Modelling Peak Oil

On Wednesday 18th January we had another of our Energy Journal Club meetings. Sean was talking about Hamilton (2011) - Oil Prices, Exhaustible Resources, and Economic Growth, Jelte talked to Murphy & Hall (2010) - Year in review—EROI or energy return on (energy) invested, Sebastian covered Greene et al (2005) - Have we run out of oil yet? Oil peaking analysis from an optimist’s perspective, Erkal spoke to Hamilton (2005) - Oil and the Macroeconomy, and I talked about Holland (2008) - Modeling Peak Oil.

To summarise the Holland paper:
# It started from the usual no-arbitrage Hotellings condition (prices must move in such a way so that the owners of exhaustible natural resources are indifferent between: extracting the resources, selling them and investing the financial proceeds;  and just sitting on the unextracted resources), but presented 4 models that were sufficient to generate a peak in production. You may have thought that since oil production started from zero in the mid nineteenth century and rose to the present day, and since oil is a finite resource, then any good model would show a peak in production. But most economic models of the oil market, including the basic Hotelling model, have peak production at time zero since this is when prices are lowest and demand is highest.
# The 4 models are models of cost reductions through technological change, demand growth, endogenous reserve additions, and site development. This last model in particular is novel to this paper, and is consistent with the story described in Hamilton (2011) - Oil Prices, Exhaustible Resources, and Economic Growth.
# I have two objections to this paper:
(a) It uses a partial equilibrium approach. This means that the interest rate, that the Hotelling mechanism says is the rate at which the oil price rises, is independent of the aggregate oil supply.
(b) It assumes that oil that is uneconomic to exploit now will be economic to exploit at a higher price. This ignores the possibility that the capital goods with which this future oil can be exploited do not change in price (or at least that their price doesn't rise faster than the oil price).

I'm being slightly unfair in my objections since the paper is following standard assumptions in the literature. However these objections essentially form the basis of my own work.

Limits To Growth

The New Scientist recently had an article on Limits To Growth, and this week's issue features a letter from me in response to this article. They've edited my letter somewhat, the original is reproduced below:

"The article states that economists' objections were that future innovation was not included in the model. This is to misrepresent economists' concerns to a certain extent: what is missing from LTG are prices and incentives.

LTG is essentially a 'fixed factor' model so that output is associated with certain inputs. Assuming a path for output and some endowment of input factors, we can always make the model overshoot and collapse, no matter how abundant we choose these input factors to be.

Economic models on the other hand require that these inputs be purchased by the sectors creating output. Under standard assumptions, scarcity drives up prices - a continuously rising price may spur innovation, but if it doesn't then it will instead restrict demand. Rising prices incentivise innovation, substitution or a smooth contraction in activity. Because of this, it is quite hard to construct an economic model that displays overshoot and collapse i.e. in most economic models we are automatically in the 'stabilising scenario'.

I think LTG is likely to prove closer to the truth than e.g. the endogenous growth models with exhaustible resources of Dasgupta & Heal, Stiglitz, and Solow. However, this is not because LTG is right and economists are wrong. It is because prices and and incentives have not responded to the finite nature of resources in a manner consistent with a model with rational and perfectly foresighted agents. These are wrong assumptions in much the same way that a model without prices and incentives contains the wrong assumptions.

Non-economists will get nowhere in convincing the economists, by producing models that lack economic mechanisms and incentives. Instead economists and non-economists alike have to work together to tease out the correct economic mechanisms and incentives."

Just Testing

Just testing whether I can put videos into this blog - but I'm sure there's an economics angle here: asymmetric information maybe...