The image below this post comes from the latest IMF working paper (May 2012) looking at the “The Future of Oil: Geology versus Technology” (opens pdf) which attempts to take both the models of oil availability – that proposed by geologists and that by technologists and work out what the likely price implications are going to be to 2020. An internal working paper that “does not presume that there is a constraint on how much oil can be taken out of the ground. It prefers to believe that extraction rates will depend on the price that will be able to be charged for the final product”, it makes the wonderfully understated point that “the future may not be easy”. I continue to be amazed at the number of people I meet, sitting in leadership positions, who are unaware of this issue. I have heard from colleagues of engagements in the past couple of years with groups of senior decision-makers who have refused to discuss the issue as they believe it to be a fringe problem.

World Oil Price IMF 2012 (in 2011 dollars)

This is in fact a core strategic issue for all businesses, community service providers and governments, especially if what the paper finds holds true. In the introduction, the authors state that they will:

Discuss and reconcile two diametrically opposed views concerning the future of world oil production and prices. The geological view expects that physical constraints will dominate the future evolution of oil output and prices. It is supported by the fact that world oil production has plateaued since 2005 despite historically high prices, and that spare capacity has been near historic lows. The technological view of oil expects that higher oil prices must eventually have a decisive effect on oil output, by encouraging technological solutions. It is supported by the fact that high prices have, since 2003, led to upward revisions in production forecasts based on a purely geological view. We present a nonlinear econometric model of the world oil market that encompasses both views. The model performs far better than existing empirical models in forecasting oil prices and oil output out of sample. Its point forecast is for a near doubling of the real price of oil over the coming decade. The error bands are wide, and reflect sharply differing judgments on ultimately recoverable reserves, and on future price elasticities of oil demand and supply.

The paper is technical and, I am assuming rigourous, it is clear from my reading of it that they were struggling to model to large range of unknowns on the process that they had set themselves. They state that there are wide bands of error in the model as the future is unknown, “there is substantial uncertainty about these future trends that are rooted in our fundamental lack of knowledge, based on current data, about ultimately recoverable oil reserves, and about long-run price elasticities of oil demand and supply”. The model forecasts a “near doubling of real oil prices over the coming decade”, with a global average growth rate of between 3-5%. Given that the Chinese, Indian and Brazilian account for 25% of global GDP and their growth rates are forecast to be at least 5% over this period, it suggests many countries will stagnate or go backwards.

The model doesn’t necessarily tell the whole story as yet. A couple of quotes stood out for me as the heart of the matter as it relates to peak oil.

Our data and analysis suggest that there is at least a possibility that we may be at a turning point for world oil output and prices. A key concern going forward is that the relationship between higher oil prices and GDP may become nonlinear if oil prices become sufficiently high. The problem is that, at this moment, historical data contain very little information about what that relationship might look like. But we are not entirely without information, because a number of authors in other sciences have started to ask pertinent questions, and have done some early pioneering work.

This is a key issue – because we have no past data it is very hard for economists to predict future behaviour as they base most of their modelling on the past. I think this is a key issue for most corporate leaders as well. The past holds an important place in their thinking and moving to a situation which is untried and very difficult to predict fills many people with a deep sense of unease. People may attempt to lift their unease by falling into previous behaviours that have worked for them – following the crowd (best practice), bunkering down (being conservative), not making decisions (reviewing the direction) are three that come to mind. unfortunately, these are not the behaviours that will assist organisations to deal with the situation.

The second quote follows on from the first:

The simulations find that following permanent declines in the growth rate of world oil output, the model generates much larger negative output effects than the conventional neoclassical model, because a share of the stock of technology would become obsolete. This channel has never yet been of sufficient importance to explain the historical data, and our empirical model does not contain it. Changing this would lead to simulation results with lower GDP growth.

So, I understand this to mean that when the stock of technology that would be obsolete (once oil is too expensive to run it) is included in the model, the downwards effect on GDP will be greater than they have stated. This driver has not been included as it does not explain historical behaviour. I would think that is because we have not had a situation where our technology has decreased in complexity rather than increased. Our historical trajectory has been to move to cheaper and more dense forms of energy, which as they became cheaper and ubiquitous generated large amounts of technology which relied on that energy. As the energy intensity of our economy decreases, this technology will no longer be useful (as it will be too expensive to run). This inconvenient (physics) truth gets in the way of the substitutability concept, a key concept in economics, as they own later in the piece.

Several important contributions challenge economists’ automatic assumption that elasticities of substitution between oil and other factors of production must be much higher in the long run than in the short run. The objections include that this assumption is not consistent with the historical facts (Smil (2010))13, with real-world practical limits (Ayres (2007)), or with the laws of thermodynamics, specifically entropy (Reynolds (2002), Ch. 10). Our empirical model presently makes the conventional assumption that elasticities will after some time be higher at higher prices. A plausible alternative that could reconcile the economists’ view with the above objections is to assume that elasticities are very low in the short run (due to rigidities, adjustment costs, etc.), significantly higher in the medium run (as the rigidities are overcome), but much lower again in the long run if there is a sufficiently large shock to the growth rate of world oil supply, because there is a finite limit to the extent that machines (and labor) can substitute for energy. If this assumption was incorporated, the model would forecast significantly higher oil prices in the event of a sufficiently large and persistent shock to world oil supply.

So, if the economists admit the energy physicists know what they are talking about, then the effect on the price of oil will be WORSE than what they have already modelled. Politicians, policy makers, corporate and community leaders need to get their heads around this information and what it means for their businesses, communities and countries.

We have less than 10 years.