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

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Research Spotlight: Demystifying the oil market

Oil pump at sunset-stock photoIn summer and spring of 2008, prognosticators said oil prices would rise to $200 or more a barrel, and forecasts for $300 oil still linger. But forecasters hold little sway over the real price of oil, current or future. Unlike the stock market – which moves according to incident, expectations, confidence and occasional mania – oil markets move on the more tangible fundamentals of the real asset.

James L. Smith, Cary M. Maguire Professor of Oil and Gas Management in SMU’s Cox School of Business, shows in his research that the oil price spikes of summer 2008 will not necessarily be the trend in the future. Based on supply and demand factors – an analysis of which is missing in many of the high-end forecasts – Smith reveals the causes behind the much-debated high trajectory of oil prices and how the OPEC cartel had a lot to do with it. In “World Oil: Market or Mayhem?,” published in the August 2009 Journal of Economic Perspectives, Smith offered a view of things to come based on history and fundamentals.

Global demand for crude oil has increased by 80 percent overall since 1975, whereas actual OPEC production and non-OPEC supply have each grown by just 24 percent. During the 1980s, while global demand for oil was shrinking, the supply of non-OPEC oil was expanding robustly, putting substantial downward pressure on price. OPEC producers responded by cutting output nearly in half between 1979 and 1985. After the steep decline of the 1980s, OPEC production was not fully restored until 2004.

“OPEC’s production restraint represents a commercial choice, not a geological ultimatum or a reflection of high marginal costs,” Smith says.

From the period 2004 to 2008, global demand increased by 33 percent, while non-OPEC supply decreased by 23 percent. Although OPEC members responded by increasing their production, they lacked sufficient capacity (after years of restrained oil field investments) to bridge the growing gap between global demand and non-OPEC supply. Prior research by Smith revealed that OPEC’s goal is to set the price, and members synchronize production levels in pursuit of that goal.

Consumers have suffered from OPEC’s failure as well as its success: Failure to manage installed capacity has increased price volatility, while success in restricting capacity growth has driven up the average price level. OPEC’s production capacity – 34 million barrels per day – is virtually unchanged from 1973. Meanwhile, the volume of its proved reserves, deposits that could have been tapped to expand capacity, doubled over that span. In comparison, non-OPEC producers have expanded their production capacity by 69 percent since 1973.

During the second half of 2008, the collapse in demand for oil around the world was due to economic decline. Despite global consumption (and consequent depletion) of almost 700 billion barrels of crude oil during the past quarter-century, the stock of remaining proved reserves has doubled from 700 billion barrels in 1980 to an all-time high of 1,400 billion barrels.

“Consider the impact of horizontal drilling in oil and gas,” Smith says. “Huge resources that were previously uneconomic can now be developed because of that technological advance – an example being the Williston Basin, the largest undeveloped oil resource in the U.S.” He adds that advances in the processing of seismic data beneath the ocean floor revealed large oil deposits in the Gulf Of Mexico and Brazil, previously hidden beneath layers of salt.

“We peeled back another layer that we previously didn’t know how to penetrate,” he adds. “New technology can have a big impact on the resource base and price.”

Read more from the Cox School research blog