Contrarian Wisdom Isn’t Necessarily Better Than Conventional Wisdom

For years, many observers (including myself) have argued that — from an environmental perspective — it is preferable for energy prices to be higher, so as to (1) discourage consumption of energy, mostly from fossil fuels which generates significant environmental impact, and (2) make various forms of energy efficiency and cleaner (if not zero-emission) alternative sources of energy more economically attractive to customers, which in turn will produce a virtuous cycle of further improvement in energy efficiency and alternative energy to penetrate markets in an ever-increasing fashion.

Recently, Carl Pope (formerly CEO and Chairman of the Sierra Club) penned an article that aims to turn this wisdom on its head.  In “The Road To Climate Heaven Is Paved With Ever Cheaper Oil”, Pope makes the point that the most environmentally-damaging forms of oil — such as the oil sands in Alberta — are intrinsically the most expensive to produce.  As a consequence, if oil prices were consistently at $70/barrel or less, production from these resources would be unprofitable and would relatively quickly cease, which in turn would (paraphrasing here) save the planet from future horrible devastation.

Pope notes that — of world oil demand at levels around 85 million barrels per day — about 80 million barrels per day can be sourced from relatively-clean conventional oil resources that are economically recoverable at much lower prices, rather than the dirty stuff which are economically viable only at higher prices.  In other words, the world supply curve for oil is pretty flat and low up to about 80 million barrels per day, and then goes vertical beyond that.

Assuming that his analysis of global oil supply is approximately accurate, Pope asserts that we just need the largest consumers of the world to somehow reduce demand levels by about 5 million barrels per day — permanently — and then the dangerous sources of marginal supply will be shut out of business.

It’s an interesting argument.  But I am not persuaded.

First of all, let’s consider how we got here:  World oil prices have consistently been hovering in the $80-120/barrel range since mid-2007 (except for a brief period in 2009 during the absolute trough of the global economic meltdown).  Why is this?  Except during the economic standstill, global oil demand has been robust at (as Pope says) around 85 million barrels per day — even in the face of high (and generally increasing) prices.  Note that U.S. demand has essentially been declining, so the rest of the world (especially China) has been picking up the slack.  (Imagine for a moment how much more demand there would have been had prices not increased so substantially!)

Put aside for a moment the question of how to achieve a demand reduction of 5 million barrels a day from the developed economies.  (Pope himself fudges on this point by stating that the developed economies could “encourage transportation efficiency and fuel diversity” in some unstated way.)  What would happen if Pope’s dream were somehow to be achieved?

At first, as Pope would hope, world oil prices would no doubt fall.  I don’t know if they’d fall by tens of dollars of barrel, but it’s possible.  If that were to happen, it almost certainly would cause a significant increase in demand within not-too-much time, which in turn would spur prices upward again.  Eventually, this force of increased demand would push prices back into the range that again makes viable production from the dreaded dirty marginal resources.

This is the notion of an equilibrium, central to free-market economic thought:  that any exogenous shock to the system will produce a response from the market that will tend to bring the system back into balance.

For Pope’s fantasy to play out, there would have to be not only an immediate reduction in developed-world demand for oil on the order of 5 million barrels per day (thus dropping oil prices to a significantly lower level), but an ongoing reduction from the developed-world to offset the faster growth in oil demand that would be generated by much lower oil prices that would somehow need to be maintained by ever-shrinking demands from the developed world.

I simply don’t see this happening.  Efficiency won’t be enough; it requires a massive shift off of oil for transportation — the “fuel diversity” for which Pope argues.  Low-cost natural gas (largely due to fracking, another environmental bete noire) for compressed natural gas vehicles and better (higher performance and lower cost) batteries for electric vehicles will help, but daunting investments in fueling/recharging infrastructure would be required for either (or especially both) to achieve mass-penetration — and I don’t see the money for these laying around.

With his recent article, Pope reaches for a similar conclusion, but coming from a different angle, as those who are seeking to forestall the construction of the Keystone XL pipeline to thwart access to markets for oil sands from Alberta and thereby prevent their development as a means of protecting the planet.  They share a supply-oriented mindset:  curtail supply by whatever means necessary (in Pope’s case, taking actions to depress market prices; for pipeline opponents, fighting legal/regulatory battles) to prevent consumption of a particular source of oil.

In my mind, this is not the way the modern economic world works.  In the market-oriented economy that generally prevails around the world, it is demand — not supply — that drives all the mechanisms.  World oil markets are fungible:  pushing down in one place will cause counterbalancing forces elsewhere, mostly negating the initial restriction.  Trying to control markets by somehow altering supply is futile, as the forces of demand will insidiously work around any inhibitions.

To see an example of this, look at the ineffectiveness of the so-called war on drugs:  demand may be lowered from unfettered levels but nevertheless remains abundant, against all social wishes.  The market is not destroyed; be assured, the market remains — it’s just been driven underground to all sorts of illegal and nefarious suppliers.

Similarly, the lack of a Keystone XL pipeline will not prevent the tapping of the Alberta oil sands (as long as oil prices are high enough).  Participants in the market are too nimble and inventive.  Oil sands output is already being shipped to the U.S. not only over existing pipelines, but as they approach capacity, by an increasing number of rail cars.  In addition, the Canadians may build their own pipelines to the Atlantic or the Pacific Coasts, allowing oil sands to reach world markets even with constrained access to the U.S. if Keystone XL is never built.  So the opposition to the pipeline will mainly have ended up being for naught — other than to drive up oil prices a little bit, due to the extra costs introduced into the market by denying an economically-attractive project from being built.

I respect Pope for all he has done in his career for the environment, building awareness of the critical issues our planet faces and generating urgency for action.  But, at least in his most recent writing, his unconventional economic wisdom does not ring true to me.  I’m often a contrarian myself, but in this case, I believe that Pope’s out-of-the-box thinking should probably be put back in the box.

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