Peak Oil Again?

Is "social meltdown" imminent?

Crude oil prices hover between $90 and $100 per barrel and U.S. gasoline prices are again north of $3 per gallon. Since 2002, the price of a barrel of oil has risen more than four-fold. Are we running out of oil? A new report by the German think tank Energy Watch Group (EWG) says so. The EWG report argues that the world reached the peak of oil production last year and supplies will fall from about 81 million per day now to just 39 million by 2030. "The world is at the beginning of a structural change of its economic system. This change will be triggered by declining fossil fuel supplies and will influence almost all aspects of our daily life," declared EWG founder Joerg Schindler. This fast onset of oil supply shortfalls, warns the EWG report, could trigger the "meltdown of society."

At the heart of the EWG analysis is its drastic downward revision of estimated world oil reserves. The Oil & Gas Journal estimates that world oil reserves are 1.3 trillion barrels and BP offers an estimate of 1.2 trillion barrels. By including unconventional sources of oil, Cambridge Energy Research Associates (CERA) triples reserves to 3.7 trillion. The EWG derives its figures by joining other peak oil proponents skeptical of Middle Eastern reserve claims. Like other oil peakists, they believe that Middle Eastern governments are lying about how much oil they have in the ground and, as a result, slash over 300 billion barrels from their total, calculating world reserves at only 854 billion barrels.

First, a bit of perspective. Daniel Yergin, chairman of CERA, noted that this is the fifth time the world is said to be running out of oil. "Each time—whether it was the 'gasoline famine' at the end of World War I or the 'permanent shortage' of the 1970s—technology and the opening of new frontier areas has banished the specter of decline," asserted Yergin. "There's no reason to think technology is finished this time."

Higher prices do generally mean that supplies are becoming relatively scarcer. So what is causing today's scarcity? Most people have forgotten that by the mid-1990s, the price of oil dropped to around $10 per barrel. Why? Because the world was awash in oil relative to demand. The oil crisis of the 1970s provoked so much field development that there was a 25 percent excess capacity. Low prices also meant that there was very little incentive to invest in projects to increase supply. For example, when oil prices collapsed in the 1980s, the number of exploratory drilling rigs in the United States fell from 4500 to under 1000.

At the beginning of the 21st century, economic growth in India and China surged after they finally managed to shrug off the shackles of socialist planning. Strong world economic growth soaked up the excess production capacity, which has now fallen to around 2.5 million barrels per day. Generally a cushion of 5 million barrels per day is necessary to keep prices low. Most of the excess capacity is in Saudi Arabia. The world currently consumes about 86 million barrels per day.

Fearing that the U.S. economy was about to slow down, the Organization of Petroleum Exporting Countries (OPEC) cut exports by 500,000 barrels per day in early 2007. Now afraid that higher oil prices will provoke a world economic recession and reduce the demand for their product, OPEC has opened the spigots by 500,000 barrels in November.

The rise of resource nationalism is also bedeviling oil supplies. Some 77 percent of world reserves are owned by governments—and they are trying to extract as much revenue as possible from them. The result, according to an October 31st report by the investment firm Goldman Sachs, is that greedy governments are killing incentives to bring new supplies to market.

"West Africa, Russia, the UK, Canada, and various Latin American countries have pursued very aggressive tax regimes on oil production profits, with Venezuela even shifting to the extreme of the nationalization of its assets," notes Goldman Sachs analsysts. "These policies substantially increase the costs of production and the price of oil required to incentivize investment. Over the past few weeks, Canada, Nigeria, and Kazakhstan have all suggested higher government royalties on production." For example, the Washington Post reported that above certain thresholds, Russian taxes siphon off $19.15 of a $20 a barrel price increase.

In addition, the International Energy Agency (IEA), the energy watchdog which was established by the developed countries during the 1970s oil crisis, finds that government oil companies are failing to invest enough to keep oil supplies flowing. Claude Mandil, head of the IEA warned last year that his agency's World Energy Outlook 2006 report "identifies under-investment in new energy supply as a real risk." In other words, the world could experience an even worse oil supply crunch because of the economic incompetence of governments in places like Venezuela, Iran, Mexico, and Nigeria.

Interestingly, despite a four-fold increase in the price of oil, world economic growth has been pretty robust. For example, the U.S. economy grew at 3.9 percent rate last quarter and inflation and unemployment remain low. Why? In September 2007 paper entitled, "Who's Afraid of a Big Bad Oil Shock," Yale University economist William Nordhaus speculates that the reaction of consumers and businesses to steep oil price increases is muted because they regard them as temporary. In addition, the cost of energy is less important to the budgets of businesses and consumers.

In 1980, when oil reached $101.70 per barrel in real terms, spending on gasoline was 4.5 percent of GDP, 7.2 percent of consumer expenditures, and 6.2 percent of personal disposable income, according to a March 2005 report by Goldman Sachs. If oil prices reach $105 per barrel, the report noted that gasoline spending would reach 3.6 percent of forecasted GDP, 5.3 percent of consumer expenditures, and 5.0 percent of personal disposable income. Prices would have to rise to $135 per barrel to equal 1970s levels. In addition, it takes only half as much energy to produce a dollar of GDP today than it did in 1980.

Instead of the "meldown of society," a likely and painful scenario is that greedy and incompetent government oil producers will continue to under-invest, causing a shortfall in supplies that will drive up prices and provoke a global economic slowdown. Expensive oil also encourages consumers and businesses to invest in energy efficiency that will combine with the slowdown to cut demand. Reduced demand will drive down oil prices as steeply as they rose. Some day peak oil production will be reached, but most oil reserve estimates suggest that there are good reasons to doubt that that day is now at hand.

Ronald Bailey is Reason's science correspondent. His most recent book, Liberation Biology: The Scientific and Moral Case for the Biotech Revolution, is available from Prometheus Books.