In the late 19th century, Western civilization reached a turning point. Industrial progress seemed unstoppable, coal was plentiful. But the search was on. The earth gives, and entrepreneurs and fortune makers take out the seeds of the earth. They wanted something bigger and better. This was a new beginning for the energy world and we transitioned from coal to oil. These were the pioneers, investors and travellers seeking new fortunes. What they found was black gold.
The United States seemed to have plenty of it. And oil wells were drilled in Pennsylvania and Appalachia to get it out of the ground. The message spread far and wide, and soon Pennsylvania was covered in a thick forest of oil rigs. It was a harbinger of times to come for the whole energy industry.
What caused investors and explorers to search for the black gold? We know coal was abundant.
1. Energy Resources: Supply and Demand Interact
At the end of the 19th century, the energy industry depended on coal. New technologies such as the internal combustion engine entered the market. Without the demand for the internal combustion engine, oil would not have gained market share so quickly. Internal combustion engines had a higher efficiency, had a smaller size and they were generally more versatile to use.
Historically, Britain contributed massively to the development of external combustion engines. But in the early 20th century, the United States had a leg up in the development of marine propulsion. Oil was the fuel of choice. And yet, the British Empire didn’t seem to be too much bothered because it had a fully intact coal-based infrastructure in place. Coal was widely available, relatively cheap and easily accessible. So a technological revolution made oil the primus inter pares of energy commodities. I have previously written on this subject in a previous article on the transition from coal to oil referring to the work of Erik J. Dahl (2001) from the U.S. Defence Technical Information Center.
The first energy transition was quite different from the second energy transition. During the first energy transition, Europe transitioned from a civilization that was largely dependent on charcoal and firewood to meet most of its energy needs to one that depended on coal. There is a reason why a large swaths of Western Europe are meadows and fields and why few forests have remained in a landscape that was covered by forests. They were cut down for shipping, firewood and the production of charcoal.
On the European continent, crude oil was found in larger quantities in Romania and Russia. Roughly at the same time oil producers tapped into oil reserves in Azerbaijan. Even today, some parts of the landscape eerily reminds visitors how industry and oil production are intertwined and that you cannot have one without the other.
Industry and commerce need cheap energy. Without cheap energy economic growth would stall. So economic growth depends on cheap energy. Both are linked. If energy becomes more expensive, prices will be passed on to consumers who will spend more money on energy and less money on goods and services.
2. The SND Trajectory: Oil Production Has Moved Along The Bell-Shaped Curve All The Way From 1870 To The Present Day 2019
Statistically-speaking, oil production output follows the standard normal distribution (SND) closely. Oil production levels look like a bell-shaped curve. What do I mean by this?
Well…Initially, oil production rises slowly, but oil production picks up as production levels increase, partly because of economy of scale. Oil production then grows even faster and at one point oil production levels reach a tipping point. Once that tipping point has been reached, oil production declines again. It declines further after having reached the peak, but then declines more gradually. Every oil rig on the planet has a different production curve.
But let’s say for the sake of the argument that we sum up production levels of all oil rigs of any particular country and we add them all up. What we get is a bell-shaped curve because even though production levels may vary individually, they add up in total. We find the same principle applies to other energy commodities such as coal and natural gas. They happen to follow the bell-shaped curve.
3. Oil Became the Primus Inter Pares of the Energy Industry In The Early 20th Century
Falling oil reserves (the amount of recoverable oil reserves) are not the main cause for the decline in oil production. In fact, oil prices play a much bigger role than most people think. Cheap oil, which means oil that is easy to extract, which is located near the surface, that stuff is getting harder and harder to find these days. This has a significant effect on both capital expenditure (CAPEX) and operating expenditure (OPEX). It means projects take longer to pay off.
At the same time, the inflation-adjusted return and the asset value of these projects after taking into account all the expenses that have to be paid is often less than what you would get for conventional proven oil reserves. So it becomes much harder to finance new projects. Thanks to low interest rates and tax incentives, this is still a viable option. But oil prices are not very high.
The technology that is used to extract oil out of the ground is becoming more sophisticated. We can see this happening with deepwater oil platforms. Oil companies have to pay more for O&M (Operations and Maintenance). Extracting oil becomes more capital-intensive, and the industry consolidates further as costs spiral. We have fewer market players.
4. Oil Production Plateaus And The Oil Industry Consolidates
Private investors may find it more difficult to compete with state-owned enterprises and national oil companies that are operating in a highly-regulated market place. This is a gradual process in which the oil industry consolidates, leaving fewer players in the oil business. We have to keep in mind that conventional oil production declines as older, proftable oil fields have been used up. This exacerbates the situation.
Assuming for the sake of the argument that shale oil could fully make up for conventional oil production that has been lost, it would not solve the situation. Higher prices would make it unattractive for consumers to buy diesel because the financial crisis of 2008 / 2009 has reduced purchasing power of consumers (in Western countries).
Conventional oil production has declined for some time. If we look at the amount of shale oil to crude oil production production levels, we see that shale oil has helped to keep oil production high. Global oil production has essentially plateaued, with some growth hapening.
Our oil dependance comes at a high cost to the wider economy and entails lower economic growth in other sectors of the economy. Energy underlies all economic activity in a modern, industrialized economy. Energy prices feed into other commodities, and price hikes find their way into the goods and services sector.
5. We Have Reached A Plateau For Oil Production, As Prices Rise Alternative Fuels Become More Attractive
Economists have long argued that demand for oil is inelastic in industrialized nations, which means consumers are not very price-sensitive when it comes to oil consumption. The argument is that oil prices can go up or down, but there will always be a demand. To some degree, that is true. But there are some caveats. The argument was rock solid in the 1970’s, the 1980’s. But starting in the 1990’s we have seen changes.
The reason is that alternative energy sources have become commercialized and have entered the global energy market. Natural gas production has picked up, renewable energy has grown by leaps and bounds. In the 1970’s, many industrialized countries still relied on oil for electricity generation. That has had a huge impact on oil demand. Nowadays, most countries in Western Europe don’t use oil to produce electricity.
6. The Advantages That Oil Has Matter (Slightly) Less These Days
Oil has multiple advantages over other energy sources such as coal and natural gas.
Oil needs less space: Less space is needed to transport oil from one location to another. Coal needs a lot more space.
…is in liquid form: Oil can be transported in liquid form, which means you can pump it from one storage facility to another. Very convenient.
…reduces labor costs: Coal has to be carried (bulk) from one storage site to another, which is very time-consuming. In terms of logistics, this leads to higher labor costs.
…has a high energy density / the calorific value of crude oil is very high: Crude oil has a much higher energy density than either bituminous coal and anthracite.
Oil can be used as a means of exchange: There are other aspects. Both coal and oil can be stored almost anywhere for an extended amount of time. So it shouldn’t surprise anyone that both commodities were used in international trade.
7. Why Electric Cars Haven’t Been Commercialized
Electric vehicles (EV’s) actually rely on an infrastructure that was build before the digital age began. That infrastructure was specifically build by men to get from point A to point B anywhere on the map without restrictions. Asphalt paving was used so the population could get from A to B, to make use of internal combustion engines. The fuel-dependant economy relied on a wide road network, build with bitumen which is an oil product. Industry and commerce could deliver goods and services anywhere in the United States.
The reason why oil became the fuel of choice was because it enabled industry and commerce to use it in so many different ways. There were so many different applications for oil and the wealth generated from selling oil-based products (including pharmaceutical products and chemical products) spread throughout the population. You just couldn’t do that with coal. So we see a progression. With the energy transition from coal to oil, demand became a determining factor. There were more people that needed oil for different things in their life. Oil could be used in the energy industry and in other sectors.
We know how to turn coal into fuel via coal liquefaction. That process is laborious and does not compare well to oil refining. Much higher oil prices would be needed to make coal-to-fuel profitable.
Oil fueled economic growth because it allowed for some many uses. It was all about flexibility what to use it for / how use it. And it made the population more mobile, more productive. As productivity increased, the economy grew and more oil was needed to create more economic growth. The electricity grid, both high voltage and low voltage networks, dramatically increased on the back of cheap plentiful oil.
For EV cars, we would need to build an even bigger electricity network. Which would require more oil.
Another point to consider is this: Multiple applications of oil products in the energy sector and beyond allowed the Middle Class to increase. A Middle Class of that scale never existed in the West before the oil age, not in Europe, not in America. During the coal era that started in the 19th century, the Middle Class was very small and only possessed a fraction of the wealth the Middle Class later inherited in the 20th century. Oil spread wealth more evenly.
Now: Electricity allows for more complex processes in a society, but electricity networks require an existing fossil fuel infrastructure for it to work. Relying on renewable energy alone and just adding more EV cars would likely result in fewer people being able to drive. Few people can afford EV cars and they will be found in places where the local infrastructure still works. It could be a misallocation of capital.
The oil age worked because so many different people used internal combustion engines, which paid for the whole infrastructure building roads and bridges and the power grid, street lights and traffic lights and so on. It may be possible that we can solely rely on electricity. It may even be possible to have an EV infrastructure powered by electricity, just electricity.
But without a shadow of a doubt, our economy would have to change in fundamental ways. An economy that relies on electricity without any fossil fuels as an alternative backup is vulnerable to all kinds of threats. This could be anything from cyberattacks attacking the smart grid infrastructure, to electromagnetic storms hitting the earth. A fuel-based economy that functions as a backup would give people some leverage in times of crisis.
So relying on our electricity network without any backup is a suboptimal solution to our current energy predicament. Not every town or village in our completely fuel-dependant economy was connected to the electricity grid. Power grids spread from the cities to the countryside. To this day, not every village in the U.S. is connected to the electricity network.
That was a major reason why fossil fuels have been used in the first place. Coal and oil are transportable units of energy. Energy units have to be interchangable for this to work. For example, one (energy) unit of sweet crude oil in one place has to be similar to one (energy) unit of sweet crude oil in another place. Oil and bituminous coal were used by industry and commerce anywhere on our planet. Oil and coal could be exchanged for hard currency. On that basis, it is not yet clear if electricity can fulfill the same role, as a transportable store (unit) of energy that can be exchanged against hard currency and forms the backbone of the global economy.
We use electricity for banking transactions and in international finance but electricity cannot be stored as easily as fossil fuels. Storing electricity reduces the Energy-Return-On-Energy-Invested (EROI), referring to another article that I wrote. That is an important difference between fossil fuels and renewable energy (assuming that renewable energy will or should replace fossil fuels).
8. Oil Prices: What Oil Prices Tell Us, What Oil Prices Don’t Tell Us
For most of the 20th century, oil prices remained fairly static in inflation-adjusted terms. Only fairly recently have oil prices begun to fluctuate more widely, in inflation-adjusted terms. The last time we have seen price fluctuations of this magnitude was when oil began its ascent around the year 1900, and Texas oil exploration began. Only temporarily has the price of oil reached 100 U.S. Dollars per barrel of oil. This was followed by a major recession in 2008 / 2009.
If the oil price should go up to 100 U.S. Dollars per barrel of oil, it is likely we will see another recession but that one will be worse. On the other hand, oil exporting countries like Saudi Arabia, Iran, Venezuela, Mexico all need high oil prices for their economy to function as they rely on commodities exports for their nation’s wealth. Russia is more self-sufficient and can withstand economic downturns, but oil exports still play a major role in Russia’s economy.
9. Is The Future For Renewable Energies Set In Stone?
Renewable energies will stay with us for a long time to come but it is not without question that they will face pernicious competition from other energy fuels such as nuclear energy which has a much higher Energy-Return-On-Energy-Invested. And all this depends on three essential factors: that the market price for crude oil rises significantly, that renewable energies continue to be subsidized (an important question for the taxpayer), and that the essential forms of renewable energies (wind, solar, biomass, hydropower & geothermal energy) achieve grid power worldwide.
Many thanks for the shared interest in the energy world!
This article is just meant to inform the reader of recent developments in the energy industry at large and to share knowledge and insights with a wider audience. The author does not put forth investment recommendations.
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