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A research paper by Eyal Dvir of Boston College and Ken Rogoff of Harvard suggests some interesting parallels between the recent behavior of oil prices and what was observed at the very beginning of the industry. I've been doing some related research on the history of the oil industry that looks into the events behind historical oil price shocks. Here I describe the first oil shock, which occurred a century and a half ago.
The far-right panel above displays the most recent behavior of the real price of oil, following the price as it rose from about $30 a barrel in 2003 to almost $100 a barrel on average during 2008. In terms of the magnitude of the real price increase, that's pretty similar to what happened over the decade of the 1970s (middle panel), and amazingly also very similar to what happened during the U.S. Civil War, a century before OPEC even existed (left panel). I was interested to take a look at what happened to produce the first oil shock of 1862-1864.
Edwin Drake had drilled the first commercially successful oil well in Pennsylvania in 1859, three years before the left panel begins. Prior to that discovery, people had been getting illuminants from sources such as whale oil, grain alcohol, and gas and liquids derived from coal, asphalt, and shale. Then as now, obtaining liquid fuel by these methods was a very expensive proposition, and Drake had no trouble selling his crude for $20 a barrel, which would correspond to $476/barrel in 2009 dollars. Needless to say, the discovery that such precious stuff could be obtained just by drilling into the earth stimulated a frenzy of drilling in the vicinity of Oil Creek, Pennsylvania. Many of these wells also successfully produced oil, and the price had plummeted below 50 cents/barrel (about $12 in 2009 dollars) by 1861.
But it turned out that in each new well, the flow rate dropped fairly quickly as oil was removed, and the drillers also had difficulty figuring out how to prevent water flooding. After an initial phenomenal rate of success, total production from all wells in Pennsylvania declined in 1863 and fell further in 1864.
At the same time, the demand schedule was shifting to the right, due to war spending and most importantly a new tax on alcohol (a competitive source of illuminants) of $2/gallon, which gave a $40/barrel competitive advantage to crude. The result was that the real price of oil quintupled by 1864.
Fortunately, Oil Creek turned out not to be the only place oil was to be found in Pennsylvania. Yields from other, much larger fields in the state ended up dwarfing the modest volumes of the pioneer wells, driving the price back down. Production from the state as a whole would end up increasing by an order of magnitude from the levels of 1865 until reaching what proved to be its true peak in 1891. Today Pennsylvania produces only 1/5 as much oil as it did in 1891.
And, again fortunately, much larger fields were discovered in other states that ended up dwarfing the volumes produced in Pennsylvania. Oil production from the United States as a whole would continue to rise until reaching what proved to be its true peak in 1971. Oil production from U.S. fields today is about half what it was in 1971.
And, again fortunately, even larger fields were exploited outside the United States. World oil production continued to increase until reaching a bumpy plateau in 2005. Just as the price path since 2005 parallels that seen in the 1860s, so does the graph of world oil production.
As for where world production is headed from here, if optimistic projections from Iraq are borne out, the global peak is still ahead of us. But when the global peak will arrive is a bigger question than I want to take on at the moment, so let me just make two quick observations now. The first is that, although economists are used to thinking about increased production as coming from technological progress, in the case of the oil industry the biggest factor has instead been the exploitation of alternative oil fields that proved to be much bigger and better than the originals. As production from each one fell, so far there has been something better to replace it. But I do not understand those who conclude that this will always be the case, or who assume that the outcome is necessarily subject to the control of technology or incentives. Second, I submit that when demand booms and production is stagnant, it is possible for the price of oil to quadruple in a short period of time.
I say that because that's exactly what we've seen happen on three different occasions.
Posted by James Hamilton at January 11, 2011 04:56 PM
The "Oil Drum" and the "Energy Bulletin" offer great insight into "Peak Oil" if you don't know of them already ... They have great archives ...
http://www.theoildrum.com/
http://www.energybulletin.net/
Here is an interesting piece by Jeff Rubin ...
Is There Enough Oil to Pay Our Debt?
http://www.jeffrubinssmallerworld.com/2011/01/05/is-there-enough-oil-to-pay-our-debt/#
Our currency and credit creation mechanism, fractional reserve banking, is entirely dependent on debt ... As economic growth slows then stops then contracts vast amounts of debt will be unpayable and new debt will be untenable ...
The only way forward is exclusively sovereign credit money underwritten by the country itself and not debt ... Without a conversion to sovereign "credit" money the economy implodes as our currency and credit is sucked into the vortex of the largest credit bubble in history ...
Posted by: mmckinl at January 11, 2011 06:36 PM
Well, now. There were two oil shocks in the '70's, no? Looks good as a single event on the graph, but I think a bit of a stretch in the historical record. (So what is it: rate of change or price level? Hell if I know.)
So what are you doing in sunny San Diego? A history of oil prices, or are you laying the groundwork to prepare us for another oil price shock?
By the way, my take on the Tierney-Simmons bet is here: http://www.aspousa.org/index.php/2011/01/the-tierney-simmons-bet/
Posted by: Steven Kopits at January 11, 2011 06:47 PM
dear sir really yuou are great. i like very much your oil information.
Posted by: ccvvsnmurthy at January 11, 2011 07:10 PM
Steve Kopits: Yes, 2 or even 3 different events in the 1970s. I'll have a much more detailed review of postwar events in a subsequent post I plan shortly describing my new paper.
Posted by: JDH at January 11, 2011 07:42 PM
I hate when people do this, but I'm compelled to do it anyway: Great post. You've posted many in the past few years I've been reading, but I generally feel it's best not to distract from the discussion.
Posted by: aaron at January 11, 2011 08:14 PM
I'm pretty sure the 7:10pm comment is a spambot.
Posted by: aaron at January 11, 2011 08:16 PM
To: Steven Kopits
A truly excellent piece on the Tierney -Simmons bet. I would recommend everyone read it ...
Your analysis on the increase in production costs and demand destruction is top notch ... Your passing comment on dubious "proven" reserves of OPEC was spot on ...
What is missing is the effect of peak oil on financial markets. Once the implications of peak oil are understood leveraged debt (fractional reserve banking) becomes increasingly implausible creating massive destruction of currency and credit.
I look forward to your analysis on the financial impacts of peak oil on the banking system ...
Posted by: mmckinl at January 12, 2011 02:01 AM
Oil seems to have reached its peak price according to oil shock history.
But now the USA has added FED shock of adding USD to the market, so the price of oil may double in next 2 years in USD terms without anything much happening in either demand or production. And it will.
As many have suggested, oil will go up with 15% volatility up to 160USD in 2011, and 190USD in early 2012.
The bad news are, starting from around 140 USD oil prices will be out of phase with stock market due to drag on economy, and at 160-180 USD they will move 180 degrees out of phase, as oil prices will be driven by FED easy money still around and low interest rates, and killing the recovery of most Western economies (except Northern Europe).
I would not be surprised if in 2012 we will see either price controls on gasoline or extra taxes on oil companies or both, as the USA economy keeps going down in H2 2011 and 2012, while energy/food inflation up, and tax incomes down.
Also, clear wish of the USA to control even more oil producing countries to try to drive prices down fast will become obvious in 2012, and reasons to enter parts of Iran soon will be searched for, as high commodity prices evaluate the USA biggest IOU "export" - the USD.
Posted by: Ivars at January 12, 2011 03:34 AM
"Second, I submit that when demand booms and production is stagnant, it is possible for the price of oil to quadruple in a short period of time." So you say that the law of supply and demand still works. It make sense that the price rises to ration supply to those that are willing to pay the most. If the price stays high, new energy saving technologies become profitable, and what were uneconomic energy sources become economic. I believe that p;ices have usually come down, so the long-term scenarios don't come true. I think the peak oil concept is not very useful, due to the interaction of prices and technology. If oil becomes relatively scarce, it gets rationed by price - it never runs out.
Posted by: Rich Berger at January 12, 2011 05:00 AM
Just curious. But we have a research paper that shows state change in response to oil shocks. That leads to a bigger question, is this a common property of the economy? And if so, then the Taylor rule doesn't work through a state change.
Posted by: Matt Young at January 12, 2011 05:42 AM
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