Research Spotlight: Does “peak oil” really drive energy pricing?

Stock image of oil barrel stuffed with dollarsThe concept of peak oil captures the imaginations of policymakers, analysts, researchers and the public – and never more so than when prices are skyrocketing.

But from the viewpoint of an energy economist, the idea of a peaking resource such as oil ushering in an era of reduced growth doesn’t hold water.

Energy economist James Smith of SMU’s Cox School of Business provides calculations in new research which show that the “peak” is an unreliable indicator of resource scarcity, particularly for oil markets governed by the fundamentals of price, supply and demand. While the idea of peaking may offer some indication of scarcity, it cannot be relied upon to draw firm conclusions.

The concept of an exhaustible resource reaching a peak and thereafter becoming exhausted came into play in 1956, when M. King Hubbert first introduced the hypothesis. His predictions seemed to prove out in the 1970s when U.S. oil production in fact “peaked.” But that decade’s energy crisis gave credence to his theory even though peak oil was not the culprit.

A lot has been learned since then, says Smith, the Cary M. Maguire Chair in Oil and Gas Management in the Cox Finance Department. His central message is that the fundamentals are missing in the equations that should be factored into the ideas of peaking.

“Any well functioning market economy, endowed with a limited amount of an exhaustible resource, will apportion production through time according to prevailing economic incentives that reflect market fundamentals – by which I mean the cost of production, discount rates, the strength of current versus future demand, and the availability of substitutes,” he writes.

Smith says that price will indicate a production trajectory according to supply and demand. “Producers are driven by attempts to maximize profits,” Smith explains. “As a producer, I have oil reserves. If I believe they will be really scarce in five years, I’m not going to produce as much today, because I’ll be rewarded more later when the price is higher. So I leave these resources in the ground. That’s part of an inter-temporal balancing.”

Alternatively, consumers are looking to maintain their standard of living in daily affairs. “We regulate consumption of many things according to price,” Smith says. “If something becomes more expensive, we find a cheaper substitute and this makes us better off than buying what has become more expensive. We have more effective income that way.

“Consumers react to price and perceived price signals. If something is overpriced, they substitute, conserve and reduce. And since we haven’t exhausted the supply of a resource like oil, the resource is not priced out of reach. We may have pushed the price of it being out of reach five years or ten years down the road.”

Consumers are doing their part in conserving and protecting their standard of living by stretching income – not just today, but in the future and over their children’s foreseeable lifespans, Smith says. “The producers are in it for the money, bringing resources to market when it’s most advantageous and beneficial to consumers. ‘I don’t want to sell oil when you are not willing to pay for it,’ the producer would say. ‘At the point when you do value it, I will bring it to market.’”

From this perspective, “the peak has as much to do with peaking demand as it does with physical constraints on supply. Both sides are working toward the same end,” Smith adds. “Consumers get satisfaction from prudent consumption; producers are receiving income to distribute some of it to shareholders.”

Written by Jennifer Warren

> Read the full report from the Cox School of Business faculty research blog

About Kathleen Tibbetts

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