No bell curve in the jaws of peak oil

October 26, 2009

If levity were allowed in the serious matter of running out of cheap oil, one might say “A funny thing happened on the way to the peak.” The maximum rate of global output may be somewhat higher than the already reached ca. 87 million barrels per day, but world oil does not want to go there. Like a frightened horse in a dark forest, it has stopped; keeps neighing and shaking its sweaty head, letting the rider (global society) know that this is it. No further! A clear sense of direction has been lost and those mysterious lights that flicker here and there only make our mobility provider turn its insides out.

The notion that accelerated drawdown of a nonrenewable resource must reach a climactic bliss point of intensity beyond which market incentives move into high gear to substitute away from it is beyond debate. But oil is a resource like no other. The economy’s ever more evident inability to reduce dependence on it while retaining growth raises the strong possibility that the peak — as rationally defined, rather than empirically experienced — will never be reached.

What proved to be correct for individual nations, well-defined regions, and specific fields in the relatively early stages of exhausting traditional oil — namely reaching an “objective” maximum rate of output and declining smoothly thereafter — seems staggeringly improbable for the entire world in the sunset phase of the petroleum age. What looked like a summit, arching against a clear sky of commonplace obviousness from a distance, is turning out to be the mirage of a Sphinx from the near.

To show this, we need to keep in mind that in the life of any geographically defined oil wealth — from a single well to the planet — there are three peaks: One relates to physics, the other to economics, and the third is the actually recorded, de facto peak. Let’s start with this last one since it is the most transparent.

“De Facto Peak”

Data on peak resource experience suggests that the zenith of exploitation should be somewhere around the point where reserves become half depleted. As far as oil is concerned, we can throw this compass into the wastebasket. Disagreements over how much is left are too big to be reconciled by averaging.

The time may have come for the empire of economic soothsaying to sign the instrument of surrender.

We don’t have the slightest idea of how much oil the world will produce in four decades and how much the barrel will command. And this is not the customary apology forecasters inevitably utter in their own defense — the hoary old song and dance about lack of reliable data and the demon of irreducible imperfections that haunts even the most up-to-date models. Uncertainty surrounding oil is made of sterner stuff when official U.S. Government statistics on proven reserves suggest that at current rates of consumption the world will run out of oil in about four decades — period.

If we take all the factors that may have a significant effect on the long-run demand and supply of oil (which account for its expected exchange value and the marginal cost of production, respectively), we get a cloud of point estimates, dense enough to darken the space delineated by the horizontal axis of time (running from now until 2050) and the vertical one, showing prices all over the place between an inflation-adjusted $20/b and $600/b.

As will be explained below, neither physically nor economically motivated ex ante calculations can be relied on to identify when world oil output will max out, if it has not done so already – an opinion based on supply’s multiple-year thumb-twiddling in the face of demand’s desperate cries for help.

The global peak will reveal itself to be an eminently ex post phenomenon. Looking back a few decades after the time when the nearness of the maximum rate was suspected, the whole exercise of locating it will be as trivial as running an index finger down a column of numbers. But the year and the event itself will hardly be just another milestone in social and economic history. This simple statistic will be forever cited amidst references to a vital turning point in the evolution of identity, civilization, and consciousness.

“Ideal Physical Peak”

In physical terms, the maximum rate of oil output (“peak oil”) may be expected to occur when the energy deployed to gain an additional unit of energy contained in new output become equal. Since material used in oil production as well as material derived from oil have theoretical energy equivalents, the above statement accounts for the entire process of physically interpreted costs and benefits finding equilibrium at a point that may be called the Ideal Physical Peak (IPP).

Extant methodologies applied to investigate an energy source’s costs and benefits in terms of energy may be rudimentary and limited, but they are, nevertheless, pertinent.

Energy Revenues on Energy Invested (EROEI or EROI) and similar indices designed to gauge the barrel equivalents of oil needed to gain a barrel equivalent of oil from various sources of energy should not be neglected by policymakers. Even if figures are cardinally flawed, ordinarily they are still highly informative. That is, the absolute value of an individual entry may be disputed, but its size relative to the rest of the entries calculated with the same method is loaded with implications. For instance, if EROI estimates made by several independent analysts show that the production of bio-methane costs more in energy than the energy it provides, the wisdom of its continued subsidization deserves a closer look.

Pure physical measures can direct the exploitation of energy sources toward the highest quality and easiest accessible sources, and they can also be used to search for the theoretical maximum rate of output of any exhaustible resource. The oil industry started with a very high number of barrels gained per barrel invested and has been proceeding toward lower and lower (EROEI or EROI) rates. On its way to the uneconomical region where the energy gained from oil is less than the energy used to access it, production must go through an easily missed perfect balance. The implied output per period may be considered the IPP.

Oil production may overshoot or undershoot the IPP. The first may occur as a result of subsidization (sustaining physically disadvantageous output levels by making economic sacrifices) and the second through either conscious policy or sheer inadvertence. As it will be argued below, this second alternative of undershooting applies to global oil.

“Ideal Economic Peak”

The equalization between the long-run benefits and costs of production and the price of oil is the closest rational measure of practical significance to gauge the location of IPP. But even this concept is elusive. Only an ideally functioning price system, guided by appropriate government institutions and policies that take into account social costs and benefits and protect against market failures could accurately estimate the maximum output rate at the optimizing, physical loss-and-gain-equating break-even point.

Such a flawless system exists only in textbooks; hence the “ideal” in the name Ideal Economic Peak (IEP). Structural shifts, movement through the business cycle, global monetary developments, and technological progress can easily alter general agreement about the peak’s previously-believed altitude even within a nation.

In econ-speak, development of a geographically delimited oil reserve makes sense as long as the net present discounted value (NPDV) of a given project is positive. NPDV is obtained by summing the discounted differences between annual benefits and costs per year. Using the prevailing market rate of interest as the discount factor, the NPDVs for all the investment projects needed to exhaust the reserve in question are listed in descending order. Since positive numbers become smaller and smaller before turning negative, the series must include a potentially feasible project with an NPDV of zero or close to it. And that is exactly where the traffic light of business rationality turns red. Negative NPDVs signal loss-maker undertakings and they will be crossed out with a thick felt pen.

The flow of capital into reserve development is likely to exhaust a well or a field by showing only positive NPDVs. It is unlikely to do so for a nation with substantial oil reserves and it is a sheer impossibility for the planet as a whole. Reasoning in this last respect requires a short detour.

Once a clear guiding light, the market rate of interest has become a flickering glowworm in the swamp.

To verify and adjust the results of the above-described process of determining the limit of capital flow into reserve development, petro-economists also calculate the “internal rate of return” (IRR). IRR is obtained by including it in the NPVD equation in place of the market rate of interest as an unknown, setting the equation to zero and solving for it. Project selection is based on comparing IRRs with the market rate of interest, the most general measure of profit-making potential derivable from alternative uses of the available capital, i.e., its “opportunity cost.”

A specific project should be undertaken only if its IRR exceeds the market rate of interest and should be rejected if it falls below.

Assuming that all oil companies follow this rule, the expansion of worldwide oil reserves will continue until the global oil industry’s IRR (which may be called the “marginal efficiency of capital in planetary reserve development”) exceeds — however slightly — some appropriate measure of the worldwide market rate of interest.

Considering the “marginal efficiency of capital” separate from the market rate of interest is a key element of Keynesian economics. It is easy to see why. For the concept of opportunity cost to make any sense, profit-making alternatives independent from any specific industry must exist. In the policy space determined by Keynesian thought — by and large the “mixed economy,” experimented out during the American New Deal to become the global economy’s institutional-ideological foundation since World War II — causality runs from the interest rate to a specific industry’s marginal efficiency of capital. Indeed, monetary measures designed to influence investment decisions through targeting the level of interest rate has played a critical role in the government’s guidance of national economies.

But now we can say good-by to all that. In the chaotic fog of instability and mistrust that has descended on the world of money and finance during the past two and half years, few things are as clear as the inability of traditional monetary policy to stimulate real (i.e., not speculative) investment by pushing interest rates below presumed IRRs or the economy’s aggregate marginal efficiency of capital.

Rates stuck at near zero (“super-teaser”) levels is a testimony of enduring general difficulties across the economic landscape and are next to useless in guiding investment decisions in a constructive fashion. If they tell anything at all to a firm that would like to find out if capacity expansion is worthwhile, it is to get quickly into the gaming parlor of short-term, speculative, liquid investments.

Central bank policies to cure the current economic downturn by flooding the banking system with liquidity may well turn out to be more harmful than it now appears. Betting stubbornly on the success of “quantitative easing” to restart the growth of prosperity is reminiscent of the liquored-up rake’s crazy martingale.

The gradual loss of soundness inherent in pursuing the materially unattainable economic policy objective of everlasting, uncoordinated, and ecologically forgetful output maximization goes hand in hand with a growing inability to look at the interest rate as if it were an alert traffic cop directing the flow of capital.

The fact that economic wellness has become subservient to oil remains a blind spot for most economists.

The crux of the illness invalidating contemporary analysis is the nonrecognition that an exhaustible resource is constraining economic growth and that this phenomenon is intimately related to the crisis of monetary-financial institutions. A cardinal manifestation of this infirmity is the constant search for parallels to a radically novel situation by combing the annals of “bubble history,” from the royal defaults of England’s financially challenged Edward III to the housing debacle.

“Definitive” new books about credit cycles written by first water professors of economics trying to convince a bewildered public that the future is symmetrical to the past (although with proper policies and “political will” we may just be able to avoid its pitfalls) only deepen the darkness of our generation’s culturally inculcated ignorance. Instead of bolstering the will to unpack defunct notions, they strengthen faith in them.

A correct diagnosis of the world’s economy’s convulsive disarray will not emerge on a decisive scale until the following epigrammatically compressed simple truth becomes pre-analytical certainty: The increased throughput of oil — from free energy manna at the production site to energetically inaccessible molecules of filth and fumes — is tied to an economic system that feeds on exponential growth, which in turn, depends on an even faster acceleration of debt. A growing supply of relatively cheap oil has been the foundation upon which financial innovation which, by its very nature produces not only beneficial (capital allocative) but also parasitic and ponzi schemes, built layer upon layer to insane and obviously untenable heights using the real economy as prop, excuse, and structural material.

Evidently, when the increasing flow of inexpensive oil changes into a constant flow of expensive oil, the sky-high pile of rickety financial instruments is the first to catch the blackleg. The infection develops quickly and is transmitted mercilessly across national boundaries, classes of obligations, and economic sectors.

An important threshold had been crossed.

It is hardly a mere coincidence that the collapse of the global financial casino coincided with the divorce between cheap oil and the full utilization of the rest of productive resources. We will never see the two of them together again — a situation loaded with the awesome implication that the world will be knocked back and forth between recession and aborted recovery as the oil price roller coaster alternatively encourages and discourages profligacy with our body economic’s vis vitalis. This emergent cyclicality reveals that the collision between humanity’s material ambitions and the planet’s physical constraints is not a single dramatic event as symbolized by the more than three decades-old “overshoot and collapse” meme. Rather, it is an extended, macrohistorically recognizable temporal process.

While the comprehensive cataplexy that has taken hold of basic schemes of national and international economic management challenges both traditional macro-policies and their micro foundations, it also ensures that the global society will be prevented from completely satisfying its Leviathan appetite for oil.

“Though this be madness, yet there is method in it.” (Polonius)

World oil output will never max out at IPP because it will not even reach IEP, which one may justifiably expect to come before it. And the prevailing form of global economic self-organization with its fragmented interests, jumbled signals, equivocations, and short-run mentality, will not be able to push oil-based production and environmental degradation as far as a world government possibly could by overriding mercantilist and corporate interests in pursuit of a firm program to drill, drill, drill!

If the planet lived under a regime of technocratic socialism in which the World State’s Vice President of Paradise Engineering (à la Huxley’s Brave New World) were in charge of investment decisions regarding natural resource development, then, for a while, oil would flow more copiously than it did under prevailing circumstances. But at what price? No one would know since central planning destroys the price system and creates unbearable social and political tensions as shortages counterbalance artificially created abundance in the priority sectors.

Since the prevailing global system of decentralized decision centers (mistakenly labeled as some version of a bona fide “market economy”) is unable to push oil production beyond a certain level without coming apart at the seams; and since the general public rejects the idea of world government, future generations may also have some oil. A collective instinct of self-preservation at the species level might be at work. It seems to prevail as the fundamental conviction held by generations of economists, namely that an endless growth in material welfare is the economy’s long-run steady state — mankind’s natural equilibrium condition — is being chewed to pieces by time’s iron teeth.

In fine, there are no explicit institutional parameters that would help advance along the path of post-oil enlightenment and regeneration in ways that, at the moment, most people would not consider economic self-mortification.

To the extent that the windows of perception can be wiped clean, there is only one piece of advice: Hold on to your hat! As far as global oil is concerned, Mr. Market’s climbing harness will not be there to secure a smooth descent on Mr. Hubert’s nonexistent down slope.

Tags: Fossil Fuels, Oil