Energy is the basis of economic wealth and growth. First there was wood and charcoal, followed by wind power in various forms, and then small water powered mills. The development of coal as a source of energy was a large leap in energy exploitation. The great expansion of the industrial age was based (dominated by iron production and steam transport) on the development of coal use. But it was oil and its various products which became the real driver of current economic development. Natural gas is becoming important as an industrial raw material and for fuelling electric power stations. It has been just a by-product of oil well drilling, but now it is of interest in its own right. But gas is hard to store and hard to transport.

The presence of oil has been known for some time. In the Book of Daniel, the bible refers to the "burning bush". When drilling was undertaken a kilometer from that spot in 1927 the great "elephant" oil reservoir Kirkuk was found. Asphalt was used to embalm mummies and in 670 AD, petroleum was used by Emperor Constantine IV as an early version of napalm in battles. Commercial exploitation of oil started in Rumania in 1857, followed in 1859 by the discovery of oil in the USA. The major early use was for the production of kerosine for lighting and as a cooking fuel.

The development of the internal combustion engine created a mass market for oil products as the motor car age commenced.. The conversion of shipping from coal fired steam engines to oil fired steam and diesel added further demand for oil. Giant fields in Texas increased the supply potential so that prices were driven down. The Texas Railroad Commission was given the authority to limit oil production to the US demand thus acting as a government sanctioned cartel. In 1971 the limits were unleashed as the USA could no longer supply all the demand. OPEC replaced this cartel with another.

As oil demand grew, larger and larger investments had to be made in drilling, pipelines, tankers, service stations, and refineries. The oil industry is the largest of all. It is so large that oil dominates world politics, and has done so for some time. Back in 1947, just after the end of the second world war, in a little book "Science, Liberty, & Peace", Aldous Huxley wrote "One of the contributing cause of recent wars has been international competition for the world's strictly localized sources of petroleum, and the current jockeying for position in the Middle East, where all the surviving great powers have staked out claims to Persian, Mesopotamian and Arabian oil, bodes ill for the future." The only thing that has changed is the names and boundaries of the oil rich areas.

Technology has made many improvements in the extraction and delivery of oil products. Improving knowledge of geology and improved seismic techniques have made the discovery of oil traps better. Once giant IBM 7094 computers costing millions of dollars were used for basic analysis of primitive seismic data. Now improved computers, seismic techniques and mathematical methods have benefited the whole process of finding the oil. Unfortunately, all of the good areas have been found and there is not much scope left for big finds. Improved drill bits have increased the rate of drilling and were the basis of the Howard Hughes business empire. Instead of screwing short lengths of piping together, long lengths of pipe is run off from big spools of piping. Logging instruments that go down the drill hole provide important information. These have made the Schlumberger name famous among geologists because of the improvement this family made. Many techniques such as pumping gas or water into the well, and using shaped explosive charges down the well, have increased the output of wells. Enormously expensive rigs have been developed to extract oil from under the ocean floor.

But for all the improvements, we are up against the economist's "law" of declining marginal output. Just about all the easy oil has been found and is being extracted. It has been a long time between the discovery of "elephants" (fields of over a billion barrels). The ratio of dry holes being drilled has increased, the cost of drilling per foot has increased, and the size of find is decreasing. One geologist reported some time back that we are finding oil at a quarter the rate we are extracting it.

There is a lot of work done by mathematicians and statisticians on oil discovery and extraction data. For instance, the data shows that wells take 11 years from initial discovery to have the production infra-structure put in place and commence delivery to refineries. The United States Geological Survey (USGS) has a lot of information on the development of US oil geology and production, however its predictions of oil yet to be discovered are not respected by many geologists. Politics and business secrecy have now distorted information that makes prediction of oil current and future supply difficult. Recently, Shell was obliged to admit that 20% of their reserves they reported to the stock market were unrealisable. The reported reserves are important for maintaining share values.

The most important analysis of oil data was made by the geophysicist M King Hubbert in 1956. He analysed production figures for the US and predicted that the rate of production would reach a peak in the early 1970's. The controversy that this created ended when his prediction came true. Oil wells individually reach their maximum output when they are half done and then decline in production. Statisticians have the "central limit" theorem that shows that adding up wells with this production characteristic will combine into the classical "Gaussian" bell curve. Since we are still approaching the half way point of consuming all the predictable total oil bequest it is difficult to be precise about the timing and level of the production peak, but it is about now. The range of total eventual oil recovery estimated by geologists vary from 1.8 trillion barrels, to 2.12 trillion, to the very optimistic 3 trillion guess by the USGS. (My statistical analysis reduces this to a mean value of 2.2 trillion with a standard deviation of 200 billion) The peak year will therefore be between 2004 and 2009. Still, even though OPEC data is suspect, the peak is near enough to now. Accelerated drilling, pipelining, rig making, ship building, and refinery building cannot overtake the peak arrival assuming the enormous amounts of capital was available. If ever increasing production was possible in the medium term, it would mean that the eventual decline in output would be more dramatic and the final production date would become sooner.

The term "peak oil" for the point of maximum oil production is supplemented by the term "crossover". This is the point at which OPEC reserves become greater than reserves in non-OPEC countries. Political analysts see this as a time when the supremacy of OPEC countries will become apparent.

The only conclusion to be made from all this is that our consumptive growth oriented capitalist society has also peaked and will have to be replaced by a society that uses less energy. Motor fuels are seen by economists as having a low elasticity. This means that the changes in the level of consumption are very small in comparison to changes in price. Conversely, a change in the level of consumption compelled by a shortage means a very high increase in price. This is a consequence of the irreplaceability of liquid fuels in transport. Experience from the 1973 crisis suggests a demand elasticity of 0.0125.

So when the peak gets established, there will be price increases. These may quite erratic as the oil speculators react and over-react.

Since of the serious issues that the shortfall of petroleum will create, many optimists publisise the many options for the substitutes economists play much faith on. Because energy is so fundamental to civilisation's material, the holding of energy assets becomes more important than monetary assets. The economics of business in monetary matters is driven by the relationship of fixed costs (to create the productive capacity) to variable costs (the productive costs per unit of production). Business has to reach a level of sales and sale price that will cover both the variable costs and pay off the fixed costs over a reasonable length of time. So it is with energy accounting. The energy content of the plant must be considered for its ability to return the energy consumed in a reasonable length of time. This is accounted for in the ratio of the rated energy production level of the plant to the energy consumed in the creation of the plant. This is the EROEIC (energy return on energy invested in capital) and has the dimensions of inverse time (percent per year). It is the proportion of the energy consumed in creation in time. The inverse of this ratio is the time taken to pay back the energy investment. The equivalent of the variable costs is the ratio EROEIP (energy return on energy invested in production) which gives the ratio of the production of energy produced to the energy consumed in production. For instance there has been much promotion of the process of producing ethyl alcohol as an energy fuel from the growing of corn for fermentation and the distilling off of alcohol. In some cases the EROEIP calculates out at just under unity. This means that the energy available from the fuel produced is just under the amount of energy consumed in the farming and distillation of the alcohol. No industry can survive having variable costs higher than the sale price. This process is uneconomic in energy terms even if subsidies makes it economic in monetary terms.

ENERGY PLANT PRODUCTIVITY CYCLE.

The graph above is a not-to-scale plot showing the energy consumed against the energy produced in a energy producing plant.
First, energy is consumed in the building of the plant and its scale is indicated by the value of EROEIC as described above.
The production phase is shown by the two plots rising up the graph and their relationship is indicated by the EROEIP as described above. This ratio must be sufficiently above unity for the net energy produced to rise above the energy invested in the plant's capital.
This plot also indicates that there is energy consumed in the de-commissioning of the plant. This can be included in the energy invested in the capital plant.
In the case of nuclear power plants this de-commissioning energy can be quite large. The de-commissioning of the Dounrey plant in Scotland for example, is going to be a long process and under the current plan, will not be completed until the year 2047.

In addition to these important energy ratios, the energy costs of distribution must be considered this can undo the economics of extraction. The appropriate ratio is ELOT (the energy loss on transmission) and is the ratio of the energy loss per distance transmited to the energy actually moved. For instance certain high tension lines may have a ELOT of 4% per thousand kilometres.

In wealthy countries, economics and politics are dominated by the growth fetish. These are the countries that consume the major portion of petroleum products. With oil production peaking, growth will not be possible. The capital that could drive growth will be consumed in paying for more costly oil.

After the peak, production is expected to decrease by something like 2-6% per annum as most existing wells will be past their individual production peaks. So the availability of oil will be down 10% in a few years after the peak. Ignoring the dramatic changes in price this will produce, consider what this physically means (assume the reduction in proportion all over current uses). The use of oil based agricultural fertilizers will be down 10% along with 10% less diesel for tractors inducing a decline in food production. Plastics production and therefore the manufacture of plastic products will be down 10%. Liquid fuels for transport will be down 10% for motor vehicles, aircraft and for shipping. People will have to use their cars 10% less, there will be 10% less people flying in and out of the country, and there will be 10% less import and export of goods. The transport of supplies into supermarkets will decline 10%.

The economic implications of this are dramatic naturally enough but in reality the 10% reduction will not be uniform all over. Perhaps the tourist industry may find that there is a such a large drop in visitors flying in that the whole industry collapses. Other commercial activities may expand in consequence. The bicycle industry might very well expand as people have to give up their motor vehicles. The dogma of free trade and globalization will be replaced by de-globalization and re-localisation of industry.

This link is the work of a law student who saw the need to tell people the truth about oil.

This is the classic web site prepared by Jay Hanson with scores of links on oil and economics.