Oil Prices and the Mayflower Problem
29 Aug, 2008 02:34 pm
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Reduce text sizeDo oil prices really tell the market what it needs to know when it needs to know it?
In a parallel universe far, far away where neoclassical economists run everything and conditions allow for perfect markets and perfect information, finite energy resources gradually climb in price as they are depleted. This encourages the development of substitutes over time and results in a smooth transition from one energy system to another.
Back on Earth events in the energy markets are moving along a trajectory quite different from that of our doppelganger universe. This is much to the chagrin of earthbound neoclassical economists who, as it turns out, run practically everything here when it comes to government economic policy and corporate management. Until recently the real prices of oil and natural gas had been declining for more than a century, and the neoclassical economists took this as an indication that technology was expanding the resource base by making more and more of these fossil fuels extractable.
But as Douglas Reynolds explains in his paper, "The Mineral Economy: How Prices and Costs Can Falsely Signal Decreasing Scarcity," one simply cannot know whether declining real costs for finite mineral resources are due to increasing information about where to find them, advances in the technology for extracting them, or both. Let us back up for a moment and explain why this is so. While doing this we will also discover why price signals about the depletion of finite resources such as fossil fuels are likely to come so late in the cycle of depletion as to endanger any society which relies on such resources for normal functioning.
First, we must understand the so-called "Mayflower Problem." The name comes from the analogy of the Mayflower landing on the Massachusetts coast where the Pilgrims set up the Plymouth Colony in 1620. In those days the most valuable commodity was fertile land. Certainly, the most fertile land in America was not found in Massachusetts. It would have been best for the Pilgrims to have traveled up the Mississippi River to Iowa. But, of course, they didn't know about the American prairie. It would take another 200 years before Europeans began to settle the Great Plains and take advantage of its rich soil. Finally, the rest of the West would be settled, but the largest find of fertile land had already occurred. True, California had rich land, but that land had already been settled long before by the Spanish.
The analogy suggests what experience demonstrates. For any finite resource the pattern of discovery is small, large, small. It takes time to discover the most productive areas for any resource when there is very little information about where to look. As knowledge about where to look expands, it becomes easier to find a resource and as a result larger discoveries occur. But at some point, all the large discoveries will have been made and therefore more information about where to look will not yield additional large discoveries. The pattern then reverts back to small discoveries.
Oil exploration appears to be in this final stage of small discoveries. We are making a lot of small discoveries, but finding very few of the huge so-called elephant fields characteristic of the Texas oil boom of the 1930s or the Mideast oil finds of the 1960s. In fact, discoveries appear to have peaked back in the mid-1960s. Currently, worldwide oil consumption is running just over 30 billion barrels a year. But, discoveries are running about 9 billion barrels. That can't go on forever without declines in oil production.
The same pattern is occurring in natural gas, at least in North America, where furious drilling in response to high natural gas prices has only been able to maintain production levels. In fact, natural gas production has stalled out in North America since 1998 and appears to have peaked.
Of course, technology can and does expand what is considered a resource. That has certainly happened with both oil and natural gas. For example, oil from the Canadian tar sands can now be extracted profitably. And, deep water drilling has become commonplace. When it comes to natural gas drilling, well fracturing techniques have made it feasible to produce far more gas from shale than before.
So, how does all of this impact energy prices? From the beginning of the oil age in 1859 expanding information about where to find oil led to increasing discoveries and finally to the discovery of many supergiant fields. As those discoveries continued, the market came to expect that the discoveries would go on for such a long time that there would be no need to worry about oil supplies or substitutes anytime soon. Even though supergiant discoveries have been few and far between in the last 30 years, the oil markets have remained oversupplied, in part, due to the increasing energy efficiency of the world economy and the vast development of new hydrocarbon resources found during the last oil boom of the 1970s. In addition, advancing technology was thought to be expanding the extractable resource and making it cheaper to obtain.
So thoroughly entrenched were these ideas that only nine years ago the price of oil reached $10 a barrel with the expectation that prices would be going lower. Today, the price of oil has vaulted to more than 10 times that amount. Oil production has been flat for the last three years, and this is despite the large investments being made to find new oil. Part of the problem, of course, is the low investment by state-owned oil companies which now control the lion's share of oil reserves, some 77 percent. But the real question is whether technology, both for finding and extracting oil, is finally being outpaced by depletion. If so, why didn't this show up earlier in the price? Why haven't oil prices been rising gradually over time rather than generally falling (except during the 1970s oil crisis) in real terms until this decade?
The reason is that the assumptions about the power of technology in bringing oil to market have been essentially unverifiable; since the claims can't really be verified, they can't be disputed. And, given the low price of oil in the previous two decades, no one felt confident in disputing them--except for a few iconoclastic geologists familiar with the work of M. King Hubbert who were keeping tabs on world oil supplies. Their alternative explanation for the role of technology is that it is depleting oil resources faster rather than merely expanding the total resource.
Because oil producers believed prices would likely stay low or head lower, they had little incentive to hold reserves in the ground waiting for higher prices. Instead, they produced nearly as quickly as they could. A continuously well-supplied marketplace also came to share the expectation that prices could only remain low because of the application of and expected advances in technology and because large new finds would be made if the surplus ever dried up and made it profitable to explore more vigorously. When the ultimate extent of a resource cannot be effectively verified as in the case of oil, the market tends to be backward-looking.
Though many in the oil industry are now acknowledging possible near-term limits to oil, the dominant view remains that there is plenty of oil yet to find and that technology and proper investment will bring it to the surface in ever-growing quantities for several decades more. This view is accepted even though it is public knowledge that few large fields have been discovered in the last 30 years. The price of oil then has largely been a function of immediate supply and demand. The vaunted futures markets developed for energy in the 1980s were supposed to look ahead. But as recently as 2004 when front-month prices for oil were posted at $55 a barrel, the futures prices for 2008 remained stuck at not far above $30. So much for the predictive powers of the futures markets.
Reynolds piece published in 1999 predicts that the price curves over time for oil and other finite minerals will actually look more like the following:
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Source: Hubbert Peak of Oil Production
The price of a finite resource can decline for a very long time as new techniques allow the available resource to grow and as the all important rate of extraction rises exponentially. Then, suddenly the resource can become scarce as the peak extraction rate approaches amidst robust demand. This may very well be what is happening in the oil market today and in the some regional natural gas markets.
Of course, what has been happening prior to this point is that the market price has merely been providing what Reynolds would call the illusion of decreasing scarcity. In reality, finite resources start to become scarcer from the first day they are taken from the ground. But the impossibility of judging the ultimate size of any finite resource (since it is both hidden from view and a function of technological developments) can create an illusion of plenty for a very long period.
Reynolds model can, of course, be applied to other finite resources such as coal and metal ores. Presumably, one day we will see that same kind of exponential acceleration in the prices of coal and various key metals such as copper, zinc, lead, and even aluminum shortly before their production peaks. (Some think we may be seeing such an acceleration in coal, but the peak in coal production may be a few decades out yet.) Perhaps of immediate importance in this regard are rare metals such as rhodium, indium, gallium and others that have recently skyrocketed in price. Many of these rare metals are critical in electronics, oil refining, and chemical processing. So little is known about the size of the resource for each that it is hard to tell whether the prices reflect temporary shortages or the last days before the peak in world production.
One thing, though, ought to be clear. The time for a simpleminded faith in the power of technology to solve our energy and other resource challenges is probably over. We will now need to do far more than sit back and allow the experts to solve every problem by simply finding more supply or developing appropriate substitutes in the nick of time.
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Add to Newsvine| [1] | Comment by Sterling925 - 1 Sep, 2008 07:00 pm Mr. Cobb. Thanks for the insightful article. You may find a great deal more at theoildrum.com. |
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| [2] | Comment by Gregor
- 1 Sep, 2008 07:47 pm Kurt, Are you claiming that North American NG production is flat, even though USA NG production is rising? I happen to believe based on my research that the only reason USA NG production is rising is b/c of the higher price, which has brought on more supply at much higher costs. I'm also aware that the new shale production is masking declines in conventional NG, that Canadian production is still on a treadmill, and that the production profile of new shale NG wells is such that they peak fast and flame out. Would you not agree that at higher prices, say above 10/MMbtu, that there is now the prospect that North American NG will rise--led by the USA? G |
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| [3] | Comment by Mr Kurt Cobb - 1 Sep, 2008 08:57 pm Gregor, I say North American natural gas "appears to have peaked" because I am hedging a bit. Canadian natural gas production, according to the National Energy Board, is dropping year-over-year and is expected to end down about 300 billion cubic feet for 2008 versus 2007 by my calculations. U. S. production appears headed for a rise above levels last seen in 2001 when marketable production hit 20.6 tcf. The run rate for 2008 would be the equivalent of 21.3 tcf. We might move above the current plateau for a bit as the U. S. exploits shale resources. But I would refer you to the work of David Hughes of the Geological Survey of Canada on the likely future of Canadian natural gas production. It looks very grim indeed. Also, you might want to look at a summary of Jean LaHerrere's work on The Oil Drum or his original article. I think that unconventional production will not allow us to avoid the coming cliff in North America production which LaHerrere judges to be around 2010. That's when long-lived conventional production is expected to start dropping like a stone, proving once again that you can't produce what you don't discover. Could this cliff be delayed a few years? Of course, but not for long and not by unconventional gas production which while ramping up quite nicely won't be large enough to counter the coming cliff if LaHerrere is correct. So, to answer your question. Yes, in the short run I think American production can rise and probably allow North American production to exceed the plateau. But, in my view, the relief will only be temporary. |
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| [4] | Comment by Gregor
- 1 Sep, 2008 10:03 pm Thanks Kurt. I saw David Hughes present at ASPO in Boston, in 2006. Grim indeed. My research also shows that both Canada and Mexico are already taking advantage of our NG, via exports. Though Canada is still a net exporter of NG to the US, the balance is shifting quite alot. I remain impressed with the market's ability to take advantage of the very cheap BTUs that can be purchases via NG, even as North American NG remains largely landlocked, without an export vehicle (Save Alaska LNG). My call is that Canada and Mexico, like the US, will import virtually no LNG over the next year as long as cheap NG can be had for less than or around 8-10/MMbtu. Global LNG volumes are going for much more than that, as I am sure your are aware. Even in northern hemisphere Summer. However, the US analytical community remains only interested in the increased production, and has now built a wide consensus that an NG glut is here. My views on general NG outlook here: http://siliconinvestor.advfn.com/readmsg.aspx?msgid=24871370 Best, and thanks for the reply and your writings. Gregor |
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| [5] | Comment by Gary McMurtry - 3 Sep, 2008 03:56 am Nice article. I wonder about the meaning of the "actual production" versus the "Hubbert trend" in the Reynolds piece that is illustrated here. They are both production over time curves. The Hubbert trend would assume the extraction technology at the date of estimation, and the "actual production" would in theory estimate with advanced extraction technology unknown to Hubbert or earlier researchers. However, the "actual production" over time in the plot is less than that estimated by Hubbert until it is near the peak. That would only be so if the producers gradually slowed production on purpose, which is unlikely based upon past experience, in general (there are some exceptions, in Saudi and OPEC, for example). What is shown is the same overall reserve, just shifted forward in time. If there is indeed advanced production that extracts more oil or gas than would have otherwise been attainable, then the area under the curve grows, and the peak is shifted forward in time if the rate of extraction is held constant. If the rate of extraction increases, but not the efficiency of extraction, then the production curves are backwards, and the Hubbert trend becomes the actual trend. Price is a trivial dependent variable of the resource (geology) and extraction (technology). It is just a manifestation of demand. |
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| [6] | Comment by Mr Kurt Cobb - 3 Sep, 2008 02:14 pm Gary, I think you are correct that price is a trivial variable if by that you mean that it's not a reliable indication of future supply, only current demand as you suggest. With regard to the trend of production, the Hubbert trend here is an idealized representation of the same total production over time including all the effects of technology. The actual production may or may not follow the suggested curve for any one resource, the curve of which will depend on myriad factors including geopolitics, economic recessions, etc. But I think in the case of oil, we are actually seeing this slowing or plateauing of production though the shape of the oil production curve looks quite a bit different from the actual curve illustrated. Whether that slowing is due to deliberate withholding of supplies is subject to debate. I suppose it also depends on how you define deliberate. Would the failure of national oil companies to invest in exploration as money is diverted to social and military needs be considered a deliberate slowdown in production? Or would the slowdown be an inadvertent consequence of a policy that is not consciously trying to do that? For the purposes of my analysis, I'm not sure it makes much difference. The petroleum system is an above-ground and below-ground system inextricably combined. I think Reynolds model does a pretty good job of modeling such systems because the distinctions between intentional and unintentional production decisions don't seem to be that salient to the ultimate result: A surprise increase in prices near the peak. |
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| [7] | Comment by Zagros Madjd-Sadjadi - 10 Sep, 2008 01:49 am Your statement "In a parallel universe far, far away where neoclassical economists run everything and conditions allow for perfect markets and perfect information, finite energy resources gradually climb in price as they are depleted" is not accurate unless you also allow for perfect foresight. The problem is that technology can (and does) reduce the cost of extracting natural resources. This reduction in cost can (and does) reduce the market price. I should also point out that reliance on Hubert's Peak for worldwide production is based on reliance on existing technology and an existing number of oil fields (or at least having the rate of existing oil field discoveries decline). This is a fundamental fallacy. For example, when the cost of production does rise, even in the short-run, it produces incentives to invest in new technologies for extraction of oil (shale oil, oil sands, etc.). The Canadian oil sands today are accounting for an increasing share of oil production because the higher price makes extraction there viable. If technology can push down the price, the trend in Canadian oil sands pricing may actually start to decline. Similarly, shale oil, of which the United States is estimated to be sitting on 1.5 TRILLION barrels may eventually prove economically viable (this compares to total US "proven" oil reserves of 20 to 30 BILLION). In the short-run to make it viable, the price will have to stay over $100 a barrel for a few years. However, if it does stay at this amount, to the extent that oil shale does become viable, Hubert's Peak will become irrelevant for a long time (although eventually it will return when those supplies reach their limits). Indeed, the price of oil could drop dramatically once again as new technology to extract oil shale drives down prices (as technology inevitably does). Another problem is that price is not driven solely by supply but by the interaction of supply and demand. If the price begins to rise quickly, individuals can (and do) make adjustments that cause demand to fall. This fall in demand can serve as a break on prices and cause them to decline. So it is not so automatic that prices will ever rise exponentially at any point whatsoever. What actually happens is more of a roller coaster effect. Prices rise, new technology springs into action, prices fall and decline or flatten until that technology reaches its limit and then the pattern continues. Thus we are likely in for many more times that we will be hearing that we are "running out of" natural resources before we actually get anywhere near the limit of them. Indeed, at present worldwide rates of consumption, the oil shale that lies within the United States will buy the entire world at least another 50 years of consumption even if there is no oil shale anywhere else on the planet (which there is, so the time horizon may actually be measured in hundreds of years). Luckily, however, since this oil will be very expensive using present technology, it will become clear that we ought to transition to other forms of energy. We will never run out of oil, not because we exhaust it all, but rather because the cost of extraction will get so high that we cannot afford not to find an alternative. The same is true for every other natural resource and the market will provide us with the answer as to when we will be forced to make that transition (if we wait until then, the price will start to rise, causing individuals in lower incomes to not be able to afford it anymore). Zagros Madjd-Sadjadi Associate Professor of Economics Winston-Salem State University |
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| [8] | Comment by Mr Kurt Cobb - 10 Sep, 2008 04:04 am Thank you Prof. Madjd-Sadjadi for an excellent summary of the neoclassical view. Where we actually disagree is that you measure everything in terms of money, and I measure everything in terms of energy. I do not doubt that market mechanisms often work much as you suggest. But they are unlikely to work as you outline for replacing oil. I plan to take up the reasons for this in my next column which will be about the problem of receding horizons. Oil shale is a case in point. It always seems that we are on the cusp of exploiting it in a big way, if only the price were (plug in a figure). But after that price comes and goes, the oil shale stays in the ground. I look forward to your response to my next piece should you decide to write one. |
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| [9] | Comment by M. Simon
- 22 Oct, 2008 11:00 am Metals are recycled. |
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| [10] | Comment by greenskidusautoparts
- 4 Feb, 2009 05:07 am On balance, it is quite unlikely that aggregate demand for oil will collapse, as it did after the two previous price spikes, just as it is unlikely that massive net new oil supplies will come on stream in the near future. This does not mean that prices will remain as high as they are today for the indefinite future: such stability is improbable. But it means we should expect a sustained period of relatively high prices even if “peak oil” theorists are proved wrong. If proved right, this would be true in spades. |
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| [11] | Comment by dedicated server
- 1 Jul, 2009 01:41 pm Given the weaker forecast at landfall, things are not looking as dire. Bad, but not catastrophic. Still showing a near direct hit on the LOOP, but damage has come down, to weeks rather than months. CAUTION: Just because the storm is weakening, and therefore less forecast damage to the GoM infrastructure, doesn't mean this storm can't kill you. Stay safe, stay gone! |
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