July 14, 2005
Further discussion about economists and peak oil
The many interesting and thoughtful responses to my invitation for more open communication between economists and others about peak oil has led me to a clearer understanding of exactly what it is we're seeing differently. Here I attempt to state a little more narrowly and precisely what I see as the key substantive issue that I believe may most merit further consideration from both sides.
First I would like to thank all of you who contributed to the discussion of issues raised here, both in comments on my original post as well as in parallel discussions at The Oil Drum, Green Car Congress, Peak Oil Optimist, and Environmental Economics. These comments represented a very wide range of views on this topic from some extremely knowledgeable people coming at the question from a great number of different specialties.
The key point I tried to make in my original post was that a predictable sharp differential in the price of oil across time creates a very strong incentive for any government, corporation, or individual who would like to become richer, and that any of these actors who respond to these incentives will at the same time be helping to move society in the needed direction in order to try to cope with the coming production decline. I attempted to make these points with a numerical example, pointing out that if oil sold for $60 today but $200 in two years, here's how producing governments could make themselves richer, and even if they didn't, here's how oil companies could make themselves richer, and even if they didn't, here's how you and I could make ourselves richer, as a result of such a price differential, and here's why such responses would help make the adjustments smoother.
A very common objection that some of you raised was that we don't know that the price of oil will be $200 or any other particular number in two years, as if the undeniable reality that the future is inherently very uncertain somehow makes the whole analysis irrelevant. For example, Ralph writes that the argument, "assumes that the future scarcity of oil is known with enough accuracy that a significant fraction of the market players would bet on that predicted scarcity." Z notes:
The main point to understand, IMHO, is that the whole peak oil issue is full of uncertainties ( date of the peak, duration of the plateau, depletion rates, maturity and scalability of alternatives etc ... ). You cannot expect markets to have a rational behavior consistent with absolute knowledge ( oil will be at $200 in two years ) while real information available is scarce, short term and in some important cases guarded as national secret.
Robert Sczech, Lamb, and Professor Goose make similar points, while Felix, M1EK, Stuart, Avo, and Jeffrey Miller all give examples where market participants did not correctly anticipate the future.
A related objection is that oil companies don't care about longer term profits, but are only concerned about immediate returns. Heading out at the Oil Drum writes: "Expecting anyone to wait around to make $1 million a day a year or two from now seems to be rather unrealistic." Michael Watkins concurs: "today's profits and *cash flow* (for reinvestment) are king, not future profits," and r_ adds some useful personal testimonial to this.
Absolutely correct, all of you. Nobody-- not me, not you, not the market-- can know for sure what the future holds, and any of us need to be compensated amply if we're to be persuaded to forego having something right away. But let me ask you a question: if you believe that oil companies would always prefer to keep whatever dollars they have right now, rather than give up current resources in hopes of having even greater rewards in an inherently unknowable future, how do you suppose all that oil got taken out of the ground in the first place? The oil industry involves enormous lead times-- you have to spend huge sums many years in advance of getting anything back. And the projects are fraught with incredible risks-- geological and engineering risks as to how much oil you'll recover, economic risks as to the price you'll be able to sell it for, political risks as to whether the host government will appropriate your entire investment, not to mention sheer environmental hazards as the drilling moves into increasingly hostile terrains. Why did the oil companies ever make such huge investments in the first place in an inherently uncertain world? To me, the answer is obvious-- it's because the prospect of even greater future rewards was sufficient incentive to persuade them to be willing to expend current resources in spite of not knowing exactly what the future would bring.
I personally have great confidence in the potential power of such intertemporal incentives to get things done-- I think the willingness to take risks in the hopes, but not promise, of obtaining future reward is largely responsibile for having shaped the world that we see today. Moreover, I'm convinced that each of you has great faith in the power of these intertemporal incentives, because, as I pointed out, it's precisely the response to such incentives that would cause the remaining oil to be extracted. But what I don't understand is the apparent unwillingness of some of you to examine exactly what the intertemporal incentives would be as we approach peak oil, and why so many seem to resist my suggestion that the response to such incentives will in fact play an absolutely critical role in determining how society makes the transition away from oil.
Let me therefore attempt to lay out the lines of the dispute a little more sharply. At one extreme might be those who believe that these intertemporal incentives are so powerful and human ingenuity so great that we will successfully make the transition away from a petroleum-based economy with scarcely a hiccup. At the other extreme are those who might insist that any intertemporal incentives are completely irrelevant for influencing anybody's decisions, that nobody's ever going to try to figure out how make more profit from the fact that the resource base is diminishing, and so we'll just keep going down the highway in our SUV's at 70 mph until we drive off the edge of the cliff together.
I think there's plenty of room for intelligent people to look for a position in between those two extremes. But it's going to be impossible to sort out the character of that middle ground, and figure out exactly what's in store for the world in the years ahead, without much better communication between economists and others studying this issue than we've had up to this point. And we economists are going to be at a loss about how to participate in the discussion, unless you are willing to explore with us how the nature of the incentives that people face may have the potential to influence and change how things will turn out.
Posted by James Hamilton at July 14, 2005 09:40 PMdigg this | reddit
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Actually I would like to continue the dialogue that Econbrowser started, and which continues both there and in comments there and here. I am helped a little in this by an article in todays St Louis Post Dispatch, to which I will refer in a bit. [Read More]
Tracked on August 17, 2005 08:18 PM
JDH, while I agree that "those who believe that these intertemporal incentives are so powerful and human ingenuity so great that we will successfully make the transition away from a petroleum-based economy with scarcely a hiccup" is one extreme, I don't agree that "those who might insist that any intertemporal incentives are completely irrelevant for influencing anybody's decisions" is the other. I believe in the power of those incentives. What I fear is that geology and physics might defeat them, in the sense that we will find that the only "substitute" for oil is a much poorer society with many fewer people in it.
If we are to avoid this future, and the very unpleasant transition to it, we must all start taking it as a serious possibility, no matter what the futures market may seem to say.
Posted by: Avo at July 14, 2005 11:29 PM
It might be useful to remember the example of poor Norman Angell and his 1909 book "The Great Illusion". He argued that the arms race then in progress in Europe was based on a fallacious idea that nations had an incentive to attack one another. I think his argument got distorted into a naive claim that war was impossible simply because it would be foolish. His was roughly the "economic" view.
It seems to me that on his own terms, Angell was quite right. But fallacious or not, the usual political forces drove Europe into the epic waste we call World War I.
It's quite possible that the fits of anxiety in Congress over the CNOOC bid for UNOCAL are a harbinger of a purely political (rather than rational, economic) set of forces which could feed paranoid competition for oil. That kind of a cycle could create a self-fulfilling passage to large scale war quite in spite of all our best interests.
The politics of oil worry me more than the physics at the moment. But I'm still learning the science.
Posted by: STS at July 15, 2005 12:19 AM
What we discovered towards the end of the last thread was the fact that oil futures prices contain hardly any information about future oil prices that isn't in the current price (in one study actually being slightly worse than just guessing the current price).
After reflecting on this fascinating fact for a while, here's my understanding about what's going on: useful information about near term (next year or two) oil supply problems or demand increases gets immediately incorporated into *current* oil prices. Everyone figures it's not *that* big a deal to store the oil, so any significant contango cannot develop because otherwise people would have incentive to store oil - buying current cheaper oil and simultaneously selling more expensive oil futures would be a zero risk way to make money. That kind of transaction would have the effect of dropping future prices and raising current prices until the difference came in line with storage costs.
The core question before the oil markets at present is: given that supply is constrained, how high do prices have to go to get demand back to some reasonable cushion below supply? $50 oil has been found wanting in this respect, so we are now exploring $60 oil to see if that will do the trick. Since it take a little while to see the effect of each market level on demand, people wait a bit before being willing to trade it up higher, hence the relatively gradual rise of the last year.
This seems entirely consistent with peak oil theory. If you believe supply is going to peak and flatten fairly soon, what the markets need to do is find out how high prices have to go to achieve the same effect on demand. If supply then starts to deplete, the markets will need to figure out the correct price to match the depletion rate. Since visibility into future depletion rates is almost non-existent (and hasn't been a focus of peak oil research and writing), no-one has much clue what that will be.
So I guess I'm not seeing any inconsistency between current oil prices, current oil futures prices, and peak oil theory, even under the efficient markets hypothesis. I also suggest that peak oil theory doesn't offer a way to make money in the current oil market *unless* you believe you know, at least roughly, the date of peak and the depletion rate in the future. Am I making any sense to economists?
Posted by: Anonymous at July 15, 2005 01:34 AM
Not intending to be anonmyous!
Posted by: Stuart Staniford at July 15, 2005 01:35 AM
One more comment and then I promise to go to bed. What I suggest is that if you disbelieve peak oil and believe CERA:
you have an excellent profit opportunity. Sell $60 2008 oil futures now, confident in being able to fulfill the obligation with abundant $10 oil when 2008 rolls around. (We know very well what oil sells for when there are "6 to 7.5 million" bpd of excess supply).
Since oil remains at $60, give or take, the market appears not to believe CERA. Presumably Daniel Yergin is not well capitalized enough to affect it himself (perhaps as a result of following his own advice on oil trades in the past, one wonders? :-)
Posted by: Stuart Staniford at July 15, 2005 02:15 AM
A related issue, with a possibly different reaction.
Governments of oil-consuming countries and persons/companies consuming might anticipate coming shortages and reduce consumption (e.g.by raising gas taxes), thus reducing demand keeping a lid on market prices.
This is, partly, what has happened in Europe, not just because of peak oil issues, but mainly for environmental reasons.
Posted by: khr at July 15, 2005 02:48 AM
The parts of the world that are very poor (and consume relatively little petroleum) are the ones with significantly higher birth rates and population densities than those parts that use lots of petroleum.
So if petroleum vanishes and we are unable to replace it, why do you assume the great "die-off"?
Personally, I'm reasonably sure we'll find a set of alternative transportation fuels. It'll probably cost a bit more than oil, but even a doubling or tripling of transportation costs isn't going to punge the globe into cataclysmic poverty.
Posted by: Barry P. at July 15, 2005 04:22 AM
In the previous thread, somebody asked whether any economists believe that oil is not finite. Thus was brought Adelman's claim that for the next 25-50 years, it is "for all intents and purposes, infinite."
To that I will ask, do any of you peak-oilers believe that the energy from our sun is finite? I would expect many to say "no, but for all intents and purposes, for the next 50 years we can assume it is." This is what Adelman was saying: there is enopugh oil that for the next 25-50 years, we can treat it as infinite.
If you disagree with that, good for you. But don't put words into his mouth. We all kmnow the mass of the earth is finite, and the quantity of oil within it is finite. For the foreseeable future, though, that finiteness is basically meaningless to us.
Stuart: I feel like I'm banging my head against a brick wall, but I must respond to the argument "given that supply is constrained, how high do prices have to go to get demand back to some reasonable cushion below supply?"
If price increases are driven by outward movements of the demand curve, as they currently are, then increased prices will not reduce demand. "Demand" is a function, a relationship between how much people want to consume at a given price, it is not a fixed number.
Given a fixed supply curve, an outward movement of the demand curve will lead to increased quantity consumed *and* increased price.
The price of oil is not increasing because of scarcity of oil, but because more people are willing to pay more, and the production capacity, at any point in time, is fixed. The price of oil is high now in part because not very long ago, it was very low, and when it is very low, there is little investment in oil infrastructure. When you hit a capacity constraint, supply goes vertical and price spikes up. Relax the constraint and the price comes down. The current high price is transitory: increasing capacity cannot happen overnight.
Excess production capacity is an expensive luxury. In 1998-99, we had too much of it, and people stopped building more. Now we need more, and there's a time lag until we can get it.
The current price is a rather predictable outcome of the price a few years ago, not a sign of the end times.
Posted by: Barry P. at July 15, 2005 05:08 AM
From the previous thread,
"the effectiveness of the incentives die out at the rate 1/(1+i)^n where n is the number of years ahead the peak in oil production is and i is the interest rate. If i is big and n is reasonably sized, this may not be a very powerful incentive today."
It seems to me that the nature of the "disagreement" between peak oilers and economists can be crystallized in the discounting formula imbedded in the previous statement, if we decompose i into the risk free rate r and risk premium p, where p might represent the range of forecasts of the price of oil. If we say a reasonable forecast of the price of oil in 2 years is $200/barrel give or take $180/barrel (which is not too far from how I might summarize the range of views expressed in this excellent discussion), then an implied 100% discount rate might not be so unreasonable. Markets might not always (or rarely) be "right", but they are usually doing their best to forecast the unforecastable.
Posted by: Joe Doyle at July 15, 2005 05:47 AM
First, what a relief to have discovered Econbrowser (via Energy Bulletin). I am a "peak oil probationer" rather than a "peak oil activist". Intellectually honestly and sheer scientific curiosity compel anyone who is tempted (for whatever motives) to adhere to a controversial theory such as peak oil to familiarize himself with the best and brightest arguments of "the other side", and I have been seeking the best and brightest for some time now. Now I have found them -- what a different level this is to the primitive, populist crap written by Lomborg and Simon, not to mention a few ideologists on the peak oil side of the debate. After all that gas and all those gasbags, oxygen at last!
Professor Hamilton, Suart Staniford, what you are saying is this:
If the peak oil "extremists" (dieoff by 2010) are so smart, why aren't they millionaires by now? And ditto for the ultra-optimists at the CERA end of the spectrum. They should be real rich too, as SS points out, by selling oil futures for 2008 and raking in a fortune in three years time.
Just for the information of the general reader (and apologies to JH for being somewhat redundant): the economist who IMHO has addressed the issue of market prediction best is D. N. McCloskey in his/her book on entitled "The Vices of Economists, The Virtues of the Bourgeoisie", in an essay on the One-Hundred Dollar Bill Theorem (i.e. why we do not find $100 bills on the street).
"If the experts were so smart, they would be rich. They are not rich. Therefore, it follows rigorously they are not so smart. It's blackboard economics..."
And here's a delightful extract I'm sure JH will enjoy:
"Economists are routinely asked at cocktail parties what is going to happen to the interest rate or the price of housing or the price of corn. People think that asking an economist about the future is like asking the doctor at the party about that chest pain. You get an expert to do his job for free. Take corn. Any agricultural economist in the Midwest gets asked her expert opinion on what will happen next month to its price. Surely she must know better than just the futures prices printed in the newspaper, this expert, if anyone does. It would be poor news to be told that after all no one does know, or can. But an economist who claims to know what is going to happen to the price of corn better than the futures market is claiming to know how to pick up $100. With a little borrowing on the equity of her home or her reputation for sobriety she can proceed to pick up $100 thousand, then $100 million, then more. It's easy."
[If any readers want the rest of this essay for free (the whole book is on Questia.com and I've got a subscription), please let me know.]
As for economists, so for peak oil experts and CERA optimists.
We just don't know precisely when the shit is going to hit the fan. And yet the one thing we do know, pretty much for certain, is that the shit IS going to hit the fan -- and that's why, until further notice, I remain on the "peak oil" side of the continuum.
Posted by: Cathal Copeland at July 15, 2005 06:01 AM
Stuart, I'm extremely impressed. It appears that you took a look at the spot-futures data, along with perhaps my essay on contango and some of the other literature, and correctly concluded that there's absolutely no way to interpret that data other than to believe that the storage arbitrage that I've been talking about is an extremely powerful force that one sees very dramatically confirmed in each day's price structure. You then reformulated a hypothesis consistent with what the data were forcing you to conclude, and did all this in less than 24 hours with, I'm supposing, no formal economics background. Sounds to me like the behavior of a real scientist, and, I'm guessing, a brilliant one at that.
I too have been trying to formulate a story about peak oil along the lines you relate, but have been hung up so far on a point related to the one that I think Barry is making about what we actually saw happen on the demand side along with the time path of the physical quantity of production.
Posted by: JDH at July 15, 2005 06:58 AM
That the company was prepared to invest in "Thunder Horse", shows that they are willing to invest if there is a chance of finding a good oil pool.
Posted by: Big Al at July 15, 2005 07:05 AM
What I'd like to know is this:
Assume that you *knew* that oil would be $200 in 2 years (let's just remove the uncertainty as a factor for now). Furthermore, let's say that you are running a well with a 100,000 bpd capacity and a 10 year supply at that capacity, but you could get by on with a skeleton crew and pay off the interest on your capitalization loans at 250 bpd and $60/bbl. They're just made-up numbers, not even important to my point, but if necessary, I can keep reconstructing this scenario to make it in your best interest to wait. My question is this: Is there any reason that anyone could think of why you wouldn't back off production for 2 years?
Off the top of my head, I can think of a few: you are sharing the reservoir with one or more other competitors and they will pump it dry while you wait (a "commons" scenario). Or, once you have tapped the well, you need to pump it in a certain amount of time or the pressure will bleed off. Or, you have a time-limited license or a license that requires you to pump at capacity (use or lose). Another would be that if you *knew* oil would fall back to $60 (inflation adjusted) after a year or so (what does it matter if you pump the $60 oil now or later as long as you get the $200 oil in the middle?)
Do any geologists/engineers know of any *technical* reason why you would have to keep pumping at low prices with the certain knowledge that prices will go up dramatically? This is what I thought James was after in his first post.
Posted by: Eric H at July 15, 2005 09:06 AM
Eric H, I believe that Heading out in his post over at the Oil Drum was trying to give some examples of an answer to your question, but I don't think you'll find it very convincing. I feel that Hal Finney, in his comments over at Oil Drum, nailed the issue on Heading out's point perfectly, which is, even if these adjustment costs prevented you from capping the well completely, surely it makes sense to reduce production somewhat, and the definition of "somewhat" is the point where the spot price equals the futures price plus cost of carry. I think the only way Heading out comes up with any conclusion other than that is to assume in effect that the cost of carry is arbitrarily large, either because the interest rate is arbitrarily large (the firm insists on cash now no matter how much future cash it foregoes) or that the physical adjustment cost of reducing the flow today by even one barrel is arbitrarily large. And don't forget above-ground storage as another way to accomplish the same thing.
Posted by: JDH at July 15, 2005 09:25 AM
I think Barry is accurate on at least two points: one, prices can go up even with rising production if people are willing to buy more even at higher prices (simply look at what percentage of their household income they were willing to spend in years past), and two, present oil prices have an effect on future capacity (so past prices have an effect on current production). When I first entered engineering school in the early 80s, everyone was saying, "go into petroleum, young man". 10 years later, I hired someone to give us some training in fiber optics splicing and found that he had taken that advice only to find that nobody wanted to hire petroleum engineers or geologists after 1985. So apparently college career advisors are no better at predicting the future than futures contract traders, since they were obviously overproducing geologists and underproducing fiber optic technicians.
Is there a "bullwhip effect" here? In 1979-1985, high prices draw out more production and lower demand, and more production of producers. The lowered demand overshoots the increased production, and you have a problem of both too many producers and too many producers-in-training. I doubt there is any feedback from oil companies to college career advisors. The field got so swamped that you couldn't *pay* students enough to take petroleum engineering classes (and *nobody* was paying), but now all of the producers have retired and some of the companies probably dropped out in the late 90s. It is going to take a few years to either draw the producers-in-training back from the fields they went into, 2-5 years to get new ones through the universities, and a little time to ramp up the infrastructure (discovery and extraction equipment) to find and extract more. I heard a few weeks back on NPR that the recent re-opening of Libya for exploration has revealed the fact that even American companies haven't built significant new capability since the 80s.
Posted by: Eric H at July 15, 2005 10:51 AM
Bear in mind that for many producers, reducing production in anticipation of higher prices in the future isn't an option. There is simply too much political pressure to pump at the absolute maximum.
For the US administration, rising energy prices are politically very damaging. Even were they to recognise potential future supply constraints, the need to maintain popularity and win the next election overrides wider concerns. The oil majors and those countries who are reliant on the US for military protection would not dare to supply less than they are capable of delivering.
Contrast this with countries where no such political constraint exists. Why is Russia taking control of its oil reserves and now experiencing 'difficulties' in its export of crude? Why are Iranian officials increasingly suggesting that production should be eased back?
I generally agree with the economic analysis that has been put forward regarding the incentive to hoard in anticipation of future profits, but the political dimension -- a constant thorn in the side of 'pure' economics -- does much to undermine this line of reasoning.
As a final note regarding Stuart's thoughts regarding contango:
"Everyone figures it's not *that* big a deal to store the oil, so any significant contango cannot develop because otherwise people would have incentive to store oil - buying current cheaper oil and simultaneously selling more expensive oil futures would be a zero risk way to make money."
If you think this is possible, then fine, go ahead and try it. Buy 1 million barrels of light sweet crude on the spot market and take delivery, with the intention of holding it for four years or so. Start phoning around to see who has the facilities to store this oil. Think about it. One million barrels.
...and yet you're now hoarding a mere 17 minutes of global oil usage.
How many players would have to pursue this strategy to flatten the price curve? And how much storage would be needed?
Posted by: FT at July 15, 2005 11:25 AM
Morgan Stanley trades physical oil (not just futures) and has storage all over the place:
Posted by: John Norris at July 15, 2005 12:10 PM
Replace "demand" with "demand at the current spot price" in what I wrote last night, and hopefully it will be clearer. If you believe that the present price increases are temporary, then you should join Mr Yergin in selling a bunch of 2008-2010 futures at the current price of about $60.
JDH: Thanks for the kind words - formal training is limited to two years of high school economics in the UK. I have read a few economics books (popular and texts) in the last year in pursuit of a different project (trying to understand the potential economic impact of computer worm incidents - much of my work in the last few years has been concerned with computer worm spread and containment).
It seems to me that if one believes the idea that the current high prices are just due to underinvestment in the oil industry, you would expect major backwardation in future prices. We can loan to the future via storage, so contango can never get very large. We cannot borrow from the future if we do not yet have the capacity we need, so there is nothing that prevents future prices from falling significantly below spot prices in a temporary supply crunch (or am I missing something?). There are a number of very short price spikes in the natural gas market data where the futures market do not follow the spike - suggesting the market understood this was a temporary crunch.
Since oil futures are at about $60 out to 2010, the market seems to be forecasting something in the range from "supply growing slightly but tight and unable to keep up with the recent demand growth trend" to "supply flat or starting to fall slightly". The market obviously does not expect heavy oil, coal liquidification, or tar sands to make large differences to the supply situation in the next five years.
When Matt Simmons says "Oil prices will be $100 by the end of the year", that can be interpreted as follows. We know that $90 oil (in 2005 dollars) caused a recession and a contraction in oil usage immediately after the Iranian revolution. So $100 oil would presumably keep oil usage falling in line with a healthy supply decline rate. So Simmons is saying that by the end of this year it will be clear that there is going to be permanent depletion at a healthy rate going forward. This seems in the range of reasonable scenarios if you believe him about Saudi oil (his book is solidly argued, and the shifting set of prevarifications out of the Saudis are not reassuring), and if you also believe the last few years of Russian production increases are a last hurrah from working over old Soviet fields which will end abruptly once modern extraction technology has rapidly sucked the last corners of the fields dry.
OTOH, it's also reasonable to argue, given the very poor transparency in the reserve data, that production declines still affect a minority of countries, and that only a few countries (the UK, Australia) are really in free fall - most countries that are declining are doing so much more slowly and some have declined only slowly over an extended period. So maybe peak is still a few years off and then decline will be slow. Maybe $60 is already more than enough to handle the situation, given that it takes a long while for conservation measures to take effect, and that we are already seeing news stories of economic distress in Asia due to the high oil prices*.
So the market doesn't know, and it's waiting for more data. But it is definitely not suggesting that the current situation is just a hiccup that will be solved soon.
* It seems that Asians are currently loaning money to Americans so that the latter can outbid the former for oil. Somehow, that seems unlikely to last.
Posted by: Stuart Staniford at July 15, 2005 12:19 PM
"Bear in mind that for many producers, reducing production in anticipation of higher prices in the future isn't an option. There is simply too much political pressure to pump at the absolute maximum."
Absolutely correct. In addition, most oil producing countries (perhaps with exception of Russia) are desperate to obtain the foreign exchange in order to buy food and other essentials (Saudi Arabia, Egypt etc). Reducing output is not a realistic idea.
Posted by: Robert Sczech at July 15, 2005 12:25 PM
"Morgan Stanley trades physical oil (not just futures) and has storage all over the place"
Undisputed. But can they affect the curve in the longer term? With above-ground reserves, Morgan Stanley attempts to act as a short-term swing producer. The quantities are miniscule.
Playing this game in the longer term means you're fighting those with underground reserves. Fancy taking on Saudi Arabia or Iran with your storage tanks in Rotterdam?
Posted by: FT at July 15, 2005 12:31 PM
First I want to congratulate Jim Hamilton on a very stimulating blog exchange, more stimulating than I think he expected. I am about to be out of the country and not blogging for over five weeks, so this will be my last shot on this. Just a few points.
The "bullwhip" argument, also known in economics as the "cobweb," is certainly ubiquitous. There are many lags in the oil industry on both the supply and demand sides. This combined with all the uncertainties leads to tendencies to cycles and fluctuations. As the time series Jim has shown demonstrate, these tend to take the form of sharp upward spikes in price from time to time, the shit hitting the fan periodically, but never definitively and "once and for all" (even if the dreaded peak appears as it will be a long way down to zero production from there), followed by more gradual, if bumpy declines in real price.
Let me note at least three sources of uncertainty, although most should be obvious. One is the supply side one much discussed here, that we do not know how much oil in the ground the Saudis have in particular. Another is on the demand side. Surging demand in China and to a lesser degree in India has been the unexpected recent element pushing prices up. Now many are expecting that to continue, but this is far from certain. Just as Japanese growth slowed rather suddenly, so could Chinese. (A sideshow on this is the increasing tension between China, Japan, South Korea, and some other Asian countries over islands near potential oil supplies, which could get really nasty if the price of oil keeps rising).
The final source of uncertainty is the behavior of the other agents in the market. This brings us back to the Ising and related econophysics models, the sudden outbreaks of herd behavior. In fact most of the serious price spikes in the past have been accompanied by frenzied buying for inventories, not just for immediate consumption. Jim DH has in the past written papers arguing that we cannot prove that there are speculative bubbles, although perhaps more recent experiences have softened his views on that matter (the "misspecified fundamental"). But clearly herd behavior does go on in this market and is an extra exacerbating factor in the shorter term volatility, if not necessarily the longer term fundamentals.
Finally, the group that probably has the longest term perspective, even longer than the biggest oil companies, is the Saudi royal family. Of course they, or at least some of them, are also probably the best informed of any of us regarding the most crucial unknowns on the supply side.
All the best to those involved in this discussion, and have fun.
Posted by: Barkley Rosser at July 15, 2005 12:34 PM
As Avo says, the key debate isn't about incentives (or for that matter reserves, or the "peak" date, or depletion rates, or prices), it's about the substitutability of oil,
which for me translates into economic terms as:
between people who think the sky is about to fall (99%+ declines in GDP over a few decades, billions dead), and those who think that the impact of oil depletion on economic growth will be minor (+/- 0.1% annual GDP growth impact of the geologic uncertainty, with 3% trend annual economic growth and other uncertainties easily +/-2%).
Prices can rise, while supply is going up (eg the last few years), and they can fall while supply is going down (the early eighties).
So, why would "peak" oil mean $200 oil? We can have $10 oil with lower oil production than today, and $200 oil with higher oil production. Monstrous Cafe standards plus incentives for hybrids etc.. might well lead to the former, and strong, unrestricted transportation demand growth to the latter, particularly when considering that gasoline is already selling for $200 in most of the EU and people are still driving.
At any rate, the difference between the two envisioned futures is not about $200 or $10 oil, or about production levels of crude oil in 2010/2050, or about the amount of oil in the ground. It's about how easily we can substitute oil. Will the world fall to pieces when we run out, or will the impact be minor?
That's not a question where petroleum geologists have much expertise.
It's simply taken as an article of faith by many "peak oilers" that oil cannot be substituted without major upheaval, and when they see economists "assume" the opposite, they think that those economists must be ignoring obvious reality.
Economists do have to rely on engineers, chemists and other scientists to assess the technical possibilities for substituting petroleum.
What they've got a good grasp of is the fundamental factor behind economic growth: accumulation of physical and intellectual capital.
"Peak oilers" have a different explanation for economic growth, access to cheap energy, more specifically conventional crude oil.
Therefore, predicting the future course of humanity boils down to predicting oil production, and the expertise for that lies with petroleum geologists, who surely know better than economists.
Posted by: Heiko Gerhauser at July 15, 2005 12:53 PM
I'd like to draw attention to Douglas Reynold's paper:
"The Mineral Economy: How Prices and Costs Can Falsely Signal Decreasing Scarcity"
A few excerpts:
"...there is only the appearance of decreasing scarcity...the explorer does not know total reserves of the resource base as he searches for and extracts the natural resource. The explorer never entirely knows how big the resource base is but does gain information about the potential location of new reserves as discovery proceeds. That reduces exploration costs. The lower exploration costs can cause the price to fall over time, until eventually scarcity of the resource causes the price to rise. The true scarcity is only revealed towards the end of exhaustion...The problem is that the true size of the resource base is never known. Society does not know if technology is actually overcoming scarcity or not until demand for a resource outstrips supplies. It is even possible for a price shock of incredible magnitude to surprise an economy within one or two years after a hundred years of declining prices and increasing production."
Reynolds, being formally schooled in both econ and geology, bridges the "communication gap" between the two fields.
Posted by: John at July 15, 2005 12:59 PM
"Since oil futures are at about $60 out to 2010, the market seems to be forecasting something in the range from "supply growing slightly but tight and unable to keep up with the recent demand growth trend" to "supply flat or starting to fall slightly". "
Bingo! This is a critical point. Chris Skrebowski, Editor of the Petroleum Review UK, made a similar point in an interview in April 2005. The number of new megaprojects (oil)in the works is not likely enough to satisfy existing field depletion and expected demand increases by 2008ish. Some like the IEA might say that this is because industry 'under-invested' in new and replacement capacity and has to play catch-up. Others like Colin Campbell might say this is because we are approaching the peak.
Irrespective, we are approaching a tight period -- either the end of oil peak, or an artificial peak-like period due to the time lag in investments.
One may read the tea-leaves either way.
(I've been following the Econbrowser threads, well done!)
Posted by: Robert H at July 15, 2005 01:23 PM
My own view, as a chemical engineer, is that oil can be subsituted by renewables, coal, efficiency and nuclear energy at modest penalty and fairly rapidly. And that feeding those switching costs and lag times to models of future economic growth indicates a comparatively small influence of geologic uncertainty. Economic policy in India for example is something I'd regard as a more significant unknown.
That's how I see a pessimistic depletion scenario (more correctly, what I projected on that basis two years ago, actually economic growth and petroleum supply growth have been higher than projected, the petroleum supply projection was based on Laherrere's work, a petroleum geologist and a pretty pessimistic one at that):
And this one's my view of an optimistic oil/nat gas supply scenario:
The only major difference is the way the fuel mix evolves over the next hundred years.
Posted by: Heiko Gerhauser at July 15, 2005 01:26 PM
Also an engineer, but I am sceptical that 'we' can substitute for petroleum without signficant economic penalty--I am an infrastructure engineer. There is just too much infrastructure which cannot be easily adapted if the innovations are too different. That is not say that there may not be breakthroughs; but as of today I believe such adaptation would involve big penalties.
However, I think that we are already seeing some substitution of medium and sour crude for light sweet crude. Some might even have convincing arguements that light sweet crude has peaked, and has been substituted with the heavier oil -- with the market doing what it does best.
But what happens when there isn't enough heavy oil to satisfy demand, even when the market is willing to pay more? A previous comment suggested that future price ceiling might be that of a more sustainable (but presently more expensive) alternative. Maybe. I think previous comments about efficiency might hold some answers -- I think of the mpgs of Hummers and Model Ts.
Posted by: Robert H at July 15, 2005 01:48 PM
Heiko: substitutability is intimately related to the depletion rate. If you have a substitute (or a conservation idea), you have to implement it, which requires making an up front investment that then gets some ROI. If the ROI on your investments is not good enough, it will fail to overcome the contracting effect of the depletion. (This kind of analysis can be done either in money terms, or energetic terms - it's clearer to me in energetic terms because that directly models the hard physical constraints of the situation without the complicated business of money supply cluttering up the situation - at least the money supply is poorly understood by me).
Take conservation. Suppose the physical capital stock of your economy usually turns over at 5% a year. Suppose, inspired by high energy prices, you start to replace it with stock that is twice as energy efficient, the same price (or embodied energy), and otherwise just as good in all respects. You can now grow your energy use at 2 1/2 percentage points less each year (in the short term) to have exactly the same level of real economic growth as you would have had. However, suppose you are encountering a situation where you have 5% less energy supply each year, whereas you had been accustomed to having 3% more energy supply each year with a certain level of investment in the energy sector. But your best currently available conservation option is the 2x stuff. Now, one way or another, you are going to suffer at least a 4% growth penalty on the amount of non-investment goods and services the economy provides, relative to the scenario where you could continue to get a hold of 3% more energy each year without additional investment over the current investment rate. You either have to do less stuff, or you have to make bigger investments to increase your efficiency faster - but those investments will be made at the cost of goods/services that otherwise would have been available for consumption now.
Similar reasoning applies to new and different energy sources - the ROI must be poorer than the resource that is depleting or you would have used them already. Thus, the more you initiate them in the short term, the more you have to divert resources away from current goods and services in order to have the energy you need in the future. If you can't, or won't, make enough of that investment each year to overcome the depletion rate in your main energy source, then your available goods and services will go down even more in the future.
The worry about high depletion rate scenarios is that energetic ROI on currently known substitutes for oil does not appear to be very good. We will need better ones if we do encounter rapid depletion. If the "Julian Simons" school of economics is right, we'll innovate our way out of the problem by figuring out solutions which require much less energy investment to produce better ROI than outlined above, and we'll perform that innovation faster than the depletion rate. In a high depletion rate scenario, Simons is asking a great deal of those of us who innovate. It often takes 10 years to go from cool new idea to product with a proven business model, so it's hard for R&D to pay back real fast. (I'm not saying it can't be done, just that it sure makes me nervous as hell - which is why I'm obsessed with the subject).
(It occurs to me that some of the emotional heat that scientists have for economists might come from a sense of being taken for granted).
Posted by: Stuart Staniford at July 15, 2005 02:21 PM
An observation on petroleum data transparency or opacity; in the case of OPEC: Adam Porter, BBC, reports: "...Kuwait for example still claim exactly the same reserve level as they had in 1985 despite pumping millions of barrels every day since then...[the OPEC quota race]" http://news.bbc.co.uk/2/hi/business/4681935.stm
Now, drink from a glass, don't refill it, but see how it remains full... a worthy illusion for a circus side-show.
Kuwait has limited areas to explore for oil, and I recall that the reserve revisions were made without any new finds being announced.
Can any economic model work with this sort of smoke and mirrors? Can markets and professionals be this easily deceived, or are they perhaps a bit too naive to question the fundamental assumptions and data?
Does the current US$ 60 per barrel price reflect belief in the illusion, or does the market see through it? I am not sure who has been fooled.
Posted by: Robert H at July 15, 2005 03:38 PM
I forgot to be clear that in the 1980s, OPEC members 'bid-up' their reserves in order to increase their production quotas...
"...The larger the reserves a country said it had the more it could pump...As a result in 1985 Kuwait revised its reserve estimates by 50% overnight.
It was soon followed by United Arab Emirates, Iran, and Iraq. In 1988 Saudi Arabia became the last to join the revised reserve estimates party, adding a whopping 88bn barrels."
Posted by: Robert H at July 15, 2005 03:43 PM
"What they've (economists) got a good grasp of is the fundamental factor behind economic growth: accumulation of physical and intellectual capital.
"Peak oilers" have a different explanation for economic growth, access to cheap energy, more specifically conventional crude oil. "
So then the question becomes what factor does cheap energy play in the mass accumulation of physical and intellectual capital?
It's kind of a chicken and egg question. Have we been able to create all our wonderful technology due to access to easy cheap energy, or has our ability to use our intellect to create our complex technology allowed us to utilize different substances for energy?
Posted by: lamb at July 15, 2005 04:01 PM
Robert, as far as the suggestion that markets may be naive, of course all humans are subject to error. Nevertheless I would say that bettors and gamblers tend to be pretty hard nosed people. Do you think you could walk into a poker game among professional gamblers and find them to be naive innocents whom you could easily fool? Probably not. In the same way I expect that most speculators in the futures markets are not the kind of people who naively believe everything they hear. At least, not the ones who have been around for a while and still have their money.
It comes back to the same point. If, in order to sustain your world view, you find yourself forced to assume that hard-nosed market players are naive, you need to question your assumptions. They may be wrong, but they're not naive. Anybody can be wrong. Even, dare I say it, you or I.
When I look at oil prices I think, "I am more likely to be wrong than the market, because there are more of them than me, and they have studied the problem longer and harder than I have". Anything else and I'm just fooling myself. Frankly I think the same thing applies to most of us.
Posted by: Hal at July 15, 2005 04:29 PM
Barry P asks me, "So if petroleum vanishes and we are unable to replace it, why do you assume the great "die-off"?
A good summary of the role of oil in producing the global food supply can be found at http://www.museletter.com/archive/159.html
Also, an overview of the problems related to supplies of water and topsoil (in addition to fossil fuels) can be found in Walter Youngquist's book Geodestinies:
Posted by: Avo at July 15, 2005 08:22 PM
Prof Hamilton initiated this discussion by drawing attention to the expected price discontinuity of crude oil (from $60 to $200 within the next few years) due to peaking oil production. Many valuable contributions were made regarding the question how (or not) to profit from this anticipated price rise. I would like to generalize this topic by drawing attention to a related and, in my opinion, equally interesting question on how to estimate the present value of a given oil field. As we approach and pass the peak of oil production, oil prices will rise. At the same time, the amount of oil in the ground declines day by day due to depletion. Since the value of the oil field will eventually decline to zero, it follows that there must be a point in time where the value of the oilfield reaches an absolute maximum. The question is precisely when should we expect that maximum value to be reached. Is that maximum value achieved today or is it reached later? It seems to me that the answer to that question depends on the expected longevity of the field. A field with a very long reserve ratio will most likely not achieve its maximum value before competing fields of smaller size are all exhausted. Applying this hypothesis to the oil fields owned by an oil company, it seems to me that the stock price of an oil company will reach its maximum value long after we pass peak oil. This should be especially true for the stock of those oil companies which have extremely long reserve life (more than 20 years). Finding and buying these stocks seems to me the best way to profit from the coming price discontinuity.
Posted by: Robert Sczech at July 15, 2005 10:17 PM
Going back to Hal's reply on my question on the 'smoke and mirrors' game of OPEC quotas & reserves and whether the markets are concerned:
While I would hope that the market is savvy enough to rationalise the impacts of the OPEC reserve games (and its associated risks), I am still left wondering whether the markets might have accepted 'de facto' such inflated reserve estimates?
Perhaps naive is not the best description for the market and its players. Is there a better description for the markets given the *apparent* acceptance of upwardly revised OPEC reserve estimates in 1980s, static for two decades, but where plenty of pumping and withdrawl has occurred from those reserves with no significant new finds?
Or is my concern about OPEC's smoke and mirrors irrelevant if what matters is addressing the immediate needs of investors in the petroleum industry? Are the OPEC reserve games then just a red-herring and provocation to peak-oil advocates?
Posted by: Robert H at July 15, 2005 11:24 PM
That's why I loaded up on oil stocks after learning about peak oil.
And I would buy oil futures if I could figure out the best way to do it. (Try finding a futures broker that lists its fee schedule online.)
Posted by: Avo at July 15, 2005 11:24 PM
It's not obvious that peak oil particularly implies that oil prices will continue to rise all that much once we are on the decline. Eg suppose there were a constant 3% depletion rate. If it took $70 oil to cause a 3% reduction in the first year, $70 oil will probably cause another 3% reduction the next year and so on. The price doesn't have to keep going up and up to keep usage dropping and dropping.
Fluctuations in the decline rate will necessarily cause some changes, but that could go either way.
One might argue that some uses for oil will be harder to substitute than others, and thus will take higher prices to eradicate later in the depletion cycle. Eg maybe fuel oil goes early as people use wood stoves and superinsulated houses, but diesel is harder to substitute (or something). Somehow, I doubt this is a dramatic effect though.
So I'm not sure your question is quite well formed.
Posted by: Stuart Staniford at July 16, 2005 12:17 AM
"Perhaps naive is not the best description for the market and its players."
For the last decade, corporate executives
have spent huge amounts of money lobbying Congress to prevent the Financial Accounting Standards Board from requiring that options be expensed in corporate income statements rather than simply being noted in the footnotes. (It looks like FASB may finally win this battle but last minute moves by Congress may yet stop them).
Now the reason that executives have wanted to keep the options off the income statement, and have fought so hard to do so, is, clearly, that expensing options reduces reported earnings per share.
However real economic earnings per share for corporations are of course exactly the same whether options are expensed in the income statement or merely reported in a footnote.
Furthermore, with only the slightest effort anyone can access a company's 10-K on line, read the footnotes, and figure out the option expense for themselves.
So we have this huge decade long fight over where a certain number is reported - in the income statement or the footnotes. The financial situation of the company is the same regardless of
where it is reported.
The only possible reason for this fight is that many people must believe - and be willing to spend
millions in lobbying efforts - that the market confuses reported earnings with real economic earnings.
And there is evidence that the people who believe that the market is confused in this way are correct. It is widely expected (and is already starting to occur) that companies will curtail the size of their options packets once they are forced to expense them.
So here we have a blatant case where the facts are
easily discernible where the economic reality seems to be less important than appearance.
How can we reconcile the claim that the market is rational and far-seeing with cases like this which seem to suggest the opposite?
If the market is not rational in this case, why should we suppose that it rational in others?
Posted by: Jeffrey Miller at July 16, 2005 08:25 AM
Jeffrey, you've been making some very interesting points, both here and in the previous thread. I hope to get a new post up about the middle of the week to try to explore some of these ideas in a little more detail.
Posted by: JDH at July 16, 2005 09:26 AM
lamb wrote: "So then the question becomes what factor does cheap energy play in the mass accumulation of physical and intellectual capital? Have we been able to create all our wonderful technology due to access to easy cheap energy, or has our ability to use our intellect to create our complex technology allowed us to utilize different substances for energy?"
Economic growth is, in reality, the result of a complex relationship involving all three. Intellectual capital lets us build more sophisticated physical capital. The physical machinery allows us to apply more energy, or to apply it in more efficient fashion. But the ability to use external sources of energy -- ie, energy other than just human muscle power -- is the dominant factor for increased productivity, hence increased wealth. Take away any one of the three, and the feedback loop of economic growth fails (of course, there are other ways, such as institutional failures, to screw it up). Growth theory has, for the most part, ignored the role of abundently available energy. That may have been a reasonable simplification -- we've been able to expand our available energy supply exponentially for as long as economics as been a recognized discipline.
But even back-of-the-envelope calculations suggest various scary scenarios. Given the relationship between energy use and wealth, it does not appear possible for the entire world to achieve the level of wealth of today's richest economies. Given current use, the richesst economies -- the US/Canada, western Europe, Japan/Korea/Taiwan -- have already outgrown their domestic energy supplies. In 100 years, at current trends, those economies will have burned through the readily available world supplies of today's common fuels.
Posted by: Michael Cain at July 16, 2005 10:00 AM
when this discussion is over - who will adjudicate the winners ? who will deliver the verdict ? or will we all go our separate ways a little wiser but still holding diverse views ?
the market is always right.
the market is made possible by people holding slightly differing views. ( a market in which everyone holds the same view is called a panic.) if the market is 'wrong' - then place your correct bet and make your fortune. there will be slight movement in your chosen direction and the market will be right once again. if you insist that the market is still 'wrong' - bet again tomorrow.
keep teaching the market a lesson about peak oil, and get incredibly rich. if there is a flaw in the peak oil theory somewhere - then the market will teach you a lesson.
so you will either get a fortune or an education. looks like a win-win situation to me.
if you own oil, pump it, sell it, and use the money to bet on the oil futures market. that is a lot less risky than leaving it in the ground, or even in storage tanks above ground. o yes, and as you buy oil futures you will be stimulating the market price of the oil that you are about to sell next.
some people i know would actually prefer the supply of oil to be a bit more secure. they have 1,300,000,000 people, massive dollar reserves, and nuclear weapons. someone send me the address of their website and e mail and i will let them know how it can be done.
except that without the insecurity the futures price would soar. so it seems that you get an education in this business whichever way you turn . . . .
Posted by: gillies at July 16, 2005 10:49 AM
I have not asked whether the price of oil will rise. My question was more general. I asked at what point in time will a given oil field reach its maximal economic value. That value can be defined as the integral over the product of the fluctuating oil price (which I personally believe will rise substantially at least in US Dollars) times the remaining producible reserves in the field over time.
Your suggestion that oil production and consumption could both decline year by year at 3% per year with prices not exceeding $70 per barrel would be a miracle given that presently demand is growing at 2% with oil prices around $60. I would bet that oil prices will far exceed $200 on the other side of the Hubbard peak. In Europe gasoline is already priced at this level and consumption is still growing. Why should it be any different in the US?
Posted by: Robert Sczech at July 16, 2005 11:11 AM
I'm ading into swift water that is well over my head but here goes (a bit of graduate level economics but not an economist nor engineer). Do the current and future prices of commodities really capture and appropriately weigh the relevant information, given the increasing complexity and amount of information being generated about how the world works? Particularly given the nonhomogenous distribution of information and our human limitations in processing it?
It seems to me that a fundamental problem is the limitations of our brains versus the complexity of the system, both the natural parts and the human constructed parts, that we are immersed in. The dynamic system of life on this planet is extremely complex with many lag times in positive and negative feedbacks, many of which are unkown. Given the structure of our brains, we can only deal the interactions of a limited number of variables at any given time. Because of the system's overwhelming complexity, we develop an area of expertise with a reductionist approach, understanding more and more about less and less of the system but loosing the "big picture" in the process. As a consequence, our actions even in the aggregate sometimes have unintended consequences, some of which are disastrous. Given the limitations of our senses, we tend to detect those things in our size and time scale and to ignore those things that are out of sight due to size, distance or time. For example, we forget that there is more life (microbes) in each of our colons than all of humanity on earth. We tend to overlook long term trends, much like the frog in the water if the stove parable. An example is the fact that the April 1 snowpack in the Pacific Northwest has declined 50% since 1920, a hugely important fact for irrigated agriculture, salmon and hydropower. We also reason with serious cognitive biases, such as the tendency to seek confirmatory evidence for our beliefs and to weigh positive evidence confirming our beleifs heavier than negative evidence of equivalent strength. If we are to function indvidually day-to-day, we have no alternative to trimming our mental model of the way the world works down to what we can deal with and assuming the rest is essntially static status-quo, whether it is trading futures or developing policy for preventing the spread of infectious disease or maintaining food production. And once we have a belief, correct or not, we are very reluctant to re-examine it.
We seem to have a perfect storm approaching in the form of population growth, increasing water and energy scarcity and globalization. To me, globalization means that we are linked together in more complex ways than ever before with more common access to technology and information. Events in a given region, whether natural, political or economic, now ripple farther and faster than ever before. Will China now have to tolerate the starvation of millions the way they did several decades ago? The global human population is increasing, as is the nature of any life until it reaches a limit or a peak. For animal populations, that peak is usually followed by crash due to multiple factors involving resources and predators, often microbial. Because of greater transmission opportunities, higher population densities of any species inevitably lead to the emergence of infectious diseases that coevolved with them. Witness the emergence of H5N1 avian influenza in the rapidly expanding poultry population of south east Asia and note the great concern that through built in mutation mechanisms it could become highly transmissible to humans, becoming the new Spanish Flu. As something on the order of 10% of US airline passengers originate outside the US (globalization), such a virus will likely spread world-wide very quickly.
On the food side, a base level of caloric intake is required to sustain an adult human. Having less than that leads first to death of the young from the combined factors of starvation and disease (microbial predators). So humanity must increase the diversion of more of the earth's resources toward human food production. But water is becoming a critical resource in many areas, particularly in the critical grain-growing areas supporting dense populations such as India and China, where "fossil" acquifers are being drawn down faster than they are being recharged. Proposed solutions to the water problems usually involve more energy, such as lifting water farther, moving it greater distances, recovering it from human waste streams (where it is contaminated by human enteric infectious agents) or desalinzation. China's
On the energy side, the EROI from crude oil is declining. Period. Coal per unit of energy will contribute more green-house gasses as well as other undesirables such as mercury unless scrubbed, also costing energy yield and having an intial cost that is being resisted by most in the energy industry. The previous dogma was that increasing CO2 would improve agricultural yields because CO2 increases plant growth. Recent work suggests that this is not the case, that other feedbacks (e.g., ozone) in the complex atmospheric part of the life system, which we do not understand well, will have a greater negative effect than the positive effect of increasing CO2. One major component of the green revolution was based on the increased use of chemical fertilizers, which also require significant energy input. Now emerging is the understanding of mechanics of the negative impacts that the application of chemical fertilizers as managed previously has on soil dynamics, such as water holding capacity. Another feedback of unintended consequence.
At the limit, even collectivley we can never have perfect understanding and always will be faced with uncertainty but it seems we must act as if we do and are not. It also seems that because our political and economic systems are structured with virtually no long term accountability or jeapordy (loss of pensions?), the timeframes of politicians and CEO's are too short and their models of the way the world works are unneccessarily truncated.
Posted by: FishEpid at July 16, 2005 12:45 PM
So far the focus has been on oil spot prices and oil futures. Wouldn't the stock prices of companies supplying solar, wind, nuclear, and geothermal equipment also have some predictive value?
Posted by: Texas Al at July 16, 2005 12:47 PM
For whatever its worth, I signed up for a commodities account after reading JDH's early entry about going for oil futures if you're certain about peak oil. In speaking with the broker who was to be placing my bid for a 2011 futures contract, he noted that he was also starting to really get into oil futures personally as there was quite a bit of movement in the markets. I casually asked him what he thought about peak oil. He responded "I've never heard of it". That was all the incentive I needed to start saving for additional futures contract/options purchases.
This really doesn't completely fit in with what has been discussed here to date except to suggest that perhaps there are many, many futures traders who should really know better that have never heard of the topic being discussed today, and that's why futures prices may not be reflecting "peak oil".
Posted by: Tim at July 16, 2005 04:28 PM
Good luck with your trades, Tim. A couple of points. First, there's a difference between a broker (who sometimes knows next to nothing about the market) and a trader. Second, there are a number of arbitrage relations that have to hold between spot prices, storage costs, futures prices, and option prices, and it's possible to make a fine living from recognizing deviations from these, even if you don't know the first thing about peak oil. One of the things the market does is amalgamate the expertise of a great number of different people, any one of whom may just know how certain pieces of the picture have to fit together.
Like Gillies says above, it's a win-win situation for you. Either you'll get rich, or else you'll discover that the world's in better shape than the peak oil community has been telling you. But either way it comes out, don't blame (or thank) me, because I honestly don't know which one it's going to be.
Also make sure you understand how the margin call is going to work if the market moves against your bet.
Posted by: JDH at July 16, 2005 05:00 PM
Given that real markets don't behave the way ideal markets do, the next logical step would be to determine the extent to which a real market is rational and well informed by comparing its behavior to the behavior of a perfectly ignorant and irrational market (reacting only to past trends and not predictive at all) as well as an ideal market.
I know this sort of thing is more easily said than done, but has anybody ever tried doing something like this?
Posted by: Texas Al at July 17, 2005 03:25 AM
A lot of highly educated people have posted here, so many in fact that sometimes it's difficult to have a general idea of the discussion. I would like to clarify something.
Sometimes, it is useful to pay attention to who's saying what. It's like climate change. If you listen to some media and the US government, you may make the wrong assumption that a debate is raging in the scientific community between the proponents and detractors of global warming. A closer look though, shows that the vast majority of scientists don't doubt that climate change not only is a dangerous possibility, but is allready happening (of course, nobody really knows the extent of the temperature rise and a lot of other factors and changes).
With the peak oil issue I would like to follow the thread started by Heiko: "It's simply taken as an article of faith by many "peak oilers" that oil cannot be substituted without major upheaval, and when they see economists "assume" the opposite, they think that those economists must be ignoring obvious reality."
Well let's look at the three different issues, peak oil (geologists), energy transition (physicists, chemists and engineers), and economy (economists), and who is best qualified to make predictions.
Peak oil: geologists say there is peak oil and peak natural gas comming. Discuss whether (for oil) it comes in the 2005-2010 or in the 2010+ timeframe.
economy: economists should be the best qualified to asses things like the price of oil, possible recession, etc.
Energy transition: more complicated. We could make three groups: the nuclear energy camp, the renewable, and the "fantastic energy source comming" camp.
A lot of people simply dismiss peak oil with the argument "they'll come with something up". In that camp fall such things like Nuclear fussion, and hydrogen energy from the oceans.
There are only two different types of energy, renewable and non renewable. Nuclear energy is not renewable, and the claims that useful uranium reserves would last long are heavily contested. A world based on renewables would necessarily be less energetic than today, and definitely not "business as usual". Now, incredible solar cells able to provide TWs of energy also falls into the third category.
And so we can Analise who says what:
Geologist: peak oil a reality. Could be now, could be in ten years.
Physicist: either "nuclear fusion in 50 years" like they said 50 years ago, or "historical total energy peak probably next decade and energetically-poor world awaiting us."
Engineer: either "fantastic energy source comming", "technology will solve it" or "current infrastructure is so dependent on cheap energy that the world will be fundamentally different after peak oil and gas."
Economist: either "peak oil? it is only a theory" or "well, it could be decades away, and the market and human ingenuity will make for a smooth transition to other sources of energy."
So, for me, it is clear that economists are either in denial about peak oil, or have absolute faith in the market and human ingenuity (technology) and ignore accordingly what some scientists say. They assume world economy will function in EXACTLY the same way it has for the 200 years of upward hubbert curve.
Just for the record, I am a physicist (and from Spain, so sorry about my English and the long post)
Posted by: MikeT at July 17, 2005 03:59 AM
JDH, thank you for posting an economist's well-though-out viewpoint on peak oil. I especially appreciated your extrapolation of future demand-destruction from the previous local maxima in the 1980s.
However, even though economics brings much useful information to this discussion, I'm reluctant to base policy on the futures markets. :-) Why?
1) As we've seen in this discussion, research suggests that markets predict even obvious trends quite poorly beyond a 5 year timeline. We've also seen that stock prices can be affected by relatively transparent shenanigans with options. While arbitrage is a powerful force, it seems to work best when the numbers are easy to crunch.
2) Futhermore, we've seen that oil futures in particular do an especially poor job of predicting future oil prices.
3) Many major oil players--including the US Government and the House of Saud--may make economically irrational decisions for sound political reasons. It's analogous to the weird exchange rate distortions we're seeing right now.
4) There's a lot of missing information. Nobody knows how demand destruction works in the $60-200 price range, how much oil is really left in Ghawar, or whether the United States is crazy enough to backstop oil with coal-to-gasoline conversion in the long run.
5) Although many of us are regrettably ignorant of economics, we are not necessarily ignorant of the consequences of *blindly* trusting economists. Over in the anthro department, they tell some pretty awful stories. :-) And as for the wisdom of markets, well, I lived through the dot-com boom.
6) Jared Diamond's recent historical work suggests that societies really can survive happily for hundreds of years, recklessly exhaust their natural resource base, and collapse in spectacularly horrible ways (resource wars, 90% population declines, mass cannibalism, etc). He also argues that such catastrophes are generally avoidable with enough foresight.
So, all things considered, I'd prefer it if we did a little more planning and spent a little more R&D money now, even if oil is only trading at $60/gallon. (Of course, I also wanted companies to invest more in Y2K remediation back in 1995, but they recklessly procrastinated until ~1998, when they were saved by technological innovations that allowed them to remediate at far lower cost. So what do I know? But maybe we won't always be so lucky.)
Posted by: Eric at July 17, 2005 07:01 AM
on climate change, there is general scientific consensus about the direct physical effect of greenhouse gases, indeed, how "dangerous" said warming is and what the best way to address that "danger" is, however, is a different question. It does not follow that "Kyoto is right", from "assuming a range of reasonable scenarios involving no climate policies at any stage the world's average temperature will probably rise by 2-3 degrees Celsius by 2100".
Posted by: Heiko Gerhauser at July 17, 2005 07:03 AM
Economist are neither in denial about peak oil, nor do they have absolute faith the the market and human ingenuity will cause the economy to function the same way. What economist believe is that the market does a very good job of allocating resources efficiently. Even if everyone is less well off 20 years into the future, a market economy is the most efficent way to get there.
Also, as to the issue of substitution, this involves much more than just substituting one form of energy for another. For instance, if the price of oil makes that European vacation too expensive, then maybe I spend that relaxation/leisure money on something much less energy intensive, such as "therapeutic" massages.
Posted by: Roy at July 17, 2005 07:13 AM
The main issue I have with James Hamilton's argument is the logical jump from peak oil to $200 oil without consideration of what peak oil advocates mean by peak oil.
In the "Olduvai theory we'll go back to the stone age with plenty of war, starvation, chaos scenario" presented by many peak oil advocates, there is no opportunity to profit, only an opportunity to head to the hills with a bunker full of food and fuel and plenty of ammo in the hope of avoiding the big die-off of most of humanity.
You won't make money on oil stocks, because, well either the "energy profit ratio" will drop to 1 so that the companies require 1 barrel of oil to produce 1 barrel of oil and so won't make any money even at infinite prices, or they'll just get expropriated.
For addressing that extreme view of peak oil, arguments about price signals are irrelevant.
If, on the other hand, peak oil merely refers to a production maximum for conventional oil and a gentle decline (a few percent per annum) thereafter, world oil prices could be held steady by say unconventional oil, or explosive development of hybrid vehicles, or massive gasoline taxes in the US, or an economic recession in China etc... After the second oil shock, OPEC kept prices steady in nominal terms (though not after accounting for inflation) by continuously adjusting production downwards, so declining prices together with declining production isn't exactly unprecedented.
James Hamilton's argument holds true in so far as it's saying that there are very few people with money betting on much higher oil prices in the near term.
I don't know what Tim thinks the future will bring, but if it's "resource wars", think of what a war with China, or a nuclear terrorist strike on New York, would do to your oil futures position. And as it's your money, I'd think very hard about whether your bet on oil futures is much better than gambling, even assuming that Campbell has got his oil extraction forecast right this time.
Posted by: Heiko Gerhauser at July 17, 2005 07:46 AM
The effect of any given oil price on usage will have a significant lag - as it rises, it will seep into people's consciousness and cause changes over time. People don't wake up every morning, check the price of gas, and decide how far to drive that day. Instead, they drive to work each day, fill up at the pump every so often, have an emotional reaction to the cost of the fill-up, and then, perhaps a few months down the road, face some decision that will impact their oil usage (where do I go on vacation? should I chuck in the towel on my money-losing trucking business? Should my next car be a Prius? A Hummer?) The aggregate of those decisions make up usage changes.
So we don't know that $60 oil create 2% usage increases - 2% is the effect of a weighted average of prices over recent months and years (the vehicle mix on the road today was largely bought during the era of $10-$30 oil). There are now a string of news stories about significant distress in Asia due to high oil prices. So it seems $60 is going to have at least some restraining effect on usage.
I don't claim to know that $70 oil produce a 3% decline in oil usage over time (we don't know). We do know that $90 oil, last time it happened, caused a pretty good sized recession and large effective oil conservation efforts. Maybe it will take more this time, or maybe that will still be enough to produce significant contracting oil usage.
My point was - I don't believe you should expect prices to go up and up and up, unless you believe the depletion rate will go up and up and up on the far side of peak. As JDH has argued, the effect of the futures market and the possibility of storage is to cause any predictable future contraction in supply to be instantly reflected in today's prices. So if we get to a point where the future depletion rate is clear (let's say we have far better oil market statistics than today), then the market will try to quickly pick the right price to set in motion that depletion, and then stick to that price (very roughly speaking - obviously the real world will be messier, but I believe that will be the dominant dynamical behavior of the market).
I don't think depletion is priced in yet, but for good reason - it's very hard to tell reliably when it will start or how fast it will go.
As to Europe (where I grew up). It's true they tolerate gas prices 2x or 3x higher than in the US. They also drive cars that are half the weight and much more fuel efficient than in the US and average miles driven per person are significantly lower.
Posted by: Stuart Staniford at July 17, 2005 09:06 AM
It does not follow that "Kyoto is right", from "assuming a range of reasonable scenarios involving no climate policies at any stage the world's average temperature will probably rise by 2-3 degrees Celsius by 2100".
I agree. But it surely is "right" to reduce carbon emissions. So Kyoto is at least better than to do nothing, and wait and see whether we cause a catastrophic climate change. The market alone is surely not going to solve that one.
On Peak Oil, it surely is right to start reducing consumption now. Whatever your point of view is (technological fix, powerdown, of die-off), we could at least agree on that.
Posted by: MikeT at July 17, 2005 09:07 AM
Any comments or opinions on the following situation? Can economic theory help rationalize the risks/impacts of peak oil given the high probability of its occurance within the time of the following problem? (I'm using the Danish Board of Technology's peakoil before 2020 conclusion).
If a public utility is required to develop a 20 year solid waste (garbage) management plan, can it credibly assess peak oil in the financial evaluations and comparison of options? Trucking (diesel use) is a big part of the solid waste management; incineration and co-generation is another option. However, there is no way to reliably estimate energy costs 20 years out (even though the US DOE, NEB try to).
Can one resolve this? Or, is it just wishful thinking being able to rationalize the future?
Posted by: Robert H at July 17, 2005 09:12 AM
"Also, as to the issue of substitution, this involves much more than just substituting one form of energy for another. For instance, if the price of oil makes that European vacation too expensive, then maybe I spend that relaxation/leisure money on something much less energy intensive, such as "therapeutic" massages."
I agree with you. Less energy doesn't necesarily mean economic breakdown. Can people live confortably with less energy than nowadays? A big yes! What I'm questioning is the belief expressed by most economists here that the market economy alone will take us there in the most efficient way.
A lot of the discussion here seems to revolve around the question of whether the market anticipates peak oil, whether that gets reflected in the oil prices, and whether you could profit from that knowledge to become rich.
In that regard, I agree with Heiko that even if you firmly believe the ASPO depletion timeline (2007 peak), and "know" prices will go up, it is risky to bet the bank on oil futures. You don't know a lot of other factors that come into play on the other side of Hubert's peak that will heavily influence oil futures. It could be reduced consumption, government intervention (controlled prices, nationalisation), recession, war, etc...
So the fact that you're not able to become billionare doesn't mean Peak Oil is not nearly there (nor the contrary is true).
An example of what an economy "expert" means:
A renown German economic institution, casts yearly oil price predictions. The have been wrong for a number of years. In fact, the oil price has consistently been 50%(!) higher than their prediction. For this year they predicted 37$pb, so 50% more would be 55,5$pb, which seems so far to be spot on for the whole 2005. They are on to something.
So what's my point? It is not that economists don't have a clue. A 50% deviation is for all intents and purposes a completely useless prediction... until you see that it is consistently 50% too low. That is not a completely randon, no-clue prediction. That hints at a study based on probably useful information, that is incredibly biased and good at believing prices will remain low. You only have to take that into account, and adding 50% to their prediction will give you an extremely good oil price guess.
Posted by: MikeT at July 17, 2005 09:36 AM
The reason I find the discussion initiated by James Hamilton so useful is that there are so many different people who have actual expertice in a number of fields. Most interesting of all is discussing something like Peak Oil with economists. I think economic theory will have to change (adapt) to acknowledge that the world is finite. The mechanisms that it now has to deal with depletion, solve things by using external inputs (or substituting resources). The Earth was big enough until now. When the world enters depletion of something you cannot replace, things change. I think the economic theory that has been useful for 200 years of nearly constant growth, does not necessarily apply when the conditions required are no longer met. Some economists don't believe that, so the sooner we begin to talk to each other the better.
What I would really find interesting is if some of the economists here expressed their (different) views on IMHO one of the most important matters:
The Industrial revolution was accompanied by the financial revolution. The world economy is based on debt-based currencies, the reason it is doomed to perpetual growth or failure. Banks lend money they don't have in part because there is confidence that next year the economy will be bigger, and will be able to pay for it. If a dotcom bubble ends in tears, the fed and US government throw fiscal discipline out of the window and flood the world with newly made money and the next bubble ensues.
If we accept a total energy plateau (doesn't matter much whether it is this or next decade), absolute growth will cease to exist. Of course you can grow without consuming more energy, but only to some extent. And much less during depletion, because when oil and gas are depleted we may have to carry on with (being optimist) half?, two thirds? of the energy we enjoy now. How are the debt-based currencies (and societies) supposed to function once there is no absolute growth? doesn't that spell doom if currency reform is not carried out? (back to gold standart?). Those are things that obviously don't have anything to do with the market being efficient at managing resources.
I don't mean to disturb anyone, nor pretend I know something you don't. On the contrary, would really appreciate if some of the intelligent people in this discussion would expose their views on the matter. Specifically some of the economists.
If someone is interested in some of the things I wrote, a different, out of the box thinking, economic (financial) source:
Posted by: MikeT at July 17, 2005 11:12 AM
Hey folks, great thread. I like the idea that people can speak all they want, but if you want to know what they really believe, see where they put their own money. So on that note, it seems that those with significant training in the field of economics seem to suggest away from the idea of buying oil futures as the futures don't currently suggest an impending oil shortage.
Do I correctly assume that all of you who espouse this idea of avoiding oil futures because the future just isn't clear enough to support that, instead continue to fund your retirement plans (rooted in stock market)? Isn't the idea that the stock market can continue to grow in light of peak oil (whenever it comes) just as tenuous? If so, are you just sitting on your retirement savings in a money market?
For what its worth, I continue to fund my retirement plan realizing that it may become moot if the economy fails. I also am starting to buy oil futures with spare cash, and finally have just bought a boat (because it looks like a retirement (in 30 years) of leisurely boating and fishing will likely be out regardelss of the exact date of peak oil).
Posted by: Tim at July 17, 2005 11:15 AM
A clarification from my ealier post. I don't think a market economy would make any needed transition in the most efficent way possible, just more efficently than any other option. Would anyone want Tom Delay or Nanci Pelosi making these decisions?
Also, I'm not sure I'd agree that our economy is based on debt-based currencies and hence doomed to perpetual growth or failure. While it might be painful, I see no reason our economy can't transition to zero growth. even at a lower level of economic activity. Banks may lend a lot less money, but there will always be at least some projects with a positive return on investment.
Posted by: Roy at July 17, 2005 12:31 PM
I disagree that markets and prices are irrelevant even for the most extreme (as you put it, Olduvai) scenario. On the way to global collapse, there would still be opportunities for profit-- oil futures speculation, short-selling, precious metals, and investment in whatever panicked consumers would be trying to buy the most of. A major consideration might be cashing out at the right time, but I don't see why it can't be done.
After the collapse, markets would still exist, but they would be local, barter markets. Not that I personally subscribe to the Olduvai theory, I'm just saying that markets are an inherent human behavior and nothing short of extinction would make them irrelevant.
On Peak Oil, it surely is right to start reducing consumption now. Whatever your point of view is (technological fix, powerdown, of die-off), we could at least agree on that.
Deliberately reducing consumption won't accomplish anything unless you get buy-in from all consumers. If you convince or legislatively force let's say the USA to consume less, wouldn't this lowered demand slightly lower prices and encourage greater consumption by other countries? It seems to me that the only way to get buy-in from all consumers is for the prices to rise high enough that they voluntarily start using less.
A better policy solution might be to fund R&D efforts into increasing the REOEI for solar, wind, and nuclear.
Question to everyone:
Are there any historical examples of industries that could only exist as long as some finite quantity remained undepleted? If so, I wonder if any inferences can be drawn to the behavior of a market as a whole that's based on a depletable resource.
Posted by: Texas Al at July 17, 2005 01:33 PM
MikeT, I'm not sure if this is what you're asking for, but here are a few things I can say. (1) Between 1981 and 1985, U.S. petroleum use fell 2% while real GDP increased 13%. (2) In a standard class on the theory of economic growth, the first lecture would usually cover a model in which there is no growth in population and no technological progress, because that's much easier to understand than a situation where things are growing. It is true that those bare-bones models assume that you could keep on producing at the same quantity, if you wanted. If you restrict those models with a continually shrinking resource base, the question is going to be the extent to which you may be able to substitute capital or technological progress for some of the energy (better or more expensive machines that use less energy). You can certainly set up assumptions in which there is no technologically feasible way to keep life going, though even then I want to come back to Roy's point above as to what is the best practical human institution for dealing with the situation, even though "best" would in that case not be a cheerful or optimistic scenario. (3) The fundamental defining characteristic of economics is the study of things that people want yet are inherently and unavoidably scarce and limited, not the study of things that are unlimited.
Posted by: JDH at July 17, 2005 02:05 PM
With respect to MikeT's reference to www.financialsense.com, I recommend the audio interviews available via their 'broadcast/newscast' page. Some good discussions.
Re: Texas Al:
Are there any historical examples of industries that could only exist as long as some finite quantity remained undepleted?
How about a mining town come ghost-town once the mine dries-up? It may not be an exact comparison, but if the economy of a community isn't diversified, it has little resiliency for the future. Industrial examples which have been suggested are whale oil and cod fish -- renewable resources pushed beyond their abilities to renew. But then whale oil was substituted with kerosene, and cod with haddock and etc...
Posted by: Robert H at July 17, 2005 03:11 PM
"Between 1981 and 1985, U.S. petroleum use fell 2% while real GDP increased 13%"
These numbers are quoted often, but I wonder whether they do reflect the loss of manufacturing taking place during those years due to outsourcing to poorer countries. After all, this was the period where globalization was reinvented in order to shift the energy intensive industries away from our shores. For the statistics to make sense, one would have to compare total world economic product versus world energy consumption. Restricting that comparison to the US only does does not really take into account the energy spent in producing all the products imported to the US from abroad.
Posted by: Robert Sczech at July 17, 2005 08:00 PM
There is an upper limit for the price of oil. That limit is given by the fact that oil imports must be paid for by the export of real goods. At $200 per barrel, the cost of our present oil imports would be roughly equal to the value of all our present exports. This indicates that $200 is at the upper limit which the US economy could afford to pay for imported oil. Since the manufacturing sector of the US economy is in a long term decline, and since oil imports must increase in coming years due to declining mational production, it seems to me that the upper limit for the price of oil which we could possibly afford to pay will decline in coming years. May be it is this fact which the future market is discounting.
Posted by: Robert Sczech at July 17, 2005 08:20 PM
I also see no reason our economy can't transition to zero growth. There is steady-state economic theory. The question is whether it will be let to transition without having to crash first to convince everyone of the need to do it. Because that is again not something the "market" alone could manage. At least some "outside" reforms would be necessary, even if you thing a steady-state (sustainable) economy could be achieved with fiat currencies.
Posted by: MikeT at July 17, 2005 11:29 PM
Robert Sczech wrote,
"At $200 per barrel, the cost of our present oil imports would be roughly equal to the value of all our present exports."
Well, that sure is a mind-bogling idea. Oil import cost as high as all exports combined!. Then this 200$ limit is really an absolute theoretical limit. But I find it equally difficult to believe that the U.S. economy (and dollar) could go on with half as much as that. Half the value of the exports and the trade deficit would rocket to incredible highs. I dare say unthinkable. I don't think Asian central banks would be able (or willing) to finance that.
Posted by: MikeT at July 17, 2005 11:37 PM
"(1) Between 1981 and 1985, U.S. petroleum use fell 2% while real GDP increased 13%"
You are citing a very special period, where the U.S. applied conservation measures after the second oil shock. And that was surely easy as the U.S. economy had so much fat to be trimmed. You don't know what the rate of depletion will be, but surely not less than 2% per year, not 5 times less as in the example. And what's more important, I don't doubt the ability of the economy of becoming more efficient (again, example of the EU Being twice as energy efficient as the U.S. at comparable living standards), but after a few years of reducing consumption, it becomes much more difficult to improve efficiency. And depletion is for decades (depending on the base energy level that the alternatives will provide).
"(3) The fundamental defining characteristic of economics is the study of things that people want yet are inherently and unavoidably scarce and limited, not the study of things that are unlimited."
Yes, but it doesn't cope well with things that have no alternative, or expressing it differently, it doesn't set it's price right. Specifically doesn't take into account if it jeopardises the future of our children. Example: if you leave fishing to the market, the price of fish will really rise only when it is too late and the resource is depleted. Instead of matching captures to the natural reproduction rate, and be able to fish, say, 1 million tons per year FOREVER, the "market" fishes 10 million tons a couple of decades, exhausting the fisheries and the future generations won't ever be able to fish more than a couple of thousand of tons. That surely is not an efficient way to manage resources in the long run. (problem of the commons)
"Deliberately reducing consumption won't accomplish anything unless you get buy-in from all consumers."
Allright. You would need some kind of Kyoto protocol for energy. There is allready one: The Uppsala protocol (http://www.peakoil.net/uhdsg/UppsalaProtocol.html). It basically says every country should reduce it's oil imports so as to match the rate of global depletion. That way it is fair to both rich and poor nations.
Of course that would be the rational, human way of dealing with things, and we all know how successful global initiatives have been in involving all countries (Kyoto anyone?). But I can think of no other way of averting resource wars. Ideas anyone?
Posted by: MikeT at July 17, 2005 11:45 PM
A word or two concerning futures markets.
Many here seem to view them as places where people can make money by predicting the future better than others. Now, of course, the future is unknown, and much research into financial markets has shown that the next movement of any financial instrument is strongly stochastic.
Basically, the genesis of futures markets, and what is still their most valuable, is in being a place to trade uncertainty.
People who sell into a futures market are usually giving up the potential of higher prices in the future for a definite price. That is, the absence of uncertainty is worth something to a seller. A bit like buying insurance.
As I said before, in the near term, volatility always dominates over trends. The guy buying the futures contract is usually somebody who is comfortable using short-term volatility to make short-term profits. If you're good at it, you will make money, and people who are bad will soon get chased out. Of course, the aggregate profits over time will eventually be related to long-term trends, but most of the guys going long are playing the volatility in the near-term.
In a futures market, the future price is usually a function of the current price and the current interest rates. If something is commonly believed to be about to happen in the future, then that is incorporated into the current price.
The futures market isn't really a price prediction market, its a market for the value of near-term uncertainty.
Posted by: Barry P. at July 18, 2005 12:41 AM
I doubt China and India would think this Uppsala protocol is fair if they have to start reducing what is already a small fraction of US oil usage.
Posted by: George at July 18, 2005 05:45 AM
Texas Al, all economists would agree with you that the private market would not make the right decision on fishing, but would instead deplete the stock against society's best interest, and of course we see that in the historical record. It's known as the tragedy of the commons, and arises from the fact that nobody owns the fish in the sea. But somebody does own the oil, and that ownership gives them an incentive to sell it for the best price. As I've described, that desire to sell oil for the best price in fact does work in society's interest in terms of helping reduce current demand, save the oil for the future, and generate a gradual price path (at least to the extent that people can anticipate) to facilitate a smooth transition.
Posted by: JDH at July 18, 2005 06:18 AM
Are there reasons "oil" could act like a "commons?"
Could the incredible quantities in play be enough to cause that effect?
I think for the end consumer, the commons effect is quite real. Buying a Prius won't increase your chances to have access to gasoline X decades from now - certainly not over the SUV drivers down the street. Hence CAFE standards, and the like.
Maybe the existence of CAFE standards argue that oil is already being viewed as "like" a commons politically ...
Posted by: odograph at July 18, 2005 08:01 AM
Odograph, certainly when two different property owners could drill for the same reservoir of oil, there's definitely a commons effect that would lead them to race to get the oil out first. I don't think that's a good description of the situation in many places at the moment, though it has been important in some cases historically.
As for consumers, it's true that the consumer doesn't personally take into account that future effect. However, the consumer has to pay for the gasoline, and the amount you have to pay for the gasoline depends on how much is available to sell. Because the seller of oil today is surrendering the right to sell that particular barrel in the future, they must be compensated for that, and the compensation is going to be related to how much the seller thinks that barrel would have been worth in the future. In this way, the consumer, by looking only at today's price, is in fact taking into account the future scarcity, and this was the point of my original post. If the oil sellers try to maximize their profits, and if they expected oil's price to rise quickly in the future, it will be in the sellers' interest to hold some oil back from the market today, which would then raise today's price and make it in the interest of consumers to cut back their consumption today, even though the consumers aren't thinking about the future scarcity, they're only thinking about what they have to pay today.
Posted by: JDH at July 18, 2005 08:20 AM
I'm really asking if economists have played with the idea of "near-commons" conditions. Or if there are known markets that "act that way" even without the meeting formal requirement of a resource "in common."
On how well "today's price, is in fact taking into account the future scarcity" ... that's the heart of the thread.
As I've said, I think we simians are pretty good at such price projections, but not perfect. That's just my worldview. Simians with extensive economic conditioning ... I mean study, may answer differently ;-)
Posted by: odograph at July 18, 2005 08:51 AM
a policy of using military power to secure oil supplies may mean that the theoretical maximum of $200 / barrel oil may never be achieved.
the policy transfers some of the cost of a barrel from the u s consumer as e g a motorist to the u s consumer as taxpayer paying for endless war. at some point the consumer with less after tax income consumes less, and those economies who have less military clout, lose out and begin to have less appetite or purchasing power for for the u s exports.
when you burn this candle from both ends - who knows - the theoretical maximum oil price may be down closer to $100.
Posted by: gillies at July 18, 2005 12:46 PM
so, if the effect of pursuing a policy of endless war were to secure the oil, but raise the price (inclusive of the cost of security) from $70 (say) now to $100 -
are you with the hawks or the doves ?
Posted by: gillies at July 18, 2005 12:51 PM
o k -
that was a trick question. the pentagon does not keep a full set of accounts.
so, you will never know what the oil costs.
Posted by: gillies at July 18, 2005 12:55 PM
"Are there any historical examples of industries that could only exist as long as some finite quantity remained undepleted?"
Passenger pigeons. See M. Perelman, The Preverse Economy (2003) (ISBN 1-4039-6271-5) for a discussion of the inability of markets to deal with issues of resource depletion and sustainability.
Posted by: tee at July 18, 2005 02:13 PM
With regard to the Pentagon, here's an attempt, likely with some bias from an agenda, to quantify the externalities not captured by the market price:
Gasoline Cost Externalities Associated With Global Climate Change (update)
Gasoline Cost Externalities: Security and Protection Services (update)
The Real Price of Gas (11/98, 43 pages)
Posted by: FishEpid at July 18, 2005 02:39 PM
Oops. Newbie to blogs.
Gasoline Cost Externalities Associated With Global Climate Change (update)
Gasoline Cost Externalities: Security and Protection Services (update)
The Real Price of Gas (11/98, 43 pages)
Posted by: FishEpid at July 18, 2005 02:52 PM
According to the British government in 2002, there is a hidden miltary cost to securing access to 'cheap' petroleum . Back in 2002, the Guardian reported about 16 GBP per barrel military cost which was borne primarily by the US. At the time this was close to the price of a barrel of crude. Here is the link...
So, given that the market sets a crude oil price where there is a large hidden miltary subsidy, I beleive that it is reasonable to conclude that the market is not efficiently allocating resources (finanical or otherwise) because of the corrupting effects of the military subsidy.
Since Iraq and Afghanistan, I also suspect that one could argue that the cost of the military subsidy has increased significantly... On the flip side, there is the value-add component of producing and using all those bombs and missiles...
Posted by: Robert H at July 18, 2005 03:55 PM
The "hidden" military cost of securing access to cheap petroleum is certainly a factor to consider. It should however not be overlooked that the military threat allows the US to enforce the Dollar as the oil trade currency. This in turn allows the US to pay for the imported oil with printed Dollars instead of delivering real goods in exchange. So while the military cost might be significant, the overall effect of this strategy could be beneficial to the US. Just look at the many trillions of Dollars held by foreigners. Many of these Dollars represent payment for imported oil. The imported oil is not really paid until these Dollars return home.
Posted by: Robert Sczech at July 18, 2005 06:27 PM
Barry P (re futures): Good post.
JDH: "If the oil sellers try to maximize their profits..."
This is really the key point. Oil sellers will try and maximize profits OVER TIME, and withholding supply in the present to drive up the price doesn't necessarily achieve that.
Even if we were at peak oil right now, that still leaves 1 trillion+ barrels of conventional oil to be recovered. The last thing producers want is an oil price so high that it triggers heavy investment in alternative fuel technologies and promotes wide-ranging conservation measures (not to mention initiating global recession).
If speculators try to drive spot oil prices higher as a result of arbitraging a perceived future price spike from peak oil, it's in the longer term interest of producers to fight such action if prices rise too far, too fast.
Of course, if producers are already maxed out on production, they've got a problem. So maybe they then talk about 'raising quotas', 'increasing capacity' and get a few respected analysts to dispel fears of an impending supply crunch (e.g. CERA's recent "Worldwide Liquids Capacity Outlook To 2010 ? Tight Supply Or Excess Of Riches").
Posted by: FT at July 19, 2005 06:14 AM
i think i'll make my own reply to my question about when markets can act as if they were based upon a common resource.
my untutored response is that when a product is widely produced, plentiful, and fungible it will be consumed without regard to future scarcity.
no one actor can influence price by refusing to buy or sell. there will be someone else.
both "opec" and "cafe" were responses to this near-commons condition. first opec attempted collusion among sellers, and then cafe (etc.) attempted collusion among buyers.
the interesting thing about "peak oil" is that it might represent a change of phase (attempting an allusion to physics research into "onset of turbulence"), when markets leave this condition in which buyers and sellers have no influence (without collusion) to one in which supply matters.
Posted by: odograph at July 19, 2005 08:09 AM
the question "is today's price, in fact, taking into account the future scarcity?"
amounts to "are we there yet?"
Posted by: odograph at July 19, 2005 08:17 AM
"Wouldn't the stock prices of companies supplying solar, wind, nuclear, and geothermal equipment also have some predictive value?"
Subsidies to the existing fossil fuel producers are so great compared to those given to renewable sources (and nuclear) that "orders of magnitude" is a poor way to describe it.
That brings up a general issue - I expect the US to continue to increase subsidies for the old stuff in an attempt to stave off popular discontent -- this will, of course, distort the market, at least in this country.
(For instance, we already pay for as much of the road budget via property and sales taxes as we do via gas taxes, and this is likely only to increase - this is an effective subsidy which prevents alternatives from taking root as quickly as they would otherwise do - it's basically an oil demand stimulus in a sense).
Posted by: M1EK at July 19, 2005 08:50 AM
One of the side issues being raised here is that old bugaboo of conspiracy theorists, fractional reserve banking. Maybe JDH could write about that someday.
When banks make loans, they are for the most part backed by assets. Although these loans increase the money supply, it does not inherently grow faster than the economic base. There is no built-in assumption of economic growth as a fundamental foundation for the economic system. If growth slows and stops, we will reach a steady state where banks are making new loans at the same rate that old loans are being retired. There doesn't have to be a crash.
Now, of course there will be problems if particular loans are made on an assumption of certain economic conditions, and then those conditions change. This could be as simple as an interest rate change or as severe as a recession or depression. Loans which looked good based on the assumptions in place when they were issued may prove to be unwise in retrospect given the actual economic conditions that occur. To the degree that bankers are assuming continued economic growth, then, a fall into a recessionary state will be costly and cause banks to lose money. In the old days they would fail but these days the government steps in an props them up or arranges mergers to keep things going.
The point is that contrary to frequent claims from critics, the modern capitalist system is not inherently predicated upon an assumption of growth. A steady state can work just as well. The only problems arise from unanticipated changes, which can make past decisions and sunk costs turn out to have been mistakes. But to the extent that changes are anticipated, such problems can be avoided. In particular, we could transition to a no-growth scenario if necessary without much pain, as long as we see it coming.
Posted by: Hal at July 20, 2005 09:45 AM
JDH says, there is no "commons" problem because "somebody does own the oil, and that ownership gives them an incentive to sell it for the best price."
Talking the abstract this way, as a good chunk of our our half-a-trillion-tax-dollars-per-year military (50% of world military spending) is sitting right in the middle of you-know-who's oil patch strikes me as impossibly academic (and I'm an academic, too!). Our yearly military budget is comparable to the price we pay for oil per year.
Sure it's technically 'their' oil now, but how long will that be the case when push comes to shove in the next decade?
For those interested in basic numbers about energy, energy use, and energy supplies, I have a pdf here:
(now I study the brain, but I was originally educated as a geologist).
Posted by: Marty at July 20, 2005 02:53 PM
See also Andrew J. Bacevich’s The New American Militarism: How Americans Are Seduced By War.
It seems like a good book (haven't had time to do more than peak in), and acutally (sadly) has a chapter called "Blood For Oil"
My quick review of the chapter is here:
Yes. Again sadly, some military commentators see us heading to resource wars to solve this problem.
Posted by: odograph at July 20, 2005 04:57 PM
The UAE has one of the greatest vested interests in creating investments that will last them beyond the era of oil. They are small with practically no farmland.
Their investments are in free trade, buildings, malls, sports facilities, airports, business and theme parks - they want to boost tourism, which is definitely an energy intensive industry. Dubai will soon have the world's tallest building, the greatest set of artificial islands, the largest malls, the largest theme parks, and perhaps the world's first extensive underwater hotel.
These investments don't sound like preparation for an energy-poor future. And the dubai rulers are not short-sighted. The sheikh has a fairly vested interest in leaving his grandchildren a legacy. They know that oil is running out, but they are not betting on the world running out of energy.
So, investments from them can either be viewed as hopelessly naive, or maybe because they can hire the best advice in the world, (maybe they already have) one might like to bet where these guys are betting.
BTW. Dubai does not have a purposely weakened currency. the emirates dinar AFAIK is a strong currency.
Posted by: Prakash at July 22, 2005 12:10 AM
Once again in an effort to keep the discussion moving forward I'm closing off comments here, in hopes that you'll continue your discussion of these issues in the thread from the peak oil entry of July 22. Please feel free to respond on that later thread to any issues you may have seen raised here, and thank you once again for helping to bring so many different perspectives into the conversation.
Posted by: JDH at July 22, 2005 09:33 PM