The Oil Drum

[editor's note, by Dave Cohen] This is a 1st draft of an essay in progress. It is quite long, but I believe your patience will be rewarded upon reading it. I solicit your comments and criticisms. Any mistakes are, of course, my own.

Over the longest possible term, since 1870, oil prices have not reflected predictions made by economic theories of finite (fixed stock) non-renewable resources like conventional oil. Consider the following quote from On the Economics of Non-Renewable Resources by Neha Khanna, an excellent introduction to the subject.

Economists add another dimension to this distinction between renewable and nonrenewable resources. Since economics is concerned with the allocation of scarce resources, for an economist non-renewable resources not only have a fixed stock, they are also in limited supply relative to the demand for them. Thus, old growth trees with life spans of as much as 1000 years while renewable by the common definition, may be classified as non-renewable by economists due to their relatively slow growth to maturity and few remaining stands....

Similarly, while coal would be considered non-renewable by some, most resource economists would consider it renewable due to the vast remaining stock. At current rates of consumption of about one billion tons per year, it is estimated that there is enough coal to last approximately 3000 years. From an economic perspective, there is no immediate coal scarcity simply due to its fixed stock. It is as if it were renewable. There is no scarcity rent associated with its extraction.

This essay will ultimately argue for the startling hypothesis that what Khanna says regarding coal also holds for oil in the market and finally comment on the tragic near-term consequences for humankind of this false & misleading market signal.

On December 28th, the Energy Bulletin included a link to a paper called Technology and Petroleum Exhaustion: Evidence from Two Mega-Oilfields (pdf) by two economists, John Malcolm Gowdy and Roxana Julia, from the Rensselaer Polytechnic Institute in New York. Here's the abstract.

In this paper we use results from the Hotelling model of non-renewable resources to examine the hypothesis that technology may increase petroleum reserves. We present empirical evidence from two well-documented mega-oilfields: the Forties in the North Sea and the Yates in West Texas. Patterns of depletion in these two fields suggest that when a resource is finite, technological improvements do increase supply temporarily. But in these two fields, the effect of new technology was to increase the rate of depletion without altering the fields' ultimate recovery - in line with Hotelling's predictions. Our results imply that temporary low prices may be misleading indicators of future resource scarcity and call into question the future ability of current mega-oilfields to meet a sharp increase in oil demand.

The paper is fairly standard fare for the peak oil community but what turns out to be of interest is the application of the work of Harold Hotelling regarding the Extraction of Exhaustible Resources and their discussion of the economic view of resource scarcity as regards oil. Examining the use of EOR technology in the historic production of Yates (West Texas) and the Forties (UK North Sea), Gowdy and Julia conclude that temporary incremental production gains are offset by later steeper decline rates in the tail end of production without increasing the overall URR. Their main conclusions are essentially that 1) oil is not being treated as a finite resource as the oil field analyses predict and 2) temporary production gains mask real scarcity and result in misleading low oil prices. Let's look at the work of Hotelling in the context of peak oil and see where that goes. This post runs a bit long so I hope you'll bear with me here.