Archive for March 1st, 2011

The trouble with Peak Oil…

Most indications are that world wide oil production is at its peak.  A recent Wikileaks document suggests that the US believes the Saudis are overstating oil reserves and are already at their peak.  If that’s true, the world may be producing more oil now than it ever will in the future.  This could last a few more years, but at some point production will start to drop off.

If you’re an optimist you can hope that oil sands, off shore finds, and alternative energy can pick up the slack.  That’s not very likely.  Oil production drops off relatively rapidly and its not easy to replace the amounts of oil Saudi Arabia produces.  At the time of the Iraq war there was hope that Iraq might have more reserves than thought (Saddam had been inefficient at discovering/drilling for oil, thanks to all his foreign policy adventures), but continued sabotage and instability there assure that any significant Iraqi oil won’t be on line for probably a decade or more.  Off shore finds are modest, and oil sand production is actually down from its highs.  It will take a lot of investment to have enough production to alter the trends.  Even if we opened up Alaska and off shore areas to unrestrained drilling it won’t change the fact that oil production will slow.

The long term problems that could cause are numerous, but right now we’re dealing with the short term. The trouble with peak oil is that any slight change in demand or concern about supply can turn into a major price shift.   Nothing illustrated this better than the price run up of 2008, followed by a massive collapse of oil prices when the recession hit.  Oil prices leaped to over $145 a barrel, though a portion of that was due to the weakness of the dollar.   When the recession was in full bloom after the financial crisis hit, the price went down to about $30 a barrel.   Now with unrest in Egypt and Libya, the price is hovering at near $100 a barrel.   That sounds cheap compared to 2008, but as recently as five years ago people were alarmed by the prospect of $100 a barrel oil.

Consider this graph of oil prices:

From 1996 to 2005 we hovered between $20 and $40 a barrel.  That price indicated that production was still easily meeting demand, as those prices were historically still quite low adjusted for inflation.  Even during the late nineties boom years the price stayed low.   That helped the economy boom, and was one reason the US budget could be balanced for a short while.   Between 2005 and the summer of 2007 price started rising up to consistently around $60 a barrel.  This was considered high, and reflected the increased demand for oil caused by the economic boom – especially continued growth in India and China.  Then in 2008 the price soared.   Some of this was simply increased demand, and some of it was due to factors like unrest in Nigeria, the kinds of oil produced, etc.   But if we’ve hit a peak, this is how it would look.

Because demand for oil will stay pretty much the same if price changes are minor or moderate, a slight imbalance between supply and demand will require significant changes in price to reach a new equilibrium.   For example, if due to stagnant supply or high demand the desire for people to buy $70 a barrel oil increases by 2%, it might require the price to double in order to cut some of that demand so that demand ultimately equals supply.   If a recession causes a drop in demand (which it did), then the price will fall dramatically as suddenly supply easily meets demand.

You’d expect this kind of behavior at peak because if production can increase, states would do so at prices well over $100 a barrel — there are huge profits to be made.  If production were actually dropping, however, decreases in demand would not yield such a dramatic drop in price — the decline in supply would factor in.   Note that even though the world economy did not revert back to the boom years of the early 00’s, oil prices started to climb back to over $80 a barrel by mid-2010, before the unrest in Egypt and Libya.    An increase in economic growth will start a quick and significant increase in oil prices.   That in turn causes recessionary pressures, as money going to pay for oil does not go into the economy.  This will make it much more difficult to grow out of this recession.

In the past when a recession hit you took your lumps, the economy adjusted, and then it was back to onward and upward.   Yet since 1900 our economic health has been increasingly dependent on cheap energy.   The last 100 years has been an era of incredibly cheap, plentiful and easy to transport energy via oil and coal.  Oil has been essential to increased transportation of goods and services, and without it the economy would collapse.  If we’re hitting a peak, high oil prices aren’t only here to stay in the long run, but while we’re at the peak price fluctuations will be common, and higher prices are likely to undercut nascent economic recoveries.

Now add in Libya and Egypt — or other unrest in the region.  A lion’s share of the oil comes from the Mideast and an Arab world that has seen dictatorships and corruption blossom due to oil revenue.  Citizens were paid off with the money that came in, while leaders grew corrupt and spoiled.   Gaddafi could play military games throughout Africa, and fancy himself an anti-western Arab nationalist.  The Saudi Royal family could act like a mafia family, but with the protection of sovereignty and royal titles.   As the youth rise up against those practices, any unrest or shortfall in oil production (Libya’s production is down 50%) can cause significant price increases.   The current $100 a barrel is due less to that than fears of what might yet be to come in the region, but clearly events in the Arab world directly affect our economy.

We’re going to have to get used to this volatility.  It reinforces the fact that this recession can only be cured by restructuring our economy, and ultimately by preparing for much more expensive (and perhaps hard to get) oil.   From behavioral changes to policies designed to create a more energy efficient economy, the need for major adjustment cannot be ignored.   There’s no magic spell either — “drill baby drill” won’t cut it, and just investing in alternatives isn’t enough either.   We have to question policies, regulations, and our very way of life.

Because, even though things still seem normal now, this challenge is coming just as sure as change is coming to the Mideast.  The ride has just begun.