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.

FILED UNDER: Economics and Business
Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.

Comments

  1. Bithead says:

    Here’s the thing Kevin doesn’t seem to understand; Increased domestic drilling is not merely a capacity issue, but rather one of price stability as well.

    And the other half here is I don’t think it true that there isn’t much left. I agree that the supply of currently attainable oil is going down. But I don’t see this as the same issue you apparently do, James.

    I’d point out that each time there’s been a major price spike, that the response to the problem at each occasion, was two things; The technology for finding the stuff got better… and the inclination for developing sources we’ve always known were there, but for reasons of what I call greenie madness, have been unwilling to tap… ANWR, as an one example of many. These factors combined to not only add to capacity, but more importantly, add to supply diversity, which in turn is a natural control on prices.

    The price flux as you mention can only occur if that supply diversity isn’t there. It’s the problem we ran into in ’72. we figured we didn’t need to dril herev at home very much because after all the Arabs would do it for us. Thus the greenies are happy. Even happier they were wehn we didn’t build refining capacity. Thus our current problems.

    As for the government, all that really needs doing is to get the government out of the way of such exploration drilling and refining. That is the biggest roadblock to our energy needs being handled… both now and in the future.

  2. A. Benjamin Cota says:

    “”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.””

    Gee, I guess today’s JUNE 17 closing RECORD PRICE of $58.50 a barrel shows that people are about as smart as Kevin Drum thinks they are. Futures prices have been above daily prices for months, too.
    I guess reality trumps ‘theory.’

  3. Steve Verdon says:

    $58.50 is not a record. Try adjusting for inflation first. Yes it is high, but calling it a record is highly misleading (guess you aren’t as in touch with that reality thing as you think). Further, since Kevin is predicting prices as high as $200/barrel why aren’t current prices higher?

  4. Jon says:

    Furthermore, looking at the future price for oil contracts all the way out to Dec 2009, one sees a *decline* in price past the Dec 2005 contract.

    IOW, oil delivered in March 2006 is currently priced cheaper than oil delivered in Dec 2005. Dec 2009 oil is priced nearly $5 cheaper than Dec 2005. Odd that.

    Either we’re much closer to fuel cell breakthroughs than most think or there are other factors in play that most people simply don’t look at or are simply unaware of. I’m guessing the latter is the reality here and I’m not giving any hints other than to enquire as to the number of bull spreads Mr. Cota has in place.

    We may *well* be running out of oil – the market sure doesn’t say so tho – and those with the most to gain and lose are playing with far more chips.

    Oh – what the heck – here’s a hint – take a look at the Baltic Dry Freight Index…..

  5. kaz says:

    No the market does not think we will have a supply issue later because it wants to be optimistic as per economic theory, of when the price is high there will be more supply. But can you build an Oil factory? Can you find whats not there by giving more cash? There is only about 500K BPD spare capacity
    My prediction $70 in 60 days.

  6. Rick DeMent says:

    Actually if you really understood Peak oil you would know that oil should be cheapest at the very peak.

    Another point ANWR is simply not relevant to the issues of world oil price. It’s not a terribly large find and the Alaskan pipeline only has so much throughput, currently it can only deliver a little over I million bpd IF (and that is a very big if), we had the tankers to haul it.

    Finally the flat earth economists would tell you that as prices rise that investment in discovery and extraction technology will rise, and that is not happening, in fact it is going down as companies scramble to bid on claims and contracts of existing reserves. This has been pretty well documented.

    Oh and fuel cells right now and for the foreseeable future are a complete boondoggle, at least for privet transportation. Any “breakthrough” that might make fuel cell powered autos practical is ether being suppressed tin-foil-hat style or it only exists in the mind of the hopeful.

    I honestly whish that the free market crowd would start insisting that the US government end all subsidies, tax breaks and giveaways and let the market do the work you all say it should be doing. Petroleum is one of the most heavily subsidized industries in the US and that seems to be just OK by almost 100% of internet libertarians.

  7. I and only I says:

    “On the impossibility to deceive the reality, the man tries to deceived itself.”
    “Deal With Reality or Reality Will Deal With You.”

    Peak Oil is here.

    Dick Cheney in a 1999 speech he gave while still CEO of Halliburton, stated:

    “By some estimates, there will be an average of two-percent annual growth in global oil demand over the years ahead,along with, conservatively, a three-percent natural decline in production from existing reserves.That means by 2010 we
    will need on the order of anadditional 50 million barrels a day.”

    But, before to enter in a global economic collapse, Israel will attack Iran between August and November.And the US will going with him.

    From Newsinsight:
    Going after Iran.The US prepares for the Third Gulf War.

    “Yesterday, we published intelligence of US forward planning to attack Iran for its clandestine WMD programme (“ US prepared for Iran war with split Nato”), and it has come within days of the French/ Dutch rejection of the European Union (EU) constitution. We foresaw this possibility (Commentary, “Good morning, America,” 3 June 2005), but events have rolled faster than we expected.

    The man leading the Iran war-planning is the US defence secretary, Donald Rumsfeld, and in almost a repeat of George W.Bush’s first term, he has gone about the task of coalition-building for the war excluding the secretary of state, Condoleeza Rice. There are no stories yet of squabbles between them, as were replete between Rumsfeld and Bush’s first-term secretary of state Colin Powell, but things could get there as the war fever hots up.

    According to our intelligence, the plan to attack Iran will gather pace after certain crucial debates in the US Congress in July. The broad idea is to go with another “coalition of the willing” against Iran as in the First and not so much the Second Gulf War, and a Britain-led Nato will be a key player in that coalition. Diplomatic sources say that since the EU constitution was rejected by France and The Netherlands, Rumsfeld has been planning and succeeded in dividing Nato for the Iran war.

    The Britain-led Nato will not include Germany, and will comprise generally pro-US states like Spain, Poland, Romania, Portugal, and the Czech Republic. With the exclusion of Germany, France will not be able – or as able as before – to put spokes in the war preparation. With the European Union tottering and the Euro getting hammered in the markets, French resistance will be weak against a second war in the Middle East in two years.

    But despite what we wrote, the Iran war so soon, and with the boundless acrimony it is sure to generate, is surprising on another level, and that is seeing the general nature of second-term US presidents, who turn to the enterprise of making themselves look good to history. The first term of Bush we all know, when an almost evangelical America attacked Saddam for non-existence WMDs, a fact known to the president, the CIA, and the neo-conservatives lead by the vice-president, Dick Cheney.

    Cheney is less in evidence now, the neo-cons also appear to have had their day or term, as you like it, or they may be lying low, and generally, the fur is not flying about America, not since, at least, the Iraq elections, and the EU harakiri. But Iran war preparations and the war eventually will return the spotlights and hate on America, and a classical second-term US president should not like that.

    So why is Rumsfeld hammering another coalition into shape, but more controversially, attempting to hammer Germany and France out of shape? Perhaps, there is no other option. The European Union tried through non-offensive means to get Iran to de-weaponise, but not only Iran thumbed its nose at them, it threatened Scud attacks on Israel, and is shopping around in Africa for dirty bombs, that is bombs that can spread radioactive death through conventional explosion, without triggering a nuclear holocaust. But it is terrible, such a bomb, all the same, and the Al-Qaeda has come close to having it from the nuclear blackmarket since 9/ 11.

    In other words, Iran has threatened state terrorism against Israel and other US interests in the Middle East, and the EU has done nothing about it. A while ago, a US thinktank got together ex-US and former EU diplomats for a game battle of nerves against Iran, and the EU lost every time. Its diplomats just could not pitch for an offensive against Iran. Without the threat of exercise of the final option, that is offensive action, no adversary will bend, and Iran just got the EU to bend and bend on its weaponisation programme.(…)”

  8. hugh says:

    Actually if you really understood Peak oil you would know that oil should be cheapest at the very peak.

    At peak the rate of production is at its highest.
    However the price of oil is based on supply versus demand. Even before peaking supply can outstrip demand – what is sure is that once the peak is reached supply will decrease.

    The Britain-led Nato will not include Germany, and will comprise generally pro-US states like Spain, Poland, Romania, Portugal, and the Czech Republic.

    The reporter shows a very poor understanding of european politics. Tony Blair (uk primeminister) would be incapable to get the backing of parliment and the public for any attack against Iran – it is now generally assumed that he will stand down before the end of his term due to a collapse in his popularity because of his backing of the iraq war.

    Zapatero (spanish primeminister)was always againt the iraq war and was elected on this basis. He would never agree to a war on iran.

    This would give rise to a very reduced coalition of the unwilling (last time it was the uk plus a few token jests from other countries).

  9. John Salson says:

    “Oh and fuel cells right now and for the foreseeable future are a complete boondoggle, at least for privet transportation.”

    Oh no! How will we cope without transportation for our privets?