The Real Oil Extraction Limit, and How It Affects the Downslope

There is a lot of confusion about which limit we are reaching with respect to oil supply. There seems to be a huge amount of “reserves,” and oil production seems to be increasing right now, so people can’t imagine that there might be a near term problem. There are at least three different views regarding the nature of the limit:

  1. Climate Change. There is no limit on oil production within the foreseeable future. Oil prices can be expected to keep rising. With higher prices, alternative fuels and higher cost extraction techniques will become available. The main concern is climate change. The only reason that oil production would drop is because we have found a way to use less oil because of  climate change concerns, and choose not to extract oil that seems to be available.
  2. Limit Based on Geology (“Peak Oil”). In each oil field, production tends to rise for a time and then fall. Therefore, in total, world oil production will most likely begin to fall at some point, because of technological limits on extraction. In fact, this limit seems quite close at hand. High oil prices may play a role as well.
  3. Oil Prices Don’t Rise High Enough. We need high oil prices to keep oil extraction up, but as we reach diminishing returns with respect to oil extraction, oil prices don’t rise high enough to keep extraction at the required level. If oil prices do rise very high, there are feedback loops that lead to more recession and job layoffs and less “demand for oil” (really, oil affordability) among potential purchasers of oil. One major cut-off on oil supply is inadequate funds for reinvestment, because of low oil prices.

Why “Oil Prices Don’t Rise High Enough” Is the Real Limit

In my view, our real concern should be the third item above, “Oil Prices Don’t Rise High Enough.” The problem is caused by a mismatch between wages (which are not growing very quickly) and the cost of oil extraction (which is growing quickly). If oil prices rose as fast as extraction costs, they would leave workers with a smaller and smaller percentage of their wages to spend on food, clothing, and other necessities–something that doesn’t work for very long. Let me explain what happens. 

Because of diminishing returns, the cost of oil extraction keeps rising. It is hard for oil prices to increase enough to provide an adequate profit for producers, because if they did, workers would get poorer and poorer. In fact, oil prices already seem to be too low. In years past, oil companies found that the price they sold oil for was sufficient (a) to cover the complete costs of extraction, (b) to pay dividends to stockholders, (c) to pay required governmental taxes, and (d) to provide enough funds for investment in new wells, in order to  keep production level, or even increase it.  Now, because of the rapidly rising cost of new extraction, oil companies are finding that they are coming up short in this process. 

Oil companies have begun returning money to stockholders in increased dividends, rather than investing in projects which are likely to be unprofitable at current oil prices. See Oil companies rein in spending to save cash for dividendsIf our need for investment dollars is escalating because of diminishing returns in oil extraction, but oil companies are reining in spending for investments because they don’t think they can make an adequate return at current oil prices, this does not bode well for future oil extraction. Continue reading