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Introduction

7

Dynamic analysis also has applications in allocating capital costs over time. In a very capital-intensive industry such as energy, it is important to be able to allocate such costs across units of production or consumption. Capital cost allocation procedures are developed in chapter 13 and applied to the costs of electricity generation, energy transport, renewable energy production, and services from household appliances. These costs are important inputs to the many market models considered in this text, and have implications for energy supply. A case in point: Shell Oil Company expects that renewable energy sources will provide half of our energy needs by 2050. Which markets renewable sources penetrate––and how fast––will be strongly influenced by their characteristics and their costs.

If a problem can be modeled using linear equations, it is usually easy to solve––even if the model is quite large. In linear programming, we maximize or minimize a linear objective function subject to linear constraints. We apply this technique to oil refining and energy transportation in chapter 14.

In chapters 1–14, most of the analysis was done under the assumption of certainty. However, we face large uncertainties in most aspects of our lives and with uncertainty comes risk. Energy is no exception; it is a risky business. Government policies, the economy, and competition influence energy prices and costs, and all three can provide unpleasant surprises, threatening not only profits, but, in some instances, a company's very survival. Should we want to reduce risk, we have various choices, including organized futures markets with standardized contracts where parties do not know who is on the other side of the trade. With futures and options markets, discussed in chapter 15, we can lock in future prices for energy products that we want to buy or sell to reduce and manage risk.

Sometimes a player would rather provide a ceiling or a floor for the price of energy. A refinery might want to lock in a minimum price for its product and a maximum price for the crude oil it buys. To do so, it can buy or sell an option on a futures contract for these products. These standardized contracts, also discussed in chapter 15, give the buyer the right, but not the obligation, to buy or sell a futures contract depending on whether a call or put option has been purchased. If it is not profitable, the option is usually allowed to expire. However, if the option is “in the money,” usually the buyer closes out an option for a cash settlement rather than taking delivery, as with futures contracts.

Energy is produced in a technically complex industry. Uranium requires sophisticated processing; coal is gouged out of the earth with huge equipment; refineries use complicated processes utilizing catalysts to break down oil and reshape it into the products we have come to depend upon. Natural gas is transported through complicated pipeline networks with computer systems to monitor and measure its location. With the information revolution, even more technical choices influence how firms are organized and how they function. Some of these technologies and how they are being used are considered in chapter 16.

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