'JUST IN TIME' INVESTING RISKS SHORTAGES, BUT...

Philip Verleger - Jun 08,2021

Businesses across the globe have adopted “just in time” (JIT) inventory practices to reduce costs and boost profits. Developed in Japan in the 1970s for manufacturing processes, JIT has more recently spread to investments, as well. In 2021, JIT has caused significant economic dislocations in the microchip business, forcing key industries such as automobile manufacturers to cut output. Now, the International Energy Agency (IEA) has proposed in its Net Zero by 2050 report that the fossil fuel industry adopt JIT, saying no new oil and gas exploration is needed going forward. An oil market dislocation like the chaos now seen in the chip industry could occur if the IEA’s plan is followed. However, if appropriate economic policies are pursued -- as happened with the Covid-19 crisis -- broader economic fallout from such oil market upsets could be largely avoided.

Intel CEO Pat Gelsinger told a virtual session of a Taipei trade show that developments during the pandemic had created a “cycle of explosive growth in semiconductors” that strained the global supply chain. It will take a couple of years for the industry to address the shortages of foundry capacity and other necessary inputs, he added.

According to the Economist, the two world firms that make the world’s most advanced chips -- Taiwan Semiconductor Manufacturing Company and Samsung Electric -- plan to spend almost $60 billion this year to boost production capacity. Intel will invest $20 billion. Altogether, chip manufacturers and firms such as foundries that supply inputs to these manufacturers may invest more than $100 billion in 2021, a significant amount, albeit well less than total international upstream oil and gas expenditures.

The chip shortage resulted because investment in capacity lagged sales growth for more than 10 years. One consultant described chipmaking to the Economist “as a good example of what economists call a ‘pork-cycle’ business, named for the regular swings between under and oversupply first analyzed in American pork markets in the 1920s.”

The consultant no doubt describes the “corn hog cycle” where high corn prices were observed to lead to lower pork prices as farmers liquidated more pigs than usual due to the cost of corn. The liquidation led to lower demand for corn and lower corn prices, but higher pork prices because the liquidation that preceded it reduced supply.

The economist Paul Krugman wrote about the “Oil-Hog cycle” in 2001, when oil prices were around $17 per barrel following the 9/11 attacks on the World Trade Center. As he observed, “Alas, it’s all too likely that today’s oil price plunge will set the stage for tomorrow’s oil price surge, in a repeat of a cycle that has been a major source of world instability these past three decades.”

The IEA’s call to halt oil and gas exploration invites a repeat of the current microchip disruption with possibly much more disastrous results. Examined closely, the prolonged interruption in chip supply warns of developments that could cause a similar oil market disturbance. The problem starts with contractors, the companies that supply machinery to chipmakers.

Writing on the chip shortage, the Economist noted that many parts used in chips are produced in older factories that are smaller than today’s standard. The lack of the desired-sized “wafers” limits the ability to boost output. Furthermore, capacity expansion is limited because toolmakers cannot produce the equipment to make the needed wafers.

If the IEA’s proposal is adopted, one can easily imagine a situation where firms seeking to increase oil production in five or 10 years to meet global demand will not find the equipment or trained workers necessary to drill onshore or off.

Hoarders and Other Disasters

The chip shortage has been exacerbated by hoarding. Bloomberg reporters noted, for instance, that chip stockpiling began in China. Huawei Technologies, the Chinese chipmaker that dominates the global market for 5G gear, began accumulating chips because it feared that US sanctions would cut it off from its primary suppliers.

Fears of oil supply shortages would likely have the same impact. Consuming nations have been known to accumulate stocks of oil and other commodities when future shortfalls appear likely. Oil prices will rise quickly in 2026 if it appears that supply and demand will be out of balance in 2027.

Disasters could further complicate the issue. A fire at a major Japanese manufacturer of chips for autos in March and the Texas freeze in February disrupted supply. Problems followed because there was no surplus capacity. This is a problem that is all too familiar to the oil industry. Oil prices have doubled following production disruptions at times when surplus capacity did not exist. Few believe this will not occur again.

Finally, oil markets are characterized by manipulation by large producers. Oil producers have often cut supplies at times of tight capacity to raise prices. Such manipulation would be highly likely if oil producers viewed impending shortages as possibly their last opportunity to realize high prices for their output.

The IEA did not recognize this reality in its Net Zero by 2050 report. Instead, the study outlines its assumptions on future price moves as follows: “Prices are increasingly set by the operating costs of the marginal project required to meet demand, and this results in significantly lower fossil fuel prices than in recent years. The oil price drops to around $35/bbl by 2030 and then drifts down slowly towards $25/bbl in 2050.”

With all due respect to the IEA, these words represent the fairytale nature of the agency’s Net Zero report. What is worse is the fact that pressure from the IEA and other national and international organizations threatens to discourage or force cuts in oil and gas exploration investments. The reductions could create a “chip-like” situation where global oil demand in the late 2020s or early 2030s cannot be met, just as chip demand today cannot be satisfied.

The potential shortage would probably occur when the oil-field service industry’s capacity has been decimated by the lack of expenditures on drilling. Again, the analogy from the chip industry is almost perfect.

Economic Consequences

Many will assert that economic catastrophe awaits if the IEA’s advice is applied and events indeed play out as described. Representatives of Opec-plus nations told the St. Petersburg International Forum in Russia early this month that large oil price spikes will occur if the IEA’s advice is followed. Saudi Energy Minister Prince Abdulaziz bin Salman reportedly referred to the IEA road map as a “la-la land’ scenario.”

These views must be treated with as much or more skepticism as the IEA road map itself. History reveals that the global economy has performed well though much more daunting disruptions than the one likely to be associated with a rapid transition away from oil if -- and the caveat is very important -- economic policy adjusts, either in anticipation or as the economic disruption develops.

The world’s economic leaders did a terrible job adjusting to the quadrupling of crude prices that constituted the 1973 oil price shock. World economic leaders did a better, but incomplete, job following the 2008 Great Recession. In contrast, the economic crisis associated with the Covid-19 pandemic has been excellent.

One must hope that economic policy responds to potential oil shortages associated with the energy transition as well as it did in the 2020 economic crisis. The burden falls not on the energy sector but economic policy.

Philip Verleger is an economist who has written about energy markets for over 40 years. A graduate of MIT, he has served two presidents, taught at Yale and helped develop energy commodity markets since 1980.

This is the third in an ongoing series of World Energy Opinion pieces on the implications of the IEA's Net Zero by 2050 road map. The first and second can be accessed via the following links: (WEO Jun.7'21) and (WEO Jun.4'21).

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