Peak oil: the economics behind the problem

Let’s get back to peak oil. Previously I defined the peak oil phenomenon and discussed some of the science underlying the issue. In this post, I’m going to talk about the economics behind peak oil, the dynamics that underlie worldwide consumption and production of oil.

To review where we are so far: at some point in the relatively near future, natural limits to the rate of oil production will cause the daily supply of oil to top out and then enter a steady decline. This peak is the inevitable result of the geology of oil fields, and will occur long before the world’s oil supply has been fully extracted from the ground.

Demand for oil, on the other hand, is not likely to decline anytime soon. Quite the opposite. In 2004, China passed Japan to become the second largest consumer of oil, after the United States. If Chinese oil consumption continues to parallel the country’s economic growth, China will catch up to the U.S. in about 20 years. And China is by no means an isolated case, although it is one of the largest single drivers of increasing demand. The same story is playing out across the globe, particularly in Brazil, India, and Russia.

Currently, worldwide demand for oil is about 84 million barrels per day. And worldwide pumping capacity is…about 84 million barrels per day. That’s right, we’re already bumping up against the ceiling of our pumping capacity. In the past, the world could rely on Saudi Arabia’s spare pumping capacity to smooth out temporary supply fluctuations. For example, during the first gulf war, Saudi Arabia moved quickly to make up for the interrupted supply from other Gulf States, and managed to keep the resulting oil shock from being worse than it was. These days, however, even Saudi Arabia is pumping at full capacity.

Now, pumping capacity is not quite the same thing as peak oil. We can theoretically increase pumping capacity, whereas peak oil places a harder limit on production rates. But new pumping capacity takes time to develop, so the high gas prices and dramatic fluctuations we’re presently seeing are a foretaste of what’s to come. Demand is overtaking supply due to large-scale, systemic trends, and we shouldn’t expect gas prices to revert to “normal” anytime soon.

The good news is that sustained high oil prices by themselves aren’t that bad for the economy. We can have robust growth even when gas is dear. And, as some have pointed out, high gas prices have the positive side effect of making alternative energy sources more economically attractive, which is a key to long-term adoption.

The bad news is that, while high oil prices themselves are not necessarily crippling to the economy, plenty of evidence suggests that severe fluctuations in oil prices are in fact very bad for the economy. Sudden jumps in the price of energy — which is a key input to, well, just about everything — cause ripples throughout the economy. I’m not old enough to remember the oil shocks of the ’70s all that well, but I’m told they weren’t very much fun.

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