Oil Depletion and the Law of Diminishing Returns

Michael Hartl — Wed, 24 May 2006 14:50:00 -0700

Most people—including, lamentably, both most scientists and most politicians—don’t have a good understanding of economics, and as a result there is much confusion on the subject of oil depletion—sometimes called (in rather alarmist fashion) “peak oil”. My own thinking on the subject was sparked by David Goodstein, a physics professor at Caltech (where I got my physics Ph.D.). Goodstein is a principal exponent of the view that oil production will peak very soon (within one or two decades), and has expressed his view clearly in lectures and in his book, Out of Gas: The End of the Age of Oil. Goodstein is a clear thinker and an accomplished scientist, and he makes a compelling case; I am inclined to believe his claim that, at least when considering conventional sources and proven reserves, we are “running out of oil”. And yet, unlike him, I am not particularly worried. How can this be?

The answer begins with (a variation on) the law of diminishing returns, which says that people tend to exploit the best sources of a material first, so that over time the quality of these sources tends to decrease. (This formulation of diminishing returns is slightly different from the definition you might find in an economics textbook, but the two are closely related.) For example, copper miners first seek out the richest and most accessible ores, and switch to inferior ores only when the best sources have been exhausted. The law of diminishing returns might seem obvious, and it should. Unfortunately, commentators often fail to mention by far the most interesting aspect of this law: despite the law of diminishing returns, the price of material goods tends to decrease over time! Virtually all resources are cheaper now than they were in antiquity, for example. The reason for this is simple, yet profound: the productivity of human labor tends to increase fast enough to overcome diminishing returns. The result is that, despite diminishing returns, human beings are materially much better off now than our ancestors were, simply because we are so much more productive. It is worth reflecting on how remarkable this is, and how contrary it is to our naive intuition.

The second part of the answer lies with free markets and the price system. In a free market, as a material resource becomes depleted, its price rises (for a fixed quantity demanded). The increasing price provides an incentive to search out new sources of the material, to develop new technology to extract the resource in a new way, or to find a substitute for the resource. There is, of course, no guarantee that these new sources will be found, that the requisite technology will be developed, or that a suitable substitute will be found, but the historical evidence is unambiguous: humanity has never “run out” of any resource (or failed to find a suitable substitute) when free markets have been allowed to operate. Quite the opposite—since price is fundamentally a measure of scarcity, and prices (in inflation-adjusted dollars) of material goods have decreased over time, we are forced to conclude that we have more now of virtually everything.

Consider now the case of oil. When oil production peaks, its supply will begin to decrease; as a result, for a fixed (or growing) quantity demanded, the price will increase. As the price climbs ever higher, the incentive to exploit currently marginal oil sources (such as tar sands) will increase; sources unprofitable at $40/barrel might be highly profitable at $100/barrel. (As an aside, please understand and reject the nonsensical pseudo-thermodynamic arguments against tar sands and the like. For example, the so-called energy return on energy invested [EROEI], which supposedly makes tar sands unviable, is not fixed by physical law, but rather is a function of the technology used in extraction. Some sources of oil today, including many deep-sea deposits, had an EROEI less than one using the technology of twenty years ago, making their extraction uneconomical at the time. It is perfectly possible for a resource with an EROEI less than one now to have an EROEI greater than one in the future.) If, as has happened historically, improved technology more than compensates for the inferior quality of new oil sources, then the price of oil will eventually drop below the price that originally provided the incentive to develop the technology.

Of course, in a physical sense there must be a finite amount of oil, so if we continue to consume oil we must “run out” eventually. Luckily, oil is not the only source of energy; whether or not we run out of oil is irrelevant if we can find substitutes for its uses. Unfortunately, current “alternative” energy sources are not price-competitive with petroleum; fortunately, as scarcity forces the price of oil up they will become so. Moreover, the incentive to invest in, say, solar energy will be much higher if oil is trading at $100/barrel than it is at $40/barrel. As a result, if history is any guide, when oil is sufficiently expensive these incentives will lead to some major breakthrough in one or more alternative sources of energy, and ultimately the price of energy will actually decrease, as it has for centuries.

(I should note that petroleum has costs not reflected in its current price, most notably the cost of pollution and the taxes spent on military efforts to maintain stability in the oil-rich Middle East. It would probably be a step forward to include these costs in the price of oil somehow, such as a special tax on gasoline. Alternative sources still wouldn’t be price-competitive, but the cross-over point would certainly come sooner.)

Improvements in the productivity of labor, as the result of specialization and improving technology, have always allowed humanity to overcome the law of diminishing returns. It is possible that oil will be the exception; perhaps no one will figure out how to make tar sands a viable resource, or perhaps a “major breakthrough” in alternative energy won’t occur. Given the historical evidence, though, the onus is on those who think oil is different from other resources to prove their case. Moreover, for those who are optimistic enough to think that disaster might be averted somehow, the onus is on them to show that their preferred solution is better than the one provided by free markets and the price system.

When allowed to interact in free markets, human beings have shown a remarkable ability to overcome all manner of challenges, including the supposed depletion of natural resources. I am therefore sanguine about our prospects of thriving, even as we run out of oil.

Eikonoklastes by Michael Hartl: Oil Depletion and the Law of Diminishing Returns

Oil Depletion and the Law of Diminishing Returns