Friday, May 28, 2010

Why we will (probably) never run out of oil

A lot of ink has been spilled (and bandwidth eaten) over a looming prospect that neither we nor generations of our descendents will ever witness--the day we run out of oil.  Yes, petroleum is a fossil fuel and exists in a finite quantity.  But, doing simple math of estimating reserves, estimating consumption over time and coming up with some ominous date in the future does no one any good at all. Either the oil doom-and-gloom crowd don't understand basic economic principles, or they understand them quite well and they don't think a peasant like you is nuanced enough to understand.

This blog post is going to help one side or the other, and I have a lot more faith in you than I do  them.

The Bama Oil & Exploration Company, Inc.

Let's say I'm digging a well in my backyard because I'm tired of paying the water company all that extra dough to fill my pool, water my garden, wash my cars and spray the kids down.  About 150 feet down, the drilling rig breaks through a layer of rock and finds something.  But it's not an aquifer--it's a reservoir of light, sweet Alabama crude. I am now an Oil Man.

Big Oil sends a team of geologists and oil production experts out, and they estimate that my field has about 13 million barrels of reserves, and that given today's production technology, about 10 million barrels can be brought to the surface at a rate of about 1 million barrels each year.  At today's spot price of about $70 a barrel, Bama Oil & Exploration is worth about $700 million.  I won't have to worry about the extra dough for pool filling and kid spraying, after all.

After about five years of production, geological and other estimating technologies have improved, and it turns out that there were really about 17 million barrels down there, and there are 12 million left.   And, technology has improved a great deal in just the last five years.  Instead of achieving 77% production rates, rates are now around 88%, meaning I have about 10-1/2 million barrels left.

We've been producing in the same field for five years, and we still have the same amount of oil down there than we thought we'd started with! 

What the doom-and-gloom crown don't tell you about is the economic concept of production possibilities, time and the effect technological change has on production.  This is not an oil only concept.  It applies in every market.

I'm an economist, so I can't have a discussion on economics without a chart.  To the right is what's called the Production Possibilities Curve.  The vertical axis, C, represents capital (plant, equipment, etc).  The horizontal axis, L, represents labor. Any point on the one of the curved lines represents a mix of capital and labor that produces the same quantity of a good or service.  It doesn't matter if the good or service is oil, gas, coal, legal services, cars, buildings, widgets, software or blog posts--substituting more labor for capital will not increase production any more than substituting more capital for labor.  Certain industries, like oil production, are very capital intensive.  Oil producers spend hundreds of billions of dollars on capital but don't spend as much on labor.  Conversely, legal services are labor intensive.  What this means is that most industries have mixes of capital and labor that are defined by the nature of the industry itself, rather than the decisions of the producer.  The producer may fiddle a little here and there with the mix, but his or her industry most likely determines the general neighborhood of the mix.

What the producer will not do is produce an amount that falls to the left or below the curve.  The profit motive causes the producer to add more capital and labor until the curve is reached.

What the producer cannot do is produce an amount that falls to the right or above the curve, and the limit is imposed by the state of technology at the time the production commences.  This is important to understand.  The production possibilities chart I have presented here shows two curves--one for period t and one for period t+1.  As a result of the growth of technology between the two time periods, the same mix of capital and labor is capable of producing a greater quantity. Only a change in technology can cause the entire curve to shift out and up (conversely, only external intervention in the market can cause the entire curve to shift in and down, but that's a blog post for another day).  And, technology tends to have a larger impact on capital-intensive industries than labor-intensive industries, because technology tends to affect the productivity of capital more than it does the productivity of labor.  That is, more efficient capital tends to make labor more efficient, but more efficient labor has a much more limited effect on the productivity of capital.

I will assume you agree that if the price of something increases, producers are willing to produce more of it.  And, that if the price of something increases enough, producers are willing to develop new technologies to produce more quantities more efficiently.

Going back to Bama Oil & Exploration Company's field: given the relationship between the reserves we have in the ground and the rate of production at which we can operate, we can generate another chart--depicting a production decline curve.  On the vertical axis, Q, we show the quantity of oil in the ground.  On the horizontal axis, T, we show time.  Again there are two curves shown in the chart, one for each time period in which the estimate is made.  Over the life of the well (or the field), we estimate the amount of product remaining given an average production rate.  But notice that the curves are concave, meaning that the production rate is horizontally asymptotic.  As time increases, the rate of production slows at a decreasing rate. That represents the fact that extraction and production technology increase over time, such that a fixed relationship between reserves in the ground and current production rates does not exist.  This is one of the things that the doom-and-gloom crowd don't tell you:

As the price of oil increases over time, extraction technology improves, such that our ability to produce oil from a known reserve increases vis-a-vis production estimates made during previous time periods.

There is another factor at play here as well.  Increases in technology also have the effect of improving our ability to find, analyze and estimate the amount of oil in the ground.  This is the second thing that the doom-and-gloom crowd don't tell you:

As the price of oil increases over time, the technology for exploration, analysis and estimation for reserves improves, such that our ability to identify economically productive reserves increases vis-a-vis estimates made during previous time periods.

These are two demonstrable facts associated with petroleum production.  While oil is a finite resource, the truth is we really don't know how much we have left.  We have estimates, but those estimates are made using a set of technologies and assumptions that will not be in place tomorrow.  And, while production rates today are greater than they were just a few years ago, the estimated rate of production is again based on a set of technologies and assumptions that won't apply a few years hence.

There is a third factor involved which needs no chart at all.  As oil prices increase, alternative energy technologies that are not cost effective today will become more cost effective tomorrow, especially as (you guessed it) the technology to develop and deploy them improve.  And this brings us to the third thing that the doom-and-gloom crowd don't tell you:

As the price of oil increases over time, alternative energy sources become more feasible economically, such that the demand for oil increases at a decreasing rate, causing further revisions of estimates regarding demand, production and available reserves.

If you ever find yourself in a debate regarding the future of fossil fuels, I hope you'll use these three points.  Tell your friends or opponents that technology improves our ability to find new sources of oil; that technology improves our ability to squeeze every last drop out of the reserves; that rising prices make other energy technologies more feasible and that because of all this, we will probably never run out of oil.

Or coal.

Or natural gas.



Ormond Otvos said...

You forgot EROI, so I will forget your analysis. Seems fair.

GulfCoastBamaFan said...

That's because EROI does not take the factor of time into account, and this discussion is about how technology changes production possibilities over time.