Betting on Peak Oil

John Tierney wrote a great New York Times column in response to the Maass article on Peak Oil in the Sunday NY Times Magazine that I criticized. Tierney and Matthew Simmons, who is the point man for the Peak Oil team, made a $10,000 bet as to whether in 2010 oil would be above or below $200 a barrel (adjusted for inflation to be in 2005 dollars). The bet was designed in the spirit of the famous bet between Julian Simon and Paul Ehrlich, which the economist Simon won when the five commodities Ehrlich said would rise in price, actually fell substantially.

I am a betting man. And when I see that the NYMEX December 2011 crude oil future is priced under $60 a barrel, under $200 looks like a pretty good price to me! So I asked Simmons if he wanted any more action.

He was kind enough to write me back:

I have had a slew of economists offer to make same bet. I am actually not in bookie business and pondered whether it was even appropriate to make this Visable Wager to help focus people on how absurb we still price energy. >

I had a barrage of economists writing yesterday to scorn on the notion that oil prices could ever stay evevb at current levels, let alone rise.

My universal response is to prove to anyone why a natural resource with such high value added and extreme capital intensity to convert into usable finished oil products should be called “too expensive” at a price of ten cents a cup.

This is Freakonomics at its best.

One final note about gasoline prices.3.20 a gallon equates to twenty cents a cup. It only buys the ability for a person or several people to travel a mile and a half in a few minutes.

Go find a rickshaw driver or horse and buggy that will deliver the same journey for a price 30 to 40 times as much and you have found a pretty good deal.

We still give energy away and as demand surges ahead of supply, real economic pricing will soon end almost a century of fantasy prices.

One thing that Simmons is definitely right about is that oil and gas are mighty cheap by volume compared to other things we consume. Imagine that a brilliant inventor came along and said that he had invented a pill you could drop into a gallon of distilled water to turn it into gasoline. How much would you be willing to pay per pill? For most of the last 50 years, the answer is next to nothing, because a gallon of gas usually costs about the same as a gallon of distilled water.

But, one place where I think Simmons’ logic goes awry is that he seems to be arguing that because a gallon of gas is so valuable relative to say, a rickshaw driver, it should be as expensive as a rickshaw driver. In reasonably competitive markets, like the ones for gas and oil and presumably rickshaws, the determinant of price is how much it costs to supply the good, not how much consumers are willing to pay. That is because the supply of the good is close to perfectly elastic over some reasonable time horizon. If there were huge profits to be made at some price, firms will compete away the profit by lowering price. How much consumers like the good just determines the quantity consumed when supply is perfectly elastic. That is why water, oxygen, and sunshine, all incredibly value products, are virtually free to consumers: it is cheap or free to supply to them. And that is why we use a lot of gas and oil, but not many rickshaws at current prices.

If the cost of supplying oil suddenly jumped, then prices would certainly rise, more in the short run than the long run, as people figured out how to substitute away from using gas and oil. (Rickshaws, most likely, won’t be the primary form of substitution, at least not in the U.S.) Whether we should care about “Peak Oil” boils down to (1) will the cost of supplying oil jump, (2) If it does jump, by how much, and (3) how elastic is demand.

As I read through the 100+ comments I got on my last blog on peak oil, it seems that there is strong disagreement on each of those three points.

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  1. IMHO, the main problem is that people never expect extreme things to happen.

    Once something unexpected happends, people realize that they did not thought “out of the box”. Now they try to prophet even more extreme things.

    Instead of understanding that “we were yesterday stupid expecting oil costing $20 a barrel forever”. Human nature prefers to say “there is something miraculous in oil prices. They will continue to rise”.

    The issue is not ineconomics. The issue is with human nature unable to distinguish past and future. And trying to assume we can predict everything.

    PS. for a discussion on how bad (and stupid) people is the human race at having predictions see http://www.fooledbyrandomness.com/prediction.pdf
    there you will see a funny story about the “prediction agency” that predicted oil prices for 25 years to be $27 for the next 25 years. Six months later after oil doubled in price they “revised” the 25 year estimate to $54. Nobody even understood they will be better off not forcasting at all…..

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  2. Pawnking says:

    Some freaks are ahead of the curve when it comes to rickshaws. Imagine the economies by using the homeless to pull them!

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  3. Steven says:

    Fischer-Torpsch, applied to coal, will alone guarantee oil prices will not reach $200-a-barrel, because it can produce both gasoline and diesel more cheaply than you can refine them from $200/barrel petroleum. And we and the Chinese both have plenty of coal.

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  4. Alan Kellogg says:

    Steven,

    We also have a lot of trash and garbage. Using CWT technology to convert it to oil we could keep the price down. Hell, we could even apply it to coal. And once we run out of trash, garbage, and coal we could start growing crops solely intended for conversion to oil.

    Humans are more adaptable than some like to think. We are reluctant to do something until we absolutely have to, but once the necessity becomes clear we make the changes necessary. We are obstinant, we are not stupid.

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  5. Aaron says:

    Go find a rickshaw driver or horse and buggy that will deliver the same journey for a price 30 to 40 times as much and you have found a pretty good deal.

    India has banned rickshaws.

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  6. Nathan says:

    I was about to write in on the last post, but will instead write in on this one to say, wow… it went a little bit over my head.

    The kernal of the issue to me in this debate though is that the complexities are so dense as to make a future outcome unknowable. My limited understanding of this issue I can compare to my limited understanding on how currency markets fluctuate or why.

    From my perspective freakanomics, economics, finance, society and modern markets in general have never faced a problem like this, jumping off at so many levels. We have not only the basic supply and demand questions to think of, but the environment, sociological and geo-political issues to boot. I think it is foolish for any one person to think they know what will happen. What is not foolish is to do as modern corporations do though on a societal level and that is to diversify our energy sources as quickly as possible.

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  7. Peter L says:

    Building an oil refinery is very expensive, even a small one is well over 1 billion dollars. It takes several years to build and bring to operation — and that is after years of legal fighting over where to build it. I dont know much about sythetic fuel from coal and Fischer-Torpsch, but given that it is not as mature technology of standard oil refining, it is likely to be much more expensive and take longer to build those than standard refineries. If there are not any coal-oil plants being built right now, I think it is highly doubtful that they will produce much to effect gasoline prices by 2011.

    The same argument can be made about any alternatives to oil. To bring them online in any meaningful amounts will require lots of time and massive investment (and thus risk!). And what about the demand side? How likeley is it that we can take the world fleet of cars and replace all of them in a few years with cars that are much more efficient? And even if we could — think how much energy and oil that process by itself would require to manufacture parts, assemble and transport.

    Then energy/economy relationship is very complex, chaotic even. I agree that predicting prices is folly, but that won’t stop me: I doubt that oil will get to 200 by 2011, because on it’s way there it will trigger a massive recession. The old saying “money makes the world go round” is not correct – “energy makes the world go round”. And cheap, plentiful energy is the single biggest variable in driving economic growth.

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  8. Taed Wynnell says:

    If you want to make bets of this sort, I’d recommend that you look at LongBets (http://www.longbets.org/), which is run by The Long Now Foundation, whose basic goal is to get people thinking LONG term (thousands of years). One of the immediate goals is to create a large (think building-sized) “clock” that can handle at least 10,000 years with minimal maintenance (since we don’t know how technologically adept people will be 8,000 years from now).

    But LongBets is for people to put their money where their mouth is on topics that are years, decades, or even centuries in the future. The money goes into escrow for that time, and at the conclusion of the bet, the money goes to the charity of the winner’s choice.

    There are some interesting bets on record there — very much worth a look-see.

    There’s a $20,000 bet on AI between Mitch Kapor and Ray Kurzweil (famous computer dudes), a $10,000 bet on a start of a serious world government, one on the expansion of the universe, one on where where extraterrestrial life will first be discovered, and so on.

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