November 2005

A World with Less Oil: The Consequences

U.S. oil production is at its lowest level since 1950, while global demand continues to grow. As investment in production and refining capacity has lagged in recent years, energy prices have soared. Although there are similarities with previous oil price fluctuations, the current situation has certain specific features. Many are alarmed by the possibility of global oil production peaking in the near future but fail to grasp the implications of such a situation. At a November 2 AEI panel discussion, James D. Hamilton presented his view of the likely aftermath of declining oil production, and the consequences that he believes are already on the horizon.

James D. Hamilton
University of California, San Diego

It is clear that as oil is pumped out of the ground, the stocks diminish, and you need to find new oil fields. Most of the world’s oil comes from super-giant fields, and these are no longer being found.

U.S. oil production peaked in 1970. We are currently producing the least oil in fifty years. It is not cheap imports that have reduced this--quite the opposite--it is lower U.S. production that has forced up the oil price. However, the fall in production is hardly due to a lack of effort.

Based on the geology, the same decline of oil production will happen on a global scale. The only question is “when?” The easy answer is “not yet.” More still seems to be being found. If you had asked in the early 1980s, you would have thought that the oil supply would have run out by now--but that declining trend had more to do with politics than with geology. The Iran-Iraq war was the key factor forcing down production and increasing the price of oil.

In the past two years, there has been a huge surge in demand. China has only accounted for 8 percent of oil consumption, while the United States has accounted for 25 percent. However, the change of world oil demand between 2002 and 2004 has 36 percent from China and only 18 percent from the United States.

China’s oil demand has grown at 7.5 percent per annum for fifteen years. That rate makes you a major player pretty soon. That trend projected for twenty years would leave China consuming 30 million barrels per day--relative to the current 20 million barrels for the United States. Where will this extra oil come from? If you have supply reaching its peak (which it will, eventually--regardless of how optimistic you are), coupled with the exponential growth in Chinese demand, this presents a serious challenge.

Poorer countries are those with the fastest growth of petroleum, but this growth declines as countries become richer. The 7.5 percent growth of China will not continue at that rate, but the basic challenge of high production will.

Economists acknowledge that price will reconcile supply and demand by choking off the demand and increasing the supply from difficult areas. So, have we seen the effect of price on demand? China has insulated its people from the price somewhat--selling gas at lower than the world price--so this has delayed the response to higher prices.

In the United States, sales of big cars have declined in response to price, despite the efforts of auto manufacturers to offer significant employee discounts. We must remember, however, that vehicles sales will not effect this year’s oil consumption as much as it will next year’s, when the effects of better fuel economy have more fully fed through.

If you need to reduce consumption very quickly in response to events (such as the Iran-Iraq war), the oil price has to go up very high. In real terms, the oil price peaked in 1981 (at $95, in current prices), but it took a long time for the high price to erode demand.

There is a broad trend of declining real oil prices from 1981 to 1997. In this period, the engineers’ exploration kept ahead of the geologists’ constraints, so to speak. In the past few years, there really has been a dramatic rise in the oil price--due to a surge in demand. We should see a rise in exploration spending, although there will be huge lags on supply. Both responses of supply and demand to the change in price will take time. The key aspect of the supply side is expectations.

Another contribution to supply is storage. (This can be below ground, and includes keeping it in the reservoir by pumping it out slower). Economists suggest that people do not supply at $60 if they expect the price to be at $200 in several years’ time. By encouraging people to store now and sell later, this reduces the current supply and increases future supply. There is therefore a powerful economic incentive for the current price to match future expected supply and demand. This is inter-temporal arbitrage. The capacity for storage allows speculators to drive these prices together. This speculation today will create incentives to deal with the pending problem. The prices today and the profit-maximizing economy is leading people now to demand less and supply more, well before we are running out of oil, and this will facilitate a smooth transition.

On the New York Mercantile Exchange you can buy oil for future delivery. Futures prices show what the market thinks will happen to future demand and supply. If you look at 2011, the futures price is lower than the current price. However, there is not a huge difference between the current and futures price (and there never is), due to the capacity for inter-temporal arbitrage. This suggests that we are not quite on the edge of the cliff yet.

The quality of crude oil produced by non-OPEC suppliers in terms of viscosity and sulphur content is falling, which indicates that we have used up the best oil, and are left with lower quality product. When oil products must meet a multitude of different county-by-county environmental standards, this further increases the costs of production.

Why are we getting our oil from places that are vulnerable, such as the Gulf of Mexico (offshore in a hurricane alley)? It is because the easy extraction fields in places like Texas are no longer available, and so we are moving to parts of the world that are a lot less geopolitically attractive, such as Nigeria. The most reliable sources of oil are used up first, and the best sources are now gone.

I believe that we will see the price rise over time and feel that the long-run crunch is unavoidable. We will see more industrialization of India and China as a real new source of demand. These temporary disruptions of supply will become more severe, since we must now get oil from more hazardous places than Texas.

I also think that we can expect the general public to blame “greedy oil companies,” rather than appreciate the forces of supply and demand.

Roger M. Kubarych
Council on Foreign Relations

We should not anthropomorphize the market. It is a collection of disparate views and information that produces a price.

There is a lot more to the energy sector than oil. We are seeing a lot more usage of exotics and renewables, coal, natural gas, and oil sands. We will also see a rebirth of nuclear power, under the competitive pressure of nations such as Japan and France, which will lead Americans to realize that it is the way to lower energy bills.

Today, Brazil is masterful at using renewables, such as ethanol. Scientists will increasingly allow this to be done in other places.

There is an internal incentive for renewables through carbon trading. Windmills are augmentative and incremental, but they are not reliable when there is no wind, as happens even in the North Sea sometimes. This unreliability is also true of solar power.

New technology and new uses, such as coal and oil sands will prove incredibly lucrative. Where will the money come from to fund this? There is a high savings rate in Asia and lots of money stored elsewhere. The most important thing is to cure the fear of falling oil prices. People were burnt in the mid-1980s after investing hugely in alternative fuels. Investors are scared of downside risks, of which cheap oil is the most significant. But, when it becomes clear that oil prices are not falling back, we will get these investments, and the energy crisis will not look so forbidding.

Kevin A. Hassett
AEI

It is useful to think of how the government might react to this. We know that tax subsidies work, and that consumers respond to them. But before the subsidy, people are deciding rationally.

Should the government step in if we are running out of oil? Pollution and congestion Pigouvian arguments (that taxes can internalize social environmental costs) do not apply to the ineffectiveness of the price mechanism.

Some critics claim that consumers fail to invest sufficiently in energy conservation (e.g. insulation) to save money, but there is not much evidence to suggest the opinion that the price mechanism is failing to represent costs properly. Adjusted for the risk that energy prices could fall, people are rationally deciding in line with energy prices not to invest in insulation.

Transportation overwhelms all other demand for energy. Americans move things around mostly through the private sector. Only 1 percent of journeys occur through mass transit. This is the lowest share of any developed country. If this was increased to 10 percent, Saudi oil imports could be zero. Is this possible? Why does mass transit work so poorly? We will not see much change by getting people to move to more efficient vehicles, so we need new ideas to make transportation more efficient.

Phillip L. Swagel
AEI

With respect to the potential policies: the gas tax, fuel standards, incentives for refineries and the role of storage facilities, what are your ideas of these? Should policy be slowing things down (easing the need for adjustment to a less oil-based economy), or speeding it up?

I would also like to ask about the prospects for alternative energy sources, such as hydrogen or coal. To what extent does this interact with the supply response for additional exploration?

James D. Hamilton

One of the things that we have been doing is to simultaneously subsidize and restrict activities--that is true of nuclear power, and it is true of refining. This is an odd notion. We have a legal environment that is not conducive to many of these investments. But, I resist the notion that we should subsidize the refineries to make this happen. I have a general distrust of that.

The Strategic Petroleum Reserve (SPR) is an excellent idea in terms of military-type disruptions--if we have a major problem in Saudi Arabia, for instance, it would be a good idea to tap into that. However, it is extremely irresponsible to suggest (as New York senator Charles Schumer did) that the SPR should be used to resist the general high price--it just does not make sense as a policy tool for that purpose.

As for the next phase, the most likely development is with oil sands, which will make a difference. Oil shale is further down the road, and problems are fairly serious there. Hydrogen, of course, is not a fuel source, but just a way to get the energy from another source to make your car move. But, overall, I see a real problem with Congress picking the winner here. I think that what Congress will do is pick the corn growers, for the ethanol. We really want to let the market choose the winners.

AEI research assistant Chris Pope prepared this summary.