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Friday, March 18, 2016

Peak Oil Revisited: Did I get anything right?

Mike Smitka, Economics, Washington and Lee University

In 2014 I wrote on the arrival of peak oil. That now appears at best premature. So what did I get wrong, and what (if anything) did I get right?

In my initial post I made two key assumptions. The first was that fracking would not be that important, because it remained a high-cost method of extraction. The second was that Saudi Arabia still had market power, and that therefore would respond to rising costs by cutting output. The third that changes in demand would be modest. Finally, though not (then and now) relevant, I assumed that alternative energy sources would remain marginal and substitution away from petroleum small.

Let me begin with the last, irrelevant point: alternative energy. In fact there's a lot of progress, progress that may be outstripping improvements in the (mature) thermal energy sector. Both wind and solar technologies see steady improvement, while thermal technology is changing less rapidly. (The key innovation of which I'm aware, but about which I know no details, is the ability to ramp up and down "base" generating capacity quickly. That improves the business case for intermittent power sources – solar and wind – because "base" capacity can be cut or boosted within a shorter time frame. As a result, as several papers at the 2015 Industry Studies Association conference in Kansas City argued, widespread windmill networks such as that in the Minnesota region can predict what the system as a whole can deliver 15 minutes in the future and hence bid into the short-term market. While in practice the marginal cost of solar isn't zero, it is lower than that of coal or even natural gas. Hence "green" sources can in practice lower hydrocarbon demand. At present that is a modest slice of the overall market, and current low hydrocarbon prices impede investment in additional capacity. Public policy – will governments take action in the face of global warming – comes to the fore. I simply don't know how much is now being invested in alternative sources, and the total quantities remain modest from a global perspective. With every passing year, the likelihood that incremental demand will be met through investment in renewable capacity improves, and hence my sense is that with each passing year the cost of such capacity lowers the ceiling on long-run energy prices. Now the devil lies in the details, which I don't know, but at least conceptually I can make the case that the longer low prices persist, the more likely that they will persist even longer. [Is my prose confusing? Well, so in this case is the real world.]

...green energy's not important today, but each year the impact on tomorrow's prices becomes more significant...

Second, I overestimated the role of Saudi Arabia, in that I read what is happening to their marginal cost of extraction as reflecting such costs for the market as a whole. So while their costs of extraction are rising, their market power is falling. At the same time, the marginal costs of producing in the Bakken formations, once a well has been drilled, may be (for me surprisingly) low. When supply is in excess, so that market power considerations don't matter, it's the low cost (marginal) producer that matters. The Saudis are no longer that. As I argue in an August 2015 post (and have long argued to classes in my teaching at W&L), OPEC in practice is not a cartel, and the Saudis are by themselves too small to be able to swing the market in their favor.

I've not tried to spell this out in a careful model, "excess" is not a term that an economist uses because at some level supply always equals demand. What I have in mind is a oligopolistic price leadership model, where producers collectively find it easy to not cheat too much – not pump too aggressively – when demand is strong relative to potential output levels, but devolve into a price war when faced with negative demand shocks. But it may be simpler, and result in the same bottom line, to view the industry as having zero costs once a well is in production. At the wellhead there is then no incentive to reduce production, ever. Wells do gradually dry up, and so output from an individual location declines over time. In periods of low prices, oil drillers can't cover the cost of new wells (or investing to boost production from existing ones), so eventually the supply curve shifts in and (for a given level of demand) prices rise. But in the short run the supply curve is fixed and steep – "price inelastic" in economics jargon. Demand is also steep, but can vary in the short run. The result is volatile prices.

Finally, there's that fracking problem. It's clear that there's large heterogeneity from well to well. In some spots – the center of a field – a single well will produce a lot, but as you move further out the average falls, and the variance rises, you have the occasional well that does really well alongside onces that are dry. (I doubt that's the actual geology, instead this is a variation on the standard diminishing returns story that economists employ.) So costs vary a lot, and some wells run dry quickly, but not all. Furthermore, once the core infrastructure is in place, transmission pipelines to the fields (if only to the nearest railroad), then it doesn't take long to drill a new well, and there are a lot of drilling rigs. So while on average fracking is a high-cost operation, particularly at the front end, that hides a lot of variation. And there a lot of oil fields.

At present fracking has been a U.S. thing. Some countries in Europe have banned it, others allow it in principle but local permits haven't been forthcoming, the NIMBY thing. Some attractive formations are in places without a lot of water, and fracking needs a lot: environmental issues are real. But Europe is only a fraction of the earth's surface, and there is the potential for using this comparative new set of technologies around the world. And set of technologies it is: it's not just ability to fan out multiple pipes from a single hole, it's not just the how-to of fracturing rock and then recovering oil from a wider variety of geologies, it's also the ability to employ seismic data to know where and how to drill.

So what I underestimated is the potential for technical change in the industry. Implicitly I assumed it was a mature industry, that the exploration of the earth's surface [but not necessarily the ocean bottom] for potential oil formations was largely complete. Similarly, within a known formation, I assumed that the ability to use seismic data to delve into local details – the ability to do a "CT scan" of rock layers 10,000 feet down – had reached its practical limit. Yet again, after a century and a half of experience, drilling itself was a static technology. Finally, the same was true for how you actually get the oil out once you've drilled.

...will "peak oil" remain forever sound in theory but irrelevant in practice?...

I was wrong in each instance. Capabilities are better; in economist-speak costs are lower. And at least in my mind the fracking revolution has really only begun. Without these technologies, no one paid attention to "tight" formations. There are likely a lot out there, in Iran and the Russian Republic and China, in Brazil and Venezuela and Mexico, some of which will have enough water and all that. Has the minimum price at which it makes sense to drill risen? Likely, but not by enough to mean "peak oil" is at hand. I do believe that we are in an era of diminishing returns, where the base price will trend up. If the economies of South Asia and Sub-Saharan Africa grow – which I pray is the case, that the next couple decades will see another billion or so people pulled out of poverty – then the demand side will encourage renewed exploration and recovery. The longer that takes, though, the greater the potential of non-petroleum energy sources, and the demand for petroleum (and natural gas) will be for chemical products and not for their energy content. In that case, "peak oil" may forever remain sound as a theory but irrelevant as a practical concern.

Sources I scan on energy issues:
  1. WTRG Economics
  2. Nick Butler at the Financial Times
  3. James Hamilton at EconBrowser