Editore"s Note
Tilting at Windmills

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June 2, 2005
By: Kevin Drum

PEAK OIL....PART 4....When I last left you hanging, I had spent a few thousand words trying to convince you of several things. First, that the daily rate of oil production in the non-OPEC world will peak within a few years and then begin an irreversible decline. Second, that this is the result of geology and can't really be stopped. And third, that there isn't much oil left elsewhere in the world to make up for this. As a result, global oil production will probably hit a peak around 2015 and then begin a long, slow decline. That date is just my own guess, of course: other analysts provide estimates for the production peak ranging from 2005 to 2035 or beyond.

Does the precise date of peak oil really matter? To some extent, of course it does: if production has already peaked, the world economy is in big trouble and there's no time to prepare for it. If it peaks in 30 years, there are plenty of things we can do in the meantime. Even ten years is better than nothing.

But in another sense it doesn't, because something has already happened that's equally important: the world has run out of spare pumping capacity. That's the subject of this post, but before I dive into it I want to take a brief detour and investigate some decidedly non-mainstream oil economics. Don't worry: it will all make sense before I'm done.


Most economists believe that the price of oil has only a moderate effect on the world economy, and as near as I can tell this is true. But it's a different story if you take a look at changes in the price of oil. The chart on the right, courtesy of GlobalSecurity.org, plots both oil prices (in constant 2000 dollars) and economic growth over the past 35 years. I've extended it to 2005, and you'll see that over that time there have been four periods in which oil prices have spiked suddenly (i.e., risen more than 50% in less than 18 months): 1973, 1979-81, 1989-90, and 1999-2000.

There have also been four periods of recession during that time: 1974-75, 1980-82 (a double dip), 1991, and 2001. This can't be written off as a coincidence. Oil shocks don't necessarily cause recessions, but they pretty clearly play a role, either in touching them off or in adding fuel to the fire. The conclusion from this data is pretty obvious: although the world economy can chug along reasonably well with either high oil prices or low oil prices, it grinds to a halt when oil prices spike up suddenly, producing widespread recession and stubbornly high unemployment rates. For those thrown out of work, this is bad news indeed.

So what causes oil prices to spike upward?


Supply and demand, of course. In particular, the first three oil shocks were caused by sudden drops in supply: the OPEC embargo caused the first oil shock, the Iranian revolution caused the second, and the Gulf War caused the third.

All three could have been worse than they were. The 1973 embargo was short lived and Iran actively worked to stabilize oil prices by increasing its production. In 1979, when Iranian production plummeted during their revolution, Saudi Arabia stepped in and increased production. In 1990, when Iraqi and Kuwaiti production fell, Saudi Arabia stepped in again and maxed out their production levels. Without those interventions, especially Saudi Arabia's, these shocks would have been even more devastating than they were.

But it's not only during oil shocks that Saudi Arabia's enormous production capability has come in handy. In fact, ever since 1980 Saudi Arabia has used its spare capacity on a routine basis to smooth out bumps in global oil supply, keeping the world economy on a relatively even keel. For a quarter of a century, Saudi Arabia has been the key swing producer on the world oil stage.

Unfortunately, the days of Saudi intervention are over. Current world demand for oil is about 84 million barrels per day, and current world production capacity is about....84 million barrels per day. As Amy Myers Jaffe points out, OPEC's spare capacity and thus the world's has dropped nearly to zero in the past few years. Everyone is pumping full out.

This is why prices are increasing now even though there's been no oil shock. It's not because of a sudden disruption, it's because demand is now bumping up against supply. What's more, this is a permanent condition: new capacity takes years to develop, so even in the best case supply will only barely keep up with future growth in demand. There's not much margin for error.

In the short term, this doesn't mean much: prices will most likely continue to bounce around based on inventory levels and seasonal/regional demand. In the longer term, however, prices are likely to rise steadily and become far more sensitive to supply problems. With Saudi Arabia now pumping at very close to its maximum capacity, even a moderate oil shock somewhere in the world will make $50 per barrel oil seem like a bargain.

This potential for instability is far more dangerous than mere expensive oil. The economy can adjust to high oil prices, and to the extent that high prices reduce consumption and spur innovation, they can even be positively beneficial. But as we saw above, wildly fluctuating oil prices are a different, and far more damaging, story. What's worse, future oil shocks are likely to be fairly frequent since it will take only a small disruption to remove a few million barrels a day from the world market. Venezuela's production dropped by 2 million bpd for a few months in 2003 just because their oil workers went on strike, for example. With Saudi Arabia already pumping at capacity, we can't expect them to bail us out when stuff like this happens in the future.

So that's the predicament we're in. Since supply disruptions are a predictable part of the oil business, and there's no one left to make up for future shortfalls, the result is likely to be oil that's at $50 a barrel one day and $200 a barrel the next bringing recession and unemployment in its wake. We'd all like to see the world consume less oil, I think, but reducing consumption via frequent and nasty global recessions is not what any of us had in mind.

This is what peak oil has brought us to. The actual peak may happen this year or it may not happen for a couple of decades, but just the fact that we're close means that we've already hit the point in the curve where spare capacity is a luxury of the past. The result will be increasing global instability caused by a turbulent economy held permanent hostage to terrorists, unstable dictatorships, resource wars, and natural disasters.

There's not a lot we can do about this in the short term, but a halfway sensible energy policy could do a lot of good in the medium and long term. I'll finish up with a few words about that tomorrow.

Continue to Part 5.

Kevin Drum 12:36 AM Permalink | Trackbacks

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