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.