Tuesday, April 17, 2012

Supply when demanded: Why the free market can't address peak oil

A friend of mine has to close their business. It's a fresh business that was founded during the stimulus boom. It's a green business, which took advantage of the government's stimulus measures aimed at green conversions for homes. It's a business which is now no longer profitable since these measures were retracted, one of many I'd assume. This is the simple face of a problem we will all face in our own way sooner or later; that the needed changes to address peak oil comes at a 'net loss' in today's economic terms.

If you're not familiar with peak oil, there is a good primer on the subject here. It's a long read though, so I will briefly explain the gist. Peak oil is not oil depletion, rather it decribes the peak and decline in the rate of oil production from a single well, a group of wells, or the entire world. It also describes the cost of this energy, with the first 50% on the rise towards peak starting cheap and getting increasingly expensive and even more expensive as production declines.

Peak oil is a complex, frightening, and quite frankly boring concept to understand but a simple analogy I use is "the slushie". When you first buy a slushie, it is relatively easy (cheap) in terms of sucking power (energy) to get the slushie. This ease persists until you deplete your slushie about 50%. After the 50% mark, drinking your slushie becomes more difficult (expensive). You have to stop slurping, stir the straw, etc. If you look at your "rate of consumption" of the slushie it has peaked at the 50% mark and goes into decline. The more you deplete your slushie well the slower your rate of consumption becomes. At about 20% it almost becomes so annoying (uneconomical) to drink your slushie you consider either turning it upside down and forgeting the straw or just throwing it away. We can't turn an oil well upside down, so the only option is to call it "depleted" and move on. No well has ever completely depleted, they've just become uneconomical (or too damn annoying) to get the remaining oil out. This is peak oil in a nutshell and global peak oil is a problem as the price of oil directly translates to the cost of production and the cost of living.

There are several common lines you might hear to describe (or more accurately "write off") this problem from all sides:

From the conservative/economic the most common belief I hear is that the free market as a natural response to high oil and gas prices will find "alternatives" more economically viable and realistic as oil & gas become more and more unaffordable. This is the pure and simple supply/demand view; that oil (being a source of energy and a commodity) is subject to the same rules as any commodity in our modern market and if the price should climb too high a similar replacement at a lower cost will be turned to. As an example for this "alternative" we will use natural gas.

From the liberal/environmentalist the most common belief I hear is a variation on the conservative theme. Usually it involves a subsidy of some sort from the government to create the incentive to innovate the so-called green "alternative" energy economy.

You might be wondering why I am saying "alternative" instead of simply alternative. The reason why is: none of the "alternatives" are truly alternatives. None of them. They are all derivatives, meaning that even if oil is not directly used by it, it still depends on technology either during the chain of production or during it's lifetime that does depend on oil.

A simple example of this dependency is "green" transportation, or the idea that the hybrid will somehow help ween us away from oil. For the sake of simplicity we will not even look at the sorts of transportation integral to our supply chain (nobody ships product in a Prius). The real question is, how much oil will it take to build the "alternative" in the first place? It doesn't matter if your car runs on garbage, the car still took oil to build in the first place and all of the technology needed to replace existing technology will take oil to build as well. It doesn't stop there though, the car is built using machines that were themselves built using the supply chain, other oil powered machines, and so on. These machines all need maintanence themselves which takes tools built with oil powered machines. Nevermind the roads, electrical infrastructure (think of all that copper!) , etc. Our advanced technological state fittingly has an advanced supply chain, and that entire supply chain runs on oil.

Now I know: the common rebuttal to this point is that technically in terms of what is getting done we have non-oil powered alternatives to most basic processes of our society. You might look at mining and say we did that before oil or you might look at farming and say we did that before machines. Of course we did, but we had energy subsidy back then too: like slaves (well we still do have them today, don't we Foxconn?). However often over-looked is the fact that back then we didn't have 7billion people, industrial scales of production, or GDP growth fueled by consumerism. To truly understand the gravity of the problem you must put everything into context.

Getting back to the original point, both the left and the right's argument for the switch to greener and more efficient energy is essentially supply and demand which relies on a flawed notion, that there is an alternative of which to balance against. Whether the demand is the natural result of the so-called "invisible hand" of the free market or manufactured in other areas with incentives, they both make the flawed assumption the change comes at a profit and not a loss. Both sides agree that the change will only come at a profit and will be reactive and not proactive in nature.

We have made an assumption in all of these scenarios in which a change to green energy can occur, that assumption is that 'people will react accordingly and in their best interest', this assumption is a two edged sword. The left-wing argument is a variation of the right-wing theme, so we will use the pure supply & demand - high prices equals alternative energy theory as a basis. Let us assume the supply & demand model works as expected and people switch to natural gas (of which the drilling process is itself an oil derivative). The expected ease of demand on oil should lower the price of oil, correct? If the price lowers however, the amount of so-called "incentive" to move away from oil also diminishes relative to the price. At a low enough price it will actually no longer make "economic sense" to move away from oil and so people will either not switch or possibly even switch back (hey, where did all of those numerous scooters I saw on the streets in 2008 go?). Being that our entire technological base is oil, the incentive to switch is further diminished by the perceived "economic boom" cheap energy with the room to grow provides - how ever temporary. When energy is cheap consumerism will likewise be equally cheap which translates to what we consider to be "economic health". As the past 4 years have shown, even after a complete collapse in demand it only takes 4 years of a "slow economic recovery" to push it back above $100 / barrel. How people reacted to the collapsed oil price is just as important as the reaction to high oil prices. People resumed consuming and old energy consuming habits. The natural gas boom in the U.S. further adds to the sense of "energy security".

Addressing peak oil and the implementation of derivative renewable energy sources will come at a net-loss, and this has to be accepted if we're to ever accomplish it. Neither side of the supply & demand theory can properly address the issue. If the price of oil is high: the price of derivative sources will likewise be high. Derivative sources are technically advanced, they require metalurgy and very modern materials only made possible by the basis of simpler oil powered large-scale production and distribution. The little incentive to switch is emotional in nature, either via fear of even higher oil prices at which a certain point becomes unaffordable, or a deeper moral obligation to "go green". It's inevitable that enough investment results in a collapse in oil price which could potentially result in a much more expensive cost-of-living or net-loss. If oil price doesn't collapse, the goal hasn't been accomplished making that situation moot. If the price of oil is low it becomes the defacto source of energy while free market incentive evaporates. While the "alternatives" during a cheap energy period would likewise be cheap, in comparison to the cost of oil they are still very expensive as their energy returned on investment is significantly lower. The cheap energy leaves a perception of room for economic growth in which our GDP model happily accomodates. Only a proactive approach, with the common understanding that the change comes at a net-loss but in the long-term provides a net-gain for everyone will accomplish our goals as a society to move away from oil. Not changing will result in the biggest net-loss, a perpetual recession and multiple lost generations.

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Richard Fantin is a self-taught software developer who has mostly throughout his career focused on financial applications and high frequency trading. He currently works for eQube gaming systems.

Nazayh Zanidean is a Project Coordinator for a mid-sized construction contractor in Calgary, Alberta. He enjoys writing as a hobby on topics that include foreign policy, international human rights, security and systemic media bias.

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