Oil Prices and the Mayflower Problem
29 Aug, 2008 02:34 pm
Do oil prices really tell the market what it needs to know when it needs to know it?
Back on Earth events in the energy markets are moving along a trajectory quite different from that of our doppelganger universe. This is much to the chagrin of earthbound neoclassical economists who, as it turns out, run practically everything here when it comes to government economic policy and corporate management. Until recently the real prices of oil and natural gas had been declining for more than a century, and the neoclassical economists took this as an indication that technology was expanding the resource base by making more and more of these fossil fuels extractable.
But as Douglas Reynolds explains in his paper, "The Mineral Economy: How Prices and Costs Can Falsely Signal Decreasing Scarcity," one simply cannot know whether declining real costs for finite mineral resources are due to increasing information about where to find them, advances in the technology for extracting them, or both. Let us back up for a moment and explain why this is so. While doing this we will also discover why price signals about the depletion of finite resources such as fossil fuels are likely to come so late in the cycle of depletion as to endanger any society which relies on such resources for normal functioning.
First, we must understand the so-called "Mayflower Problem." The name comes from the analogy of the Mayflower landing on the Massachusetts coast where the Pilgrims set up the Plymouth Colony in 1620. In those days the most valuable commodity was fertile land. Certainly, the most fertile land in America was not found in Massachusetts. It would have been best for the Pilgrims to have traveled up the Mississippi River to Iowa. But, of course, they didn't know about the American prairie. It would take another 200 years before Europeans began to settle the Great Plains and take advantage of its rich soil. Finally, the rest of the West would be settled, but the largest find of fertile land had already occurred. True, California had rich land, but that land had already been settled long before by the Spanish.
The analogy suggests what experience demonstrates. For any finite resource the pattern of discovery is small, large, small. It takes time to discover the most productive areas for any resource when there is very little information about where to look. As knowledge about where to look expands, it becomes easier to find a resource and as a result larger discoveries occur. But at some point, all the large discoveries will have been made and therefore more information about where to look will not yield additional large discoveries. The pattern then reverts back to small discoveries.
Oil exploration appears to be in this final stage of small discoveries. We are making a lot of small discoveries, but finding very few of the huge so-called elephant fields characteristic of the Texas oil boom of the 1930s or the Mideast oil finds of the 1960s. In fact, discoveries appear to have peaked back in the mid-1960s. Currently, worldwide oil consumption is running just over 30 billion barrels a year. But, discoveries are running about 9 billion barrels. That can't go on forever without declines in oil production.
The same pattern is occurring in natural gas, at least in North America, where furious drilling in response to high natural gas prices has only been able to maintain production levels. In fact, natural gas production has stalled out in North America since 1998 and appears to have peaked.
Of course, technology can and does expand what is considered a resource. That has certainly happened with both oil and natural gas. For example, oil from the Canadian tar sands can now be extracted profitably. And, deep water drilling has become commonplace. When it comes to natural gas drilling, well fracturing techniques have made it feasible to produce far more gas from shale than before.
So, how does all of this impact energy prices? From the beginning of the oil age in 1859 expanding information about where to find oil led to increasing discoveries and finally to the discovery of many supergiant fields. As those discoveries continued, the market came to expect that the discoveries would go on for such a long time that there would be no need to worry about oil supplies or substitutes anytime soon. Even though supergiant discoveries have been few and far between in the last 30 years, the oil markets have remained oversupplied, in part, due to the increasing energy efficiency of the world economy and the vast development of new hydrocarbon resources found during the last oil boom of the 1970s. In addition, advancing technology was thought to be expanding the extractable resource and making it cheaper to obtain.
So thoroughly entrenched were these ideas that only nine years ago the price of oil reached $10 a barrel with the expectation that prices would be going lower. Today, the price of oil has vaulted to more than 10 times that amount. Oil production has been flat for the last three years, and this is despite the large investments being made to find new oil. Part of the problem, of course, is the low investment by state-owned oil companies which now control the lion's share of oil reserves, some 77 percent. But the real question is whether technology, both for finding and extracting oil, is finally being outpaced by depletion. If so, why didn't this show up earlier in the price? Why haven't oil prices been rising gradually over time rather than generally falling (except during the 1970s oil crisis) in real terms until this decade?
The reason is that the assumptions about the power of technology in bringing oil to market have been essentially unverifiable; since the claims can't really be verified, they can't be disputed. And, given the low price of oil in the previous two decades, no one felt confident in disputing them--except for a few iconoclastic geologists familiar with the work of M. King Hubbert who were keeping tabs on world oil supplies. Their alternative explanation for the role of technology is that it is depleting oil resources faster rather than merely expanding the total resource.
Because oil producers believed prices would likely stay low or head lower, they had little incentive to hold reserves in the ground waiting for higher prices. Instead, they produced nearly as quickly as they could. A continuously well-supplied marketplace also came to share the expectation that prices could only remain low because of the application of and expected advances in technology and because large new finds would be made if the surplus ever dried up and made it profitable to explore more vigorously. When the ultimate extent of a resource cannot be effectively verified as in the case of oil, the market tends to be backward-looking.
Though many in the oil industry are now acknowledging possible near-term limits to oil, the dominant view remains that there is plenty of oil yet to find and that technology and proper investment will bring it to the surface in ever-growing quantities for several decades more. This view is accepted even though it is public knowledge that few large fields have been discovered in the last 30 years. The price of oil then has largely been a function of immediate supply and demand. The vaunted futures markets developed for energy in the 1980s were supposed to look ahead. But as recently as 2004 when front-month prices for oil were posted at $55 a barrel, the futures prices for 2008 remained stuck at not far above $30. So much for the predictive powers of the futures markets.
Reynolds piece published in 1999 predicts that the price curves over time for oil and other finite minerals will actually look more like the following:
Source: Hubbert Peak of Oil Production
The price of a finite resource can decline for a very long time as new techniques allow the available resource to grow and as the all important rate of extraction rises exponentially. Then, suddenly the resource can become scarce as the peak extraction rate approaches amidst robust demand. This may very well be what is happening in the oil market today and in the some regional natural gas markets.
Of course, what has been happening prior to this point is that the market price has merely been providing what Reynolds would call the illusion of decreasing scarcity. In reality, finite resources start to become scarcer from the first day they are taken from the ground. But the impossibility of judging the ultimate size of any finite resource (since it is both hidden from view and a function of technological developments) can create an illusion of plenty for a very long period.
Reynolds model can, of course, be applied to other finite resources such as coal and metal ores. Presumably, one day we will see that same kind of exponential acceleration in the prices of coal and various key metals such as copper, zinc, lead, and even aluminum shortly before their production peaks. (Some think we may be seeing such an acceleration in coal, but the peak in coal production may be a few decades out yet.) Perhaps of immediate importance in this regard are rare metals such as rhodium, indium, gallium and others that have recently skyrocketed in price. Many of these rare metals are critical in electronics, oil refining, and chemical processing. So little is known about the size of the resource for each that it is hard to tell whether the prices reflect temporary shortages or the last days before the peak in world production.
One thing, though, ought to be clear. The time for a simpleminded faith in the power of technology to solve our energy and other resource challenges is probably over. We will now need to do far more than sit back and allow the experts to solve every problem by simply finding more supply or developing appropriate substitutes in the nick of time.