Saturday, January 24, 2009

Peak Oil Post #2: Question of Economic Scale

The next question is: what does a shortfall mean for the price of oil? The question depends on the price elasticity of oil demand; in other words, it depends on how much oil prices change for a change in the quantity supplied. Let's try to use some real world data (this is a total simplification, but it is still worth considering). In 2004, the average cost of a barrel of oil was $42.35 and world oil demand was 82.41 million barrels per day. Then, oil began a steady rise, and by the second quarter of 2008, oil prices were constantly around $100 per barrel. That's a 159% percent RISE in price. Did oil demand plummet by 40%? 25%? 10%? 5%? 1%? Actually, it didn't decrease at all; world oil demand during that period was higher than it was is 2004 by around 3%. So, huge rises in price (at least in the short term) don't decrease the demand for oil at all. If a 159% rise won't decrease demand, how much will prices rise if oil production falls by 6.7%? Quite a lot.

Oil demand in the United States is significantly more elastic, but there are still limitations. First, there is the delay; oil prices started to rise after 2000 but behavioral changes only started occurring eight years later. Second, cutbacks were relatively small. It would be easy for the U.S. to cut demand by 5% without hurting our standard of living, but a cutback of 15% would be far more difficult for most people. Third, because the United States uses so much oil, it is far harder for everyone else in the world to cut back on oil consumption. In Europe and Japan, people do so much conservation that it would be difficult to make any more significant cutbacks; once you drive a 40 mpg diesel car less than half as much as the average American and take public transit for 10% of your trips, there is not much more you can do. It is even harder for countries like China to reduce oil consumption; again, if you consume 1/3 of the oil as the U.S. per capita, it is far harder to find ways of making cuts without hurting economic growth. I guess I am trying to say that it would be hard for us to extrapolate the U.S.' decline in oil consumption with a worldwide decline for the reasons stated above; America's situation is fundamentally different.

Plus, all of this is ignoring the economic harm done by high oil prices, which makes any transition quite different. Consider that rising gas prices were the force that originally began hurting the Detroit Big Three and the economic damage that would be done by a loss of the automobile industry if it were to happen again.

If Peak Oil happened rapidly enough, it could lead to economic harm that would be far more destructive. Many policy experts did a "war game" involving oil production: While they were assuming that violence and political activity would disrupt oil supply, a sharp drop in oil production would essentially do the same thing. Their predictions were double-digit inflation and a 28% fall in market prices (for the record, the current 1 year decline of the markets is around 35%), and all of this was done with TEMPORARY POLITICAL CRISES. Peak oil is not a temporary phenomenon; it implies a decline in fuel production that will last for far longer than any political crises.

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