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Saturday, February 23, 2008

Different Measures of Oil Scarcity

A very naive view says, "There is a fixed amount of oil. We use some every day. Therefore the government needs to do something, and quick!!"

I used to think that the best way to deal with this type of objection was to point to the moving "window" of oil supplies. When you divide total reserves by annual consumption rates, you obtain "years of reserves." And this number certainly doesn't drop by 1 every 12 months. In other words, the alarmists can (correctly) say, "At present consumption rates, we only have x years of oil left!!" But this overlooks the fact that oil companies don't go out and find every last drop of oil right away; no, they only go out and find more supplies as they use up existing supplies. We always have (give or take) x years of oil left. An analogy I liked to use was a young boy looking at how much his family eats at dinner every night, and then looking in the pantry. He freaks out and says, "Mom! At current rates we're going to run out of food in four days!!"

However, a few months ago I learned that the measure "proven reserves" was not a purely technical concept. It also relies on the price of oil, because "proven reserves" are those oil reserves that can be profitably brought to market, given existing technology and prices.

In retrospect, this is a perfectly reasonable component of the definition. After all, it does no good for an oil company to know of a billion barrels of oil at the center of the earth, which would cost $2000 / barrel to bring to the surface. Economically speaking, that oil doesn't exist and shouldn't be counted as part of our "known supply."

On the other hand, putting the market price into the mix changes the rosy interpretation of the figures showing "years of oil supply" holding up over the 20th century. Back when I thought "proven reserves" was a purely technical concept, I thought that oil companies were literally finding more oil deposits, and in fact at a faster rate than they were depleting the known deposits (since annual consumption rates steadily increased over the 20th century).

Now that could still be true, and in fact probably was for most of the century. (Here's a great case for optimism.) But since 2000, oil prices have shot up enormously. And so that alone transforms particular barrels of oil into "proven reserves," whereas in 1987 they were not so classified.

This is a little weird. (Again, I'm not criticizing the definition, I'm just saying it's a little weird.) The whole point of the "years of oil left" statistic was to reassure us that we weren't in store for a supply crunch. But if the only way we get the number of years to hold up, is for the market price of oil to go to $120/barrel, then is that figure really reassuring after all?

Indeed, even if the alarmist view were correct, and all the world's oil were sitting in one giant pool of known volume, that figure of "years of oil left" might be fairly stable. If the owner(s) of the oil forecast the future perfectly, then the price of oil would rise over time with the rate of interest, so that the owner(s) were indifferent between selling a barrel on the spot market or holding it for another year and selling it at the higher spot price in the future. (I'm assuming no other costs of selling the oil.) As the spot price rose exponentially, the number of barrels purchased per year would decline. There's no reason to expect that the statistic of "years left of oil, at current consumption rates" would be constant from year to year, but it wouldn't ever hit zero. And yet, this scenario is perfectly consistent with the people suffering tremendously from depleting energy supplies.

(Actually, now that I type out the above, I realize that this scenario shows the flaw with looking solely at the "proven reserves / current consumption rate" statistic. It doesn't have anything to do with whether the "proven reserves" are calculated as a technical exercise or if they include market prices. But the next scenario involves the inclusion of market prices in the definition, and shows why it can be a bit weird...)

OK now consider this example instead: What if tomorrow, there is a fabulous discovery of a $50 gadget that allows your car to run on oxygen? Soon enough the worldwide demand for oil would fall tremendously. Depending on the applications of the new gadget, it's possible that the price of oil could fall to $5 / barrel. In that case, much of the current "proven reserves" of oil would disappear, and if rates of consumption didn't fall as quickly, then the "years of supply" figure might drop sharply as well. But of course, the new discovery is wonderful! We are clearly much more secure in our energy supplies because of it!

So as I mulled these things over, trying to tinker with the various statistics to come up with a better measure of our energy situation, I realized that the single best indicator of the scarcity of oil was...

...the market price. Duh.

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