The first oil shock

A research paper by Eyal Dvir of Boston College and Ken Rogoff of Harvard suggests some interesting parallels between the recent behavior of oil prices and what was observed at the very beginning of the industry. I’ve been doing some related research on the history of the oil industry that looks into the events behind historical oil price shocks. Here I describe the first oil shock, which occurred a century and a half ago.




Price of oil measured annually in 2009 dollars per barrel. Left panel: 1862 to 1865. Middle panel: 1973 to 1981. Right panel: 2002 to 2009. Data source: BP Statistical Review of World Energy 2010.
oil_price_1862.gif

The far-right panel above displays the most recent behavior of the real price of oil, following the price as it rose from about $30 a barrel in 2003 to almost $100 a barrel on average during 2008. In terms of the magnitude of the real price increase, that’s pretty similar to what happened over the decade of the 1970s (middle panel), and amazingly also very similar to what happened during the U.S. Civil War, a century before OPEC even existed (left panel). I was interested to take a look at what happened to produce the first oil shock of 1862-1864.

Edwin Drake had drilled the first commercially successful oil well in Pennsylvania in 1859, three years before the left panel begins. Prior to that discovery, people had been getting illuminants from sources such as whale oil, grain alcohol, and gas and liquids derived from coal, asphalt, and shale. Then as now, obtaining liquid fuel by these methods was a very expensive proposition, and Drake had no trouble selling his crude for $20 a barrel, which would correspond to $476/barrel in 2009 dollars. Needless to say, the discovery that such precious stuff could be obtained just by drilling into the earth stimulated a frenzy of drilling in the vicinity of Oil Creek, Pennsylvania. Many of these wells also successfully produced oil, and the price had plummeted below 50 cents/barrel (about $12 in 2009 dollars) by 1861.

But it turned out that in each new well, the flow rate dropped fairly quickly as oil was removed, and the drillers also had difficulty figuring out how to prevent water flooding. After an initial phenomenal rate of success, total production from all wells in Pennsylvania declined in 1863 and fell further in 1864.



Annual production (in millions of barrels per year) from all fields in Pennsylvania and New York, 1859-1865. Data source: Derrickā€™s Hand-Book of Petroleum (1898).
oil_prod_1862.gif

At the same time, the demand schedule was shifting to the right, due to war spending and most importantly a new tax on alcohol (a competitive source of illuminants) of $2/gallon, which gave a $40/barrel competitive advantage to crude. The result was that the real price of oil quintupled by 1864.

Fortunately, Oil Creek turned out not to be the only place oil was to be found in Pennsylvania. Yields from other, much larger fields in the state ended up dwarfing the modest volumes of the pioneer wells, driving the price back down. Production from the state as a whole would end up increasing by an order of magnitude from the levels of 1865 until reaching what proved to be its true peak in 1891. Today Pennsylvania produces only 1/5 as much oil as it did in 1891.

And, again fortunately, much larger fields were discovered in other states that ended up dwarfing the volumes produced in Pennsylvania. Oil production from the United States as a whole would continue to rise until reaching what proved to be its true peak in 1971. Oil production from U.S. fields today is about half what it was in 1971.

And, again fortunately, even larger fields were exploited outside the United States. World oil production continued to increase until reaching a bumpy plateau in 2005. Just as the price path since 2005 parallels that seen in the 1860s, so does the graph of world oil production.



World oil production, 2003:M1-2010:M9. Includes lease condensate, natural gas plant liquids, other liquids, and refinery process gain. Data source: EIA.
oil_prod_2004.gif

As for where world production is headed from here, if optimistic projections from Iraq are borne out, the global peak is still ahead of us. But when the global peak will arrive is a bigger question than I want to take on at the moment, so let me just make two quick observations now. The first is that, although economists are used to thinking about increased production as coming from technological progress, in the case of the oil industry the biggest factor has instead been the exploitation of alternative oil fields that proved to be much bigger and better than the originals. As production from each one fell, so far there has been something better to replace it. But I do not understand those who conclude that this will always be the case, or who assume that the outcome is necessarily subject to the control of technology or incentives. Second, I submit that when demand booms and production is stagnant, it is possible for the price of oil to quadruple in a short period of time.

I say that because that’s exactly what we’ve seen happen on three different occasions.

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29 thoughts on “The first oil shock

  1. mmckinl

    The “Oil Drum” and the “Energy Bulletin” offer great insight into “Peak Oil” if you don’t know of them already … They have great archives …
    http://www.theoildrum.com/
    http://www.energybulletin.net/
    Here is an interesting piece by Jeff Rubin …
    Is There Enough Oil to Pay Our Debt?
    http://www.jeffrubinssmallerworld.com/2011/01/05/is-there-enough-oil-to-pay-our-debt/#
    Our currency and credit creation mechanism, fractional reserve banking, is entirely dependent on debt … As economic growth slows then stops then contracts vast amounts of debt will be unpayable and new debt will be untenable …
    The only way forward is exclusively sovereign credit money underwritten by the country itself and not debt … Without a conversion to sovereign “credit” money the economy implodes as our currency and credit is sucked into the vortex of the largest credit bubble in history …

  2. Steven Kopits

    Well, now. There were two oil shocks in the ’70′s, no? Looks good as a single event on the graph, but I think a bit of a stretch in the historical record. (So what is it: rate of change or price level? Hell if I know.)
    So what are you doing in sunny San Diego? A history of oil prices, or are you laying the groundwork to prepare us for another oil price shock?
    By the way, my take on the Tierney-Simmons bet is here: http://www.aspousa.org/index.php/2011/01/the-tierney-simmons-bet/

  3. JDH

    Steve Kopits: Yes, 2 or even 3 different events in the 1970s. I’ll have a much more detailed review of postwar events in a subsequent post I plan shortly describing my new paper.

  4. aaron

    I hate when people do this, but I’m compelled to do it anyway: Great post. You’ve posted many in the past few years I’ve been reading, but I generally feel it’s best not to distract from the discussion.

  5. mmckinl

    To: Steven Kopits
    A truly excellent piece on the Tierney -Simmons bet. I would recommend everyone read it …
    Your analysis on the increase in production costs and demand destruction is top notch … Your passing comment on dubious “proven” reserves of OPEC was spot on …
    What is missing is the effect of peak oil on financial markets. Once the implications of peak oil are understood leveraged debt (fractional reserve banking) becomes increasingly implausible creating massive destruction of currency and credit.
    I look forward to your analysis on the financial impacts of peak oil on the banking system …

  6. Ivars

    Oil seems to have reached its peak price according to oil shock history.
    But now the USA has added FED shock of adding USD to the market, so the price of oil may double in next 2 years in USD terms without anything much happening in either demand or production. And it will.
    As many have suggested, oil will go up with 15% volatility up to 160USD in 2011, and 190USD in early 2012.
    The bad news are, starting from around 140 USD oil prices will be out of phase with stock market due to drag on economy, and at 160-180 USD they will move 180 degrees out of phase, as oil prices will be driven by FED easy money still around and low interest rates, and killing the recovery of most Western economies (except Northern Europe).
    I would not be surprised if in 2012 we will see either price controls on gasoline or extra taxes on oil companies or both, as the USA economy keeps going down in H2 2011 and 2012, while energy/food inflation up, and tax incomes down.
    Also, clear wish of the USA to control even more oil producing countries to try to drive prices down fast will become obvious in 2012, and reasons to enter parts of Iran soon will be searched for, as high commodity prices evaluate the USA biggest IOU “export” – the USD.

  7. Rich Berger

    “Second, I submit that when demand booms and production is stagnant, it is possible for the price of oil to quadruple in a short period of time.” So you say that the law of supply and demand still works. It make sense that the price rises to ration supply to those that are willing to pay the most. If the price stays high, new energy saving technologies become profitable, and what were uneconomic energy sources become economic. I believe that p;ices have usually come down, so the long-term scenarios don’t come true. I think the peak oil concept is not very useful, due to the interaction of prices and technology. If oil becomes relatively scarce, it gets rationed by price – it never runs out.

  8. Matt Young

    Just curious. But we have a research paper that shows state change in response to oil shocks. That leads to a bigger question, is this a common property of the economy? And if so, then the Taylor rule doesn’t work through a state change.

  9. Ricardo

    Professor,
    In your three periods consider the following.
    1862-1865 Us leaves gold standard. Impact of the Greenback.
    1973-1981 Nixon defaults on gold standard commitments and closes the gold window.
    2002-2009 Greatest implementation of quantitative easing in the nation’s history. Gold:dollar ratio approaches the most unstable relationship in our nation’s history (with the possible exception of the 1970s).
    I believe that your research will show that such things as demand will have some effect on the price of oil but monetary events probably have a greater effect. Note that in periods of monetary stability the price of gold was amazingly constant.

  10. Steven Kopits

    MMCKINL -
    I don’t quite recall the ’70s oil shocks as having the same effect in the financial sector–albeit perhaps the effect was more pronounced in the emerging economies with the re-cycling of petrodollars. (“Countries don’t go bust.”)
    I would just about kill, though, for an analysis on the impact of oil prices on re-employment. Is the US energy-constrainted? I think so (but not in December!). If so, what does that mean? How much of the unemployment rate can be attributed to oil prices? Can any at all?
    This is a central question in both economic and energy policy. If oil prices are restraining re-employment, then either we want to understand that employment may remain higher than expected for longer, or that getting more energy into the marketplace is a top priority.
    Further, if we go from energy constrained into another oil shock, then the forecasts we have for both budget balance and employment are materially wrong.
    So oil prices and employment are potentially an important topic. Is anyone in Washington covering this topic?

  11. ppcm

    The oil price spike, in 2008 seems to be more driven by paper interest, than by physical delivery.Yes,there was a large demand.
    The air transportation industry was showing skepticism on the nature of the spike in price ,Soros was as well disturbed by the ongoing speculation on oil.To be remembered the funds size, allocated to commodities was (from Bloomberg memory 800 billion usd)
    Interesting study, to be read as it provides an insight of the actors and commentators value added when explaining commodity price volatility.
    Some info on oil speculation Air transportation Last revised 2008
    http://www.raa.org/LinkClick.aspx?fileticket=UdLS10ZUbgU%3D&tabid=176&mid=647

  12. rayllove

    Whether history ‘rhymes’ or otherwise, I don’t see energy prices being as much of a problem as what bubbles etc. might be. In fact, I suspect that bubbles and the consequent busts, and some related improvements in efficiency, should keep the demand for energy in check.
    The problem though is not the result of fiat currency, or the lack of a standard, but instead that of constraints caused by imbalanced wealth-distribution and the resulting shortfalls in purchasing-power.
    The problem is that the value of labor is falling and this is limiting capital formation in a synergistic loop. But… without limits on the creation of liquidity, and as nations become increasingly dependent on lending, investment, and etc., asset bubbles are inevitable and increasingly so as less and less wealth can be derived from labor.
    So… it is not that a gold standard is needed, but rather, that wealth-distribution must be addressed by some sort of index on productivity gains or on growth. Basically, exploitation must be eliminated before any other significant progress is possible, but of course the most influential people, and nations, all depend on exploitation and the resulting conflicts on all levels.
    In other words, the global economy has not just become too dependent on unproductive financial services, but also on wars and on crime and on a formula that ignores the negative external costs.

  13. silly things

    Prof. Hamilton,
    Your quote further below is too narrowly focused on oil as an energy source. Increase production of energy will come from technological progress. Various form of energy available to man is essentially infinite. What we need is better technology to exploit these energy sources.
    “The first is that, although economists are used to thinking about increased production as coming from technological progress, in the case of the oil industry the biggest factor has instead been the exploitation of alternative oil fields that proved to be much bigger and better than the originals.” – Hamilton
    I think a much more interesting question is:
    Q1. Why, this time, capitalism will not give us the next energy source right when we need it?
    For one things, we already have nuclear energy waiting in the wing for decades. All that is needed is an economic environment that is less hostile toward it.
    The next interesting question I have is:
    Q2. Will the transition from one energy source (oil) to another energy source be very rough on society? Just to limit the broadness of this question a bit, will major economies collapse and will wars be fought over it?
    I actually think this can spur economic growth. Imagine all the infrastructure that have to be built. Look at the investment in green tech today.
    At any rate, it seem really difficult to be very pessimistic on either question. I’d love to hear some thoughtful views to the contrary.

  14. mmckinl

    To Steven Kopits …
    “I don’t quite recall the ’70s oil shocks as having the same effect in the financial sector–albeit perhaps the effect was more pronounced in the emerging economies with the re-cycling of petrodollars. (“Countries don’t go bust.”)”
    ~ Fed policy was to inflate then Volcker stepped in when it got out of hand.
    “I would just about kill, though, for an analysis on the impact of oil prices on re-employment. Is the US energy-constrainted? I think so (but not in December!). If so, what does that mean? How much of the unemployment rate can be attributed to oil prices? Can any at all?”
    ~ The unemployment is because of the debt bubble bursting. The financial crisis and peak oil are two different phenomena though I am suspicious of the timing of the crisis …
    “This is a central question in both economic and energy policy. If oil prices are restraining re-employment, then either we want to understand that employment may remain higher than expected for longer, or that getting more energy into the marketplace is a top priority.”
    ~It is a double whammy. Re-employment is hurt by both the deflationary spiral and oil price rises.
    “Further, if we go from energy constrained into another oil shock, then the forecasts we have for both budget balance and employment are materially wrong.”
    ~Of course the forecasts are wrong … There hasn’t been any truth out of Wash DC about any of this. Peak oil is not even mentioned … the ongoing deflation ignored.
    “So oil prices and employment are potentially an important topic. Is anyone in Washington covering this topic?”
    More like covering the situation up …

  15. Jeffrey J Brown

    One minor correction, the US peak was in 1970.
    The key problem for oil importing countries like the US (incidentally, the US became a net oil importer in 1948, 22 years before our production peaked), is the supply of global net oil exports, especially given the rapid increase in “Chndia’s” combined net oil imports.
    Here is a brief summary of the differences between Peak Oil and Peak Exports:
    http://www.energybulletin.net/stories/2010-10-18/peak-oil-versus-peak-exports
    Our analysis suggests that the US is well on its way to “freedom” from our dependence on foreign sources of oil, just not in the way that most people anticipated.

  16. Jeffrey J Brown

    Regarding oil prices, no matter what specific years that one picks as the starting and ending points, the period from the late Nineties to the end of this decade was characterized by a double-digit average long-term rate of increase in average annual oil prices. For example, from 1998 to 2008 the average rate of increase in US spot crude oil prices was about 20 percent per year.
    However, what I find interesting is the progression in three year-over-year annual price declines in the 1997 to 2009 time period: down to $14 in 1998, down to $26 in 2001 and down to $62 in 2009. Note that each successive year-over-year price decline was to a level that was about twice the level reached during the prior decline.
    If this pattern holds, the next year-over-year price decline would bring us down to an average annual oil price of about $120, in the context of a long-term average double-digit rate of increase in annual oil prices, which is what we are seeing in 2010, versus 2009.

  17. ScottB

    Thanks for the overview.
    So do you view the 2008 spike as demand-driven, as opposed to speculation-driven?

  18. Hitchhiker

    It would be quite a leap to say that U.S. production peaked in 1971 due to availability of oil. I would say that it peaked due to a combination of two factors, the emergence of an environment movement and incredibly low marginal costs of mid east oil. The former could be ignored and allowed to gain power as long as the latter proved dependable. An examination of restrictions on drilling in this country imposed over the last forty years makes it clear that we chose to stop producing oil here and simply chose to buy it overseas. Nothing wrong with that as far as it goes but, the oft repeated claims of politicians to stop the dependence on foreign sources rings hollow when no corresponding lifting of restrictions ensues.
    Many technologies are already here to compensate for lack of increasing world wide proven reserves of easy to pump oil but, the environmentalists are fighting all with equal fervor. Again, no problem since we have declared oil evil and our all powerful legislative body has decreed that power should come from sources such as solar and wind so we can rest comfortably in the knowledge that even though the market has been prevented from supplying us with cheap energy, our beneficent politicians have the situation well in hand through shrewd investments made on our behalf with our money in alternatives with unproven track records and nonexistent business plans.

  19. mmckinl

    ~ “I would say that it peaked due to a combination of two factors, the emergence of an environment movement and incredibly low marginal costs of mid east oil.”
    ~~~ Then how do you explain the Alaskan pipeline and the North Sea Oil ventures ???

  20. eric

    ~ “I would say that it peaked due to a combination of two factors, the emergence of an environment movement and incredibly low marginal costs of mid east oil.”
    ~~~ Then how do you explain the Alaskan pipeline and the North Sea Oil ventures ???
    ~~~~~ Not only that, but how would you explain the fact that, the US, like every other region in the history of oil production, has never regained its peak production. As Professor Hamilton points out, no technological advances have ever allowed a region to regain its peak production; instead, in order to get more oil production has had to shift to other regions. What we will do when the earth as a whole has reached its peak is not at all clear, but based on the history of oil production, we should not be too sanguine about technology coming to the rescue.

  21. Jeffrey J Brown

    Re: Hitchhiker
    This article shows the 1972 Texas and 1999 North Sea peaks lined up with each other:
    http://www.energybulletin.net/stories/2010-10-18/peak-oil-versus-peak-exports
    These two regions (which accounted for about 9% total cumulative global crude oil production through 2005) were developed by private companies, using the best available technology, with virtually no restrictions on drilling, and the initial declines in both cases corresponded to sharply rising oil prices.
    I’m afraid that Peaks Happen, even in the best of circumstances.
    But the real problem is global net oil exports, and the data show that we are being steadily outbid for a declining supply of global net oil exports.

  22. JDH

    Jeffrey J Brown at January 12, 2011 09:07 AM: One can measure this different ways. I’m using a 12-month moving average of U.S. field production of crude oil (from EIA), and that series peaks in July 1971.

    ScottB: Yes, I regard booming demand and stagnating production as the principal causes, though I acknowledge the possibility that speculation may have contributed to the final spike in prices. Note the series plotted here is an annual average.

    Hitchhiker: Among other problems with your theory, in 1974 we paid 4 times as much for that Middle East oil as we had been paying for the product of Texas in 1972.

    s@ndy: I have a paper published in the Journal of Econometrics in 2003 (working paper version here) addressing precisely this question. The answer I came up with from that statistical analysis is an oil price movement that substantially exceeds the previous 3-year high. I’ll post a new paper on this subject this weekend, which takes a look at what happened in a large number of different historical episodes, some obviously more minor events than others.

  23. Qc

    Great post. Nice to have the increase in oil price in a historical perspective. Very much agree with you that the wild card is Iraq in term of knowing whether the peak is ahead of us or if we are in fact already in a post-peak world. Although some great news came from deep-water discoveries in Brazil, these are unlikely to make any significant difference in term of world oil production before we are well into the next decade.
    I also think that US car manufacturers are at last waking up to this new reality (see http://www.reuters.com/article/idUSTRE70C4T520110113).

  24. Anonymous

    World oil production, 2003:M1-2010:M9. Includes lease condensate, natural gas plant liquids, other liquids, and refinery process gain.

    Should read: World oil production, 2003:M1-2010:M9. Includes lease condensate (which have only about 65% of the energy-per-volume of oil so we are attempting to fool you by mixing them in here), natural gas plant liquids (ditto), other liquids (likewise), and refinery process gain (and so on).

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