An urban legend to comfort America: demand for oil creates new supply

This is the third post in a series examining “urban legends” about energy that comfort Americans.  These five myths are:

I.      Our massive reserves of unconventional oil.
II.     We’ll run crash programs to solve peak oil, just as we mobilized for WWII.
III.    Demand creates supply, by raising prices.
IV.    Oil is Oil, even if it is not oil
V.    Demand creates supply, from new technology.

As I have described at length in previous posts, we know astonishingly little about our available energy resources, consumption patterns, and alternatives.  To illustrate this, nobody has answered the question at the start of chapter II:  what is our source of information about the monthly volume of Saudi Arabia’s oil exports?  Please place your answers in the comments.

Chapter 3 — Demand creates supply, by raising prices

This is core belief of mainstream economists, a bastardized version of Say’s Law that says, “Supply creates its own demand.”  (Lord Keynes so described Say’s Law in his General Theory of Employment, Interest and Money, 1936.  See this for additional analysis).

In brief — a full explanation requires drawing supply/price and demand/price curves — modern economics sees that increased demand forces up prices, which over time brings forth new supply.  We often see this dynamic at work in daily life, and esp in disasters.  A demand for pumps after a flood pushes up prices; pumps are brought in to meet this new demand.  Unfortunately, conventional oil is a special case. 

The supply curve for oil does not always rise with increased prices.  The supply is finite in a way different from other minerals.   Oil is found in a relatively small number of places which have special geological history and rock formations.  It is a organic liquid — it flows away and gets eaten by microorganisms.   This is the foundation concept of Peak Oil.  At some point our production of conventional oil will peak — as it already has in so many of the world’s largest fields — and then will begin a decline (perhaps after a plateau). 

Estimates of the decline rate have risen in the past decade, from the roughly 3% based on the experience of the “lower-48” American fields, to the 8% – 15% seen in fields harvested for much of their life with advanced methods (e.g., water flooding in Ghawar, nitrogen flooding in Mexico’s Cantarell).

Peak Oil as a transitional period

Peak oil is the transitional period following peaking of global conventional oil production, in which the world moves to new energy sources. There are three major elements to this transition.  These forms of energy are more expensive than conventional oil.  Hence the oft-state belief that they will force energy prices down from current levels misses the point.  Rather it is higher oil prices, following peaking of conventional sources, which drives the transition to these other sources.

First:  replacing conventional oil with other sources

Unconventional liquid fuels:  such as polar and deepsea oil, heavy oil (e.g, Venezuela), bitumen (e.g., Canada’s oil sands), kerogen (e.g., NW US oil shale), converting coal to diesel, converting biomass to ethanol.

Alternative energy:  such as geothermal, nuclear, marine, solar, wind (note:  these require electric transportation systems, either using batteries or train/trolley systems).

Second:  higher prices forces behavioral changes.

  1. Reduced discretionary consumption (e.g., vacation locally instead of at DisneyWorld, moving the thermostat higher in summer and lower in winter).
  2. Capital investments that yield increased efficiency (e.g., insulating buildings).
  3. Substitution, as high prices change cost structures (e.g., local goods replace far-away ones, rail transport replaces trucks, walking replaces driving).

Third:  higher prices spurs research and development of new sources, such as two described later in this series

  1. New biofuels, such as cellulosic ethanol (new enzymes which allow converting switchgrass into ethanol) and algae farm to fuel systems,
  2. Fusion, such as the polywell.

It is a race

Most expert forecasts see the world’s output of conventional oil peaking occurring sometime in the next 20 years.  Peaking of individual fields and regions has usually been recognized only after the fact, so this may have happened as long ago as 2005.  Surveys of new projects, such as Petroleum Review’s Megaprojects survey, show a substantial decrease in new production after 2012 — while production continues to peak at the world’s giant and supergiant fields, with decline rates following peaking of 8%-plus.

Peaking may be followed by a plateau (of unknown duration) or an immediate decline.  Publicly available information is insufficient for more than guesses.

On the other side of the equation, how quickly can new sources (as described above) be rolled out on a scale sufficient to replace the conventional oil we rely upon today?  Probably decades. 

It is a race, and the clock has started.  Will there be a gap in time between the decline old sources and the emerging new sources?  If so, prices must spike during that period to destroy demand — priced-based rationing — so that supply and demand balance.  Since many years (or even decaddes) will be required to build these new sources, fecklessness today could mean a long, deep recession like nothing we have seen in America since WWII.

Most of the comments to this post will give their guesses as to how this will work out.  What they will not do is cite of expert studies modeling these factors.  While modeling this is possible, America instead prefers to guess about these things — and then plan based on these guesses.  Future generations probably will not understand our reluctance to fund research by our experts on these questions.  Esp if the results are not pretty.

The faith-based plan:  It will all work out OK, because God helps those who will not help themselves

Our adaptation to peak oil will be rapid, from a historical perspective.  The work of Robert Hirsch and others suggests that in two decades we will have passed through the transition, one way or another.  If we start soon and plan well this transition might be smooth, with a little luck.  Bad luck and fecklessness on our part and it could be a 20 year depression.

Everything — wars, famines, plagues — works itself out eventually.  As John Maynard Keynes wrote in 1923:

“In the long run we are all dead. Economists set themselves too easy, too useless a task if, in tempestuous seasons, they can only tell us that when the storm is long past the ocean is flat again.”

Our goal for the transition called peak oil should not be to live through it.  Just getting up each day will accomplish that.  Rather we should plan and work to ensure the prosperty of ourselves and our descendents.  Passively watching our oil supplies decline while doing nothing, trusting to fate, might lead to our children cursing us.  And deservedly so.

Please share your comments by posting below.  Please make them brief (250 words max), civil, and relevant to this post.  Or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).

For more more information

Some posts about unconventional and alternative energy sources

  1. Links to articles and presentations of some A-team energy experts , 11 November 2007
  2. The most dangerous form of Peak Oil , 8 April 2008
  3. The three forms of Peak Oil (let’s hope for the benign form) , 23 April 2008
  4. The world changed last week, with no headlines to mark the news, 25 April 2008
  5. Fusion energy, too risky a bet for America (we prefer to rely on war) , 4 May 2008
  6. Peak Oil Doomsters debunked, end of civilization called off , 8 May 2008
  7. When the King of Saudi Arabia talks about oil, we should listen , 2 July 2008
  8. Red Alert: the Saudi Princes have annouced the arrival of Peak Oil , 11 July 2008
  9. Good news about oil, but for our grandkids – not us , 14 July 2008
  10. The secret cause of high oil prices , 6 August 2008

Here is an archive of all my articles about Peak Oil.

To see studies about energy — including oil, coal, nuclear, and alternative energy — see the FM Reference Page:  Peak Oil – Other Resources.

5 thoughts on “An urban legend to comfort America: demand for oil creates new supply”

  1. Fab, the key issue is price. As you say: “These forms of energy are more expensive than conventional oil.”

    Whether they are ‘conventional’ or not is not really the issue, the issue is the price of producing a fuel that is good for transportation. The US estimates cost for recovering Oil Sand based on Alberta, less than $30/ bbl (capital plus operating).

    How cheap does it have to get to be counted as ‘conventional’? It doesn’t matter. What does matter is that there’s a LOT of oil available at higher prices. But nobody has a good framework for discussion how much at what price points.
    I’m increasingly confident we won’t see $200/bbl (avg 2008 USD) in the next two years. I would be more surprised if it was over $150 (20% chance) than if it was under $100 (40% chance) — but I’m not investing any of my money in my guesstimates of future prices.

    Higher prices increase supply — this is no myth. (It’s the Law of Supply!)
    Fabius Maximus replies: (1) I am using “conventional oil” supply as an analytical basket, to distinguish it from other supplies. It does not matter how cheap mining bitumen gets, it does not become like light/sweet crude.

    (2) Most of these companies have said that oil must stay above $70 for them to run profitably. The sheet you mention gives estimates from 2004 reports, using even earlier data. Things have changed in the past 5 years.

    Equipment, labor, land, royalties, taxes — costs have been (and are) skyrocketing as production has increased. Also, at some point Alberta might insist on environmental restroration — not leaving Alberta looking like a moonscape. That will not be cheap.

    The sheet did not state their assumped price for natural gas costs, the major energy input used, but probably they used the five-year average of aprox $3; in the last 12 months its been aprox $9. Since Canada’s nat gas supply is limited (and needed by other US and Canadian users), massive expansion of bitumen mining will require nukes (the first application already has been filed); these will be even more expensive.

    (3) I will restate this point (again). The vast amount of the oil we produce today comes from conventional sources. This production will peak and decline at some point in the next decade or so, as forecast by virtually all experts in the field. Higher prices will not increase the supply of this specific resource.

    None of the available unconventional and alternative resources today operates on a sufficient scale to replace convention oil. The synfuel output of Alberta does not even replace the falling production of N. America’s fields. The process of gearing them up will be long and expensive. There might be a gap between falling conventional production and rising replacement sources, which could be painful.

    (4) “this is no myth. (It’s the Law of Supply!)”

    What is taught to children as “the law of supply” is a general theory about the behavior of goods. There is no way to prove that it applies to every good at every time. As I explained, over a long time (decades or more) it will probably prove true for energy. But that’s the not relevant issue, is it?

  2. Tom Grey: Actually, high prices in the short run don’t increase supply, if there is no reserve of supply or substitutable items.

    EG, could high prices increase the supply of trees on Easter Island?

    Thats the key: What production reserves exist for the existing supplies? What altertate substitutes are available?

  3. Rumor has it there may be a coup in Nigeria.

    The ruling PDP had raised the alarm that certain foreign interests, intent on creating instability in Nigeria with the goal of containing her rising international profile, were working in concert with a coalition of opposition politicians to topple the federal government.

    I don’t know how serious this rumour is or, if the rumor is true, what it might entail.

    But is it a potentially significant possibility concerning which we should be alert to.

  4. steve from virginia

    First of all, people are just going to have to get by with a lot less. Consumption is a dead letter. Most of what people do with themselves is non- essential. Our ‘non-negotiable lifestyle’ is time wasting, money gambling (speculation) and business transaction churning.

    The greatest shortage in this lovely world is useful, interesting things for people to do.

    Rising prices (correlative values, because we are in a deflationary environment.) will not increase supply; the mechanism here is different than described by Say’s Law. Keep in mind, when the deflation takes hold in earnest, people won’t spend. Conservation is coming, either by intent and discipline or imposed by circumstance.

    Finally: Base load power source; molten salt reactors. There is a lot of Thorium, the reactors don’t melt down or blow up and proliferation can be designed out. More material is online: “A Brief History of the Liquid-Fluoride Reactor“, posted at Energy from Thorium, 22 April 2006.
    Fabius Maximus replies: The link goes to an article which leads off with a description of the USAF’s atomic-powered airplane, my favorite-ever Defense program!

    Also, it is not clear that either the world or the US is experiencing or heading toward deflation. Inflation and deflation are public policy choices, alternative monetary responses to real world events.

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