Some simple economics for the "Peak Oil" debate

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hpx
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Some simple economics for the "Peak Oil" debate

Since the "Peak Oil"-thread seems to be turning into the usual "yes!no!yes!no!"-type of contest, and also including the usual far-out conspiracy theories, I thought I would write a short little something from an economic perspective. I'm not a PhD in anything, I'm just unusually bright XD

How do we decide if "Peak Oil" is true? First - let's define it. "Peak Oil" is the theory that we have tapped all the easy oil-wells, and its getting harder and harder to find efficient ways of getting that so essential black fluid out of the ground. Usually, this theory is coupled with the belief that the global oil-extraction curve will take on a certain familiar bell-curve shape. 

First, let's examine the evidence that everyone can understand. We are drilling oil at deeper and deeper levels in the ocean, and several countries are now actively looking to explore the entire Arctic region for oil wells. Clearly, our extraction methods are getting more complicated, and it costs more to drill for oil. Technology has obviously already helped A LOT in cheapening oil extraction. But there is no denying the fact that oil is getting harder to get out of the ground. Incidentally, this could have been predicted completely "a priori", because we all know that economic activity tries to maximize profit, meaning the easy oil wells would always be emptied first, and the hardest left for last.

Second, let's go briefly into the world of physics. Now, if we rule out humanity colonizing other planets, we can make one simple observation : There has to be a finite amount of oil on the globe, currently. If you believe in abiotic oil, the question that has to be answered is "is more oil re-created than we drill out of the ground currently". That question will lead you to an answer of if the global oil reserves are increasing or decreasing. Obviously, we have to differ between "known reserves" and "unknown reserves". If we take the economic perspective again, we find it highly unlikely that there would be any giant oil-fields not discovered (though not impossible!), considering their economic value. Much time has been spent looking for oil, in fact, it may be the most searched for commodity in the history of man!

So, there is a finite amount of oil, or (if you believe abiotic), there is an amount that is either increasing or decreasing (with the "increasing" scenario being extreeeeeemely unlikely). Using this knowledge, we can draw the conclusion that oil reserves around the globe are probably decreasing. Going back (once again) to economics, it is pretty clear also that as the reserves are drawn down, the remaining reserves become more and more expensive to access. 

So far, I don't think I have said anything that anyone disagrees with. Both "Peak Oilers" and non-"Peak Oilers" tend to agree that "conventional crude" is becoming more and more expensive, and will have to be replaced. So, can it be replaced, by Nat Gas, Nuclear, Solar, Wind etc.? This is a much more complex question, but lets try this one as well.

What do we mean by "replace"? If we simply mean : Can we build enough power plants to generate the same amount of Net energy by using Nat Gas, Nuclear, Solar etc., then the answer is pretty simple. Yes. Ignoring "renewables", there is still enough energy resources on the planet to sustain us for quite a while. "Peak Uranium" and "Peak Gas" is far further down the line than "Peak Oil". But, and this is the important point, we have answered the wrong question. What are you going to do with electricity (or gas) if you want petroleum-based fuel? Either you build a LOT of electric cars, or you find a way to convert electricity into some oil-like substance. Both can be done, but it is very expensive (and electric cars suck. railway is better in that case). 

And, once again, think about the economics. By simple observing that this is only done as part of stupid subsidized "green initiatives" (which are counterproductive), we realize that any solution which relies on substituting oil for other energy sources is going to be more expensive than oil is currently. How much more expensive? Probably not possible to predict yet. Linear projections usually fail, but until we see large-scale investment in power sources to replace oil, we should know that it is yet not economic to do so. Most specifically (if we talk about oil from a vehicle-fuel perspective), we can be quite sure that current oil prices are not high enough to allow for replacement by other energy sources.

So, energy will become more expensive. I cannot see how you can argue with this statement, though I encourage everyone to try. What will this do to the world economy? It will simply mean that more effort has to be put into energy production, and less into everything else. All economic activity that requires much energy will be affected negatively, and energy-cheap activities will be more profitable. Some of the most highly energy-consuming activities may be halted completely, because no one wants to pay for them anymore. We should also make one rather crucial observation : Complex economic processes are usually more energy-consuming than more simple economic processes. Take agriculture, for example (and no, I'm not saying that we will go back to horse-and-plow-farming, this is an example) : You can increase crop yields by x% by using chemical fertilizer. This will make the total cost y% higher. As long as x increases faster than y, you should add more fertilizer. However, if chemical fertilizer (which costs a lot of energy to create) gradually becomes more expensive, you will start moving back the curve. The more expensive chemical fertilizer becomes, the LESS of it you want to use, because the increasing crop yields will not make it worth your while. Obviously, rising food prices will counteract this effect to some extent, but my point is that as one input (energy) becomes more expensive, it pushes the economic equation in some direction, leading to further changes. The reason we rarely have to consider such effects is called the free market and the pricing system.

Let's take a look at things that are likely to suffer the worst from higher energy-prices :

  • Commercial airlines : People will take the train or bus instead.
  • Auto-manufacturing : Already suffering from overproduction, this market should get slaughtered as gasoline prices go up. In fact, it is already being slaughtered in the West. Everyone expected the market for autos to keep growing for-ever, but it is topping out in the West (still climbing in China)
  • Shipping : Sea freight is cheaper than air freight, so air freight will drop first. Whether or not sea freight will become expensive to the extent that we "de-globalize" remains to be seen, I would expect that it will happen for certain things. Everything that we can make fairly cheap locally and not transport around the globe will likely revert to local production (here be economic opportunities!). However, I do not expect us to try and grow pine-apples in Scandinavia. It will still be cheaper to ship them here then trying to alter the climate of the Northern Hemishpere. 
  • Mining : Here's a nasty one, especially for those who would like to see much more gold and silver hit the market. While iron, copper and base-metals may be crucial for much economic activity, gold and silver is generally not. Mining is horribly energy-consuming, which means that quite frankly, if energy becomes expensive enough mines that are low-yield will simply be abandoned. Probably not uranium mines, though. 
  • Crappy plastic consumer electronics : I include this as an example of effect you may not think of. While the manufacturing cost for your late iPod/iPad/iPid/iStupid is probably extremely low, it may still be un-economic to make them in current quantities. Why? Because they are almost dead last among people's priorities (food, housing, heating, transport, clothing, practically everything is more important than an iPad, unless they start making them digestable). "Luxuries" in general, especially those that aren't considered "luxuries" anymore because most of the middle-class can afford them, will suffer hard if energy becomes more expensive. Remember what I said about the time used to produce energy will be increasing, and the time for everything else decreasing? This junk will go first.

So, by now you either think "hmm, he may be on to something here", or "argh! just another peak oiler". My point, if I may sum it up, is this : Technology has always, and will always continue to increase our living standards. However, our current wealth levels are relying on a continuing supply of all the commodities we can currently produce, at a cost equivalent to what it currently costs to produce them, and this is especially important for energy since it is an input to everything. Simple economic thinking gives us clear indications that energy will become more expensive because of less conventional crude oil. Simple economics simultaneously tell us that we will replace one energy source with another if necessary.

But at a cost. The size of this cost is hard to predict (screw linear projections, I don't think they will work in this case), but we can at least be certain that it will have an impact on all markets that currently rely on petrofuel (some more than others). How do you prepare for whatever it is that may be coming our way? As always, the answer is very, very simple. Save more, consume less. Invest wisely, and never trust TPTB to tell you anything true about anything.

I hope this has been useful to anyone, and please point out any logical errors I may have committed.

Edited by admin on 11/08/2014 - 06:18
HappyNow
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nice work hpx

You made me think of something else with the comment about iStuff.

We may return to durable goods that can be repaired from the generally disposable attitude we have today.

All these portable devices that keep becoming outdated or easily broken.    Junk furniture that can't be moved without becoming wobbly.   The "energy" to fix things may re-emerge.   Items may become upgradeable again and consumers may prefer to buy items that are of better construction in the first place or can be repaired.  That is more efficient than recycling by a long long shot.

__________________

Swing trade indexed ETFs. Long physical gold, silver, and 1 miner.

donpaulo
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a few points on energy

firstly that the paradigm is broken when 5% of the population consumes 25~30% of the energy. I think the safe conclusion is that a balancing of accounts is forthcoming. Neocons and other flat earth thinkers can continue to deny this fact but the long term trend is not curving in North America's favor.

secondly every Wing, Wang and Wong ascribes to consume energy like your average Smith, Jones and Johnson. Factor in that East and South Asian purchasing power is growing its a no brainer to conclude that the market share of energy is going to alter. The Chinese auto market alone easily displays this in spades.

Thirdly peak refining/production is already here. Using the refinery of the pacific's cost of 12.5 Billion I think its fair to assume that such projects are not likely undertaken. If one concludes that oil production will not increase as it has in the past, yet the global population and consumption of energy will continue to increase the maths just don't add up.

Fourthly if one assumes that domestic energy consumption will take precedence over exports of said energy, those who rely on imported energy will find the amounts of energy constrained to say the least. Or said populations will be forced to make due with less energy. How this affects consumption models is profoundly interesting from where I sit.

Fifth that oil is finite and will remain so until it isn't. Or as Taleb would describe it as a positive black swan. Until such time as oil is grown it is finite. Its a fact of life and denying it doesn't make it any less so. As time marches forward those in the denial camp will become more and more marginalized as global reality sets in.

Sixth human consumption patterns have not changed over the years. As a species we move either up or down the food chain to exploit resources as technology offers us access but the consumption is driven by basic human desire. Therefore a world of sunshine, kisses and holidays is not forthcoming any time soon. Solar and Wind and other renewables have an important role to play but will quite likely be a small portion of the consumption pie.

Finally a  model that is built on never ending growth is a flawed one IMHO. Disruptions in this model are when opportunities and fundamental change occur.

The key for those of us trying to figure out where the trend is leading us will be to figure out how to either maximize returns and or to protect our assets. We are afterall humans and subject to human wants needs and desires.

Personally speaking I have moved down the energy consumption curve. I assume many others have done so as well. Best of luck to us all.

silversalmon
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donpaulo wrote: firstly that

donpaulo wrote:

firstly that the paradigm is broken when 5% of the population consumes 25~30% of the energy. I think the safe conclusion is that a balancing of accounts is forthcoming. Neocons and other flat earth thinkers can continue to deny this fact but the long term trend is not curving in North America's favor.

secondly every Wing, Wang and Wong ascribes to consume energy like your average Smith, Jones and Johnson. Factor in that East and South Asian purchasing power is growing its a no brainer to conclude that the market share of energy is going to alter. The Chinese auto market alone easily displays this in spades.

Thirdly peak refining/production is already here. Using the refinery of the pacific's cost of 12.5 Billion I think its fair to assume that such projects are not likely undertaken. If one concludes that oil production will not increase as it has in the past, yet the global population and consumption of energy will continue to increase the maths just don't add up.

Fourthly if one assumes that domestic energy consumption will take precedence over exports of said energy, those who rely on imported energy will find the amounts of energy constrained to say the least. Or said populations will be forced to make due with less energy. How this affects consumption models is profoundly interesting from where I sit.

Fifth that oil is finite and will remain so until it isn't. Or as Taleb would describe it as a positive black swan. Until such time as oil is grown it is finite. Its a fact of life and denying it doesn't make it any less so. As time marches forward those in the denial camp will become more and more marginalized as global reality sets in.

Sixth human consumption patterns have not changed over the years. As a species we move either up or down the food chain to exploit resources as technology offers us access but the consumption is driven by basic human desire. Therefore a world of sunshine, kisses and holidays is not forthcoming any time soon. Solar and Wind and other renewables have an important role to play but will quite likely be a small portion of the consumption pie.

Finally a  model that is built on never ending growth is a flawed one IMHO. Disruptions in this model are when opportunities and fundamental change occur.

The key for those of us trying to figure out where the trend is leading us will be to figure out how to either maximize returns and or to protect our assets. We are afterall humans and subject to human wants needs and desires.

Personally speaking I have moved down the energy consumption curve. I assume many others have done so as well. Best of luck to us all.

Awesome work! I'm too tired to keep responding :-)

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For me the kicker was EROI.

For me the kicker was EROI. The best reference is this:

www.feasta.org/documents/risk_resilience/Tipping_Point.pdf

The usage as above to me is a function of available for consumption, driven by purchasing parity. This means that only the top X% really will be able to afford it. Like gold, lobster and other luxuries. To me, however, the key difference is understanding that perpetual debt expansion requires increased economic activity to balance and 'pay the interest'. This drives a constant need to 'grow out of the debt', which creates more debt. The result is economically mandated growth. 

To grow we consume fossil fuels. the most economic fuels to consume (most work produce for work consumed to get it, is that with the highest EROI(Energy returned on invested). Light sweet crude, accessed from shallow land fields. If we select a fuel with a lower EROI, it means we're putting in more of the previously dug up fuel to get back 'less' energy as a result. This means to consume the same amount of energy, production has to increase by the lower difference (the gap), just to maintain parity with existing energy consumption, but we need growth, so the economy doesn't fail.

This means that substitutions for oil are really a VERY VERY POOR substitution, as their EROI means you need a much larger production base than what oil currently supplies. This means you will see a non linear consumption of this new lower EROI energy source. If it costs the Saudi's $16 per per barrel, but the Canadians $80 per barrel for tar sands to produce, then the tar sands would require a supply base 400% larger to produce the same net energy outflows.

THAT to me is the problem. You knock off the 'easily available' energy sources of high quality an the production scalability of other energy sources becomes a serious, serious problem. If you look at the number seriously with a clean head, you will certainly see that alternative energy, whilst noble haven't a snowball in hell's chance of even denting the problem.

The best we can hope for is the successful ramping of next available energy sources as our nett energy declines to soften the decline. Given history over oil, I suspect we know how this will play out. 

"Neocons and other flat earth thinkers can continue to deny this fact but the long term trend is not curving in North America's favor."

Don't count out the largest military the world has coupled with mounting unemployment. That's a problem just waiting to solve itself. (NOTE : I'm not American, no nationalistic pride in that coment)

Also, on alternative energy sources, as a New Scientist loving geek I see no tech solution. Portability and stability of other energy solutions are serious problems as well, hydrogen is hard to store, electricity is costly to store and the best current solutions use massive amounts of highly limited elements. Coal cannot be used directly in small engines(toot toot says Thomas), this leaves burning room temperature liquid hydrocarbons as the best solution. 

So yes, another peak oiler, but I won't trying convincing anyone that producers are deliberately do this or that to run up prices, or reserves are lies, or oil will run out (it won't). The problem will become that of availability at the cost (in terms of effort to collect) so energy can continue support the current society without change, along with the built in perpetual expansion requirements. As you can read in the tipping point article above, we're not exactly well equipped for a change being forced on our highly efficient and fragile system.

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