The Oil Drum

On October 24th, Dr. James Hamilton of Econbrowser commented on The Tragic Consequences of the High Discounting of Oil Extraction [1] in his story Is peak oil irrelevant?

Figure 1 -- Click to enlarge

If Dave had gazed not at a century of prices but rather at just the last 15 years of the price of oil relative to the PCE deflator, would he have drawn the same conclusion? If all we had was the graph above, it would seem quite natural to conclude that a rising scarcity rent could well be one factor in the recent behavior of this commodity price...

... I am not at all prepared to dismiss the hypothesis that scarcity rents have indeed started to make a contribution to oil prices over the last five years, and will become more apparent over the next five...

Admittedly, if the oil price should fall from here down to $30, then I'll have to conclude that scarcity rents have had nothing to do with the recent price moves.

But if Dave is right about the geology, oil is not going to $30.

Not knowing of any good evidence to contrary, I'll just make the simplifying assumption that I'm right about the geology.

We'll return below to some of Hamilton's other observations as we consider what meaning to draw from the history of oil prices over the last several years.

[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.