Limitations of the Hirsch report on peak oil

Here’s a prime example of what I complain about in some of the discussions about how to deal with peak oil.

Robert Hirsch, Senior Energy Program Advisor for Science Applications International Corporation, and Roger Bezdek and Robert Wendling of Management Information Services, Inc., circulated a report last February titled Peaking Of World Oil Production: Impacts, Mitigation, and Risk Management. Their report has been widely promoted by many of those concerned about depletion of global petroleum reserves. For example, last week Energy blog declared:

I, and a few others, believe that the Hirsch report is the most important, comprehensive and authoritative message on the mitigation of the peaking of oil.

And Richard Heinberg wrote:

If the content of the Hirsch report is to be believed– and there is every reason to think it should be– then this is a document that deserves the close attention of every leader of government and industry in the U.S. Newspapers and newsmagazines should be running excerpts and summaries.

Dozens of other favorable mentions of this study have appeared in the last few weeks in places such as Peak Oil News,
Global Public Media, and
Guerilla News Network.

Here is a flavor of what one finds in the Hirsch report:

World oil demand is expected to grow 50 percent by 2025. To meet that demand, ever-larger volumes of oil will have to be produced. Since oil production from individual reservoirs grows to a peak and then declines, new reservoirs must be continually discovered and brought into production to compensate for the depletion of older reservoirs. If large quantities of new oil are not discovered and brought into production somewhere in the world, then world oil production will no longer satisfy demand. That point is called the peaking of world conventional oil production….

Some economists expect higher oil prices and improved technologies to continue to provide ever-increasing oil production for the foreseeable future. Most geologists disagree because they do not believe that there are many huge new oil reservoirs left to be found. Accordingly, geologists and other observers believe that supply will eventually fall short of growing world demand– and result in the peaking of world conventional oil production.

I’m sure that most of my economist readers are shaking their heads in disbelief at this point, but for the benefit of anyone who is not, let me spell out exactly what the problem is with this kind of analysis. How much oil is demanded at any given time depends, among other things, on the price. A very, very large quantity would be demanded if the price were $1 a barrel and practically none would be demanded if the price were $10,000 a barrel. The quantity that is profitable to bring to the market also depends on the price. The reason economists want to pay so much attention to the price is because it is the one variable that is guaranteed to adjust and adapt to any and all unforeseen circumstances that may develop so as to ensure that demand always equals supply. Supply equals demand today, supply will equal demand in 2025, and supply will equal demand in 2050. Whatever Hirsch means by “peaking of world conventional oil production,” it certainly isn’t the condition that “production will no longer satisfy demand.”

I suppose that if one did have the view that demand was something that just grew on its own without any regard to the price (as this study seems to me to do), the claim by economists that supply will always satisfy demand would seem profoundly bubble-headed. From such a perspective, I’m sure it requires great restraint and civility to pretend to recognize the opposing view that some economists think that supply will equal demand, before dismissing it on the basis of the opinions of those who really know how much oil is in the ground.

Since Hirsch is using this notion of “world oil demand” in a way that he presumes holds meaning to any reader, but is definitely not the way mainstream economists would use the expression, I simply have to guess about what he thinks he means by the phrase. My best guess is that he has in mind something along the lines of the answer to the question, if prices don’t change too much from where they are now, what would the quantity demanded be at any given point in the future? Confirmation that this assumption is not just Hirsch’s definition of “demand” but is furthermore the foundation for the whole analytical framework comes from the report’s later assessment that

As world oil peaking is approached and demand for conventional oil begins to exceed supply, oil prices will rise steeply.

So now I think I’ve got the picture. The price stays stupidly frozen for ten or so years, and then all of a sudden starts shooting violently upward.
Readers of my earlier remarks or related points made by Steve Verdon will know my opinion about this idea. Basically, if Hirsch is right, he would be able to turn himself a handsome millionaire by buying oil, or oil futures, or oil options, before that rapid price increase. That opportunity would be available not just to Hirsch and his two co-authors, but also to all their cousins, and my nephews, and all the people in China, to take a few examples. For Hirsch’s vision to be accurate, none of those people, not one of us, is going to be clever enough to take our profits. Because if we did, that of course would cause the price of oil to rise well before we get to the peak, and people would begin making all the adjustments that Hirsch wants to discuss, on their own, without needing any good instructions or advice from him.

And good instructions and advice he has plenty of– what kind of engines to put in our cars, which energy sources to be developing, all with a dramatic and forceful timetable spelling out exactly when we need to do all this. He’s quite certain that nobody will act on those implications of his analysis that could make anyone who follows them quite rich, but at the same time hopes that we we will believe in his analysis sufficiently to want to implement policies that would render those who are forced to follow them unambiguously poorer.

Now that’s an interesting model of human behavior.

281 thoughts on “Limitations of the Hirsch report on peak oil

  1. The Oil Drum (Heading Out)

    World oil demand grew last year much more rapidly than anticipated, despite an increase in price at the end of the year. It appears that it is likely to do so again this year, even as prices continue to rise. I have paid over $6 a gallon for gas in the UK without demurral, since I needed a car to get where I was going. The point at which Demand Destruction kicks in, and at what level, is a matter of some interest and debate. There have been riots already in parts of the world and there are financial problems in India where the price is subsidized. Yet it is anticipated that demand will continue to rise globally through the end of the year. Both the US and China are at the point of buying more oil for their Strategic Petroleum Reserves, which will also drive the price higher, depending on how rapidly they impliment those plans. By the way demand does not depend just on price (you might want to revisit the papers describing the economic impact of a shortage of natural gas concurrent with a severe winter in the US as President Carter took office in 1977).
    And, forgive me, but I still get the feeling that you don’t understand the reality that in most cases, once an oilwell starts producing, the owners will keep it doing so, in many cases regardless of the price they get for the oil.

  2. JDH

    Heading Out, I did read your earlier post on keeping a producing well operating, and you’re correct that I was not persuaded by the argument. I do not claim that the owner would shut the well down, only that the owner would reduce production to the point at which the spot price plus the cost of carry equals the futures price. Are you claiming that there would be an infinite cost of reducing production by one barrel, or an infinite interest rate at which the future is discounted, or that small adjustments are physically impossible? If not, then the claim that profits are maximized by choosing to operate at the point at which spot price plus cost of carry equals the futures price is simply a mathematical proposition.
    In addition, the owner of the well is not the only agent in a position to profit from a violation of this arbitrage condition, given above-ground storage.

  3. JDH

    Sorry, Heading Out, I got so interested in your second point that I forgot to respond to your first point. I do not insist that price is the only thing that influences demand, or even that it is the most important thing. Rather, my claim is that the price can and most assuredly will adjust to whatever value is needed in order to equate supply with demand.

  4. RayJ

    In defense of the Hirsch report, I think the issue that they are trying to raise is that a sudden rise in tne price of oil will have cause a reduction in demand that will be difficult to adjust to. This is what the Goldman Sachs report referred to as “demand destruction.” Of cause, supply is always equal to demand but a sudden, large change in the supply demand balance and the resulting price spike cause problems. During the California energy crisis when prices rose from a normal $30-50/MWh to $500-600/MWh in three months, demand always equaled supply but any one who went through that experience will remember the resulting shocks to the system; businesses folding, a major utility declaring bankruptcy, blackouts, etc. Of course the critical issue is all about how much time everyone has to adjust; oil rising from $10 to $60 in 7 years is quite different from a similar six-fold increase in say a year or two. Such a dramatic increase is conceivable if panic sets in because the market suddenly becomes convinced of an impending shortage.
    I therefore believe that the problem with the Hirsch report is that they decribe a real phenomenom but in language that economists will not use.

  5. Davidw

    I think RayJ has ‘hit the nail on the head’. Both OilDrum and JDH are talking about the same thing, but past one another. There are 2 types or levels of ‘demand’- the one that will match supply at a particular price point (JDH’s demand), and the one we would like to have to continue with our standard of living (OD’s demand). People in Zimbabwe would love to drive their cars but have had to revert to horse and cart given the country cant pay to import enough oil at $60 per barrel, hence demand adjusts- but at what social cost?

  6. T.R. Elliott

    “I therefore believe that the problem with the Hirsch report is that they decribe a real phenomenom but in language that economists will not use.”
    Then I think economists need to realize that the little sandbox they’ve created for themselves is fine and dandy, but when looking at the analysis of real world problems (e.g. peak oil), they should focus on the problems, not symantic or terminological subterfuge.
    What I’ve found several times when interacting with economists is that they find some particular nugget of “misconception” or terminology not to their liking, then decide that the speaker is hopelessly confused. “If only they understood economics” the economist will huff and walk off.
    I’d really like to know what JDH thinks of the work of folks like Daly, for example, or others in the Ecological Economics community.
    It’s quite obvious, for example, that demand will match supply, and that price (or Govt intervention) will force this to be the case. But in and of itself, that’s a pretty trite observation, in my mind–from a physics/engineering perspective. We get it. Prices rise. Demand is destroyed.
    My question: how would you model this?

  7. Factory

    “geologists and other observers believe that supply will eventually fall short of growing world demand”
    Hmm just pretend that they didn’t use those words to express what they thought, instead pretend they said:
    “geologists and other observers believe that supply will eventually fall enough so that the cost of petrol will noticeably affect it’s usage”
    The problem here is that the geoglogists are using the term as:
    “An urgent requirement or need: the heavy demands of her job; the emotional demands of his marriage; an increased oxygen demand.”
    Whereas you are thinking of demand as:
    “The amount of a commodity or service that people are ready to buy for a given price: Supply should rise to meet demand.”
    Both are correct definitions, but one is an economic term, whereas the other is a layman’s term.
    One could say that the report is at fault for using non-economic jargon in an essentially economic sentence, or that JH is at fault for demanding precise economic jargon in a report that is not designed for economists.

  8. jb

    And I think that you all are missing the fundamental point of JDH’s post – every issue you’ve described is, by definition, knowable. It is known that winters will change demand. It is known that some fields are exhausted and others aren’t. And it is known that panics can occur when supply falls dramatically, further upping the price.
    Having said that, there is a futures market in oil, with 7(!) year futures options available. Why are 7-year oil futures still priced in the $30 – 35 range, given what you guys ‘know’ to be true about peak oil?
    Secondly, you talk about the social cost of rapidly rising oil prices. There are also significant social costs involved in forcibly switching people to lower consumption systems/technologies too soon.
    Remember, we’re basically saying ‘either you believe the large, uncontrolled mass of people who invest in the oil futures market, or you believe the small number of peak-oil pundits. Historically, pundits in any field are often wrong, because they focus on things that reinforce their message, and ignore or downplay things that don’t. I’m not saying that these pundits are wrong. I am saying that if I jumped on a bandwagon every time anyone said ‘X is going to be a problem in less than 5 years’, I would be much, much poorer.

  9. Jim Miller

    Much of these discussions are about semantics. The fact is that there is a finite amount of oil on the earth and one day there won’t be anymore. Between today and that last day production will start to decline, and it may be that we’ve reached that point. But whether we have or not, the fact is the amount of oil is limited.
    The process of economic development,almost by definition, involves the use of energy to become more productive. Virtually all humans want to be better off,so energy is needed.
    The math,in concept,is relatively easy. The oil will run out one day so it is necessary to have other forms of energy if mankind wants to maintain or continue to improve its lifestyle.

  10. Donal Fagan

    jb wrote: “Why are 7-year oil futures still priced in the $30 – 35 range, given what you guys ‘know’ to be true about peak oil?”
    Would a palm tree futures market have saved Easter Island from a sudden economic decline, war and cannibalism? That’s not simply rhetorical; if you think a modern market could have saved the Rapa Nui, I’d like to read your explanation.
    Perhaps the markets will continue to function and some clever people will prosper from energy depletion, but I fear that demand destruction will mean that many more of us will have no job, no heat and no food.

  11. The Oil Drum (Heading Out)

    Grin – actually JDH and I agree on one thing, that those who use predictive models beynd the point where significant Demand Destruction begins to occur are venturing into the land of fiction. (From the point that the basic model conditions no longer apply). (My particular target was Cooke’s “Oil – Jihad and Destiny” in my post last Sunday). And looking at overall national behavior there is some question as to whether Russia is beginning to hoard oil, working on the premise that JDH proposes that it will be worth more later. But while this can be applied on a national scale, I don’t think, because of the agreement when you join a supply pipeline, that it applies to individual well owners, though I do not know for a fact. Further the high costs of generating the well, drive the owner to production as an ROI as soon as technically feasible. And once out of the ground, finding places to store it becomes expensive.

  12. odograph

    The line:
    “World oil demand is expected to grow 50 percent by 2024”
    is actually footnoted:
    “U.S. Department of Energy, Energy Information Administration, International Energy Outlook – 2004, April 2004.”
    I think what Hirsch is trying to do, rather than present this number as his own, is to show how other people’s projections don’t match the available reserves.

  13. Joseph Somsel

    I too was struck in reading the report at the treatment of future oil demand. It wasn’t a precise formulation but who doubts it? It does make the assumption that prices are held constant. I believe the point the authers were trying to make is that we would LIKE the supply to continue to increase to meet demand growth at current prices, i.e. business as usual.
    The PURPOSE of the report was not to forecast future demand at some price point but to explore the technological options for convential oil substitution and their physical delivery timing. It achieved its goal albeit without economic rigor.
    So how would an economist guide a small fry investor to make a profit given our view of the market ahead?
    Buying futures in an increasingly volitile market is risky to one’s financial health. Are there oil leaps? I’ve proposed elsewhere that equity in US stripper wells might be safer – I wonder if there are hedge funds or the like to pool small investments in strippers? Besides oil, one can make a case for natural gas although they usually have shorter lifetimes and the production peak is beyond oil. Simple stock purchase in E&P companies with solid reserves seems easy IF they have good management.

  14. FTX

    Some great comments on this thread.
    Personally, I don’t think it’s just a matter of semantics, but I can understand why some posters see at as such. I too am getting very tired of economists taking laymen to task for incorrect usage of the sacred words ‘demand’ and ‘supply’. When we hear that there was excess demand for U2 concert tickets, I think we all know what was meant.
    However, I don’t think Professor Hamilton is guilty of this here. My reading of his post is that he’s extending the arguments he gave in the WSJ Econoblog debate with Robert Kaufmann. At the end of this he gave a powerful articulation of his views:
    “We only have so much in the way of resources to cope with these great challenges — only so much capital to invest, only so many geologists to figure out how to get at the oil that remains, only so many engineers to develop alternatives. It is precisely because I agree with Robert about the importance of this transition that I think it’s critical that we put all our resources to their best use. And I honestly believe that the best way to ensure that happens is to count primarily on the same system that has generated the fantastic improvements in global living standards over the last few centuries, namely, individuals choosing to direct the resources they personally control to those activities that yield the highest personal reward.”
    This is the crux of the argument. Do we follow some of the recommendations of the Hirsch report, incurring potentially huge transitional costs in doing so, at the same time risking pouring resources into solutions that have no guarantee of success? Or do we allow more free market principles to enable the transition, with some assistance from government in terms of private incentives and possibly some form of energy tax?
    It’s a highly debatable point. I lean towards JDH’s view, but with trepidation, and that’s because I’m not convinced the market is going to give us price signals sufficiently in advance. I’m not sure that traders and producers are going to smoothly artbitrage future prices into the present to enable an *orderly* transition to take place.
    And that’s because there are too many variables for anyone — ANYONE — to be certain of future oil production levels.

  15. Eric H

    I think the Caleeforneea electricity crisis is the wrong example to use. In that case, the price mechanism was legally thwarted from its normal function (despite the soaring cost of production, the price to consumers was fixed at a constant rate). In fact, the California Crisis is either an example that works in JDH’s favor, or at the very least demonstrates how wrong thinking about the price mechanism leads people (perhaps especially well-meaning politicians) to the wrong conclusions.
    Also – for Prof Hamilton – I remember from college that it was always difficult and overly cumbersome to distinguish between “demand” (i.e. the curve) and “quantity demanded” (the amount desired or delivered at the intersection of the supply and demand curves). I think that demand for oil will not change in the short term as prices rise, but the quantity demanded will change in accordance with the price elasticity. In the longer term, demand itself will change, meaning the *quantity* demanded at all prices will change. Could someone come up with different, one- or two-syllable terms for “demand” and “quantity demanded”? Especially for the purpose of disambiguating with the lay definition of demand noted by Factory?
    Although I am not an economist, I share this frustration with people who speak as in the Hirsch report. I do not think it is a semantic debate. I think that they actually think (as Jevons did in his coal report) that demand is a constant that remains at a steady state, or keeps growing at its historical pace, no matter what happens with supply or prices. If they know how much is (actually or theoretically) in the ground, they can calculate a time at which it will all be depleted. I think that there are people who really believe that you can calculate depletion with something like a ballistic equation and predict that on such and such a date, you will open the newspaper to the headline, “Last Drop of Oil Pumped; Saudi Arabia collapses 25 ft, sets off sand-nami; President (Jenna) Bush and Dale Earnhardt Jr. III refine, burn last gallon of gas in gala ceremony!” I thought it was interesting that your co-blogger in last week’s WSJ discussion opened with a flat refutation of that scenario; obviously he thinks that perception is both wrong and ubiquitous. It’s a conceptual problem, not a problem with word choices or meanings.

  16. T.R. Elliott

    Excellent commentary. I agree with the gist of the many comments pointing out that one should (a) look to the markets, e.g. the futures market, for signals as to what will happen in the future and (b) one should be very cautious about expending large funds to incorrectly or inefficiently solve a problem that would more efficiently solve itself through market means not invisioned at present.
    But ANALOGIES about whale oil and the stone age not ending for lack of stone are useless (as some, not JDH, would argue). I’ve yet to hear anyone point me to the predictive power of the futures market. And I’ve yet to hear someone tell me why demand destruction would not significantly reduce the price of oil so that $100 oil in 2010 will not happen (even after peak). I’m told that people will bet on $100 oil in 2010 (based on their collective hunches)but how many people will hold such a position if demand destruction pulls the price of oil down to $40 a barrel.
    I’m not a peak oil fanatic. Nor anti-economics. But I do think we need a REALITY BASED community focusing attention on this issue. In some of the more ideological sectors of the economics community, there is no problem–markets will solve it (e.g. whale oil isn’t necessary) and in the extreme peak oil community, they’ve already locked themselves in with military rations and weapons.
    I think the most important investment right now for peak oil is good solid analysis (such as JDH is contributing to). Honest assessments of the what we might face.

  17. odograph

    I think in broad strokes the US DOE is saying that people are going to burn 50% more oil, and Hirsch is saying “Where you gonna get it?”
    Maybe you have to back up to the DOE report and see that they’re doing … projecting from current demand? If it represents what the world wishes they could burn in 2025 … the question is still “where you gonna get it?” or “if you can’t get that much, who will afford it?”

  18. RayJ

    Eric H,
    When wholesale prices started rising in California in spring of 2000, San Diego residents felt the pain first because their local utility had already paid off their stranded costs and could therefore pass along the wholesale costs directly to their retail customers. It did not take long before some price control was put into place; the utility borrowed to purchase wholesale electricity, held down the retail price for customers, and recovered the difference over a longer period of time. While San Diego was only about 20% of the deregulated CA market, it showed what would have happened in the rest of the state if retail prices where allowed to fluctuate with wholesale prices. I agree that the crisis may not have been as severe as it ended up being (e.g. a utility would not have gone bankrupt) but it would have still been painful. It remains to be seen whether government will take a hands-off approach and let the market and the economy handle the shock if oil prices spike for an extended period of time.

  19. odograph

    Do economists have any tricks to tell us if $60/barrel oil is signal or noise? Trend or volatility?
    It seems kind of like passing the buck to ask (yet again) for the geologists to go get rich and prove the trend 😉

  20. RayJ

    You are right about the crux of the argument. From a risk management perspective, the Hirsch report is arguing that hedging by taking some action now will be cheaper than the potential cost of dislocations to the economy. They also believe that the cost of the hedge is not that large and that the economy can afford it. Of course, if the amount they recommend spending is of the order of magnitude of the cost of a peak oil induced price spike, then it will not be worth doing.

  21. JDH

    I see this as a conceptual issue, not semantic. The core message of the Hirsch report is the claim that markets will not respond to this problem. The point of my post is that this represents an assumption, with no supporting analysis or evidence, rather than a conclusion of the Hirsch report, and that the authors don’t even recognize that it’s an assumption in part because of the fuzziness with which they use the expression petroleum “demand”.
    T.R., I welcome everyone into our sandbox, and have no objection if non-economists want to use the phrase “petroleum demand” to talk about something other than what economists would mean by that expression. My only request is that, if you do so, you need to define the expression. Don’t tell me, “everybody knows what it means,” because I’m telling you, no, I don’t know at all what you mean by “demand”. I offer one definition in my post of what I think you probably mean, but if that’s not it, then give me your definition.
    And I won’t settle for some vague references to “maintaining our standard of living.” The object you’re talking about is a quantitative measure with physical units. You should be able to give me a precise quantitative definition of that object if you want to use the expression “petroleum demand.” If your definition is conditioned on a particular level of income and price (as I’m suggesting it should be), then tell me the income level and price that you’re assuming, so that we can all be clear about what you’re assuming and what you’re concluding.
    Using terms without defining them is an invitation to confuse yourself and everyone else.

  22. The Oil Drum (heading out)

    I don’t read the Hirsch report the same way as odograph. I think that what it was saying in part is that we have a huge inertia against change in the size and needs for fuel of our current transportation fleet, and that this cannot be turned around in less than about 20 years without significant impact, and that 20 years requires that R&D funds be invested now to find a new answer. Short of having that 20-years, we are in trouble. I believe that the 20-year time frame is reasonable, and I would hesitate to say that the US has a wonderful tech transfer program, since that is a world I live in, and from experience that amount of time from lab to broad use is a good first approximation.

  23. T.R. Elliott

    JDH: I agree that one has to quantify and/or qualify the analysis. And to draw upon accepted terminology (or concepts). And I also highly commend your efforts to focus attention on this issue and to disambiguate where possible. Since I’m dabbling in this issue from both ends–looking at the economic issues and the geological issues–as are many–I’m operating at the intuitive level and will grasp at terms to help quantify/qualify–or confuse, as the case may be. And as a dabbler, I’m not reading something like the Hirsch report with a fine tooth comb–from either perspective, geological, or economic. I don’t have the background, time, nor perhaps interest. But….I do believe what should be happening is that economists read the Hirsch report and work with those in the geological and energy fields (energy production/consumption, etc) to refine our collective understanding of the problem. My fear is that the two communities will continue to speak past one another. There are real problems to solve, or at least to quantify/qualify, hopefully in a way that both communities–or at least segments of both communities–can agree upon. Now that would be progress. The efforts you–and folks like Oil Drum–are making will hopefully lead in that direction.

  24. odograph

    There is huge boulder of inertia, and “where you gonna get it?” is the message that should be spray-painted on its side.
    I think the economists here agree that we won’t be burning 50% more oil in 2025 (yes?) … so rather than goading geologists into investments, they should be telling us what happens next.

  25. Avo

    Many thanks to JDH for these continuing discussions of peak oil. The more people who know about the potential problems we face, the better.
    A small comment on the economics from a non-economist: if the market is really our best hope, should not tax policy reflect this? What tax policies would best help the market find the best possible solution? It seems to me that this is where economists could make a very important contribution.

  26. Eric H

    RayJ – Quite right about San Diego (and it seems to me like there were one or two other rural providers that had paid off and were likewise deregulated). It was painful, but at least SD customers had the proper motivation to back off on the quantity of power demanded. Unfortunately, the San Diego market did not dominate the state demand. Seems like I remember that buildings in LA and SF were leaving their outside architectural lights on throughout the crisis period (though peak output hours don’t occur at night). But let’s remember that the building of electric generation facilities on the basis of predicted future demand was not exactly guided by the price mechanism, either.

  27. knzn

    All this talk about the definition of “demand” is obscuring the more important issue: if Hirsch is right in substance (particularly in what he implies about the consensus of geologists), then why are oil futures prices so low? If Hirsch is right, you should be able to buy 7-year futures and keep rolling it over every 7 years until the price of oil skyrockets. You may have to invest some money along the way, but eventually you’ll be a gazillionaire. Either (1) Hirsch is wrong; (2) oil traders are stupid; (3) there is an imperfection in the oil futures market; or (4) it is expected that substitutes for oil will become available. I wish that people would specify which of these they think is the case and why.

  28. Allen

    How much different would current demand for oil be if countries such as Nigeria, India, and others remove their pricing controls on oil?

  29. Nathan

    JDH, you say
    “So now I think I’ve got the picture. The price stays stupidly frozen for ten or so years, and then all of a sudden starts shooting violently upward. Readers of my earlier remarks or related points made by Steve Verdon will know my opinion about this idea.”
    but in the ten or so years before the 1970 peak in U.S production, prices did just that. Prices stayed low after the 1970 peak, but that was because there was a substantial supply overhang.
    Similarly, there was a peak in gas in the U.K section of the North Sea, but prices for most of the 90’s were the equivalent of $20 or less. They are now around $100.
    Is this the kind of market efficiency you are relying on?

  30. Jon

    First, another great post, Professor Hamilton…
    Okay – couple of points: First, how many times have we “been close to running out of oil”? At least 3 or 4 that I can think of….absolutely YES, the PO crowd might be right – this time – but when they’re talking about unilateral forced changes via the heavy hand of government, I sure as heck like to see a whoooole lot more “proof”.
    Second – governmental interference as a “solution”. Can I just say “GAAAAHHHH”? Higher prices are what drive innovation and the market is the best mechanism for finding and promoting new innovations. Goverment sponsored/supported/subsidized innovation is not responsive to market needs/demands and funnels monies away from areas it would be productively used. How often do “bad” governmental programs die as opposed to corporate ones? Think of it this way – there’s a *lot* of money potentially at stake here – esp if the PO crowd is correct. Would you rather have a single and fixed vision of the future, or a thousand companies constantly battling each other for a piece of the pie? I’ll go with profit seekers every single time.
    Third – the PO crowd ought to be celebrating the current “high” (And still way less than inflationary adjusted peaks) prices b/c it IS forcing conservation and innovation: There IS economic incentive to find new ways to use oil efficently and from new sources such as oil shale as well as making alternative power sources that much more viable – which in turn, attracts more money to them.
    Fourth – PO is at best a moving target – if prices do double and treble from the current level, how many of the readers here will use the same amount of gas as they currently do? Obviously, demand will drop and when demand drops, the supply timeline lengthens out. Assuming a constand rate of demand is not only silly, but downright dishonest.
    Look – PO people can be justifiably worried about a lot of things – and if they *are* worried about the financial impact of rising crude oil prices, then they ought using the means at their disposal to hedge their perceived risks – just buy Dec 2009 futures – which at the time of writing ar $59 poer barrel.
    Me? I’m going to worry about keeping governmental interference at an absolute minimum.

  31. RoyYoung

    jb wrote:
    “Having said that, there is a futures market in oil, with 7(!) year futures options available. Why are 7-year oil futures still priced in the $30 – 35 range, given what you guys ‘know’ to be true about peak oil?”
    When I checked the Nymex screen today, Nymex WTI contract for 2011 is over $58/bbl! There has been a fundamental shift in the futures market in the last 6 months that is different from the (now outdated) heavy backwardation shape some people are referring to.
    Energy market Profs have recognized the following facts:
    1) The Saudis have not been able to increase output in meaningful amount to put a lid on crude price hikes.
    2) Demand from US and China is far more robust than anyone thought possible under $50+ crude price.
    3) OPEC understand point 2)and has moved their long run upper price band target from $30 to $40 or may be $50/bbl.
    4) Instability in ME, VZ, and RU means the risk of supply disruption is far greater than over supply.
    Take away the semantics, I think the bottom line is that marginal cost to increase world oil production capacity is much higher than in years past (infinity if we have truly reach peak oil), so it will be difficult if not impossible to maintain reasonable rate of economic growth while maintaining current rate of energy consumption (Energy Consumed/GDP). So the choice is either lower future econ growth rate, or lower rate of energy consumption per unit of output.

  32. odograph

    Jon – do you think governmental interference is at an absolute minimum?
    I think the government’s project of lower oil prices has a significant effect on our preparedness for anything else.
    It is kind of sad to look at their price projection (figure 11, bottom left of page 9, in the pdf):
    They were wrong about prices falling in 2002, so they just try again in 2005 …

  33. Jon

    Odograph wrote:
    “Jon – do you think governmental interference is at an absolute minimum?”
    I wish! The hand of government is everywhere – from the SPR to road subsidies for suburbia to directing alt fuel research – which rewards certain projects and punishes other on merits other than their financial viability. (The financial viability of the campaign contributions is of greater importance…)

  34. Hal

    With regard to futures markets, “jb” asked above, “Why are 7-year oil futures still priced in the $30 – 35 range?” I just wanted to point out that this is wrong, 2010-2011 futures prices are in the $55-60 range. But the basic point is still true, the market is not forecasting a big price rise between now and then.
    In fact, as Prof Hamilton has explained in the past, with a commodity like oil that is relatively cheap to carry over into the future (either through storage or simply by pumping it more slowly from the ground) you will never see a major price premium going forward in the futures markets (what futures traders call “contango”). Prices six years in the future are never going to be a lot more than they are today. This is another way to see the falsity of the assumption in the Hirsch report that prices will only shoot up as we hit the peak. In fact they will increase years ahead of time.
    The big question in my mind is whether the high prices we see today are actually a reflection of that phenomenon, fears of future shortages. JDH had an article on the topic last month I think showing some statistics which suggested that this is not what is happening, but I need to go look at that again.
    JB also makes a good point, which Prof Hamilton mentioned in his last sentence as well. Taking regulatory steps now on the assumption that PO is a near term crisis can be very harmful if the assumption is wrong (as the markets suggest it is). For example, many Peak Oilers call for increased oil taxes in order to discourage consumption. They don’t see that this will make the country poorer and leave us in worse shape to withstand the eventual consequences of an oil shortage. Taxes distort investment flows away from the economic optimum.
    Just as an obvious example, increased oil taxes could reduce travel and car purchases and send airlines and car makers into bankruptcy. The shock waves would ripple through the economy and cause other businesses to cut back. Venture capitalists would have less to spend and private R&D would be reduced due to belt tightening. The result: less research into new technologies, some of which might turn out to be crucial for dealing with PO and other future problems.

  35. Jon

    Odograph – up thread you wondered “what happens next?”
    I have no idea – nor does any honest person. Sure, it’s fun to speculate and wonder – but a lot can and will happen over the next years – and this is precisely *why* I want the markets to determine our path, rather than the government dictated solution.
    Where would you rather put your money on the best result for a liquid (!) future: The limited vision and slow movement of a government program or a thousand rapaciously innovative and greedy companies constantly morphing and changing to new monetary opportunities?
    Me – I don’t believe in economic Creationism – give me evolution every time.

  36. Stormy

    Interesting discussion.
    I would suggest that instead of blaming the Hirsch report for not properly seeing the relationship between price/supply/demand, economists should do that modeling based on geologic factsand I do not consider the futures market a substitute for modeling.
    Yes, if prices rise too high, the demand will abate until prices relax. But what are the economic consequences during that abatement? And what if prices rise again because of continuing decline? Flesh out a real world scenario for a change.
    Geologists are not economists. Economists are not geologists. Nor are economists experts in alternative energies. (Greenspan blithely believes that we can easily tap the vast frozen methane deposits off the continental shelf.)
    And we know that economists will not touch any global warming issues with a ten-foot pole. But the insurance industry will. Ah, yes, the market will handle it.
    In short, economists have little more to say other than, Well, we will just consume lessand the price will abate. Problem fixed. Well, right now, it is economists who are running the show. And frankly, I am not impressed.
    After the Enron debacle, I had to chuckle at Forbes protesting against any new regulations, arguing that, after all was said and done, the market forces did their work. Yup, they sure did.
    Market forces is just as slippery a term as any other. And it seems to be an excuse for hard thinking.

  37. Cerqueira

    I’m not an economist but could anyone explain why the price of oil should remain at very high levels after peak production is achieved? Even at $60 a barrel there are several cost effetive alternatives (e.g. ethanol, liquified coal). None will be able to displace oil in the short term, but then all that is needed is to suplement the production.
    Couldn’t that be the reason for the (mostly) constant 4-7 year future options prices?

  38. odograph

    Jon – I think could draft a wonderful economic strategy working from a blank sheet of paper ;-). Not really.
    Given the current mess (dysfunction) though, I think the better strategy is gentle redirection. Ethanol subsidies may be damaging, but redirection toward efficient ethanol production may be the best redirection we can manage. Hydrogen fuel cell research may be misguided, but redirection toward better batteries may be all that is possible. Etc.
    Most importantly, for this discussion, the DOE’s rosy price predictions and demand curves may be damaging, but maybe they can be balanced with something a little more cautious.

  39. Jon

    Odo – your blank piece of paper works just fine for me!
    Ethanol? Two issues there – A) still a great debate with competing studies as to whether or not it is enery inefficient wrt production and B) the subsidies received “shade” out other alt fuels by reducing the cost of production. If it was/is a viable alternative, it will do just fine on its own. Methinks the ethanol mandates in the recent energy bill have more to do with ADM and Cargill’s contributions than ethanol’s reality.
    The DOE – I agree – they’re likely offbase. But, I’m also thinking a tree falling in the woods – the DOE’s projections have 0 impact on my business – the price of natural gas and crude does and that’s what I watch.

  40. Jon

    When you speak of the Enron debacle – what precisely are you referring to? The tar and feathering of Arthur Andersen during the post-collapse witch hunt? Or some sort of “market” failure?

  41. RayJ

    When PO happens, the world capability to consume oil will still be there if no viable alternatives exist in sufficient quantities. One of the things that will reduce that capability to consume to the actual demand will be high prices (rationing will be another but less efficient mechanism to achieve the same reduction). The big issue is whether 1) the resulting oil price is high enough soon enough to motivate the market response that will solve the problem, or 2) governnment should take proactive action to mitigate the problem.
    PS: Note that I distinguish between the actual demand at a specific price and the capability to consume at, say, zero price. This distinction is similar to that between actual production and the capacity to supply. Apologies to economists if I have not used the correct language:)

  42. odograph

    On Enron, if you ever get the chance to see “The Smartest Guys In The Room” do it:
    I had some business relations with SCE plant production gusy, and what I saw in that movie dovetailed with what I heard from by buddies. The partial-deregulation in California, drafted in part by industry players, allowed tremendous manipulation. They simply shut down low-cost California production, in order to import higher-margin power.
    It drives home the difference between a “deregulation” bill, and a free market.

  43. billy

    Carqueira – according to Matt Simmons, $60/barrel is still considered getting oil on the cheap. why, that’s only $0.18/pint of oil!
    $100/barrel = $0.30/pint.

  44. FishEpid

    Both deliberate disinformation and hidden bias in market information misleading people making expenditure decisions – isn’t that a major component of the problem? Although predictions about the future will always have an unavoidable level of uncertainty, it seems to me that the market price signals could be considerably less biased. For example, on the science side it appears that without signficant technological innovation, the EROI on ethanol is pretty close to a wash. If that is right, aren’t investment decision-makers expecting ethanol to be a major petroleum substitute being misled by the current market signals and government policy, whatever its reason? These individuals range from those deciding on a new car to those deciding on building a new gas station and to the corn farmer buying a new 150 hp tractor at about $700 per hp and so on. On the science side, coal produces considerably more CO2 per BTU than natural gas. In the opinion of far more scientists than not, human source CO2 is driving some undesirable climate change. Aren’t investment decision-makers expecting coal to be a substitute for natural gas in electricity production are being misled by a WSJ op-ed author writing that global warming is theology and not disclosing that he is a board member of one of the largest coal companies?

  45. Jon

    That’s pretty much my impression from the traders I know in the energy business – the partial dereg was an invitation for disaster – particularly since it prohibited any sort of vertical integration.
    A free market it was not – more like a market designed by committee….

  46. Donal Fagan

    Some have written that market forces should steer technology rather than dreaded government intervention. As the US, State and Local gov’ts presently subsidize the oil industry in a myriad of ways, from handouts in the latest Energy bill to paving roads, when should we switch over to these market forces?

  47. Jon

    Now. (Assuming you’re talking about getting rid of oil subsidies…) In fact, the sooner the better.
    Unfortunately, most oil companies have figured out that the real gushers are located in D.C. and don’t cost that much to develop.

  48. Joseph Somsel

    I think of oil as a productivity enhancer. Here’s some hard numbers.
    I drive to work – it takes me 10 minutes each way and costs me a tank a week at $40. My alternate transport is an electric trolley/bus that takes 1 hour 15 minutes each way and costs $55 a week but my employer might buy me a transit pass giving me no out-of-pocket costs.
    I save over two hours a day by driving at a cost of $40 per week plus wear and tear on the car.
    So how does that affect my productivity? Rather than sit on a bus, I work overtime. At $80+ an hour, I gross $160 a day extra or $800 a week. That $40 in gasoline earns me $800 a week, a 20 to 1 win before income and sales taxes. (OK, so I don’t work 10 hours everyday, just most days. Likewise, I could take public transport AND work OT but I got a life! Marginal utility of time?)
    That’s why I’ll continue to buy gas (or whatever makes my current or future car run) – this demand won’t be economically destructed for some time. That’s why most economies will continue to buy liquid transportation fuels at much higher prices – it’s the productivity leverage.
    China and India hope to capture this productivity boost by using petroleum too. Unless they can find an equivalent booster, they are going to “demand” oil too because it is one of their best ways to spend their incomes.

  49. M1EK

    “They don’t see that this will make the country poorer and leave us in worse shape to withstand the eventual consequences of an oil shortage. Taxes distort investment flows away from the economic optimum.”
    Taxes to assess externalities are an assistance to, rather than a distortion of, the correct operation of the market. Certainly there are a ton of subsidies today keeping the suburban motoring lifestyle cheaper than it ought to be, from restrictive zoning laws preventing urban infill to oil exploration subsidies to military adventures. At a bare minimum, a gradual tax for “global warming externalities” would help overcome some of this past structural misinvestment.

  50. muhandis

    Relating to the original post by Prof. hamilton:
    “…I suppose that if one did have the view that demand was something that just grew on its own without any regard to the price (as this study [Hirsch]seems to me to do), the claim by economists that supply will always satisfy demand would seem profoundly bubble-headed…”
    BINGO!!! I believe that with respect to the models used by US DOE EIA and IEA (Paris), this is exactly how they work. A long-term price is assumed fairly flat for models. Long-term economic growth (consumption) is based upon the averaging of past growth rates. It is also assumed that there are sufficient reserves and that a higher price triggers the next tier of slighly more costly production. So, bubble-headed could be a good description of the modelling process. (I realize that the models are more complicated that this, and that there are plenty of cavaets regarding the assumptions, but…)
    How bubbleheaded is it? In the 1998 IEA long-range forecast for world oil production, the middle east is shown as peaking around 2016ish while the rest of the world is shown peaking about about 2012ish. The gap between known supply and expected demand (for a happy, prosperous world economy) was made up with an ‘unidentified non-conventional’ plug. Since then, the ‘non-conventional plug’ has been replaced with Saudi Arabia/Middle East with no new discoveries and no technical justification. Meanwhile demand growth and matching supply continue the same trend as the past. These models do not address the implications of price shocks and demand feedback mechanisms, and essentially results in a politically ideallized forecast, not a range of realisitc scenarios.
    Now keep in mind the that the ‘unconventional oil’ in the 1998 forecast is just a balancing item!!! It is unidentified! See Fig. 3.9 of
    compare this to fig. 3.4 of where middle east becomes the balancing item.

  51. gillies

    “Do economists have any tricks to tell us if $60/barrel oil is signal or noise? Trend or volatility?”
    reading all of the reactions to the beautifully written argument that began this thread – i am starting to suspect (a) that you should never take investment advice from someone who is consumed with the rightness of a single particular idea. and (b) peak oilers seem to be strongly materialist – peak oil is the ‘real’ fact that cannot be denied, while investment, production, storage, manipulation, obfuscation, politics and speculation are somehow ‘unreal’ factors that can be disregarded.
    one way to distinguish trend and volatility is simply to take the gently but steadily rising long term average of the real price (inflation adjusted) of oil. i believe it now lies at around 40 dollars / barrel. so to gamble on a price rise you must already commit yourself to pay a massive premium, even today.
    looking back over 35 years of the oil price it is clear that the ‘unreal’ factors are the ones in the driving seat.
    as with all markets – the day that everyone says without exception, ‘oil has to go up’, is the day that the market has to turn. meanwhile my own speculation would be that oil is going to $40 via $70, or to $30 via $80, or to under $20 via over $90.
    you have heard the ‘peak oilers.’ they are pedestrian and literal minded materialists. this is from a ‘spike oiler.’

  52. Jon

    Hey Mi3k,
    Good to see you’re alive
    You bring up some excellent subsidy examples – am thinking it might be interesting to split them up in terms of “pure oil”/gas related v general transportation. Example – roads can be used by vehicles using pretty much any sort of “fuel” (Other than legs – bikes, highways and all that) – whereas subsidies for oil exploration and quite possibly/probably military adventures, are fuel specific.

  53. Prakash

    The hirsch report is based on a simple model which gives a “wedge” to every oil alternative. The wedge is basically a supply graph that is first a flat line at zero, which is the time it takes from the information is received (“oil price is mighty high! Its going to remain high!We can go ahead and build that oil alternative”) to the first drops of oil coming out from the alternative source ( he considers coal to oil, gas to oil and enhanced recovery – dismisses biodiesel (my favourite!) ). Then, it is a straight line going upwards.
    First of all, i have to admit that he is thinking of “demand that would sustain our way of life” and not the more economically correct term. However, i don’t hold that against him.
    In essence he considers 3 scenarios – wedge begins at time of peaking, wedges begin 10 years before peaking, wedges begin 20 years before peaking. He says that in the first scenario, “we’re hosed, major time.” Second scenario is “struggle, but will survive, have to adjust to lower standard of living, though” Third scenario is “least cost in terms of dislocations, etc.” Pls. note that items in quotes are my words. I was just thinking of catchy lines to describe an academically very detailed report.
    Prof. Hamilton’s point about future markets CAN BE INCORPORATED INTO THE HIRSCH MODEL. The existence of 7 year future markets just changes the scenarios by 7 years. And, probably 5 years is a better model because the oil price volatility may be too high for the 7 year contract.
    A 5 year future market would give additional lead time of 5 years in every case. Effects will be mitigated likewise. Demand shortfalls (again talking about “demand that will maintain lifestyle”) will be MUCH LESSER because the last 5 years of production will bring in much more oil than the 5 years before them. Sorry, can’t explain it graphically in comments!

  54. Joseph Somsel

    M1EK wrote: “Certainly there are a ton of subsidies today keeping the suburban motoring lifestyle cheaper than it ought to be..”
    So we pay our taxes to governments to support the commonwealth – taxes are certain, the question is what do we get back?
    In the specific case of my transportation, the local transit authority only takes in 10 cents in the fare box for every budgeted dollar. I’m subsidizing the public transit system that is useless to me.
    I’m also “subsidizing” the gasoline delivery system to pave and police the roads, prevent piracy on the high seas, and give a tax break (perhaps) to the oil companies that make it all possible.
    In so far as I can see, “subsidizing the suburban motoring lifestyle” looks like a clear winner. Might that conclusion change? Of course, but we should always remember that things are the way they are for a reason.
    Taxing externalities sounds like a great idea! But who determines what is an externality and how much should we tax it? I’d be glad to see a tax on greenhouse gas emissions; one honest reason is because I would personally benefit, unless the tax were too high. It’s a slippery slope.
    As to proactive substitutes, Henry Kissinger argued against the Synfuel Corporation back in the 70s, saying that we could spend billions on shale oil development that the Saudis could bankrupt with a twist of a valve. Perhaps the Saudis no longer have that power but conventional oil’s proposed replacements remain a huge bet. I don’t remember the SAIC report offering estimates of the capital required to balance oil depletion.

  55. Donal Fagan

    Joseph, I calculate that gasoline currently costs between 4 and 16 cents a mile. At my firm, we are reimbursed 40.5 cents per mile, so I tend to use that as the actual cost of driving a car. I would assume it costs somewhat more to finance, insure, repair and drive an Escalade than an Elantra, but with the SUV subsidy, maybe not.

  56. M1EK

    Why am I not surprised?
    In fact, the direct user fee (fare) for driving is usually zero. Zero percent. Zero dollars and zero cents. The gas tax is not a user fee, as I pay it when I’m driving on roads which don’t get any funding from gasoline taxes. Tolls are the only thing that compares directly to transit fares.
    Overall, the subsidies to motor vehicle use are far higher than that to transit customers. This is, like some of your more technical stuff on nuclear power, my area of expertise; so I’d advise you not to bother on this one.

  57. M1EK

    “roads can be used by vehicles using pretty much any sort of “fuel””
    problem with this counter-argument is that the vast majority of all spending on roadways is for the benefit of the suburban commuter. For instance, you wouldn’t need the typical 6 lanes of a exurban arterial to support bike riders, transit users, truck deliveries, etc.; huge cities in Europe get by with trivial amounts of pavement per capita.
    Far simpler to just account the whole lot as a road subsidy. If they want to switch to user fees, I guarantee you your local bike riders and transit users will come out way ahead, given the tons of property and sales tax spending on suburban automobile commuters.

  58. T.R. Elliott

    Gillies: I agree in some ways with your single minded comment, e.g. beware the snake oil salesman. But you are still wrong enough. I worked at QUALCOMM, for example, a company with a single minded focus that bowled over a TDMA/GSM assumption that was considered a done deal. I think your comment lacks due consideration of what really happens in the worldsingle minded focus brings about change. What is the track record of economists in predicting the future? Are economists better investment advisers? Do they manage their money better? Im not picking on economists, but Im not going to ASSUME that they are any better at telling me what will happen. Sorry, but I really am interesting in this peak oil issue from an economics and geological perspective. And I think you are putting words in the peak oilers mouths. Do peak oilers not believe in unreal factors? Thats silly. Of course we do. But when did OPEC start colluding on oil prices? It was when the US approached/reached a geological peak. Economics and politics do exist within an environment, dictated by the laws of physics. Geology must also be considered, as must entropy. And energy efficiency. And the problem that large numbers often produce a qualitative as well as a quantitative difference. The past is not always a predictor to the future. Whale oil arguments are not necessarily a clue telling us that as oil production peaks, there will be alternatives.
    For the commenter who anonymously pointed out that peak oil discussions bring out the masses for uh discussion I would love to know specifically what you had in mind. My own perspective is that this is a case, peak oil that is, in which a broader range of peoplemany of whom are of sound mind and with very honorable and deep analytical backgroundshave taken notice of something that draws them into the dialog, whether in an economics forum or elsewhere. I think this is good. If the intent was to imply that this discussion should instead take place within the economics sandbox I referred to earliergreat, but that just means economists will continue to publish their papers within their sandbox, talk amongst themselves, and perhaps that makes them happy but Im not sure it achieves the goal thatperhapsJDH has considered when contributing or commenting on this discussion.

  59. Anonymous

    Gillies – I enjoyed your comment, even as a Peak Oil moderate. My best guess (not certainty) is that we are in for tighter supplies from here on out. I may change that opinion … when I figure out what’s wrong with the “oil depletion” argument.

  60. Jon

    Perhaps my point wasn’t clear enough – it was wrt to subsidy on oil v subsidies on alternative fuels – NOT transportation sectors per se.
    Highways are currently primarily used by cars burning gas – but can also be used by cars using diesel and biodiesel and electrics and whatever other forms of propulsion that might arise including meth-fueled hamsters. The fuel itself doesn’t matter – and a road subsidy is NOT the same thing as a direct oil subsidy: Should a viable oil/gas substitute suddenly appear, the roads will still be used.
    But yes – you do make a fine point wrt to subsidies for the structure overall – much as another commentator felt that mass transit subsidies didn’t work to his benefit – and both are fine examples of why and how subsidies distort.
    Which leads back to splitting up subsidy talk into fuel-specific v overall transportation. Of course there is some/a significant amount of crossover – however, there is also a fair amount of separation as well.

  61. M1EK

    “But yes – you do make a fine point wrt to subsidies for the structure overall – much as another commentator felt that mass transit subsidies didn’t work to his benefit – and both are fine examples of why and how subsidies distort.”
    No, they aren’t. As in past discussions with you, you’re trying to equate two actions of hugely different scale because you happen to like one of those subsidies (the big, motor vehicle one) and don’t like the other one (the little transit one).
    They aren’t like two thumbs on a scale. The transit subsidy is a thumb; the single-occupant-driver subsidy is an entire elephant.

  62. Joseph Somsel

    M1EK sayeth: “so I’d advise you not to bother on this one.” An appeal to authority – from you?
    As usual, M1EK, you either miss the point or evade the conclusion. We use our income to create more income and a better life by supporting our government through our taxes. Subsidizing the petroleum industry and hence the road transport infrastructure has been a wonderfully productive investment. In most cases, (not all, and not for always), this has been a much better societal investment than in public transportation systems. I gave a clear, specific example.
    I live within the city limits of the 10th largest city in the US in a three bedroom detached house, with a front and back yard, 7 fruit trees, and a two car garage. My kids can play in the streets and walk to school. Yes, my wife drives them to soccer practice and piano lessions. I prefer this to an apartment with no car and taking a subway to work, perhaps like Europeans with half the per capita income. Petroleum supports my preferences so I support government policies that supports petroleum.
    I will further support prudent government policies that intend to continue that productivity advantage and my preferred way of life in the face of petroleum supply depletion.
    In spite of Mr. Elliott’s hard-on about my whale oil jest, he has a good point – there are limits to understanding the world using an economist’s paradigm. Economics is just one way of looking at the complexity of how humans survive on this planet. Useful, yes; omniscient, no.
    Thanks again to Prof. Hamilton for encouraging and facilitating these exchanges.

  63. M1EK

    Oh, and I forgot the key relevance: the entire road network subsidy issue is important because without it, the US economy wouldn’t be so irrevocably tied to cheap oil. $100/barrel will hurt us a lot more than it hurts the French or the Germans, and it’s NOT because of nuclear power.
    Looking at expensive oil and continuing to subsidize suburban sprawl like we do is difficult to characterize as anything but moronic.

  64. Jon

    Not sure how much more clearly I can state this – but I’ll try again.
    I don’t like subsidies. Period.
    I don’t like little ones. I don’t like big ones. I don’t like them for trains and not for planes. I don’t like them, Mi3k I am. I don’t like them for green eggs or ham.
    But then again, from our prior discussions, you already knew that.

  65. Jim Glass

    Just asking, but does anyone remember how just six short years ago everyone in the oil indsutry was bewailing how prices were out of control on the *down* side — with oil at single digits/b in the USA?
    “To better understand the producers dilemma let’s look at a year end snapshot. On December 29th IPE February Brent closed at $10.61 and NYMEX February light crude closed at $11.70. On the same date one of the major crude oil marketers was offering to purchase crude for as little as half that amount. The table shows some ranges for posted prices….”
    And remember how the oil companies were slashing, budgets, production, people, human capital in response?
    Is it really more credible that the price shift from then until today is due to “peak oil” suddenly making itself felt for the first time in 100+ years — or that this is yet another example of the price of oil being *volatile*, as can easily be seen by eyeball…
    … due to the standard, long-known process of supply responding to demand with a delay. “Volatile” of course meaning that price goes down too.
    That happening when the second half of the lag cycle kicks in as sharp price increases produce the standard result of restraining demand while bringing forth increased production…
    Here’s something else I’m just wondering about: People are seeing “bubbles” everywhere these days — has anyone at all speculated about one in oil prices? It seems to fit the bill for a bubble by both economic and psychological standards.
    Economically a bubble supposedly occurs when money is loose but the CPI doesn’t rise so price rises have to push through in some kind of asset: stocks, Japanese bonds, land, houses … why not oil?
    And psychologically a bubble is supposed to be supported, when the price of an asset suddenly shoots way up from the long-term trend, by a lot of people believing that from now on price can *only* go up … sure the price has always been volatile in the past and fallen after similar rises by normal economic rules, but from just now on, from this moment, things will be *different*, there’s a special new reason that applies only now, as it never did before, so prices will only go up!
    Sounds like oil is as good a candidate as any other for bubbledom to me.

  66. Jim Glass

    “Would a palm tree futures market have saved Easter Island from a sudden economic decline war and cannibalism? That’s not simply rhetorical;”
    Well, a functioning market for trees sure would have kept Easter Island from running out of trees, assuming they had value to the natives. For if trees grew scarce the tree owners would have had the powerful incentive to increase their wealth greatly by preserving their appreciating tree stocks and growing more as fast as they could.
    Of course if there was no market, but only a commons, and the chief warlords simply gave the orders to cut all the trees down to help build their religious statutes, or to pursue their cannibalistic wars or whatever, well then the trees would be gone.
    But to attribute that to some kind of market failure would be, frankly, a rather stretched bit of rhetoric.
    If one equates the chief warlords with the political forces and governmental powers that be, it would seem rather more like the political-governmental powers running over the market, stopping the market from what it was trying to do, with them acting on the tragically costly conceit that they knew best.

  67. muhandis

    Here is a question: is it realistic to assume only supply responses to increasing petroleum demands–i.e. demand is increasing so let’s increase supply, but not price?
    If it is realistic, then the IEA and EIA models previously referrenced for 1998 and 2002 world energy outlook are infact not ‘bubble-brained’.
    Otherwise, the official EIA and IEA forecasts for world petroleum demand are just political garbage, as they fail to account for demand-price responses.
    I think that depending how one answers the question, it might help shed some light.

  68. Jon

    Good question about “ridiculous”. I’ll start the guessing with “It makes for a good quote”.

  69. Jon

    Well, the press is rather oily at times, even if that is a crude statement. Writing stories is probably not all it’s cracked up to be – they’ll just have to drill a bit deeper, otherwise they’re just carbon copies.

  70. Stormy

    Regarding your request for clarification re Enron: Market transparency, the separation between analysts and sellers. Forbes comment stunned me. Free markets work best with real transparency. And yes, regulation is required.
    The rest:
    I, for one, think that some services should not be privatized: Water, roads, electricity, sewerage, and the military for starters. Some parts of the world should not be up for saleor privatized.
    All this talk of subsidies seems a bit loose. I am not quite sure how we identify subsidies. But be that as it may. Using the rather loose definition of subsidy, I would suggest that businesss misuse of the environment is an enormous subsidy. So has been our unwillingness to insist on pollution controls regarding the car. This list could be quite extensive.
    Regarding Kissingers remark that the Saudis could easily have stopped Synfuel with a twist of valve: Hogwash. Tax systems are there to make choices. Blame our own choices, not a Saudi valve. Kissingers remarks were political; they remain political to this day. He now has the Saudis for clients.
    As a matter of record, according to Simmons, by being reasonably good world citizens, the Saudis have accommodated the worlds desire for cheap energy. Perhaps they should not have done so.
    The abundance and timing of oil onto the world stage have made it remarkably cheap, as it has remained to this day. This will not be true for the next generation. Like lazy couch potatoes, we will have to decide what is worth the energy and what is not.

  71. Jon

    Might I ask whether or not you believe Enron broke existing financial laws?
    As for analysts – yes – there ought to be more separation between the analysts and the sell side – but might I also point out that it was an analyst whose name I’m forgetting, that first threw up a red flag wrt Enron’s financial statements? In addition, how exactly should we enforce separation between analysts and the sell side? If nothing else, Enron demonstrates the exquisite need for one to do one’s own homework wrt to price…..
    Yes – “subsidy” is a rather loose term and you provide some fine examples of indirect subsidies. I’ll clarify “direct payments”.
    Such as those to farmers in Central California who receive massive discounts on government supplied water and have little economic incentive to use efficiently.

  72. Joseph Somsel

    “Hogwash”? In the event, Henry K. spoke the truth! (Hard to believe, I know.) Synfuel Corporation would have been overpriced and unmarketable before it reached full production! A waste of billions. Please prove otherwise.
    I do agree with your opinion about infrastructure. Taxes are eternal – wisdom is putting them to use in productive ways, like roads and sewage treatment.
    If you think the EIA and IEA models are rosy, check check the USGS estimates of oil and gas resources. What are these guys smoking?
    You who scoffed (repeatedly) at the whale oil analogy, check out this article tracking whale oil production and prices – peaked at $1500 a bbl in 2003 dollars. A Hubbert Curve for a biological non-renewable resources, here:
    My purpose wasn’t to be an Optimist – I don’t see anything comparable to kerosene in our horizon (and I’m looking hard). Neither am I a Pessimist, building an energy efficient fallout shelter stocked with guns.
    Count me in the “Buckle Down” school – there are ways to make a transition to a post-Peak world, albeit at considerable expense.

  73. Stormy

    Apparently, the laws to which I am referring were loosened some years earlier–Lieberman, I think, was one of those instrumental there. Not sure, though. My memory here is not the best.
    As far as market manipulation in California, I do think so, but I am not a lawyer in this field. I am, however, enough of a citizen to be quite outraged. Perhaps you should ask a Californian. 🙂
    I do think that major power grids and suppliers of power should be government owned; they would then be immune from foolish cost-cutting in the effort to increase profits and would also be immune to market manipulation such as happened in California. In addition, the grid is very interdependent on all its parts. The failure of one private supplier because of negligence can affect all.
    England is a bit ahead of us in deregulation. I suggest the following report based on their experience as of 2003. Deregulation is a mixed bag and often not quite what its proponents say.
    The following site references a number of interesting articles, including ones concerning California.
    In short, I am not convinced that market forces work best in all areas.

  74. Stormy

    If you wish to protect an fledgling industry because in the long run it will protect the nation, then
    Tax the product of the mature industry (oil) so that it cannot crush the newcomer.
    You can’t have your cake and eat it too. And we are talking here about the future of a nation.
    Face it: We are addicted to cheap energy and complain about OPEC whenever they raise prices. (And sometimes it is just a couple of refineries going off line for a bit.)
    OPEC is faced with a curious “market” problem. If they raise prices, then they encourage alternate energy sources. If they continue to turn on the taps, then they hasten the day when their golden goose will be out of eggs.
    I would suggest to you that oil, in this respect, has been a curious problem in terms of market forces: Supply can be made abundant quickly, but that supply has a real life span. In this respect, it has not been a good competitor for other sources of energy.
    Or maybe I should say, it has too good a competitor for other sources of energy. A wise government would have realized this problem and acted.

  75. Donal Fagan

    “Well, a functioning market for trees sure would have kept Easter Island from running out of trees, assuming they had value to the natives.”
    Is there a current example where the market system rewards conservation of critical resources in the face of high demand?

  76. T.R. Elliott

    Somsel: I’m familiar with the whale oil curve (as discussed by ASPO). I’m simply pointing out that many of the arguments I hear are analogies. The Ehrlich/Simon bet. The whale oil/kerosene argument. And the “running out of stones” argument. That’s all.

  77. JDH

    Donal, fine wines are often stored for years in hopes of appreciation. Top race horses get better health care than you do.

  78. Stormy

    Have you read a “A Short History of Progress” by Ronald Wright? Napa Nui writ large–looking at precisely that issue through the lens of all the great, past civilizations. It’s a short and interesting read. But that discussion is outside the range of this blog, I think.
    Regarding alternatives…a number of countries are already pursuing them. It is the wise thing to do. The U.S. has no energy policy but to argue over the Alaskan Wildlife Preserve.
    Major oil companies are now running ads regarding the coming problems with oil.
    Now, the cynical will look at this as a self-serving way to raise prices. I think not. Exxon is positioning itself for nuclear.
    Change is in the air. Too bad it can’t find its way to a certain Texas ranch.
    At least everyone is talking. But then we talked in the 70’s too.

  79. Albert

    Dr. Hamilton: thank you for your response to my last post regarding the article on energybulletin. You pointed out:
    Albert, statements such as the following in the report you cite,
    “to support this doctrine of material consumption, economists must assume that the natural world offers a limitless source of the raw materials necessary for the finished goods that are to be consumed,”
    suggest to me a rather profound lack of economic training on the part of the authors of this report.
    Here, however, is the main problem that has been stated in one way or another: the lack of multidisciplinary approach with regards to the economic effects of Peak Oil.
    I believe a one-dimensional approach/analysis often falls short of giving an accurate picture because often you can have a completely conflicting if not contradictory analysis in another.
    Take, for example, the nature-vs-nuture debate. In one instance, from the scientific camp you have the argument that we are created to have certain traits and it is otherwise impossible to change them (as applied to the issue of homosexuality), vs. the psychologists’ camp that say that certain areas can be influenced at certain times, etc.
    So, my suggestion to you, Dr. Hamilton, is to pick a discipline – any discipline (some suggestions: ontology, history, geology, physics) and allow that to be factored into your overall analysis.
    To the rest of the economics crowd: I’m not asking any of you here to become experts in such fields, but my suggestion is that it would give you a more accurate picture of “reality” as it pertains to the future of our species.

  80. Marty Sereno

    Even a man of wealth and taste still might not be able to power his car with a fine wine or a racehorse (only 1 hp, or about 1000 watts), and so perhaps JDH’s analogy with oil is not perfect (despite how much I like to make analogies).

    You may say, well, we are not so stupid as the Easter Islanders because we have better markets, and we’re not so stupidly enamored of large stone statues on an obviously limited island. I say, the world has a lot more parts than it did on Easter Island, and very few individual people understand even a small subset of them, as is quite apparent from the threads in this discussion. But like Easter Island, many far flung parts of our much larger island are intimately interrelated.

    Find me a person who is an excellent mathematician, a good computer scientist, an economist, an oil geologist, an oil investor, a physicist, a nuclear engineer, a solar cell engineer, a sociologist, a brain scientist, a cognitive scientist, a mayor, and a congressman. Looking back on Easter Island, *we* can easily see what their problem was — from the vantage point of a fossil-fueled jet plane visit, a fossil-fueled airplane or satellite photo, radioactive dates, pollen deposits, and oral histories. Clearly, they had no one who could step back, take in the current picture at the time, together with a few hundred years of their previous history, and then convince their people to do a more sensible thing.

    Many people such as myself think we may have gotten ourselves into much the same situation as the Easter Islanders, but just that we are on a much bigger, much more complex island. Sometimes it can appear that economists are merely priests who are praying that the market will get scientists and engineers to find a solution to our upcoming tight spot. Those of us looking at the science of energy and of evolutionary biology are aware that there is a distinct possibility that our much more complex system could very well run up against similarly unforgiving limits to those that decimated the Easter Islanders — who eventually descended into cannibalism — or to the limits that ‘right-sized’ countless earlier animal and plant populations that unknowingly and unthinkingly overshot their resources. We have gotten to where we are only after many harsh prunings visible in the geological record of the Paleozoic, Mesozoic, Cenozoic, the Pleistocene, and the Renaissance — when perhaps 70 million people perished in the Americas in the century after the Europeans arrived in the Americas.

    When Captain Cook arrived on Easter Island, the few “small, lean, timid, and miserable” residents could only excitedly mutter the word “miru” (timber) to the uncomprehending English speakers on the ships (J. Diamond). If *we* screw up, there will be no Martian cargo ship to visit us, and even if one did, it is likely the Martians would not comprehend our requests for “oil”, which is made from several hundred million year old plankton (Ghawar). Many of us are worried that the market is going to screw up. The genius of the market decided to disinvest in renewables up until 2004. Many of us trying to stand on higher ground think this may turn out to have been a strategic mistake at a crucial turning point in human history.
    I don’t claim to know the best route forward through the forest that includes things like the genius of the market as well as an American public, half of which somehow simultaneously manage to believe in their cell phones (and hence the Maxwell equations), internet browsers, but not evolution. My only heuristics are, try to keep and open mind, don’t ignore history, and don’t rely on someone else to figure things out — all the main points have to be present together, inside single brains.

  81. Patrick

    Certainly, the oil peakers are missing the ‘economic’ perspective, and a good lesson here.
    After reading the Oil Peak advocate Campbell’s description of oil being like beer in a glass, I conclude that Campbell is wrong. Oil is like toothpaste in the toothpaste tube. We will never run out of oil – it will just get harder and harder to squeeze it out.
    He thinks the economic view is wrong and the view of natural scientist is right. but how much oil is there *is* an economic question: It’s a different answer if oil is $10/barrel vs $100/barrel.
    So I have one question for them, or you, since you’ll actually understand the question:
    What is the price elasticity of the supply of oil?
    Sure we know that in a rational world, oil wouldnt just shoot up in a short period of time … but wait, it did recently. Will it fall because we are in a bubble or due to new supply/demand changes? or is this plataeu permanent?
    The differences between short and long-term elasticity is what makes for the volatile market. It’s possible that excessively high prices can cause a crash later (viz. DRAM price/demand cycle history).

  82. muhandis

    I like the toothpaste analogy, but beer and pubs makes more sense from the point of view of sources and field depletion as analogies go…
    I also wonder whether we err by somehow rationalizing costs as absolutes. Is $100 today really the same as $100 twenty years ago? What would $200 oil really mean if we had a period of intense inflation? I would be curious to know what a barrel of oil has cost with respect to loaves of bread and bottles of milk.

  83. Donal Fagan

    Economists must do much better than architects, because fine wine and racehorses are not on my list of critical resources.:-( Somewhere there must be a commodity that applies. I know it isn’t timber, because the government has to regulate logging. I know it isn’t fish, because many fisheries have been depleted. Has the futures market offered any warning signs to the fishing industry?

  84. oil wars

    I dind’t have time to read everything hear but from what I did I never saw the most important word regarding oil prices come up – inelasticity. Demand for oil is very inelastic – that is demand tends to change very little even with fluctuations in price so the price is largely determined by supply – a slight under supply of oil and prices increase dramatically and a slight oversupply and prices really crash.
    The statement in the original post that if oil was selling for $1 then lots and lots of oil would be consumed is false. Does the person think people are going to spend all day driving around in circles just to consume more gas because its cheap. No. Demand just doesn’t change that much with respect to price – it is inelastic. And you can see this by just looking back a few years to when oil was at $10 and consumption wasn’t very different.
    So I keep coming back to it but if you want to discuss oil prices the first thing you have to recognize is the inelasticity of demand for oil.
    BTW, it is also this inelasticity that makes OPEC such a good idea for its member states. By cutting back on production a little you can increase prices a lot and significantly enhance your overall revenues.

  85. Donal Fagan

    Stormy: Thanks, I’m always looking for another book. Amazon loves me, but the wife just rolls her eyes when the packages show up.

  86. M1EK

    “Not sure how much more clearly I can state this – but I’ll try again.
    I don’t like subsidies. Period.
    I don’t like little ones. I don’t like big ones. I don’t like them for trains and not for planes. I don’t like them, Mi3k I am. I don’t like them for green eggs or ham.
    But then again, from our prior discussions, you already knew that.”
    Yes. I knew that you’re equating a thumb on one side of the scale to an elephant on the other side because you don’t want to give up the elephant.

  87. Stormy

    Not even Simmons claims we are “running out of oil,” and he certainly qualifies as a “peak oiler.” There are great quantities of oil still in the ground. Even the Saudi’s can pump for decades yet.
    Yet, Simmons claims that the Age of Oil is coming to a close.
    The following–still in draft form–is an interesting report on Saudi issues. Much of what is said here may be new.
    As an aside, I often thought that the world’s limited refinery capacity was simply a way of making some people very rich. Now, I am not so sure. The issue may be more complicated than that.
    Life in the West is full of subsidies–small and large–that have made life very comfy at the expense of others. Dream on. Those subsidies will disappear one by one…like teeth being pulled.

  88. Stormy

    Peak oil is real–you just have to get a handle on how to define it.
    As an important aside, reports are just in that the vast Siberia peat bog–an area greater than the size of France and Germany combined–has begun to melt rapidly. Within the space of three years, thousands of lakes are appearing where none had been before. This is fast.
    The resulting release of billions of tons of methane could be an ecological landslide. For those of you who have access to the New Scientist link:
    At some point, economists are going to have to sit up and smell…whatever. And yes, the melting of that peat bog is a subsidy…the bill collector is at the door.

  89. Petronius

    Giles –
    Thanks for insulting me. I didn’t know “spike oilers” were so good at stereotyping. I could add that conservatives want to regulate the heck out of everyone’s personal and social life. I bit of a digression from our topic, I’m sure.
    The larger issue –
    Alot of you guys are missing the point. I know the Economist magazine missed the point in their feature expose’ about Oil. The issue has nothing to do with a belief in materialism or our single party system and mega media in America.
    Start what what we agree on. The Sky is Blue. We agree that the oil resource is finite. The question then becomes what will happen to both the local (U.S.) and global economy when the price must rise to lower demand sufficiently enough to meet ever lowering quantities of supply?
    That’s what I want to know. I figure price goes up, but after that I’m not so sure. I see the price of WTI broke $66 today. The media sure doesn’t have a clue about oil prices since they blame “refinery” outages for increases (if a refinery goes DOWN, the demand goes DOWN, not UP). I figure the answer is pretty simple: demand is outstripping supply at the old price points of $20-$40 a barrel. Finding an economist to say that’s the answer is a whole different ballgame.

  90. T.R. Elliott

    Petronius: You’ve expressed my opinions exactly. I understand the economists who say that oil is unlimited (all a matter of price) but that argument, to me, is trite at best and subterfuge at worst. The world consumes approximately 80 mbd of oil. Odds are that the world is going to struggle to jack this production up too much higher than this, and will then struggle to keep it from falling. Shocks based on natural disasters and political disasters will exacerbate this.
    So lets model this. One can then determine the implications. What is the futures market telling us? I dont think anyone really knows. Because nobody knows how peak oil will affect the economy. Hence talking about what the futures market is telling us is like telling me that the experts dont understand what impact peak oil will have, but a million people who also dont understand what impact peak oil will have somehow collectively understand. Ok, fine. Prove that one to me. Or give me evidence that the futures market in fact has a predictive power that we should rely on. Im just not sure. I think the futures market is great. Its an insurance scheme. Insurance is a good thing. But insurance companies dont predict hurricanesI believe they rely on science to do thatand then the insurance companies use historical precedent and other tools to come up with the appropriate pricing. And then the govt steps in to clean up the mess when the insurance companies get it wrong.
    Thats what the futures market is to me. A large insurance scheme. Thats good. But given that humans will only use the available fossil fuels once, there is little historical precedence to tell us how this will play out. Anecdotes and analogies are the best we have.
    In summary, Im not sure how progress is to be made, but Im pretty sure were not advancing much here. Unfortunately, I suspect its the same everywhere. No progress. Except the price of oil this morning.

  91. Ev Verguizas

    So, let’s see if I’m getting this right. The price of oil rises because of …whatever. It could be peak oil(PO) or inoperative refineries, or something else altogether. Demand is decreased in the face of this (presumably because that consumption was inessential or perhaps the consumer just could’t afford it or was able to find an alternative to oil). There will be a (relative) excess of oil. Some will not sell at that price and a lower price will eventually work itself out through the usual market mechanisms.Supply and demand are in synch. Demand then rises, for whatever reason; some oil is sold at the old price but the (relative) scarcity of the oil brings on higher prices. In turn a new equilibrium is reached between the new demand and the existing supply.Supply and demand are in synch. And so on, successively. In the words of Prof.Hamilton, “Supply equals demand today, supply will equal demand in 2025, and supply will equal demand in 2050.”
    There is a principle in informal logic called the “principle of charity”; in a few words: construe your opponent’s argument in the strongest way possible. The reason for doing this is both side’s agreement that we are after the truth and not trying to score points.
    Using the principle of charity I think it is reasonably clear that the concept of demand as used by peak oil people generally is not that used by economists. The question is, from the economists’ perspective: what does it mean? Does it mean anything? I think it is fair to say that PO proponents are trying to address a certain technologically irreducible limit below which, if the availability of petroleum falls, much of our industrial, agricultural, transportation, and even financial economic structure will falter. It is, for purposes of this particular conversation on that limit, irrelevant whether supply and demand are in equilibrium. What matters at that point is more a question of social utility or standard of living. Given a reduced availability of gasoline with its price bid up, Chicagoan John Smith will forego his RECV vacation in Florida. He’ll go to Devil’s Lake in Wisconsin instead.John will pump some money into the economy but, being a rational actor, will spend less than he would have in Florida. The campground owner in Ft. Lauderdale will lose out on John’s rental. The familiar ripple effect will go out. If enough of this happens,and given that oil undergirds our entire economy, you can have a recession or even a depression some time in the future.
    Prof. Hamilton construes Hirsch’s argument, in generous mode, this way: “The price stays stupidly frozen for ten or so years, and then all of a sudden starts shooting violently upward.” I can think of better and more reasonable ways to construe this argument than setting up a straw man. For example, an erosional model in which, in the face of increasing scarcity, supply and demand
    do their equilibrium dance but at lower and lower points on the scale of social utility or standard of living. In this model we would not jump off the edge of a precipice but slide by degrees into that dark night. And that, in fact, appears to more closely mirror the idea that most PO advocates have of the future development of this crisis.
    One further point regarding Hirschs’ formulation of the argument. On p. 64 of his report, Hirsch states,”Under business-as-usual conditions, world oil demand will continue to grow, increasingly approximately two percent per year for the next few decades.” Under business-as-usual conditions! I believe a fair reading of this is that Hirsch is aware that there is interplay between supply and demand but that he is here, as elsewhere in his report, showing that the trendlines for future petroleum supply and for present consumption trends are in conflict. This is a somewhat rough approach but, given the uncertainties of the data, it’s about as good as we can get. Hirsch’s main focus, which is the possibilities of mitigation given different scenarios for the development of the crisis, is well served by the development of the argument.

  92. Playerslight

    Oil wars –
    If oil is inelastic, why wouldn’t OPEC increase the price to $10,000 a barrel? Oil is relatively inelastic in the short term, but experiences increasing elasticity in the long term. I won’t sell my SUV the day gas spikes 20 cents, but if it stays there for a year or two I’m certainly going to re-evaluate its’ necessity. If prices remain high for extended periods I’ll probably re-evaluate my living conditions as well.

  93. Gene Stone

    I did a little calculation relating number of barrels of oil to number of shares of stock outstanding. For example, when buying one share Exxon you have reserve of 3.41 barrels per share; one share of BP gives you 5.6 barrels per share. Canadian Oil Sands gives you 10.9 barrels per 1-unit holder (it is a Canadian energy trust). I am curious as to why more is not written or discussed about huge reserves in oil sands in Canada, some have said it is close to amount in Saudia Arabia. Can you enlighten me?

  94. Paul

    Regarding price elasticity of oil–I recall numbers I’ve seen from the late 1970s:
    10% in short run (e.g. drive less), 50% in long run (e.g. buy more efficient car)
    I have not seen any more recent estimates. Wonder if anyone has newer estimates.
    Regarding efficiency of markets: politics and economics are much different views of reality. Real world much more like Easter island. Look at production on a country by country basis. Much of production is determined at the state level. In some cases such as Mexico the decision is by default based on funds allocated for production/exploration.
    From an economist’s point of view, efficient production decisions are based on the price of selling oil today vs. the present value of the future price is production is deferred. From real world politics(applying to dictatorships as well as democracies), the decision is based on keeping the public happy with the current government RIGHT NOW or, in a democracy, in the time frame to the next election. No successful politician will sacrifice current well being in exchange for well being after his term of office. If you look at the production of countries such as Indonesia or Nigeria, they produce flat out because they could really use the money right now. The fact that the oil would be more valuable in the future is irrelevant. Social stability and satisfaction with the government demands maximum current production regardless of future benefit lost. In this environment, with few producers concerned about the long run, it is quite conceivable to have a high rate of production followed by a dramatic drop off as supplies run out. Historical evidence is showing just such a pattern. A variety of producers have passed their peak production, but continue to produce flat out rather than save some for the future, when prices may be higher. This has been true regardless of whether oil prices are at historic highs or lows. Economic theory suggests that profit maximizing producers should cut back when prices are low. This rarely happens.

  95. Stormy

    Economists have difficulty thinking about this stuff because they deal with tautologies and balance sheets. They simply tell us when the balance is out of wack and tell us how to move money around so that it goes back into wack. (Consume more, China. I dont care if you are getting slave wages.)
    Ev Verquizas,
    The trite examples you give regarding vacation time are a wee bit below the mark here.
    Nonetheless, you present the argument nicely. Is it not time for an economist to reply? Or are they going to insist on consulting their balance sheets and call us all idiots?
    Or is this blog topic just a sandbox for bozos while the real economists are off doing real-economist work, debating the futures market in China, or the latest Fed rate hike?
    Lets put it this way: If transportation energy becomes more expensive, then there will be an inflationary effect on everything transportation affects: not only food but the cost of all those wonderful things our companies put together in underdeveloped countries and turn around and sell to us. (Brazil now sends cashews to India for peelingits cheaper. The cashew you eat has been around the world.)
    All those multinational firms sending parts hither and yon because of cheap labor are going to find their margins cutand cutand cut. Cheap labor has been deflationary. The recent rise in oil, which is inflationary, is offsetting that deflationary trend. In the end, inflation will win.
    In addition, we will see some new thinking regarding globalization. Factories will be nearer the consumer. So will food sources. Offshoring in some areas will have to be brought home. Now, while some of this is good news, extrapolate out a bit. Keep upping the price of oil to see what has to give or be re-arranged.
    Peak oil is hitting just before global warming will really dig its unwieldy toes into the planet. There is not much I can say to those who insist that its effects are the result of left-wing ravings. But even now, the ice roads into Alaska–very very important roads–have less and less of a window each year. And that monstrous peat bog in Siberia is not just for mosquitoes. Nor is the fact that hurricanes are now increasing in intensity.
    Party on.

  96. Peter

    FishEpid understands both geology and economics, yet his post was ignored. David Pimentel writing in Natural Resources Research (Vol. 14:1, 65-76)proved that methanol production (and all other fuel biomass schemes) uses more energy then is available in the resulting liquid. Right now that production is subsidized with cheap petroleum.
    According to FishEpid, misinformation is skewing futures. He said, “If that is right, aren’t investment decision-makers expecting ethanol to be a major petroleum substitute being misled by the current market signals and government policy, whatever its reason?”

  97. odograph

    That’s funny. I was grumpy yesterday and Stormy is grumpy today. 🙂 While I think I understand my own impatience (with the similarity of the last five articles?), I think I should have found a better way to express it. If I could write like Ev, I suppose I would.
    Ultimately I think I need to be patient, and see how this thing breaks. I don’t think anything anyone writes in a glorious PDF report for the federal government, let alone a few paragraphs in a blog comment, it going to tip the equation.
    If this is peak oil, we should see it in the lack of a rebound (the lack of a regression to the mean) in oil and gas prices. Or any fall will be followed by a quick bounce.
    As an aside, I like my Prius ;-). I’m so spoiled by having to buy gas only every few weeks that I feel wounded when I actually have to stop and tank up. Take that you economist Hummer drivers ;-)_ 😉

  98. muhandis

    RE: Canadian tar sands:
    The theoretical reserves might be larger than Saudi Arabia so long as there are massive amounts of natural gas to extract the oil.
    Unfortunately, like the rest of North America, Canadian natural gas is peaked, or very close to peak. Each year a new record number of wells is completed, but production stays flat or dips slightly (ie. each new well produces less than its previous generation). Depletion of existing fields is about 25-28% annually. The next NEB update will be in November (
    Also, one has to realistize that Saudi Arabian reserves are smaller than common believed. After decades of exploration, its extraction relies on a handful of aging wells nearing their half-life.
    So, in the big picture, Canadian Tar sands will help, but not ever be able to off-set peak.

  99. Anonymous

    This is called accumulating or cascading postive feedback. The hotter it gets the hotter it gets.

  100. muhandis

    Please consider that Hirsch has specific terms of reference to work within, these would have outlined some of the assumptions made.
    The business-as-usual scenarios are those of continued economic growth with energy production being entirely supply-side managed. What Hirsch was doing was evaluating the differences of switching from energy being supply side to demand side governed, and what affects demand-side management techniques would have if intiated at different intervals from peak/or the supply/demand switch.

  101. Peter

    Jim Glass responded to Donal Fagan’s contention that a palm tree futures markets would not have saved Easter Island with a) an ad hominem attack (Islanders were peasants without modern economic theory) and b) a misappropriation of so-called Tragedy of the Commons market defense.
    I personally don’t think there are free-markets now, just appropriate rewards for deference to free-market ideology. To adapt Jim Glass’s comment to my analysis;
    “Of course if there was no market, but only a (commons=consensus trance) and the (chief warlords=chief economist) simply gave the orders to (cut all the trees down=use up the oil) to help build their (religious statutes=suburban dream), or to pursue their (cannibalistic wars or whatever=Iraqi war) well then the (trees=oil) would be gone.”
    Sound familiar?

  102. Playerslight

    “David Pimentel writing in Natural Resources Research (Vol. 14:1, 65-76)proved that methanol production (and all other fuel biomass schemes) uses more energy then is available in the resulting liquid. Right now that production is subsidized with cheap petroleum.”
    8655kg = 8.655 tonne = 340.730 bushels of corn/ha (
    340.730 bu/ha x 0.4 = 136.3 bu/acre (probably Pimentel was using 2000 numbers)
    The average bu/acre in 2004 was 160.4, which is 10.185 tonne/ha, or 10185 kg/ha.
    This translates into 39,105 kcalx1000, or significantly more than was shown by Pimentel. This was the first glaring error that jumped out at me when I read Pimentel’s paper that was discussed in the article suggested by Peter. I’m curious how many other skeletons are hiding in his calculations; I’ll have to examine his other assumptions later.

  103. Jon

    2004 was an outlier in terms of corn b/a. This year is projecting roughly to be 138 b/a – much closer to trend line yields.

  104. Joseph Somsel

    Many of these EROEI calcs are flawed since they ignore energy QUALITY. Domestic hot water is a fine match with solar because both are low quality energies. Electricity is the highest quality energy commercially available. “Quality” can be defined as controlled differential temperature against ambient. (There’s more rigorous definitions of course, this is off the top of my head.)
    Canadian tar sands do require natural gas for processing. That gas is only available because there is no pipeline to take it other markets. In the future, that supplemental input energy can be provided by a nuclear reactor providing process heat. Likewise, Venezuelan heavy oil and oil shale in the Rockies could produce liquids using supplemental nuclear process heat.
    For a model of what peak oil might look like, watch North American natural gas. With limited LNG imports, Henry Hub gas acts like world oil, especially of late as environmental rules largely prevent fuel swapping. I know that Elliott disdains analogies but this one has predictive merit.

  105. TCO

    The discussion seems to be missing consideration of cartel/game theory aspects. And how the current war/terrorism threat play into that. (Not saying this is everything in the price or that the geology has no effect.)
    I am an advocate of opening ANWAR, etc. because I hope it will crack the cartel.

  106. Playerslight

    “2004 was an outlier in terms of corn b/a. This year is projecting roughly to be 138 b/a – much closer to trend line yields.”
    Fair enough, although the point I was trying to show was the efficiency aspect of this argument. Agricultural yields trend upwards, production costs trend downwards, and ethanol production is still in its relative infancy. The other thing not discussed in his report was the role up and coming agricultural production areas, like Brazil, would have on this equation. Brazil is still a relatively untapped agricultural production area with a potential for high ag yields, and already commands a good portion of the soybean market.
    Forgive me if I’m a little jaded towards Pimentel, but I had memories of his 1998 paper, where his production numbers came from a paper he wrote in 1991, which came from who knows where.

  107. Peter

    Recent agricultural production increases directly correlate with non-sustainable and ever-increasing natural-gas fertilizer inputs.
    Pimentel’s constribution are the “externalities” in the equation, such as the cost in energy to operate the system i.e. tractor, fermenter, etc. Other studies have merely measured the simple caloric content of the corn.
    All biofuel (and nonconventional fossil fuel) analysis hides current petroleum energy-supports in the infrastructure

  108. Jon

    Actually, the cost of production has been ratcheting up rather quickly the past few years: many fertilizers are oil/nat gas based, diesel isn’t getting cheaper, natural gas is used for drying grain down to storage levels and land rent is escalating again (For several reasons)
    But you’re correct – it’s well worth it to double check numbers – stats are so easily manipulated…
    The interesting point about SA ethanol is that it comes from sugar cane – haven’t seen acres required per gallon of ethanol production comparisons, but would hazard to guess it favors sugar cane over corn. Plus, with the far cheaper land costs it is no surprise that Brazil has a booming ethanol industry.
    One thing to consider with our domestic ethanol production – right now, it is still a blended product rather than a substitute for unleaded. That will change in time, but what this means, is that ethanol usage is heavily tied in with gas usage – many don’t realize that. E-85 is slowly showing up in more pumps – but the blend requirements are using up the lion’s share.

  109. Playerslight

    Thanks for you insight, Jon. I spend most of my time researching agribusiness issues (supply chain management and whatnot), and not enough on more fundamental ag-economics. You’ve reminded me that I have been neglecting that part. 🙂
    “Recent agricultural production increases directly correlate with non-sustainable and ever-increasing natural-gas fertilizer inputs.”
    Are inputs increasing? I haven’t studied this on an aggregate scale, but the few input supply firms haven’t been selling or applying a great deal more fertilizer than previous years. Just charging a bit more for it, like Jon said (and I now recall).
    “Pimentel’s constribution are the “externalities” in the equation, such as the cost in energy to operate the system i.e. tractor, fermenter, etc. Other studies have merely measured the simple caloric content of the corn.”
    I know that’s what he’s doing, but I’m concerned because I don’t know where his analysis is coming from, and what he’s including. How is he separating his fixed and variable energy usage (i.e. energy used within fixed/variable costs)? For example, is he incorporating fuel usage by people commuting to work in the steel mill? Can you see how this ‘estimate’ would continue in perpetuity? Not knowing how he has arrived at these assumptions leaves room for all sorts of mischief. Yes, there is an energy quotient hiding behind our current market, but has he arrived at the right number? Perhaps I should email him for clarification of his calculations.
    All biofuel (and nonconventional fossil fuel) analysis hides current petroleum energy-supports in the infrastructure.

  110. Jon

    Ironically, I’m on the cash trading side of the business – I compete with and sell to ethanol plants all the time…I wish I could pay what they can with their subsidies….
    Most of the producers I work with are using fewer and fewer inputs per year – and using much more efficiently as well. Every dollar not spent is another in their pockets. Herbicide specific seed tech has done some amazing things in that regard – along with GPS based yield analysis and new planting techniques, etc etc. All sorts of correlations out there. This year’s corn crop is going to prove how much genetics have improved over the past few years….
    What SC aspect do you work on?

  111. Jim Glass

    “I am curious as to why more is not written or discussed about huge reserves in oil sands in Canada, some have said it is close to amount in Saudia Arabia. Can you enlighten me?”
    The Athabasca field is estimated at 1.6 trillion barrels — six times what the Saudi’s have, one whole lotta oil.
    The industry considers 300 billion+ of that to be readily recoverable at today’s prices and technology. (Of course this amount increases as technology improves even if prices don’t rise — e.g. if technological productivity increases at a modest 2% a year then in 35 years what would be recoverable today at double today’s price will be recoverable then at today’s price. And if price rises too on top of that like some have been saying … potentially one whole lotta oil)
    Official proven reserves at the prices of a few years ago are 177 billion barrels, second only to Saudi Arabia.
    Production is quite profitable and ramping up. The main deterrent to its development in the past was the high up-front cost that was at risk of not being recovered if the Saudis should drive the price down to around $15 (see 1998). But if the Saudis have lost the power to do that, as so many say …

  112. Jon

    You’d better not be suggesting a class project here!11!!!1 Professor Hamilton just might assign us a bunch of homework….

  113. Hal

    T.R. Elliott, economists don’t think that oil is “unlimited”. And Stormy, economists don’t just deal with tautologies and balance sheets. I don’t see how either of you could hold these beliefs after reading JDH’s many essays on this topic. Where has he ever said that oil is unlimited? Where does he limit himself to tautologies and balance sheets?
    For a good introduction to the economic way of thinking I recommend the best seller Freakonomics by Steven D. Levitt. It’s an highly entertaining and amusing book that shows how the world looks when you think about things economically. There’s not a balance sheet to be found.

  114. gillies

    if the rising price of oil is an indication of peak oil – must we assume that the quantity of houses in the united states is also over the top and in sharp decline ?
    and if the geologists can tell us about future the price of oil, should we ask the men in the quarry about the future price of houses ?
    and how can we be sure that it is the supply of oil which is now in decline – and not the supply of dollars, euro, yen, and yuan which is in record surplus ?
    if greenspan kept moving up the interest rate to twelve per cent, there would be a danger of ‘peak oil’ disappearing altogether . . . halliburton might even have to impose a small surcharge on army laundry . . . .

  115. Playerslight

    I’m working on agribusiness value-chain relationships, especially those between farmer cooperatives and private processing facilities. Basically I am examining the role third party/government funding plays in enticing farmers to work together with other private industries to get off the efficiency/yield bandwagon and into niche/specialty markets. I’m currently in the midst of an M.Sc. thesis on this subject, but I’m not that far into it yet. Just enough to know how bloody big of a project it’s going to be :-).
    Maybe an interesting project would be to take Pimentel’s assumptions on the amount of fuel required to grow a hectare of corn and multiply it by the number of hectares grown in the USA last year, 29,810,000. Pimentel said it takes 88 litres, or 23 gallons, of diesel to grow a hectare of corn. This means it took 685,642,000 gallons of diesel to grow last years corn crop. I’m curious how close that is. Anyone have a source for that sort of information?

  116. Jim Glass

    “Jim Glass responded to Donal Fagan’s contention that a palm tree futures markets would not have saved Easter Island with a) an ad hominem attack (Islanders were peasants without modern economic theory)”
    What an odd definition of “ad hominem attack”: pre-moderns didn’t know modern theory. Take that, Aristotle! Newton! (Mr. Donal calling those Islanders ‘cannibal warriors’ seems rather more like an ad hominem in my mind.)
    Actually, what I said was that if a market for trees didn’t exist on Easter Island, then one could hardly ascribe the dearth of trees there to the failure of the market. That doesn’t seem like much of an ad hominem ether, more like very simple logic.
    Yet don’t we see this illogical construction all the time: “Market mechanisms were *never* tried with X, and X is now a mess, therefore markets caused/ couldn’t prevent/ can’t remedy the mess with X”? Easter Island as just one more example.
    “To adapt Jim Glass’s comment to my analysis; ‘Of course if there was no market, but only a (commons=consensus trance) and the (chief warlords=chief economist) simply gave the orders to (cut all the trees down=use up the oil) to help build their (religious statutes=suburban dream), or to pursue their (cannibalistic wars or whatever=Iraqi war) well then the (trees=oil) would be gone.’ Sound familiar?”
    Your “chief warlords=chief economist” blows the whole thing. Economists only *dream* of having the power of a warlord. But other than that… Well, yeah!
    If Bush decided to save himself in an election by ordering the military to destroy all the Redwoods so terrorists couldn’t hide in them, or by using them all as rollers while building giant monuments to his Creationist God, then those trees would be gone.
    But to blame that on a failure of the market would be pretty dim, eh?

  117. Jim at The Energy Blog

    Gee, I didn’t think a rather innocent post would play a part in this much debate. My comments on the Hirsch Report still stand, but should be expanded. The importance of the report is 1) since it was prepared for DOE, it should increase the awareness of the consequences of declining oil production, especially to congress and the administration 2) it clearly explained the consequences if adequate measures were not taken to mitigate the decline in a timely manner and 3) it gave a very good explanation of the technologies that were available to mitigate the decline.
    Regarding supply and demand, I believe both sides of that debate have been expressed very well. My concern is, how much of a change in our standard of living will be caused by shortages in supply. At some price, probably above $85.00 a barrel the general population will start to take the problem very seriously and take strong conservation measures. I only hope that their are enough hybrid and plug-in hybrid vehicles available at that time so that we at least have a viable alternative for our personal transportation. My own point of view is that $85.00 will be reached in 2-3 years and will remain at that price or go higher until we get some alternative transportation fuels. I see no way that supply can keep up with the consumption that most Americans are used to.
    Refinery capacity rather than oil supply will probably limit supply in the next five years. But oil is currently being produced at record levels and how long that rate of production can be kept up is questionable, let alone meets the increased desires of consumers as population increases and developing countries try to increase their standard of living.
    As has been widely discussed, the energy bills largest omission was not including new standard for vehicle mileage. Conservation is the largest single thing we can do to mitigate the high fuel prices that accompany decline oil production. This program would cost the government almost nothing.
    The energy bill does not appear to have taken adequate measures to do much of anything about peaking as Hirsch tried to point out. It places its emphasis on 1) subsidies for the oil industry, which does not need and subsidies 2) continues and expands the funding for the hydrogen economy, which may eventually pan out, but not it time to avert the short term (next 10-15 years) consequences of declining oil production 3) includes funding for nuclear power plants, which might have some use in the hydrogen economy. If you are following that line they may make a little sense, not to me.
    The bill does continue the clean coal program which I think is necessary and a better alternative than atomic energy. A small part of the coal program is coal liquefaction which, as Hirsch points out, could play a huge role in mitigating the decline of oil. This is proven technology which has not been used in the US and we cannot wait for market forces to encourage it. Only a small part of the funding for a couple of large demonstration plants is needed. The time required to build these plants is too long to take the risk that we do not have modern technology for these plants in hand. This is much more important than the subsidies and tax incentives for many other programs.
    R&D spending for biofuels was increased incrementally. I defend the present and future subsidies for these fuels. Pimental does not get the picture. For years he has taken his position based on technology that is outdated. Ethanol from corn or biodiesel from soy beans may or may not have a positive net energy balance. See Shapouri at, for the other side of the story. We do not have enough land to grow enough corn or soybeans to make fuel in the massive quantities that we will require. Developing technology, which improves the energy balance and permits large scale production of ethanol by making the ethanol from any cellulosic material, is on the verge of being demonstrated and the language of the energy bill was changed to include this technology in the definition of biofuels. In the meantime the current technology is being improved every year and deserves support. The infrastructure required and acceptance of these fuels is worth the cost of the subsidies. They should not require any federal subsidies if the price of oil remains above $60.00
    A start up company is beginning to market a process that grows algae from the CO2 in power plant waste, thus reducing greenhouse gases. The algae is then used, in proven technology, to make biodiesel. Whether this startup can make it on its own, time will tell. If we could make biodiesel from algae, which seems very likely, it could alone solve all of our transportation fuel problems and DOE has been remiss in not following through on earlier programs it had on this technology. For those of you who are interested I have a blog on this technology at
    Regarding the tar sands, there are technologies, being used by some, that obtain all their energy from byproducts of producing tar sands oil. In the short term getting some of our oil from tar sands may help mitigate very short term deficiencies in oil. The potential reserves are huge, but only a small portion can be exploited with current technology. Big oil is getting involved, so they may find a way. But even if the waste of natural gas is eliminated, there are still problems with water usage and the environmental mess made by the mining methods that are used.
    I thank anyone who has read this far and hope that you have gotten some insight on my view of The Energy Revolution.

  118. Jim Glass

    “Is there a current example where the market system rewards conservation of critical resources in the face of high demand?”
    All around you. The giant ecological/pollution disaster that was Eastern Europe at the fall of communism, and which will be being cleaned up for generations, happened where there was no private property. What did those governments care what they polluted? It didn’t cost them anything. There was no market in that land.
    If you mean something smaller like conservation societies might recognize (if they were willing too) sure, lots. The plunge in the elephant population in South Africa was dramatically reversed by putting them in parks where operators and local townspeople profit by showing them to tourists — thus giving them an incentive to protect the elephants and their habitat. Now there’s an elephant glut in SA, it’s literally giving them away and preparing to cull them, because they can’t support all they’ve got.
    Market fisheries are a big success. Etc.
    “I know it isn’t fish, because many fisheries have been depleted. Has the futures market offered any warning signs to the fishing industry?”
    Yikes, yet *another* example of a ‘there is no market with X, and there’s a problem with X, thus the market is failing X’. Sheesh.
    C’mon, the most basic point about market mechanisms seems to be being missed here. You can’t have a market in something unless somebody owns property rights in the thing.
    Who owns the fish in the sea? Nobody. So anybody can just sail around and take out all they want, that’s why ocean fisheries are depleted. Who owned that land that Eastern European industries so awfully polluted? Nobody, so there was nobody motivated to stop it. Who owns the elephants that are still be decimated in other parts of Africa? Nobody, so nobody has an incentive to organize to protect them. Who owned the trees on Easter Island and had an incentive to protect them and grow more… ?
    If you want something to be protected give people an incentive to protect it — like an ownership interest of some sort. Absent that, don’t blame the market for your problems.
    Now, one might ask your own question from the other side: is there an example of any finite supply commodity or resource (which is all of them, of course) that has been and is traded in markets, that the world has ever run out of to our cost? (Copper’s been traded an awful long time, whale oil … you name it).

  119. muhandis

    RE: TCO, “…because I hope it [ANWAR] will crack the cartel.”
    What cartel? If you mean OPEC, it hasn’t been a cartel for years. Each member is pumping flat-out and cheating on quotas. Quotas keep being raised to close the gap with what is being produced.

  120. T.R. Elliott

    Hal: Just to clarify, when I say “unlimited” I’m referring to the argument that are commonly made that increasing prices and substitution will make oil tantamount to unlimited because there will be no financial incentive to pumping out that which remains. All well and good, but I think it is misleading and this argument is often misunderstood by the public. Freakonomics does seem to be something to put on the reading list, but I’ve read significantly in macroeconomics, monetary theory, and have looked at rebuttals of economics like “Death of Economics” “Butterfly Economics” and “Debunking Economics” to ensure I understand contrary positions. I’ve also looked a bit at ecological economics arguments such as Daly and Lutz. Freakonomics seems more on the sociology end of the economics spectrum. Interesting, amusing, but more than that–I’m not sure. Monetary theory, in my mind, is where economics has made the greatest contribution. Many of the instruments developed for the financial markets also seem quite valuable.

  121. charles matthews

    “Supply always equals demand”- a strong restatement of efficient market theory.
    With all that implies.

  122. Z

    Imagine a shop that sells food ( food is energy btw ), but there’s only enough for 50 people. Now there’s a hundred hungry people waiting outside to buy some. Let’s look at the consequences :
    1/ Economic theory : The shop owner raises prices so that only 50 people can eat. The 50 other die of starvation ( demand destruction ) but that’s no big deal. Everything is dandy.
    2/ Human theory : There’s a riot, deads everywhere (including the shop owner ) and the shop is looted.
    Homo sapiens sapiens =/= Homo economicus
    I find it rather amusing that the more the price of oil rise, the more we have peak oil related articles on this web site ( to deny any problem, of course ).

  123. Z

    You mean IF peace breaks out.
    In case you didn’t understand, my little parable is exactly what is happening now in Iraq. That’s also the meaning of the Carter doctrine. I wonder why all these politicians don’t believe that the ‘market forces will save us’ ?

  124. Davidyson

    There are at least four types of “demand”:
    – The economist’s demand – which ist always equal to supply (or vice versa)
    – The current overshoot demand – which is the demand people would have on the basis of the prices they *expected* when they made an investment (“I’ll buy the SUV because with oil prices at $25 a barrel, I can afford it – oops, now it’s $65 and I can no longer afford it, so I have to sell it at a big loss” – same principle applies for industrial investments)
    – The extrapolated demand – which is the demand in a business-as-usual-scenario without demand destruction.
    – The demand/supply that is needed to keep the economy growing and the standard of living at at least the same level. This demand is obviously a function of the technological and social efficiency of our societies. These efficiency coefficients are in turn a function of time, energy invested and, most importantly, the physical and engineering laws (predominantly thermodynamics), which usually behave according to the effect of diminishing returns.
    The economist’s supply/demand equation mainly generates volatility, as long-term developments and external factors are not very well taken into account. Markets are far from perfect and subject to all sorts of wild distortions.
    The current overshoot demand is what produces actual economic hardship for people in the short term. It can also be expressed as the (negative) surprise about the price development.
    The extrapolated demand is a completely fictional number which can only be used as a reference value to judge whether we will have to deal with more or less than a “business as usual” scenario.
    The needed demand/supply is most difficult to number, but the “realest” one in the mid and long term. Prices lowered by demand destruction might satisfy an economist, but, as in the food example above, might actually cause real world hardship for people. If the demand destruction is drastic enough, the hardship might actually cause a recession or depression, because the economy can no longer grow, shrinks, and a vicious circle begins. At some point the energy price gets low enough for the economy to recover and the cycle begins anew.
    As for the alternative sources of energy:
    – You have to invest energy to research them, and if you have found something viable, to deploy them.
    If markets only react when we have passed peak oil, mitigation will first *contribute to the problem of less available energy*!
    – All engineering meets diminishing returns at some maturity point. In some areas the point is reached quicker that in others. For some suggested energy solutions, physical limits tell us that it will never ever get very usable, no matter how much money we throw at it. Solar cells, for example, have been know for decades, but even with the current quite large level of investment in R&D, the cells currently sold at any sort of realistic price have no more than 10-15% efficiency (still they pay back the invested energy wihtin 2-7 years).
    – The is no guarantee at all that we will find an energy source that is better than or even equal to oil. Actually it seems that the probability is very low. Still, many people believe that humankind by the use of market forces will find the technological solution in time to give us a continuous business-as-usual scenario. It perceive this as very naive. Yes, there are some things we can and must do, but hey, I have not yet seen a single, even best-case, model of how to compenssate for the drop in oil supply in time.
    A link, anyone?

  125. Donal Fagan

    So oil is safe because someone owns it, and it is part of a market, which keeps tabs on it.
    On BBC yesterday, Talking Point, in response to a caller question (Have we peaked? When might we peak?), Dr Adnan Shihab-Eldin, OPEC’s director of research, said that Peak Oil predictions were inaccurate because they ignored revisions for the current reserves (“you improve your understanding of the current fields”) which could extend the peak 30-40 years or, with tar sands, further maybe until the end of the century.
    That would be great, but how does the market judge whether OPEC is telling the truth? Simmons tells us that OPEC doesn’t open their books for outside audit, and it seems pretty clear that they have not responded to the latest price hikes.
    In fact Simmons tells us no one even bothered to tally of actual reserves before he started his research.

  126. Miles

    Quite amusing.
    Once upon a time paper money was underwritten by gold.
    In a modern economy it is underwritten by energy, with enough cheap energy of sufficient quality one can do just about anything. You can mine copper out of your backyard.
    If you convert all our energy sources into equivalent barrels of oil, then you can go on the oil standard.
    This gives a much clearer picture.
    So when the oil supply declines, wealth is being removed from the economy.
    To change to an alternative technology takes years, at least 20 years, probably 50 years. Do markets anticipate well 10 years into the future? It takes a lot of barrels (oil standard) to replace the infrastructure. If we have a reduced supply of energy we can not replace the infrastructure, the roads, the airports, the airplanes.
    To put infrastructure in perspective consider the ashphalt road. These roads need repair, resurfacing every 20 years, 5 years with heavy use. So we need ashphalt to repair them, but ashphalt comes out of the oil barrel, supply has declined so it is not available. Okay we can use concrete instead, so we need to dig sand and limestone, so we need new machines, we need to transport the sand and limestone, energy to make concrete and we need to transport it to where it is put down as roading. All of which takes more barrels of oil, but we have less. Ouch thats the problem.
    So if we want to move to say a dominantly electric powered economy we need to build our nuclear power plants whilst energy is readily available. Remember it takes about 7 years to build a plant, there is a large investment (more oil barrels, we are on the oil standard) in transmission lines, distribution etc We need then to invest in research on batteries, electrify public transport and so forth.
    Otherwise one day you will go down to your garage, say fill her up, the attendant will say, thats $1000 please. In fact the garage may be closed because not enough customers can afford the prices… Welcome the new depression!
    Oh yes, fertiliser takes energy, barrels again, will you be able to buy food. If nothing else it’s food for thought.

  127. Joseph Somsel

    One major thread of thought is that we need to look at central planning solutions. No doubt, this is a worthwhile exercise.
    But the genius of the free enterprise system is that billions of people are continously hussling to make themselves a better deal, or at least a less bad one. A change in the physical supply of oil will produce the same result. Many of us are already planning ahead.
    My outfit, TBM, has new and better reactors on the drawing boards, as do our competitors worldwide. They are all passively safe and less capital intensive. Even the efficiency is up a tad. The team with the best design wins the sales (usually) and gets the bigger cubicals and free donuts on Fridays so we’re trying hard!
    Toyota, Ford, GM, etc are rushing higher fuel economy autos and trucks to the market. Light bulb manufacturers are making more efficient bulbs. The list goes on.
    An era of really cheap energy is passing. While some of us think we’ve squandered it, I see we’ve been able to make huge investments in knowledge, social cohension, infrastructure that will prepare us for the world ahead. It won’t be easy, but mankind has faced and met worst challenges before.

  128. PVanderwaart

    There are two likely explantions for the absurd attempt to counter a broad, conceptual arguement (peak oil, declining oil production) with a narrow technical arguement (definition of demand), either PhD-itis or political pre-conception. Whichever it is, the economic argument is badly flawed.
    Supply is only guarenteed to meet demand in a free market, and the energy market is highly regulated on both supply and demand sides. Demand can, and does go unmet when prices are not free to move. Easily understood example: when supply does not meet demand for a hot toy at Christmas (e.g. Tickle Me, Elmo) retailers do not raise the price, they just go out of stock. Some customer demand is met, some is not; the customer either waits, or chooses something different. (That small numbers of items change hands at higher prices on the secondary market is not important.) The toy market is regulated by public opinion: Target, for example, must avoid the loss of good will that would result from raising the price of the toy to “market” levels.
    The same phenomenon is present in the energy market. CAFE standards, for example, distort the market. Car manufacturers earn less ROI on high mileage models than on low mileage models, indicating a rationing of big low mileage cars. This translates into an unmet demand for fuel.

  129. odograph

    With fair warning, I’m sure businesses and individuals could make their choices: between new technologies, increased efficiency, or just paying the freight. Judicious government programs could probably help that process, but I’m with those who are cynical about how judicious such programs can be.
    Toyota, Ford, GM, etc are all making cars for other markets that value efficiency higher. Given sufficient customer demand, I’m sure management inertia could be overcome.
    The disagreement in this thread, and at the level of policymakers, is what constitutes fair warning?
    I guess the grumpier among us might even see some things (hydrogen economy) as a sop to avoid warning … we’ll see.

  130. odograph

    “Car manufacturers earn less ROI on high mileage models than on low mileage models, indicating a rationing of big low mileage cars.”
    Yup. A common refrain in the US is that big cars and SUVs have a higher profit margin. They market “upward” for that reason. Too bad the couldn’t figure a way (like BMW or even Mercedes) to craft a small and expensive model.

  131. knzn

    PVanderwaart: There are any number of reasons why supply might temporarily fail to meet demand in the spot oil market, but these market failures are not severe enough to undercut JDH’s basic point. The oil futures markets are essentially free (except for limit moves, but those are only temporary). Whatever else you may believe, you must concede that “insufficient supply to meet demand” would eventually lead to a very large increase in price, unless price regulation is so extreme as to border on insanity. If peak oil is imminent, why don’t the oil futures markets anticipate rising prices?

  132. TCO

    Questions on futures market. If a future is at $60 at one year or at 5 years. Does that mean that expected value of oil at that point in time is 60 (that year) dollars?
    So a constant dollar future (given no deflation expected, some inflation expected) would actually indicate a lower real dollar expected value? And would indicate that anyone holding oil should NOT stockpile it since it will not only lose real price value, it will have no time use of money return?
    To all those people saying the market might be wrong: Sure it might, in either direction. Unless you have insider information, why would you advocate that in effect the government invest in oil futures (speculate to the upside, by building alternative capacity and the like). Of course, even given current expected prices, arguments could be made that the government should take actions such as changing the rules to allow refineries, drilling etc (in effect the externality becoming less important).
    One can also make arguments that there are certain types of technical research that the market will not finance because the values realized are too diffuse (inadequately patent protected or too short a term of patents, yada yada). I don’t see anyone advancing the supports of such a sophisticated argument though.

  133. knzn

    TCO: The relationship of futures prices and expected spot prices is complicated and not universally agreed upon. For most markets, it is considered “normal” for futures prices to be even higher than expected spot prices, because buying the futures essentially allows you to “virtually” finance and store the commodity at no cost. I gather, however, that the oil market tends to exhibit “backwardation”, where futures prices are typically lower than the spot. The usual explanation for backwardation is that people who expect to own the physical commodity (e.g. oil producers) are willing to sell futures at low prices in order to hedge their risk (so they don’t have to worry about the possibility that prices will unexpectedly go even lower). All this is small potatoes, however, compared to the potential impact of peak oil, if futures traders expected that scenario.
    One point that occurred to me is that oil markets are probably assuming a certain amount of government intervention, so the free market argument (in its extreme form at least) depends on the market not only being free but being expected to be free. In particular, among other things, oil markets are probably expecting that the government will subsidize the development of alternative forms of energy, thus reducing the expected price of oil.

  134. Z

    “If peak oil is imminent, why don’t the oil futures markets anticipate rising prices?”
    You mean like the markets anticipated the dotcom bubble bust ?

  135. Max

    JDH: “How much oil is demanded at any given time depends, among other things, on the price… demand always equals supply.”
    Jim Glass (referring to Canadian tar sands): “…if price rises too on top of that like some have been saying … potentially one whole lotta oil”
    JDH: Demand EXCEEDS supply when 1) supply can not be increased at ANY price as with post-peak oil, AND 2) when your precious Substitution Effect breaks down because there are no substitutues for oil in many applications. Note that in Dafur demand for food currently exceeds supply and the problem has nothing to do with price. Economics is subject to the same laws of physics as everything else as well as being woefully incapable of dealing with sociological issues that affect economies. Dismal science indeed.
    Jim Glass: The EROI of tar sands is currently 2 barrels equivalent oil invested to 3 barrels equivalent oil extracted. That ratio is expected to decrease as the easy stuff is mined first. Once EROI of tar sands reaches unity, it cannot be energetically gotten at any price. There is an upper limit to your “whole lotta oil” and it has to do with — again — physical reality, not price.
    Yes, I’m an engineer, and yes, I intend to take JDH up on his challenge to buy oil futures options if we get a pullback.

  136. RayJ

    TCO writes: “Unless you have insider information, why would you advocate that in effect the government invest in oil futures (speculate to the upside, by building alternative capacity and the like).”
    Actually the government has invested in oil futures in a big via the Strategic Petroleum Reserves (SPR). It probably cost about about $20-30 billion to fill it up but at current sport prices is now worth about $40-45 billion. I am sure some economists who believe the government should not intervene in markets would think this was a bad idea and that the money could have been better spent on tax cuts. Obviously many other people think this insurance against a sudden drop in oil supply is money well spent. I would like to hear JDH’s opinion if he is still following this thread.
    Joseph Somsel writes: “One major thread of thought is that we need to look at central planning solutions.” and goes on to extol the virtues of the free market. My position, and I think many would agree, is that both government led central planning solutions and free market solutions are needed. Let’s not forget that the current fission based nuclear industry started off as a government program just as the most of the current research into nuclear fusion is government led. On a forum like this, people tend to focus on what they think the government should do because that is the area where policy can be influenced.

  137. Joo Carlos

    Okay, I am not an economist and I am near the geologist side here (I am a biologist, so I know hard science better than social science).
    But I see that there some issues that the geologists are saying that the economist aparently don’t get any hint until now.
    First, the geologists afirm that the Oil Companies and OPEC countries are lieing about the oil reserves and future oil production. Well, oil companies lied when Hubbert foresaw that the peak oil at the continental USA was to happen between 69 and 72. We see the geologist saying that the current reserve numbers that the OPEC countries give us are lies. And if any profession have any hint if the oil companies and OPEC countries are lieing IMHO are the geologists, so IMHO it is reasoable to think that the oil companies and OPEC countries are really lieing.
    Now, if the Oil Companies and OPEC countries are lieing we have an information assimetry situation and we have a not perfect market to crude oil’s futures options. So, future oil prices will say nothing if there is a peak oil next year or 20 years from now, because the information assimetry make the futures options market go brind.
    Second, if you look the hypothethical peak oil graphic at Wikipedia (“Hubbert Peak”), you will see that the oil production will get to a peak and start to go down fast. The oil production will not get flat before go down, the oil production will go down immediatly after the peak. So, if we consider that diferent energy sources need time to build up the infrastructure we can be sure that will be too late to try change the energy infrastructure if we are one or two years before the oil peak. Remember that from the point #1 above that future markets cannot predict WHEN the peak oil will come because there is information assimetry, so it is possible that is too late and that the oil peak will happen this year or next year (AS SOME GEOLOGISTS ARE SAYING WILL HAPPEN).
    Third, the Huppert Peak model (see hypothethical graphic at Wikipedia) predict that before the peak oil come there is a small time period where the oil production will grow lower than the oil production grew some years before. I am not an economist, but IMHO if the oil production start to grow slower (something the model predict will happen just before the peak oil) the oil prices will start to go up constantly. After the oil peak the prices will start to go up EXPONENTIALLY because the production will go down exponentially. Today the crude oil price is $66 the barrel and IMHO is reasonable to think that the oil price will go up to $70 or $80 when the winter come to north hemisphere. IMHO, the price pattern we see today is compatible with the time period that come just before the oil peak.
    Finally, about new thecnologies that will save us from disaster: I don’t believe at teeth faries…
    Sorry the bad english, my native language is portuguese.

  138. Max

    Playerslight: “Why wait for a pullback?”
    Good point, especially since the relationship between option premium and spot market price is nonlinear.

  139. Playerslight

    “Good point, especially since the relationship between option premium and spot market price is nonlinear.”
    Do you have a paper I could use to read up on that concept? I’ve seen it (in passing) used in the electricity market, but I’d like to know more about it.

  140. knzn

    Max: “Demand EXCEEDS supply when … your precious Substitution Effect breaks down because there are no substitutes for oil in many applications.”
    Not true. Those applications will simply stop. There is some price of oil at which any given application, if it cannot find a substitute, will no longer be profitable and/or feasible. In that case the application will be halted, and demand will fall until it equals supply. To take an extreme example, if people in cold climates can’t afford oil, can’t move to warmer climates, and can’t find substitutes for oil-derived heating fuel, they will simply freeze to death. Dead men demand no oil.

  141. Jon

    The simplest place to look would be the Black Scholls model….the amount of premium paid on the option is really dependent on the price of that particular underlying future – NOT the spot price. There may well be a spread ratio between the spot and back month, but those are nonlinear for a variety of reasons – such as time, liquidity, seasonality factors, etc.
    The relationship between the option and the underlying future is, for the most part, dependent on time to expiration, volatility of the underlying and whether or not the option is in or out of the money – and by how far.
    Since we’re talking long-distance calls that are a long ways out of the money, any interested buyers really just ought to step up to the plate and buy them – whatever they might save thru a pullback won’t be that much given the odds of them flat out missing the trade if they’re correct.

  142. Jon

    Are you aware of the differences between the futures markets and equity markets? Not sure if your comment was meant to be snarky or…..

  143. Max

    knzn: “Not true. Those applications will simply stop. There is some price of oil at which any given application, if it cannot find a substitute, will no longer be profitable and/or feasible. In that case the application will be halted, and demand will fall until it equals supply. To take an extreme example, if people in cold climates can’t afford oil, can’t move to warmer climates, and can’t find substitutes for oil-derived heating fuel, they will simply freeze to death. Dead men demand no oil.”
    Okay, I see where you strict econo-centric thinkers are at, and your extreme example is apt. But debating whether demand falls due to prohibitive price or due to irreversible supply decline is a chicken-and-egg exercise and relevant only to academics. JDH criticizes the Hirsch report for its loose usage of “supply” and “demand” as you criticize me. When Hirsch says that “supply will fall short of demand,” all of us [who are not economists?] know what this means: THIS CAN’T GO ON. In nature, exponential growth is almost always followed by exponential decline. I have no problem with JDH pointing out Hirsch’s incorrect usage of econ terminology — after all, this is an econ forum and it’s his econ forum. What bugs me is the singling out of a minor point in a report whose major point is the consequences of oil depletion. I think econs need to admit that there are real problems that the market cannot fix. Fixating on a technicality seems a bit disingenuous.

  144. PVanderwaart

    One thing that I don’t understand is why opinion on the net energy yield from agriculture-derived alcohol is so mixed. Aside from the fact that considerable number of years of US experience, there is the experience in Brazil where a significant percent of liquid fuel is alcohol.
    KNZN: I’m not responsible for the futures market. However, it is clear that in 50 years or so, petroleum production will be considerably lower than today, and it is not clear how the fuel shortfall will be replaced. I think that we can agree that if it is not replaced, the international economy will adjust by massive contraction.

  145. Jon

    Closing call prices a/0 8/12/05 for Dec Crude 2009.
    The future itself closed at 59.65 per barrel.
    A few selected calls:
    $60 = 9.23
    65 = 6.05
    70 = 3.72
    75 = 2.15
    80 = 1.23
    90 = 0.39
    Therefore – for those who assume we’ll see $100 or more….pick your poison. A $60 call will net you, assuming a $100 expiration, over $30 per with a $9 cost. A 70c would get you 27 for less than 4. A 90c would show almost 10 for 39 cents.
    At that’s just assuming a $100 close – and no pricing above or early exiting (Just trying to keep it simple….)
    All you have to do is figure out which gives you the best risk/reward ratio according to the metric you choose.
    BTW – let’s not forget, that adjusted for today’s dollars, the peak price for oil is about $95 per barrel…..about 50% higher than the close of today’s spot price.
    These are financial facts – how you utilize them and why is entirely up to you. The market economy gives you this option, as it were, to hedge yourself and make money thru buying risk from those who wish to sell it.

  146. Playerslight

    I know I’ve been bugging you quite a bit, but I’m very interested in this topic, one I know little about. Although you’re currently working in this field, and therefore not in need of books and whatnot, can you suggest a good primer on learning about the options/futures market? It can be mathematical, advanced, or introductory, but I would enjoy something fairly rigorous and comprehensive that I could chew through. My other coursework has prevented taking a course in this, but I think I should know something about it, given my eventual degree. Plus I find it fascinating, and incredibly useful to the agricultural sector.

  147. JDH

    Max, we also talked about this issue of whether it’s just a semantic point earlier in this thread. I don’t agree with you that it is just a matter of terminology. I think it’s a substantive issue of when prices will respond to these forces and how those price responses will change the outcome. The peak oil community seems convinced that prices won’t do anything until all of a sudden we’re past the peak. I think they’re led to assume that in part because of the language and framework that they use to talk about the issue. That’s not a semantic concern, it’s a question of what is actually going to happen. I’m saying not just that Hirsch is using the term “demand” incorrectly, but that, because he is thinking about the nature of demand incorrectly, he’s coming up with the wrong picture of what’s going to happen. Whether he wants to use economists’ term “demand” or not, the economic concept of demand is, I’m arguing, the correct one to use.
    What’s going to happen in my view is that prices rise well before the peak, meaning that consumption does not rise at the rate Hirsch assumes, meaning that the peak does not come when Hirsch assumes, and meaning that the preparation for the peak is more complete than Hirsch assumes.

  148. Jon

    How technical do you want to be? There are a number of tomes of achingly detailed analysis about options pricing and there are also many, many which give good overall basics – and for 90% of people, good enough is enough. Options are a fiercely competitive market, so I wouldn’t worry too much about the “fairness” of a price – altho a price can tell you a great deal about what participants “think” of the market overall. But it is good to know the basics of time and beta (How much the option moves relative to the underlying – when the underlying is at the strike price, the beta is .50).
    Have a couple of books at home whose titles I’ll look up for you – been in the futures markets for 20 years now, so my knowledge is primarily war-won – but I’ll try to post those titles later.
    And yes, an understanding of how ags (Or any future) is priced, who participates in the market and why would be very useful on your side. Example – I’m long crude oil right now since I have to hedge my shipping costs: the cash loss I’ll take will be offset to some degree by the gain in the futures. Not enough ag people use these tools.

  149. qizba

    Let me try to weigh in on this discussion. I can understand that adherents to the laws of economics will probably correctly argue that changes in price will always insure that supply and demand remain in balance. It’s not even really a matter of economics; the laws governing the natural world show us that consumption of a given resource (demand) cannot possibly be greater than the availability of said resource (supply). I think even a child could understand that you couldn’t eat three bags of potato chips if you only had two. Price is just a mitigating factor in what is essentially a natural equlibrium. However, oil is not quite like potato chips. Oil is the basis for just about everything we’ve come to consider as normal in industrialised societies. The lifestyles enjoyed in industrialised societies require a certain amount of oil, and if that oil is no longer available, either through restrictive price increases, the peaking of global oil production, or (likely) a combination of both of these factors, changes in lifestyle become necessary and inevitable. It is true that price can insure that supply and demand remain balanced, but at what cost? If industrialised socities and economies can no longer function as they presently do due to high oil prices, then I would say that constitutes a crisis. If memory serves me, the US currently consumes approximately 18 million barrels of oil a day, of which about 60% is imported. That is the amount of oil the US requires to function as it presently does. If that oil is no longer available due to price increases or scarcity, then the US cannot continue to function as it presently does. That means that some industries and individuals have to go without or get by with less. I don’t think any economist can accurately predict the social, political, or even economic ramifications of such a scenario. Yes, supply will always equal demand, but a decrease in demand in industrialised socities would be disruptive and traumatic in the short and medium term. Who in the industrialised world would like to volunteer for a decrease in his/her daily allottment of fossil fuel energy? I certainly didn’t see Bush or Cheney’s hands raised.

  150. Joseph Somsel

    Yep, most people here are TALKING about energy. Maybe I should get back to work DOING something about it….
    Yes, we need both policy and the hustle of free men. It’s just that I see as a train of thought in too many peak oil enthusiasts that government imposition of solutions is the only way we’ll deal with the problem (draconian CAFE, for example). I’m much more heavily weighted to free market solutions. As I’ve admitted, the nuclear power business is in bed with the government. Our big problem is that we haven’t found a way to them get out!
    I would note that the civilian nuclear power industry does have its roots in the Manhattan Project. Some of the scientists and engineers involved were so excited about the peaceful uses of fission that they worked on power reactors in their spare time.
    After the war, many jumped into the civilian side of the Atomic Energy Commission which had a very interesting reactor development program. For many years, only the government could OWN fissile materials so private inventors had to beg the government for permission AND materials.
    Much good groundwork came out of the AEC efforts, including our current light water reactors. Did you know that the base technology of the pebble bed reactor was developed for the nuclear rocket engine that was to take us to Mars?
    All this talk about the predictive properties of oil futures is misplaced! A “future” is a financial instrument to help traders. If you want a real market forward price curve, look at going long – equity in oil in the ground that can be brought to market.

  151. Jon

    Why do you assume there is no room for subsitution and efficiency? Are you personally using the absolutely least amount of oil you can without “affecting” your lifestyle? Etc.
    IOW, there is a tremendous amount of oil consumption that can be “saved” when prices makes it “worthwhile” to do so.
    Think about it this way – why did Chiese demand for oil ramp up so suddenly? Why did they choose oil rather than other sorts of energy sources? Are they operating at peak efficiency?
    BTW – I’ve voluntarily raised *my* hand…and if you haven’t, you’ve essentially said that oil is *under*priced relative to what you consider your return to be.

  152. Playerslight

    “Have a couple of books at home whose titles I’ll look up for you – been in the futures markets for 20 years now, so my knowledge is primarily war-won – but I’ll try to post those titles later.”
    I would really appreciate that, Jon. I will be travelling all next week, so if you don’t hear an appreciative post that’ll be the reason. As for technical level, my only futures/options course was introductory and 3 years ago, so I’ll be crawling at the beginning, but I do have access to some pretty good resources at school that I could tap. I love books written by guys on the front lines, with war-won backgrounds like yourself. I’m sick of sanitized textbooks.
    “Not enough ag people use these tools.”
    Agreed. Considering my research and education is basically in operations management, not enough agribusiness people use decision-aids like linear programming, statistical inventory control, historical production information databases, or–for that matter–computers in general. All ag grads at my school are given rudimentary training on hedging, but most forget it by the time they graduate, and don’t have a solid enough backing to use it as a risk mitigation device. I’ve met farmers with grade eight educations who would put masters students to shame with their knowledge of the futures markets, but as a sector in general, my general impression is that agribusiness firms don’t use some important tools that would make their lives easier and their profit margins thicker. But enough mental wandering. Thanks for your response!

  153. Jon

    Heh – you must know many of the same folks I do……
    Gimme a couple of hours – but also worth your time to spend a few minutes at a good bookstore (As if it wouldn’t be anyway)
    FWIW, the CBOT and CME websites have decent educational links – a shade dry, but better than nothing. I’m sure if you contacted a local merchandiser such as myself, they’d be glad to sit down and spend some time talking about what they do futureswise and why and who for.
    Something I’ve noticed is that options are one of those things that people either instinctively “get” or “don’t” (Along with short selling) – and many attempts at “education” are met with glazed eyes…..

  154. ERH

    Several Comments from a chemist with more than a passing familiarity with economics:
    (1) Corn-based ethanol is a net energy loser. Sugar cane-based ethanol is superior but could still be an energy loser depending on the production path. Corn-based ethanol producers have succeeded in averting competition from the importation of (largely cane-based) ethanol into the U.S.
    (2) Pure ethanol fueled IC engines may well be superior to those using gasohol if the incomplete combustion products (esp. acetaldehyde) can be eliminated from the exhaust. Ethanol greatly increases the water solubility of nonpolar gasoline constituents. Ethanol/gasoline mixtures can and will facilitate mobilizing toxic gasoline components (e.g., benzene) into the groundwater–certainly a much worse outcome than the current MTBE contamination problem.
    (3) A very political presidency acting in concert with a congress devoid of any scientific and economic capability should not be allowed to select energy sources or conversion technologies–especially when the actors have an average time horizon of 1 3/8 years. Fortunately, this time around only $15 billion was wasted. Prior administrations of both parties did far worse.
    (4) For some the best policy regarding petroleum is to tax it now. Unfortunately much of the tax is being collected by others, some hostile to us. Whether you like this or not it IS the most important component of the Bush energy plan.
    (5) In any event I heartily recommend that those lacking familiarity with petroleum economics go review the literature regarding the marginal costs of the timing of petroleum production. This may not help predict the future but it will surely help you understand the past.

  155. muhandis

    It’s not that there is no room for substitution or efficiency, but limited opportunities. OECD nations have been busy remaking themselves as energy intensive, petroleum dependant societies — meaningful substituations and efficiencies will require significant changes in social behaviour and our notions of material consumption.
    Think of where you live as an individual: what are your energy alternatives to your place of work? How you live? To schools, shops, services? What are your alternative sources of food?
    Essentially less energy means less wealth, which means a lot less stuff consumed. This also means our notion of a happy consumption driven ‘free’-market global economy is heading into a wall, likely faster than most realize.
    So, the economy contracts… and we adapt. The problem will be how easily we can give up our material lifestyle addictions–this is not a matter of economics but of our social fabrics. The urban and rural physical, social and economic infrastructures built over the last 50 years were seldom designed to be energy efficient–they were built for the short-term, for the moment, for profit and egos.
    As an aside, I think the Darfur food-money analogy is good one (apart from Darfur’s inground oil resources lending some irony). So, I guess that in the *most* extreme scarcities or crises, Mr Smith’s Invisible Hand might be that of the Grim Reaper… not a happy thought, but one consistent with history repeating itself.

  156. Max

    JDH: “The peak oil community seems convinced that prices won’t do anything until all of a sudden we’re past the peak.”
    I think that is an unfair reading if not a straw man b/c: 1) the argument that prices won’t move until we’re past peak is clearly nonsensical; 2) PO folks acknowledge the timing uncertainty.
    JDH: “What’s going to happen in my view is that prices rise well before the peak…”
    I could not agree more. This seems self-evident. Consider the famous bell curve (admittedly a simplification). Once it starts to roll over, demand must fall, meaning higher prices. Could be what we’re seeing now — we won’t know until after the fact. I think savvy PO’ers would readily admit that recent price movement proves at most that we may be NEARING PO.
    JDH: “…meaning that consumption does not rise at the rate Hirsch assumes, meaning that the peak does not come when Hirsch assumes, and meaning that the preparation for the peak is more complete than Hirsch assumes.”
    I think you’re saying that it’s a negative feedback loop. Agreed.
    You began by quoting Hirsch: “World oil demand is expected to grow 50 percent by 2025. To meet that demand, ever-larger volumes of oil will have to be produced.”
    If I read you correctly, you cite this quote b/c you think Hirsch is saying that demand increase will remain constant despite price. Again, that would be nonsensical, esp. for someone of Hirsch’s caliber. It’s fair to say that he uses these numbers to demonstrate the absurdity of the 2025 projections of certain agencies. The point comes through w/out digressing into the kind of strict exactitude you seem to think is necessary.
    With due respect, I do believe that you are creating straw men here whether you realize it or not.

  157. TCO

    (Refrains from discussing Econ 101 with people who don’t know it. it’s been done too many times before. And they will misuunderstand even this veiled comment…but that’s because they are like people on the net who argue that quantum mechanics can’t happen.)
    On other points: I guess one of my questions about the “futures” mentioned is as simple as what is it? Is it a purchase now (dollars down now) of a contract that someone else will supply oil at some time X? It’s a little bit different than a stock option, where you pay quantity x for in essence the bet that a an equity will be worth more than quantity y in the future. I don’t really know all this stuff. But the volatility of the asset would drive the value of the stock option, no? Along with the expected value. But the comodoty option would reflect the expected value, discounted back. But I guess the beta of the discount rate would include the effect of volatility? Or not? Is it the same thing? Help…I’m options stupid.

  158. odograph

    Interseting poll just came in:
    “AP-AOL Poll on Gas Prices”
    Note the classic “blame” section (question 3) and the traditional categories for said blame.
    I would have liked to see a “depletion” category of some sort … but can you really “blame” depletion in the sayme way you can blame oil companies?

  159. Jon

    Here are two titles that might be of interest:
    “Options as a Strategic Investment”, Lawrence McMillian. Strategy oriented with an excellent primer on the hows and whys of pricing – without too much Greek.
    “Agricultural Options”, George Angell. Similar, but a bit “simpler”/less complex and with an ag orientation.
    Of the two, I’d go with McMillian hands down – but Angell might be best to read first.
    Beyond these, there are plenty of others you might want to read depending on the direction you wish to head.

  160. Jon

    Essentially, yes wrt to futures. Above I posted the closing price and several call strike prices for Dec 2009 crude. Buying said future allows you to take delivery of X barrels of crude in Dec 2009 at $59.65 per barrel. The money you put down, margin, is going to be roughly 10% of the total cost of each contract. This contract is obviously tradeable and need not be held until expiration – in fact delivery is pretty rare.
    This is quite different than buying an equity or futures option – these give you the right (buying) or obligation (selling) to provide the underlying at X strike price on Y date. Again, these are also tradeable and again, very few ever get exercised.
    Futures tend to be used as I use them: Insurance policies or hedges. Example – I know I’m going to ship 3 million bushels of corn next spring: In fact, it’s already been sold. I don’t know however, what my shipping costs will be as that is set at time of actual shipment (It can be future set, but usually at time of) – therefore, to ensure the profitability of my sale, I need to hedge shipping/fuel costs. Thus, I’m necessarily long crude futures at the moment b/c I’m trying to reduce my risk exposure to fuel price changes. Should the market for crude go down, I’ll take a small loss on the futures, but I’ll gain an equal amount on the reduced shipping costs. The converse is also true.
    IOW, futures are used by people like me to hedge risk exposure – risk of adverse price movements.
    Options – options are indeed priced basis the volatility of the underlying contract. Corn is a much more stably price commodity than soybeans – therefore, it’s options are less expensive all other pricing factors being the same.
    And yes, the discount rate is very much a factor in the Black Scholes model – you have to account for the return of investing your cash in tbills v investing in an option. But since interest rates don’t change all that dramatically (Usually), it tends to not be a huge factor. Strike and underlying price, time to expiration and volatility are the biggies.
    Hope that helps a little bit at least….

  161. Jon

    Actually, I’m acutely aware of the repercussions of price movements – and not just of oil. Perhaps this is due to/why I’m involved in the business I’m in…..
    As for the rest – I guess we’ll have to agree to disagree – I happen to think that socially and culturally, we’re quite able to make fairly significant changes in a fairly short time. People, when they don’t look to a paternalistic government for help, tend to move quite rapidly when their pocketbook is effected.
    Market pricing of electricity and $5 per gallon gas will drop consumption quite rapidly and there will be many, many profit opportunities to take advantage of these switches.
    I wish I still had the link – perhaps someone out here has it? – showing % of income spent on energy costs. IIRC, it’s been in a steady decline, basically forever – and frankly, while there may be some upticks along the way, I’m pretty sure human innovation will continue that trend – even if it is as simple as consuming less energy.
    Interestingly, much of the social “change” advocated by many PO advocates (Not an insult!!!) – an end to suburban sprawl, lessened emissions of CO2, increased public transportation, etc etc – will occur organically as a natural result of sharp price increases in fuel costs. Not only can PO people make money by buying crude futures, but they also get to see the changes they wish to see, made. This is your basic win/win, no?

  162. Hal

    As far as oil options, Prof Hamilton had an article on this a few weeks ago, including links to an online Black-Scholes calculator you could use to decide what the options price should be given your own assumptions –
    I was using the calculator to price some out of the money call options (like $80 or $90 a few years out) yesterday and strangely, it seemed that the implied volatility (i.e. the value you have to plug into the calculator to get the market options price) was actually down a little bit, more like 31% than the 33% when the article was written last month. I guess that means the market is a bit more skeptical about oil continuing to rise than it was a month ago.

  163. Jon

    That’s an excellent point – just for kicks, take a look at crude futures when plotted on a log rather than linear graph….% return absolutely does matter…a $1 move at $50 != a $1 move at $100….

  164. TCO

    So Jon, the price is expected to be 90% then dollars and 10% now dollars (so you have to discount 10% of it forward). I know you talked about this before, but other than this margin effect), the price would seem to be an obligation to pay/buy, no? Is the reasonable interprestation that this is the expected price then? Or is there some option value that must be added, subtracted? (and by which party, the seller or the buyer) And how does this relate to the comments you had earlier about being less than or more than spot…are those rules of thumb or arbirtrage-style expected results?)
    I’ll get the book too. Looking on Amazon. How tough is it? I’m comfortable with Brealey and Myers or Copeland. But not a rocket scientist.

  165. Marcel

    I think that what Hirsh meant by “demand” is simply a projection of “normal” GNP growth rates, with current oil intensities.
    That is, if the global economic system is to perform as expected, then this would be the demand. What Hamilton is saying, I guess, is … “don’t worry, the world is not going to grow as expected”. The system will slow down (with all that means in terms of social and human costs) but we, the rich w’ll get our oil, even if a bit more expensive.
    That’s the economists “solution”. For the rest of us, let’s get on doing something practical, like taking the economists out of our future.

  166. Jon

    Muhandis and others,
    It occurs to me, that one of the issues in/with this thread, is that we’re talking past each other on different levels. Unless I’m mistaken, there is genuine concern with the PO group (Warning, gross generalizations ahead!) that there will be a seismic shift upcoming and soon, with our cultural and economy as we know it due to a lack of energy inputs: That the upheavals we’ll see are going to cause enormous problems. As a result, we need to take action now to alleviate these and to soften the “blow”…(Or something similar).
    Let me just say that this is a *perfectly* valid concern – and you may *well* be right!
    On the other side, the marketeers such as myself see a future where subsitution and market forces will provide a just dandy “solution” – solution being quoted for many of us don’t really see a “problem” per se – as much as a possiblity/probablility of change. In addition, we see prices where they currently are and see a “story” that doesn’t make “sense” relative to that which you are telling – and again, you may well be correct – markets are imperfect: They are only an aggregate of current knowledge.
    One thing that marketeers such as myself do a lousy job of, is expressing the reality of “change” – and I think this might be b/c change is absolutely fundamental to the markets themselves. IOW, b/c change is at the very heart of what a market price is, we tend to forget that others don’t necessarily see that we’re all over it. And we instinctively recognize without saying, that change is both “good” and “bad” – in fact, we tend to not even put those labels on it – just that it is.
    Look at it this way – most marketeers are fundamentally evolutionary wrt to social occurences – some will always win, some lose and change is the constant. Yes, it would be nice perhaps if the world stood still – but it never does and biology shows us what happens when stasis does occur.
    Have no idea if this makes any sense at all – but am attempting to at least recognize that YES! change will occur – and in fact already IS! And am also trying to show that many like myself have an unabiding belief that “evolutionary” processes will also choose the “best” solution in the long run.
    But now, it’s time for a beer.

  167. M1EK

    “Interestingly, much of the social “change” advocated by many PO advocates (Not an insult!!!) – an end to suburban sprawl, lessened emissions of CO2, increased public transportation, etc etc – will occur organically as a natural result of sharp price increases in fuel costs. Not only can PO people make money by buying crude futures, but they also get to see the changes they wish to see, made. This is your basic win/win, no?”
    No, it’s not. Rebuilding the suburbs so that they CAN function in an era of car-pooling first, transit use eventually is a 20-30 year process, which will require a lot of money, which we won’t have, thanks to high oil prices.
    The market can’t fix this problem fast enough to prevent a crash. We’d have to have started a long time ago, or at least RIGHT NOW, and by that I mean (1) stop subsidizing suburbia and (2) start rebuilding the rail network.
    No profit opportunity exists serving exurbia with transit even at $10/gallon. Far before $10/gallon, those exurbanites will be hit so hard on their disposable income that the macroeconomic effects will hurt those of us who thought ahead and live in the city.

  168. M1EK

    “One thing that I don’t understand is why opinion on the net energy yield from agriculture-derived alcohol is so mixed. Aside from the fact that considerable number of years of US experience, there is the experience in Brazil where a significant percent of liquid fuel is alcohol.”
    Even as a net energy sink, there’s a place for this stuff. The problem comes when people blithely assume it can just be a drop-in replacement for petroleum, which it can’t.
    It CAN provide some additional supply (in SOME places grown SOME ways it’s not an energy sink, or in SOME places it was going to go to waste anyways, i.e., the energy-in was already spent).
    But biodiesel, for instance, only works when there’s an unutilized ‘waste stream’ as there is today. If you grew those crops on purpose for fuel, you would, as people keep pointing out with ethanol, be in a losing game.

  169. knzn

    Just to help us go for the record of longest thread in the history of economic blogging…
    I want to suggest seriously that people concerned about peak oil should take their case to Wall Street. If running out of oil is something that the government needs to be concerned about now, then it is also something that can make money in a reasonable time frame. But a few random individuals buying options is not the way to do it. You need to spread the risk and let people hold these oil bets as components of larger portfolios. Start hedge funds. Use your expertise in geology and engineering to convince investors that there is money to be made. This is already happening, but the degree of concern expressed by people like Hirsch suggests that it needs to happen a lot more.
    (I get particularly annoyed these days when I read someone complaining that speculators are driving up the price of oil. That is exactly what the speculators should be doing.)

  170. odograph

    “People, when they don’t look to a paternalistic government for help, tend to move quite rapidly when their pocketbook is effected.”
    compare and contrast to this man-on-the-street interview today:
    “‘That’s $50 to fill up a small truck. That’s a little too much. Just waiting for somebody to do something about it,’ San Francisco driver Joe Murphy said.”
    So here on this blog we comment with our various degrees of familiarity with economics and geology … while Joe wait’s for someone to do something?
    Actually I think the comment above is correct, and that Joe can respond, if and when he decides it’s up to him. Of course (referring to my earlier post) he may just “blame” somebody.

  171. T.R. Elliott

    JDH’s last post makes me realize I’m much more in sync with his position than I may have originally thought.
    I’ve questioned the accuracy of the futures market (I’m no expert) but do believe that the price of oil will rise (in the futures market and in the spot market) as we have evidence of peak oil. My point all along is that we may be seeing evidence of peak oil in the spot market now and the futures market may be reacting to that (I think that is what has happened, by the way, the futures market has been looking in a rear view mirror).
    But the questions about purchasing $100 futures in 2010 (or $80 or whatever) threw me off because I don’t believe we know exactly how much oil is worth as supplies tighten (because of demand destruction). I think there is a price ceiling out there somewhere through, say 2010, and we won’t know what it is. Oil will find a new price regime that will reduce demand and increase exploration and the search for alternatives.
    But I am concerned about the ability of the world economy–which I think is overleveraged and imbalanced–to gracefully handle these transitions to new pricing regimes without some serious financial crisis or serious recession.
    And I still think there is a longer term–say 2025 through 2050–problem that is so serious–or potentially serious–that the futures market and economomics can tell us little about it.
    Personally, after studying this topic for a few years, I put significant $$$ into energy funds and a PIMCO real-return (commodity indexed) fund when oil was $30/barrel and then, when oil popped up above $50 and dropped back down, moved more $$$ into these same funds.
    So the question is: Am I one of the stupid speculators who will lose big time when the bubble bursts. Or am I one of the investors who has read the writing on the wall and has–through the market–sent a signal that I think energy will become more dear in the near future.
    Obviously I think the latter, but I wouldn’t be surprised to see an unwinding for a time (say a couple years), particularly if the world economy hits a bump in the road. But with demand so close to what it appears the world can produce, risks are huge and that, in and of itself, argues for a higher price for oil.
    So in summary, I think the market is telling us something right now.

  172. albert

    Here’s a problem with your analysis: we’re not going to see demand destruction. Instead we see riots, so far in Yemen:
    and Bolivia:
    In truth it’s hard to determine what’s going to happen to the price of crude. But what’s clear is that demand destruction will likely _not_ occur on significant levels (i.e., whole countries eliminated from the supply chain).

  173. T.R. Elliott

    Albert: I don’t see it that way. I think there will be pain. And we will have irrational responses such as trucks blocking freeways to complain about the price of fuel. But we’ll see a lot of people make small changes that will significantly reduce consumption. Oil has been a very cheap and wondeful resource. As the price increases, people are going to make choices. Some will riot. Many will consolidate trips to the store. Oil companies will start coal liquifaction. Etc.
    I believe we have a major long term problem. My focus right now is on the next five years. I think we’ll see some demand destruction and some adverse affects on economic growth (and possible unwinding of some imbalances).
    And a few riots here and there.

  174. Jon

    Only time will tell as to what “peak” price will be – but let’s look for some clues. In today’s dollars, peak price occured in 1980 at $95. It is quite reasonable to assume that the price would be significantly higher than that – at least in my opinion – after all, what happened to prices past 1980? They didn’t get high enough to seriously change the world.
    So let’s double it and get $185.
    Crude’s at $60.
    There’s one helluva lot of profit potential there.
    And that’s only doubling the record high, inflation adjusted.
    So – you may absolutely be a very prudent investor – and if you’re correct – you stand to profit quite handsomely. Only time will tell us whether or not you listened well….

  175. Jon

    Odo – that’s a great quote – thanks.
    Perhaps Joe ought to consider ditching the truck? Perhaps Joe himself ought to “do something” about it?

  176. Jon

    Didn’t quite follow your questions above – but not really sure what you’re looking for – are you interested in why deferred futures are price at the levels they are relative to spot prices? The factors effecting option prices? I’d be happy to answer to the best of my ability, but don’t want to get off track…

  177. Hal

    I think what TCO is asking is how to interpret futures prices. Are they, in effect, the market’s predictions about what the price will be when the futures contract matures? Or is there some kind of discounting effect that would mean that we have to adjust the futures price in order to get a good prediction?
    From what I understand, the futures price is best interpreted in the most straightforaward terms. It is the expected price of what the commodity will be worth at the time the contract expires, in the dollars of that period (not in today’s dollars). Therefore when we read that oil futures for, say, the year 2010 are selling for $59/bbl, that is the market’s best guess at what oil prices will actually be on that date.

  178. RayJ

    JDH: “What’s going to happen in my view is that prices rise well before the peak, meaning that consumption does not rise at the rate Hirsch assumes, meaning that the peak does not come when Hirsch assumes, and meaning that the preparation for the peak is more complete than Hirsch assumes.”
    Actually, my take away from the Hirsch report is that they do not make assumptions as to when the peak will occur. The report has a table that shows predictions ranging from 2006-7 through 2025 to never, and in their conclusions they state “Peaking will happen, but the timing is uncertain.” . The report looks at 3 scenarios for the effectiveness of price mitigation based on how long before the peak the effort starts (at peak, 10 years before and 20 years before the peak). Basically they conclude that if the peak occurs in the next 10 years, we will be in trouble because of the long lead times to develop alternatives. Of course if one believes that the market will provide the correct signals early enough, then no mitigation program is necessary.
    In terms of the current level of oil prices, the critical issue is what information the market has priced in. If the market believes that the peak is 30+ years away, then the current price rise is due to a lag in investment/an unexpected rise in demand; in that case, investment will catch up in a couple of years and prices will drop to more “normal” levels. If the market believes that the peak is only a few years away, then the recent run up is the beginning of a spike. The market could be wrong in either case. In the first case, there will be a price spike when the market realizes that the peak is going to occcur sooner than expected. In the second case, prices will drop sharply when it becomes clear that there are plentiful oil supplies after all.

  179. muhandis

    Your reply reminded me of an old BBC TV series (shown on PBS). It was James Burke’s Connections series in which technological innovation occurs due to some need or necessity. But the path of invention was often tangential in that an innovation in one area might find its real use in another area.
    I expect peak oil to be the necessity that mothers many inventions.
    However, the built urban environment, the economic fabric, communications lines, system of trade, industry, agriculture have been fairly rigidly developed around the assumption of abundant cheap energy.
    My role is an infrastructure engineer and planner for a large urban utility. So, for me, in my profession, addressing peak oil is one of risk management, and evaluating opportunities for resilient systems.
    The problem is that there are huge amounts of sunk investments and imbedded energy in existing roads, pipelines, sewers, buildings etc… So, any innovation will have to address the adaptability and resiliency of the existing investments, existing buildings, sewers, etc…
    By comparison, I feel that Hirsch is just illustrating a peak oil risk and resiliency analysis — what happens if we do A, B or C? When do actions need to occur on a relative scale? what are implications if we wait? etc…

  180. PVanderwaart

    “Rising prices really do reduce demand for oil. Check out Brad Setser’s analysis of import statistics:
    Doubling ticket prices would reduce demand for air travel, too, and would certainly have a contractive effect on the economy.
    A very large portion of the US economy is devoted to satisfaction of elective demand: restaurants, sports, tourism, media, etc. It can all fold up in a heartbeat, as demonstrated by the hardships in the vacation/tourist economy after 9/11.

  181. T.R. Elliott

    PVanderwaart: I agree completely. We’ve just not hit the price at which we see appreciable signs of consumer decisions to forgo the elective demands.
    Longer-term, we’ve still got a big problem (say 2020 to 2050). Intermediate term, e.g. in the next fifteen years, we’ll see demand destruction if prices continue to rise. With attendent economic hardship of one sort or another.
    Perhaps we should start referring to it as plateau oil?

  182. Jon

    Yes, no, maybe.
    It really depends on why the trade was made – to illustrate I’ll give a real example.
    Corn for delivery Dec 06 is trading at about $2.50 per bushel right now. Many of the farmers I work with have already sold some out there – over a full year ahead and the reason isn’t b/c that’s where they think price will be, but rather because they *don’t* know where price will be. It might be higher, it might be lower – but that particular price, is a place where they can lock in some profit and reduce some risk.
    Think about it this way – if the future price *is* what participants expect the spot will eventually be, why trade there at all? It takes money to put on a position and your return against expected value is nil. IOW, you have no expectation of either making or losing money if the future price represents what you think the spot will end up at time of delivery.
    Therefore, many trades occur when price moves outside of expectations – either too low or too high. You buy something b/c you feel it’s worth the downside risk for the upside return – and vice versa. You might also trade b/c you’re using the futures as a cash hedge – that by locking in said price, you’ve eliminated future adverse cash risk.
    What price really ultimately represents on the simplest terms, is a point where a buyer and seller agree to meet – both participants feel that further “risk exposure” is unwarranted and that according to their metric, they are best served by making the trade.
    So really, price depends on your perspective – a hedger looks at it in terms of risk. A speculator in terms of potential. To put in oil terms, an oil producing company would buy futures to hedge a cash delivery forward sale. An oil user would sell futures as a hedge against their cash purchases (If price tumbles and they’re locked in at a high price, the short futures position makes back that loss). So neither of these trades is really dependent of what they perceive the price will be x years down the road, but is more focused on eliminating that risk altogether.
    Speculators however, look at that price and view it in terms of potential – if you thought crude would top out at 68, why would you buy here at 66? Your risk/reward ratio would suck. However, if you think that 90 is probable and that 60 is now the floor, you almost have to buy on speculative terms.
    Does this help at all? Or just muddy up the waters some more? I can toss in backwardation if you’d like and what that “signals” – but that gets a little weird….

  183. Jon

    Good post. You said it far better than I did when I tried to address “change” as being a fundamental part of being a marketeer. Absolutely I recognize that if the PO scenario holds true, there will be many significant changes to be made – people like me often do a lousy job of saying that, if only b/c we assume that others see that we not only recognize it, but thru our philosophy, had embraced it.
    My distaste for government “solutions” arises from this: none of us can truly see into the future and what we might decide upon as today’s best course, could easily and almost certainly will be, invalidated by the future. Markets comprised of constantly reacting folks, IMO, do a far better job of addressing the realities of change than does a single, static decision.
    Which leads back to the original contention of this thread – the prices as determined by those with the most to gain and lose don’t agree with the PO theory. Now, it could *well* be that PO is real and prices are now beginning to react – and as a consequence, we are beginning to see a tidal wave of change. Certainly in your role with a utility and the long lead-times present, you have to make certain educated guesses – however, I’m sure you’ll also recognize that history is filled with very expensive and very wrong guesses. Somewhere in the middle lies the truth.
    And yes – change will be quite expensive – but the spur for innovation will be equally great. There’s a huge amount of money at stake and a huge amount to be made/saved by finding our best path.

  184. odograph

    On “government ‘solutions'” I think we are seeing a mess across the board. In a pure, simple, traditional, model governments fund education and basic research. Those graduates and that research is cycled into industry for application and productization.
    That’s been broken down every which way, to an ungainly mess. University researchers build patent portfoliois and seek the perks normally associated with IPOs. At the same time government funds flow to industry, not just for research, but to underwrite their very day-to-day operations.
    It is very easy to say the market should figure out the solution to “peak oil” but … well, disassemble the “value netowrk” constructed around the “hydrogen economy” and then we’ll talk!

  185. knzn

    PVanderwaart: “Doubling ticket prices would reduce demand for air travel, too, and would certainly have a contractive effect on the economy.”
    If you look at the posting to which I refer, it deals with the last 3 years, a time when the US economy has been expanding. I’m actually quite impressed with what has happened. Like many people, I was worried about what might be happenning in the past few years if oil demand were inelastic: (1) rising oil prices might force up the general inflation rate; or (2) rising oil prices might force people to reduce drastically their consumption of other things and thereby cause a recession. It turns out, oil demand is not as inelastic as I had feared. Instead of general inflation or recession, we got shifts away from oil. (We also got more borrowing from abroad, which is probably not good, but still, it could have been a lot worse.)

  186. camille roy

    This is a ridiculously long thread, but I still have a comment.
    Simmons’ main point, as I understand it, is that Saudi reserves are not only over-estimated, but that their main fields are vulnerable to collapse in production. Their use of water to push out the oil can keep up production but lead to dizzying drops in production & exhaustion, past a certain point. We may be ten years from that point, or 3 months. He thinks it quite possible that a catastrophic drop in Saudi supply could happen at any time, even this winter.
    I don’t think the futures market has enough info to price in this risk.

  187. T.R. Elliott

    An overview article–The black art of oil pricing–that mentions JDH.
    Also has the chief economist for the bank of scotland telling us that”
    Every year the supply curve moves up and to the right. The worlds oil is never going to run out. The stone age did not end because we ran out of stone, but because technology moved on. We havent run out of stone, wood or coal.

  188. Miles

    It is hard to price a future price an event when one does not know a date of delivery.
    How would you like a contract to deliver corn but the delivery date is maybe tomorrow, maybe in 20 years, but there is a small probability it won’t be deliverable for 50 years.
    Further because of the asymetric information, we won’t recognise it untill maybe a year or two after it has arrived.
    Current price rises may be partially political, partly demand expansion in India and China, partly a lack of shipping, partly due to the firing of skilled people and the lack of training replacements of a few years ago, and partly that the refineries mix is poor, we need more refineries that can cope with sour crude.
    So given the level of uncertainty why is it reasonable to expect the market to anticipate a price rise due to oil production peaking?
    What we do know is that to change to a different energy source takes a long time.
    We also know that the ‘new solution’ does not exist at the momment to supply a reasonable replacement for oil. It is now consensus that Hydrogen is a non-starter, electrification is a possibility provided you are prepared to catch a train, tram or drive an electric car or scooter, walk or go horseback.
    If you look at the history of technology the internal combustion engine was pre 1900, electricity the same, hydrogen has also been around that long, jet engines since about 1930, Nuclear power since 1940.
    So the market may enable a ‘new’ solution but don’t count on it being useful until say 2050.
    But the new solution may only be available if we are prepared to invest longterm in R&D.
    Bright spots on the horison include the conversion of farm waste such as straw and wood (lignin etc) to sugars hence alchohol or diesel. This may go a long way to meet US demand.
    Nanotechnology to build fast charge lithium batteries, giving an electric car maybe 300 km range.
    The use of genetic engineering to grow algae that produce diesel, or improving the output of oil/wax bearing plants. Grow olives, Oil palms or advocados for oil. etc
    Then we need to build the infrastructure, plant the trees etc
    So how will the market price this in or invest given the uncertainty.
    I want to borrow money, but I may not be able to pay it back for 10,20, or 30 years, I just don’t know.
    So please explain why the market would finance this?

  189. Jim Glass

    “What we do know is that to change to a different energy source takes a long time.”
    I dunno about that. When World War II arrived Germany was able to switch to gas + oil from coal in pretty short order, and remained a pretty credible economy doing so.
    South Africa also switched to oil from coal during its embargo years, and did OK for it. They still use a lot of it, IIRC.
    There’s a heck of a lot of coal in the world (and the US happens to be the Saudi Arabia of it).
    BTW, people have been using coal in major quantites a whole lot longer than oil, its consumption is still rising as it always has, it’s finite in supply of course … I wonder why there isn’t notable concern about “peak coal”? It’d be tough to have the grid run out of electricity all of a sudden.

  190. T.R. Elliott

    And as with many peak oil discussions, this one starts running down into the weeds with similar arguments (or lack thereof) made over and over again. Is the German ANALOGY for coal pertinent. Perhaps. Perhaps not. This type of non-analysis is called GUESSING. What was the GDP of Germany. What was the reliance on oil? Did the stone age not end due to a lack of stones? What’s the capital investment to produce the necessary oil and gas from coal? What impact will that have on GDP? What volumes can be produced?
    Sorry, but these types of discussions are fine and dandy to throw a few ideas around, but without real analysis, real modeling, it’s pointless.

  191. mikeB

    Patient A needs a quantity of type AB- blood in order to survive.
    Patient B needs a similar quantity of O blood, also in order to survive.
    The quantity of AB- blood costs $100,000.00
    The quantity of O blood costs $10.00.
    Please calculate for me whose “demand” is greater.

  192. Frank Richards

    This thread looks like the perfect chance to ask something I’ve been wondering for a while.
    Economists are very fond of berating layfolk for misusing the terms supply and demand. OK, what term should we use to replace our sloppy “demand”?
    To give a toy example. I make and sell “purple crunchies” on Ebay. For several years, supply and demand are in equilibrium at $10/unit. Then I get some press, and in the face of constant supply (massive investment required to raise production), the average Ebay price rises to 12.50, and stays there because now that people know about purple crunchies the “demand at 12.50” is now what the “demand at $10.00” used to be.
    So what term do the economists think I should use for the underlying “want” that has risen and caused the “demand at 12.50” to equal what the “Demand at $10.00” used to be?
    That “underlying want” is what laymen “misuse” the term “demand” to mean. What term do economists use?

  193. col

    That’s an increase in demand, due to higher awareness. More people know that purple crunchies are available, and some of the new people are willing to bid more $10

  194. TCO

    A change in the market desires themselves (such as a “fad” for purple crunchies) means the entire demand curve shifts up (“demand increases”). This is different from a change in demand satisfied (movement along the curve rather than displacement of the curve itself) from a price change.
    This stuff is so fricking basic.

  195. Frank Richards

    >>A change in the market desires themselves (such as a “fad” for purple crunchies) means the entire demand curve shifts up (“demand increases”). This is different from a change in demand satisfied (movement along the curve rather than displacement of the curve itself) from a price change.
    This stuff is so fricking basic.
    Uh, look dude if it was so fricking basic, JDH would agree with Hirsch that demand will rise, and wouldn’t be berating us laymen for saying that rising demand has raised the price of oil by 50%.
    I agree. Demand goes up, supply doesn’t change so price rises until CONSUMPTION matches supply. So why is it that economists have hissy fits when normal people say exactly that?

  196. RayJ

    I have been thinking about James Hamilton’s concern that the authors of the Hirsch report did not have a clear grasp of the concept “demand” as economists will use the term. Turns out that Hirsch’s co-authors are economists Bezdek (PhD in econs from Illinois) and Wendling (MA in econs from George Washington) with extensive experience economic forecasting and econometric modeling. I wonder whether they dropped the ball in their loose use of term and whether that invalidates the conclusions of the Hirsch report.

  197. TCO

    because people keep confounding movement along the curve with movement of the (demand or supply) curve, itself. There are all kinds of cool conversations we could have and sophisticated things we could discuss, but when people mangle that basic concept, there’s little point in moving forward. It’s like talking to someone who has no concept of how a chemical equilibrium reacts to a displacement to partially (but not completely) offset the displacement.
    How can we move to some interesting discussion of elasticities and geology, etc. when we have people who don’t understand how to graph a supply and demand curve and look at the intersection and think about how movement OF one curve creates resultant movement ALONG another curve. Sheesh.

  198. TCO

    (movement of the intersection).
    Really: this is about the first lecture of a decent course in micro.

  199. Frank Richards

    >>because people keep confounding movement along the curve with movement of the (demand or supply) curve, itself.
    >>(movement of the intersection).
    >>Really: this is about the first lecture of a decent course in micro.
    Is there nomenclature for it? Both things happen. (Movement of the curve, vs movement along the curve. eg)
    My BS is in Physics. We have that kind of abstraction, and we have the words to cover it: Position, velocity, accelleration. Speed vs. velocity. Friction, even ‘stiction’. A whole vocabulary.
    If this is “the first lecture in a decent course in micro”economics, then someplace on the web is that lecture, with all the definitions written on the chalkboard for me to read.
    Where is it? I’m trying to meet you on your own terms. If Econ is a real science, then those terms are written down.

  200. col

    An upward shift (increase) in the demand curve will cause an increase in the quantity supplied.
    contrast= increase in demand vs increase in quantity demanded, the latter occuring when there is an increase (shift) in supply.
    In the above example, supply is perfectly inelastic (=vertical) due to “(massive investment required to raise production)” so the increase in demand does not lead to an increase in quantity supplied, just price.
    and yes, this is page 1 of microeconomics

  201. Frank Richards

    >>In the above example, supply is perfectly inelastic (=vertical) due to “(massive investment required to raise production)” so the increase in demand does not lead to an increase in quantity supplied, just price.
    Quod erat demonstrandum. You just said there was an increase in DEMAND even though the quantity supplied didn’t change.
    Therefor it’s cool for me to say that an INCREASE IN DEMAND made the price of oil rise from $40 to $65/BBl even though the number of barrels changing hands didn’t change (as it doesn’t seem to have since last fall.)
    IOW, economists get over yourselves. Demand rises, supply doesn’t, price does. If demand wasn’t up, the price wouldn’t rise.
    I repeat, DEMAND, in educated layman’s English, can go up even if supply is totally unchanged. And if the economists say otherwise, those educated, competant, articulate laymen are going to say that the economists are spouting bullshit, and they will be right.

  202. Jack Edmonds

    From another retired geologist:
    It seems that the speculations about the social, economic, and political effects of peak oil by geologists, engineers, and other technical people have tended to create confusion about what peak oil represents. The concept of peak oil was not developed from geologic nor economic theories but by the observation of the annual rate of production of individual oil fields and groups of fields within certain states of the U.S. Hubbert fit a curve empirically to noisy production data. By examining historical data he observed that the rate of production of an oil field, or group of fields, typically increases over a period of years and declines slowly fter reaching some maximum rate (the peak) after about half the oil has been extracted. Once the decline has begun, the rate of production of the field cannot again be returned to this maximum rate regardless of the price of oil. The increasing production rate before the peak is the result of a coincidence of economic, geologic, and production factors favorable to the oil business. The decline in production after the peak is primarily caused by depletion of the oil.
    Curves fit to the rates of world production suggest that the maximum production rate for the earth is between 85 and 95 million barrels per day for conventional oil.
    Political and economic events can change the shape and timing of the oil peak. For esample, if the Saudis decided that it was in their pests interests to limit production to its present rate the could flatten the Saudi production peak and extend the life of their fields. However, after a few years the production rate would begin to decline anyway.
    It is important to remember that the peak oil scenario is a prediction. Just because it has described the oil production history of the continental U.S., the North Slope of Alaska, and the North Sea does not mean that it will necessarily describe the production of the entire world. However, it does seem very reasonable for economists to use the scenario of peak oil as a basic assumption in making their predictions.

  203. col

    “it’s cool for me to say that an INCREASE IN DEMAND made the price of oil rise from $40 to $65/BBl even though the number of barrels changing hands didn’t change ”
    its possible.
    It really needs to be seen graphically
    to be fully understand

  204. odograph

    A two dimensional line graph shows the relationship between two variables. One of those variables may be dependent upon the other, or not.
    When other conditions change (in the multitude of variables not being graphed), a new curve must be drawn.
    I’d (based on my old background in chemistry and engineering) just call this a new environment, or as I said, new conditions.
    I suppose you might say the “curve moved” … but that doesn’t make as much immediate sense to me as just saying it is a new environment.
    You’ve got a price/demand curve for heating oil … and then winter comes … new conditions … or the curve moved … whatever.

  205. col

    Its generally not thought of as a new environment in economics. You can have a theoretical shift which never materialises, or the curve shifts back to its original position.
    In the case of demand for heating oil, this may be the following Spring.

  206. odograph

    This might sound like a nit at first sight, but I have trouble believing any curve ever shifts back to its original position.
    Mandelbrot found chaos in cotton futures … right?

  207. col

    ever heard of the munell fleming model?
    you can model an increase in government spending
    which doesn’t actually lead to an increase in output because it crowds out out other spending under flexible exchange rates.
    so the “IS curve” remains unchanged.
    i know what you mean though

  208. TCO

    Frank: Here is the basics:
    FYI: I am not an economist. I have a natural scientist. I don’t need to defend them.
    They have all the correct terms in econ as well. The confusion of terms is not their fault, but their aggravation. Like hearing someone use ‘power’ and ‘work’ interchangebly.
    The basic thing is that movement of one curve (say tha 20 unit demand shift shown in the example) does not result in a 20 unit increase, because of price feedback. See how the supply curve (which has not changed in terms of a curve). It’s just the intersection that changes. But because the supply curve is increasing, the price increases and the demand satisfied increases but not as much as the initial shift. It’s like Le Chatelier’s principle in chemistry.
    There are lots more interesting things to discuss here: time frames, costs (variable versus including capital), the elasticities (structures of the curves), what it looks like with price controls or taxes or subsidies, yada yada. As well as the geology itself.
    But if we keep getting people calling kinetic energy, momentum…how are we going to progress to how curvature of band structure in GaAs affects the mobility of free electrons? (But it’s not as bad as all that. If you have half a brain, you can read first 3 chapters of Mankiw Micro in the tub and have the right concepts straight.)

  209. col

    Thanks Jim, TCO.
    Maybe now sensible discussion can take place.
    btw Le Chatelier’s Principle is also used in microeconomics, ususally reserved for grad courses.

  210. Frank Richards

    Ok so if I have this right, there is no single term for “shift in the demand curve”. So as China gets richer and more people there want gas for their cars, the only phrasing that will make the economists happy is “the demand curve is shifting to the right”.
    Sheesh dudes. You ought to do better than that. If demand is taken, howabout “desire” or “want”.

  211. Jon

    That might work – certainly I “want” a Ferrari and I’ve demanded one as well, but she who controls the purse strings doesn’t agree with me.
    That being said, from a trader’s perspective, I frequently see an interesting phenomenon – as price rises due to increased demand, demand sometimes accelerates in the short-term, which is a little counter-intuitive at first. What happens is that people rush to lock in prices before they sprial out of control. IOW, the rising prices attract a certain amount of demand in and of itself.
    FWIW, this is usually a pretty good signal that a top is nigh…..

  212. col

    And that helps explain stock market bubbles.
    How about: as more people get cars, there is an increased desire for gas at any given price
    => shift in demand

  213. TCO

    Did you read the article? If demand has changed, that should mean (proper usage), that the underlying want (the curve itself, the summation of different buyer’s indifference prices) has changed. IOW, that is what is happening with China. Demand is increasing.
    If we have a supply disruption (shift the supply curve), then the change in quantity delivered is changed (not demand at least in immediate case). However, there is no “shortage” as long as there is not rationing. (Or you could say there is a shortage right now from prospect of people who want oil free). And the reduction in amount consumed/delivered is LESS THAN then amount of the shock (because of the elasticity of the demand and supply curves themselves).
    Don’t get all mad at the economists. For those who understand this day one lecture, there should be no confusion about shifts in teh environment versus the feedback tendancy that mitigates them.

  214. Arthur Smith

    Two things wrong with James Hamilton’s points, which I don’t think have been quite touched in all the comments here yet (though knzn was close a couple of times).
    1. The argument about getting rich by hoarding and buying futures assumes the peak oil people believe prices will inevitably keep rising. In fact, that’s incorrect – as Ken Deffeyes explains in “Beyond Oil”, a commodity peak is characterized not by continuing price increases, but by greatly increased price volatility. That’s an observational fact, not a theoretical economic point, but it certainly ought to make anybody cautious who is thinking of betting on oil (or oil companies) right now. The same sort of volatility comes out in other models, such as of ecological systems, when a critical point is reached.
    Volatility causes (without government intervention at least) strong fluctuations in investment in expensive sources and alternatives and in the R&D to make them cheaper, making both supply and demand even less reliable. The time delays make the problem somewhat more difficult than classical micro-economic analysis suggests.
    2. Just because supply is equal to demand doesn’t mean all is well and good with the world. In particular, watching prices rise or fall with market forces does nothing to avoid “render[ing] those who are forced to follow them unambiguously poorer.” Economics can model decline just as well as growth; what Hirsch and his colleagues are talking about are ways to mitigate the human suffering they see as inevitable consequences of the end of the oil age.
    There are many paths for our collective action here (including inaction), but only one which would, if successful, make those who follow “unambiguously richer”: finding an alternative to fossil fuels that can provide the same supply at a lower price. Investment in energy R&D should be in the $300 billion/year range, $75 billion/yr in the US, not the paltry $2-3 billion we have now, most of it wasted on stupidies like hydrogen cars.

  215. TCO

    Look, dude. We may be screwed EVEN IF the government does something. If we’re running out of oil, we’re running out of oil.

  216. Jonathan Bernstein

    Backwardation in oil markets revisited
    JDH has said that because oil futures in 2009 are priced lower than they are now, the market is expecting lower prices then. I would like to note that in the near month futures, no significant backwardation exists. In fact, as we anticipate today’s open, the March 2006 future is a dollar higher than that of the October front month. I also note that the October 2006 price, which was lower than the front month last week, is a dollar higher than the front month price as I write this morning.
    In classic backwardation, the prices trend down in sequence month by month from the front month. that would be the usual sign of a short term supply/demand squeeze.
    Yes, the December 2009 future is five dollars lower than the front month. That difference is a real attention grabber and I wouldn’t dismiss it. But in a sign of illiquidity of back months — note that not too many other delivery months are even traded for 2009; no prices are posted for those. Most of us who trade for a living, don’t care too much about the back months anyway, let alone delivery dates that are years out, for any commodity I know of… too illiquid.
    If oil companies are now inking contracts to sell oil for $62/ barrel to industrial or commercial customers for delivery in 2009, that would be important news.

  217. Joseph Somsel

    Mr. Bernstein’s observation is, I think, that long term contracts for oil are rare. (Correct me if I’m wrong.)
    In natural gas, I was puzzled as to why US gas producers have been reluctant to sign long term supply contracts. While the usual market speculative issues remain, an important insight was about the physical nature of US gas wells.
    In the US, the typical new well takes 6 months of planning, permitting, and drilling. Once in production, most of the gas is gone within 9 to 12 months, leaving a long but low flow rate production tail. Hence, a five year physical delivery contract means a bet on several generations of yet UNDRILLED wells. With the declining size of North American gas fields, such bets are increasingly risky.
    For oil, a typical well life is longer but I would suspect that that the same considerations as natural gas would apply. Domestic fields are also smaller and a horitonal well has higher initial flowrates but a steeper decline once the water/oil interface reaches the well bore.

  218. Jonathan Bernstein

    My comment is that longterm contracts are, illiquid on the exchange traded futures market, such as the Chicago Board of Trade, Chicago Mercantile Exchange, NYMEX, etc. In these markets I don’t think you can buy or sell in quantity without driving the price away from where you were originally quoted when you are dealing in long dated contracts. That’s why I thought JDH was perhaps overstating things when he talked about what you could buy right now for delivery four years out on the futures market.
    I have the impression that if you want to deal in large size for energy for more than a few months in advance, oil companies do deals to provide physical crude oil and refined products to customers, and that financial firms set up customized oil related derivative products. I don’t however have first hand experience with these.
    In the exchange traded products people deal in the near month contracts to hedge (or speculate) and will roll the contracts out to the new month when the old front month is superseded.

  219. JDH

    I’m not persuaded by your argument about illiquidity on the long-term futures contracts, Jonathan. That long-term backwardation has been a feature of this market day-in day-out for quite a while now. Your argument is, if you tried to make a big purchase, the price would change? So, make a small purchase. Buy as big a volume as you like until you’ve moved that price to the point where there’s no longer any excess profit to be made. If it’s really such a thin market, one brave little peak oiler can step into this market, move the price, and set it where it should be so that producers and consumers are all getting the right signal. And earn themselves a nice profit by doing so.
    I don’t agree with you that such purchases would move the market, and I don’t agree that thinness of this market would in any way mitigate any of the points I’ve been making. These contracts exist, they’re available for trade and do trade each day, and if you think they’re trading at the wrong price, the profit is anybody’s to be had.

  220. Jonathan Bernstein

    Dear JDH,
    I love to read your site and I think you are doing a wonderful service by running it. I am gratified by the high level of your posts and that of most of the readers. I am also grateful that a tenured professor at a major university such as yourself, shares your thoughts and even acknowledges our comments as you do. Therefore I hope that if we can’t quite agree that we can keep things friendly. I certainly meant no disrespect by my liquidiy comments.
    Not to pick too many nits, but according to ESignal, the quote software that I use, the December 2009 futures did not trade every day in July; in fact they failed, according to my data, to trade on 7/7, 7/12, 7/14, 7/19, 7/22, 7/27, and 7/29, at least during the day session. In August so far performance has been better in this regard, so far trade has been missed only on the 10th and 15th. Nor do I see as much as 15 trades occurring on any given day.
    Why does this matter? Okay, I haven’t tried it on this particular contract — and yes, to the credit of your argument, the 12/09 futures do have a substantially more open interest than I would have expected — but I will tell you exactly what has happened to me (and my trading capital) when I have tried to trade illiquid instruments. I put in a bid to buy at the last quote, the quote moves up before my order gets executed. I have to move my limit up. And again. Finally I get filled on the order and I pay a few hundred dollars more per contract than intended (assuming I persist). It gets even harder when I’ve tried to get out. I’m not alleging conspiracy here: the local has to build in profit in order to take the other side of my trade because it can be awhile before he or she in turn can unload it.
    I don’t mind moving the price my way when I am already in the trade. I mind that it moves against me before I get in, and again, when I try to get out. The “transaction costs” can get pretty horrendous even when things do go my way on an illiquid instrument(and heaven help me when I have been wrong).
    In my early days as a trader I found (it’s funny now!) that in a winning trade in the options on Swiss Franc futures, that I actually owned about 15 percent of the contracts outstanding, while I held a single digit number of contracts in position! It was a sweet winning trade but in order to get out I had to share my winnings with the floor traders, big time! It may be economically irrational of me but I am very chary of repeating the experience even when my reasoning tells me that a trade in an illiquid instrument may well have good profit potential.

  221. TCO

    bernstein, spoken like a trader. But still if the price is significantly out of whack, then so what. Someone. EVen a very small buyer (if you really think the market responds so much to buy orders) ought to drive the price to it’s proper place. And we should see dramatic volatility as well. daily or hourly fluctuations of tens of dollars.
    I just don’t buy it.

  222. TCO

    Well lots of people aren’t irrational, JB. Arbitrage, arbitrage, arbitrage. (They may be misinformed or making improper predictions…but cheesy nickels on the sidewalk don’t sit there. If you really think they don’t, start your own hedge fund, get over your irrationality and start picking.)
    If the futures are really lower then expected, I would imagine it might have something to do with margin effects or with risk (of satisfaction of the contracts). JDH: what is the risk picture here for futures contracts? (that they get honored?)

  223. JDH

    TCO, when people talk about the role of risk aversion in influencing futures prices, they are usually thinking about hedgers. For example, an oil producer that knows it will be selling oil and wants to eliminate uncertainty about price could sell a futures contract, thus locking in the price at which the oil is going to be sold. If the producer is willing to sacrifice expected return in order to reduce risk in this way, it might be willing to sell a futures contract for less than the value it expects the future spot price to be.
    However, there’s always room for speculators (defined as anybody who doesn’t actually want to physcially buy or sell that future oil) on the other side of this contract, and if the speculator agrees that the future spot price is likely to be more than the futures contract price, they will expect to make money by taking the other side of the deal. There’s risk to a speculator on either side of a contract, but if all the hedgers are on one side (for example, producers wanting to sell futures contracts), maybe there aren’t enough speculators around to absorb that risk unless there is some premium to compensate them for insuring the hedgers.
    I don’t believe any of that is germane to our discussion here, however. If you (a speculator) believe the price of oil is going to be above $60 a barrel in 2011, then you would expect to make money buying a futures contract for that now. If you’re confident that the price is going to be a lot higher than $60 in 2011, then you should be confident that you’re going to make a lot of money on every contract you buy, and I don’t think you should let Jonathan’s concerns slow you down for a minute from trying to make all that money.
    The only thing that should slow you down is if in fact you’re not all that confident that oil is going to be selling for substantially more than $60 a barrel in 2011, or if you think there’s a big risk of it sliding down before going up and you’re worried about being able to meet the margin requirements before your ship comes in.

  224. TCO

    My question is related to thinking of the future as an investment. I want to take it apart and understand it.* Yes, I understand the motivation for a producer to hedge so that his risks and rewards are more closely related to his work, to his individual business–vice the industry. That’s not what I’m asking about. As an efficient market beleiver (I don’t buy that illiquidity stuff), I figure the price is dictated by market expectation of reward and by the beta of the instrument. I just want to understand if there is a default risk analogous to the default risk that a bond would have.
    *Feel free to send me to a book, vice giving free one-on-one tutoring by a premier teacher…but as long as you keep answering, I’ll do things the easy way. Plus sometimes, other posters educate me.

  225. RayJ

    TCO writes: “As an efficient market beleiver (I don’t buy that illiquidity stuff)”
    I thought liquidity was an essential requirement for an efficient market; all available information is incorporated into the price. The absence of trades is an indication that market participants are not confident enough in what they know about the instrument to bet on it; they therefore sit on the sidelines and don’t express what knowledge they have and as such that info is not incorporated into the price.
    Also note that liquidity is a relative term. So when Jonathan describes an instrument that trades only 15 contracts a day as illiquid, it is illiquid relative to the other more liquid instruments that trade thousands of contracts each day. Any trader knows that trading in an illiquid market is a dangerous game as Jonathan illustrates so well.

  226. TCO

    If you think the market is mispriced because of “illiquidity”, that means OPPORTUNITY! Go pick that nickel up off the deck, sailor!
    But I don’t buy it. So what if it trades once a week versus once a day? Why should that cause mispricing on a major scale for an option that is 5 years out? And why should the delta be in a particular direction? And if it really were so illiquid and influenced by individual trades, shouldn’t the price be jerking all over the place (swings of 10+ dollars each week).

  227. RayJ

    TCO writes: “If you think the market is mispriced because of “illiquidity”, that means OPPORTUNITY!”
    No, I think the market is LIKELY to be mispriced because of illiquidity. Not only am I not 100% certain by what amount but I am also not 100% sure in which direction it is mispriced. The prudent thing to do is to sit on the sidelines.
    Now, that is conclusion the majority of the market seem to agree on.

  228. TCO

    I think that mispricing because of uncertainty in future supply/demand is much more likely than mispricing because of arbitrage opportunities (poor liquidity/market innefficiency). That’s the reason to sit on the sidelines.

  229. Joseph Somsel

    Noting that long term oil futures are illiquid supports the observation that oil is depleting – few producers are willing to risk a commitment to physically deliver oil from existing or to-be-drilled wells because well productive lifetimes are getting shorter. If no one is committing to future production, there can be no market in it.
    If you’re a producer and sitting on a huge pool and only had vertical wells, then a you could sell on long contract. Horizontal wells and small pools would force you to only sell short term or spot.
    A test of this would be, is there more or less long-term production contracting than in earlier eras?
    RayJ’s post raises a good question – how much market activity and how many players are needed for the observed market price to be predictive? It’s really a Baysian process, isn’t it?

  230. JDH

    I’ve really got to side with TCO. I don’t think market thinness explains anything here. Somebody’s successfully buying these contracts (almost) every day at these prices. Why not you?
    Jonathan’s perspective as a trader is he wants to get in and out quickly. OK, so liquidity matters for that. But, if the vision of peak oil that many are promoting proves to be true, this isn’t nickel and dime stuff we’re talking about. Place your bet and put on a big smile as you patiently wait for those big profits. No rush to close your position– the longer you wait, the richer you’ll be!
    If the price was explained by a thin market, it’s exactly as TCO says, the price structure wouldn’t maintain the same reliable pattern, day after day. I say the market will sell you all the contracts you want. And if I’m wrong, just put your money where your mouth is to prove it!

  231. Jon

    Joe – your assertion is incorrect – the “thinness” of trade out in far deferred contracts happens with all commodity futures from corn to cocoa. The action is up front with some commercial hedging and spreading between a large portion of far deferred contracts. Just check out the open interest levels – lack of trade depth is not a sign of depletion, rather time distance.
    Look folks, it’s pretty simple – this is, for now, an illiquid market (So to speak). If you want to trade, put in a bid and leave it there. The Bid/Ask will probably be about a buck or so – the price you have to pay to the local doing the other side of the trade. What’s a buck when you’re going to make a hundred or so, right?

  232. Jon

    FWIW, crude’s down nearly $3 today.
    It would appropriate and somewhat ironic, if oil topped out during the midst of the longest thread in Econblogging history.

  233. Joseph Somsel

    I appreciate that the action is heavier on short vs. long term futures for all or almost all commodities – no doubt that you’re correct.
    The test I proposed was the how the ratio of very long term vs total market changes over time in oil. If oil is getting more scarce and the pools smaller, then the percentage of very long term futures should trend down. Perhaps future markets are not good indicators but I would hazard that a symptom of peak oil would be a reluctance on the part of producers to sell long.

  234. Chapomatic

    Someone Gets It

    Eagle One reports of a takedown of an alarmist about resources.
    You know, Paul Ehrlich lost the bet with Julian Simon about this stuff…

  235. The Oil Drum

    Demand and economics, or are we mushrooms?

    Just as I was sharpening my pencil to begin the post on drilling that will follow, I glanced over at Reuters, to see how oil was doing today. Given the discussion over at Econbrowser, and his apparent demand (as in command) that you can’t use the word …

  236. The Oil Drum

    Discussing prices and demand

    Over on Econbrowser there is a discussion going on relating to the Hirsch report, which we last discussed here. It is very much an economists discussion, but contains within it the continued question as to why, if the supply of oil in the world is dry…

  237. The Oil Drum

    This ain’t Ragnarok

    When is news not news?
    The ABC news tonight began with a story on the rising price of gasoline. But when I scan the headlines of the papers, the fact that we hit $66 to day is barely mentioned, And in the ABC piece,

  238. TCO

    Thus creating a high price, no? or you could just say, “a high futures price”. To make it simple.

  239. Jon

    First, sorry about the somewhat snarky tone of my post – crabby sort of day….
    That’s an interesting proposition – I’d guess I’d look at it the opposite way due to my background as a cash hedger: A known or sensed decline in supply would lead to an increased amount of hedging activity in deferred contracts – users of the end product would buy in order to be able to lock up delivery potential – in addition to hedging their upside price risk. Producers would also be tempted to buy spec longs on top of their standard buy v cash sale hedges.
    The focus here, is really on the end user – since they’re buyers, they would typically sell the futures iot to minimize price movement risk – however, in this possible situation, they’d also want to be somewhat long so they could take delivery of the contracts if necessary.
    Now, where it might get interesting in this PO scenario, is if oil was so scarce that people began taking massive amounts of delivery – if this were to occur, the spot market would go nuts as the shorts were squeezed. Long history of this sort of action with the grains.
    It is an interesting hypothesis – my guess would be the opposite – that apparent scarity would increase trading volume in deferreds – scarcity leads to volatility and increased “risk” – thus, futures would be even more necessary than usual.

  240. Joseph Somsel

    TCO is correct that a reluctance of producers to contract for far-term delivery would drive the price up. That is assuming that the consumers knew as much as the producers.
    If the producers knew more than the consumers, which is a reasonable assumption, it would dampen future price rises – I think.
    I suspect that my hypothesis is a dry hole, insight-wise, or at least weak. Futures may be too disconnected from real production to be predictive. However, increased volume of transactions is not the same as originating long puts.
    However, we may be seeing governments acting as if withholding for future price increases is in their interest. Venezuela is a case.

  241. TCO

    I think the futures are a best guess, but a best guess does not have to be a good guess. We seem to go round and round with people who think that those of us, who want to rely on the market as a best estimate are saying that it is infallible, when we’re not. We’re just saying, “what makes you think you’re smarter?”. If it’s publicly available information, that the Saudis may have cheated on reserves (like all the posts and articles in open literature), don’t you think market has priced that in (some risk of that in…because we don’t KNOW!)
    I mean soybean futures may be market’s best guess, but if we have a drought and the futures are off, that doesn’t mean the market is worse than some liberal anti-market “guesser”, it just means that some things are hard to predict for anyone.

  242. TCO

    I would love to see a graph of 5 year oil futures on top of a graph of spot price going back over the decades. It would be interesting to see if previous crunches were judged by markets (falsely) to be permanent. I.e. if this forward looking view is different.

  243. TCO

    Ok. JDH, how about cranking that out. I’ll take a coauthership. Just kidding–run with it. 😉

  244. camille roy

    Just caught up with this thread. Interesting.
    I wonder whether there are any futures markets for ag products in which there are observable price effects related to global-warming associated climate change.
    I doubt it.
    That doesn’t mean there won’t be such effects observed in futures markets when there is less uncertainty about the effects of global warming on specific crops or regions.
    The parallel case applies to peak oil scenarios and futures.
    The uncertainty relates to a real deficiency in information. It’s not asymmetrical, it’s unavailable.
    I wonder whether we are approaching an ice berg in the dark.

  245. TCO

    Very possible. OR the reverse of course (slowing the ship down, unnescessarily, when the seas are free).
    Perhaps, JDH could get another publication by doing a case study weighting analysis: imagine the peak oilers nightmare (e.g. some measure of fraud in Saudi reserves) and then what rational futures price would result from that. Then estimate what the rational futures price should be if all the published info is correct (no iceberg scenario). Then, look at the actual futures price and make some estimate of how likely the market judges the iceberg scenario to be (10%, 50%, 90%?). It’s not a killer analysis since there are so many ways one could play with it, that it is not definitive. Still it’s a useful construct to start people working with. (and better than all the people saying…”I’m worried that there’s an iceberg, but that silly inefficient market doesn’t read the same NYT articles that I do, and fails to price it in.”

  246. Ian Graham

    the last post in this thread was Oct 31, 05. I guess it’s over.
    but I just read much of it. and the evidence that oil futures 7 years out are less than the peak oil pundits predict seemed to carry the arguement for many commentators.
    I recall from my own economics training and investor training, that futures, say in currency, definitely are not predictive. The risk of being wrong dampens the price at which a trader willingly locks in a contract to buy or sell. So the trend of futures contracts shows how the market players anticipate the future, but not what the price will be on that day in the future.
    Neither do we know the price of oil in the future, but we should not therefore take the futures market as the best proxy for it.
    Ian G
    Burlington ON

  247. Raymond Day

    It seems logical to me that the earth only contains so much oil and the oil it contains is approaching depletion. Once depletion nears its inevitable end point, the question of supply and demand becomes essentially meaningless. I suggest that Stephen Leeb has a good grasp of the consequences of approaching the issue as simply a matter of supply and demand in his book, “The Coming Economic Collapse.” A resource cannot be bought at any price when it no longer exists.

  248. Peak Oil News

    Obviously you can find so much debate about peak oil and when (or if) it will occur. I tend to think that if you keep using a resource there will come a time when the supply can no longer keep up with demand. In our day and age the demand is increasing daily. It is now just a matter of timing. With gas prices as high as they have been the past few years I have to wonder if we are currently experiencing the end of the oil age (Peak Oil Resources).

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