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

10 thoughts on “Are high oil prices here to stay (repost) ?

  1. What do you mean, “apparently false”? Isn’t Gough Whitlam a continuing source of snake oil?

    More seriousl, was Jevons so wrong in terms of what he was addressing? Didn’t Britain’s competitive advantage in coal fade shortly after that period? Weren’t the new sources inferior in terms of accessibility to end users, and aren’t there huge imperfections in exploiting coal from the inappropriateness of the market’s greedy algorithm approach in this case?

    That is, market forces favour starting new mines rather than exhausting old ones completely, even though maintenenace costs on abandoned workings mean they can never be reopened as well as if they had been completely run down. This showed in Denmark’s choice between Scottish and Polish coal for its power stations in the ’80s (both had similar logistics, making this a realistic comparison).

    I suppose it matters whether Jevons was making an absolute comment or pointing at the beginning of the end, a distinction which many similarly fail to make when criticising Malthus. In each case it is really highlighting what assumptions need to be monitored to see how really near the end we are, rather than making an absolute and wrong prediction. While I can comment directly on Malthus, I don’t know Jevons’s work well enough to be sure, but it seems something worth checking out before running the risk of erecting an accidental straw man (as people do with Malthus).

  2. Many claim that the $US being reserve currency affords the USA the ability to run a larger deficit than otherwise possible. Some combine this with the fact that oil is traded in $US as meaning that trade in oil is one of the underpinnings of $US’s status as reserve currency. The argument then concludes that Iraq’s change to selling oil for Euros was a threat to USA economic security.

    Is this argument correct, based on falsehoods or merely exaggerated?

  3. I’ve added a link to a post on this topic, wbb. The short answer is “exaggerated”.

  4. Thanks John for the links & reposts.

    But now that you’ve discounted the euro & oil as cause for war and the USA has itelf, I’d say, pretty much acknowledged WMD were not the reason and humanitarianism was disavowed by John Howard explicitly where do we stand?

    The UN resolutions can’t be used as a reason because the UN itself has called the invasion illegal.

    So surely this war didn’t just happen because a bunch of neo-cons riding on the back of 911 were able to hijack the foreign policy of the USA to promote their ideological agenda that says the world must be democratised at the point of the sword. That seems too fanciful. Surely the hard-heads needed to be on board for such a momentous undertaking.

    Terrorism? How could replacing a stable if brutal state by a seething maelstrom of bombings and burgeoning terror groups be a sane reason?

    Does anybody have the first clue then why Iraq was invaded?

    Me? I’m still all about oil. And that is either because I am right or else because I still don’t understand much of the economics of it.

    So one more question (on this post anyway) – are the affordable oil reserves big enough to accomodate both the USA and a growing China without sending the price thru the roof in the medium term? And is it not true that Saddam’s antipathy to the USA wold have seen preferential deals with anybody but the USA, to the extent that Saddam was a threat to USA’s security. (Oil is mentioned plenty often in sotu’s and pnac’s as a vital interest.) Strocchi was big on the ditch saudi/hitch iraq rationale. Which is a long way of saying – oil – as far as I can see.

    Is there not plenty of noise in the USA about Chavez and given his cosying up to the Chinese, doesn’t anybody see parallels. The USA may be able to topple Chavez thru classic CIA ops. With Saddam the only way was full on assault.

  5. Oil is simply a store of energy. Engines are mechanisms to convert the storage into work. Batteries are storages and engines in one. Other energy storages are uranium, coal, carbohydrates (wood). These are all things we can transport from one place to another and feed to the engines. A human can be seen as an engine who goes searching for energy sources to keep the engine going.

    As oil gets more expensive the trick is to find a cheaper way to store energy. Energy could be stored as kinetic wheels, hydrogen, in batteries. Theoretically if an efficient way could be found to “bottle” solar energy it would render the oil issue moot.

    Much as humans evolved from hunting for food to farming for food, we could go from food farming to energy farming.

    At first humans found sustainable energy sources for their own internal engines (bodies), now we are seeking energy sources for engines that we created artifically.

  6. wbb wrote:
    And is it not true that Saddam’s antipathy to the USA would have seen preferential deals with anybody but the USA, to the extent that Saddam was a threat to USA’s security.

    Oil is a commodity—so if Saddam sold his oil only to (say) France and not to the US, France would buy less from Saudi Arabia and the US would buy more, but the supply/demand balance and the price of oil would remain the same, as long as Saddam sold the same amount of oil.

    If US policy towards Saddam had been determined by oil I think it would have been cheaper and easier for the US to become friendly with Saddam again.

    My favourite oil quote is from an ex Saudi oil minister whose name escapes me. He said: “The stone age did not end because of a lack of stone, and the oil age won’t end because of a lack of oil.” Of course the Saudis do have an interest in keeping demand for their oil as high as possible.

    P.S. I love the live preview!

  7. Leonard, any idea of the alternatives for automobile propulsion in ascending order of lead times to the mass-market?

  8. A recent agreement signed b/w Venezuela and Argentina to barter food for oil is perhaps evidence that oil is a much more complicated good than a purely theoretical commodity. Meaning that favored trading partner status for an essential good such as oil is highly desirable.

    The USA was having a certain degree of trouble attaining this status with the former Iraqi dictator.

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