Wednesday, November 17, 2004

Faith-based economics II:
The case of oil's sudden scarcity

In my previous post about "faith-based economics," I discussed the main arguments of the so-called "cornucopian" economists and why they are flawed with respect to oil. There is yet another flaw in their arguments which should concern us, one touched on by Douglas Reynolds in my original story. Let me develop the implications of what Reynolds is saying a bit more here.

Oil exploration--in fact, exploration for any resource--is subject to what Reynolds calls the "Mayflower Effect." The implication for the oil market is that a long period of seeming plenty can come to an abrupt and unforeseen end.

Here's how Reynolds explains it. When the Pilgrims settled at Plymouth Rock, they weren't getting the best farmland America had to offer, and back then farmland was what it was all about. If they had had perfect knowledge, they would have sailed up the Mississippi River to Iowa and settled there. Only a couple of centuries later did settlers find out about Iowa.

In other words, it takes time to discover the biggest and most productive areas for any resource when you have very little knowledge about where to look. As you gain more knowledge, you know where to look, and you make bigger and bigger discoveries. In the case of American farmland, surely the Great Plains were the biggest discovery of arable land. After the big discoveries are made, then the pattern reverts back to small discoveries. Yes, there are other places in the West which are suitable for agriculture, but nothing so magnificent and productive as the Great Plains except perhaps California. But, to prove the point, California's agricultural potential was already being realized as the Great Plains were being settled.

So, the pattern for discovery of natural resources again and again is this: small, big, small. The same is true with oil. It was 70 years after the first discoveries in Pennsylvania that the elephant fields in Texas were discovered. Worldwide discoveries peaked in the 1960s with huge finds in the Middle East. Now, we are finding more oil, but the days of regularly stumbling onto elephant fields seem to be over. The rate of discovery has now dropped far below the rate of depletion, something that can't go on forever without a fall in production. (Additions to reserves in existing fields continue to allow oil companies to replenish their reserves by at least the amount of their production, so far.) Yet, there is a stubborn belief that the big discoveries of the past are inevitably going to be followed by large and possibly even bigger discoveries in the future. For a time this belief is repeatedly reinforced creating the illusion of decreasing scarcity.

Government energy planners and oil industry exploration teams believe that because they have so much more information about where to look and how to exploit oil resources, they must inevitably succeed at finding ever larger amounts of oil. Yet, no amount of information can increase the amount of a finite resource. And, so at some point the increased information fails to produce the expected discoveries. This has proven true in the Gulf of Mexico when it comes to natural gas discoveries. It has proven true in the Caspian Sea area, at first thought to contain perhaps 200 billion barrels, but now believed to have perhaps 70 billion.

According to Reynolds markets tend to price oil and other commodities as if the trajectory of large finds will continue. But over time the failure to make the expected large new discoveries finally puts enough dents in this notion that perceptions in the market can shift, and when they do, they can shift with very little warning. What seemed in ample supply is now suddenly perceived correctly to be scarce. The results can be huge price spikes as the market digests the new expectation that the resource, in this case, oil, is a dwindling commodity. When that day (or more likely that year) comes, the oil market could bid up prices to levels unthinkable today, perhaps $150 to $300 a barrel, Reynolds says. He believes it's probable that a such a scenario will unfold within the next decade.

Not a pretty picture, and not one that will give you much faith in faith-based economics.

P. S. Reynolds recently got some support for his view from a top BP executive.

[There is yet another mechanism which Reynolds discusses that prevents price signals from telling us about the state of oil's supply. But, I'll cover that in a future post.]

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