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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.