Monday, November 22, 2010

The Peak Oil Myth

Here are my thoughts on Peak oil

While peak oil (via Hubbert Peak Theory) may be a valid engineering theory, it is a poor economic concept for the simple reason that engineering theories (like quant models) do not capture people’s behaviour.

Let us learn from the history of oil as narrated by investment guru Steve Leuthold

500 Years Ago… England

First let’s go back about 500 years. During the Renaissance, wood was the critical energy component in England and other European economies, much as fossil fuel is today. Wood was the primary provider of heat, light, and food preparation. However, England, having chopped down most of its trees became a large wood importer, primarily from the Scandinavian countries.

Of course prices rose as wood became more scarce causing domestic brewers, bakers, and others to go out of business hit by lower priced imports from wood rich countries. The English citizenry rebelled, having to pay exorbitant rates for wood to heat their homes, light their nights, and cook their food. Thus in 1593 and again in 1615, Parliament enacted energy conservation legislation, including limiting the use of wood in construction and mandating the use of bricks (but it took more wood to bake the bricks than to build wood structures).

From 1600 to about 1650 the price of firewood soared 80%. Then in a single year the price of wood jumped another 300%. Some families were forced to burn furniture and even parts of their houses to survive the winters. Back then, there were no government wood subsidies for freezing families.

The Wood To Coal Transition

In the early 1600s, people were aware coal was an alternative energy source. But prior to the huge rise in wood, coal was far too dirty and expensive. Chopping down trees was easier and cheaper than hacking the coal out from underground. But, as the coal industry grew, mining sophistication and technology reduced the extraction costs and as coal supplies rose prices fell.

Coal was soon found to be a far superior industrial fuel and with vast improvements in coal mining productivity the price of coal kept falling. First iron production increased with quality improving. Then came steel and steam power. The Industrial Revolution was underway led by England, which was bigger, better and earlier than old Europe. England had become the world’s industrial revolution leader. The real catalyst was the Wood Crisis.

Over 150 Years Ago… United States

Now let’s go back about 200 years to the early 1800s. Once again it’s the beginning of another hugely important energy revolution. Since Colonial times, the primary source of illumination in the U.S. had been whale oil. But by 1850 the North Atlantic had almost been whaled out by New England’s whaling fleet. The shore price of whale oil doubled and then doubled again, even though new whaling technologies had maximized oil recovery from the whales that were taken.

The high whale oil prices were also making it profitable to harpoon smaller and smaller lesser yield whales.

The U.S. was growing fast while the North Atlantic with the whale oil field yielding less and less. At the time there were, on the East Coast, no known substitutes for whale oil. By 1848 prices had skyrocketed by 600%. Then in 1848 the shortage was temporarily alleviated by the discovery (and subsequent decimation) of the South Pacific whale herds. Whale oil prices temporarily moved lower. Yes, it was a long and expensive journey for the New England whalers exploiting the new whale oil find. A whaling expedition around the horn and back could take as much as two years.

By the advent of the Civil War even this new whale oil field was played out. Low grade whale oil was $1.45 a gallon by 1865, up from 23 cents in the 1840s. To put this in to perspective, in 1868 a complete dinner in a New York restaurant cost 19 cents. A customer could buy over seven dinners for the price of a single gallon of lighting oil. It cost restaurant owners more to light the place at night than they were paying for the food they served.

The Whale Oil To Kerosene Transition

An alternative energy source became essential as high prices, population growth and shrinking supplies of whale oil combined into a crisis for businesses in east coast cities such as New York, Boston and Philadelphia. Edwin Drake set out to find that alternative. In 1858 he first found it in Titusville, Pennsylvania.

The U.S. entered the Petroleum Age. By 1867, kerosene, refined from Pennsylvania crude broke the whale oil market. By 1900 whale oil prices had fallen 70% from their highs and whale oil lamps had become collector items. Kerosene prices, with production efficiencies, became cheaper and cheaper. More importantly, just as with the development of coal as an energy alternative 200 years earlier, a chain reaction of technological and economic development was triggered. Oil soon became the new foundation of the economy not merely the low cost provider of light at night.

Lessons gleaned from the history of oil

1. People (via supply and demand) adjust to prices, where high prices leads to conservation or substitution, e.g. the wood crisis that triggered a shift to coal, whale oil crisis that led to kerosene

2. commodities obtain values only when it becomes an economic good, e.g. oil was nothing or did not have value during the age of the wood and coal or whale oil.

3. technology enhances production.

We seem to be seeing a combination of the above dynamics playout today, where alternative energies such as the production of Shale oil has been vastly expanding

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To quote University of Michigan’s Professor Mark Perry (chart from Professor Perry)

New, advanced techniques for drilling oil have revolutionized the domestic oil industry in North Dakota in ways that couldn't have even been predicted just a few years ago, and will likely also open up new oil production in other parts of the world in the near future (like the Alberta Bakken in Canada) that also would have been unimaginable before this year. That's one reason that "peak oil" is peak idiocy: it always underestimates the ultimate resource - human capital (i.e. human ingenuity and the resulting innovation, advances, new technology) - which is endless and boundless, and will never peak.

Let me add that the current high prices of energy and commodities are not only from the consumption model but also from the reservation demand model—where monetary inflation influences prices.

Of course, there are other factors involved, most of which have been government imposed: geographical access restrictions, trade restrictions, price controls, subsidies, cartels, tariffs and other forms of protectionism (aside from inflationism)

3 comments:

Filipinofreedomfighter said...

Speculation in the oil futures market, if left alone by the state, can do a good job of regulating the price of oil so that it will not run out soon and when it does, many substitutes will have emerged.

Steve in Hungary said...

Rarely has it been my misfortune to read a more ill informed article.

Once again an economist holds forth on the natural world and how "everything will be fine". Maybe all the economists should be forced to go back to college and do Geology 101! Or maybe Thermodynamics 101.

You know, only a couple of weeks ago the International Energy Agency finally admitted that conventional crude peaked in 2006 (World Energy Outlook 2010).

Ever heard of a guy called M. King Hubbert? Or watched the video of Prof. Bartlett on exponential growth?

Now, let us see what economists have done. What happened in 2008? THE WORLD'S ECONOMIES COLLAPSED!! Do you get the connection between the word economists and economies? What are they doing now? Printing money. You do realise that money is just paper don't you. Hyperinflation, stagflation, deflation. The end result is not good.

Go and do some proper research into to the energy crises that are rapidly approaching. I would recommend the recently leaked Bundeswerr report, the report for the US military and the report from the UK military. These are hard headed guys, not interested in your airy-fairy dreams come true economic miracle tales!

Allan said...

Coal replaced wood,
then crude oil replaced coal as a major energy source of humankind.
I don't see any feasible substitute for diminishing crude...