia, humans have created and innovated to provide technologies to meet human needs and desires. That won't stop. In fact it's now accelerating.

Principle No. 2: Demand always rises. It is implicit, if not explicit, in much punditry that, somehow, overall energy demand can be reined in. There has been no period in history, outside of pandemics and total wars, or the equivalent in totalitarian societies, when energy demand has not risen. Technology progress (see Principal #1) brings economic and social progress. Rising energy consumption is just a surrogate measure of rising affluence and well-being. Thus in the parlance of investors; there will never be a shortage of demand for the product inartfully called "energy."

Principle No. 3: Improving efficiency increases demand. I'm quite aware of this ostensible heresy in the face of a remarkable bipartisan policy consensus to slake the nation's energy appetite with more efficiency. Actually, the opposite will happen. The U.S. economy is twice as energy efficient today compared with 50 years ago, and our energy use is up 250%. Over the next 50 years, likely we'll triple efficiency and double energy use.

It is seductive, but uninformative, to note that replacing a specific device with a more efficient one decreases that specific energy use in that application. In the real world, not only do many more new uses emerge for that same or similar device, but many new devices and technologies appear. At the most basic level of economic reality, lowering price stimulates demand. Improving efficiency is simply one very good way to reduce costs. Markets love efficiency of course, for all its benefits (see Principal No. 1, again), and so should legislators--but we shouldn't kid ourselves about the outcome.

Principle No. 4: Electric technologies drive economic growth. Today 60% of the U.S. gross domestic product depends directly on using some kind of electric technology--the share was just 40% in 1973. The economy's increased dependence on electricity--95% of which is created without oil--is a major reason for the muted impact of high oil prices.

Liquid-fuel technologies will continue to be needed, where there use is dominantly in the transportation and agricultural domains--domains which are essential, to eat and move … obviously, but for which revolutions spurring economic growth are long-ago history. (There is another quasi-revolution in transportation brewing, by the way, entirely relating to electric technologies.)

The linkage between demand for electric technology and GDP growth is reduced, by the Energy Information Administration, to a basic forecasting tool: Every 1% point of GDP growth drives a 0.6% to 1% point of kWh growth.

Principle No. 5: The digital economy increases energy demand. By various estimates, including that of the Federal Reserve, information technology (IT) in all its forms is responsible for somewhere between one-fifth to two-thirds of America's economic growth. Quite a range to be sure, though the higher end makes sense when you include not just PCs and data centers, but the addition of microprocessors to everything from electric motors and cars to light bulbs and cook tops.

Digital technologies make us more efficient, more productive, wealthier--which, overall, indirectly but inexorably increases demand (see Principal No. 1). It also directly increases energy use from the ever-expanding constellation of exclusively electricity-consuming silicon-based technologies that didn't exist two decades ago; hundreds of millions of digital devices from desktop to palmtop, used in homes and offices, on factory floors and shipping docks, and thousands of mega-watt industrial-scale digital enterprises from microprocessor factories to massive data centers.

The past two-decade 60% rise in electric use cannot be attributed to more lights, air conditioners, motors and pool pumps, as it was during the post World War II industrial boom. In fact, that class of mid-20th century electric technology is now astoundingly more efficient; so much so that electric demand should have stayed flat or declined.

The new ways to consume electricity, i.e., digital technologies, drove the doubling of the GDP since 1979. Today's $14 trillion GDP quickly becomes tomorrow's digital-tech-electric-centric $20 trillion economy--with the attendant impact on energy demand.

Principle No. 6: Not all BTUs are equally useful. Markets chase productive technologies--visible in economic, not energy, metrics. But the energy analyst's unit of choice for counting the demand (and supply) impact of energy-consuming technologies is the archaic BTU; British Thermal Unit.

One BTU looks like any other when toted up in the government's energy accounts. This is as useful as comparing the demand for a ton of gold with a ton of wheat. You can count up 5.8 million BTUs (that's how many BTUs a barrel of oil yields) from a wood stove, or a diesel engine, or a microprocessor, or a laser. All yield (or demand) BTUs, which provides nothing informative about the different productive impacts, or reasons economies employ a technology. The relevant measure is money, not BTUs.

We pay $2 for a barrel's worth of BTUs from a wood stove; $60 for a barrel-equivalent of heat from wood alcohol powering an engine; $10,000 for a BTU-barrel equivalent of electrons feeding Pentiums; and $200,000 for a barrel's worth of laser photons.

The market, needless to say, recognizes and willingly pays for, indeed prefers the latter BTUs because they are higher quality, can do more and produce more valuable things. The energy technologies that create, manage and deliver the most expensive BTUs are the most valuable.

And, because the economic value is high, markets want more and consequently drive energy demand in large measure without regard to primary fuel cost--the cost of energy fades in to the twilight. This latter point means of course that raw energy price is a weak tool for controlling demand. (Conversely, since high-economic-value technologies are so important, this dynamic provides a lot of tolerance for high raw fuel prices--put another way, a lot of opportunity for producers to invest in new supply and expect a return on investment.)

Principle No. 7: In the end, it's always about the money. Economies are, over time, largely logical, preferring the most productive and economically valuable technologies--which generally means those with the most expensive embodied BTUs.

At the same time, there is conflicting pressure to keep a lid on raw primary energy costs, in part because economies always seek to minimize commodity costs (where one places all primary energy resources). And there is the understandable social and political reality; both lower-income citizens and countries are disproportionately hurt by a wealthy economy's tolerance for high commodity prices.

The political challenge then is at root, a tug between the stratospheric demand for highly productive technology and collateral tolerance for high-priced energy, and the gravitational pull for low-cost energy commodities. This is not really a new phenomenon--it's just hypertrophied in our modern economy. To be fair to our politicians, it is a hyper-difficult juggling act. One can only wish them well in the Kabuki dance around these realities.

Written by Mark P. Mills, a physicist and a co-founding partner in Digital Power Capital , an energy tech venture fund. Mills is also the co-author of The Bottomless Well: The Twilight of Fuel, the Virtue of Waste, and Why We Will Never Run Out of Energy (Basic Books, 2005). Mills may hold positions in companies discussed in this column, and may provide technology assessment services for firms that have interests in the companies. He can be contacted at .