I just found James Hamilton’s weblog. I should have looked for it earlier as I have his excellent text book, Time Series Analysis which is an very good text for time series analysis (although the notation is pretty dense in places so don’t buy it as an introductory text). Anyhow, in this post Prof. Hamilton has a very nice response to much of the peak oil commentary that has been going on. The gist of the post is in the following,
Suppose you told me that, as a result of a careful examination of oil reservoirs, you were certain that annual oil production was just about to plummet, and would be 30% below its current level in two years. I realize that’s a more extreme example than anybody is advocating, but perhaps you’ll bear with me in examining its implications for a few minutes before turning to a more subtle scenario.
Let’s see if we can first agree on how society ought to respond to these facts that you would be giving us. I would say that the first thing we should do is curtail current oil consumption drastically. Oil is going to be an incredibly valuable commodity in two more years, and we’ve got to stop wasting it now. By leaving more of the oil in the ground now, we could stretch out the time available to us for developing alternative sources from oil sands and coal and to make radical changes in our transportation systems. And we would need to start immediately making huge investments in those alternatives.
Now let’s consider what would happen if the government doesn’t make any policy response. Oil is going to become extremely valuable under this scenario in a very short period of time. Let’s say for discussion we’re talking about $200 a barrel two years hence. Then I would like to make the observation that, if the facts were indeed as we just conjectured, oil surely could not continue to sell for $60 a barrel today. Anybody who pumps a barrel out of a reservoir today to sell at $60 could make three times as much money if they just left it in the ground another two years before pumping it out. The same is true for anybody with above-ground storage facilities– they’re throwing away money, and lots of it, for every barrel they sell at $60 that they could have instead stored for two years and sold for $200. If oil producers did respond to these very strong incentives by holding back oil from today’s market, the effect would be to drive today’s price up. This profit-seeking wouldn’t drive the price all the way up to $200, because you have significant interest, storage, and idle capacity expenses from trying to wait around a couple of years before getting your profit. An economist would expect the end result of this profit-seeking to be that the price today is lower than what it will be in two years by an amount that reflects these interest and other expenses, but certainly far less than the difference between $60 and $200 a barrel.
Suppose, again for sake of discussion, that the outcome of this profit-seeking behavior by oil sellers was to drive the price of oil to $180 a barrel today, (that is, supposing that $180 plus two years worth of forgone interest equals $200). What effects would that have? For one thing, it would be a very powerful and effective incentive to force today’s users of oil to reduce their consumption immediately. It would likewise be a very powerful incentive for investing heavily in oil sands and alternative technologies. And, of course, it would leave us more oil in the future to keep the economy going as we make the needed transitions. In other words, the consequence of oil producers trying to sell their oil for the highest price would be to help move society immediately and powerfully in the direction that we earlier determined it ought to move in anticipation of what is going to happen in the future.
I know that many physical scientists feel that economists have a misguided, mystical faith that “markets will always solve everything.” Though I understand how outsiders might get this impression, I would guess that more than half of the published research in economics has to do with how the market can misallocate resources rather than how it always does a perfect job. But one thing in which most economists do place a great deal of faith is the powerful forces that are unleashed, for good or ill, by people’s efforts to make themselves richer. The argument I’m making here is not an abstract, mystical claim about the market, but rather a very specific claim about the particular matter of interest. The claim is that profit-seeking works strongly in this instance to make the oil price rise now rather than wait until production actually declines, and that this force further works to produce the kind of changes that society needs to make now in order to prepare for the coming production decline.
So, if you thought you were right about the physical scenario, and yet saw oil selling today for $60, how could you explain the situation to an economist, who says that, if you’re right, oil should be selling for $180? One thing you might argue is that, in some of the oil producing countries, the rulers have a precarious hold on power, so they just want to pump all the oil they can right now rather than wait a few years, even if the extra profits from waiting might be enormous. That’s a good argument to make to economists, one we can understand and listen to. But, we would respond, what about private oil companies operating in market economies? Why would they throw away enormous profits?
Here I have heard some conspiracy- or incompetence-based arguments that frankly are difficult for an economist to follow. But rather than get into those, let me just observe that, even if every single oil producing government and every single oil company in the world had no desire or is too stupid to reap the huge profits that, under the scenario we’re discussing, could be theirs for the taking, that still wouldn’t be enough to account for the current price structure. The reason, as I’ve explained here and here, is that you don’t need to control a single barrel of oil in order to profit quite handsomely, if what we’ve conjectured so far were true. If today’s price is $60 and in two years oil will sell for $200, anybody with any money to invest could profit enormously by purchasing oil futures or options. And we don’t see $200 oil, not in spot prices, not in options, not in futures.
Prof. Hamilton goes on to also discuss the n-year scenario where the drop in oil production he is talking about occurs n-years in the future. He notes that we should see an increase in the price of oil as the date of the peak draws closer and closer. Further, that as the price rises in increases the incentives to look for alternatives. I’ve blogged about this before and have been meet with obstinate refusal to believe this. There seems to be some sort of complete refusal to think that people want to get rich. Which is exactly what we are talking about. The increasing incentives are basically the opportunity to get rich. Imagine the price of gasoline is $120/barrel and you come up with a way to get 200 mpg with a revolutionary hybrid engine. You’d probably become very, very rich…or at least the company you worked for would stand to make lots and lots of money for their shareholders. But the people who don’t think that the market has any chance of finding a solution think that corporations and the people investing in them, working for them and the scientist they employ are all stupid and will not look for opportunities to make lots and lots of money. Basically people will pass by a ginormous pile of cash and not give it a second thought. Why this is, I don’t know.
In this post here Prof. Hamilton makes another point similar, I think, to one I’ve made before. That if we are uncertain about the future production of oil, then we should be equally uncertain about using government to look for a solution.
I would perhaps express it not so much as “markets are not a very good predictor” as “nobody’s a very good predictor.” It’s very hard to know for sure exactly when the peak is coming, for precisely the reasons that Robert gives.
But any such statement invites us to look at the underlying policy question…. I don’t see uncertainty about the world as something that would give us a good reason to prefer government intervention over market solutions; if the market is uncertain, then so should you be about what the best government policy would be.
In fact, the more uncertainty we have about these matters, the more I am inclined to turn to markets to assimilate that information for us. After watching the sausage-creation of the current energy bill before Congress, I have relatively little faith that Washington is going to figure out for us exactly which technologies are most promising. But the entrepreneur who brings a workable hybrid vehicle to the market will make himself or herself quite rich. The lure of earning such profits is, in my mind, a much more powerful and effective incentive than anything that the world’s leaders are likely to dream up and try to lead us to on their own.
This doesn’t mean there is no government based policy response, but we should be at least hesitant to run immediately to the government and beg for some sort of policy. Chances are that policy will be ham-fisted and will probably do more harm than good. I’m sure many readers will recall the price controls of the 1970’s (and no, I’m not saying that will happen again, but pointing to how government can really much things up).
So, to all those who think peak oil is a looming catastrophe for sure, why are the above arguments invalid?