By Benedict De Meulemeester on 6/05/2013
Do you remember the first months of 2008? Every week, prices increased. Oil prices rose near an all-time high of 150 dollar per barrel and some analysts “predicted” that they would soon reach 300. That was obviously a disaster every time you had to fill the car. But European buyers of natural gas were also affected as back then almost all the gas contracts were pegged to oil prices. Natural gas prices rose above 40 euro per MWh. And if you were impressed by the tripling of oil prices, what to say of coal that rose from a level around 50 dollar per ton to more than 200. Electricity prices were obviously affected by these increases in combustible prices and in many countries baseload prices rose to a level near 100 euro per MWh. For buyers of energy these were terrifying times. Every delay in price fixing decisions caused a frightening increase in energy costs. We had several emergency meetings with companies in those days that were desperately looking for ways to avoid dramatic increases of their energy budgets.
Most analysts agreed on the root cause of this unprecedented bull-run. As countries like China and other emerging economies grew at exponential rates, the planet just wasn’t capable of producing enough commodities to fuel that growth. The developed economies had already depleted the world’s geological reserves so much, that there wasn’t enough left now that the developing economies joined the race. We were just plainly running out of oil, coal and natural gas. That was the simple logic behind the 300 dollar per barrel prediction of a Goldman Sachs analyst that forced many buyers of energy into panic decisions. And the fact that other commodities such as copper were also rising to historical highs proved the point. The peak oil theory became wildly popular.
This was a calculus introduced decades ago by a Shell geologist called M. King Hubbert. According to Mr. Hubbert, production of oil reserves followed the elegant path of a bell-shaped curve. At some point the peak was reached and after that ever declining production rates were inevitable. Mr. Hubbert had applied his bell-shaped calculus to the US oil production and produced a reasonably accurate forecast of the peaking moment. As oil prices increased exponentially, more and more observers became convinced that we had reached or were at least near the peak of the curve of worldwide oil production. Some were even convinced that we were on the right side of the bell shaped curves of coal and natural gas production as well …
Open-minded people will acknowledge that reality is in most cases way too complicated to fit elegantly bell-shaped curves. But I have to admit, that as prices just kept on rising, even I was tempted into some Hubbert-style thinking. What explains the attractiveness of the peak theory? I believe it is our instinctive scarcity scare. Most of the people reading this blog article can satisfy their basic needs without much trouble, just like me. Just consider the most essential needs, warmth and food. Heating myself and my family means the occasional phone call to the plumber to fix my gas-fired boiler and checking gas bills and contracts from time to time. And the struggle for daily food means phone calls with my wife in which we discuss food variety and who will take the ten minutes to stop by a shop on the way back home. However, thinking about it, I have to return just two generations to find ancestors for whom the struggle for essentials was much harder.
I remember a story told by my grandfather in which he scattered white flower on his coal reserves in the shed to check whether his suspicions of a coal-stealing neighbor were true. Less than a century ago, people still had to fight daily to get their share of the scarce energy and food. Unless you are born in some old aristocratic family, you carry in yourself the genes of people that survived due to their scarcity scare. This explains why perfectly civilized societies start the completely irrational hoarding behavior or even worse, looting, as soon as the first signs of scarcity are on the horizon. Slightly ashamed of our luxurious contemporary life styles, the idea of increasingly scarce energy supplies fascinates as well as scares us. The horror picture of 300 dollar oil fascinated us, because we are silently scared of having to return to the harsh daily struggle for the scarce commodities for keeping your family warm.
Some economists kept their cool and displayed a ‘what goes up must come down’ mentality. They remarked that this wasn’t the first peak in oil prices, and that previous peaks had been followed by deep decreases. They argued that high prices would put the laws of supply and demand at work, leading to corrections. Only, as the lead times for adaptation in energy are very long, this takes some time. As the bull-run extended in time, some renegade economists started to declare that energy was a basic good and hence not price-elastic. Whatever its price, consumers would continue to consume ever more energy. And accepting the ‘inevitable’ truth of M. King Hubbert’s peak theory, even if producers wanted to increase supply, they couldn’t. The cooler economists responded that energy supply and demand are price-elastic, but it is slow elasticity.
Investing in more energy-efficient equipment and in new production isn’t done overnight. These delays explain the ‘boom-and-bust’ cycle of energy prices. Cool-headed economics has proven to be right again. In the second half of 2008, the energy prices corrected sharply and dropped back to their pre-peak levels. Peak oil (and other energy) theorists used the economic crisis as an excuse. As soon as that crisis would pass, the plain logic of the bell curves would kick in again. But isn’t the economic crisis in itself a sign of the elasticity of energy demand? If energy prices rise too high, this pushes the world into a recession, causing demand to drop sharply. The 2008 crisis (which still isn’t over, at least not in Europe) has a complicated web of causes. But high energy prices are definitely part of that. The increasing impact on their budgets of high fuel prices was one of the reasons why so many Americans couldn’t pay back their mortgages. So, even if 300 dollar oil prices and equivalent prices of other energies are possible, they would very probably be extremely short-lived, as they would push the world in a deep recession. That draws a bleak picture of life in a perpetual economic crisis on the other side of Hubbert’s peak. The last five years have learned that economic stagnation isn’t fun, so we all have a moral duty to avoid ever ending up there.
As the economy has recovered, specifically in the commodity-devouring developing economies, energy prices on the world markets have increased again, but they haven’t hit the previous highs (yet?). Electricity in many countries of Europe is currently even trading at its lowest level since 2005. And we are clearly seeing that energy demand and supply are impacted by more fundamental phenomena than just the economic crisis:
- Combined with climate policy measures, the high prices of 2008 have caused renewed enthusiasm for energy efficiency improvements. This seems to have caused a sustainable downtrend in energy consumption in the developed world (both the EU and the USA). However, the effect of this is largely undone by continuing growth in energy demand in the developing world.
- Oil production in 2011 was 1,5% higher than in 2008. So, we are not on the right side of the bell-shaped curve yet. It should be remarked that these extra barrels are increasingly expensive to produce, causing oil prices to remain high. But it looks like we still have enough oil left. Thanks to shale oil, US oil production was 16,44% higher in 2011 than in 2008 and some are optimistic that these unconventional resources could ultimately mean an end of oil imports in the US. So, Mr. King Hubbert, the tail end of the US oil production curve is not bell-shaped …
- Peak theorists that simplistically extended the peak oil theory to coal and natural gas, were ignoring the fact that undeveloped reserves of those fossil fuels were much higher than those of oil. As oil prices remain high, the world has tapped into its coal and gas reserves. Coal production in 2011 was 12,8% higher than in 2008, gas consumption grew 7,5%. This clearly shows that the peaks in coal and natural gas were nothing more than an expression of slow elasticity. Natural gas production has been boosted by conventional and unconventional gas production. I have extensively written about the shale gas revolution on this blog. If it can spread across the globe, gas abundance could become a reality.
- The prices of wind and solar power production have dropped to a level that necessitates only limited subsidies to stimulate their growth. Therefore, the growth of the share of energy produced from these renewable sources seems unstoppable.
The previous energy crisis (the 1970’s) was followed by a long period of energy abundance and historically low prices. Are the trends above sufficient for the world to be entering an age of energy abundance again? The hunger for energy of the developing economies is continuing to put pressure on the world’s energy markets. But if shale gas becomes a worldwide reality, energy abundance could become a fact, especially if it is combined with an adoption of more energy-efficient and more renewable technology by the developing economies.
There are many obstacles on the road to energy abundance. And the legendary unpredictability of energy markets makes it impossible to say if we are heading for it or not. So please don’t interpret this blog as a forecast of low energy prices. The important message is that abundance is not unthinkable. Still, we see many energy buyers that continue to be driven by scarcity scare in their price fixing decision. This is partly due to the fact that abundance stories don’t get much political and press attention. Many conservative politicians prefer the peak energy theories because they fit within their energy independence policies that are supportive of their hawkish geopolitical position. Do you really think that the American public would have allowed the sacrifice of American blood and money in the Iraq War if back in 2003 they would have known that they were heading for the abundance of homegrown shale gas and oil? On the liberal side, the scarcity scare fits within the anxiousness to do something about climate change. This seems to be the predominant policy of Europe. We need to be very careful as we are approaching a possible age of energy abundance. If Europe unilaterally choses for more efficiency and renewable rather than more (unconventional) oil and gas, we might end up with a much higher bill than the rest of the world. Can we really afford that?
Benedict is giving a presentation on this topic on our (Central) European Energy Procurement Conference on the 16th of May in Warsaw. Send an e-mail to email@example.com if you want to attend or click here.