Peak Oil News: How to talk to an economist about peak oil

Monday, August 08, 2005

How to talk to an economist about peak oil


By James Hamilton

I for one would like to see better communication between economists, geologists, and petroleum engineers about the timing and consequences of the eventual decline in global annual production rates of crude petroleum. In part the failure to communicate better with each other stems from differences in the language, assumptions, and paradigms with which those of us from different specialties approach this issue. As one small step toward bridging that gap, I'd like to lay out for noneconomists a few of the key aspects of how economists might think about peak oil.

Suppose you told me that, as a result of a careful examination of oil reservoirs, you were certain that annual oil production was just about to plummet, and would be 30% below its current level in two years. I realize that's a more extreme example than anybody is advocating, but perhaps you'll bear with me in examining its implications for a few minutes before turning to a more subtle scenario.

Let's see if we can first agree on how society ought to respond to these facts that you would be giving us. I would say that the first thing we should do is curtail current oil consumption drastically. Oil is going to be an incredibly valuable commodity in two more years, and we've got to stop wasting it now. By leaving more of the oil in the ground now, we could stretch out the time available to us for developing alternative sources from oil sands and coal and to make radical changes in our transportation systems. And we would need to start immediately making huge investments in those alternatives.

Now let's consider what would happen if the government doesn't make any policy response. Oil is going to become extremely valuable under this scenario in a very short period of time. Let's say for discussion we're talking about $200 a barrel two years hence. Then I would like to make the observation that, if the facts were indeed as we just conjectured, oil surely could not continue to sell for $60 a barrel today. Anybody who pumps a barrel out of a reservoir today to sell at $60 could make three times as much money if they just left it in the ground another two years before pumping it out. The same is true for anybody with above-ground storage facilities-- they're throwing away money, and lots of it, for every barrel they sell at $60 that they could have instead stored for two years and sold for $200. If oil producers did respond to these very strong incentives by holding back oil from today's market, the effect would be to drive today's price up. This profit-seeking wouldn't drive the price all the way up to $200, because you have significant interest, storage, and idle capacity expenses from trying to wait around a couple of years before getting your profit. An economist would expect the end result of this profit-seeking to be that the price today is lower than what it will be in two years by an amount that reflects these interest and other expenses, but certainly far less than the difference between $60 and $200 a barrel.

Suppose, again for sake of discussion, that the outcome of this profit-seeking behavior by oil sellers was to drive the price of oil to $180 a barrel today, (that is, supposing that $180 plus two years worth of forgone interest equals $200). What effects would that have? For one thing, it would be a very powerful and effective incentive to force today's users of oil to reduce their consumption immediately. It would likewise be a very powerful incentive for investing heavily in oil sands and alternative technologies. And, of course, it would leave us more oil in the future to keep the economy going as we make the needed transitions. In other words, the consequence of oil producers trying to sell their oil for the highest price would be to help move society immediately and powerfully in the direction that we earlier determined it ought to move in anticipation of what is going to happen in the future.

I know that many physical scientists feel that economists have a misguided, mystical faith that "markets will always solve everything." Though I understand how outsiders might get this impression, I would guess that more than half of the published research in economics has to do with how the market can misallocate resources rather than how it always does a perfect job. But one thing in which most economists do place a great deal of faith is the powerful forces that are unleashed, for good or ill, by people's efforts to make themselves richer. The argument I'm making here is not an abstract, mystical claim about the market, but rather a very specific claim about the particular matter of interest. The claim is that profit-seeking works strongly in this instance to make the oil price rise now rather than wait until production actually declines, and that this force further works to produce the kind of changes that society needs to make now in order to prepare for the coming production decline.

So, if you thought you were right about the physical scenario, and yet saw oil selling today for $60, how could you explain the situation to an economist, who says that, if you're right, oil should be selling for $180? One thing you might argue is that, in some of the oil producing countries, the rulers have a precarious hold on power, so they just want to pump all the oil they can right now rather than wait a few years, even if the extra profits from waiting might be enormous. That's a good argument to make to economists, one we can understand and listen to. But, we would respond, what about private oil companies operating in market economies? Why would they throw away enormous profits?

Here I have heard some conspiracy- or incompetence-based arguments that frankly are difficult for an economist to follow. But rather than get into those, let me just observe that, even if every single oil producing government and every single oil company in the world had no desire or is too stupid to reap the huge profits that, under the scenario we're discussing, could be theirs for the taking, that still wouldn't be enough to account for the current price structure. The reason, as I've explained here and here, is that you don't need to control a single barrel of oil in order to profit quite handsomely, if what we've conjectured so far were true. If today's price is $60 and in two years oil will sell for $200, anybody with any money to invest could profit enormously by purchasing oil futures or options. And we don't see $200 oil, not in spot prices, not in options, not in futures.

So how could it be that there are billions and billions of easy dollars to be made, and nobody can be bothered to collect them? Unless you have a clear answer for that question, an economist at that point is going to ask whether you're sure that you've got all the facts straight, that oil really is going to sell for $200 a barrel in just two years.

Now, you may protest that you never claimed that oil production was going to fall off as much as 30% and the price was headed for $200 in just two years, that this whole extreme scenario was just a straw man I brought up to steer the discussion my way. Fine, let's say your story is that we'll be at the point we just analyzed in n years rather than 2 years. The point I wish to make is that you shouldn't expect that the oil price will stay stuck at $60 a barrel for n - 2 years, with everybody cluelessly wasting oil and ignoring the need for alternative investments along the way, and then all of a sudden jump up to $180 in year n - 2, for exactly the reasons we just discussed. Somebody would be missing a huge profit opportunity in the price jump from $60 in n - 3 years to $180 in n - 2 years. What economists would therefore expect to see under the n-year scenario would be for the oil price to rise steadily over all these n years, gradually producing greater and greater incentives for the needed conservation and the needed development of alternatives between now and year n.

This particular understanding of the natural consequence of profit-seeking behavior is I think the heart of the issue that needs to be addressed in order for economists and noneconomists to understand each other on this issue.

There's much more that can and should be said to improve communication between economists and others studying this question. I have learned that my readers are a highly informed group representing quite a range of different viewpoints and disciplines. So, at this point, perhaps you'll allow me just to turn the discussion over to you.


At 3:01 PM, August 08, 2005, Blogger rockstar said...

Thank you for that! I'm not an economist and I get a lot of "market forces will solve the problem" whenever I talk about peak oil. It's good to have a little insight into the argument.

One thing that concerns me about the market forces argument is that building the infrastructure required to switch to another energy source (assuming we have one) is projected to take 20 years (according to the recent Department of Energy report). Markets seem to only have a 5 year look-ahead, though, as detailed here:

and here:

Given these assumptions, how can we expect the market to solve our energy problem in a timely fashion?

- rockstar

At 8:23 AM, August 10, 2005, Blogger geon said...

According to the reasoning in this article, how would an economist explain oil going from $15 to $60 a barrel in the last five years without any market anticipation? Why didn't oil producers and speculators make windfall profits five years ago by witholding or buying up oil?


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