High Prices Do Not Mean We’re Running Out of Oil

Eve S. Sprunt, 2006 SPE President • president@spe.org

I was chatting about oil prices with a vice president of a giant agricultural-commodity company. He said that in his industry, the cure for high prices was high prices. While it is difficult to get the timing correct, in the long run the same holds true for oil.

When oil prices rise, people leap to the conclusion that the world is running out of oil. In the late 1970’s and early 1980’s, soaring oil prices raised the specter of the end of the oil era. Then, in response to the high prices, demand dropped. Between 1978 and 1983, worldwide demand dropped by about 16%, and consumption in the U.S. declined by almost 20%. On the supply side, high prices stimulated a wide range of efforts to create new energy supplies, including efforts in renewable energy, oil shale, surfactant flooding, and oil production in hostile environments. New supplies of oil entered the market. The combination of reduced demand and new supplies led to a price collapse in early 1986. Fears of oil shortages receded into the background for many years.

Now, in the midst of another period of high prices, people are again worrying that the world is running out of oil. I don’t think so.

The world has vast supplies of hydrocarbons that are waiting for new technology or higher oil prices to make them commercial. Examples include ultra-heavy oil, heavy oil in deep water, and oil shale

Rising oil prices push the rates of return of many previously unattractive projects above company investment thresholds. However, companies are reluctant to invest in large capital projects with long payout times until they are convinced that the higher prices will be sustained. Even after development projects are approved, the time to bring the new supplies to market is measured in years.
When a flood of new energy supplies hits the market, prices will drop if demand does not grow faster than the increase in supply. Once capital has been invested and become a sunk cost, projects will continue production as long as operating expenses are covered. When prices are declining, everyone strives to reduce operating costs. A project will continue to operate at far lower oil prices than anticipated when the capital investment was made.

Although many alternatives to oil were investigated in the oil boom of the late 1970’s and early 1980’s, oil has remained the overwhelmingly dominant transportation fuel. But, oil is not without competition. Every time oil prices surge, energy alternatives have a boost in their efforts to enter the market. During an oil boom, investment increases not only in hydrocarbon projects but also in energy efficiency technologies and alternative energy supplies.

At some point, on the basis of a combination of price, convenience, and environmental concerns, the general public will embrace a substitute for oil. As former Saudi Arabia Oil Minister Sheikh Yamani noted in an interview in The Telegraph several years ago, just as the Stone Age did not end because of a shortage of stones, the oil era will not end because we ran out of oil. It will end when a better alternative emerges.

Those who believe that depletion of oil will drive a sustained increase of inflation-adjusted oil price should consider the results of a famous wager. The bet was made back in the last oil boom in 1980, when Malthusians were predicting that the earth was rapidly running out of many essentials. One of the foremost pessimists was Paul Ehrlich, a Stanford professor of biology, who was concerned with the consequences of overpopulation. On the other side of the bet was Julian Simon, who was one of the founders of free-market environmentalism. He believed that the ultimate resource is human ingenuity. Simon argued that throughout the course of human history, the price of natural resources had been declining in real terms.

The bet was made on a mutually agreed upon measure of resource scarcity—the market price of five metals that, like oil, are non-renewable resources. Ehrlich chose quantities of chrome, copper, nickel, tin, and tungsten worth U.S.$1,000 in 1980. Ehrlich would win if the value of the metals after adjustment for inflation was more than U.S.$1,000 in 1990. Ten years later, Simon won by a large margin. Every one of the metals had declined in price, with an overall decline of about 40% in the price of the portfolio. Simon would have won even if the prices had not been adjusted for inflation.

Ehrlich rejected Simon’s offer to repeat the original bet. Both Simon and Ehrlich offered new terms for a second wager, but had not reached an agreement when Simon died in 1997.

Next time someone tells you that high oil prices are a sign that we are running out of oil, explain why price is not a good indicator of long-term scarcity. Vast supplies of currently non-commercial hydrocarbons are waiting for new technology to bring them to market. Our challenge is to be able to produce these hydrocarbons at a price that is attractive relative to alternatives and in an environmentally acceptable way. Don’t expect sustained high hydrocarbon prices, because the cure for high prices is high prices.