This post outlines how economists typically think about peak oil, what I call the ‘standard narrative’ of resource transition. The purpose of this post is to lay the groundwork for a more constructive debate regarding our understanding of peak oil. Economists are generally less concerned about peak oil than the geologists, physicists and engineers of ASPO (see sidebar). In this post I will attempt to identify the components of economic theory that support their view and how they weave these components together into a routine resource transition narrative.
Of course, not all economists share the standard narrative perspective. Here, I use ‘economist’ as a shorthand for ‘orthodox economist’. The much less numerous biophysical economists (see sidebar), are economists and are pretty concerned. But since biophysical economists reject a lot of orthodox theory, and have a backgrounds in physics and ecology, they are economists in about the same sense that the Jehovah’s Witnesses are Christian.
There are a few orthodox economists that take peak oil seriously. Jeff Rubin, recently Chief Economist at CIBC World Markets, is clearly in the ‘peaknik’ camp. Rubin is a speaker at the recent ASPO-USA conference in Washington, DC. Rubin argues that peak oil will involve a painful transition to a less globalised world. Somewhere between the ‘peaknik’ (more concerned) and ‘cornucopian’ (less concerned) camps lies James Hamilton. Hamilton is an expert on oil shocks and has identified the steep preceding rise in oil prices as a key factor in US recessions (including the most recent one). Do a search through the econbrowser archives (sidebar) and its pretty clear that Hamilton considers peak oil to be a major problem, but perhaps wouldn’t go as far as Rubin.
I will draw together a standard narrative by combining and condensing the following analyses with a focus on material published by NZ economists:
How to talk to an economist about peak oil -by James Hamilton (publ. 2005).
What happens after oil production peaks (2005) and Energy Futures: An economic framework and some policy implications (2006) -both by Brian Easton.
Oil price assumptions for energy outlook (2005) -by Ralph Samuelson (Ministry of Economic Development) and Michael Taylor; and Oil: An introduction for all New Zealanders (2008) -by Ralph Samuelson.
What price peak oil? (2008) -by Gareth Kiernan (Infometrics).
The latter two articles by Easton, the article by Samuelson and Taylor and the article by Kiernan are the only analyses of peak oil, authored by NZ economists, that I have been able to find (apart from the odd blog post). A situation which should raise concerns in itself. If you know of others please let me know.
Economists focus their analysis on oil prices, classifying peak oil as a problem of increasing oil prices. The standard narrative counters a view that prices will rise rapidly and stay permanently high, instead arguing that prices will rise moderately and be moderated by improving technology. There are five parts to the standard narrative explained below.
1. The oil market signals increasing scarcity prior to the peak through moderate price increases.
Here economists are invoking the Efficient Market Hypothesis (EMH). Efficiency in the EMH sense means efficient at processing information. The idea is that because there is:
(a) an oil futures market where traders trade contracts for the delivery of oil out to eight years (see Mazama Science on the sidebar for data from the oil futures market); and
(b) oil traders have the incentive to make a profit and anticipate moves in oil prices by buying low and selling high; then
accordingly, the numerous oil traders act as vast information processing mechanism. Because traders have the incentive to discover and incorporate information about oil supply and demand into a trading strategy, the price of oil should reflect all public information about oil. We can reasonably expect the oil market to anticipate any scarcity issues. From a public policy point of view, the EMH suggests that because over the long-run a single forecaster can do no better than the futures market at anticipating prices, governments should allow energy markets to allocate investment, and should not ‘pick winners’ by intervening with large-scale public investment.
2. Anticipating further prices increases, oil extractors defer extraction.
If an oil company is confident that oil prices are going to go up, then the company can make more money by waiting for the price to go up and extracting the oil later. Economists use the observation that oil companies are not deferring extraction* as evidence that peak oil (here classified as a rapid price increase) is not a near-term problem and/or will not result in permanently elevated prices.
The above conclusion stems from the Hotelling Rule*, named after the economist Harold Hotelling who’s 1931 paper, The Economics of Exhaustible Resources is probably the most cited resource economics paper ever. Resource economists have attempted to determine the most profitable extraction strategy, and price evolution under different conditions. The maths are more complicated than I will go into here, but basically Hotelling finds that the assuming complete knowledge, the price of a resource should rise in line with interest rates (interest rates influence this result because oil companies can invest the profits of extraction into an alternative interest bearing alternative). The observation that historically, oil prices have generally fallen (see chart below) is used as evidence that technological improvement has overcome scarcity in the oil price ‘tug of war’ (Samuelson, 2008). According to the standard narrative, we can expect technological improvement to continue to moderate prices.
3. As prices rise, oil reserves and resources that could not be extracted profitably, become profitable.
Deepwater oil, Canadian tarsands, Venezuelan extra heavy and oil shale are not profitable to extract at $US20/barrel but become profitable at perhaps $US75/barrel or higher. There are vast amounts of unconventional oil resources. According to the standard narrative, we can expect a rise in prices to boost extraction rates above a peaknik analysis. A rise in prices also encourages discovery efforts and we can expect to discover more oil.
4. As prices rise alternative technologies become profitable, accelerating a transition to alternative sources of energy.
As for 3 above but for alternative technologies such as electric cars, biofuels, and coal-to-liquid plants. Economist William Nordhaus outlined the theory behind this in 1973. Nordhaus called alternatives that can substitute for nonrenewable resources ‘backstop technology’. Nordhaus argues that because the potential of underexploited and more expensive energy resources such as solar and nuclear are so large, we do not have to worry about spiralling energy prices. high prices create a market opportunity that investors fill by starting alternative energy industries that substitute for oil (electric cars) or provide alternative fuel (biofuels, coal-to-liquid). Historically, the price of alternatives has fallen with improving technology. The (falling) price of substitutes will therefore cap the price we pay for energy services (see chart below from Samuelson and Taylor, 2005). Electric cars, such as the Nissan Leaf, are entering the market and demonstrate this principle in action.
This chart is from Samuelson and Taylor’s article on the oil price assumptions of the 2005 NZ Energy Outlook. The High Oil Price case represents what Samuelson and Taylor believe could happen during near-term peak oil. A transitional period of elevated oil prices 2010-2015, followed by a fall back to $US75/barrel as alternatives come on stream.
5. Oil consumers cut consumption of oil by substituting away from oil. Through substitution and efficiency the economy becomes less dependent on oil.
The standard narrative is often rounded off by observing that while both oil consumption and GDP have grown, oil consumption has not grown as fast as GDP. Economists argue that the economy is becoming less dependent on oil. According to the standard narrative, we can expect this process to accelerate with higher oil prices. For example, the chart below presents NZ real GDP, oil consumption, oil prices (right axis); and GDP per barrel of oil consumption (left axis), a measure of oil efficiency. High oil prices coincide with an increasing ratio between GDP and oil consumption. GDP may grow at a slower rate through the transitional period of high prices.
Data: Statistics NZ, BP, Penn World Tables.
6. Summary
Prices rise preemptively and moderately, signalling the market opportunity of alternative investment. People respond to incentives: finding more oil, innovating and bringing alternatives to market, and reducing consumption of oil through substitution. We may experience a transitional period of slower growth but the economy adjusts.
Conclusion
Reassured? While I think that the presented theories contain important insights, I do not find the standard narrative reassuring. Following posts will outline its deficiencies, and offer alternative economic and ‘engineering/physicist’ frameworks for understanding peak oil. At this stage, we should note that the standard narrative does not offer much in the way of recent real world data, other than prices, or any demonstration of feasibility.
I am emailing a number of economists and other interested parties to make them aware of this project and to invite criticism, commentary, and error correction. Internet-based dicussion offers ‘instant peer review’ and could attract a wider audience than the traditional journal process. Perhaps this project will eventually be written up for publication in a journal. Perhaps my promotion of limits to growth considerations will be dismissed out of hand as the ravings of someone with no qualifications in economics! In any case I will push on. The following post will look at how an engineer might approach peak oil and after that I will shift back and forth between economic theory, and an ‘engineering feasibility’ analysis.
P.S. The economic theory posts will run along the following lines:
1. Adaptive markets; uncertainty; allocative and informational efficiencies.
2. Prices and costs as indicators of scarcity.
3. Liebig’s law of the minimum and the logistics of alternatives development.
4. Energy Return on Invested (EROI) and the ‘receding horizons’ problem.
5. Critical dependence on oil? Reconciling biophysical and orthodox economics.
Pingback: How Engineers View Peak Oil | Maximum Power