Peak Energy: A Reply to Kevin Drum, Part 4
First, before continuing with my response to Kevin’s series on peak oil, I just want to point out quite clearly I think that the Hubbert curve/peak oil is a valid concept. My complaints are that the hubbert curve is problematic for use in policy making, and that the model is lacking to be a truly predictive model. As for peak oil my view is that “running out” of oil does not have to be a catastrophe. Now I want readers to look at that last sentence a couple of more times. Note that I am not ruling out the possibility of a catastrophe, but that I don’t think the depletion of oil has to be bad.
Now that that is out of the way, lets move on to the fourth post in Kevin’s series. In the fourth post Kevin looks at the issue of pumping capacity and says that it is also bad. It is bad because we are running out of spare capacity.
Does the precise date of peak oil really matter? To some extent, of course it does: if production has already peaked, the world economy is in big trouble and there’s no time to prepare for it. If it peaks in 30 years, there are plenty of things we can do in the meantime. Even ten years is better than nothing.
But in another sense it doesn’t, because something has already happened that’s equally important: the world has run out of spare pumping capacity.
In discussing spare capacity Kevin writes that the 1973 embargo was a big event. However, was it the embargo or the fact that there was a cartel? The purpose of a cartel is to obtain the monopoly outcome when there are only a few suppliers. That is, you can’t have monopoly pricing (and profits) if you have two or more firms/suppliers competing. The price (and profits) are lower. A cartel on the other hand restricts output and thereby raises the price and profits. Notice the emphasized portion of the last sentence. The natural thing for a functioning cartel to do is reduce output.
Further, givent that there is a world market for oil and the refusal of the OPEC countries to sell to directly to the U.S. would have only a slight effect on the price of oil. The reason is that other countries would be willing to sell to the U.S. Moreover, since this is true for each country that can buy from OPEC there would be sufficient competition to minimize the effects of the oil embargo. So was it the embargo or was it the natural operation of a cartel which is to reduce output which does impact the price in an unambiguous manner?
Kevin’s claim that Iran offset the impact of the oil embargo by increasing production is also not all that surprising either. After all, the biggest problem facing a cartel is that the cartel members will each have an incentive to cheat on the production agreements (i.e. chisel). For a cartel to function–i.e. raise the price–the cartel must get each member to reduce output, but since the firms/members are already maximizing profits they are producing at the point where marginal cost is equal to marginal revenue. Hence, the level of production necessary for the cartel to raise prices has to fall. But this means that each firm is giving up profits in that if all other members of the cartel produce at the cartel mandated levels and the cheater increases production the cheater can achieve even higher profits.
Still, even with these oversights there is still a problem with the declining spare production capacity. It will mean more volatile prices. But is Kevin right that this problem is permanent? Maybe, but I think there is reason to be doubtful of Kevin’s claims,
This is why prices are increasing now even though there’s been no oil shock. It’s not because of a sudden disruption, it’s because demand is now bumping up against supply. What’s more, this is a permanent condition: new capacity takes years to develop, so even in the best case supply will only barely keep up with future growth in demand. There’s not much margin for error.
The thing that everybody should immediately ask themselves is, “Well how did we get all that spare capacity to begin with?” It wasn’t always there, so it seems that over a long enough horizion capacity is a variable concept. Could it be that capacity was built back during the last energy crisis and not anticipating the decline in consumption due to high prices the Saudi and others overbuilt? For Kevin’s claim to be true it has to be the case that new capacity will only be added to keep up with demand. Forever. And that demand will always stay at capacity. Forever.
Kevin also writes the following,
In the short term, this doesn’t mean much: prices will most likely continue to bounce around based on inventory levels and seasonal/regional demand. In the longer term, however, prices are likely to rise steadily and become far more sensitive to supply problems. With Saudi Arabia now pumping at very close to its maximum capacity, even a moderate oil shock somewhere in the world will make $50 per barrel oil seem like a bargain.
This makes no sense. If prices in the future are going to rise, why not right now? Is everybody in the oil industry stupid save for Kevin Drum? If this is the way things are going to evolve then purchasing current cheap oil and holding it for the future should start to drive up prices now. Also, if this is true are futures prices going up? Seems to me they should be.
This potential for instability is far more dangerous than mere expensive oil. The economy can adjust to high oil prices, and to the extent that high prices reduce consumption and spur innovation, they can even be positively beneficial. But as we saw above, wildly fluctuating oil prices are a different, and far more damaging, story. What’s worse, future oil shocks are likely to be fairly frequent since it will take only a small disruption to remove a few million barrels a day from the world market. Venezuela’s production dropped by 2 million bpd for a few months in 2003 just because their oil workers went on strike, for example. With Saudi Arabia already pumping at capacity, we can’t expect them to bail us out when stuff like this happens in the future.
There is some truth here, but it is also true that people don’t like volatility in their energy prices. One response to volatile/increasing energy prices is to cut back consumption whenever possible. Are people doing this? Well the demand for SUVs is declining (link, link, link). So the dire prediction of oil at $50/barrel one day and $200/barrel the next strikes me a bordering on the hysterical (or at the very least Kevin should be going whole hog on oil futures and strike it rich).
Kevin also references this chart to support his argument that which way oil price growth goes so goes the economy.
The chart on the right, courtesy of GlobalSecurity.org, plots both oil prices (in constant 2000 dollars) and economic growth over the past 35 years. I’ve extended it to 2005, and you’ll see that over that time there have been four periods in which oil prices have spiked suddenly (i.e., risen more than 50% in less than 18 months): 1973, 1979-81, 1989-90, and 1999-2000.
There have also been four periods of recession during that time: 1974-75, 1980-82 (a double dip), 1991, and 2001. This can’t be written off as a coincidence.
What Kevin doesn’t tell you is that these amazing coincidents also correspond with other events. Prior to the 1980 and the 1981/82 recessions also corresponds to high interest rates. The Fed Funds Rate in 1980 was over 17%. Granted higher oil prices would result in rising price levels, but that is only part of the picture, IMO. Changes in price levels are not driven solely by the price of oil. Another factor was the failed notion that the economy could be managed via the inflation rate (increase the inflation rate and you get a decrease in the unemployment rate; this view hinges on people suffering from money illusion). Also, there were the large Reagan tax cuts in 1981/82. Could that demand stimulus have been part of the reason that the Fed Funds Rate went over 19%? The people who say it was only the oil price want you to believe that there was nothing other than oil prices in causing price level changes which lead to the increase in interest rates which was what actually caused the recession. Further, if we look at a graph of the Fed Funds Rate we see that the rate also went up right around the time of each of the past recessions. So is it only oil that matters for the economy? No, that answer strikes me as just too simplisitic. Is it a factor? Sure. Is the price of oil important? Sure. Is it the only thing in the world that matters? No.
Does spare capacity matter? Sure. Is it bad that there isn’t much left? Yes. Does it have to be permanent or does it mean we have to “do something”? I am far from convinced. The problem is that “doing something” with Kevin usually means “government doing something” and that something usually entails distorting market signals. Is that what we really want to do? Try to hide the fact that gasoline and oil prices might be getting more volatile or increasing? Seems like that is a sure fire way to ensure that we are always vulnerable to the problems of volatile/increasing oil prices. Consider the situation where one week you fill up your SUV for $30 and then the next week it costs $57 and then back down, then back up. Might such fluctuations induce people to move towards more fuel efficient cars? If the answer is yes, then perhaps letting the price signals come through unadulterated is what we should do.