In Praise of Global Oil Markets: Will the Idiocy End? In-Depth Article

Two days in October 1973 (16^th and 17^th) marked the most important turning point for US energy policy.  That is when energy policy idiocy began and despite all evidence to the contrary continues to this day.  When will it end?

In October 1973, the Organization of Petroleum Exporting Countries or OPEC doubled the price of a barrel of oil and imposed an embargo on deliveries to several countries, including the US, for supporting a military operation by Israel.

Since that embargo, literally every president, even the normally economically literate Ronald Reagan, has chanted the mantra of “energy independence.”  In pursuit of that silly goal, the US has embraced a number of bad policies.

All sound analysis of oil markets proceeds from an understanding of global oil markets and the oil resource base.  Because there has been such a profound misunderstanding of these basic concepts, there has been much mischief enacted into policy.

Understanding Global Oil Markets

Dr. William Nordhaus of Yale University proposed the best metaphor for the global oil market.  Think of a bathtub with many faucets and many drains.  It doesn’t matter where you put oil into the tub or take oil out of the tub; the only thing that matters is how much oil is in the tub at a given moment.[1]  More oil in the tub will lower world oil prices and vice versa. 

This simple bathtub metaphor has profound implications for how we think about energy policies relating to oil. The first significant implication is that “energy independence” is an economically nonsensical concept.

Today, as world oil prices hover at around $50 a barrel, Japan with no oil resources pays the same on the global market for a barrel of oil as does Great Britain with plentiful North Sea resources.  So the amount of oil a country imports (a measure of supposed “energy independence”) is irrelevant to the availability of oil and its price.  If magically the US discovered oil that it could produce for $10 a barrel in Iowa, what would the price of oil be in the US?  Absent some form of governmental price control, it would NOT be $10.  It would be whatever the global price of oil was at any given moment.  Iowa would gladly export oil to any country willing to pay more than $10 rather than sell it in the US for $10.  Thus the world price of oil, no matter where produced will achieve some price that balances supply and demand (or a price based on how much oil is in the bathtub).[2]

So maybe “energy independence” arguments are not based on either the availability or price of oil.  Maybe there is some other reason we would want to produce all the oil we consume. 

As for being held hostage by hostile foreign producers, as we will see later in this commentary, they are actually more dependent on us then we are on them.  Their economies are built on an expectation of oil over $100 a barrel and they (Russia, Venezuela, and OPEC) are now scrambling.

The recent dramatic drop in world oil prices provides an excellent example demonstrating the fallacy of energy independence. A major factor in the dramatic drop in oil prices is the increase in supply in the United States made possible by new production technologies such as fracking, horizontal drilling, and 3D seismic. The increase in supply in the United States not only resulted in lower prices for oil in the US but indeed was critical to a worldwide drop, nay collapse, in oil prices. Oil prices on the global market have dropped based on a myriad of factors. But the reality is that the price will be set for oil purchased in the United States on a global market. It makes absolutely no difference in our energy policy if we buy more or less oil on the global market. Certainly oil prices will have a profound impact on the economy at large not only in the United States but in many other countries as well.  But we have no control over oil prices.

Understanding the Oil Resource Base

Sound energy policy requires an understanding of the oil resource base.  Let’s start with a profound and startling insight: The World Will Never Run Out of Oil. 

But wait, surely you must be mistaken, you say.  Oil is a finite resource and we are consuming it at extraordinarily high rates.  Surely the bathtub will run dry someday. 

Such a view belies a fundamental misunderstanding of natural resource economics.  Whale oil used to be the staple for lighting and other purposes.  Did we run out of whales?  No.  Demand for whale oil increased and the supply of whales decreased with increased harvesting of whales for their oil.  Did we wait for the last whale to be captured before we started to consider substitutes?  No. Innovators and entrepreneurs driven by the pursuit of profit explored new ways to satisfy consumer demands for the things that whale oil could provide.  Circa the 1850s, innovators on both sides of the Atlantic began to realize the potential for large scale use of crude oil in its refined state.  Circa 1890, major breakthroughs in electricity were being made worldwide, and Thomas Edison built the first power plant on Pearl Street in 1882.

Thomas Malthus and more recently Malthusians such as the Club of Rome and Dr. John Holdren base their worldviews on doom and gloom projections of future lack of availability of resources.  A view widely reflected in the media and even common sense suggests that surely population growth and resource limitations will inevitably result in disaster for the earth.  Thankfully, many Malthusians have made predictions as to how long current resources would last unless draconian steps were taken to address issues raised by their worldview.  Remarkably, these “doomsters,” as they are called have never been right.  Their track record is disastrously wrong every time.  Yet these consistent failures have seemingly not diminished their reputations or the media/public’s willingness to be persuaded that disaster is just around the corner.

Dr. Julian Simon spoke most persuasively rebutting the doomsters.  His view is that human ingenuity is the “ultimate resource,” as he titled two of his books.  He stated that:

Our supplies of natural resources are not finite in any economic sense. Nor does past experience give reason to expect natural resources to become more scarce. Rather, if history is any guide, natural resources will progressively become less costly, hence less scarce, and will constitute a smaller proportion of our expenses in future years.

He specifically applied this view to energy:

Energy is the master resource, because energy enables us to convert one material into another. As natural scientists continue to learn more about the transformation of materials from one form to another with the aid of energy, energy will be even more important. . . .

For example, low energy costs would enable people to create enormous quantities of useful land. The cost of energy is the prime reason that water desalination now is too expensive for general use; reduction in energy cost would make water desalination feasible, and irrigated farming would follow in many areas that are now deserts. And if energy were much cheaper, it would be feasible to transport sweet water from areas of surplus to arid areas far away.

Another example: If energy costs were low enough, all kinds of raw materials could be mined from the sea.

But he viewed that the “ultimate resource is people—especially skilled, spirited, and hopeful young people endowed with liberty—who will exert their wills and imaginations for their own benefits, and so inevitably they will benefit the rest of us as well.”

So, the “amount of energy” is not the issue; human ingenuity, the ultimate resource, is the issue.  We will never run out of oil because as the resource base is depleted, oil will become more expensive.  As it becomes more expensive, craven, heartless, greedy entrepreneurs will find currently unknown but clever ways to find more oil, invent oil substitutes, or develop other technology that uses an increasingly expensive resource more efficiently. 

And the shock of it all is that no one person or government will have to develop a plan or a strategy to make sure that chaos is avoided.  Rather, as Dr. Friedrich Hayek pioneered, the concept of “spontaneous order,” i.e., “the emergence of various kinds of social orders from a combination of self-interested individuals who are not intentionally trying to create order through planning.” The information contained in prices drives producers, consumers, and innovators to make myriad and sometimes microscopic adjustments that over time ensure that we will have the supplies we need when we need them.  When dislocation does seemingly exist in a market, you can be virtually assured that it is because some government action or policy has prevented the clear dissemination of price signals.  Hence, it is crucial to closely examine government policy to ensure that impediments to clear price signals are either not imposed or are removed.  Again, Julian Simon pierces the balloon of ignorance:

Not understanding the process of a spontaneously-ordered economy goes hand-in-hand with not understanding the creation of resources and wealth. And when a person does not understand the creation of resources and wealth, the only intellectual alternative is to believe that increasing wealth must be at the cost of someone else. This belief that our good fortune must be an exploitation of others may be the taproot of false prophecy about doom that our evil ways must bring upon us.

But it is understandable that some are concerned with how much oil is in the ground.  An understanding of this requires a foray into some technical distinctions regarding an energy resource that is buried deep in the earth.  Here, the distinction between reserves and resources is important.  In essence, reserves are oil that we are highly certain is in the ground and capable of being produced commercially.  Typically this means that wells have been drilled and testing has been done to increase the probability that the estimates of the amount of oil are highly reliable.  Even this category breaks down further into proved and unproved, with unproved being further broken down into probable and possible, going from the most certain to less certain.  Resources, on the other hand, are even less certain.  We know there is oil but we are taking a guess as to how much is there and how much it will cost to produce.  Typically banks will only lend money on reserves.

This brings us to the controversial question of “peak oil.”  The concept of peak oil was pioneered by a geophysist named Dr. M. King Hubbert.  Peak oil is a somewhat logical concept that means that we have reached the halfway point in available oil resources after which there is a downward trajectory in exploitation and production of the resource base.  Whatever value this concept may have to geologists, it has virtually NO importance to economists, as noted above.  Peak oil alarmism is often used by special interests to scare policymakers into embracing whatever stupid idea that will feather the nest of the advocate.

There are two refutations of peak oil; one based on experience the other on economics.  There seemed to be a consensus that the world had reached peak oil circa 1970 and that governments had to enact policies to ensure an orderly transition to some other fuel, usually renewables. Many doubted the insight that peak oil supposedly provided even before the easy refutation of peak oil by the fracking/horizontal drilling/enhanced oil recovery technological innovations.  But certainly reality brought peak oil theory to a screeching halt with the dramatic increase in our ability to access the resource base made possible by technology. 

So how much oil do we have?  I hope by now you realize this is almost a silly question to which the answer is “enough.”  The US Energy Information Administration has a somewhat technical explanation for this.  Julian Simon also has a more comprehensive answer to the question:  When Will We Run Out Of Oil?  Never!

But for the skeptics or those who can’t be comfortable without a number, here is the best information there is.

BP does an annual statistical review of world energy resources every year, and it is highly regarded. According to BP’s most recent review “Total world proved oil reserves reached 1687.9 billion barrels at the end of 2013, sufficient to meet 53.3 years of global production.”

Just remember that every prediction of when we would run out of oil or how much oil we have left has ALWAYS turned out to be wrong.  We always find ways to find more plentiful, cheaper, and more environmentally benign ways of finding more natural resources.

The recent boom in oil supplies and collapse of oil prices should teach us something about projections. We are constantly looking for new technologies to access energy supplies.  Let’s use an example of an energy resource you probably have never even heard of: methane hydrates.  The US DOE states:

While global estimates vary considerably, the energy content of methane occurring in hydrate form is immense, possibly exceeding the combined energy content of all other known fossil fuels. However, future production volumes are speculative because methane production from hydrate has not been documented beyond small-scale field experiments. 

There are three things important about the future of energy resources: technology, technology, and technology.

Just look at the role of technology in our current (March 2015) oil markets.  Currently, the most controversial issue regarding oil and natural gas is the issue of hydraulic fracturing or “fracking.”  The development of this technology allows oil to be produced in quantities and geologic formations that were historically thought to be impossible.  Essentially, various chemicals are deposited in a deep hole and put under intense pressure.  This pressure “breaks” up the rock-like formation and allows oil and gas to become available for production.  Part of this technology advance is also the ability to drill at angles and horizontally to more efficiently drain a reservoir of oil. And our insight on where to drill is informed with “4D Seismic Technology” that allows us to “see” the geophysical characteristics of formations like never before. 

Yet another technological development is enhanced oil recovery.  Here is what the US DOE has to say about enhance oil recovery:

Crude oil development and production in U.S. oil reservoirs can include up to three distinct phases: primary, secondary, and tertiary (or enhanced) recovery. During primary recovery, the natural pressure of the reservoir or gravity drive oil into the wellbore, combined with artificial lift techniques (such as pumps) which bring the oil to the surface. But only about 10 percent of a reservoir's original oil in place is typically produced during primary recovery. Secondary recovery techniques extend a field's productive life generally by injecting water or gas to displace oil and drive it to a production wellbore, resulting in the recovery of 20 to 40 percent of the original oil in place.

However, with much of the easy-to-produce oil already recovered from U.S. oil fields, producers have attempted several tertiary, or enhanced oil recovery (EOR), techniques that offer prospects for ultimately producing 30 to 60 percent, or more, of the reservoir's original oil in place.

While no one questions the ability of fracking to make many more years of oil available, some have raised environmental concerns about whether the chemicals used in fracking will spoil the water supply and whether fracking will cause earthquakes.  New York for example has banned the use of fracking because of these concerns.

The US Environmental Protection Agency (EPA) has undertaken a study of fracking that was to be completed in 2014 but has been delayed to 2016.  The preliminary results and statements of the top official indicate that there is "only an upside to hydraulic fracturing."  Despite the fact that the Obama Administration has been very responsive to environmental concerns, e.g., Keystone Pipelines and War on Coal, environmentalists continue to attack fracking on environmental grounds. http://cfpub.epa.gov/ncea/hfstudy/recordisplay.cfm?deid=244651

The fracking issue is important for another reason.  It illustrates the folly of government directed research and development (R&D).  The Department of Energy (DOE) has spent literally billions on R&D since its founding in 1978.  Billions have gone to nuclear, renewables, efficiency, and coal research.  Fracking has NEVER been a major priority of DOE’s research agenda and very little has been spent by DOE on fracking research.  A similar case could be made regarding natural gas combined cycle turbines.  These turbines are today the backbone of the electric generation industry.  Yet DOE research support played literally no role in perfecting this technology for electric generation.  These two technologies alone—fracking (including horizontal drilling, 4D seismic, and enhanced oil recovery) and combined cycle turbines—are the two most important energy technological breakthroughs in the last three decades.  And DOE had virtually no role in their development.  The lesson is a cautionary one.  Government is not good at picking winners and losers regarding commercial technologies.  Additionally, government funding of R&D can have what is called a “crowding out” effect.  The private sector will be reluctant to do research that competes with government for fear that they will not realize the full profits for their innovation and invention. 

The simple fact that oil is a fungible commodity and trades in a global market has seemingly eluded US policymakers since 1973. Believing that imports of oil from the Middle East exposes the US to jeopardy has been used by both political parties to spearhead distortions in energy markets that are with us still today.

If one makes the assumptions that oil is finite in the sense that we will run out of it and that importing oil threatens some aspect of America’s security (funding terrorism, national security due to supplies coming from hostile nations, balance of trade, etc.), then the following policies make some sense:

• CAFE:  Government should mandate that car companies increase the mile-per-gallon of cars sold in the US (otherwise known as Corporate Average Fuel Economy or CAFE) so that less fuel is needed to run cars.
• SPR: Government should store reserves of crude oil and refined products in the ground in case of emergency shortages in supply (Strategic Petroleum Reserves or SPR).
• Biofuel: Government should require that gasoline substitutes be produced from biological products such as ethanol as a way to increase supply of fuel for cars (ethanol). 
• Synthetic Fuels:  Government should establish very expensive processes for converting abundant fuel (coal) into gasoline to increase the supply (Synthetic Fuels Corporation). 
• Export Bans: Government should mandate that all oil produced in the US be consumed in the US and not exported in order to ensure security of supply.

Now make the assumption that markets work and that supply and demand will be driven to equilibrium by price. 

• CAFE:  Because there is an assurance of supply in the bathtub there is only a need to worry about price.  Consumers will demand cars that have the features that best serve their needs, of which tradeoffs between price, safety and fuel efficiency will be several of such needs.  Thus CAFE is an unnecessary policy.
• SPR: Because there is an assurance of supply in the bathtub there is no need to worry about supply shortages.  Let the private sector decide to diversify price risk by holding inventories.  SPR has turned out to be very expensive inventories of oil owned by the government funded by the taxpayer.
• Biofuel: Ethanol is more expensive than gasoline and less efficient.  Since there is no risk of shortages of oil supply this is wasteful.  Additionally, there is the unintended consequence that using corn for producing ethanol increases food prices, which is an added burden on the poor.  The use of corn (the dominant feedstock in the US) for production of ethanol from field to gas pump uses nearly as much energy than the ethanol produces as a gasoline additive.  This net loss does not include the destruction of CO2- absorbing trees to increase the size of cornfields.       
• Synthetic Fuels:  Because there is an assurance of supply there is no reason for the government to be in the synthetic fuel business.  Mercifully, the Reagan Administration put an end to this dream.
• Export Bans:  In a world of guaranteed adequate supply, it makes no economic sense to ban oil exports.

Implications and Conclusion

Most oil producing countries depend on oil revenues to meet the needs of their people.  In some sense they need us more than we need them.

Look at how the recent collapse in oil prices has scrambled global politics.  Many oil producing countries based their budgets on expectations of oil at more than $100 a barrel.  Today (March 2015), it is hovering under $50 a barrel.  Time Magazine’s January 22, 2015, edition had an excellent analysis of the ramifications of the radical change in world oil prices.

Somewhat serendipitously, it is countries hostile to US interests who are most severely affected by the drop in oil prices.  Oilprice.com identified the “Top 5 Countries at Risk” listing: Venezuela, Nigeria (Boko Haram), Iraq (ISIS), Iran (intensifying the impact of the embargo), and Russia (limiting Putin’s use of energy as a weapon).  No one could have dreamt up a policy that would be more harmful to our adversaries and more beneficial to our friends than sustained low oil prices.

One needs to be careful, however, about being completely gleeful about this situation.  The fracking revolution benefited from higher oil prices and much less exploration and development in the US will result from low oil prices.  That sector is already feeling the pain and will continue to contract as prices remain low.  But other sectors of the economy will undeniably benefit from lower oil prices, so enhanced economic growth will be the net result.

More sinisterly, many of the countries that will suffer will become more desperate and thus potentially more dangerous.  They will also be able to use rhetoric that “blames” the US for low oil prices and thus the need to impose harsh measures on the populaces of these countries.  Venezuela’s President Maduro is already using the US as a punching bag to blame the US for the failure of his and the late President Chavez’s socialist policies.

Even when we had to rely on imports of oil for 60% of our consumption, our oil policies made no economic sense.  We will always have oil available in global markets simply because it is dispersed throughout the world.  But with the advent of the production technology revolution, the unreality of these policies has become even more manifest.  But entrenched interests have grown up around all these dysfunctional and market distorting policies. 

As President Reagan said, “A government bureau is the nearest thing to eternal life we’ll ever see on this earth.”  It is not too far an extension to conclude the same about a subsidy or a mandate.  The great news is that removing all these distortions will have a positive effect on prosperity, though there will certainly be some losers.  But we are running out of time to keep putting off the myriad actions that must be taken to ensure that we have the ability to deal with the challenges we face and leave our children and grandchildren a better, energy efficient world.