Zoo Station

As oil futures stray ever close to the $70 mark, the future of an oil-based economy has become the topic du jour in the media. Many of you have probably read the widely discussed cover story in the NYT magazine this Sunday about a possible peak oil scenario. In particular, Peter Maass addresses the issue of depleting Saudi capacity, especially at Ghawar, the largest oil field in the world.

Simmons found that the Saudis are using increasingly large amounts of water to force oil out of Ghawar. Most of the wells are concentrated in the northern portion of the 174-mile-long field. That might seem like good news -- when the north runs low, the Saudis need only to drill wells in the south. But in fact it is bad news, Simmons concluded, because the southern portions of Ghawar are geologically more difficult to draw oil from. ''Someday (and perhaps that day will be soon), the remarkably high well flow rates at Ghawar's northern end will fade, as reservoir pressures finally plummet,'' Simmons writes in his book. ''Then, Saudi Arabian oil output will clearly have peaked. The death of this great king'' -- meaning Ghawar -- ''leaves no field of vaguely comparable stature in the line of succession. Twilight at Ghawar is fast approaching.'' He goes on: ''The geological phenomena and natural driving forces that created the Saudi oil miracle are conspiring now in normal and predictable ways to bring it to its conclusion, in a time frame potentially far shorter than officialdom would have us believe.'' Simmons concludes, ''Saudi Arabia clearly seems to be nearing or at its peak output and cannot materially grow its oil production.''

Steven Levitt points out many of the problems in Maass's story on the Freakonomics blog. Levitt has a specific problem with paragraph in Maass's story.

The onset of triple-digit prices might seem a blessing for the Saudis -- they would receive greater amounts of money for their increasingly scarce oil. But one popular misunderstanding about the Saudis -- and about OPEC in general -- is that high prices, no matter how high, are to their benefit. Although oil costing more than $60 a barrel hasn't caused a global recession, that could still happen: it can take a while for high prices to have their ruinous impact. And the higher above $60 that prices rise, the more likely a recession will become. High oil prices are inflationary; they raise the cost of virtually everything -- from gasoline to jet fuel to plastics and fertilizers -- and that means people buy less and travel less, which means a drop-off in economic activity. So after a brief windfall for producers, oil prices would slide as recession sets in and once-voracious economies slow down, using less oil. Prices have collapsed before, and not so long ago: in 1998, oil fell to $10 a barrel after an untimely increase in OPEC production and a reduction in demand from Asia, which was suffering through a financial crash.

Levitt responds...

Oops, there goes the whole peak oil argument. When the price rises, demand falls, and oil prices slide. What happened to the "end of the world as we know it?" Now we are back to $10 a barrel oil. Without realizing it, the author just invoked basic economics to invalidate the entire premise of the article!

I don't know if the world of oil is as simple as Levitt makes it out to be. Oil is the one commodity that makes the modern world tick, and even assuming that substitutes will come along (Levitt's contention) at some point, I am not sure the transition to a non-fossil fuel based economy will be painless for the global economy, even though I believe it is inevitable in the medium-term. In the immortal words (also quoted in the NYT story) of former Saudi oil minister, Sheik Ahmed Zaki Yamani, "The Stone Age didn't end for lack of stone, and the oil age will end long before the world runs out of oil."

In the meanwhile, John McTierney John Tierney is inspired by Julian Simon's famous bet with Paul Ehrlich to wager $5,000 with Matthew Simmons, pessimist-in-chief of Maass's story. Simmons is betting that the price of oil will cross $200 a barrel by 2010 (in 2005 prices). Whether the Cornucopians win this one too, we'll just have to wait and see.

UPDATE: Econbrowser has an excellent post on the Tierney-Simmons wager. Prof Hamilton had earlier made a must-read post on the dodgy pricing mechanism in the Chinese oil sector.