Whiskey & Gunpowder
In a recent article in his daily missive The Rude Awakening, my Agora colleague Eric Fry wrote about rising energy prices and how they might tend to moderate demand. In his humorous manner, Eric wrote:
"Energy demand worldwide is falling. So says the International Energy Agency.
"If only The Wall Street Journal would produce a 'Weekly Reader' version, we might be reading sentences like these in upcoming editions. We might also be reading sentences like, 'See Oil Prices! ...See Prices Fall!'"
The essence of Eric's article was that, as prices for oil and oil products go up, the sticker-shock for oil and its byproducts will cause people to change their behavior and consume less. After all, at the end of the day, consumers have only so much money in their pockets. As the household expenditure increases for oil-related products, it requires more of that household cash. Eventually, the funds run out. Consumption has to end.
Another way of looking at it is through the lens of classical microeconomics. The solution to high prices will be, of all things, high prices. As prices rise, demand for oil-related products (which is some or all of just about everything in our economy, when you look at it closely) will fall. At the same time, and on the other side of the trade, the supply of oil or oil-related substances will increase as entrepreneurs look for ways to bring hitherto uneconomic resources to the marketplace. In its own way, life comes to some sort of economic equilibrium.
It kind of reminds me of my days in Pensacola, when I was in flight training with the U.S. Navy. There was this watering hole located directly on the border between Florida and Alabama. Truly, it straddled the state line. It was called, appropriately, the "Flora-Bama." At a certain time of the evening, the proprietor of this saloon used to say, "You don't have to go home, but you can't stay here." Yes. Equilibrium.
So as the price of oil increases, people don't have to go home. But they will sure spend less time standing at the gas pump. And when you add up lots of microeconomic decisions, you get macroeconomic trends. All across the economy, millions of households will decide to drive less. Each household will purchase less gasoline. This will lead directly to falling aggregate demand for petroleum and its products. So prices, which are set at the margin, should fall.
Sounds good. So will prices fall? Maybe a little bit, and maybe for a short time. But the long-term trend is up, up, and up some more.
I believe that in addition to looking at the world using classical economic analyses, micro- and macro-, you have to factor in the concept of depletion. Quite simply, depletion is the tendency to empty out, to exhaust, to reduce the number or quantity of something, and in this case the supply of oil. Depletion is the heart and soul of the concept behind Peak Oil.
Peak Oil is the phrase that is associated with the work of geologist M. King Hubbert, who during his long life (1903-1988) conducted extensive research into the size of both U.S. and world oil reserves. I had the privilege of attending a talk that Dr. Hubbert gave at Harvard back in 1977. (At the time, he was teaching at MIT.)
Hubbert stood at the blackboard, drawing graphs on the slate and slapping his pointer against his poster boards, talking about oil production and decline curves. He discussed in detail the concept of "irreversible decline" of oil field production, and of the need to track it on a field-by-field basis. He then explained the process of aggregating the "micro" decline curves of individual oil fields, into a "macro" overview of total production. From these data, he discussed how he was forecasting the long-term trends in petroleum availability.
Hubbert went on to explain his concept of the "material-energy" system of the Earth, which is premised on a linear increase in the supply of goods from the crust of the Earth. At the same time, Hubbert ripped into the fiat-currency monetary system, which is premised on an exponential growth in an artificial money supply. The best way that I can summarize what Hubbert said is that there are natural, geologic controls on the material-energy system. There is no real control, however, over the monetary system. Eventually, something will have to give. Can you guess which one it will be?
Picking up on Hubbert's thesis, the root of wealth is the ability to store energy. For example, in ancient times, people stored wealth in the form of grain (the Bible is full of these tales, as is archaeology in general). Another example is that the seabed of the Mediterranean is littered with the wreckage of ships laden with olive oil, which was also used as a store of wealth in olden times. These forms of ancient wealth were, in truth, stores of solar energy, because they reflected the photosynthetic fruits of contemporary agriculture.
Going beyond grain and olive oil, however, the mines of Europe, from Spain to Romania, and later the mines of Mexico and Peru, yielded the gold that supported the accounting of many generations of nations and empires. This was certainly the case up until 1914, when most of Europe left the gold standard in order to better fight the Great War without having to pay for it.
On a day-to-day level, we all need some unit of account. People have to work and, in one way or another, get paid. By getting paid in dollars or euros or yen or yuan, we are, in essence, "storing" our work until we can go to the market and buy the groceries.
But what happens when the whole world trades in fiat currency, the amount of which in circulation inflates over time? At root, monetarism is predicated on the ability of central bankers to "adjust" the amount of money in circulation (in the United States, we call it M-1, M-2, M-3, etc.). The idea is for the so-called "money supply" to reflect the so-called "natural" need of the economy for liquidity, and to facilitate financial transactions and accounting in support of an economy that ranges across a continent, if not the world. The original justification for the creation of the U.S. Federal Reserve in 1913 was a perceived need for a central bank that could manage an "elastic currency."
But can anyone really know the "natural" requirement of the economy for "money," or for some other unit of account? "Too much money" in circulation equals inflation. "Too little money" in circulation means deflation. The historic tendency of the central bank is to err on the side of long-term inflation, but at the cost of destroying the underlying value of the pre-existing capital base.
Compare this with a gold standard. When you base things on the amount of yellow metal held in reserve, at least you have a known amount of gold in circulation. It does not change, or does not change much. The amount of gold in circulation is defined as historical gold reserves, plus mine production, minus destructive industrial applications. It is very predictable, and not inherently subject to accounting gimmicks.
Hubbert's thesis of a "material-energy" system supports the conclusion that an inflating amount of fiat currency gives people the ability to "buy" things for which they have not really worked and saved. Long term, the current monetary system creates an imbalance in the accounts of man's work, versus what can be had from nature's bounty.
Thus, with a fiat currency, we have experienced a century of what appears, in retrospect, to have been accelerated economic growth. This nominal growth has looked good on paper (no pun intended) but has also facilitated mankind in devouring the Earth's resource base, certainly as is the case in the use of oil, and to plunder the future. On the other side of this particular trade, Mother Nature has a long time horizon. Sooner or later, it will all catch up with you. My concern is that the future is now.
Getting back to depletion and Peak Oil, these concepts reflect the fact that you cannot produce oil out of the ground if you have not discovered it. After you discover the oil, you can only produce it out of the ground one time, and then only over a period of time. And once you produce the oil, it is no longer there. You have depleted the pores of the rocks, emptying them of the oil and gas that were formerly contained within. There is no "inflation" when it comes to the supply of oil. There is only depletion.
And while we are on the subject, who is it that discovers and produces the oil? It is those devilish oil companies. Not to restate the obvious, but if there were no oil companies, there would be no oil. I only mention it because I have actually met people who think that oil companies "make" oil, as if they manufacture the stuff by performing some sort of engineering alchemy on sedimentary rocks. No, no, no. Oil companies are merely God's way of moving oil, which is truly ancient, from pores deep within the rocks of the Earth, into pipelines, thence to refineries, thence into tanker trucks, and finally into gasoline tanks.
As I mentioned, first you have to discover the oil. And where is it to be found, that dark and energetic elixir? The old saying is, "Oil is where you find it." But it helps to look in the right places, particularly in sedimentary basins. You have to look for rather discrete types and series of rocks that have a rather specific geologic history. It all depends on the deposition environment of an ancient sea or river, the burial history of the sedimentary basin, the thermal history of the rocks, and the later tectonic uplift. When you look at it over the long term, oil formation in the Earth's crust is a rare event.
Generally speaking, there are only so many places on the Earth to look for oil. In fact, the world's petroleum industry stopped finding significant numbers of large oil fields about 30 years ago. Certainly, there have been many oil discoveries since then, but not nearly enough to replace the oil that was otherwise produced in the past three decades. The petroleum-consuming world (and you know who you are) has been depleting the underlying resource and living on the discoveries of geologists long deceased.
Worldwide and every day, mankind produces and consumes four barrels of oil for every barrel of what might be classified as "new" discovery (as opposed to backdating reserves to the date of the original discovery well -- don't get me started on that). And when I use the ratio of 4-to-1, I am being very generous with the statistics, so as not to be accused of being alarmist. (But if you care to know my opinion, I think that petroleum depletion, and the eventual unavailability of the substance in significant quantity, is the single most serious matter that faces mankind.)
Peak Oil is a shorthand way of saying that mankind has reached the end of the era of cheap and available petroleum. It is premised on the scientific fact that there is an upper limit to the amount of energetic petroleum within the rocks of the Earth's crust. The best current estimate is something in the order of 2 trillion barrels.
Another way of saying it is that mankind since Col. Drake drilled the world's first commercial oil well at Titusville, Pa., in 1859, has consumed about half of all of the Earth's oil endowment. That is, mankind has produced and consumed about 1 trillion barrels of oil in the past 146 years.
These trillion barrels of oil consisted of the relatively cheap, more-or-less available, easily accessible liquid petroleum that you could get by drilling a hole in the ground. This oil flowed from the crust of the Earth into the borehole under its own natural reservoir energy, or with modest assistance by artificial lift methods. This was and is the liquid petroleum that comprised the depleting resource. And now it is depleted.
In the future, instead of more and more petroleum becoming available at some higher price, there will absolutely be less and less available at whatever price. Long term, I believe that petroleum is priceless. But mankind's generally accepted economic system cannot factor for that, so we just pay the utter pittance of $65 or so per barrel these days. Enjoy it while it lasts.
Depleting and consuming the second half of the Earth's petroleum inheritance will occur at a faster rate, on a vaster scale, and with much more human conflict involved. Current worldwide oil production is approximately 84 million barrels per day, from the rocks beneath six continents and from offshore sea floors. The worldwide depletion rate has been estimated at about 5% per year (although some people estimate a higher number). This means that, absent new discoveries and production, the Earth will yield about 4 million fewer barrels of oil per day next year, just due to depletion. And every barrel of oil that gets pumped out will still have a buyer who will pay for it.
The key question to ask about the effect of rising prices on demand for petroleum products is this: Will rising prices cause demand for petroleum to fall faster than depletion reduces the total available quantity of the substance?
Because if depletion reduces the amount of available oil, and there is still strong marginal demand for every barrel, the long-term price will rise. Any reduction in nominal price is a temporary market phenomenon. Call it a trading opportunity.
What could possibly reduce oil demand by a dramatic amount? Probably nothing short of a major worldwide economic collapse. By way of historical comparison, the housing industry in the United States fell in economic value by 95% in the two years after October 1929, when the U.S. stock market crashed and, ultimately, the Great Depression commenced.
Depression or not, I cannot conceive of oil demand dropping by 95%. But that is the closest comparison I can muster.
What about tar sands? What about shale oil? These topics are other discussions for another time, but let me address them very briefly. Tar sands will not begin to meet the equivalent of what is being lost to the supply side of the market place, year over year, through natural depletion of the traditional oil production base. Even the most optimistic estimates for tar sand production from Canada's Athabasca region forecast at most about 3 million barrels per day by 2015, 10 years from now. But this quantity of what is called "unconventional oil" is less than one year's worth of depletion of the present reserve base of conventional oil.
And shale oil? I regret to inform you that the pilot plants for shale that were constructed in the Western United States and fired up with such fanfare in the 1970s have long since been shuttered. There is no such industry as "shale oil" anywhere in North America, and only the smallest-scale efforts anywhere else on the face of this planet.
It will take the United States 30 or more years to get a domestic shale oil industry up and running, and this is only if we start tomorrow morning. To add insult to injury, this does not factor in the immense quantities of scarce fresh water and natural gas that such an industry will require, as well as the environmental destruction of vast stretches of Wyoming, Colorado, and Utah.
On that regrettably downbeat note, dear readers, I bid you all farewell. As the man said, "You don't have to go home, but you can't stay here."
Until we meet again...
October 4th, 2005
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