An Economic Theory of Limited Oil Supply

We seem to hear two versions of the story of limited oil supply:

1. The economists’ view, saying that the issue is a simple problem of supply and demand. Substitution, higher prices, demand destruction, greater efficiency, and increased production of oil at higher prices will save the day.

2. A version of Hubbert’s peak oil theory, saying that world oil production will rise and at some point reach a plateau and begin to decline, because of geological depletion. The common belief is that the rate of decline will be determined by geological considerations, and will roughly match the rate at which production increased.

In my view, neither of these views is correct. My view is a third view:

3. An adequate supply of cheap ($20 or $30 barrel) oil is no longer available, because most of the “easy to extract” oil is gone. The cost of extracting oil keeps rising, but the ability of oil-importing economies to pay for this oil does not. There are no good low-cost substitutes for oil, so substitution is very limited and will continue to be very limited. The big oil-importing economies are already finding themselves in poor financial condition, as higher oil prices lead to cutbacks in discretionary spending and layoffs in discretionary industries.

The government is caught up in this, as layoffs lead to more need for stimulus funds and for payments to unemployed workers, at the same time that tax revenue is reduced. There can be a temporary drop in oil prices (as there was in late 2008), as recession worsens, but eventually demand rises again, oil prices rise again, and the pattern of layoffs and increased governments financial problems occurs again.

Without substitutes at a price that the economy can afford, economies will adapt to lower amounts of oil they can afford by worsening recession, debt defaults, and reduced international trade. There may be tendency for international alliances (such as the Euro) to fall apart, and for countries to break into smaller units (Catalonia secede from Spain, or countries break up the way the Soviet Union and Yugoslavia did).

At some point, probably not too many years in the future, the amount of oil extracted from the ground will drop, reflecting a combination of geological and economic factors. The fall may very well be quite steep. While we can’t expect to extract more than geology will allow, there is nothing to say that political and economic factors will allow extraction of this amount. If civil war breaks out in an oil producer, production may drop quickly. Or if oil prices drop because of severe recession, drilling of new fields and wells may drop off quickly, leading to lower production as existing wells deplete, and not enough new supply as added. There may also be disruption in international sales of oil. Continue reading

Why Natural Gas isn’t Likely to be the World’s Energy Savior

We keep hearing about the many benefits of natural gas–how burning it releases less CO2 than oil or coal, and how it burns with few impurities, so does not have the pollution problems of coal. We also hear about the possibilities of releasing huge amounts of new natural gas supplies, through the fracking of shale gas. Reported reserves for natural gas also seem to be quite high, especially in the Middle East and the Former Soviet Union.

But I think that people who are counting on natural gas to solve the world’s energy problems are “counting their chickens before they are hatched”. Natural gas is a fuel that requires a lot of infrastructure in order for anything to “happen”. As a result, it needs a lot of up-front investment, and several years time delay. It also needs changes on the consumption side (requiring further investment) that will allow this natural gas to be used. If the cost is higher than competing fuels, this becomes a problem as well.

In many ways, natural gas consumption is captive to other things that are happening in the economy: an economy that is industrializing rapidly will easily be able to consume more natural gas, but an economy in decline will find it hard to scrape together funds for new ways of doing what was done previously, now with natural gas. Increased use of renewables seems to call for additional use of natural gas for balancing, but even this is not certain, because in many parts of the world, natural gas is a high-priced imported fuel.  Political instability, often linked to high oil and food prices, creates a poor atmosphere for new Liquefied Natural Gas (LNG) facilities, no matter how attractive the pricing may seem to be.

In the US, we have already “hit the wall” on how much natural gas can be absorbed into the system or used to offset imports. US natural gas production has been flat since November 2011, based on EIA data (Figure 1, below).

Figure 1. US Dry Natural Gas Production, based on data of the US Energy Information Administration.

Even with this level of production, and a large shift in electricity production from coal to natural gas,  natural gas is still on the edge of “maxing out” its storage system before winter hits (Figure 2, below).

Figure 2. US natural gas in storage, compared to five-year average. Figure prepared by US Energy Information Administration, Weekly Natural Gas Storage Report as of October 5, 2012.

Continue reading

Renewables Are Overrated, We Need Cheap Oil – Interview with Gail Tverberg

This article originally appeared at

What does our world’s energy future look like? Does renewable energy feature as much in the energy production mix as many hope it will? Will natural gas and fracking help reduce our dependence upon oil and how will the world economy and trade fare as supplies of cheap oil continue to dwindle?

To help us take a look at this future scenario we had a chance to chat with Gail Tverberg – a well-known commentator on energy issues and author of the popular blog, Our Finite World

In the interview Gail talks about:

•    Why natural gas is not the energy savior we were hoping for
•    Why renewable energy will not live up to the hype
•    Why we shouldn’t write off nuclear energy
•    Why oil prices could fall in the future
•    Why our energy future looks fairly bleak
•    Why the government should be investing less in renewable energy
•    Why constant economic growth is not a realistic goal

Gail Tverberg is an independent researcher who examines questions related to oil supply, substitutes, and their impact on the economy. Her background is as a casualty actuary, making financial projections within the insurance industry. She became interested in the question of oil shortages in 2005, and has written and spoken about the expected impact of limited oil supply since then to a variety of audiences: insurance, academic, “peak oil”, and more general audiences. Her work can be found on her website, Our Finite World.

Interview conducted by James Stafford of Do you believe that shale gas is the energy savior we have been hoping for and can deliver all that has been promised? Or have we been oversold on its potential? Continue reading

Can an Economy Learn to Live with Increasingly High Oil Prices?

Prof. James Hamilton of University of California recently wrote a post called Thresholds in the economic effects of oil prices. In it, he concludes

As U.S. retail gasoline prices once again near $4.00 a gallon, does this pose a threat to the economy and President Obama’s prospects for re-election? My answer is no.

EDIT – I originally wrote this post thinking that Prof. Hamilton was looking at a broader question: Can an economy learn to live with increasingly high oil prices? After looking again at his article again, I realize that he is talking about a narrow question: Using the figures he was looking at (average gasoline prices across all grades), prices were for the week of September 17 near $4 a gallon, as they had been several times in the past, as they bounced up and down.

In that context, what he says is far closer to right than what my analysis of the broader question of whether an economy can learn to live with increasingly high oil prices, below, would suggest. There is a difference, because gasoline prices are not too closely tied to oil prices in short term fluctuations, and because the issue is likely to be as much one of consumer sentiment as anything else, as long as the issue is simply one of gasoline prices in a not-too-wide range. But I think there are some longer-term, more general issues we should be concerned about.

My Analysis of the More General Question: Can an Economy Learn to Live with Increasingly High Oil Prices?

As I see it, increasingly high oil prices weaken an economy because they reduce discretionary spending and indirectly cause people to be laid-off from work. They have many other adverse effects as well–they tend to raise food prices, with similar effect. The laid-off workers require unemployment compensation payments, and the same time they are contributing less tax revenue. All of this creates a huge imbalance between revenue collected by governments and expenditures paid out. If oil prices rise again, it will tend to make the imbalance worse.

An economy such as the United States can cover up the problems caused by high oil prices with variety of financial techniques. In my view, high consumer confidence measures the success of those cover-ups, more than it measures the actual underlying situation. One way the US government has managed to cover up how badly the economy is being hurt by high oil prices is by spending far more than the government takes in as revenue. This has happened continuously since late 2008, with outgo exceeding income by more than 50% each year, even though the country is supposedly not in recession.

Figure 1. US Government Income and Outlay, based on historical tables from the White House Office of Management and Budget (Table 1.1). Amounts include off-budget spending, such as Social Security and Medicare, in addition to on-budget spending. *2012 is estimated.

The amount consumers have available to spend on cars and gasoline is very much affected by deficit spending. With deficit spending, government employment can remain high and transfer payments can continue, without anyone really “paying” for these costs, putting more money into the economy to spend on oil and cars.

There are other government programs as well. Interest rates on homes and new cars are being kept at record lows, leaving consumers with more money to spend on cars and gasoline. Low interest rates and low taxes also stimulate employers to hire more employees. Quantitative easing helps contribute to higher stock market prices, and makes it easier for the federal government to keep adding large amount of debt.

To me, the fact that the economy is not currently completely “in the tank” speaks more to the success of stimulus programs than having anything to do with adaptation to higher price levels. Countries such as Greece, Spain and Italy do not have the luxury of being able to hide the impacts of their high cost of oil. They are doing less well financially, but were not included in Hamilton’s analysis. Continue reading