Peak Oil Debunked, or at least clarified

A big thank you to Steven Stoft of EU Energy Policy Blog for deflating part of the hype surrounding the peak oil idea, and putting my economist's mind at ease after years of looking at energy data and wondering if I'd misunderstood some basic concepts.

The peak oil theory basically says that, having grown for years, global oil supply will begin its inexorable decline. Meanwhile rising incomes around the world ensure that demand continues to rise. At some point, supply fails to meet demand and potentially societal chaos results.

Without commenting on the geological validity of peak oil, or indeed the desirability of a reduction in oil consumption, there's something about this that doesn't add up. The idea that 'demand' is a physical quantity that slopes upwards through time on a chart is highly misleading. Unless there is interference in the market (such as rationing) supply will always equal demand. This means as oil becomes scarce, the price will rise and the quantity demanded will fall, due to the price rise.

I think the IEA is at least partly to blame for this since it publishes global oil demand data on a regular basis where 'demand' consists of the quantity of oil consumed + net stock change in a given year. The economist's understanding of demand, as a relationship between price and consumers' willingness to pay with no particular quantity implied at all, is completely different.

So the market will sort itself out. This doesn't necessarily mean that the market will reach a price/quantity point that is particularly comfortable for the world economy and populous, but the implied doom of saying 'pretty soon supply will not be able to meet demand' is surely over the top.

Right, back to work...

Comments

[Alex]

Do I read this post correctly: you were concerned about peak oil not because it might result in potential societal collapse, but because it potentially challenged your understanding of the way markets work? Now that you've realised that markets will continue to function as expected - your concerns have abated?

I might put concerns about societal collapse before concerns about my understanding of economics - but that's just a personal perspective... ;-)

[Miles]

That's the gist - in a way.

I was more concerned with the notion that 'demand' is a fixed global oil requirement - with the implication that it must be met at all costs. There are of course many issues to debate which I deliberately didn't go into such as:
- how much oil we would actually need were we to live more 'sensibly'
- what would happen to societies as a result of a more or less dramatic reduction in the availability of oil
- whether, technically, we are at/beyond/far from peak oil anyway
- whether some of the unconventional sources that could prolong the oil 'tail' should be ruled out for environmental reasons

But debating all of those from the premise that '"demand" in year x will be this much, how are we going to meet it?' is a remarkably efficient way of skewing the argument in favour of 'supply at all cost' solutions and away from efforts to rationalise resource use.

I can't decide whether I'm for or against societal collapse. Keen to hear arguments on either side :-)

[Bishop Hill]

"I can't decide whether I'm for or against societal collapse".

I hope nobody quotes you out of context! :-)

Good posting though - this clarified things for me.

[Glen Peters]

The market always "works"... It all depends on how you define work. If work means supply=demand and the price adjusts to allow this then the market may always work! If work means "avoid societal collapse", then in 50 years time we may look back and say the market never did work...

I interpret the increased demand as assuming peak oil doesn't exist. That is, supply will equal demand at a reasonable price. But I do find it rather amusing that it is usually effortlessly assumed that life will go on in the next 50 years as it did in the last!

It is reasonable to argue that the price will never become too high as if the price gets too high, then production of oil will increase, or biofuels, or tar sands, or coal-to-oils, or... Basically, as the price rises, other technologies become viable.

I think a more interesting question, is whether increased prices will always cause the necessary technology innovations to keep the prices right! Can we infinitely substitute products, fuels, labour, capital, ... so that things always work in the nice we that we like!

I think the problem is that underlying all the nice BAU projections are lots of nasty little assumptions. To break conventional wisdom and address these assumptions we need societal collapse...

[Miles]

I totally agree. For all we know, global demand for dinosaur eggs might be at a 10-year high, but we'll just have to find a way to live without them.

[Basics]

"This means as oil becomes scarce, the price will rise and the quantity demanded will fall, due to the price rise." other things being equal my friend. If at the time income increases, what happens to oil consumption is infact a net effect. It could increase !

[Jack Kelly]

Thanks for the interesting article. However, I'm afraid the article has done nothing to calm my own fears about peak oil! ;-)

Unless there is interference in the market (such as rationing) supply will always equal demand. This means as oil becomes scarce, the price will rise and the quantity demanded will fall, due to the price rise.

As we approach and pass peak production for oil, production will be permanently operating at 100% because the constraint will be geological, i.e. there will be no slack in the system. This leaves the system very vulnerable to disruption. For example, if a refinery has to shut down unexpectedly then this could lead to pumps running dry because there's no spare capacity in the system and price hikes wont affect demand swiftly enough. In other words, supply will fail to meet demand! For example, the recent strike at Grangemouth caused construction to halt on a Scottish wind farm construction project because diesel couldn't be supplied. This illustrates that minor disruptions can already lead to pumps running dry despite the fact that the global markets has some (small) spare capacity and the UK has plenty of refined product in its strategic reserves. Just wait a few years until there is no spare capacity and strategic reserves have been depleted. In that scenario, supply will frequently fail to meet demand.

Secondly, your analysis appears to make the assumption that oil demand can be swiftly and effortlessly decreased as price rises (I.e. that an increase in price will lead to an instant and propotional destruction in demand). As we all know, fossil fuel is required for almost everything modern economies rely on (food production & distribution, transport, electricity etc). Sure, there might be some demand erosion from people driving their cars less but consider a farmer who is under contract to supply X tonnes of product as diesel and fertiliser get more expensive? That farmer just has to accept the price changes and continue to buy enough fuel to run his/her farm. I.e. his demand will remain constant no matter what the price does. An interesting case study is US demand. As we all know, US consumers have been hit very hard by price increases in crude oil because US consumers pay very little petrol/diesel tax so crude price increases are highly visible to consumers. Has this massive price hike resulted in demand destruction? A recent article on TheOilDrum argues that US oil demand has not decreased significantly, despite the massive price hikes. This evidence alone seems to falsify the theory that price increases will produce demand erosion which will re-balance the market. There's just too much demand momentum.

Oil really is the life blood of modern economies. Peak oil will produce higher prices, yes; but more frighteningly it will produce erratic supply. Modern economies simply cannot function healthily without a reliable supply of energy.

[Miles]

Jack,

I agree with most of what you said but I don't think it invalidates the (minor) point I was trying to make.

- Shortages such as Grangemouth lead to price increases (ok, not necessarily at the pump in the super short-term, but certainly on the crude market)
- If shortages are common, they'll lead to even grater price increases and volatility as a result of speculation (like we've seen recently in agricultural markets)
- If price is rising and Americans still aren't cutting back that just means other people in the world can't afford it
- In the longer-term the scope for increased production (if there is any, I admit I have no idea) and reduced demand through structural changes in society will bring prices down.

I don't mean to imply that any of the above is pain-free for the people involved (i.e. almost everyone)

[Noel Forrest]

Marginal cost of supply is currently rising with geological constraints, although it is well below current prices (it is about $70/bbl).

Driving prices above this level is geopolitical risk premium, speculation by commodity fund managers, and high (economists) demand from developing countries.

The falling dollar is also pushing the price up.

The high price will destroy some demand. However the industrialised world that the oil helps develop will build demand.

Supply is elastic also: The high prices make more inaccessible reserves economic so the oil consumption curve is smoothed. This is why the number of years' worth of reserves has remained constant at 40, despite upward consumption revisions, for the last ten years. There is a fair amount left (under the Arctic especially), but it will be expensive to extract.

So supply and demand have changed and will change further, but they are still elastic.

Re: the demand definition confusion, when an economist says demand he/she means the curve, which shifts when demand changes. This intersects with the supply curve to set the price and volume exchanged. The volume consumed is what the IEA call 'demand' (=volume 'supplied'+net inventory change).