GEOPOLITICAL FACTORS AND INCREASINGLY TURBULENT SUPPLY AND DEMAND

GEOPOLITICAL FACTORS AND INCREASINGLY

TURBULENT SUPPLY AND DEMAND SCENARIOS
IN ENERGY MARKETS: MODELING
REJUVENATED INTEREST IN BIOMASS ENERGY
SOURCES

Ronald F. Farina1

ABSTRACT

As the peak of global oil production approaches, increasing competition resulting from increasing
demand in emerging economies challenges traditional energy market relationships. Recent events underscore
additional disruptions and uncertainty in energy markets, resulting from random fluctuations introduced by
wars and natural disasters. This paper proposes a modeling approach to understanding and predicting the
impacts of these combined factors in the context of turbulent market conditions.

The model is capable of capturing price, yield, unit transformations, capacity and other important
data. It also proposes the use of the model to examine the role of alternative fuel technologies in smoothing the
transition from the fossil fuel era. An example of biomass ethanol is provided. The model employs generalized
network optimization methodology and provides a general structure with data from 2004 as a base case. A
brief tutorial on generalized network formulations in the energy context is included.

PROBLEM STATEMENT
Turbulent shifts are occurring in the world’s oil driven energy markets. Large new players such as
China, India and Brazil have appeared on the demand side. The energy demand among emerging economies is
likely to equal or exceed first world economies by 2025 (Figure 1). Furthermore, larger players such as China
will introduce uncertainties into traditional market relationships. China has already begun to compete with the
United States and Europe for Canadian, Venezuelan and Russian oil.

1
Ronald F. Fariña is an Associate Professor in the Department of Statistics and Operations Technology at the
Daniels College of Business at the University of Denver, USA. He has authored articles in applied
mathematical modeling and business in Brazil. A former Brazil Peace Corps Volunteer, he returned as a
Fulbright Scholar in 1991 and with Fulbright again in 1995. In 2003 he was selected for the Fulbright Senior
Scholars Program. His mathematical modeling activities and publications have included renewable energy
technology assessment models funded by SERI (now NREL). He has received grants from Brazilian federal
(CNPQ) and state institutions (FIEP).

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Ronald F. Farina

Figure 1: World marketed energy consumption by region, 1970-2025

The increase in competition is complicated by the onset of the limitations associated with a finite
resource in the context of increasing demand. The “End of Oil” or “Peak Oil” can be viewed as the point
where world production will cease to increase at an increasing rate. It will then continue to increase at a
decreasing rate. Ultimately it will peak and then, finally, decrease. “Peak Oil” occurred in the United States in
the1970s. This peak was precisely predicted by M. King Hubbert’s model in 1962. Globally, we are already
beginning to see signs of the early stages of the approach of “Hubbert’s Peak” (Figure 1). The onset can be
characterized by ever increasing, highly unstable and fluctuating oil prices. Also, in 2005, global spare capacity
reached a near 20 year low of 1 million barrels per day. Consequently, there is virtually no safety net as there
had been in the past. Some argue that 2005 is the beginning of the peak; although, most estimates of peak
production vary from 2026 to about 2039. The latter estimate was made by the U.S. Department of Energy’s
Energy Information Administration (EIA).

Hubbert’s model was based on D.F. Hewett’s (1929) statistical models of the depletion of non
renewable resources. While accurate at the time, it may be too simplistic as the global peak approaches.
Sources of variation resulting from conservation programs and the implementation of alternative fuels
technologies may significantly affect depletion. Additional uncertainties in supplies due to conflicts in the
Middle East, such as the Iraq war, further muddy the waters. Finally, significant unexpected random variations
in supply and refining capacity can occur as a result of natural phenomena, as in the case of hurricanes Katrina
and Rita.

New more sensitive and reactive tools to assist decision makers are needed. These tools could be used
to assist in developing effective energy strategies to cope with increasingly turbulent supply and demand
scenarios in energy markets. The technique presented in this paper employs a modeling approach. It evaluates
the strategic role of biomass and related technologies as the new energy mix shifts. The transition period
encompasses biomass; hydrocarbon based non-conventional oil, enhanced oil recoveries and existing
capacities. The eventual mix is likely to include mainstream biomass, nuclear, hydro, wind, solar, new oil, coal
and natural gas based technologies.

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 GEOPOLITICAL FACTORS AND INCREASINGLY TURBULENT SUPPLY AND DEMAND

Figure 2: Hubbert curve projection of global oil and natural gas liquids production

LITERATURE REVIEW

Energy Modeling

Early statistical models of depletion of non-renewable resources can be traced to D.F. Hewett. Hewett
visited and gathered data from 28 European mining districts in 1926. Hewett’s 1929 paper resulting from the
visits was the basis for M. King Hubbert’s model (1962), which correctly predicted the year of peak US oil
production.

Energy modeling was fueled in the 1970s by the OPEC oil embargo and the apocalyptic report by the
Club of Rome, Limits to Growth (1972). The short term dire consequences didn’t come to pass. However,
many of the statistical predictions regarding energy resource depletion were quite accurate as strategic energy
issues came to light. Energy specific modeling efforts followed at the Stanford Research Institute (SRI).
Nesbitt led the development of the SRI Gulf Model (1974) and the SRI-World Energy Model (1976). The term
“energy modeling” is broad, encompassing exploration and refinery modeling, local consumption modeling,
and a wide range of other specific definitions. This review will limit itself to optimization models, associated
macro supply/demand, and price/technology policy issues.

During the 1980’s provided approaches for solving and optimizing non-linear complex systems at the
Department of Energy and developed the MFUELS Model (1984). Hogan and Weyant (1992) examined
methods and algorithms for energy model composition3. Devine, Kumin and Aly applied a system of
optimization and stochastic process techniques to solar energy systems (1983). Numerous researchers
including Dembo & Zipkin (1982), Yakin (1983) and Bloom (1983)] applied optimization procedure to a
variety of facility optimization issues (e.g. power plants and refineries). PETNET (1983) was developed by
Farina and Glover under a grant from the Solar Energy Research Institute (1982), now the National Renewable
Energy Laboratory – NREL.

Fariña and Glover employed generalized network (GN) methodology (Glover , Klingman et. al. 1978,
1979) in the development and implementation of the PETNET model. PETNET addressed the question of
evaluation of biomass technologies for replacement of hydrocarbon-based technologies in the fuel and
petrochemical industries. It only took into account raw dollar comparative costs. Up to that point, it was the

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Ronald F. Farina

first time that powerful high speed GN algorithms were brought to bear on the problem of alternative fuel
technologies.

From the late 1980s through the 1990s, modeling efforts shifted from emphasis on petroleum
replacement to analysis of greenhouse emissions. The shift was partially due to a decrease in the real price of
oil. In the United States, greenhouse related models have been centered at the National Center for
Atmospheric Research in Boulder (NCAR) as well as at Stanford. Recent European efforts have included
VLEEM, the Very Long Term Energy Environment Model (2002). European models also included
SAPIENTIA, (Systems Analysis for Progress and Innovation in Energy Technologies for Integrated
Assessment, 2001). SAPIENTIA is a large-scale dynamic equilibrium model of an energy system. Other
models model, MARKAL (1999) and MARKAL-LITE (2000), satisfy useful demands or energy services,
under resources availability and environmental constraints on both global and urban levels level.

The United States government, Energy Information Administration (EIA), has a wide range of energy
market topic model modules grouped under the National Energy Modeling System (NEMS) (1992). The
module most relevant in the context of our effort is the International Energy Module (IEM, 2004).

METHODOLOGY

Objectives

The purpose of the model presented in this paper is to provide broad based decision support in the
context of turbulent market conditions. It assists the decision maker in addressing questions regarding
competition among the world’s consumers for a finite resource that is reaching its production peak globally. It
also allows for the examination of the role of ethanol as an alternative fuel technology. More precisely it might
provide the lowest mix of explicit and external costs, the most flexible reaction and best strategic protection
against disruptions in domestic supply.

Additional issues the modeling approach is capable of addressing are: exploding demand for
petroleum in emerging economies in the context of the limits associated with affordable price per barrel. Co-
product credits/debits can be effectively evaluated with the model for each alternative technology. Also,
second order impacts of the alternative co-products on their markets can be investigated. Finally,
environmental costs (e.g. biomass waste) and the impacts of renewed conservation efforts on energy supplies
and prices can be evaluated.

Method

The IEM addresses the petroleum supply and demand aspects this paper considers. However, the IEM
model is limited to simulation, which provides non-optimal solutions to these problems. The generalized
network (GN) optimization algorithm developed by Glover and Klingman et. al. (1978) is a specialized form of
mathematical programming. GN can provide solutions hundreds of times faster than conventional linear
programming algorithms. Furthermore, it allows for graphic formulation and presentation of the problems.
Graphic presentations are far more palatable than matrix oriented formats. The method’s only relative
disadvantage can be that it is static as opposed to the dynamic nature of simulation. This drawback can be
resolved through a multiple scenario approach.

In a GN formulation, each arrow or arc between model nodes represents a variable, while each node
represents a constraint. Flow out of nodes must equal flows into nodes. GN methodology facilitates
transformations across arcs, enabling the modeling of yields (e.g. gallons of gasoline per barrel of crude) and

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 GEOPOLITICAL FACTORS AND INCREASINGLY TURBULENT SUPPLY AND DEMAND

unit transformations (e.g. barrels to gallons). GN can also model upper and lower limits as well as process or
costs. Therefore each arc can incorporate:

● Price or cost per unit (e.g.$/barrel);

● Minimum flow allowed (e.g. minimal economic lot size);
● Maximum flow allowed (e.g. max. capacity);
● Transformations including examples such as:
o Process yields – such as gallons/ton of ethanol or gallons/acre sugar cane;
o Unit changes – such as gallons/barrel;
o Efficiency ratios - such as biomass/fossil fuel input;
o Currency exchanges – such as Brazilian Reals/USD.

The graphic representation with symbols for a variable can be found in Figure 3.

Figure 3: Generalized network elements

Software used for a simple aggregate model, such as, the example presented in this paper can be
solved using EXCEL template software. More detailed complex models at the refinery and barrel fraction
level require more sophisticated software, such as Glover’s proprietary (GN2PC) GN software.

Model Development

The model presented in this paper employs a GN formulation reflecting current conventional and
alternative fuel technologies. It is capable of capturing cost-benefit relationships of co-products, as well as
environmental costs and benefits.

The model incorporates current demand data relating to emerging energy consumers such as China. It
also measures the impacts of new oil and alternative fuel producers such as Brazil. The example presented in
Tables 1 & 2 represents the current base case. Other scenarios easily addressed could evaluate impacts of
conflicts such as those in the Middle East, and political shifts as in Venezuela.

Inputs related to conservation, as successfully predicted in the 1970’s, (Lovins, 1976), can be
included. In addition, the model has the benefit of yield and efficiency data from experience with ethanol
(1996, 1998, and 1999) at both NREL and the United States Department of Agriculture (USDA). The recent
developments and experience with ethanol, flex fuel technologies and bio-diesel technologies in Brazil (2004,

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Ronald F. Farina

2005) provide new model inputs. Domestic trials with LPG and hybrid vehicles provide additional information.
Environmental and social issues can be simultaneously evaluated in the context of conventional technologies
(Khosla, 2006). Some examples involve food supply-fuel tradeoffs (Post, 1991) and pollution (NREL,
2000.2001) on the negative side. Others represent reduction of greenhouse gases (Splash, 1989) (Stevenson &
Godden, 1991) ( Smith, 1991) (Sitarz,1993) on the positive side.

The initial GN formulation (Figure 4) uses the supply and demand values for petroleum by country
presented in Table 1. Ethanol supply inputs are included only for Brazil and United States. The two countries
produced 97% of the world’s ethanol in 2003. China, India and France have dramatically increased ethanol
production in 2004. Brazil is the major exporter. Table 2 [18] shows 2004 production of ethanol by country.
The gross ethanol outputs can be a bit misleading since, for example from a land efficiency standpoint, since,
for example, ethanol yields per acre for French sugar beets and Brazilian sugarcane are roughly double those
for American corn.

Table 1 :2004 Oil Production and Consumption

Oil Production - 2004 by Country Oil Consumption – 2004 by Country
RANK COUNTRY barrels/day COUNTRY barrels/day
1 Saudi Arabia 8,711,000 United States 19,650,000
2 United States 8,054,000 Japan 5,290,000
3 Russia 7,286,000 China 4,570,000
4 Iran 3,804,000 Germany 2,813,000
5 Mexico 3,590,000 Russia 2,595,000
6 Norway 3,408,000 Brazil 2,199,000
7 China 3,300,000 Korea, South 2,140,000
8 Venezuela 3,080,000 India 2,130,000
9 Canada 2,738,000 France 2,026,000
10 United Arab Emirates 2,566,000 Italy 1,866,000
11 United Kingdom 2,541,000 United Kingdom 1,710,000
12 Kuwait 2,270,000 Canada 1,703,000
13 Nigeria 2,256,000 Mexico 1,507,000
14 Iraq* 2,200,000 Spain 1,497,000
15 Brazil 1,561,000 Saudi Arabia 1,452,000
16 Algeria 1,520,000 Iran 1,277,000
17 Indonesia 1,451,000 Indonesia 1,045,000
18 Libya 1,429,000 Taiwan 988,000
19 Oman 963,800 Singapore 700,000
20 Qatar 864,200 Turkey 619,500
21 Argentina 828,600 Belgium 595,100
22 Egypt 816,900 Egypt 562,000
23 Kazakhstan 798,200 Venezuela 505,000
24 Angola 742,400 Argentina 486,000
25 India 732,400 Malaysia 460,000
25 South Africa 460,000
25 Iraq 460,000
Data source: 2004 CIA World Fact book

Table 2: 2004 Ethanol Production

RANK COUNTRY Source billion gallons Ratio to Fossil fuels used
1 Brazil Sugar Cane 4.0 8 to 1
2 United States Corn 3.5 1.3-1.6 to 1
3 China Wheat (and corn) 1 no -data
4 India Sugar Cane .5 Up to 8 to 1
5 France Sugar Beets & wheat .2 2 to one

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 GEOPOLITICAL FACTORS AND INCREASINGLY TURBULENT SUPPLY AND DEMAND

Figure 4: GN formulation: Crude Oil & Ethanol Supplies & Demands 2004: All Countries producing or
consuming 1 million barrels per day or more. “Other” includes the rest.

Figure 5: Projected biomass ethanol production, 2000-2020, (million gallons)

Model Application

As peak oil approaches, many argue that the United States and China are on a collision course in
competition for the oil on world markets. China has already courted traditional U.S. suppliers such as Canada,
Venezuela and Mexico. Furthermore, other emerging economies such as India and Brazil have dramatically

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Ronald F. Farina

increased their thirst for oil or possible substitutes. Among these substitutes is ethanol, which is included in
this model, although, any other technology could be added.

The model structure provides the energy strategist with a tool that can readily examine a virtually
infinite number of scenarios. Some examples might include possibilities of energy impacts. These impacts
might be associated with upheavals such as the Iraq war or natural disasters such as hurricanes Katrina and
Rita. It can also capture different assumptions of when peak production might occur. GN methodology
facilitates inclusion of price fluctuations and refinery capacity bottlenecks. Another issue under scrutiny could
be the relationship between price and the relative ability of different countries to pay.

Finally, the model can provide valuable market information with regard to alternative fuels
technologies. Ethanol is included as an example of such a technology. In an example, Figure 5 identifies three
scenarios envisioned by the Energy Information Administration. In fact, there is considerable evidence that the
high technology scenario is already happening. In 2004, 2% of the world’s motor fuel was biomass ethanol. In
isolated cases, dramatic changes are taking place. In Brazil, 40% of the motor fuel sold was sugar based
ethanol. In 2003, a small São Paulo company developed “total flex” engine technology, further accelerating the
transition.

Flex fuel vehicles embody existing technologies that can render the transition from petroleum based
transportation fuels to alternatives relatively seamlessly. Flex fuel vehicles come in two general categories:

1. The basic flex fuel vehicle can run on either gasoline or pure biomass based ethanol, or
mixtures of the two in any percentages. It requires no specific action from the driver.

2. The second type of flex fuel vehicle is the first type plus the enhancement of natural gas
(NG) capability through the addition of an extra tank and specialized hardware. The driver
must specifically select the NG option via a switch on the dashboard.

Estimates have been given that as many as 25 % of new vehicles sold in the United States have flex
fuel capability.. This statistic, however, is illusory since little capacity to deliver ethanol or natural gas exists
at the pump. Also, in fact, many of these vehicles are E85 or other specific mix technologies, not “total flex”.

Only in Brazil has biomass ethanol been integrated into the system over an extended period. For
thirty years, Brazil’s national biomass alcohol agency, PROALCOOL, has developed the ethanol fuel supply
infrastructure. It was accompanied by the domestic auto industry’s development and production of alcohol
vehicles. The program nearly became extinct in the late 1990’s due to low oil prices. By September 2005,
however, over 53 “total flex” models were available from virtually all of the manufacturers. Over 60% of the
vehicles sold in Brazil (Fall 2005) were at least of the basic flex fuel variety (Khosla, 2006). The demand is
market driven, given that biomass alcohol is almost exactly half the price of gasoline. While natural gas is on a
par with alcohol, or slightly cheaper, it has found less favor in the marketplace, since the extra tank often takes
up trunk space. The added weight affects the handling of the small Brazilian cars and presents an additional
hazard.

Despite its growing fuel consumption, Brazil hopes to achieve energy independence as early as 2006.
Its strategy is optimize domestic consumption and exports of its vast oil reserves discovered in the 1990’s
combined with its global predominance in ethanol production. The model presented in this paper could provide
their energy strategy decision makers with an invaluable tool. One use could be the examination of a variety of
global energy price, demand and exchange rate scenarios and their sensitivities.

The same could be said for the U.S. as it depletes its strategic petroleum reserve. It is clearly in need
for a coherent energy strategy.

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 GEOPOLITICAL FACTORS AND INCREASINGLY TURBULENT SUPPLY AND DEMAND

CONCLUSION

The GN model presented captures global crude oil flows under varying supply, demand, refining
capacity, price, and ability-to-buy scenarios. In addition, it can analyze any or all of these variables
simultaneously. This analysis can be done in the context of existing or hypothesized alternative fuel
technology, resource availability and cost scenarios.

It can also help decision makers understand the costs of environmental benefits associated with
ethanol and other alcohol fuels. All biomass fuels enjoy the environmental plus of returning to the atmosphere
no more CO2 than the plants, from which they are made, consume. On the minus side, care must be taken with
regard to agricultural practices resulting in erosion, as well as deforestation and food /fuel tradeoffs. Finally,
the model can examine impacts of random variations introduced by events such as wars and natural disasters.

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