Frankel and Rapier: The Rising Cost of Oil

There are two ways of looking at the rising cost of oil: From the point of view of the economist, who considers oil as a commodity similar to pork bellies, and from the point of view of someone familiar with the physics and the geology of oil.

Take, for example, two recent posts. The first is Jeffrey Frankel’s guest post on Brad Setser’s blog. The second is Robert Rapier’s on the Oil Drum.

Both offer radically different explanations of the rising cost of oil. (Frankel expands his explanation to include the rising cost of all commodities. For the purposes of this post, I will treat just oil as a commodity.)

Frankel argues that interest rates are a key determinant of a commodity’s price. High interest rates “reduce the demand” for storable commodities, such as oil.

If interest rates are high, he argues, then the rate of extraction will increase. Similarly, firms will less likely want to incur the cost of carrying inventory. And, finally, speculators will move away from “spot commodity contracts and into treasury bills.” Consequently, high interest rates reduce the cost of commodities.

If interest rates are low, then the obverse must happen. The cost of carrying inventory is cheaper; therefore, put more oil in the bank for a rainy day. Less oil consequently is in the market place. Firms are willing to carry a larger inventory. And, of course, speculators move in.
As for present realities, Frankel concludes that high commodity prices are a direct result of lower interest rates. In short, there is an abundance of each type of commodity; it is just being warehoused, driving up the price.

Of course, the Fed is busy lowering interest rates. One might conclude that such actions would continue to drive up the cost of commodities, a kind of vicious circle. As we lose more and more jobs and as the sub prime disaster hits more and more people, the Fed, in order to save the markets and the banks, is lowering interest rates–thus making it ever more difficult for average people to meet their bills. Thus we will starve, as mountains of plenty idly stay warehoused.

Now, the cynic in me, sort of likes this explanation. However, I do not think it fully approaches realities on the ground and in the field.

Rapier offers an entirely different approach to the cost of oil. The real cost of oil is directly connected to the cost required to extract it. He explains clearly and concisely the implications of EROIE (Energy Returned on Invested Energy).

Before I turn to his explanation, I wish to make two preliminary points:

  1. Oil is the lynch pin of our world. The cost of everything, and I mean everything , is tied to it: from cabbages to cars, from light bulbs to plastic containers, from the cost of fertilizer to the production of iron. Oil is required to make plastic products, even fertilizer. Global transportation depends on it. A sizable chunk of production depends upon the energy oil supplies, to say nothing of our electricity and heat.
  2. As the world becomes increasingly populated, more and more people depend upon it. According to the U.N., in 2000 the world was adding 79 million people each year. That means, since 2000, the world has added one country whose population is the equivalent of the United States. While fertility rates in the developed world are decelerating, not static or falling, the developing world continues its rapid growth.

Rapier offers two equations that have important bearing on the cost of oil.

  1. EROIE = Energy Input/Energy Output.
  2. Net Energy=Energy Output – Energy Input

The first equation is a ratio between the energy used to extract oil and the energy that oil provides. The larger the ratio, the more efficient the extraction is. And, it goes without saying, the cheaper the oil should be.

The second equation measures net energy. Similarly, the larger the number, the cheaper the oil should be.

Bob Lloyd, physicist at the Otago University, asserts that the concept of EROIE is not new. Anyone familiar the first law of thermodynamics understands it. But, because oil has seemingly been so inexpensive to extract, we have neglected the reality of EROIE. Oil has become a commodity similar to pork bellies, as if it were renewable or as if the cost of its creation were static.

The actual cost of oil extraction, in fact, is growing increasingly more expensive. Initially, the cost of extraction was ridiculously cheap. As Matt Simmons is fond of saying, a glass of oil was cheaper than a glass of bottled water… still is.

Texas oil in the 1930’s had an EROIE of 1 to 100. It’s EROIE was 1/100–very nice ratio. Similary, the Net Energy was 99. These numbers tell us that in the 1930’s oil was very inexpensive to extract.

In the 1970’s EROIE was 1/30 with Net Energy at 29, three times more expensive, but still ok.

Today, EROIE is at 1/15 with Net Energy at 14. In absolute terms, the cost of extraction is six times more expensive than in 1930.

Now consider the Canadian Tar Sands. Fort McHenry is booming; everyone, including the Norwegians and the Chinese want a piece of the action. Something is happening, for if you consider the actual EROIE of the tar sands, you will understand what I mean.

A report to the legislative leaders and governor of Connecticut concluded that the actual EROIE of the tar sands is 1/3, with Net Energy of 2. In other words, it takes the energy equivalent of one barrel of oil to produce three barrels. The report points out that shale in the Wyoming-Utah-Colorado area has the same EROIE as tar sands oil.

Between 1930 and 2008, the EROIE of oil increased over thirty fold, from 1/100 to 1/3. Net energy has gone from 99 to 2.

Again, consider the popularity of the tar sands, a veritable oil rush…the last great frontier. That popularity attests to the fact that oil elsewhere will not meet rising demand; that shortfalls are in the offing. In this case, the market is telling us something important.

Consider also that we have not included the enormous environmental costs in terms of water pollution and deforestation. Approximately two barrels of water are required for every barrel of oil. Those two barrels are toxic, difficult to dispose safely. Right now, EROIE stands at 1/3. What happens when the energy for clean up becomes imperative? That EROIE may be as high as 1/2…or higher. What will be the cost then?

While these two radically different explanations may not be entirely mutually exclusive, they do look at different aspects of the problem. The first, Frankel’s, seems to explain small price movements within a narrow time scale. The second, Rapier’s, looks at a larger trend over a broader time scale.

Both explanations have merit, but in final analysis, I think Rapier’s more closely fits where we are going.