We Will Never Run Out of Oil - Revisited

An article I published a few years ago with the title "We Will Never Run Out of Oil" generated quite a bit of positive feedback as well as a great deal of criticism from believers in "peak oil". I still contend that we are not going to run out of oil in any physical sense like some of the more extreme believers in peak oil believe. It is likely that over time that real prices will rise as the supply dwindles; there's a very legitimate debate about fast prices are likely to rise and what impact this is likely to have on the economy.

The case against a fast rise in prices generally rests on two points:

1. The dynamics of such a sudden shortage/rise in price of oil ignores economic incentives.

2. People have been saying that we'll soon run out of oil since the 1870's and it hasn't happened.

3. Various points about the supply of oil substitutes and ways to 'produce' oil such as coal liquification, which as an economist I'm not particularly qualified to discuss, so I tend to focus on points 1 and 2.

One of the arguments I hear a lot from Canadian believers in peak oil has to do with the cod fishery. For centuries cod were abundant on the shores of Newfoundland - you couldn't put an oar in the water without hitting a cod. However, with decades of overfishing, now the cod are all but gone. If it can happen to cod, why can't it happen to oil?

My typical response is to suggest that the difference between cod and oil is that oil doesn't suffer from the tragedy of the commons problem. The individual property rights for oil is relatively stable, whereas no property rights existed for cod outside of Canada's territorial waters - it was first come, first serve. Thus the individual oil well owner has a set of incentives that the individual fisherman does not have, so oil will not run out like the cod did.

But are the property rights to oil really all that secure? Economist David Friedman suggests that they are not:

Suppose I own underground oil, but I believe there is a substantial chance, say ten percent each year, that someone else will seize control over it. I will only leave the oil in the ground if the expected rise in oil prices is enough to compensate me not only for the interest I could have earned on the money I would get by selling the oil now but also for the risk of losing the oil. So insecure property rights result in producing more oil now, less later, and a price pattern that rises faster than in the Hotelling model.

Essentially all property rights in underground oil are insecure. It has surely occurred to the current rulers of Kuwait and Saudi Arabia that money in a Swiss bank account is a safer asset than oil under the desert. The government of Norway is unlikely to fall to a coup or an invasion the politicians who control it today cannot be confident of controlling it ten years from now, so have an incentive to pump now and use the money to maintain their political power.

In some countries, such as the U.S., much of the oil is owned by private firms, not governments. But their property rights too are insecure. As we have seen in the past, a rising price of oil results in political pressure for price controls, "excess profits" taxes, and other forms of more or less disguised partial expropriation.

The implication is straightforward. The arguments about oil geology and the cost of alternatives may or may not be correct - the basis of past evidence, the claim that we will shortly run out of oil should be viewed with considerable skepticism. But the economic argument implies that owners of underground oil will tend to pump and sell earlier than they would in a perfectly functioning market, and hence that oil prices will raise faster than the simple version of the economic argument predicts. How much faster depends on how insecure the relevant property rights are.

Dr. Friedman's argument is a very compelling one. While I still think the 'strong' forms of the peak oil argument are bunk, it's quite possible that the price of oil may rise faster than I had anticipated.

I'd like to hear your thoughts on the oil supply. How fast do you expect the price of oil to jump in the future? You can reach me by using the feedback form.