Drilling for Broke? Experts Debate 'Peak Oil'

The Wall Street Journal

August 3, 2005

Are we nearing a peak in global oil production?

Soaring demand for oil in the U.S. and in booming economies like China and India has led to increased watchfulness about inventory levels among traders. At the same time, oil companies are scrambling to find new sources for crude, while investors ask more questions about firms' proven reserves.

Amid all this, oil prices have been racing to nominal highs. Benchmark crude soared to a new intraday record of $62.30 a barrel on Monday after the death of Saudi Arabia's King Fahd and settled at a new closing high of $61.89 on the New York Mercantile Exchange Tuesday as gasoline futures prices soared.

WSJ.com asked economist blogger James Hamilton of the University of California at San Diego and Robert Kaufmann of Boston University's Center for Energy & Environmental Studies to take a closer look at the notion of "peak oil" and explore the economic ramifications of a drop in oil production.

What do you think? Share your comments on our discussion board.

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Robert Kaufmann writes: You will never wake to the headline, "Today, the world ran out of oil." Rather, global oil production will rise, reach one or more "peaks," and decline. Forecasts for the peak vary between Thanksgiving of 2005 and 2050. Personally, I think global oil production will peak between 2015 and 2025 and be a greater challenge than the "looming crisis" in Social Security.

The peak marks a fundamental change in oil supply. Prior to the peak, production can increase with little or no increase in oil prices. In the lower 48 states, inflation-corrected oil prices, or "real" oil prices, declined slightly between the end of World War II and 1970, but production more than doubled. After the peak, production declines, regardless of price increases. In the lower 48 states, real oil prices tripled, drilling more than doubled, but production declined about 20% between 1970 and 1985.

Declining oil supplies will be a watershed in the economic history of the 21st century. Because oil readily comes from the ground and is easily refined, it generates a large energy surplus that powers the non-energy sectors of the economy, such as the transportation networks that support international trade, living patterns, and modern agriculture. After the peak, each barrel of oil will require more energy to extract. This leaves less energy to power the non-energy sectors of the economy.

This reduction differentiates the peak in global oil production from previous energy transitions. As society changed from wood to coal and coal to oil, the new energy resource was "better" than its predecessor. It could be used more efficiently and generated a greater surplus. With 20 years until the peak, no fuel now being researched generates a greater surplus or can be used more efficiently than oil.

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James Hamilton writes: I agree strongly with most of what Robert said. I think this may very well prove to be one of the most important economic transitions that many of us alive today are going to witness.

Although it's true that some people are predicting that the peak in oil production will occur before the end of the year, I agree that it is likely to be a bit further down the road, though perhaps much sooner than 20 years from now. The market seems to share our view as well, since it's possible on today's futures market to buy oil for delivery in December 2011 for $60 a barrel, something to which traders would never agree if they thought world production was just about to enter the declining phase. I do think it's quite possible that global oil production in 2006 will be lower than it is now, but if that happens, it will be driven by demand reductions or geopolitical events that disrupt the flow of oil, rather than bumping up against the geological reality of which Robert is speaking.

The one aspect of Robert's analysis to which I might add a qualification is the suggestion that oil prices need not rise much until after we're past the peak. While that might be true from an engineering-cost point of view, it ignores the opportunity cost. As I noted here, it makes no sense to sell oil for $60 today if you could get $200 by holding that barrel back in order to sell it a few years later. What I instead expect to see is oil prices rising gradually as we get closer to the peak and starting to rise pretty quickly once it's less than five or 10 years out. Those price rises are in fact critical for making this economic transition.

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Robert writes: James is certainly correct -- oil prices may not rise until the peak passes, and those price rises are critical for making the economic transition. I am less sanguine than James about the market's ability to anticipate the peak and price oil accordingly. Statistical studies of futures markets indicate that the price of oil in the "outer months" (six months or a year ahead) is not a very good "predictor."

In addition to the short-run economic and political complications, the market may not be able to anticipate the geology of the peak. Oil is a geological "accident"; therefore, most of the word's oil is found in a few giant fields in a few geological provinces. For example, the U.S. has more than 14,000 oil fields, but the 100 largest will yield about two-thirds of the oil ultimately produced.

Large fields can maintain a steady rate of production for many years and then decline steeply. The markets' ability to anticipate the timing and rate of decline is limited by the lack of transparency. Without SEC rules that define proven oil reserves, OPEC's estimates are mix of geology and politics. This uncertainty is critical because much of the oil produced between now and the peak (and beyond) will come from a few geological provinces inside OPEC nations.

Anticipating the peak is complicated further by an important political/economic mismatch. OPEC nations have much of the remaining geological supply, but have relatively little capital or political impetus to increase their ability to produce oil. On the other hand, multinational oil companies have large amounts of capital, but relatively few places where they can increase production significantly -- many OPEC nations forbid foreign investment in production.

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James writes: Again, that's all very much true. 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. How much should we be surrendering right now in the way of current resources, researching and developing alternatives for energy supply and utilization, and forcing consumers to pay more now in order to make sure that we save enough oil for the future? These costs in the here-and-now are most real and tangible, and yet we somehow have to weigh them against something we only see through a veil, darkly. If you ask people today to make huge sacrifices that later turn out to be unnecessary or to be following a dead-end technological alternative, you've created poverty as a deliberate object of policy. 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.

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Robert writes: Policy is needed to help the entrepreneurial spirit anticipate the peak, but we don't need the type embodied in the current energy bill. No serious person can believe that it will help. The current bill demonstrates that Republicans and Democrats have the same view of policy, they just give tax dollars to different groups.

Sound policy should establish an economic environment that increases the economic returns and reduces the risk to long-term research and development on alternative energies. Specifically, policy should impose a large energy tax that is phased in over a long period, perhaps 20 years. Furthermore, increases in the energy tax should be "offset" by reducing other taxes, such as payroll or corporate taxes. Economic studies show that such an approach can generate a "win-win" solution -- reduce energy use (and the environmental damages not paid by users), stimulate research and development on alternative energies, and speed economic growth. Phasing in an energy tax would send a signal to entrepreneurs that there will be a market for alternative energies. The tax does not pick technologies -- that will be left to the market, which is smarter than any Democrat, Republican, or even myself!

Why is such an approach needed? If the market doesn't anticipate the peak, the price signals needed to stimulate research and development may not arrive until after the peak. By then, it will be too late to avoid major disruptions. Think about the changes needed to replace motor gasoline. Society will have to retool the auto industry, alter every gas station and retrain every auto mechanic. These changes need to start before the peak. If they start after, they will add to the disruptions caused by the peak.

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James writes: I am also very sympathetic to the idea of using taxes in this way. Usually economists look for a justification for such a policy in terms of externalities, some reason why the true cost to society of using another barrel of oil today is greater than the production-plus-opportunity cost perceived by the owners who sell the oil.

I think one such externality is related to the geographic location of the remaining world's reserves. As the U.S. and North Sea reserves get depleted, the world is increasingly reliant on places like Saudi Arabia, Iran and Venezuela, whose governments are actively using the oil revenues they receive from us in ways that are very fundamentally contrary to the interests of most OECD nations. Putting a dollar valuation on this is difficult. How many more Beslan children or London commuters might be alive today if the Saudis had not poured so many billions of dollars into promoting global Wahhabism? How much freer would the people of Lebanon be without Iran's heavy support of Hezbollah? And how much of the U.S. military budget is devoted to protecting Americans from such threats? I'm not sure, but it is clear to me that there is some externality associated with the geographic realities of peak oil.

There also is a classic economic externality that may lead to underfunding of basic research. For something like fusion, it is clearly unreasonable to expect the private market to invest adequate resources, because the benefits to society from a successful program exceed the private returns to individual investors. On the other hand, as you get into more specific and near-term technologies, the justification for government involvement becomes less clear. For example, producing ethanol from corn is a mature technology, and indeed, one which some studies suggest uses up more energy than it produces. Congressional enthusiasm for subsidies here may have more to do with farm politics than energy needs. Relying on governments to pick the technological winners is a risky proposition. One of the benefits of Robert's tax plan is that it adds some extra incentive for any workable solution but leaves it to the market to sort out which ones are the real winners.

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Robert writes: The peak in global oil production goes beyond paying a few dollars extra to fill the gas tank. The 20th century could be called the "Petroleum Age." Inexpensive oil means goods can be imported and exported at little extra cost, people can live far from work and a small fraction of the work force can feed those that produce the goods and services we associate with modernity. All of this may change after the global peak in oil production. As such, the peak isn't just an economic problem, it is one of the biggest social and political challenges for this century.

Government policy aimed at the next energy transition must strive for efficiency, which is a good thing, but too much of a good thing isn't good. Efficiency can't and shouldn't be the sole criterion. One can think of important and successful policies that were not guided only by principles of economic efficiency. Analyses indicate that the success of efforts to phase out CFCs (ozone-destroying chemicals) was based on what was thought to be possible, not what was economically efficient.

The totality of impacts may force policy makers to rely heavily on the precautionary principle, which compares the costs of being correct to those of being incorrect. We know that oil production will peak within our lifetime, we think market prices may not anticipate this peak and we know that not having alternatives in place at the time of the peak will have tremendous economic and social consequences. So, if society does too much now, as opposed to later, there will be some loss of efficiency. But if society does too little now, as opposed to later, the effects could be disastrous. Under these conditions, doing too little now in the name of efficiency will appear in hindsight as rearranging deck chairs on the Titanic.

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James writes: To me, "economic inefficiency" refers not to paying a little more at the gas pump, but rather to taking valuable resources and throwing them into the ocean to no one's benefit. We only have so much in the way of resources to cope with these great challenges -- only so much capital to invest, only so many geologists to figure out how to get at the oil that remains, only so many engineers to develop alternatives. It is precisely because I agree with Robert about the importance of this transition that I think it's critical that we put all our resources to their best use. And I honestly believe that the best way to ensure that happens is to count primarily on the same system that has generated the fantastic improvements in global living standards over the last few centuries, namely, individuals choosing to direct the resources they personally control to those activities that yield the highest personal reward. Yes, the risks are great here, but so are the private rewards to those who best figure out how to navigate our way through them.

In so saying, let me be clear that I distance myself from those who might say that there is nothing to worry about and markets will solve everything. I think there is plenty to worry about, and markets may or may not solve the problems. But what I am saying is that I see private incentives as our best hope. Notwithstanding, I enthusiastically endorse the kinds of active government assistance for those incentives that we've been discussing. And I also applaud Robert and others who are trying to call more public attention to this issue.

Surely we can all agree that greater public awareness of what is in store in the years ahead would unambiguously be a good thing.

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