Vehicle Efficiency Standards and Future US Oil Demand

With the budget crisis averted, we expect most readers are now looking to blot out the Washington drama of the past couple weeks with mojitos on the beach. Before heading on vacation ourselves, we wanted to touch briefly on one piece of policy news that’s important for oil market watchers but got buried in the budget drama.

Immediately after giving the Republican Congressional leadership another public scolding last Friday, President Obama announced an agreement with auto manufacturers, the UAW and the State of California, to raise light-duty vehicle efficiency standards to 54.5 miles per gallon by 2025. This announcement had been expected for some time, and the 54.5 number was leaked a week prior. But we’ve seen very little substantive analysis of the target either in sell-side research or the press, so we thought we’d provide some for those interested in how this rule will impact US oil demand in the years ahead.

 A Break From History

The most striking feature of the vehicle efficiency deal is that it’s the first time federal vehicle efficiency standards will actually drive transformation in the auto industry. As we pointed out in our April assessment of President Obama’s energy security blueprint, all past increases in corporate average fuel economy (CAFE) standards have come in response to oil price spikes that would have delivered most, if not all, of the desired efficiency improvements in the absence of federal requirements. When CAFE standards were first introduced in the late 1970s, high oil prices were already shifting consumer purchases away from heavy American cars to lighter Japanese imports (Figure 1). Once oil prices collapsed in the 1980s tighter CAFE standards would have had a binding effect. But for precisely that reason there was little political support for ratcheting them up any further. As a result, the standards were frozen at 1983 levels for close to 30 years.

When oil prices started rising again during the last decade, so did vehicle efficiency. Between 2001 and 2009 the efficiency of the average passenger car sold in America increased by 16 percent. This created the political space for Congress to pass, and President Bush to sign into law, the Energy Independence and Security Act  (EISA) of 2007 which mandated an a 7.5 mpg increase in CAFE standards (from 27.5 mpg to 35 mpg) by 2020 and for President Obama to raise the stakes with a 35.5 mpg target for 2016. But as in the late 1970s, these targets didn’t go much beyond what projected oil prices alone will deliver. 

Using RHG-NEMS, a version of the Energy Information Administration’s (EIA) National Energy Modeling System we run in-house for US energy market forecasting, we explored what would happen to vehicle efficiency over the next 15 years if CAFE standards were held flat at 1990s levels. We found that at oil prices currently forecast by EIA, passenger cars come close to achieving President Obama’s 2016 target thanks to market forces alone (Figure 1).

In contrast, the model year 2017-2025 standards announced on Friday go significantly beyond what currently forecast oil prices can achieve. The Administration’s 54.5 mpg fleet-wide target is broken down into a 62-63 mpg mandate for passenger cars and 43-44 mpg mandate for light trucks (SUVs and pick-ups). Market forces alone will likely deliver a 40% increase in the efficiency of new passenger cars between now and 2025 (Figure 1), but the new standards call for a 120% improvement above current levels.  Doubling passenger car efficiency in less than 15 years will require significant gains in engine efficiency, large-scale investments in hybrid, PHEV and EV production, and greater deployment of light-weight materials in auto manufacturing.  

Overselling the Benefits

While there is no doubt the new vehicle standards are ambitious, the Administration is overstating their impact on US oil demand. In his Friday press conference President Obama claimed that, combined with the Model Year 2011-2016 vehicle efficiency rules announced in 2009, the 2017-2025 standards will reduce US oil demand by 2.2 million barrels per day in 2025. If true, that would have a significant impact on global oil markets – enough to offset a 25 percent increase in Chinese oil demand or a complete halt in Iranian oil exports.

We modeled the proposed 2017-2025 vehicle standards and found they deliver a more modest 1.04 million bpd reduction in US demand below EIA’s pre-announcement projections in 2025. Add the impact of the 2011-2016 standards and you get to 1.2 million bpd in savings – still a far cry from the Administration’s 2.2 million bpd number. There are two reasons for the discrepancy:

First, and most important, is the choice of baselines. Our guess is the Administration is measuring the impact of the rules against a baseline in which little or no light-duty vehicle efficiency improvement takes place. Do that and you actually get above the 2.2 million bpd in savings the President cited – up to 2.9 million bpd in our estimate (Figure 2). But high oil prices prompted more than half of those gains, gains that were locked in by standards mandated in EISA 2007. By moving EISA’s 2020 target up to 2016 President Obama added 160,000 bpd in 2025 savings, but he can hardly claim credit for the 1.7 million bpd reduction high oil prices and the Bush Administration delivered.

Second, the Administration may not be accounting for the rebound effect that occurs when you mandate more efficient vehicles. Unlike a gas tax that encourages consumers to both buy more efficient cars and drive those cars less, standards only do the former. In fact, as improved efficiency reduces the cost of driving, overall vehicle miles travelled actually go up when CAFE standards are increased. Less oil consumed in light duty vehicles thanks to improved efficiency can also lower global oil prices by moving the marginal barrel down the supply curve. That increases oil demand in other forms of transportation or other sectors of the economy. In our analysis rebound erodes 13% of the overall MY 2017-2025 oil savings (Figure 2).

But Still Important for the US oil Outlook

While the oil savings potential of last Friday’s announcement is not as large as the President suggests, it still has a significant effect on the medium and long-term US oil demand outlook. Incorporating the proposed MY 2017-2025 light duty vehicle standards into EIA’s 2011 Annual Energy Outlook (http://www.eia.gov/forecasts/aeo/index.cfm) reduces US liquids demand by 5% in 2025 and 13% in 2035 (Table 1).  As discussed in our recent report “Assessing America’s Energy Security Options” published by the Peterson Institute for International Economics (http://www.piie.com/publications/interstitial.cfm?ResearchID=1865) this is greater than the potential medium and long-term impact of any other single policy lever currently being considered in Washington. 

Potentially more important than the change in headline oil demand, however, is the change in the balance of products consumed. The proposed standards would reduce US gasoline demand by 17% in 2025 and 35% in 2035 (Table 1). Diesel demand picks up some of the slack (a 10% increase in 2025 and 16% increase in 2035) as CAFE standards prompt greater deployment of higher-efficiency diesel vehicles.

This would add pressure to what is already projected to be a fairly tight middle distillate market going forward thanks to robust diesel-heavy economic growth in emerging economies, weaker gasoline-heavy economic growth in the OECD and increased supply of natural gas liquids. Last month we participated in the Aspen Oil & Gas Forum, an annual get together of 40-50 industry leaders focused on emerging market and policy developments. And the refiners in the room expressed concern about the sector’s ability to keep up with this trend. So while the standards will help soften average crude prices, the changing composition of US demand could increase the risk of episodic middle distillate-led price spikes like we saw in 2007-2008.