“To act in accord with a myth is the distinctive characteristic of all living things”. ─ Nicolas Georgescu-Roegen

Introduction, and Something About Oil

I would like to begin by stating that while the subject of energy economics has still not attained its ‘critical mass’ where book-length literature is concerned, there are an increasing number of short, non-technical papers that everyone should attempt to read and understand. Where my energy economics students are concerned, I mean read and understand perfectly, especially if they prefer a passing to a failing grade.

I can name three extremely valuable contributions. Their authors are Ronald R. Cooke (in ‘321 Energy’), John Lounsbury (in ‘Seeking Alpha’), and Peter Huber (in ’City Journal’). Eventually I also plan to force my students to examine a few chapters in my energy economics textbook (2007), but one has to be careful here, because as the actress Joan Collins once indicated, people who spend a large part of their time in a Facebook or Twitter mode are generally not strongly interested in academic offerings.

In l987 – following the Chernobyl nuclear disaster – Italy voted to abandon nuclear, and a similar gesture was made by the good people of Sweden about the same time. According to the (UK) Financial Times (February 24, 2009), Italy’s “relatively advanced nuclear capacity was (immediately) mothballed or dismantled.” Fortunately though, Sweden specified 2010 as the date for dismantlement, because over the last decade Swedish nuclear energy – together with hydro – has provided this country (Sweden) with perhaps the lowest cost electricity in the world, and until the curse of electric deregulation appeared, the price was also among the lowest in the world.

The new Italian facilities are scheduled to be constructed by ENEL (EN), with the cooperation of Electricité de France [EDF] (ECIFF.PK), who played a key role in the design of the reactors to be installed. This equipment will not make its appearance in Italy in the very near future though, and in fact if there is a serious nuclear accident near that country, it may never come into existence. But given the nuclear renaissance that is gaining momentum in Europe and elsewhere, a change in Italy’s nuclear plans will hardly be noticed. According to the German firm Siemens, at least 400 new reactors will be deployed globally by 2030. Moreover, several years ago Mr Vladimir Spidla, the Czech prime minister at the time, visited Finland, and among things he said that while Finland was the only country in Europe that displayed intentions to build an advanced nuclear facility, “soon almost all will join it.”

Let me start by repeating what I said in an article in the journal Energy and Environment (2004): We do not know if global warming is the real deal, or just part of a cycle, but we have discovered that gas and oil can become extremely expensive in a very short time. In these circumstances the optimal behaviour is to get friendlier with the friendly atom, and do what former Prime Minister Blair and the founder of Greenpeace suggest, which is to increase the use of nuclear energy.

What does nuclear energy have to do with the depletion of oils and gas? As emphasized in my new energy economics textbook (2007), it has almost everything to do with it, because nuclear may well be the most flexible of all energy expedients, in that it can  supply the ‘extra energy’ required to e.g. obtain the large quantities of motor fuels that voters in the energy importing countries have no intention of doing without, regardless of what they say or believe or hope. As Len Gould noted in the important forum EnergyPulse (www.energypulse.net), those voters intend to maintain their transportation activities at close to the present level – which in many cases is mandatory if they are to maintain the standard of living of themselves and their families – even if they must go to war to ensure this outcome.

The speculation versus fundamentals controversy is, in some respect, what Sherlock Holmes might have called ‘The Final Problem’. It is final because the peak-oil quandary has, to a considerable extent, been settled: a majority of observers now accept that a global peaking of the oil output is quite conceivable, and could – not will – happen in the near as opposed to the distant future. The background to this update of a previous article with almost the same name is a short piece in the New York Review by George Soros, based on his testimony before the US Senate Commerce Committee Oversight Hearing on June 3, 2008, at which time he stated that “there is a bubble superimposed on an upward trend in oil prices”, where this trend is caused by “demand growing faster than the supply of available reserves”. Readers should focus on this remark, and especially the word ‘available’, because available doesn’t mean the same thing as existing.

INTRODUCTION

"The production of energy is the moving force of world economic progress." -President Vladimir Putin

Almost a year ago, Professor Jonathan Stern of Oxford University visited the Stockholm School of Economics, where he presented a ‘pop’ version of Russian gas intentions in both their own country and regions west of the Russian border.

Not too long ago I took the liberty of publishing several short papers on speculation and the oil price. Needless to say, I felt it necessary to publish them in more than one place, and also to exploit my beliefs in this matter in several lectures, both formal and informal. My opinion – or perhaps I should say my often-repeated opinion – is that speculation is of secondary importance for explaining other than transitory movements in the oil price, and instead the key explanatory factors for oil price ‘trends’ can be derived from orthodox economic logic associated with the buying and especially the selling of physical oil.

One of my favorite daydreams features me standing in front of a blackboard somewhere, discussing e.g. speculation and the oil market, and suddenly hearing a sturdy, confident voice from some corner of the room informing me that I don’t know what I am talking about. It has been so many years since something of that nature happened, that should it take place in the near future, I probably would find myself immediately reaching for a double dose of aspirin or smelling salts, or asking if there was a doctor in the house who could check my hearing. The problem – as the late president Lyndon Johnson once pointed out – is that very few individuals possess an extensive knowledge of financial or financial-like markets, although in my teaching in half a dozen countries, I have never had the slightest problem explaining to first year students how speculation works in commodity markets.

The world oil market is a very different thing today from what it was just a decade ago. The strength of global demand for oil has surprised just about everybody – except me, of course – while at the same time it has become clear that there is and has been insufficient investment in additional production capacity.

The core issue here is that it has become increasingly difficult to locate additional large deposits of oil, and as a result, the major oil producers consider it uneconomical to look as hard as their customers want them to look. Unlike many observers in the economics faculties of the larger universities, the executives of these firms have a comprehensive insight into the cost and risk that are associated with exploring and producing in marginal regions, and as a result they are paying more attention to the preferences of their shareholders.

“Fools will be fooled” -Julie Styne (in the song ‘The Man That Got Away’)

If there is any meaning in the Jeddah Summit on Oil (June 22, 2008), it was injected by the U.S. Treasury secretary, Henry Paulson, who before deliberations began informed his audience that the run-up in oil prices did not have anything momentous to do with speculation. Exactly how that august assembly reacted or will react to this piece of news is unknown to this humble teacher of economics and finance, nor do I care, because as I have explained at both great and diminutive length, the realities of the oil price are strictly determined by supply and demand (or fundamentals). Of course, Mr Paulson did not elaborate on this theme, because if he had he might have inadvertently used the expression ‘demand destruction’, in which case when he got back to Washington, he might have found the lock changed on his office door. I doubt whether American voters would have any sympathy for politicians or high ranking civil servants who express an intention to tamper with their demand for motor fuel.

Some observers think that speculation is the cause of the escalating oil price – an escalation that, as I have pointed out in many lectures and publications (e.g. 2007), is capable of cutting the ground out from under the international macroeconomy. Put another  way, these ‘pundits’ (= self-appointed experts) believe that we are dealing with a bubble, which is a price movement  unsupported by fundamentals.

Among the gentlemen claiming that excessive speculation is responsible for the bad oil news being experienced by the buy side of that market, are the billionaire financier Mr George Soros (who admits that he is not an oil market expert, and that the oil price bubble has strong fundamental underpinnings), the influential television personality Mr Bill O’Reilly, and Lord Megnad Desai, who is a professor of economics at the London School of Economics. Many years ago Lord Desai and myself had a disagreement about the price of copper that  terminated in  the select learned journal Econometrica. I don’t recall  how the referees ruled on that dispute, although I do remember that with copper – as at present with oil – I took great care to avoid making embarrassing mistakes.

Let’s start this short paper by getting the peak oil issue off the table. Peak oil is not about the future – it’s about the past! It’s about a (generally unspoken) strategy formulated many years ago by the most important countries in OPEC, which features a decrease in the production of their invaluable oil (and probably also gas) when they get the opportunity. The present high oil price has given them the opportunity!. It’s about more money rather than less – that is to say run-of-the-mill Economics 101 profit maximization – and for students of financial economics, increasing the value of an option whose underlying is the asset called oil, by extending the exercise date (i.e. the date on which that oil will be harvested). As might be shown by serious teachers with a serious interest in the so-called dismal science, it’s about controlling certain elements of the global oil supply curve, which is equivalent to controlling the entire curve. Basically, it’s not about geology but about microeconomics, and as a result the oil price reaching a level that even I thought was impossible. It’s also about macroeconomics.

Perhaps another jolt to the delicate sensibilities of readers might be appropriate at the present time. Neither the OPEC countries nor ‘Big Oil’ have the ability nor intentions of producing the EXTRA tens of millions of barrels of oil that will be necessary to make the half-baked dreams of the International Energy Agency [IEA] and the United States Department of Energy [USDOE] come true, by which I mean the extra tens of millions of barrels that will be required to fill the global demand-supply ‘gap’ in their target year of 2030. And if the major producers do not gradually work their way up to that level, then it will never be realized, and the oil price will continue to ascend unless ‘demand is destroyed’ by an international macroeconomic meltdown. Readers can ponder what this means at their leisure, however the information provided in an important paper of James D. Hamilton (2008) does not leave much room for optimism.

Some years ago I wrote a paper called ‘A ‘New’ World Oil Market’ (2004), which I presented at a conference somewhere. The intention of that paper was to argue that the world oil market was in the process of a rapid transition, and the combination of resource scarcity and accelerating demand (relative to supply) would cause a fundamental shift in the market. I said in that paper essentially what I am going to say here, only at that time I couldn’t prove a few of the things that needed proving. All that has changed: it changed when the price of oil reached $100/b and continued to rise, because with that price and the present movements of global oil supply and demand, proofs are no longer necessary. This time the wolf is here!

In the American Navy there was once a saying that ‘On every ship there is someone who doesn’t get the message’, however on this ship everyone is finally getting the message, where everyone includes a former head of the Petroleum Industry Research Foundation in New York, who once claimed that OPEC is “on its way into a stagnant volume environment at best”. This misleading statement can be translated as ‘OPEC’s oil is increasingly unimportant’.

I would like to begin this brief exposition with a bizarre fairy tale that was confected by two well known energy experts, Amory Lovins and Joseph Romm, and published in Foreign Affairs (1992-93), which is the prestigious journal of the (United States) Council on Foreign Relations. It goes like this:

For example, the Swedish State Power Board found that doubling electric efficiency, switching generators to natural gas and biomass fuels and relying upon the cleanest power plants would support a 54 per cent increase in real GNP from l987 to 2010 – while phasing out all nuclear power. Additionally, the heat and power sector’s carbon dioxide output would fall by one-third, and the costs of electrical services by nearly $1 billion per year. Sweden is already among the world’s most energy-efficient countries, even though it is cold, cloudy and heavily industrialized. Other countries should be able to do better.

INTRODUCTION

In a recent edition of his ‘blog’, one of the authors of Freakonomics (2005) – Stephen Levitt – made a few comments about his short stay in the United Arab Emirates [UAE] state of Dubai. As most viewers of CNN are aware, luxury is the order of the day in that lucky nation, however in mulling over the details of this condition, Professor Levitt failed to emphasize the key economic element behind Dubai’s rise from a fishing village to a middle eastern version of Monaco. The ingredient to which I am referring is systematic diversification, which in this case means that emphasis is unambiguously put on the conservation rather than the production/export of crude oil – where crude oil is oil as it is found underground, i.e. unprocessed. This approach means that less than 10% of Dubai’s GNP is now directly attributable to oil, and as trade and the provision of services increases, measures may be taken reduce the output of crude even further.

Since the publication of my natural gas book (1987), many changes have taken place in this market. Globally, the growth in the demand for gas may still exceed that of all energy media, except renewables, and until recently gas was often highly recommended as an input for electric power generation. (In both the U.S. and UK, a gigantic infusion of gas-based equipment was planned before the authentic supply-demand situation for gas was identified.)

A main reason for the popularity of gas was the advent of combined cycle gas burning equipment with a very high efficiency. What happens here is that in addition to the gas turbine, there is a secondary turbine producing steam from the waste gases/heat of the gas turbine. The kinetic energy in this steam is transformed to mechanical energy that turns a generator. When compared with earlier equipment, additional electricity could be produced for a given input of gas.