Understanding the cost implications of this transition into
an era beyond easy oil is paramount for forecasting future supply, and by extension, also of price.
The importance of reaching a better understanding of the cost fundamentals contrasts sharply with
the scarcity of empirical work in this area. The main reason for this knowledge gap is the paucity of
publicly available disaggregated2, non-proprietary3 cost data. While the theoretical literature has
made significant advances since Hotelling’s path-breaking study of 1931 on the economics of exhaustible resources
The periodic price wars which break the monotony of gasoline
prices on the American Pacific Coast are an interesting phenome-
non. Along most of the fifteen-hundred-mile strip west of the
summits of the Sierras a few large companies dominate the oil
business. In the southern California oil fields, however, numer-
ous small concerns sell gasoline at cut prices. Cheap gasoline is
for the most part not distilled from oil but is filtered from natural
gas, and may be of slightly inferior quality; nevertheless, it is an
acceptable motor fuel. The extreme mobility of purchasers of
gasoline reduces to a minimum the element of gradualness in the
shift of demand from seller to seller with change of price. Ordi-
narily, the price outside of southern California is held steady by
agreement among the five or six major companies, being fixed
in each of several large areas according to distance from the oil
fields. But every year or two a price war occurs, in which prices
go down day by day to extremely low levels, sometimes almost to
the point of giving away gasoline, and certainly below the cost of
distribution. From a normal price of 20 to 23 cents a gallon the
price sometimes drops to 6 or 7 cents, including the tax of 3 cents.
Peace is made and the old high price restored after a few weeks of
universal joy-riding and storage in every available container,
even in bath tubs. The interesting thing is the slowness of the
spread of these contests, which usually begin in southern Cali-
fornia. The companies fight each other violently there, and a few
weeks later in northern California, while in some cases maintain-
ing full prices in Oregon and Washington. These affrays give an
example of the instability of competition when variations of price
with location as well as time complicate commerce in an exhaus-
Market socialism and Georgism
As an extension of his research in spatial economics, Hotelling realized that it would be possible and socially optimal to finance investment in public goods through a Georgist land value tax and then provide such goods and services to the public at marginal cost (in many cases for free). This is an early expression of the Henry George theorem that Joseph Stiglitz and others expanded upon. Hotelling pointed out that when local public goods like roads and trains become congested, users create an additional marginal cost of excluding others. Hotelling became an early advocate of Georgist congestion pricing and stated that the purpose of this unique type of toll fee was in no way to recoup investment costs, but was instead a way of changing behavior and compensating those who are excluded. Hotelling describes how human attention is also in limited supply at any given time and place, which produces a rental value; he concludes that billboards could be regulated or taxed on similar grounds as other scarcity rents. Hotelling reasoned that rent and taxation were analogous, the public and private versions of a similar thing. Therefore, the social optimum would be to put taxes directly on rent. Kenneth Arrow described this as market socialism, but Mason Gaffney points out that it is actually Georgism. Hotelling added the following comment about the ethics of Georgist value capture: “The proposition that there is no ethical objection to the confiscation of the site value of land by taxation, if and when the nonlandowning classes can get the power to do so, has been ably defended by [the Georgist] H. G. Brown.”
Producers with increasing returns to scale: marginal cost pricing
In “oligopolies” (markets dominated by a few producers), especially in “monopolies” (markets dominated by one producer), non-convexities remain important. Concerns with large producers exploiting market power initiated the literature on non-convex sets, when Piero Sraffa wrote about firms with increasing returns to scale in 1926, after which Hotelling wrote about marginal cost pricing in 1938. Both Sraffa and Hotelling illuminated the market power of producers without competitors, clearly stimulating a literature on the supply-side of the economy.
Despite the number of factors involved, technology is
viewed as being the main contributing factor behind the
improvements in oil production from major reservoirs.
Further significant advances in upstream technology
may be achieved in the longer term (Figure 6). How
rapidly these are achieved will depend to a large degree
on the level and success of R&D activity. But there are
signs that both government and corporate (oil company
and contractor/service company) spending on upstream
oil and gas R&D has fallen over the past decade, which
could slow the pace of technology-driven cost
reductions to some degree.9
Although further cost reductions are to be expected, the
rate of decline in supply costs may slow over the next
decade or so as the scope for technological advances
and productivity gains are exhausted. Nevertheless,
innovative technology may continue to open up new
opportunities for exploiting resources that current
technologies do not permit.
Dr. Adelman contributed to a debate that has raged almost since Edwin Drake discovered oil in Pennsylvania in 1859. Geologists and others have long insisted that oil is running out, but economists have countered that oil will continue to be found as long as extraction technology advances and the price is sufficient.
Dr. Adelman used the Kern River field in the San Joaquin Valley of California to prove the economists’ point. In 1942, he said, the United States Geological Survey estimated that the field had 54 million barrels of reserves. In 1986, the agency raised its estimate to 970 million barrels, based on what could be recovered by modern technology. (The oil had been there all along but had been unrecoverable at prevailing prices and technology.) Between 1942 and 1986, the field produced 736 million barrels as increasingly better technology made it possible to squeeze more oil from the ground.
His point was that reserve estimates are based on current technology and prices, not just underlying geology. The original geologists were not incompetent, he said, rather, the technology to extract oil vastly improved.
“When will the world’s supply of oil be exhausted?” Dr. Adelman asked. “The basic answer is never.” His point has been proved many times in oil industry history, most recently by widespread use of new drilling techniques that include hydraulic fracturing and horizontal drilling to force more oil from the earth. The federal government estimated that domestic crude oil production this year will average 9.24 million barrels a day, the highest since 1972. As a result of increasing production, oil imports last year fell to 36 percent of United States’ consumption from 60 percent in 2006.
This increased production — and the knowledge gained from it — pushed estimates of domestic crude reserves recoverable at current prices and technology to more than 33.4 billion barrels for the first time since 1976. The increase in natural gas reserves has been even greater: They rose to 2.3 trillion cubic feet in 2013 from 1.3 trillion cubic feet in 2000.
THE STARTING POINT
The economics of mineral scarcity were summed up in the 1952 report of the
Paley Commission (1). One member was my great teacher, Edward Mason of
Harvard (2). As Boswell said of Johnson:
His superiority over other learned men consisted chiefly in … a certain continual power
of seizing the useful substance of all that he knew, and exhibiting it in a clear and forcible
manner; so that knowledge, which we often see to be no better than lumber in men of dull
understanding, was, in him, true, evident and actual wisdom.
As Mason might have said about mineral scarcity: Forget about running out
of anything. What counts is the cost of new supply. To know this cost, follow
the price, generated not in The Market, but in a particular market. The price in
the market may reflect not only supply and demand, but also control by one or
a few sellers, who can act together to offer less and charge more. So detecting and allowing for market control is high on the agenda for understanding
The crude oil and natural gas markets have a long colorful history. To understand
them, one needs some economic theory. The dominant view, of a fixed mineral stock, implies that a unit produced today means one less in the future. As
mankind approaches the limit, it must exert ever more effort per unit recovered.
This concept is false, whether stated as common sense or as elegant theory. Under competition, the price results from endless struggle between depletion and
increasing knowledge. But sellers may try to control the market in order to offer
less and charge more. The political results may feed back upon market behavior.
These factors—depletion, knowledge, monopoly, and politics—must be analyzed
separately before being put together to capture a slice of a changing history
The other side of the story
No one should say that analyzing all of these variables is easy, it is always a temptation to blank out the conclusions and opinions of other people with who we might disagree or even just dis-like. Availability of Energy is extremely important piecing together the opaque picture is clearly in the interests of all even those seemingly most interested and closest to immediate implications of conclusions reached and acted upon.