On the price of oil

2006-04-16

in Economics, Politics, The environment

Tristan asked me a few days ago whether the status of oil as a non-renewable resource means that it must rise in price over the long term. It’s an interesting question. Here is a fairly classical economic answer. The point here is not to consider the possibility of short-term price shocks, which are quite a different sort of phenomenon, and one not related directly to the scarcity or abundance of oil in the ground. Rather, the point is to consider whether the fact that oil reserves develop at a rate that is negligible compared to the rate at which they are exploited means that oil as a commodity is destined to become ever-dearer.

I would contend that there are three prices of oil which we can consider, and two of them are highly relevant. The first cost is simply the nominal cost of any particular grade of oil at a point in time. That is to say, the cost in whatever unit of currency you care to use. These are not directly comparable, over time, because they do not factor in inflation. The second, more relevant, price is the nominal price adjusted for the rate of inflation. While there are difficulties in properly assessing the rate of inflation, a price that takes it into account as can best be managed does a better job of reflecting what the price of oil is, relative to other commodities. Economists call this the ‘real’ price of oil. The third price, which I will get into further below, is the relative price of oil as a factor of production, from the perspective of any firm and firms in aggregate.

Examining the price trend, firstly, there are considerations of supply and demand. These are fundamentally related to the rate of oil extraction, not to the total available reserves. That said, those watching the levels of reserves might anticipate future scarcity (doing things like choosing less oil intensive technology or making bets on higher oil prices in commodity markets). Sticking to flows for the moment, there does seem to be a considerable extent to which oil production can be increased in the medium term. Especially given today’s high oil prices, fields that were previously not commercially viable have become so. Likewise, fields that were depleted to the point where the cost of extracting an extra barrel of oil was at or below the value of that oil have become viable again. This kind of incentive will emerge whenever the real price of oil rises. The potential to bring new oilfields onstream in the medium turn should act to mitigate – though not eliminate – price rises in oil.

The next big issue is substitution. We use oil for a great many purposes: from powering vehicles to making plastics and fertilizers to generating electrical power. In some of these applications, it can be more easily replaced with alternatives than it can in others. While you would be hard-pressed to make many plastics without oil, electricity can certainly be generated in other ways. At present, the global system for distributing natural gas is far less extensive than the one for distributing oil. As greater scarcity and higher oil prices are experienced and anticipated, states will shift their energy production strategies towards those based on other technology. The degree to which such shifts can take place is called the elasticity of demand: the easier is it to substitute, the smaller price rises will be, both in the short and long term. In almost all cases, elasticity of demand becomes greater with time, as firms and individuals have more scope to modify their consumption and production choices.

Relative factor prices provide one market mechanism by which production choices are made. That is to say, if the price of an input – say labour – rises, firms will modify their production strategy in the short, medium, and long term to reduce the usage of that factor to an efficient level. How big the changes they make have to do with their anticipation of future movements in factor prices. Through the existence or anticipation of higher oil prices, firms will be driven to make production decisions that reduce their usage of oil, while increasing their usage of other commodities.

In the long term, major technological change also promises to help us shift away from oil. Biotechnology and genetic engineering promise ways to produce fuels and polymers from plants. Electrical generation based on renewable sources can offset that from hydrocarbons. Organizational change can also play a role. Power sources and power usage can be brought physically closer together, reducing the cost of transport. Likewise, the amount of travel undertaken by individuals and firms can be reduced through planning that minimizes it.

A final inductive point is that, while people have predicted for hundreds of years that all manner of minerals are in danger of running out, this has not taken place for any. Indeed, the real prices of commodities like gold, silver, and copper have been falling in the long term. For a lengthy statistical treatment of this, see Bjorn Lomborg’s The Skeptical Environmentalist.

The short answer, then, is that we have reasons to believe that the real price of oil does not need to increase as the commodity itself becomes scarcer, provided the above assumptions about the capacity for factor substitution and technological change are accurate. Even if not, the same considerations indicate that price rises will at least be moderated in the medium and long-term. It should also be remembered that the overall phenomenon of economic growth increases the buying power of individuals and firms. That is to say, they can each afford more goods and services than they could before. As such, the total proportion of an individual or firms spending power devoted to oil need not grow at the same rate as the price of oil.

Report a typo or inaccuracy

{ 25 comments… read them below or add one }

Anonymous April 16, 2006 at 2:54 pm

What you say is largely true, but markets will not acheive all of this on their own.

Such changes will not occur overnight. It will take a decade or two before either fuel cells or bioethanol make a significant dent in the oil economy. Still, they represent the first serious challenges to petrol in a century. If hydrogen were made from renewable energy (or if the carbon dioxide generated by making it from fossil fuels were sequestered underground), then the cars and power plants of the future would release no local pollution or greenhouse gases. Because bioethanol is made from plants, it merely “borrows” its carbon from the atmosphere, so cannot add to global warming. What is more, because hydrogen can be made in a geographically distributed fashion, by any producer anywhere, no OPEC cartel or would-be successor to it could ever manipulate the supplies or the price. There need never be another war over energy.

America’s leaders are still concerning themselves almost exclusively with increasing the supply of oil, rather than with curbing the demand for it while increasing the supply of alternatives. Some encouragement for new technologies is proposed, but it will have little effect: bigger subsidies for research are unlikely to spur innovation in industries with hundreds of billions of dollars in fossil-fuel assets. The best way to curb the demand for oil and promote innovation in oil alternatives is to tell the world’s energy markets that the “externalities” of oil consumption—security considerations and environmental issues alike—really will influence policy from now on. And the way to do that is to impose a gradually rising gasoline tax.

By introducing a small but steadily rising tax on petrol, America would do far more to encourage innovation and improve energy security than all the drilling in Alaska’s wilderness. Crucially, this need not be, and should not be, a matter of raising taxes in the aggregate. The proceeds from a gasoline tax ought to be used to finance cuts in other taxes—this, surely, is the way to present them to a sceptical electorate.

Judging by the debate going on in Washington, a policy of this kind is a distant prospect.

R.K. April 16, 2006 at 4:43 pm

The big question is whether substitutes can be found for oil in all the areas where it is consumed on a very large scale, in the time between now and when supply constraints will really start to bite.

If we can sort out transport, electrical power generation, and plastics, we will have probably done the lion’s share of the work.

Connection finder April 16, 2006 at 4:56 pm

More economic argumentation with Tristan is on his blog, here.

Cletus the Foetus April 16, 2006 at 7:33 pm

I’m no expert, but I’ve heard some information that severely conditions the optimistic assumption about factor substitution, namely that petroleum has a uniquely high quotient of energy return on invesment.

Tristan Laing April 16, 2006 at 9:10 pm

It is a fallacy to think that we can shift our energy consumption from Oil to Biodiesel or natural gas. Natural gas is already past its optimal extraction point, and will increase in price from this point on aswell. True there is much more that can be transported as a liquid, but this will always get more and more expensive (although tax funded massive infrastructure like pipelines will make it appear to get cheaper in the short term).

Biodiesel is diesel produced from grown crops. However, it simply takes more oil in terms of petroleum based fertilizers and pesticides than you get biodiesel out of it. It’s a net energy loser. So, it’s rationally absurd to think that biodiesel can reduce our reliance on oil by any degree, even an insignificant one.

We can dam more rivers and build more windfarms, but relative to the cost of producing them (which includes huge ecological costs in the case of dams) makes them poor substitutes.

The price of electricity has just gone up in Ontario, and the rhetoric coming from Queen’s Park is becoming more realistic. “We have to pay the real price for energy. Energy prices are going up worldwide. If we subsidize our energy we’ll overcomsume and provide huge debts for our children”, this was actually on the news.

R.K. April 16, 2006 at 9:16 pm

Tristan,

By definition, the more expensive oil is becoming, the harder people will look for substitutes and the more commercially viable those substitutes will be. Human ingenuity has dealt with much tougher problems!

Anonymous April 16, 2006 at 9:25 pm

Although we use more and more fossil energy, we have found even more. Our reserves – even measured in years of consumption – of oil, coal and gas have increased. Today we have oil for at least 40 years at present consumption, at least 60 years’ worth of gas, and 230 years’ worth of coal.

At $40 a barrel, shale oil can supply oil for the next 250 years at current consumption. And all in all there is oil enough to cover our total energy consumption for the next 5,000 years. There is uranium for the next 14,000 years. Milan is right about economic growth diminishing the share of energy costs as a portion of income and production costs. Our current energy costs make up less than 2 percent of world GDP, so even if we were to see large price increases it would still not have significant welfare impact – in all likelihood the budget share for energy would still be falling.

Moreover there are many options using renewable energy sources. Today, they make up a vanishingly small part of the global energy production, but this can and probably will change. The cost of both solar and wind energy has dropped by 94-98 percent ion the last 20 years, such that they have become much closer to being strictly profitable. Renewable energy resources are almost incomprehensibly large. The sun leaves us with about 7,000 times our present energy consumption – for example, covering just 2.6 percent of the Sahara with today’s solar cells would supply our entire global energy consumption. It is estimated that wind energy could realistically cover half of our energy consumption.

Technology does not remain constant, and fossil fuels are not the only source of energy. Just as the stone age did not end for lack of stone, the oil age will not end due to the lack of oil. Rather, it will end because of the emergence of superior alternatives.

tristan Laing April 18, 2006 at 4:18 am

It doesn’t take a hot shot analist to realize that, despite 98% reductions in the cost of wind and solar power, they remain a totally unviable alternative at present. What seems very difficult for everyone to understand is that at present we consume a very high absolute value of energy relative to the amount of energy consumed on the planet by humans in other ages. There are simply far more people, and many of them live lifestyles that are energy absurd. It is not a coincidence that the most profitable retailer is also perhaps the most wasteful with energy in their structural set up.

There are good reasons to believe that oil reserves have been over reported due to Opec regulations that allow countries with more reserves to sell more. There is no verification of these reserve numbers as far as I know by any body which would not have an interest in having them over reported.

It is popular to believe the fallacy that “the market will save us”. Ceteris Peribus, this might be the case. However, since Market’s don’t operate without government and military intervention, there is no reason to believe that we will choose ingenuity and sacrifice over conqueset and facism.

Sylvia April 18, 2006 at 5:23 am

“electricity can certainly be generated in other ways”

Not likely. It takes a whole lot of oil to build a dam. Just producing the concrete takes vast amounts of energy, not to mention trucking it to the dam site. All the metal going into the dam and the transmission network requires energy to smelt as well. I know they make aluminum with electric power but I don’t know about steel. And can all those utility trucks (and the helicopters for remote sites) run on electric batteries? Not to mention all the trucks and equipment used in mining and moving the materials needed to make the hydro system.

The only feasible alternative is to substitute our techno/chemical lifestyle with an agrarian one. But, being human, we won’t do that until we’re absolutely forced to.

Jack April 18, 2006 at 9:04 am

The arguments about how humanity is doomed for lack of oil are just wrong for so many reasons. Thankfully, I do not have the time or the inclination to thrash them out here. As so often in the past, history will vindicate the optimists.

Milan April 18, 2006 at 9:37 am

@Tristan,

“[A]t present we consume a very high absolute value of energy relative to the amount of energy consumed on the planet by humans in other ages.”

This isn’t a problem, provided we can keep finding new sources for it. I am willing to bet that in thirty years, we will have more and cheaper energy than we do today.

“There is no verification of these reserve numbers as far as I know by any body which would not have an interest in having them over reported. ”

Oil companies are required to disclose their reserve levels according to fairly strict guidelines. Witness all the hair-pulling recently when a couple of firms had to re-state the size of their ‘proven’ reserves on the basis of new definitions being imposed.

Even if the present oil supplies are exxaggerated to an extent, it doesn’t undermine the main thrust of this argument.

“However, since Market’s don’t operate without government and military intervention, there is no reason to believe that we will choose ingenuity and sacrifice over conqueset and facism.”

It seems increasingly evident that you can’t expect to win increased oil production through warfare. Governments and militaries have a strong incentive, in the long-term, to help along the forces of substitution and technological development.

@Sylvia

The whole brilliant thing about markets is that they will deal with the kinds of secondary effects you describe. Also, to say that dam construction is the only mechanism by which we can produce more power is simply wrong. Most viable dams in the developed world have already been built, and there are lots of doubts about the attractiveness of dam projects in developing states.

I would personally guess that the future of electricity production is a combination of fuels derived from plants using biological means (a more efficient kind of solar power, really) and through distributed networks of renewable power stations, storing power in the form of something like hydrogen to be transported to the grid. Of course, it’s possible that existing technologies – such as nuclear – will also play a big role.

Anonymous April 18, 2006 at 11:25 am

Why is solar “a totally unviable alternative at present?”

Solar electricity is the fastest growing energy source in the world – with annual growth rates in the range of 25- 35% over the last 10 years. In 2004 there was an installed capacity of over 2,500 MW globally – in Germany alone the market grew by 87% and 360 MW of solar power was installed.

Milan April 18, 2006 at 2:58 pm

@Anon,

German solar may be growing quickly, but from a fairly small base. Here is a breakdown of German electrical production, by type, in thousands of megawatts: (2003)

Hydroelectric: 4.9
Nuclear: 23.4
Geothermal/Solar/Wind/Biomass: 12.3
Conventional Thermal: 79.2

Of that, renewables in total represent just 14.3%

Tristan Laing April 18, 2006 at 8:04 pm

“The whole brilliant thing about the markets”

What faith.

“By definition”, the more expensive oil gets, the more expensive it will be to look for alternatives. Especially alternatives that require huge amounts of construction and/or exploration. Certainly its possible, but we may be getting ourselves into a situation where the market has less than 100% chance of regulating itself.

Markets are especially bad at dealing with recessions. If we want the best chance for “survival”, we ought to begin before market forces push us into rebuilding the rail system, redesigning communities, putting in mass urban transit etc…When oil becomes expensive, it will no longer be viable to build the kind of transportation systems that don’t use as much oil.

Milan April 18, 2006 at 8:15 pm

Tristan,

We’re just trading assertions: optimism against pessimism. The material question of how much oil there is is easy enough to answer. The question of how technology and economic organization will progress, we can only guess at.

To me, history indicates that adopting an overly cautious stance is probably unjustified – especially at the cost of foregoing other opportunities for investment.

B April 18, 2006 at 11:18 pm

This is all getting a bit mean-spirited. It’s not something worth fighting about at a personal level.

Sylvia April 19, 2006 at 2:46 am

“I would personally guess that the future of electricity production is a combination of fuels derived from plants using biological means…”

I don’t have the numbers but I would question whether there are enough plants on earth to supply the amount of energy supplied by oil. People don’t fully appreciate the energy density of petroleum. As I understand it, biodiesel is actually a net loser of energy when you factor in the energy used to raise the grain, extract the oil, and distribute it. And without petroleum-based fertilizers and pesticides the yields would be lower than they are now. So even if we had enough arable land to grow enough grain to supply the amount of energy we use, it would consume more energy than it produces, therefore it won’t work. Coal might be able to supply do some of the work, particularly transportation by rail. Otherwise we’ll have to use animal and human labour, in which case we won’t bother with the biodiesel and just use muscle-power to get things done. Now there’s a proven technology! If it was good enough for 99% of our ancestors, it should be good enough for us!

Tristan Laing April 19, 2006 at 5:42 am

Fair enough that we can’t guess at what technologies might save us (but we can be fairly sure that whatever technology will save us, we havn’t thought of it yet).

The question from the start was never about how much oil there is. It’s about how the price of oil will react to a)increased demand and b)increased price/difficulty of extraction. Since we’ve passed the peak production (cheap production=more production at a fixed price), production will decrease if the price remains constant. But production can’t decrease, so the price will have to go up to keep production up. So the price of oil will go up, so we’ll be pushed into a recession we’ll never get out of.

Where is the flaw in the logic?

Milan April 19, 2006 at 8:29 am

Sylvia,

“If it was good enough for 99% of our ancestors, it should be good enough for us!”

Most of our ancestors lived short, miserable lives. The life expectancy for land owners in Europe in 1800 was about 40. At the same time, infant mortality was about 200 in every 1000 live births.

We must avoid the temptation to believe that those who came before industrialization lived ideal, pastoral lives.

Milan April 19, 2006 at 8:32 am

Tristan,

I dispute that we’ve “we’ve passed the peak production.” I fully expect that our ability to extract petroleum will continue to improve.

Secondly, I see many of the technologies necessary for an economy beyond oil already. As someone already pointed out, covering a fraction of one desert with today’s (relatively inefficient) solar cells could deal with the problem. Solar technology – and other renewable – has great scope for improvement.

We can carry on discussing this after the QT, if you like, but I need to go meet Claire to plan strategy.

tristan Laing April 19, 2006 at 4:00 pm

Here’s a BBC article on peak oil production.

http://news.bbc.co.uk/1/hi/business/4077802.stm

Sylvia April 19, 2006 at 5:18 pm

“We must avoid the temptation to believe that those who came before industrialization lived ideal, pastoral lives.”

I certainly do not. First of all, I said “good enough” (trying not to be a maximizer!).

Secondly, not all agrarian (or hunter-gatherer) societies had the low life expectancy you quote (and which is repeated ad nauseum without a source). That low life expectancy seems to be the exception rather than the rule. Even the Hebrew Bible gives normal life expectancy as “70 years, or 80 for those who are strong,” which is identical to developed countries today.

Thirdly, we know far more about hygiene, diet, and medicine now and so would do better than our ancestors did as long as we don’t forget what we’ve learned during the petroleum age.

Milan April 19, 2006 at 6:00 pm

Sylvia,

The source for the life expectation I quoted is: Russell, Josiah Cox. “Population in Europe 500-1500.” His figures are supported by Wrigley and Schofield (1981); Keyfitz and Flieger (1968); Flora et al (1987); and several reports from the World Bank. I didn’t want to type out all the full citations, but I can if desired.

The source for infant mortality is: Mitchell, B. R. “European Historical Statistics 1750-1970.” London: MacMillan.

As far as I know, archeological evidence (based largely on bone and tooth analysis) confirms similarly low life expectancies in long previous historical periods. As for the Bible, it also says that Adam lived something like 900 years, and is hardly an anthropological source.

You’re right, of course, that we know more about hygiene, diet, and medicine now. That said, a reversion to “animal and human labour” would almost certainly involve a massive reduction in human welfare. The kind of intensive agriculture that has raised the mean caloric intake in Asia from 1900 calories in 1960 to about 2700 now is dependent intensive agriculture.

What we learned is one thing: the material basis for improved hygiene, diet, and medicine quite another.

Milan April 19, 2006 at 6:13 pm

Anyhow, for some reason – probably exam related stress – both of these threads (oil and factory farming) are really annoying me at the moment. I am therefore resolved to ignore them completely until I am in a happier state of mind. I have rather more pressing things to be anxious about, in any case.

Anonymous April 22, 2006 at 2:10 pm

Today’s Google banner includes solar panels and an electrical turbine.

Leave a Comment

You can use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <s> <strike> <strong>

Previous post:

Next post: