Disrupted Energy: Oil cycle is coming to an end, disruptive technology will issue the coup de grace

 Disrupted Energy: Oil cycle is coming to an end, disruptive technology will issue the coup de grace

By Michael Baxter, Chief Economics Editor
The oil cycle will die one day. Very soon.  Disruptive technology will deal the fatal blow. 

Disrupted Commentary

There is irony in this predicted impending death of the oil cycle. Up until recently its death was being forecast, but for an opposite reason.

While the book iDisrupted did not predict the precise timing of the recent crash in the oil price, it did provide the rationale for the fall, sometime before the crash occurred.

The oil cycle occurred because of the difference between what economists might call ‘short-term’ and ‘long-term’ price elasticity of demand for oil.  In the short term demand for oil is inelastic; meaning a rise in prices has little effect on demand. However, if oil stays high over a sustained period, things change. In the long run, demand for oil is price elastic. Companies invest more in oil exploration, leading to an eventual boost in supply. Meanwhile, consumers change habits, for example, many start driving cars that are more fuel efficient. Car makers will shift emphasis towards making fuel efficient cars. In time, we even develop alternatives to oil.

But, analysts and market watchers got seduced by the narrative of the short term inelasticity of demand.   While oil remained high, talk of peak oil grew, people fell for the idea that oil was going to be permanently expensive. The crash of 2008 confused the story.  While oil crashed in price in late 2008, it soon rebounded.  However, the 2008 crash was down to a sharp contraction in global demand. Economic growth by emerging countries such as China was enough to boost demand again, pushing the oil price back up.

This time it is different from 2008, but much the same as is used to be.  Oil has fallen in price largely because of rising supply. Also, China is rebalancing from investment led to consumption led growth. This is likely to lead to a much slower growth in demand for oil than we have been used to.

The cycle will turn again, however. Already we are seeing sharp falls in investment. For this reason oil may shoot back up to $100 plus, towards the end of this decade.

New technologies will mean that towards the latter half of the next decade, oil will fall back again and this time it will stay down. Indeed, the need for oil across the world will diminish. Instead, we will generate more of our energy from renewables, and where we need oil, we will see synthetic oil, created with a neutral impact on carbon emissions into the atmosphere.

At the time that iDisrupted was being written, renewable energies had experienced a period of sharp falls in price. Cynics argued that these developments has been distorted by price dumping from China and were not set to continue – a view that iDisrupted argued against.  In the 12 months since the chapter on renewable energy was written, renewables have continued to fall in price, such that renewable energy is now reaching grid parity in more and more parts of the world.

Recent examples of how the economics of renewables are becoming more compelling include:

  • This morning it was announced that scientists have made significant progress in the development of organic solar cells made of low cost plastics. These cells may ultimately be much cheaper to make than silicon based cells, while the process of making them will do less damage to the environment than the manufacture of silicon based solar panels. See challenge to classic theory of organic solar cells could improve efficiency.
  • The UK government has announced plans to test a new type of road that can re-charge electric cars while they are travelling. See off road trials for “electric highways” technology, BMW is trialling the real thing. The theory behind this idea is simply stunning. Once electric cars can be recharged while driving, for example along motorways, then the benefit of electric cars powered perhaps by electricity created from renewable sources, over cars charged by oil will become overwhelming.

For that reason the oil cycle will die in around a years’ time, and it will die because the benefits of oil, drilled from deep in the ground or below the sea, over other sources of energy will dissipate. Given the pressures of manmade climate change this cannot come soon enough.

Authors note: 

iDisrupted was published in late October, it went to typesetting in early October and the first draft was completed in the summer of 2014. The price of West Texas Intermediate oil stood at $80 in late October 2014, $90 in early October 2014, and over $100 as recently as late July 2014.  It is currently trading at $42.   

Up until very recently there was a view that something called peak oil meant oil would never again fall significantly in price.   For that reason many were taken by surprise by the crash in oil. Maybe there would have been less surprise if people had read iDisrupted.

While iDisrupted does not say that “the oil price will crash soon,” the following words describe the main reasons why the oil prices did subsequently fall, and did hint an imminent fall in price.  

iDisrupted says:

“Peak oil is supposed to apply to that date when the world’s supply of oil goes into decline. The combination of peak oil at a time when China’s thirst for oil seems virtually unquenchable; at a time when the demand from a rapidly growing emerging world includes highly populous countries such as India, Indonesia, Brazil, Mexico, the Philippines, and Vietnam, means that the price of oil and with all other sources of energy will inevitably head north faster than a polar bear retreating from melting ice caps.  

 But economic theory may present us with one flaw in that logic, and the story of convergence and humanity’s incredible ability to innovate may provide additional flaws. 

 In fact, just as the industrial revolutions of the 18th, 19th and 20th centuries were powered by ever cheaper fuel, so will the industrial revolutions of the 21st century. 

 First, consider the economics. When demand rises faster than supply, price goes up, but so too does investment. When supply rises faster than demand, prices fall and so does investment. The economic cycle is charged, at least in part, by the time lags that occur as the markets try to align the forces of demand and supply.  

 So take oil. In the late 1990s and early 2000s the price of oil was cheap, very cheap. In December 1998, the price of crude oil per barrel was just $8.64. In June 2008, it was $126. In December 2013, it was $86.  In other words, between the end of 1998 and the eve of the banking crisis of 2008, the price of oil rose 15 fold. Most said the rise in the price of oil was down to the increase in demand for so called black gold from China. This explanation is too simplistic and misses a key point. 

 When oil was going for just $8.64, investment into exploration and into new techniques for drilling for the valuable resource was inevitably much lower than it would have been had price been higher. This lack of investment led to restrictions in supply, meaning that as demand rose, supply struggled to keep pace, and prices rocketed. Under different circumstances, when price rises, investment increases, new oil finds follow and advances in techniques for drilling for oil advance at a rapid pace. 

 This is the pattern of the oil industry. The price of oil fluctuates over time. For example, in the early 1980s the price approached $40 a barrel. After adjusting for inflation, oil was at a similar price level in the late 1970s and early 1980s as it was in 2008. As a result, investment rose, and the emphasis shifted to energy efficiency – in 1973, President Nixon proposed a national speed limit in the US of just 50 miles per hour, for example.     

In 2008 things were different. The credit crunch followed by the banking crisis of 2008 meant that there was a lack of funding for investment, and a high level of uncertainty.  Indeed, in the wake of the crisis, the price of oil fell sharply. 

As a result, the normal surge in investment that accompanies high oil prices of did not occur – not immediately – and the price of oil remained high (relative to the late 1990s) for a much longer period than is normal for the oil cycle. This fuelled support for the idea of peak oil. 

But the oil cycle didn’t die, it was merely pining. In the US, the fracking and shale gas revolution has led to sharp falls in energy prices, which are now underpinning economic recovery. Beyond shale gas there is tight oil, the tar sands of Alberta, and innovations in our ability to extract oil from the previously inaccessible places of the Earth, such as beneath the ocean bed, or in the Arctic regions. 

The effect of these new sources of oil on the price of energy is not easy to predict; the timings are imprecise. But the idea of peak oil, or at least of us reaching peak oil any time soon, is beginning to look outmoded.  
@iDisrupted @JohnStraw @TheEconomist #peakoil