How high do oil prices have to rise before demand actually falls?

That was the question that a reporter from Reuters asked me this morning. Here is what I answered.

A growing economy wants to consume more oil each year than the year before. If the price of oil rises sufficiently, it can offset that tendency so that oil use is actually lower than the year before. But just how high do prices have to go in order to accomplish that?

real_price.gif

Suppose you
go back to the 1970’s and adjust the price of oil for the inflation that we’ve seen since then in order to think about the price in current dollars. In today’s equivalent dollars, oil prices would have amounted to $40/barrel in 1976. In response to the twin supply shocks coming from the Iranian revolution and the Iran-Iraq war, oil rose to a current equivalent of $95/barrel in 1980. We then saw world oil demand decline from 63 million barrels a day in 1979 to 55 million barrels a day in 1983. Certainly the twin economic recessions contributed to that decline in oil demand along with the high price of oil, though economists are still debating the extent to which those recessions were themselves caused by the oil shocks.

That episode saw an 86% (logarithmic) increase in the real price of oil, and a 14% (logarithmic) decrease in the quantity consumed. If prices had not gone up and if there had been no recession, we might have expected to see a 12% increase in petroleum demand from 1979 to 1983. So, in that episode, an 86% price increase was associated with a drop in oil consumption of 26%.

Comparing that experience with the current data, oil prices have risen from a base of around $30/barrel (measured again in 2005 dollars) in 2003 to $61 today, which represents a 71% logarithmic increase. There are a couple of features of the current environment that differ from 1980. First, I do not yet see a recession, which was quite important in bringing oil demand down in 1980, currently on the horizon. Second, the tremendous growth of petroleum demand from China that we’re currently observing did not have a parallel in 1980. Even so, it seems to me that the price increases that have already occurred should prove to be enough to make global petroleum demand stop rising and start to decline.

But the question is when. Those demand changes in part will result from adjustments in the kinds of cars consumers buy and equipment firms purchase. Most people won’t buy a new car until they really need one, so the changes can take several years before they show up in petroleum demand. The effects of the price increase so far should already be in the works, even though we may see demand rise for a while further before it starts to come back down.

And the current market atmosphere suggests that things could get pretty exciting while we’re waiting to see if I’m right about that.

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36 thoughts on “How high do oil prices have to rise before demand actually falls?

  1. CalculatedRisk

    Perhaps the ’73 oil shock would be a better comparison than the ’79 shock. Oil is now above the ’73, ’74 peak price and dollars spent on oil consumption, as a % of GDP, is also higher than in ’73 (if the average contract price for oil stays above $50 – this will be the first week that that happens).
    The economy is ’73 was in decent shape (probably better than today, but the economy in ’79 was much worse). Greenspan was quoted in the NY Times in Jan ’73 saying: “It is very rare that you can be unqualifiedly bullish as you can be now.”
    Of course there are huge differences too. America uses a larger percentage of imported oil now and a much larger percentage of oil is used for transportation as opposed to industrial uses and electrical generation.
    Still I think ’73 might be a better comparison.
    Best Regards!

  2. Mcwop

    According to Boone Pickens the price is $70 a barrell. He also sees $3 a gallon prices in 12 months.

  3. Mike

    This guy suggests an interesting possibility – that the rapidly falling prices of SUVs has more than made up the difference in rising fuel costs. People are driving more SUVs because the total cost of transportation has declined, so demand for gasoline hasn’t fallen.
    http://www.parapundit.com/archives/002853.html#002853
    Cheap SUV prices are temporary, but they last for years.

  4. J Marcus Nunes

    To say that the US economy was in better shape in 1973 would be worth an F in any exam. We have to remember that it was the inflation process which began in 1965, being responsible for the end of Bretton Woods and the devaluation of the dollar beginning in 1971, that was the major force instigating oil producers to jack prices up. The Arab-Israeli war was just the excuse.

  5. CalculatedRisk

    Marcus, the three situations are very different (’73, ’79, ’05) and that is why I quoted Alan Greenspan in ’73 to show that an authority at the time thought the economic situation was improving “It is very rare that you can be unqualifiedly bullish as you can be now.” Greenspan, Jan ’73.
    The ’79 oil shock was larger (as a % of GDP) and the ’79 economy was in worse shape (I doubt anyone would argue ’79 was better than ’73). So I felt the ’73 shock would be a better comparison to today than the ’79 shock. That seems reasonable.
    Insults don’t bother me. Too funny!

  6. J Marcus Nunes

    It wasn’t meant to be an insult. But remember, ’79 only came about because ’73 had happened. Maybe when Greenspan uttered his bullish remark he was topsy turvy after a few dry martinis. In a period war (Vietnam), price and wage controls, Watergate and rising inflation, how could he be REALLY bullish?

  7. disinterested party

    Going down (someday)

    I think—hope—I’ve found an oil-price ally in Econbrowser James Hamilton: In response to the twin supply shocks coming from the Iranian revolution and the Iran-Iraq war, oil rose to a current equivalent of $95/barrel in 1980. We then saw world…

  8. Elaine Supkis

    Hooboy! Another economist trying to riddle out the energy/finance issue!
    Cheap oil is the fundamental basis of the entire civilization of the First World countries. It was a closed club for a while but a billion Chinese have suddenly joined our club and so the price of ALL things that go into making our industrial civilization are now going up and up BUT the price of PRODUCTION is going down.
    Why?
    Heh. Cheap labor from those billion Chinese!
    We always cheated the Muslim oil pumpers by inflating our currency every time they raise prices. But now, at the Hubbert Oil Peak, this trick is backfiring on us and we are now about to tip into the cold water of the Atlantic, our Titanic has a huge hole in the hull.
    Our money is flowing out to the oil countries and the blessings of cheaper oil via inflation are flowing into China who has a death grip on our currency because we are running up debts with Asia because our rich people don’t want to pay taxes.
    HAHAHA.
    Isn’t that a funny joke?
    Solution: when it all falls apart, probably violent revolutions/coups or world wars.

  9. foo

    I see doomsday Elaine has found James’s blog. Not that her scenarios don’t make for compelling reading.

  10. Hal

    Suppose you’re right about demand falling, and oil stays high, $50 a barrel or even more. Then next year, demand falls off somewhat but the price stays in that range, and we end up producing/consuming less oil than this year. So all the Peak Oilers will crow that this is it, we’ve hit the peak sure enough, oil production is down.
    How do we distinguish a demand-driven peak from a supply-driven one? (Is there even a meaningful economic difference between the two?) It would seem that a supply-driven peak would be associated with higher prices than a demand-driven one, but today’s prices are already pretty high already by historical standards. If they stay in this range while production/consumption falls, what does that tell us about Peak Oil?

  11. Barry P.

    We seem to have another case of people confusing a shift of the demand curve with movement along a demand curve.
    It’s been clear that China and India have caused the demand curve to move outwards, which has led to an increase in price.
    Thus, the notion of “how high do prices have to go before demand falls” is a bit nonsensical: it’s the increase in demand that is driving the price up.
    Given a fixed supply curve and an outward-moving demand curve, we can expect to see both rising prices and rising consumption. Now, if the peak-oil crackpots are right, then the supply curve starts shifting upwards. This leads to increased prices and reduced consumption. So a combination of peal oil and continuing outward demand shifts means much higher prices, and an ambiguous change in consumption.
    The people asking Dr. Hamilton this question need to be shown that high prices, in and of themselves, do not move the demand curve.
    The demand curve will shift inwards for one of two reasons:
    (1) given a constant energy as a % of GDP, then we would have to see a GDP reduction, i.e., a recession.
    (2) A reduction in energy as a share of GDP. In other words, substitution by other fuels. This will likely be the case in China soon: a massive amount of electricity is generated in China by inefficient, small diesel-fueled plants. This will change soon, as China is building the Three Gorges Dam, and about a thousand coal-fired plants.
    Now, switching to the US market for gasoline: this is a bit harder to model, given that what is important to most people is the total cost of transportation per mile, which is a function of fuel costs, fuel efficiency and vehicle cost. In the short-run, which is the time between now and when we buy our next car, demand is very inelastic, so our consumption will stay about the same, and we’ll pay higher prices. If we assume that the fleet turnover is something like 5 years then about 20% of all cars are replaced each year. If the new vehicle has, say, 25% better efficency, then we are looking at a first order demand drop of about 4% per year. So the crucial question is this: do higher fasoline prices speed up the adoption of a more efficient fleet?
    But don’t forget, there are more than just first-order effects: for example, the Khazzoom effect, whereby if your car gets better mileage, you tend to drive more.
    Short answer: a vast number of little changes affect the cost of oil, and they’re not all readily observable. So prognosticating on the future price and production paths is basically little more than a crapshoot.
    Let me reiterate, the peak-oil people are Malthusian crackpots, pure and simple.

  12. JDH

    Interesting point about shifts and movements along the demand curve, Barry. Let me try to clarify how I’m thinking about this. The issue has to do with the difference between the short-run and the long-run demand curve.
    You have two ways to reduce the amount of gasoline you buy. One is to drive fewer miles. The second is to drive a car with better fuel efficiency. The first one you could change right away. The second one only makes sense to change when you’re ready to buy a new car.
    If you take the existing fleet of vehicles as given, an increase in income (making people want to drive more) corresponds to a shift of the short-run demand curve, which drives oil prices up. Later, as people replace their vehicles, they have an extra choice and can purchase cars with better fuel efficiency. That would correspond to movement along the long-run demand curve.
    I believe it’s perfectly consistent to say that demand could be both the factor that’s currently driving oil prices up and also that later could help bring them back down.
    You’re right that, at the end of this story, the total quantity demanded and the total price would both be higher than when they started, but they would not be as high as they get at their peak.

  13. mark

    Hubbert made several other predictions besides the famous peak U.S. production one. Those all failed miserably. While the basic idea is likely correct, that all production must fall under the curve, there is no reason the curve could not ne more like half a teardrop, fast rise, very long term drop off.

  14. Hal

    According to the Hirsch report, http://www.hilltoplancers.org/stories/hirsch0502.pdf , the U.S. auto fleet takes a pretty long time to turn over:
    “The U.S. has a fleet of about 210 million automobiles and light trucks (vans, pick-ups, and SUVs). The average age of U.S. automobiles is
    nine years. Under normal conditions, replacement of only half the automobile fleet will require 10-15 years. The average age of light trucks is seven years. Under normal conditions, replacement of one-half of the stock of light trucks will require 9-14 years. While significant improvements in fuel efficiency are possible in automobiles and light trucks, any affordable approach to upgrading will be inherently time-consuming, requiring more than a decade to achieve significant overall fuel efficiency improvement.” Another quote: “Recent studies show that one half of the 1990-model year cars will remain on the road 17 years later in 2007.”
    This suggests that fleet replacement as a driver for long term demand reduction will be a slow process. Maybe it will happen faster in the face of high prices, but buying new cars is expensive and most people can’t just run out and pick up a new hybrid. They’re still paying off their current cars, and it takes a long time for the fuel savings to pay for a new car, even with high gas prices.
    And even once they are “replaced”, those old cars will probably still be on the road, driven by the poor. Ironically we may see SUVs, a status symbol today, become associated with poor families who have no choice but to pay high operating costs in exchange for the up-front savings in price on what will be low-value, low-cost vehicles.

  15. Barry P.

    JDH:
    “…purchase cars with better fuel efficiency. That would correspond to movement along the long-run demand curve.”
    I think that would cause an inwards shift of the long-run gasoline demand curve.
    I generally agree with your hypothesis concerning shifting to more fuel-efficient vehicles, but we have to think of the scale of such an effect: if the inwards shift is offset by outward shifts caused by population and wealth growth, then consumption doesn’t change much. Shifting to fuel efficient cars will slow down demand growth, and thus slow down price increases, but I don’t see it creating consumption and price declines. Especially at the pace of the fleet turnover in the US.

  16. gmoke

    “A growing economy wants to consume more oil each year than the year before.”
    This is a simplistic statement and contrary to at least some experience. If I remember correctly, in the early 1990s, the USA had at least one year in which GDP kept rising while energy consumption was reduced. It can be done. In fact, it has been done. Compare the btu to unit of production ratio between the US in the 1970s and today or the same figures for Japan and Germany (I know, I know, you have to account for the greater distances in the USA).
    A better statement to start from might be, “A growing economy wants to produce more each year.” But then, again, there is some debate in the ecological community about the relationship between growth and production. More goods and services may not be contributive to greater happiness or health, after a point. In fact, they may be detrimental to both. Quality and community might mean more human growth than simply more quantities of STUFF.

  17. JDH

    By the statement, “a growing economy wants to consume more oil each year than the year before,” I meant that, if the price does not go up, then oil demand increases when GDP goes up. Certainly if the price does go up, then you could have oil demand go down at the same time that economic output goes up. This indeed was precisely my point, and the historical period I was speaking of from 1982-85 illustrates exactly this possibility.

  18. FT

    “Let me reiterate, the peak-oil people are Malthusian crackpots, pure and simple.”
    Barry: I wish I could be so dismissive of the ‘peak-oil people’ considering the credentials of those who now believe their thesis has some credibility.
    Just as a matter of interest, are you scornful of the ‘crackpots’ on scientific grounds, or because they have ignored fundamental laws of economics?

  19. Barry P.

    FT:
    My disdain from the peak-oil crowd has basically built slowly over the years, being reinforced by every encounter with them.
    (I understand that I am employing generalities here: I know there are some sensible people who honestly think we are running out of oil, but these rationalists are few and far between, in my experience.)
    The main cause is their ignorance of economics, but what’s worse is their response to this lack of economic knowledge: instead of trying to incorporate some of it into their arguments, they have adopted a fortress mentality, firing of the charge that economists don’t understand engineering or the physical sciences. Well, I am an engineer and an economist. I worked in the oil and mining industries for a decade as a process engineer and a designer. Then I got bored and went back to school to get a dcotorate in economics. Based upon my combined knowledge of these two things, I understand how little the typical engineer or geologist understands about economics. Engineers take a class called “engineering economics” which usually covers stuff like the time value of money and capital budgeting. However, they remain woefully misinformed about how markets work, and how people respond to incentives. Engineers are far too rooted in a deterministic world: learning to accept and become comfortable with the stochastic aspects of economics was perhaps the toughest transition to me.
    The other part of my annoyance is basically that the peak-oil movement has been adopted by the nutcase left as prt of their orthodoxy. The same people who sneered at economics when talking about international trade, poverty and development are now the same guys expounding peak oil.
    I discovered that trying to reason with people who still view marxist egalitarianism as the inevitable utopian end-state for humankind is a waste of everybody’s time. It’s like trying to teach calculus to a dog.
    I disagree that the peak-oil theories have any credibility. When someone’s predictions are wrong, year in and year out, then that person has no credibility. Furthermore, believing that the end-state for oil production will be the same as the middle-state is naive and simplistic.

  20. Evan Wired

    Barry —
    All your other expertise aside, tell us: Is or is not oil a finite resource, and by “finite” you can consider it absolute or simply that there’s a point where the cost to extract the oil will be greater in energy terms than is stored in the remaining oil to be extracted.

  21. Barry P.

    Evan: whether it is more costly in energy terms is irrelevant. The question is whether it is more expensive in money terms.
    For example: if it takes 10 BTU’s of hydro-generated electrcity, with a cost of 1 cent/BTU to extract 1 BTU of oil, with a value of 11 cents/BTU, then it will be extracted. This is one of the pointless canards the peak-oil guys hang their hat on. They fail (or refuse) to see that we value transportation energy a lot higher than “static” energy, and that it is these relative values that matters. All energy may be created equal, but it is not all used in equal ways.
    Now, of course oil is finite. And when it starts to get scarce, competition for it will drive up the price. This does two things: (a) it makes people want to extract the expensive oil that they left sitting in the ground when the price was lower, and (b) it makes people want to go to the other, previously too expensive, options. And there are plenty of other options. In the future, there will be even more.
    We will never run out of oil, because the last bit of oil will never be extracted: nobody will want to extract it because there will be cheaper alternatives.

  22. T.R. Elliott

    Responding to Barry’s rant:
    Since he gives his background: I am a mathematician and physicist by training, an engineer and business manager by profession (until I recently retired from QUALCOMM). And I’ve studied quite a bit of economics on the side through the years.
    My contribution to this thread?: Barry gives us more of the left/right ideological tripe that infects so much of current thinking. Oil is a high EROEI product. The industrial growth that we’ve seen over the past two centuries has been built upon access to high EROEI energy sources. Economic growth is predicated upon continued access to similarly high EROEI sources of energy. As the quality of the energy (in EROEI terms decreases, which implies more energy diverted into obtaining energy, e.g. nuclear, solar cells, etc), economic growth will slow and then actually start declining. I think this is a very likely outcome.
    The useless statement “there will be cheaper alternatives” is meaningless because “the last bit of oil” will be infinitely expensive and therefore “cheaper,” in relative terms, is both true and–to the global economy–perhaps still fatal to economic growth.
    My point: Barry’s rant is useless. Peak Oil is a serious issue, deserving of much greater consideration than Barry’s tossing about basic economic ideas.

  23. Hal

    EROEI (energy returned over energy invested) is only part of the picture. Imagine a hypothetical energy source which is inexhaustible and cheap, but for which you have to use up 100 units of the energy to extract 101 units. So for every 100 units that flows out you get a net of only 1 unit. It has an EROEI of 1.01, barely over unity. By the thinking of most Peak Oilers such a low EROEI would mean that the energy was useless. Yet, if it were truly inexhaustible and inexpensive, it would be an ideal energy source. The fact that you have to feed it 100 units to get 101 units out wouldn’t matter, if the process of doing so were easy enough.
    This kind of hypothetical example demonstrates that EROEI does not determine whether an energy source is worthwhile or economically profitable. That requires a more detailed analysis. As Barry points out, not all energy is the same. Oil and electricity are not interchangeable. These kinds of details matter. Simplifying the analysis by using EROEI can be a useful approximation but it is only part of the full situation.

  24. T.R. Elliott

    The hypothetical provided by Hal is (a) true and (b) of little use in the present circumstances (those being global energy needs). Fossil fuels are (a) high EROEI and (b) easily extracted, in the early stages, from a sizeable number of sources. But from a global and macroeconomic perspective the world will soon transition from a glut of high EROEI energy (meaning cheap) to a regime one of gradually lower EROEI and lower volumes.
    All the diatribe of left and right political nonsense aside, I believe the above is largely incontrovertible and predicts difficulties for socio-economic systems that rely on continued growth (which is largely a ponzi scheme) in order to deal with the disparities of wealth that exist.

  25. Barry P.

    T.R.:
    So economic growth is a ponzi scheme, huh? More people living longer, healthier lives is part of some giant scam?
    Our human existence on this planet is dynamic. All you appear to be saying is that the current patterns of energy use will not be the same forever. Indeed. Your assumption that the future will necessarily be worse than the present is belied by about 10,000 years of human history, but, hey, maybe we are approaching the “end times.”
    If you want to believe that we’re going to run out of oil in 5 years, and that a massive human die-off is the only inevitable result, well, good for you.

  26. T.R. Elliott

    Please Barry, you are arguing with a straw man. I said nothing of the kind. I never said massive die off. I never said end times. I’m fully aware of economic growth and the path of human history. With an education in physics and mathematics and many years at one of the top technological companies in the country (if not the world), I think I bring more than just doom and gloom. Please spare me (us?) your straw man rants.
    What I did say: Energy will become much more dear, meaning much more expensive, with much lower EROEI. And it will be less available. It will cause problems, the type of problems, at a global level, that will severely impact positive growth and may, in fact, make growth very difficult.
    My statement about ponzi schemes is simply that the libertarian non-distributionist ideology relies on economic growth to raise all boats. The right says as such. Don’t redistribute. Raise the tide, and all boats will rise.
    Unfortunately, this will become much more difficult at energy becomes dear. It will greatly strain our social system.
    That is all I said. And I think there is a great deal of credibility to these statements.
    In a practical sense, I moved a large chunk of my QUALCOMM holding about a year ago to the Vanguard energy fund. Good move. I felt at the time that supplies were tightening. If you look at upcoming large projects coming online in the coming years, I’m expecting oil to continue to be tight, with prices flucuating between $40-$80. And moving higher beyond that, probably running in the $100 range. Unless demand drops through demand destruction, in particular recession. Which also proves my point.
    Nuclear (uranium), tar sands, solar, biofuels, etc: they won’t make up the difference in the next ten years. I think it will be tight and difficult. And I think humans will have to deal with a lower energy lifestyle, and most likely we will have to rethink our concept of economic growth and the implications it has on society.
    Doom and gloom? No. But please stop looking in the rearview miror all the time. Sometimes its better to look at where we are headed.

  27. Ira

    I agree that higher oil prices should self correct and with the confluence of so many, many infrastructural compromises, I?m deeply concerned about the attractiveness of most investments. So much has been artificially influenced.
    For sometime, I’ve been of the opinion that it’s all about money supply – a change from ?it’s all about oil? ? I remember 1999 oil at $13 the barrel. But the larger, underlying issue may be the supply of $ – the supply accelerator was to the metal & the excess $ are just now being removed. Easy credit allows for the imbalances & excesses we now witness, including oil. Like the planned inflation of the mid & late 70s to combat the politics of mid-east oil price gouging, today?s massive money supply combats things too ? Most importantly, creating a more vibrant economy to better support the war on terrorism (parallels needs to fight in Viet Nam), outsourcing blue & white collar jobs, huge deficits, tax cuts, etc ? so much is masked ? we don?t see the ?70s like inflation because the govt ? is it the reporting metrics have changed or are there such strong infrastructural compromises that the economy grows little with the floodgates wide open or ?? ? but the rise in housing prices is similar to the 70s (as like almost all hard assets), flat stock market after a brutal fall, difficult job market, etc. Will stagflation be recognized again?
    And then there is productivity ? do the metrics take into account how very, very energy INefficient China is?

  28. Barry P.

    T.R.:
    Concerning your “lower energy lifestyle”: I guess all we can do is wait and see.
    I remain unconvinced that we are that close to the end of oil. When reserve replacement costs start to climb into the $20-$30/barrel range, then I will be worried. The sale of reserves is an publicly available proxy for the cost of reserve replacement, and this has consistently been below $5/barrel (as per Adelman) as recently as 2002.
    Even if you take the pessimist’s estimate of the current reserve (2 trillion barrels, Colin Campbell), and assume an annual 1% consumption growth, then the current reserve, without a single drop of extra reserve addition, will last until 2055. Assume 2% growth, and you get to 2048. (Average annual growth over the last 20 years was 1.6%.) And we know that there will be reserve additions.
    I am comfortable with the idea (albeit obviously unprovable in the present) that we will learn to make more efficient use of all energy resources over the next 50 years.
    Thus, for the foreseeable future I’m not worried about any massive energy-scarcity-driven recession, nor am I worried about having to rethink the notion of economic growth.
    Besides, when a society reaches a certain level of wealth, real per-capita growth of marginally greater than zero is not really necessary. Most people in the first world comfortably meet all of their primary and secondary needs with their current real incomes. More leisure time and more toys may be nice, but not necessary.

  29. T.R. Elliott

    I’ve looked at the ideas of Adelman and, in contrast, those of Richard Smalley. I find Adelman to be a resident of the “economics in a vacuum” school of thinking. As a physicist, this is where I find economics to be so much more ideologically inhabited, similar to say psychology, though certainly not as bad as criticism such as the literary theorists. Adelman provides few concrete reasons on why he thinks we don’t have a problem. As a member of Cato, his primary objective is to support libertarian policies, similar to Stephen Moore (with whom I’ve debated in email this particular topic, finding him similarly detached from facts).
    Smalley make a good case on why we have a problem. He believes we have a big problem. Not today. Not tomorrow. But within a generation. The question for me is how big the problem will be. You’ve stated yourself that within 50 years we will consume a significant portion of the oil that we know about. Nobody understands how humans will replace this energy. Adelman says “what, me worry” which is not very profound if you ask me. The “things will work out” school of thinking (or non-thinking) is boring. I’ll look for those who can construct actual models (since those are also the people who will have enough technical insight to help forge the path to alternative energies–Adelman sure as heck isn’t going to do that).
    The question soon will not be how much it costs to pump oil out of the ground. The question is the volume at which it can be pumped. Prices are not always set by the cost of production. Demand also sets the prices. Economists often forget this. And unlike many ideologically “living in a vacuum” economists, there are not always simple replacements for a product. Concerning demand: Oil fields have optimal extraction levels, beyond which they are damaged. Tar sands and coal liquifaction have limits as sell. Adelman will often drop terms like “tar sands” and “coal liquifaction” as if we can just turn on the tap. Not true. They will never support but a moderate percent of current consumption. Right now, it appears that the world is consuming within a percent or so of production capabilities. There is speculation about additional capacity in Saudi Arabia (we can start using lower grade sour oil from the Saudis), and speculation about Iraq’s capacity (in addition to speculation the fields are badly damaged, aside from political stability constraints).
    If we are running up against production constaints, it means that (a) a race is on to build additional production capacity and (b) prices must rise to reduce or constrain demand.
    I’m personally betting that the price of oil is currently speculative (we have not run out of oil) but speculation based upon sound reasons. The futures market (which is often wrong until reality resets it) is now saying oil will be much more expensive. Stephen Moore continued to argue for $20 oil at least a year ago. He was wrong then and continues to be wrong.
    I don’t believe the price of oil is a monetary phenomenon. From my personal financial perspective, oil is money, right now the only true money, and I’m making my bets accordingly.
    Humans are consuming capital (in the form of fossil fuels) without any idea of how they will live off income (e.g. solar energy). I believe the transition from living off capital to living off income will have seriously started within the next ten years. It will start because oil in real terms will surpass its highs in the 70s/80s, with a serious recession as the only way to limit those prices.
    Countries such as Thailand and Indonesia are already experiencing shortages because of the higher price. Demand destruction is starting in these places. If production cannot increase to meet demand, this demand destruction will percolate up into the developing countries. Unless everyone runs out to buy a hybrid (I happen to own two of them), which isn’t going to happen overnight, demand destruction will force lifestyle changes and will negatively affect GDP. And I think this is just the beginning.
    Not doom and gloom. But a very serious problem. I believe people like Smalley should be accorded more airtime and respect than the nonsense–in my opinion–that is produced by Adelman and the Cato institute (or Moore in his new job on the reality impaired WSJ opinion page).

  30. Prakash

    Hi TR,
    I think that economists do have a point in being “economists in a vaccuum” as long as there are new theories of physics still being proposed to explain the world.
    When an economist says something like “things will work out”, he is making a fair enough assumption. This assumption is being borne out very well by history. Knowledge of chemistry leads us to make a former waste product (oil) into a valuable resource. WHO KNOWS WHAT TOMORROW’S KNOWLEDGE MIGHT SHOW US?
    As long as there is no unified theory of all physics which explains everything, alpha to Omega, an economist is quite much justified in saying things will work out. Study of nuclear forces and their interaction led to terrible weapons and a useful source of energy. Today there are only speculations about zero-point energy and dark energy and god only knows, what else. An economist doesn’t have to be a expert in tapping dark energy. But he can assume that under the right set of circumstances, it might be profitable for someone in the future to be able to study the tapping of dark energy and eventually, tap it.
    But these very economists don’t leave everything to chance. They insist that the correct institutional factors be in place. There are those amongst them who design institutions that can be useful in tomorrow’s world. (for eg. Robin Hanson’s idea futures markets)
    The job of the economist is not to point out every little street and turn on the way. that is the job of actual engineers, scientists, entrepreneurs and speculators – most of whom may end up a lot richer than the economist!

  31. T.R. Elliott

    Prakash:
    Just to clarify my position: I’m all for economics, find the many ideas and theories fascinating, and agree that there is a realm for economists and a separate realm for physicists and engineers. And it is true that the solution to many real world problems, e.g. polution, may be found partly in the economic realm, e.g. trading polution credits.
    But more so than in physics, economics seems to have been infected by ideology, e.g. libertarianism, which is largely a political theory, a value system, and an ideology. Individuals such as Adelman (I would guess) and Moore (I know for a fact) live in an unreal world, distributing ideas about the powers of the free market on the internet created through a significant amount of govt money (as an aside, I worked for quite a few years at BBN, which put together the first set of arpanet routers on govt contract).
    My point? Economists such as Adelman often steer public policy through convincing arguments that the “free hand” will solve all when in fact he doesn’t know what will happen. He’s guessing. That’s not science. If the capital stores of energy are depleting to the point that consumption will soon meet production abilities, an economist cannot say that a solution will be found that will keep a smile on everyone’s face. That’s the message generated by Adelman. Don’t do anything, the market will solve all. It’s fine for him to say that, but the market may solve the problem through severe demand destruction.
    For those watching this particular issue closely (I’ve been studying energy and energy economics for a few years now–granted not that long), the Saudi’s just admitted that there is no way they can meet the grandiose requirements plance on them by the EIA in order to meet world energy needs in the coming ten years. Our energy secretary also just admitted that we have entered a new world of energy pricing, in which markets dictate the price. It is likely that we no longer have the central banker of Oil in Saudi Arabia. There is an enormous capital investment in oil consuming technology, particulary the bloated transportation sector in the US. If we see gas prices end up at $7/gallon, I think we will see a lot of imbalances unwind. The fed can’t print oil.
    Currently oil is around $60/barrel. The cornucopians predicted it would drop long ago. There are still those, including the Economist and Xie at Morgan Stanely, who think oil prices will crash. But do note that Xie’s crash is contingent on significant slowing in China and significant (and immediate) production from oil sands, coal liquifaction, etc (which is simply not true).
    I believe more economists should be looking at the implications of energy shortfalls and recommending policies to reduce the risk of these shortfalls (e.g. carbon taxes).
    Unfortunately, Adelman and his crew currently have the upper hand.

  32. Prakash

    TR,
    As you mention, there are so many indicators of oil depletion. So, why are not the futures markets responding? You mention in your earlier post that the future markets are wrong until reality hits. But, what you call reality hitting is just what the future markets do.
    Let us understand one fundamental principle. TALK IS CHEAP. Even for an expert, talk is cheap.
    Corollary of that would be “Put your money where your mouth is”
    In a futures market, that is exactly what people are doing – They are not talking, they are dealing with actual money. either their own or that of people who have trusted them with their money.
    Is this the best scenario that can ever be? No, of course not. I would prefer that a solid idea futures market exist side by side the stock and commodity markets. a market that traces the probability of events that might affect important aspects of civilization. An idea futures market would be much better placed to tackle issues like hard landings, soft landings, etc.
    But the fact remains that there is a lot of money floating around in the financial markets in the world which would rush into any chance of making a profit. Which makes these present markets a strong enough institution to hedge your bets. You may not be a speculator, you may just be a guy who is interested in maintaining your company’s energy costs the way they are. Airlines or freight firms have a vested interest in keeping energy costs predictable. Point is basically – the futures markets represents the best consensus about any “dispersed knowledge” situation. If you think that things are going to be worse than what the market predicts now, that is your chance to make some money. The tiny little signal that you send with your money IS ALL THAT YOUR KNOWLEDGE IS WORTH.
    And this is why the economists support a free market. A market allocates resources. Any interventionist policy misallocates resources because the signal of price is being distorted.
    Will making petrol more expensive right now encourage people to start car pooling more often now – yes it will. But for the economist, this re-arrangement of resources is inefficient because the trade-off (convenience for energy) results in a situation where people have lesser utility than before.
    Please note, a true economist will agree with many mechanisms like peak-pricing of power and roads, that will lead to more ecologically efficient solutions. They will agree with measures like heavier vehicles paying more road tax because of the greater costs they impose on the roads.

  33. Miles

    The interesting point is why futures markets are not predicting higher prices.
    This may be for 2 reasons
    1/ Demand destruction
    2/The people dealing in futures believe that economics/market forces will solve the problem
    What the ‘peak oil’ crowd are saying is that the refineries are operating at close to peak capacity, the tankers are operating at peak capacity, the investment in oil industry infrastructure has been inadequate, because the oil companies know something. They have chosen not to invest but distribute capital, because they know they do not have a better use.
    Why buy up other companies at such a high price of oil. Amalgamations usually occur when prices are low, there is excess supply.
    Tainter explains the collapse of societies using economics. It is to do with the marginal cost of resources.
    There have been many civilisations prior to this one. Why are we immune? We should not be overconfident. The greeks had a word, hubris.
    The argument of the scientists (geologists, engineers etc) is that the resource is finite. There are lots of uses of oil as cheap energy, such as transportation and food production. That it is the ability to do work using cheap energy that underwrites the economy.
    That cheap oil and gas is used in many areas of the economy that cannot be replaced by electricity.
    That the economists have got it backwards, energy in different forms is the real currency, not money.

  34. disinterested party

    About that house-price oil-price bubble

    I’m definitely sticking to my $40-a-barrel guns: A sudden and mysterious drop in China’s oil consumption helped to push down the International Energy Agency’s estimate on Wednesday of global demand for this year. After growing 11 percent in 2003 …

  35. tt

    You are forgeting what is important. It is not oil peaking. What is important is that the increase in supply would not meet the increase in demand.
    Here are people calling themselves engineers and economists proclaiming that oil production can never decline.
    Most organisations estimate oil peaking at 2008 Cambell, to 2025 CIA, to 2037 IEA. The US peaked in 1970. UK, Egypt are already declining. Russia would start declinging after 2010.
    The Futures exchange does not reflect higher prices because my dear fellows it is not supposed to. If the exchange predicted the future there would be no bubbles (due to confidence) and no crashes.
    Oil would not meet demand definitely before 2020. I cannot be wrong except in two cases:
    1. China or US undergo a 1927 depression for a couple of years.
    2. Option 1.

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