Knowledge Problem

Michael Giberson

Daniel Yergin’s peak oil commentary in last Saturday’s Wall Street Journal has set the econoblogosphere to chattering, or at least those of us in the energy corner. In addition to the clash of the titans, i.e. James Hamilton’s “More thoughts on peak oil” rejoinder to Yergin, the mere mortals are going at it, too.

Michael Levi did a quick round-up of reactions at his Council on Foreign Relations-based blog, then added his views. He expressed some exasperation about the “muddled, often faith based” arguing that goes on when peak oil is the topic.

I think he’s right: ideas often get muddled when peak oil is the topic. A big part of the problem is how the term “peak oil” frames the debate.

The problem with peaks

The term “peak oil” draws attention to the wrong issue. Try an analogy: During any given football game, there will be a point at which the football reaches its maximum height. Call it “peak ball.” Two things are obvious: first, after peak ball, the football will never again be that high; and second, the peak ball moment has almost nothing to do with the overall game. If you want to understand the football game, don’t worry about peak ball. People who frame the discussion in terms of peak ball will miss the point; the game’s real action is elsewhere.

Even experienced analysts get thrown off track. Consider Hamilton’s “More thoughts” rejoinder to Yergin.  Hamilton begins by trying to clarify just what he wants to discuss, stating three propositions as the “core claims that need to be evaluated.” Oddly, he then dismisses the first two propositions as so obvious as to not require additional thought (so what was it about the first two “core claims” that needed evaluation?) In any case, he thinks he is going to evaluate his third core claim: “This peak in global production will be reached relatively soon.”

But look at what he actually writes about in the rest of his essay. Beyond some swipes at Yergin’s peak oil discussion, Hamilton’s evaluation focuses on the slow supply response to increasing world demand for oil over the last few years, what economists’ call the price elasticity of supply. Hamilton said:

I was not among those who claimed that the peak would arrive by Thanksgiving 2005, nor 2007, nor 2011. But I am among those who did claim, and still believe, that the slow rate of increase in annual oil production over the last 5 years has caused significant economic problems for countries like the United States.

And he concluded:

I submit that meeting the growing global demand for crude oil over the last five years has posed significant challenges for the world economy. And those who worry that the next 5-10 years might be like the last should not be dismissed as crackpots.

In both claims, Hamilton draws attention to the slow rate of the supply response relative to demand growth. He is right, this is where the action is with respect to understanding recent oil market developments … and nothing about what he said depends upon whether the peak in world oil production did happen in 2005 or 2007, or will happen in 2011, or won’t happen until 2100 … and framing remarks as about peak oil distracts attention from the real issues.

Hamilton framed his article as if it were about peak oil, he titled his article “More thoughts on peak oil,” but when he gets down to explaining what he thinks is important, none of his article depends on peak anything.

Supply and demand: Boring and relevant

The underlying issue remains that the short run price elasticity of both supply and demand for crude oil are low, which means shifts in the supply or demand relationships become manifest mostly in changing price. Over the last several decades, most oil price shocks have been precipitated by supply interruptions. The duration of historic supply shocks has mostly depended upon the Saudi government’s willingness to use its spare productive capacity to fill the gap until the interrupted producer recovers.

When readily available spare capacity can fix an oil shock, there is little reason for significant investments by other producers to expand their own supply capability. When significant increases in supply appeared called for, they take years. The great non-OPEC supply boom of the early 1980s was mostly a delayed supply response to higher oil prices of the 1970s. Given the inherent years-long delays in any substantial supply response, it isn’t surprising that the price increases of 2005-2008 didn’t bring an immediate outpouring of new supplies.

The oil price run-up of 2005-2008 was mostly driven by a demand-side shock: increasing demand resulting from rising incomes in developing nations, especially China. Saudi production dipped a little rather than increased as post-2005 oil prices continued higher, and that response may have set the stage for the sharp price spike of 2008. All of these developments are well analyzed in Hamilton’s 2009 paper, “Causes and Consequences of the Oil Shock of 2007-08.” (Ungated version here.)

Conceivably, Saudi reluctance to increase production revealed the exhaustion of its spare capacity. Over the last few years there has been a lot of speculation about Saudi Arabian reserves, and not a lot of real information available publicly. But an alternative interpretation was that the demand-side shock – rapidly increasing world demand for oil – led the Saudi’s to reevaluate the reserve price they put on their spare capacity. In any case, the spare capacity seems to be back: in 2011 Saudi production reached a 30-year high after it increased production in response to Libyan supply interruptions.

Don’t be distracted

Yergin, not Hamilton, may be to blame for this latest round of peak oil debate. But the thrust of Yergin’s WSJ article was to undermine any focus on peak oil and to suggest the interesting action is elsewhere. Obviously I agree with Yergin on this point. It is perhaps a bit ironic, given the peak oiler-based anti-Yergin outrage that has erupted, that Yergin accepts the basic idea of a peak. He just believes the peak is at least 20 or so years away and will be long and flat and lacking in much social drama. Yergin’s error, to the peak oil crowd, is not being alarmed.

I also agree with Hamilton: the slow supply response to higher prices over the last few years have contributed to significant economic problems in the world economy. It seems quite reasonable to worry about how these issues will continue to play out over the next five or ten years.

Sure, it is possible to frame the explanation of crude oil prices over the last few years or the next ten as a “peak oil” story, but whether we are or are not at peak world oil production is essentially irrelevant. The question of peaking distracts from examination of the real action.

My advice to oil industry analysts: Use some other approach to understanding and explaining oil industry developments.

Don’t peak.