Environmentalists have a very strange relationship with the price of oil. I asked around among friends, students, and online acquaintances and every one replied without question that high oil prices were a good thing if you care about the environment. Why? Well, high prices discourage consumption they said. Not only that, high prices enable alternative energy sources. Of course, both of these statements are correct, but if you look deeper into the economics of oil and gas, it is not so easy to say that you should pray for high oil prices if you care about the environment.
Supply-side economics in the energy sector are very difficult to wrap your head around. It’s far too simplistic to say that oil or gas is a finite resource (which it is, of course) or that the annual quantity of oil or gas supplied has peaked (which it may have) and so to conclude that increasing oil prices are a one-way street to environmental Utopia.
Oil, from an economics perspective, is best thought of as a series of small resources, or plays. Each play has some physical and economic characteristics, the most relevant of which are the costs to extract a barrel of oil given current technology, the quality of the oil extracted, and the fiscal regime (taxes, royalties, etc.) in which the play is located. Of course, plays have different environmental attributes as well. A light oil play in Texas is vastly different from a heavy oil play in Venezuela or an oil sands play in Northern Alberta. From a supply perspective, the finite nature of the physical resource is largely irrelevant – what you need to know is how much oil is available to the market at a given world oil price, and how much do we expect to be able to produce over the next few years given a reasonable forecast of prices and technology. This is, at a very coarse level of detail, what you see when companies or countries report reserves. The problem with using these data is that they tell you next to nothing about how much oil there is in the ground, or how much companies could produce profitably at higher (or lower) prices. So, if the world’s proven and probable reserves are 1500 billion barrels, and current production is 90 million barrels per day, this does not mean that we will “run out of oil” if we keep producing at those rates in less than 50 years. It means we will run out of oil that we know about that we can produce and deliver to market at costs of less than about $60/bbl unless technology changes.
As we run out of the $60 or $80 oil that we know about today (and we will) one of two things will happen. Either new energy sources will emerge to continue to supply those products which we derive from oil at a comparable cost, or the price of oil will be bid up (in econ 101, think of the supply curve shifting slowly to the left). As that price goes up, there will be some decline in consumption, but the increase in price will also unlock previously financially non-viable energy sources. If you live in Alberta, you need only look up Highway 63 for evidence of this, while folks elsewhere can take a trip out out to the deep water of the Gulf, the North Atlantic, or the North Sea – the fact that $70-$80 oil is now the benchmark price means that oil sands plays and deep water wells which would have been the stuff of fantasy 10 years ago represent wonderful financial opportunities today. As more of these deep water wells are drilled or oil sands plants are built, the technology will improve, and the costs will go down. Now, it’s tempting to think only about alternative energy sources which would qualify as renewable, but the market does not discriminate unless forced to by policy.
If you want an example of supply-side forces in action, look no further than natural gas. Up until 2 or 3 years ago, the North American gas market was in crisis…well, if you were a consumer at least. As recently as 2007, Us domestic natural gas production was in steep decline, prices were increasing rapidly, and imports from LNG were becoming an energy security necessity. Then, something happened. In the late 1990’s, a new technology now known as fracking was beginning to emerge and show promise. The graph above tells the story of what has happened since. North American onshore gas production has move from conventional to unconventional plays with tight and shale gas accounting for an ever increasing share of production. Natural gas is still a finite resource, but between 2008 and 2009, despite abysmal natural gas prices, US economically viable gas reserves doubled and the US has gone from peak gas to abundant gas in a matter of 10 years. Why? Because of technology and the push that technology got from high prices. In fact, North American LNG import terminals are likely to go the way of the dodo, while new export terminals are springing up on the west coast. I am not sure that this makes environmentalists happy at all.
When you think about alternative energy sources, and their ability to compete with fossil fuel sources, you have to look at them like a fossil fuel play and ask: What are the costs to deliver the same end product? What is the potential for technological improvement? How well does it fit into our energy supply chain? When it comes to substitutes for unconventional sources of oil and gas, the answers are often “much more expensive,” “high but uncertain potential for improvement,” and “we can use it if we all buy new cars and/or build new fueling stations.” If you are an environmentalist, I would humbly suggest that you start dreaming about low oil prices. A low oil price means one of two things – either we have found new, less costly ways of extracting oil which almost certainly means lower energy and GHG input per barrel (let’s hope it isn’t just due to external costs being imposed on the environment) or that we have found alternative means of getting around or heating our homes, and thus reduced the amount people are willing to pay for oil. If you are an environmentalist, I have to think that either of those sound better than oil sands and shale gas.
Another way to think about is that if oil is at $150, some suit in downtown Calgary is signing off on drilling wells on the extremities of the earth. The artic. The ocean. Mining dirt in Fort McMurray and processing it into usable fuel.
There’s a lot of oil out there. We just need sufficient incentive to drill it.
Exactly my point. The real question is not how much $60 oil we have, but how much oil we have that costs less to get out of the ground than it would cost to replace with a substitute or through demand destruction.
I think you’re being a little simplistic when it comes to a couple facets of your argument.
One
“As more of these deep water wells are drilled or oil sands plants are built, the technology will improve, and the costs will go down.”
These are expensive, long to develop, capital intensive plays with uncertain flow through rates and a host of other uncertain variables. There are all kinds of natural limits you can butt up against (water use if the oil sands significantly scales up, black swans when it comes to deep water drilling). All the technology in the world isn’t going to make bitumen anything less than 20-40% oil when it comes out of the ground. There are limits to natural capital that all of the tech in the world can’t solve whether it makes sense from a price perspective or not.
I’m fairly indifferent to the price of oil. I’m more of a fan of the price going up because of the limits it puts on the depletion of natural capital but there are a lot of moving parts here. The price of oil will do its thing. I’m currently more worried about food price volatility/climate change related matters and its effect on politics around the world. If what happened in Moscow this summer happened in Chicago (and it will eventually) you’re going to be hearing a different tune from south of the border.
Two
You seem to have been sucked into this view that environmentalists are this homogenous block who all want electric cars and alternative fuel sources so we can continue to run this amazing and trouble free transportation system we have.
I don’t think electric cars are worth the rare earths that you dig out of the ground to run them. Looking at it from a systems perspective, our road system is an investment in infrastructure that is simply unsustainable (damn that word). Two cars a household, the investment in public space for private property (parking), ever widening roads and the vehicles that fill them, this is not planning, it’s madness.
Hi Duncan, great to have you reading and commenting.
There is absolutely no question that I am being simplistic, but I haven’t met someone who can explain supply-side economics in 1000 words or less without making a few simplifying assumptions along the way. You are also absolutely correct about physical limits, but I would argue that it is too often the case that physical limits are confounded with economic limits. It is certainly true, for example, that you cannot increase the energy content of bitumen, but you can certainly drill wedge wells, use solvents, increase steam-oil ratios, and deploy other technologies to enhance the recovery of bitumen from a given play. You are also correct that no one (or at least not I) can predict which technologies will see the highest rates of technological progress. That said, I think it is generally true that people look at oil and “old” technology and wind power as “new” technology, under the presumption that learning rates are exponential and so cost decreases are going to be larger in the newer technologies. Unfortunately, all the arguments you make about oil also apply to alternative energy sources, be they biofuels or wind/solar power. There are physical limits, significant unknowns, likely unintended environmental consequences, etc. and some of them will see radical cost decreases while others will not.
I agree with you 100% on the effect of extreme events in the US in shifting the policy space. If you would have seen another major hurricane or two hit the US coast the year after Katrina, I don’t think there is any question that you would see much more stringent climate policy in the US and you would see a much more active role from the US on the international scene. You could ask the question of whether aggressive climate policy is more likely to happen with high oil prices, but I think the better question is to ask whether we have reasonable substitutes for carbon-based fuels…if you believe in triple-digit and increasing oil prices, you are implicitly saying that the substitutes are much more expensive (true) and this also makes climate policy more challenging.
On your second point, I don’t think that at all. I think most people (myself included) have their favorite technologies that suit their lifestyles and preferences and would like to see those take over. It isn’t a big surprise to me that you are anti-electric-car, but you are certainly in favour of a different urban infrastructure model which is in many ways a bigger challenge than throwing some 30amp feeds out to people’s detached garages in the burbs. I am all in favour of more integrated planning (we must talk about Edmonton’s Green Plan soon) and building environmental valuation into these decisions directly.
We don’t disagree on as much as you think.
Interesting article, although I’m not sure I follow your main argument. You seem to be saying (and correct me if I’m wrong) that high oil prices are bad for the environment because they make things like oil sands and shale gas profitable. I follow that part, although (as you point out) high oil prices also provide incentives to develop alternative energy technologies.
But then you say that low oil prices indicate that either we’ve found a cheaper way of extracting oil (which you suggest would produce lower GHGs) or we’ve more or less switched off oil. The first part of that doesn’t make sense to me, because most GHGs are produced by burning fuel (not producing it) and lower prices will mean higher consumption. In any case, I think this scenario is not realistic, since we aren’t going to find magical ways of extracting unconventional oil and gas as cheaply as conventional: it inevitably takes more energy because it’s a lower quality deposit (and we’re unlikely to discover more giant conventional fields). The second part (we’ve switched off oil) seems like an outcome for the distant future – which would have to be preceded by higher oil prices. We’re not going to magically switch to cleaner technology if oil is at 30$/bbl – without massive govt intervention.
So, living in the present (as opposed to the distant future), low oil prices (which are a bit hard to imagine) would just indicate higher consumption and less investment in renewable energy. However, I do think that extremely high oil prices would be bad for renewable energy development because it takes energy to develop new technologies – and 200$/bbl oil would likely shift a lot of capital to the oil sands. So, I think gradually rising prices would be the best scenario. If some new information hits the market that drastically increases the price of oil (say, Saudi Arabia writes down their reserves and cuts production dramatically), that would be bad.
Hi Surdas, thanks for reading and taking the time to comment. I have to disagree with your contention that “we are not going to find ways of extracting oil or gas” at lower costs than conventional. Natural gas disproves that entirely. The line between conventional and unconventional is a moving target, but shale and tight gas are unconventional by almost anyone’s definition. The cost of gas out of shale wells in Alberta and elsewhere is far cheaper than out of “conventional” wells in the same jurisdictions. In fact, you do see people shutting-in conventional production while unconventional production expands. I do agree that we are unlikely to discover giant conventional fields. Importantly, high oil prices don’t drive people to seek out low GHG energy – they drive people to seek out oil or a good substitute. Some of those might be low-GHG sources, but only high GHG prices will create a preference for low-GHG oil substitutes over high GHG ones.
The thought process I am trying to drive here is not to think about oil prices as purely a force which acts on the demand side, and to also think of prices as a consequence of the interaction of supply and demand, not a driver for supply or demand. For example, you argue that low oil prices will drive lower investment in renewable energy – this is certainly true in a vacuum, but I would push you one step further and ask you why oil prices are low? Suppose that there is a breakthrough on par with horizontal drilling and fracking that leads to massive cost reductions in next gen biofuels. The availability of a cheap substitute for oil would drive down the price of oil, and rather than that driving down investment in the renewable energy source, it would be because of the investment (and breakthrough) in the renewable energy source.
I think it’s tempting to think of oil sands and renewable fuels as fundamentally different because of their environmental footprint. Unfortunately, in the absence of pricing policies on those environmental attributes, the race is simply to provide energy to the market which is signaling value through the price. Whether the ramp up is slow or fast, the technology which can best do this will be the one which is adopted the fastest.
thanks again for reading.
“The thought process I am trying to drive here is not to think about oil prices as purely a force which acts on the demand side, and to also think of prices as a consequence of the interaction of supply and demand, not a driver for supply or demand. For example, you argue that low oil prices will drive lower investment in renewable energy – this is certainly true in a vacuum, but I would push you one step further and ask you why oil prices are low? Suppose that there is a breakthrough on par with horizontal drilling and fracking that leads to massive cost reductions in next gen biofuels. The availability of a cheap substitute for oil would drive down the price of oil, and rather than that driving down investment in the renewable energy source, it would be because of the investment (and breakthrough) in the renewable energy source. ”
_
That is a great point. It is extremely difficult (maybe impossible) to predict specific innovation with any accuracy.
If your point is that high oil prices have both positive and negative effects with respect to the environment, then of course I agree. But if your point is that between high and low oil prices (in the near future) environmentalists should hope for low, I don’t think that makes sense. It’s not realistic to hope for a massive breakthrough in low-emitting technology without experiencing high oil prices for some time. Scarcity is the basic motivation for these technologies.
Of course, govt can affect these incentives as well and I think they should. That would be better than a purely supply-driven high price (for the reasons you mention). On the other hand, I’d like to see the government with the cojones to turn 10$/bbl oil into 100$/oil. They wouldn’t be around long. So you do need “real” oil prices to rise as well.
Fair point. However, we are having the same discussions now about the need for higher oil prices to drive substitutes as we have been having for years. The key learning is that there is always substitution going on, and prices reflect the relative quality of the substitutes. I think it comes back to the reality that high oil prices do not necessarily drive the search for breakthroughs in low-emissions technologies…they drive the search for oil and for good substitutes for oil. High gas prices did drive a lot of changes including a strong push for renewables, but they also drove horizontal drilling and fracturing technology because it was about creating an energy source that was a good substitute for $13/GJ conventional gas. $4/GJ shale gas is a great substitute for $13/GJ gas and can be used directly for electricity generation. Solar power, which Ontario tells me needs 42c/kWh to make money, amounts to the equivalent to about $55 dollar/GJ gas run through a power plant w 50% efficiency. So, the market was interested in replacing gas, and had no broad incentives for emissions-free or low-emissions techology, and so the cheaper substitute wins out and prices drop. My point was more that to ignore the fact that fossil fuel sources may be unlocked, that there may be technological progress in these industries and that this is at least as likely to happen in response to higher energy prices as is an emissions-free innovation. If you want emissions-free innovations, price emissions.
It seems that all of you forgot that oil is not exclusively for energy. It is for making polymers and all kind of plastics (not to mention other chemicals for fertilizers).
One will not get polymers from the wind or burning bio-fuel.
E-cars are just utopia. What you gonna use to create electricity for them? Grass?
Thanks for reading Wojciech. I certainly am well aware of the various products sourced from oil, but as with energy, these products have substitutes which are for the moment less attractive than those sourced from oil. As oil supply tightens, some of these substitutes will be viable, but others will be core to the residual demand for more expensive oil. On the electric car file, I do think there is a market for them, but they are not a panacea, but they now feed into the demand system, and the willingness to pay very high gasoline prices will be reduced for some segment of the market.
AJL
Andrew, I understand that the point of your post was to remind everyone about the supply-side effects of high oil prices; however, would these effects completely offset any gains in increased energy efficient technology that high oil prices would produce? My guess is that they would at the aggregate level due to population growth, but possibly not at the per capita level.
IMHO, this post was a great round-about way of criticizing peak oil theorists without actually calling them out.
Good question, Joel. I think this is hard to say. At play are the elasticities of demand (how much does consumption drop and how much of that is offset by efficiency gains) and the elasticity of supply and specifically something you could call the emissions elasticity of supply. How much do emissions per barrel increase as you move up the supply curve. In oil sands, you could certainly argue that is a steeply increasing function, at least locally, but that you might see some decrease in the long term. If you look at projects like Laracina’s or Petrobank’s, both of these have the potential to open up resources with lower emissions per barrel, but require extensive capital and are a big risk. There are other technologies out there as well that rely more on electricity (in situ upgrading from Shell in Peace River, for e.g.). Long story short, it’s hard to say how correlated energy and emissions per barrel is with the cost of extraction.
Important observations, Andrew. I think the point is most succinctly encapsulated in one sentence you wrote above, towit “If you want emissions-free innovations, price emissions.” I would amplify this by suggesting that if you wish to achieve a specific outcome, it is unrealistic (and frankly wishful thinking) to rely on an inadequately structured market to do your work for you. Reliance of this type suggests either a high degree of complacency or a fundamental failure to apprehend the complexity of society – or both. In the end, markets are great tools, but they still need to be shaped by policy and that can be hard work.
More generally, while it may be possible to set forth a few plausible statements of principle about the way markets function (eg “scarcity leads to increased prices in light of continuing high demand” and “increased prices lead to a search for substitutes”), the outcomes arising out of the interactions between resources, technological innovation and markets over time are fundamentally unpredictable. Thus, if societies (or more precisely groups within societies, whether local, regional or global) wish to at least shape the field of possible outcomes in a context where markets are some of the key tools available to us, the proper conceptual space in which to operate is that in which social norms are formed and, in the case of the modern state, regulatory powers are exercised. (Obviously, I don’t accept the fundamentalist idea that “free and open markets” are themselves desirable outcomes – markets are tools; important tools, but tools nevertheless.)
Given this, regarding carbon emissions, the best way to proceed may be by getting adequate societal agreement to put a price on all carbon emissions in order to better shape the market for energy (as your remark quoted above suggests). Then, as non-carbon substitutes come to the fore in light of a market that discriminates against high-carbon outcomes, it will be necessary to be ever-vigilant and to deal with the deleterious consequences of some or all of those substitutes too; all in a never-ending process of adjustment.
Alternatively, another possibility would be to coax into existence social norms that stigmatize excessive carbon emissions. Thus, even where the price of carbon remains ‘low’, it may well be possible to stigmatize its use through non-market social mechanisms. Such a process might mirror the growth of the organic food industry in North America and Europe which has operated through a scheme of moral choices, combined with follow-through by markets that developed in order to cater to those choices (ever more efficiently), providing options that fit within the zone of acceptable moral bounds.
Returning to your original thesis, then, because of the complexity of social and economic realities, without a much more detailed picture of the world over time (which we will never have), I agree that it is impossible to state what impact specific prices of carbon will have on the anthropogenic emissions of CO2 into the atmosphere (I’m not sure that you would state your thesis in this manner, so I may be taking some liberties). We do know however that, if we can achieve a consensus to limit those emissions by such means as are available, and are willing to make the efforts required to do so, the outcome that matters – CO2 levels in the atmosphere – can be influenced profoundly over time regardless of the price of carbon.
Bernie, thanks for reading and for taking the time to make such extensive comments. I agree with your emphasis on the sentence regarding carbon prices – that was the key for me as well. I am a very firm believer in carbon pricing. Not sure if you saw the RFF piece this week, but they are advocating for a global negotiation based around the price of carbon, which is a great concept. Otherwise, instead of having a discussion about the value of carbon (and thus about the value of carbon-free alternatives), you end up concentrating on who deserves more valuable emissions rights because of what they have (or have not) emitted in the past.
I am not sure I would re-state my thesis as you have. I do think there are a lot of moving parts that you need to deal with, so simply assuming that a carbon price will lead to a decrease in emissions is too simplistic. I would, perhaps, restate it as “there is always a carbon price which will generate emissions reductions, but the magnitude of that carbon price depends on both the value of carbon emissions in our society and how that value will evolve over time, but perhaps more importantly on the cost of substitution away from high-carbon fuels”. I do find it amazing that the same groups who would often advocate for really high carbon prices seem to also advocate for the concept that emissions-free fuels will save us money, and are not more expensive. Those two ideas are fundamentally inconsistent.
Thanks for reading!
AJL
Andrew, actually you’ve got it all wrong.
The rising cost of oil only brings new fields into play when the profits are made by oil companies in a growing economy thirsty for more oil. Then, of course, you’re absolutely correct.
But what environmentalists are asking for is prices that would be inflated by governments so that the cost of oil would contain some small part of the social cost of extracting it. So consumer prices would be higher but oil companies would not see a penny of that increase.
In that situation, the first thing that happens is that demand declines. And when demand declines, the unconventional fields would be the first to be abandoned.
Of course, if we’re to kick the fossil fuel habit altogether, the wedge between consumers and oil companies will have to grow. So we’d get to the point where most of the consumer cost of fossil fuels would be in taxes. In this environment, where demand is declining and oil companies are seeing less and less profit, there is absolutely no incentive for more drilling.
Hope this helps,
Adriana Mugnatto-Hamu
federal Green Party candidate, Toronto-Danforth
Climate Change critic for the Green Party of Canada
P.S. Thanks for this site and the intelligent discussion here. I just got pointed to it by a supporter.
Hi Adiana,
Thanks for reading and for the comment. I think that you and I are saying the same thing. No question that a price increase, regardless of the reason, will lead to a demand decrease. For the most part, if price goes up due to a tax increase or a war in the middle east, the effect on drivers’ costs of using their car relative to the cost of public transit increases, and so some demand reduction will occur.
My post was meant to highlight the fact that a supply crunch and induced price increase is not necessarily a substitute for a carbon price in that it does not price in any new externalities, and is actually more likely to exacerbate external costs. The reality of most externalities tied to oil production is that they are tied to the use of energy or other expensive inputs (solvents, etc.) in production or to the cost of drilling in more remote and sensitive locations. The use of these inputs, or the costs of drilling in remote locations, becomes more bankable as the revenue to oil producers (and here I will explicitly separate it from the price, as you suggest) increases. The inspiration for the post was in watching the re-tweets and discussion around the Wikileaks cables regarding saudi oil reserves, and that there seemed to be a sense around the many environmental groups that I follow that this was good news. A global supply crunch induces new energy sources, but there is no built-in advantage or disadvantage for clean ones.
Thanks again for reading,
Andrew