Are high oil prices here to stay (repost) ?
There’s been a lot of interest in oil lately, so I’m reposting a piece I posted last year (here and on Crooked Timber if you want to check the comments from last time). Also of possible interest is this older piece on whether the Iraq war was all about oil ? And here’s a piece about the idea that America has a crucial concern in making sure that oil is priced in dollars, not euros.
h3. Will the oil run out ?
Oil is the paradigm example of an exhaustible resource (there’s a charming, but apparently false, belief that oil comes from decayed dinosaurs) Whenever the price of oil rises sharply then, it is natural to ask whether this is a mere market fluctuation or an indication of the impending exhaustion of the resource.
A couple of points of clarification are necessary before we come on to the main issues. First, the price of oil is typically quoted in $US/barrel, for some specific grade of oil such as West Texas light sweet crude. This need not be an accurate indicator of the cost of oil in general, because of variations in the purchasing power of the US dollar and because the relative prices of different types of oil fluctuate. The current upsurge in prices is due in part to the devaluation of the dollar against other major currencies and also in part to a particular shortage of the light grades of oil most suitable for producing petrol.
Second, oil will never simply ‘run out’. As the supply of any commodity declines, prices increase and, for relatively low-value uses, the costs exceed the benefits. Where they are available, low-cost substitutes become more attractive. Before the 1973 increase in prices, oil was commonly used as fuel in electricity generation and home heating. Following the increase in prices, most oil-fired power stations were converted to gas or coal. Where natural gas was readily available, the same was true of home heating. The relevant question then, is not whether oil will run out, but whether it will become so scarce as to be uneconomic in its main uses, the most important of which is as fuel for motor vehicles.
h4. Jevons and Hubbert
Critics of predictions of resource exhaustion have plenty of history on their side. In the 19th century, the eminent economist W.S. Jevons predicted the imminent exhaustion of reserves of coal. He was wrong, as were a series of subsequent prophets of resource exhaustion, most notably Paul Ehrlich and the Club of Rome in the 1970s. Time after time, scarcity has been met by new discoveries and by improvements in resource technologies that have made it economic to extract resources from sources that were once considered valueless. In the case of oil, the estimate of ‘proven’ reserves in 1973 was 577 billion barrels. The Club of Rome pointed out that given projections of growing use, reserves would be exhausted by the 1990s. The economic slowdown from the 1970s onwards meant that the actual rate of growth was slower. Nevertheless, between 1973 and 1996, total usage was around 500 billion barrels. Yet at the end of the period, estimated reserves had actually grown to over 1000 billion barrels.
This is a pattern that has been repeated for many other commodities, and should give pause to any advocate of the exhaustion hypothesis. (Nearly all the additional reserves came from upward revisions of estimates of reserves in existing fields, seen by optimists as reflecting technological gains)
Yet believers in the exhaustion of oil reserves have some history on their side too. Their key exhibit is the Hubbert curve which is supposed to show that oil output from a field should peak about 25 years after discovery. If you buy this story, oil output should have passed its peak a year to two ago. The big success for the Hubbert curve was Hubbert’s 1956 prediction of the peak in US oil output around 1970.
The current period of high prices and short supply gives some support to advocates of the Hubbert Curve. The really striking events however, have been those relating to reserves. For the first time, downward revisions to estimated reserves have become commonplace. The Shell company has been the most notably affected so far, being forced to announce a series of downward revisions in estimated reserves, apparently because of problems with Nigerian fields. But there have also been suggestions of similar problems many other oil-producing countries, either because reserves have been overstated for political reasons, or because fields have been mismanaged.
Of course, some fields are still expanding. For example, new leases are being issued for deep water prospects in the Gulf of Mexico. But the very fact that such marginal prospects are being explored is an indicator that oil companies expect high prices to persist.
On balance, I think that current high prices are likely to persist and to rise over time.
h4. What does it matter?
Oil looms large in many geopolitical discussions. While claims that the Iraq war was ‘all about oil’ are unduly conspiratorial, it seems clear that, if it were not for the presence of oil, the Middle East would not be a central focus of US foreign policy. The 1973 OPEC ‘oil shock’ (an embargo imposed in protest against US support for Israel, followed by a quadrupling of prices) was widely blamed for the stagflationary recession of the 1970s, and was seen as indicating the strategic vulnerability of the West to attacks on its supply of oil.
Most of this is and was an illusion. In reality, the oil shock was a consequence rather than a cause of the collapse of the postwar economic order based on the Bretton Woods system of fixed exchange rates. A central element of that system, the convertibility of the $US into gold at the fixed price of $3835/oz had been rendered unsustainable by inflation, and had been abandoned in the early 1970s, beginning with the Smithsonian agreement of 1971. Increases in the price of other commodities, including oil, were an inevitable consequence. The price of wool, for example, had doubled before anyone outside the oil industry heard of OPEC.
Similar points apply to the supposed vulnerability of the West to the cutting off of oil supplies. An embargo similar to that imposed by OPEC in 1973 might necessitate some form of rationing, but this is scarcely the ‘moral equivalent of war’. It makes no sense to maintain military preparations for a possibility that could be dealt with by reducing consumption.
Still the fact that such things make no sense doesn’t mean they won’t happen. Permanently high gasoline prices will be a big psychological shock for US consumers and could produce some irrational responses, such as a desire to invade Middle Eastern countries