Are high oil prices here to stay ?

Paul Krugman has a piece on oil. This is as good a time as any to put up a long post I’ve been working on about oil and whether it’s finally going to run short, points on which I broadly agree with Krugman.

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

11 thoughts on “Are high oil prices here to stay ?

  1. Presumably this will change some calculations for the Clayton’s FTA.

    Will it produce beautiful sets of figures?

  2. My problem with the Hubbert curve is that it is ad hoc. Hubbert’s first prediction came when oil prices were very stable. I bet if we checked many Hubbert enthusiasts/practioners projected a peak in the 70s and when they didn’t happen they added another curve (i.e, two curves to get two peaks, one local the other global).

    Also, being right with an ad hoc model is possible. For years everybody thought the Phillips curve was a reliable model. It too was ad hoc and when it was used for policy for too long and people caught on to the “trick” inherent in such policy the Phillips curve went vertical and left people wondering what the Hell happened. What happened was an entire generation of economists forgot their basic economic theory…people don’t suffer from money illusion.

  3. Steve – you don’t fully understand Hubbert’s analysis. He first noticed that a single field’s production followed a curve. There are geological reasons for this. He then noticed that the discoveries in a region under continuous exploration also followed the same curve. He then predicted – accurately, in the case of the lower 48 – that production would follow the same curve as discovery, but with a time lag unique to the region. The peak oil people are guilty of doing some post-hoc curve fitting, but the globe as a whole is not a region that has been under continuous, uninterrupted exploration, much less production. But the global discovery peak was many years ago, and that curve shows no indication of changing its general direction.

    Leaving aside all that, the estimates for ultimately recoverable oil (oil where the energy returned on energy invested is greater than 1) range from 2 gigabarrels to 3 Gbbl, both of which include some stretch via technological advances in production. We’ve produced about 1.1 Gbbl. As time goes on, the EROEI has fallen continuously, again for geological reasons. Until the time that EROEI reaches 1, increasing demand and increasing cost of production will drive the price up. Scarcity issues, perceived or real, will only add to that trend.

  4. Consensus oil price forecasts in March this year were for $26/barrel in 2004 and $23 in 2005. Friday’s price was $40 which emphasizes the value to society of investing millions of dollars in providing sound economic forecasts by funding worthy jobs such as my own. The forecasts I saw in March accounted for strong Chinese and east Asian demands but not for the recent mess in Iraq.

    OPEC is a lousy cartel (I agree with Morris Adelman, the oil market is competitive apart from occasional periods of OPEC discipline). Oil prices in the long-run should gravitate toward the marginal cost of proving up an extra barrel of reserves. These costs have jumped about over time but declined in the late 1990s. They might decline again given developments in exploration technology. My guess is that OPEC greed in the face of current high prices will, on balance, drive prices down in the medium term. And long term there are abundant reserves in Saudi and plenty of substitutes in the form of shale oil/tar sands etc.

    But this is a guess. A more realistic model forecasts future oil prices = F(extent to which OPEC can dominate the oil market, net growing Asian demands, political ideology of the forecaster). I have thoughts only on the first two influences. Boosting the market for oil creates greater incentives for an OPEC style cartel to survive by making the ‘cheat’ option relatively less attractive for the average producer but creates different incentives for high-cost producers to cheat. It’s a classic ‘on the one hand, on the other hand’ instance of economics evasiveness.

    An Australian digression: An outrageous instance of lack of local entrepreneurial flair was the transfer last year to a US mutual fund, for a pittance, of the Central Pacific shale oil deposits in Queensland. Given the billions BHP gambled on what turned out to be worthless foreign adventurism one wonders why they didn’t inject $100m or so into CP as a punt that CP was indeed being truthful in claims that they could make a commercial go at extracting oil from shale oil at oil prices of less than $15/barrel. The Greenies despised CP because of its environmental costs but, they can catch the train to their next demonstration, and their concerns were, in any event, being addressed by CP.

    Given the public subsidies that had long been fed into CP it was a stupid loss for Australia.

  5. JQ,

    Your post seems to imply that economic supply/demand forces are behind the recent – and, in your view, sustainable – increase in oil prices. However, yet as Harry Clarke points out, political risks and events have arguably driven the recent price increase, not an underlying shift in supply or demand.

    The recent reserve downgrades at Royal Dutch/Shell have not been followed by downgrades at their peers, which suggests it is not a systemic issue, and is particular to RD/Shell.

    I think it’s a bit early to start predicting an ever-rising oil price. Your introductory comments are spot on, and should have guided you to the same conclusion.

    As you also point out, the “Arabs have oil, therefore US invades” argument is also grossly over-simplistic.

  6. I think that we have to keep in mind the huge amount of oil we use, about 75 million barrels per day. BHP were boasting a while ago about a find of 300 million barrels and while they had reason to be pleased since it’s worth $12 billion, it’s only 4 days supply. A number of important fields are close to extinction – Bass Strait has only about 6 years, most of the North Sea about 10 years and as Klugman notes there have been no big discoveries. Oil from shale has never been feasible, it’s always been over the horizon – “it will work when the oil price is just a bit higher”. CP didn’t fail because of the greenies, it failed because they couldn’t make it work. The technological fix will come not from shale, but from energy efficiency.

  7. Morgan Stanley offer a range of $20 to $80 bbl for the next year ‘But we can’t honestly present a new baseline forecast in the face of as much uncertainty as at any time in the past three decades’ The higher price is based upon political instability in Arabia and reflects, as they point out, the lack of elasticity in oil demand.

    I’m somewhat incredulous at JQ’a playing down of the impact of the 70’s oil shock on the economy at the time. $80bbl as Morgan Stanley points out, is the dollar equivalent of price peaks during the 70’s. I reckon a few of Costello’s budget figures would get blown out of the water if oil got to that price and that’s assuming that the overall supply situation is the same as it was in the 70’s.

    As to the issue of supply, the important point to note is that we don’t know how much reserves are out there and we are unlikely to find out until companies/nations run out. Russia has just passed a law making figures on oil reserves and supplies a state secret. Other authors have pointed out, (since the late 90’s), that the figures given for reserves in many gulf countries have not changed for some years – an unlikely scenario where new reserves are being found in exactly the same quantities as exports! Shell was forced to make it’s disclosure, I imagine, because it couldn’t fulfil it’s contracts.

    The other side of this equation is of course, the behaviour of demand. Although Morgan Stanley’s low price is based upon a hard economic landing in China – the inelastic nature of demand and the growth of global trade suggests that it won’t just be China that will have a hard landing if the price of oil goes through the roof!

    Pessimists should also bear in mind the fact that global grain reserves are being eaten up at a very fast rate and that within 2- 3 years they will be at point that will have a marked upward affect on the price of grains. (i’ve seen doubling mentioned by way of comparision to 1970-1 when there was a similar shortage b4 the ‘green revolution’)

    I’m just going to go out now and plant the potatoes…I’ve got a still round here somewhere…wonder what it’ll do to the timing…I could just drink it…

  8. Why should countries like Saudi even bother to prove new reserves when current low-cost reserves are so large?

    There are also strategic reasons for reticence. Suppose shale or some alternative can be exploited at $30US/bl but fixed set-up costs of doing this this are huge. When will risk-averse firms begin to develop alternatives? Presumably when costs of extracting oil are expected to permanently exceed $30 in the near-term future. But this becomes hard to forecast if the size of low cost reserves aren’t known.

    People won’t develop alternatives simply because oil prices are high because this can be due to of cartel cohesion –they will want to know for sure that prices can’t in the medium term collapse back to competitive extraction cost levels much less than $30 so they don’t lose their dough in uneconomic projects.

    This then poses the risk of societies suddenly facing dramatically higher energy prices but with long lead times in getting alternatives going.

    Social insurance is for government to subsidise research into alternatives, particularly flexible alternatives with low set-up costs. It might also provide a case for providing price guarantees for alternative fuels subject to high fixed costs. This offsets one risk but poses another, namely potentially huge costs of lost present value in developing technologies whose time has not really come.

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