The Irreverent Economist

Oil Slick

A peculiar chapter in my academic training gave me insight into the murky dynamics of modern energy markets.  I wrote my undergrad thesis on the copper mining industry, and was later introduced to the “cobweb model” which explains pricing dynamics in agriculture.  The key insight is that commodity investment decisions involve very high fixed costs, and are made years ahead of when production comes on stream.  These realities limit the response of commodity supply to changing market prices.  Since producers respond collectively to price incentives, with a lag, changes in supply intensify price swings, rather than dampen them.  And since high fixed costs are typically financed with debt, producers have to keep on diggin’, pumpin’, and plantin’ to meet their obligations, regardless of market conditions.  These dual realities explain commodities’ extreme price volatility.

The rapid depletion of the world’s hydrocarbon endowment led many analysts to believe, understandably, that we are headed inexorably toward scarcity and high prices.  However, the distinguishing feature of modern energy markets is not high prices, but high volatility.  As easily-accessible reserves are exhausted, the constraints of long lead times and high fixed costs are tightened, further attenuating the link between supply and price. In economic parlance, energy output becomes inelastic to price changes.  In such circumstances, relatively small shifts in demand can produce large swings in prices—which move through the industrial supply chain to influence (and disrupt) virtually every sector of the economy. In the long run, what matters for economic growth is the cost, rather than the price, of energy.  As James Howard Kunstler notes, oil above $70 hurts consumers, while oil below $70 hurts producers.

Volatile price signals skew consumer incentives and throw investors off the scent of underlying market dynamics—which only reinforces the long-term trend toward depletion.  The recent collapse in energy prices will delay the push toward alternative energy, as consumers and businesses waste a precious resource that should be husbanded for future needs.  Deep-pocketed vested interests (oil companies, automobile companies, utilities and agribusiness, to name a few) fight legislative efforts to alleviate our classic “tragedy of the commons.”  We have known for at least 50 years that we will soon run out of oil, but have made only limited progress in developing power sources that consume less energy than they produce.  There is no small risk that we run short of vital resources before we have completed the conversion to renewables—all of which require energy for their production and distribution.

As Kunstler warns, our fascination with technology has obscured the basic fact that machines are distinct from the energy needed to run them.  Technology can play a vital role in the development of alternatives, but is no panacea for the depletion of hydrocarbons; no one can overturn the first law of thermodynamics.

So here we are, with spot oil trading around $30/bbl, while the marginal cost of extracting it rises beyond $60.  Econ 101 says price cannot remain below marginal cost indefinitely; the pendulum must eventually swing back to the other extreme.  Grab the tiger by the tail:  energy is a good long-term investment, if you don't get eaten alive!

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