Free Term Paper on Oil, Economics, and Business

This is a good-news/bad-news entry. Since the 19th century, there has been both a regular and periodic concern that fossil fuel supplies will be inadequate to support and maintain the world’s energy-dependent economy and society. In the 20th century, the most prominent advocate of the theory of impending trouble was the well-respected geologist and geophysicist M. King Hubbert, who predicted in 1956 that U.S. crude oil production would peak between 1965 and 1970. U.S. crude oil production did in fact peak in 1971. Hubbert further predicted in 1974 that global crude oil production would peak in 1995. However, world oil production has not yet peaked.


I. Introduction

II. The Centrality of Oil

III. The Flow of Oil

IV. The Patterns of Energy Consumption

V. Oil Production: The Intensive Margin

VI. Fossil Fuel Production: The Extensive Margin

VII. Price Volatility

VIII. Conclusion


OilIn the 21st century, there continues to be widespread concern and support for Hubbert’s contention that the fossil fuel era would be of very short duration. Some analysts argue that Saudi Arabian oil production may have already peaked and may now be in decline. Saudi Arabia is the largest supplier of crude oil exports to the world market. Others argue that total world oil production, if it has not already peaked, will peak in a few years.

The first piece of good news is that world oil production has not yet peaked and may continue production at current, or higher, levels in the foreseeable future—decades or more. The second piece of good news is that, even if the pessimists are correct, it is likely that there will be cost-effective fossil fuel substitutes for oil that allow continued economic growth and improvement in living standards for the population of the world. There is no question that the fossil fuel content of the geology of the Earth is finite.

What is the bad news? Just as the world is now predominantly a fossil fuel economy, the world is likely to continue to be a predominantly fossil fuel economy for at least the next several decades, if not the balance of the 21st century. And, of course, when fossil fuels are used, they emit greenhouse gases. The 1997 Kyoto Protocol amended the international treaty on climate change to assign mandatory targets for the reduction of greenhouse gas emissions, and the 2009 Copenhagen Accord raised the question of setting more ambitious targets (though little was actually agreed to). If there are adequate fossil fuel resources to maintain or increase our global fossil fuel consumption, then there will be unavoidable tension between maintaining and improving our energy-dependent standard of living for the growing population of the world and curbing greenhouse gas emissions. “Unavoidable tension” is a polite way of saying a political catfight. And this, moreover, is an international political catfight that may take decades to resolve.

The Centrality of Oil

The primary source of energy used by the world economy comes in a variety of forms: petroleum (crude oil); natural gas; coal; and hydro, geothermal, solar, wind, biomass, and nuclear energy. Electricity is a derived form of energy that can be generated by any of the primary energy sources. Many energy sources have multiple uses. For example, wind can power turbines to generate electricity or propel sailing ships. Sunlight can generate electricity photovoltaically or directly provide space heating. Natural gas can be used for space heating and cooling or to generate electricity. Coal can be used for transportation (locomotives and steamships), space heating, or electricity generation. These energy sources compete with each other in the energy market, and this competition determines which source is the most cost effective and technically efficient alternative for each specific use.

There is, however, only one energy source that broadly competes with all other energy sources in all uses. This is petroleum. The competitive centrality of petroleum, in addition to petroleum’s predominance as the largest single source of energy for the world economy, is why so much attention is focused on world crude oil supplies. Because of petroleum’s worldwide competitive interconnectedness to the markets for all other sources of energy, when the world oil market sneezes, each of the markets for other types of energy at least sniffles.

The Flow of Oil

The standard way that energy economists think about the amount of oil produced and consumed is in barrels per day. There is a good reason for this. Oil is always on the move. It flows in drill pipes from underground geological formations to the surface of the Earth. There it is temporarily deposited in lease tanks before beginning another journey by pipeline to a refinery. A refinery is a vast network of pipes, pressure vessels, and storage tanks through which oil flows as it is converted from crude oil to refined products such as gasoline, jet fuel, and heating oil.

Refined products leave the refinery and move to market through pipelines. Sometimes crude oil and refined products also move great distances around the world by ocean tanker. Since time is money, there are large economic incentives to minimize the amount of time that oil spends in storage tanks along its route from geological formation to refined-product customer.

The United States uses about 20 million barrels of oil a day. How much is that? An oil barrel is 42 gallons, so 20 million barrels a day equals 840 million gallons per day. And how much is this? Visualize a red one-gallon gas can used to fill a lawn mower. Start at Miami and line up 42 of these one-gallon cans across the northbound lane of the interstate highway from Miami to Chicago. Repeat that lineup of cans across the interstate all the way to Chicago until the northbound lane is full of gas cans. That is 840 million gallons of oil.

Now, blink your eyes, and all the oil cans disappear (i.e., the oil is consumed). Tomorrow, blink your eyes again and all 840 million oil cans—full of oil—reappear. The vast production network of wells, pipelines, tankers, and refineries replaces yesterday’s consumption with today’s new production.

This is a logistic miracle. It happens every day, day in and day out, 365 days a year. It happens not only in the United States, but all over the world. And world production and consumption is 85 million barrels of oil a day.

The planning and implementation imperatives that this daily feat of logistics imposes upon the oil industry are the practical reasons why industry operators commonly measure production and consumption in millions of barrels a day. Oil, of course, is not the only source of energy. So it is useful to have a measure of energy that allows comparison across the various types of energy. That measure is the British thermal unit, or Btu. Production and consumption statistics are also kept on an annual basis. But beneath the annual numbers, energy is moving in a ceaseless hourly and daily flow.

The Patterns of Energy Consumption

The world used 472 quadrillion Btus of energy in 2006 (and an estimated 508 quadrillion in 2010). A Btu, or British thermal unit, is the heat equal to 1/180 of the heat required to raise the temperature of one pound of water from a temperature of 32 degrees Fahrenheit to 212 degrees Fahrenheit at a constant pressure of one atmosphere. An atmosphere is the air pressure at sea level. A quadrillion is a million billion, or 1015. This is a tremendous amount of energy. The word used to mean a quadrillion Btus is quad.

Between 1985 and 2009, U.S. energy consumption increased 27.5 percent, from 76.5 quads to 94.6 quads. Fossil fuels supplied 66.1 percent of U.S. energy consumption in 1985 and 78.4 percent in 2009. Fossil fuels also supplied 68.0 percent of the 18.1 quad increase in U.S. energy consumption over the 1985–2009 interval. Between 1985 and 2009, the total renewable energy consumption in the United States increased 1.6 quads, or 25.8 percent. This net increase reflects a 2.0 quad increase for the combination of biomass, geothermal, solar, and wind forms that is partially offset by a 0.3 quad decrease in U.S. hydropower. In general, although the use of hydropower increased on a worldwide basis and decreased in the United States, the pattern of U.S. energy consumption is similar to the pattern for the world. Over the quarter century from 1985 to 2009, both the United States and the world increased total energy consumption. For both the United States and the world, by far the principal source of total energy consumption was fossil fuel. In relative terms, fossil fuels lost a few percentage points of market share. But for both the United States and the world, increased fossil fuel consumption accounted for roughly 70 percent of the total increase in energy consumption. Use of nuclear power increased in both absolute and relative terms in the United States and worldwide. With the exception of hydropower outside the United States, renewable sources made relatively modest contributions to both absolute and relative energy consumption in the United States and on a worldwide basis.

Oil Production: The Intensive Margin

Economists have long considered two general approaches to increasing or maintaining the production of output: the intensive margin of production and the extensive margin of production. Think of a tomato farmer. If the farmer wants to increase production, one way to accomplish this is by getting more output from her existing fields. This can be achieved by installing irrigation, applying fertilizer, hiring more labor to pick and cultivate more carefully, applying pesticides and herbicides, and the like. These production enhancement techniques are all examples of expanding output at the internal margin of production.

There is also an external margin of production—an alternative way the farmer could expand production. She could plant, cultivate, and harvest additional fields of tomatoes. She could manage the new fields in exactly the same way that she managed her original fields. If she were to follow this approach, the farmer would be expanding output at the external margin of production. Not surprisingly, if there are economic incentives to expand the output of some commodity, there are production responses at both the internal and external margins of production.

Terms of art in the oil and gas industry are resource and proved reserves. Resources exist in nature. Proved reserves are an artifact of humans. Resources are the total global endowment of fossil fuels that nature has bestowed upon us. Resources exist, whether they have been discovered or not. Proved reserves are the portion of a discovered resource that is recoverable (or producible) under existing technological and economic conditions.

To understand how the concept of the internal margin applies to oil production, it is necessary to review a little petroleum geology. Oil does not occur in huge underground lakes or pools. What is often called a pool of oil actually appears to the naked eye to be solid rock. The oil is contained in the microscopic pore spaces between the tiny grains of sand that make up the rock. Porous rock that contains oil is called reservoir rock. The reservoir rock of the Prudhoe Bay oil field on the North Slope of Alaska could be cut into thin slabs, polished up, and used as the facing on a bank building. Passers-by would be none the wiser.

Geologists speak of source rock, reservoir rock, and caprock. Source rock is the progenitor of fossil fuels. Eons ago in geologic time, plant and animal life lived and died and were deposited as organic material in sedimentary basins. The Earth’s crust moved and buckled and bent and folded over upon itself. This process rolled organic sedimentary material deep underground, where, over the course of geologic time, heat and pressure converted the organic sediments to fossil fuels—petroleum, natural gas, and coal.

Fossil fuels are solar fuels. The energy they contain derives from the energy of the sun. But the production process that created them is much more roundabout—millions of years more roundabout—than the process that uses the energy of the sun to warm a solar water heater.

Oil formed in the source rock is pushed by underground pressures through various strata of permeable rock until it is trapped against a layer of impermeable rock—the caprock. The source of the pressure pushing the oil into the ultimate strata of reservoir rock is often water driven by a subterranean aquifer. If no caprock stops its pressuredriven journey, the oil escapes to the surface of the Earth—on land or under the oceans. These are natural oil spills. One of the largest known deposits of oil in the world—the Athabasca Tar Sands in Alberta, Canada—is such a natural oil spill.

Nature abhors a vacuum. Nature also abhors a partial vacuum. Oil in a strata of reservoir rock is under great pressure, trapped between a water drive and the impermeable caprock. It requires tremendous pressure to force oil to flow through solid rock from the source rock to the caprock. When a well pierces the caprock and enters the reservoir rock, a partial vacuum is created. The great pressure differential between atmospheric pressure at the surface of the Earth and the underground reservoir pressure causes the oil to flow to the well bore and then up through the well casing to the wellhead at the surface.

In the 19th century and the first half of the 20th century, successful oil wells were often allowed to erupt as gushers and temporarily spew a fountain of oil from the drilling derrick. This is no longer the case. Reservoir pressure is precious and managed carefully. As natural reservoir pressure dissipates, less and less oil is forced through the reservoir rock to the well bore, and daily production declines.

Not all the oil in place in a reservoir is produced. In the earliest days of the oil industry after Col. Edwin Drake drilled his discovery well in 1859 near Titusville, Pennsylvania, as little as 10 percent of the oil in place was produced before the natural reservoir pressure was exhausted and primary oil production ceased to flow. To offset the loss of production as primary output slowed, secondary production techniques were developed.

There are many different kinds of secondary production technology. The classic secondary production technique is the walking beam pump, which resembles a mechanized sawhorse bobbing up and down. Others include drilling injection wells and pumping water, natural gas, or carbon dioxide into the reservoir to maintain pressure. Secondary recovery shades into tertiary recovery, such as injecting steam to make heavy oil flow more freely or injecting surfactant detergents to maintain reservoir pressure and to wash oil out of tight pore spaces and help it to flow to the well bore. From the inception of production, modern reservoir engineering now uses whatever techniques are cost effective to maintain reservoir pressure, improve flow, and increase the ultimate recovery of oil in place. The result has been a significant increase in the percent of oil in place that is recovered through production. In the 20th century, 10 percent recovery became 30 percent recovery. Now it is often possible to achieve 50 percent or higher ultimate recovery of the oil in place. Higher prices for oil make application of expensive enhanced recovery technologies more cost effective and also encourage the development of new technologies.

A large fraction of the oil discovered from 1859 to the present remains unrecovered and in place in known reservoirs. This includes recent discoveries of shale oil (i.e., oil embedded in shale and only extractable by new technologies that force it out using pressure). At historical and current prices with historical and current technologies, it has not been cost effective to produce it. Most of the oil in place that has not qualified to be designated as proved reserves will likely never be recovered and produced. But if petroleum becomes more scarce relative to our desire to benefit from its use, its price (adjusted for inflation) will rise, perhaps dramatically. If, or when, that occurs, a variety of responses, interactions, and consequences will ensue. One of these responses will be at the intensive margins of production. New discoveries will be developed more intensively, and old oil fields will be intensively reworked.

Fossil Fuel Production: The Extensive Margin

The fossil fuels are all hydrocarbons. Petroleum is the most widely used fossil fuel with the largest market share of any energy source, because transportation is such an important use. Liquid transportation fuels—for example, gasoline and jet fuel diesel—are easier, more convenient, and less costly to store, transport, distribute, and use than solid or gaseous fuels. However, the resource base for petroleum is smaller than that for coal and natural gas.

Engineers and scientists can convert the hydrocarbons in coal into liquid fuels. The Fischer-Tropsche process (named for two German chemists) is the best-known technology. It was used by Germany in World War II and by South Africa during the apartheid embargo. A variation of the backend of the Fischer-Tropsch process can be used to convert natural gas to liquid fuel. Exxon-Mobil is building a big gas-to-liquids (GTL) plant in West Africa. Qatar is building a very large GTL plant in the Persian Gulf to facilitate the marketing of its substantial natural gas reserves. The output of a GTL plant is equivalent to an environmentally friendly diesel fuel. We are on the cusp of extending the commercial production of liquid hydrocarbon fuels to natural gas. Higher oil prices will extend the commercial horizon to coal-based liquid hydrocarbon fuels.

The recent exploration activity focused upon the Lower Tertiary geologic formation in the deepwater Gulf of Mexico is another illustration of the relevance of the extensive margin. Two-thirds of the surface of the Earth is covered by water.

There has been considerable exploration for and production of oil and natural gas on the great deltas of the shallow near-shore outer continental shelf—the North Sea, the Bight of Benin, the Gulf of Mexico, the South China Sea, and so on. Exploration and production in water depths up to 10,000 feet and at geologic horizons 25,000 feet beneath the ocean floor are now possible.

Vast new areas about which we now know relatively little have become accessible. Attractive prospects will not be limited to just the near-to-shore relatively shallow waters bordering the continents. New deepwater geologic horizons lie before us. A great adventure will continue. If the last 50 years of history in the Gulf of Mexico tell us anything, the technological limits will not long remain at 10,000 feet of water depth and 25,000 feet beneath the ocean floor—that is, as long as adequate environmental safety measures can be put in place. For liquid hydrocarbon fuels, Hubbert’s peak lies before us—perhaps a long way before us.

Price Volatility

Following World War II, oil prices were quite stable for a number of reasons. Prices spiked in the early middle 1970s following the Arab oil embargo. Prices spiked again at the end of the 1970s and in the early 1980s, coincident with the Iranian revolution. In the early 1990s, the first Gulf War was accompanied by another spike in prices. In 2006, due to supply dislocations in Alaska, Venezuela, Nigeria, and Iraq, prices spiked again and reached nearly $80 a barrel. We can learn a number of things from these price spikes.

First, short-term demand for and supply of oil are quite inflexible. Small dislocations on either side of the market can cause big swings in price. Second, volatility is a two-way street. What goes up often comes down. The price bust in the mid-1980s and the soft markets of the late 1990s and early 2000s illustrate such turnarounds. The big downward slide of prices from the 2006 highs punctuates the message. Third, economic recessions are often attributed to oil price spikes, but we should be cautious about such suggestions. In every instance, oil price spikes were accompanied by restrictive monetary policies applied by the sometimes draconian U.S. Federal Reserve restrictions. Fourth, there is upward pressure upon prices due to increasing demand for energy from the growing economies of India and China. This is good news. The world is a much better place with billions of Indians and Chinese participating in dynamic economies that are demanding more energy than it would be were these countries failed societies with stagnant demands.

There is a further general lesson in our experience of price volatility. As prices fluctuate, we adapt. The original Honda Civic and the SUV are classic examples of our response to higher and lower prices. In an important sense, $75 oil and $3 gasoline are a bargain. In terms of what oil (and, potentially, other liquid hydrocarbon fuels) does for us, and what we would have to give up without it, there are no readily available cost-effective substitutes.

In Europe, high fuel taxes cause gasoline prices to be more than $5 a gallon. But even at these prices, motor vehicle use in London has to be restricted in order to reduce congestion. As a hypothetical example, consider the effects of $5-a-gallon gasoline in the United States. If gasoline cost $5 a gallon because of long-term higher crude oil prices, this would be equivalent to a price of $125 a barrel for crude oil. Such prices would cause much pain, but after adjusting and adapting, it is unlikely the economy would suffer long-term collapse. Supply-side initiatives at all dimensions of the intensive and extensive margins, however, would be undertaken with incredible creativity and vigor. Demand-side responses would also be significant. In the short run, high-tech modern versions of the original Honda Civic would be widely adopted. In the long run, land-use patterns and building design and construction would change.


Fossil fuels are the workhorse of the world energy economy. Nuclear power is making a growing contribution to electricity generation. Outside the United States, new hydro facilities have also contributed to increased energy consumption. Nonhydro renewable energy use has grown rapidly from a small base. But these nonhydro renewable sources make a very modest contribution toward meeting increased energy demands or total energy use. It is likely that supplies of fossil fuel resources will be ample to meet growing energy demands for the foreseeable future.

Consumption of fossil fuels generates carbon dioxide. Many environmentalists believe that the greenhouse effect of increased atmospheric concentrations of carbon dioxide is the principal cause of global warming. In The Skeptical Environmentalist, Bjorn Lomborg (2001) expresses reservations about the extent of environmental degradation due to human activities and the link between carbon dioxide concentrations and global warming. Nevertheless, serious people consider the links between human activity, fossil fuel use, increased carbon dioxide concentrations, and global warming to be very strong and regard the situation to be very serious. Moreover, in light of the 2010 BP–Deepwater Horizon disaster and other such human-caused events, the problem of preventing oil spills and containing environmental damage associated with spills is regarded as equally serious.

Modern societies and the global economy are built on fossil fuel use. There are now no cost-effective substitutes for fossil fuels. Reducing carbon dioxide emissions significantly will require dramatic changes in the way we organize our activities and live our lives. Many people, especially skeptics, will not make these sacrifices happily. If the skeptics are correct, we will incur great costs for few, if any, benefits. The resolution of these questions will become an increasingly important item on the global political agenda.


Edward W. Erickson



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