A Primer on Peak Oil

I ran across three separate articles on peak oil at well-regarded financial news sites today: The Economist, The Financial Times and Le Figaro. I thought I’d give you a run down of what they were saying and what it means for the economy and investing.

What is Peak Oil About?

Let’s start with The Economist:

As the developed-world economy tries to gain momentum, it faces a persistent headwind. The oil price remains stubbornly over $100 a barrel, acting like a tax on Western consumers. Some blame the high price on evil speculators—Barack Obama unveiled plans to increase penalties for market manipulation on April 17th. But there is a simpler explanation: that supply is inadequate to keep up with rising demand.

The concept of peak oil—the idea that global crude production may be at, or close to, its limit—is far from universally accepted. One leading asset manager talked recently of the world being “awash with energy” because of the exploitation of American shale gas. Nevertheless, oil is still the main fuel for cars and trucks. And crude output (as opposed to alternatives such as biofuels and liquids made from gas) has been flat since 2005.

A number of countries (including Britain, Egypt and Indonesia) have turned from net oil exporters into importers in recent years. And although rich countries have curbed their energy-guzzling a little, demand continues to surge in emerging markets.

This has left the oil market very vulnerable to temporary supply disruptions, such as the war in Libya.

This is a good synopsis of the real issues for individual economies. Let me get into how the peak oil argument is framed first before we look at what is happening. There are two versions of the peak oil theory: the hard peak oil view and the soft peak oil view.

Hard peak. The esoteric argument, derived from M. King Hubbard’s now undisputed prediction of peak oil in the (lower-48) United States, is that half of all oil reserves were consumed by 2005 or so and that means we have less than half left. According to Hubbert’s analyses about the relationship between reserve discovery and production and the rates of production decline in exploited oil fields, this would mean we have hit the absolute peak of oil production globally. The point is that no matter what happens, production from conventional oil sources will not increase… ever. That’s what I would call the "hard peak oil" argument. This argument is controversial.

Soft peak. The most relevant argument is a bit more subtle – and this is the one the Economist delves into. Here, it is not disputed that we will one day hit an absolute peak when half of the world’s extractable oil reserves have been consumed. Nor is it generally disputed that technology will be hard-pressed to increase production levels when we have consumed half of the oil. What is important here is that the cost of incremental supply exceeds the price at which demand destruction kicks in. Put simply, we are now at a point where oil prices are so high that if they go any higher, people cut back on consumption, threatening recession. I call this the soft peak.

The Impact of Oil on the Economy

Clearly, we have seen demand destruction a number of times in the last 40 years. In fact, every global recession in that time frame was preceded by oil shocks except the one after the tech bubble. We have had four global recessions on the heels of an oil price shock: in 1973, 1979, 1990 and 2008. So, the mechanism for how high oil prices lead to demand destruction and recession – as well as social unrest – is clear. The question is whether oil prices are high based on oil market fundamentals that are consistent with the soft peak oil argument or whether the rise in oil prices is due mostly to commodities speculation.

If you are a politician, you don’t like demand destruction because that slows growth and makes you look like you are presiding over a sluggish economy. The concept that these prices are due to some controllable factor is therefore very compelling for politicians and they will always act upon it. The Economist begins their article describing Barack Obama’s plans to go after commodities market manipulators for just this reason – high oil and commodity prices are politically combustible and President Obama’s plan is an attempt to defuse this as an election issue come November.

Politicians of all stripes will do whatever they can to tamp down these high prices. For example, in Argentina, President Cristina Fernandez de Kirchner has complained bitterly about high prices and Argentina,’s new role as oil importer. Fernandez has blamed the country’s oil company YPF for not increasing production. Her view is that the company’s Spanish owner Repsol is a rent seeker bent on extracting wealth from the company without adequately reinvesting in the Argentine economy. Recently Fernandez took action, nationalising the company and has decided to seek partners to exploit Argentine oil reserves, most likely China’s CNOOC or Sinopec. But clearly, peak oil could also explain Fernandez’s dilemma.

As for the speculation argument, there is plenty of evidence to support it. Commodities have been financialized, meaning they are readily available for purchase and sale as financial assets via primary and derivative financial markets. That means that the Fed’s zero rate policy causes investors in fixed income and annuities to seek alternative investments in commodities and other financialized real assets like precious metals. With commodities, Professor of Economics Randall Wray, of the University of Kansas City at Missouri and a frequent Credit Writedowns contributor, calls commodities speculation "The Biggest Bubble of All Time":

An April report by expert Jeremy Grantham looks at the last decade’s bubble in commodities; Frank Veneroso expands upon that in a more recent report. Here’s the elevator speech summary. Take the top 33 commodities that are globally traded—everything from gold and oil to to rubber, flaxseed, jute, plywood, and something called diammonium phosphate. Over the past 110 years, an index price of these 33 commodities has declined at an annual rate of 1.2% per year. (Sure there are variations across the commodities—this is the average. And so much for inflation hedges. Commodities prices fell—they did not keep up with inflation. If you liked negative returns, commodities were a good bet.) Although demand for these 33 commodities has increased a lot over the century, new production techniques plus successful exploration has resulted in a declining price trend.

Further—and this is a bit surprising—deviations from the trend follow a normal distribution (you learned about this in high school; it is a bell curve with nice properties; chief among these is the finding that about 68% of outcomes fall within one standard deviation; about 95% fall within two standard deviations (once a generation); and you’ve got just about a snowball’s chance in hell of finding outcomes that are three or four standard deviations from the mean).

But what is more surprising is that over the past decade, the price rises you find for these 33 commodities are just about beyond the realm of possibility—2, 3, and 4 standard deviations away from trend. It is a boom without any precedent. Quite simply, nothing even close has ever happened before, in any market, including hi tech bubbles and real estate bubbles.

Professor Wray’s conclusion: speculative fervour is causing an asset price bubble in the commodities sector, not just for oil alone.

Le Figaro: Hard Peak

Looking at the other side of this, I saw in Le Figaro on peak oil and the controversy over oil reserves. My translation of an excerpt from French is below, with a chart from that article

…According to the USGS, "undiscovered but technically exploitable" reserves total 565 billion barrels for oil, and 158,760 billion cubic meters for natural gas. That is the equivalent of seventeen years of world consumption in 2011 for oil and fifty years for gas.

The U.S. report took into account neither the reserves of the United States, subject of separate studies, nor so-called unconventional resources like oil and gas from shale or tar sands. The estimates are based on the study of the geology of 313 areas across nine major world regions. three-quarters of the potential are concentrated in four of them, South America, sub-Saharan Africa, the Middle East with North Africa and the Arctic. Adding so-called proved reserves to those newly identified by the USGS would provide sixty years of oil consumption at the level of 2011 consumption.

Biased data

A misleading picture, protests Jean Laherrère, former head of exploration techniques at Total and president of ASPO (Association for the Study of Peak Oil and Gas). This work is "not scientific", he condemns, citing estimates from the USGS in 2000, not verified by facts, and reflects the ignorance of the authors about the realities of oil exploration. Concerning oil, "public data are either political or financial, and are mostly biased", warned Laherrère in a note circulated at the Club of Nice, a conference of energy experts in late 2010. As confirmation of these criticisms, hardly had the USGS published its estimate when the U.S. Department of the Interior congratulated it. In a statement released Wednesday, the agency welcomed the visit of Secretary Ken Salazar to Brazil to forge energy partnerships in this region among the world’s richest reserves of oil.

Without denying the existence of huge reserves of oil and gas yet undiscovered , Laherrère and many experts worldwide working for decades on the notion of "peak oil" ("peak oil", in English) recall that operated field production declines at 4.5 to 6.7% per year. All while world demand rises. "The production has been roughly constant over the past seven years despite an increase in crude prices by about 15% per year," noted climatologist James Murray and economist David King in an article published on Peak Oil in the scientific journal Nature (January 26, 2012).

Faced with uncertain numbers but the inexorability of the underlying trend, seven experts including Laherrère published a forum last month at lemonde.fr calling on presidential candidates to anticipate an energy transition, otherwise " it will be chaotic" with "disastrous economic consequences."

The Financial Times: Soft Peak

That’s the hard peak view. And as I have said, it is controversial. The Financial Times takes up the soft peak story:

It’s nothing new, this questioning of what permanently higher oil prices means for world economic growth. Gregor MacDonald, Chris Nelder and Gail Tverberg are just a few of those who’ve been dedicated to considering the economic effects of an energy-constrained world. James Hamilton has been attempting to bridge the gap between peak oilists and economist for years; his ‘How to talk to an economist about peak oil‘ post (from 2005!) is a must-read.


The question of what that impact will be, and how it will be managed, is much more interesting than straw man arguments about when exactly the oil will “run out”.

I think that’s it exactly. Even forgetting about the hard peak story, we can focus in on whether the soft peak story explains much of the run up in oil prices and what impact this could have over the longer term. It may be the case that peak oil explains much of the increase in prices irrespective of speculative excess. In my view, then the story about a "chaotic" energy transition with "disastrous economic [and investing] consequences" would be the same.

  1. Ian Brett Cooper says

    If you mean Peak Oil (what you call the ‘hard peak’) is controversial in the sense that global climate change is controversial – i.e. only scientists and educated people believe in it, while ignorant people, flat-earthers and economists don’t, then yes, ‘Peak Oil’ is controversial.

    1. Edward Harrison says

      I have to say it is controversial in a neutral framing to present the information neutrally. But I certainly think there is lots of evidence that the peak for conventional sources was reached in 2005. Moreover, common sense would tell you that shale oil, deepwater drilling, and oil sands projects are clearly attempts to find more marginal and expensive carbon-based resources because the easy stuff has dwindled in availability. Clearly, prices have risen in large part due to dwindling cheap oil availability. I stress the soft peak story because it takes a lower bar to understand and accept.

    2. FalkBurger says

      peak oil schmoil, what about LNG? There’s such a glut of natural gas right now, we could price our way right out of this recession if there were LNG pumps at every gas station. Conversion kits have been around for twenty years at least, where is leadership, where is action, where is T. Boone Pickens? What the hell happened?

      1. Edward Harrison says

        What I have been asking is why there isn’t fuel switching. So I agree with you that it is suspicious that natural gas prices are so low compared to oil. But that doesn’t negate the reality that oil production from conventional sources has peaked. Don’t dismiss this fact because it is important.

  2. David_Lazarus says

    Peak Oil I thought was that the production of oil had peaked. That has thought to have already occurred around 2005. There is plenty of oil out there in the world, probably enough for a century or more, but not at $5 that the Saudis once had. It now costs much more to get each barrel of oil out. There is plenty of oil in Canada in tar sands but the cost of extracting it is very expensive and the environmental cost is huge. Most of the cheap easy finds have already peaked. North Sea oil peaked more than a decade ago. The US peaked decades ago, even though Texas finds are still producing oil in small but steady amounts. 

    1. Edward Harrison says

      Yes, David. 100%. I think you are restating what I have written about the difference between the soft peak and hard peak arguments. Both groups agree with you that there is plenty of oil left. The constraint Hubbert pointed out is extraction rates once we reach a certain level of depletion.

      The soft peak argument is the one most people get and that’s the one you reiterated about the end of ‘cheap’ oil. I should point out, the soft peak argument is perfectly compatible with the hard peak one i.e. cheap oil has run out BECAUSE we have reached the maximum level of production of conventional sources.

      1. David_Lazarus says

        But we could still have as much as 70% of all the worlds oil still under the ground but in small ultra expensive to extract fields. Hence why I did not mention the split of oil because that is unknown but oil production may have already peaked. The Saudi’s have been very secretive about its production and reserves for decades and could have peaked already and with the rising costs of maintaining the kingdom in a state of peace they may only have a few decades of falling production left. For the foreseeable future we will have high volatility until it is clear exactly how much oil Saudi as swing producer can actually muster. After that the price will rise inexorably. 

        1. Edward Harrison says

          Right, people can accept what you just said about cheap oil. That’s the winning argument. I think people understand this and we need to spread the word. It’s not about running out of oil. It’s about running out of cheap oil.

          1. David_Lazarus says

            Cheap oil was the weapon that Saudi Arabia to kill off any diversification away from oil. Though sensible governments have already prepared the diversification. Germany and Denmark will have significant renewable energy production by 2020. Europe has already made significant energy efficiencies especially in automobiles. The US and Australia are the real laggards and will be hurt most by the next oil shock. Then you will see the F150 owners cursing hybrid motorists when they cannot afford to drive to work. A sensible approach would be a climbing gas tax that over time drives up the average efficiency of US vehicles. Such a tax could be used to eventually pay off the deficit, but until then could be used as stimulus. 

        2. Blissex says

           Lots of people tend to forget that the largest oil producer is actually the Russian Federation, and that Iran matter a lot too. In particular there have been reports by Iranian defectors that official estimates of Iranian reserves are wildly exaggerated for political reasons, and that’s a major reason why they Iran want to develop a nuclear fuel cycle.

          As to the Saudis, how bad is their reserve situation? Well, they are buying 16 nuclear power stations to generate electricity, largely for desalination plants…


          1. David_Lazarus says

            Yes the Iranians are copying the Saudi in exaggerating their output for political reasons. Their oil fields have been working for more than a century so must be running dry. If the west had made more of a transition to other fuels the Middle east would be less of problem politically. They would have to face their political problems head on.

    2. Blissex says

       There is a lot of literature on Peak Oil, and several sources address your points.

      One essential observation is that oil will never be fully extracted, because once it becomes more expensive to extract than alternatives, it won’t be.

      The critical point is when oil energy becomes more expensive than muscle energy, and for example it becomes cheaper to harvest grains with lots of cheap peasants than with an expensive oil powered combine-harvester.

  3. Aitor Calero García says

    My 50 cents. You didnt mention the EROEI concept, energy return on energy invested. The real underlying problem is that this ratio has been falling steadily since 2005 for the oil industry. It is assumed that an EROEi of 10 to 1 is needed to maintain our society. The more expensive in energy terms the oil the less energy will be available to be used in other works. Moreover, the process of extracting oil needs oil by itself, making it more expensive as reserves goes down. The road ahead looks very bad and no other alternative sources are in place.

    1. David_Lazarus says

      Some efforts have been made by reducing food miles which reduces the energy required to feed people, and many other green measures. Part of the problem is that many in the US believe that cheap oil is their birthright and denounce anything that means a change in how they live. Look at the flak that Obama has got for the rising cost of gasoline in the US when it is clear that it is a global demand problem. With China having a surge in car sales this will mean that they are demanding more oil and with peak oil production the extra demand flows straight into higher prices.

  4. Sam Powrie says

    I think you are complicating things with this ‘hard’ and ‘soft’ business. Put simply and realistically, the only oil production that really matters with regard to ‘futurology’ is conventional oil. The exploitation of all other liquid and semi-liquid hydrocarbons (as well as oil shales etc) is just a response to the peaking of this conventional production. The real issue if EROI. My understanding is that if we haven’t charted an alternative course (or courses), when the EROI of unconventional production gets below around 8:1, it can no longer usefully contribute to economies. My understanding is that this is the situation right now. In other words, in terms of economic outcomes, unconventional oil doesn’t matter a jot. The vast shale plays will be exploited for sure as will deep water and so on. However there will be a cost in redirected wealth, in all likelihood redirected from the maintenance of industry, society and ultimately social capital. In other words, the world has already changed.

    1. Edward Harrison says

      Actually I think it is important to talk about the end of cheap oil and to emphasize that this is the key determining factor. That is why making the distinction is necessary. Just look at the Figaro article and compare the arguments to the Economist and you can understand the confusion. Those are two different arguments and it needs to be clarified.

  5. FalkBurger says

    I’m too old for this! It took me two weeks to find this comment box. But, hear me out. What’s all this peak oil handwringing? Remember T. Boone Pickens? Why are there not LNG (Liquefied Natural Gas) pumps at every service station in the dam nation? We’ve had twenty years to get ready! Just how powerful is that oil lobby? Did they stop this or has the imagination of America failed completely? Or am I nuts? SOMEBODY PLEASE TELL ME!

    1. David_Lazarus says

      It will require huge investment to provide a natural gas delivery network. Without the investment in new automobile designs why build a new fuel delivery network. Electric vehicles are more likely as an interim because you can simply plug into the home electricity grid. LNG is more practical for larger vehicles but since the US has a pathetic public transport network they are forced to hang on to oil. Europe has already started the conversion to other fuels for public transport.

  6. FalkBurger says

    A huge investment is just what’s needed right now; we’re in the mother of all recessions, fcs. And battery tech. doesn’t come free, you know. They’re making that huge investment, no problem. My question is, with all the handwringing about “we need innovation, we need business to hire and spend all those cash reserves, et c.” – why is nothing getting done? My bet is on the oil/auto lobby. I’m sure they’re buttonholing all and sundry with tales of LNGeddon.

    1. David_Lazarus says

      They have been, and one benefit of all that lobbying was that it saved them investing in plant and research to find solutions to it. Don’t forget that the big three lobbied against increases in the CAFE fuel efficiency standards for a long time. That had a good payback for them. It saved them having to invest heavily to cope with any such changes. Bizarrely they had to do that research if they wanted to export to Europe, whose fuel efficiency standards were a lot higher. 

  7. FalkBurger says

    So Big Finance got us into this mess, now Big Oil et al. are keeping us there; all for their own narrow interests and profit. The role of government is just to dole out the rights to destroy whatever parts of the world some profit can be wrung from and keep people believing their vote means something. And in case the people get wise, the National Surveillance State is already in place to suppress the malcontents. Man, it’s gonna be ugly. I’m going to keep up the LNG drumbeat though, while hoping for some event that might scare some sense into them.

    1. David_Lazarus says

      Yes that is the corrupting influence of Citizens United. The corporations now feel that they have a right to say what they want. The US needs serious political finance reform but I doubt that anything will happen until the next financial crisis, which will be here sooner than the experts realise, because the problems that were there before have just been papered over. The big US banks are not appreciably stronger than they were in 2008. They just look it because of trillions of Fed funding and loose monetary policy. 

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