One of the questions that comes up in the face of Mr. Money Mustache’s unrelenting optimism about the state of the world is, “Will human prosperity continue even as we run out of the cheap fossil fuel energy that has powered us for the last 200 years or so?”.

In a nutshell, I always say: “It’s not just cheap oil that is the primary source of our wealth these days, it’s the cheap exchange of knowledge.” On top of this, I think the world economy is innovative enough that it will be able to adapt to the inevitable increase in oil prices as our supply gets squeezed, by replacing that energy with other sources.

To balance my own optimism, I asked for the opinion of someone with ideal qualifications to shoot me down: Jacob Fisker, founder of the blog earlyretirementextreme.com has done academic research and writing on the phenomenon of Peak Oil, as well as pretty much everything else. Since putting that blog on pause, he has retired from early retirement to do some work in the area of quantitative financial analysis. And he holds a pessimistic view of the future of humanity’s current high-consumption approach to prosperity.

Introduction:

MMM: From my understanding of peak oil so far, it looks like the problem in a nutshell is that the world has 1.2 trillion barrels (1200Gb) of known oil reserves at best, and we are using about 85 million barrels a day. This works out to less than 40 years of known supply at current consumption. However, production towards the end of known reserves tends to decline, which means we’ll have decreasing supply even as demand tries to increase. Is this still up-to-date knowledge?

ERE: A lot of confusion comes from the exact definition of the word “reserve”. The problem is that reserves are underground where it’s impossible to look and verify directly how much is actually there. Therefore reserves have to be estimated. Think about how you would go about doing that. Say you want to estimate how much money I have in my wallet (it’s not a lot, because I rarely need to spend cash). Say your first guess is $12. I then ask you what probability you assign to it, and you give a more accurate answer: “I think there’s a 50% probability that you have $12 or more.” This is called a P50 estimate of my money. I then ask you what your P90 estimate is. That is, if you had to estimate it with 90% probability of being right, what would your estimate then be. Probably lower, maybe $3. So your P50 estimate is $12 and your P90 estimate is $3.

Now, if you were a scientist or a petroleum engineer, you’d give your estimates as P50 estimates because if you had to estimate a lot of different people’s wallets, your average would be correct (on average). Half the times you’d estimate too high and half the times you’d be wrong. In effect, your P50 estimate would probably be the correct average.

On the other hand, if you were an accountant or a money lender trying to figure out if I was actually able to pay you back if you lent me some money, you’d prefer a more conservative estimate, the P90 estimate. If you had to estimate a lot of different people’s wallets using the P90 estimate, you’d tend to underestimate the correct total sum be a significant degree.

Now suppose you just P90-estimated my wallet to worth $3.—But then you see me take $5 out of my wallet. OMGWTFBBQ what just happened? Well, apparently it turned out that I actually had more than $3 in my wallet. So while your P50 estimate of $12 is still correct (as far as you know), your P90 estimate was clearly wrong, so you update your P90 estimate: “Well, he just spent $5, so he probably has a bit more yet in that wallet. On the other hand, I have no reason to believe that my original P50 estimate of $12 was wrong. So I’m updating my P90 estimate to $10.”

Now it so happen that different people use different estimates and yet talk about them as if they where the same thing. For instance, a businessman would say that my “reserves” just increased by $2. That is, the new $10 minus the $5 I spent relative to the original $3. In particular the businessman would say I just discovered $2. The scientist would say: “Hey, the $2 didn’t magically appear out of nowhere. It’s just that your original P90 estimate was too pessimistic and you’re just revising your numbers”.

Hence, there are two ways of interpreting this:

1) The businessman would say that first it was virtually proven (with 90% probability) that I had $3. Then later it was proven that I found $2 more. So everything is good since I keep finding money.

2) The engineer would say that I most likely will turn out to have $12.

The entire peak oil debate boils down to this.

The US Securities and Exchange commission (SEC) mandates the reporting as P90. This has lead to so-called reserve growth. If you draw a curve it’ll look as if the oil business is honky-dory and they keep finding new oil. The confusion comes about because they actually do discover new fields from time to time. However, this contribution is trivial compared to the updating of old numbers. The wallet analogy is that while they’re finding small wallets from time to time with a few cents in them (estimated by P50), the P90 growth comes from revising old numbers. It doesn’t help that new oil finds are presented in he media as being huge, like “Scientists estimate as much as 100 billion barrels under the north pole!”. That sounds like a lot and in today’s prices, it’s 10,000 billion dollars which is enough to pay off the half the US national debt. That’s a lot of money. However, it’s not a lot of oil; it’s only a few years of use.

So if you ask the oil companies, they’ll point you to a P90 reserve graph and tell you that because reserves are growing it’s safe to invest with them, because, hey, reserves are growing steadily.

However, this is just accounting trickery. If you ask the engineer that, as long as he knows I’m not putting money into it, then going from a P90 of $3 to a P90 of $10 doesn’t mean I found a new wallet worth $7. It means that my old wallet was bigger than estimated. I may still find a new wallets in the future, but P90 updates should not count as new discoveries. Only actual discoveries should count as discoveries.

If you draw a reserve growth map back-dating, what you could call “accounting discoveries” to their original wallets or oil fields as it may be, you’ll find that the actual real-world discovery rate peaked in the 1960s. Since then we’ve been finding less and less oil. This points asymptotically to a total global oil endowment around 2000-2500 billion barrels in the world. Out of those we have used about half which leaves a P50 estimate of around 1200 billion barrels left.

The world is using some 25 billion barrels per year (the US with a population of 320 millions uses about a quarter of this. Europe with a population of around 600 millions uses another quarter. And the other 6000 million people on the planet uses the other half.).

Naively, you could take 1200Gb as reserves and divide the current rate of use (25Gb/year) and you get about four

decades. However, while the math works like that with a wallet, it doesn’t work that way in an oil field. In reality the extraction rate for a newly developed oil field will rise. Then it will peak, and then it will decay exponentially at a rate of some 3-5% per year.

Just like cash flow (not assets) determines the solvency of a company, the extraction rate (not the total P50 reserves) is what’s important to the economy, since that’s the rate it actually becomes available for use. If you add the total extraction rate from the fields of the entire world you will due to the mathematics of it (central limit theorem for the math geeks) get an extraction rate that’s the shape of a bell curve. The peak of that curve is called peak oil.

At that peak geological limitations dictate that oil production can not be increased. It does not matter how many checks economists write. There is no way to increase supply. Since it’s supply-constrained energy prices go up. This sends a signal to the economy to demand less. If, then, prices go down again and use goes up, the prices shoot up again. This happens faster and faster as supply declines and shocks are sent through the economy. This is what we’re currently witnessing.

Fun fact: If you ask OPEC whose production (and thus income) is decided by the relative size of their respective reserves, you’ll see they don’t update them at all even as oil is pumped out and nothing new is found—one would expect reserves to decline, but they don’t.

1: Other Sources of Fossil Fuels

MMM: Do numbers like those above include natural gas reserves? Here in the US, we have seen enormous natural gas discoveries in the last decade, and it has caused gas to become extremely cheap even as crude oil and gasoline are pricier than they were 10 years ago. What do you make of articles like this one in the New York Times?

The US has over 300 trillion cubic meters (500 billion barrels of oil equivalent) of natural gas on the books these days. That is close to half of the entire world’s crude oil reserves, just in one country and it is in addition to the oil. And the coal. Both natural gas and coal are pretty solid substitutes for liquid oil for transportation (except jet fuel, but even that can be refined from coal). Am I understanding this correctly or exaggerating?

ERE: The numbers above (1200Gb) only include conventional oil. Here “conventional” means easy to get as in drill a hole in the ground or shallow waters and pump it out. I think it’s important to consider the concept of “energy-returned-on-energy-invested” or EROEI. This is how much fuel energy one gets back from putting in energy to get the fuel. The following analogy might help: “Imagine that you get your food from supermarkets which are all underground. To get food you have to throw a rope down with a bucket and haul the food up. Without loss of generality, we can assume that a bucket full of food is worth 10000 kcal. If it requires 4000kcal of effort to haul a bucket up, you’re good because you can eat 4000kcal of food from the bucket and have 6000kcal left which you can sell or share. Suppose the underground supermarket runs out. You then have to find a deeper one which takes 7000kcal to haul out. That’s okay you still make 3000kcal on net. Once that runs out, you go still deeper. The new depth costs 9000kcal worth of effort. You now only get 1000kcal. You’re 6 times poorer than you used to be for the same effort. Once that runs out and the next supermarket costs 11000kcal to haul out… well, you’re done. You might as well not bother because now you’re running a deficit and you’ll eventually die of starvation if you continue. Hence it’s important to consider EROEI. It MUST be higher than 1 and the higher it is, the richer a society which runs on that energy source is because it needs to dedicate less effort to to getting its energy supply and can do other things.

Oil has the highest EROEI of all known energy sources. Higher than nuclear, wind, solar, water, and unconventional fossil fuels.

Recently there has been a boom in US natural gas from fracking shale (a kind of underground tar). This has led to a large drop in natural gas prices because the increase in supply was so unexpected and there are nowhere to store the excess. Since this has happened in that last couple of years I don’t know for a fact whether industry and government agency (those two are practically the same thing) estimates are overly optimistic as usual (there are some reports that production is peaking already) or whether supply can keep up with demand.

Thus US has LARGE reserves of coal. All fossil foils have the problem of contributing to climate change leaving the world for future generations in a worse place than we received it. In that sense, coal is much worse than gas, so hopefully shale gas can provide some short relief while politicians, voters, consumers, and corporations suddenly transition to a focus long-term thinking. Okay, I’m joking. Like that’ll ever happen. We do see organizations, like the military, who is not subject to constraints like getting re-elected or not getting booted by the board after failing the next quarterly earnings adopting perspectives that are somewhat longer and ordering new ships that run on natural gas.

In any case, oil is much superior to gas and coal in terms of how useful it is. There’s a reason that you’re not pouring coal into the tank when you go to refuel your car. There’s a reason why eletric cars are hybrid (with an oil based engine). There’s a reason that Germany and Japan lost WWII (they didn’t have access to oil and had to ultimately had synthesize their own out of wood and coal while the allies did have access to oil). Converting coal or gas into gasoline via the Fischer-Tropsch process is mature technology but it’s not as good as the real thing. It’s more expensive. In summary, the combination of oil and internal combustion engine provides the cheapest and highest power to weight ratio of any engine and fuel combination.

2: Using Energy More Efficiently

MMM: When I analyze businesses, households and small factories around me, I find that they have paid very little attention to energy consumption. Because the energy is so cheap as a percentage of sales, and engineering knowledge is sparse, most of them have made decisions that cause them to waste great amounts of energy (and great sums of potential profit). The only businesses I have seen that take energy use seriously are the largest ones which operate on thin margins, run by optimization-minded people: Wal-mart, FedEx/UPS, and the airlines. And the only consumers who do so are a few of the most dedicated readers of ERE and MMM :-)

Given a change in energy prices and an increase in awareness, do you feel we could make major gains in energy consumption relative to GDP (say, 50%?), with minimal change in our actual quality of life or level of output?

ERE: This is because energy is still relatively cheap compared to how much we get out of it, even at $5/gallon. However, we have already seen some changes in attitude in the younger generations. Owning a car is no longer seen as nearly as desirable by Millenials as it is by older generations where getting your first car was almost a rite of passage. Some even see owning an SUV or a large truck as slightly silly or old-fashioned. The cities are getting repopulated. Urbanism is on the rise. Suburbanism is on the decline. Who is going to buy a poorly insulated 3000sqft house 20 miles away when gasoline is $5/gal and heating is several hundred dollars per month; money which only people who have high salaries can afford—and that grudgingly.

So people are definitely open to change. They’re not set in their ways. Ten years ago when I first became aware of this problem the consensus thinking was that people were completely inflexible when it came to their energy use.—That they’d prefer to engage in a Mad Max scenario rather than make some strategic choices in terms of where to live, what to live in, and how to get around. This is why I began to learn how to live a low-energy lifestyle in 2000. I found that the self-reliance from saying no to consumerism and doing things yourself was much more fun than buying new stuff and putting it in the attic a few months later. I also found that it allowed me to save a lot of money. “The more you know, the less you need to spend”. Because all spending is in some way a compensation for ignorance or skills or an indication of how vulnerable one is to the economy. I wanted to reduce my vulnerability to the economy as much as possible. The nice side-effect was that I saved a ton of money and now I’m much wealthier than the median consumer (although not as wealthy as MMM). Because of this lack of vulnerability, the credit crises also barely registered. I mean I read about it in the news and I was able to buy even more investments but it didn’t affect our lifestyle at all.

Because of that I no longer worry about peak oil or peak energy. I would say, though, that people are going to experience it in different ways. People who adopt MMM or ERE lifestyles are probably only going to experience it indirectly through the laments of other people. Those who don’t prepare at all, rely entirely on pulling out their credit card and buying their way out of all their problems are likely to crash hard when gasoline prices cross $10/gal. I say this with a P90 probability.

3: Renewable Energy Can Be Big

MMM: I often hear criticisms of alternative energy (especially solar and wind) as being insufficient to power the future world. But when I calculate the area of solar panels required to meet my own total energy needs, or the entire world’s, it works out to a fairly feasible land area. This Wikipedia picture makes this dramatic point visually: http://en.wikipedia.org/wiki/File:Solar_land_area.png — covering land the size of those dots little black dots with solar panels would meet the world’s energy needs completely.

And this is with only solar power. If we leave our other power sources in the mix , it seems like we have a pretty robust network of energy with several alternatives.

Some say “yeah, but it takes energy to MAKE the solar panels”. But a well-placed solar panel can pay back its encapsulated energy within a year even with today’s technology. Way back in 2006 before the recent solar manufacturing boom, the estimated range was 0.7 – 4 years: http://www.energybulletin.net/stories/2006-06-16/energy-payback-roof-mounted-photovoltaic-cells

And manufacturing efficiency can surely grow (since energy is cheap right now, saving energy is not high on the list of solar panel producers).

So it seems that the world’s energy budget for producing solar panels need only be (at maximum) a single year’s worth of energy production. And what’s more, solar power is already cheaper than grid-produced power in many areas, even without subsidies. So I’d expect quite a bit of conversion to happen automatically over the next few decades, as people invest their own capital because of favorable return on investment. (A watt of solar panels costs 83 cents and produces over 20 cents of electricity per year, even right now with 10 cent/kWh electricity) http://www.ecobusinesslinks.com/surveys/free-solar-panel-price-survey/

ERE: The problem is transmission and storage. Solar doesn’t work so well in Alaska or in the dark. Storage (batteries) bring the cost up locally and line losses (ohmic resistance) on the grid brings the cost up regionally. This is why you can’t set up a 5 Terrawatt solar facility in Arizona and transfer the electricity to Maine. The line losses would be too large. So while solar is an adequate replace when and where the sun shines, it’s not a solution elsewhere.

Remember that oil still beats electricity when it comes to expense and power/weight for the fuel plus power plant. If you calculate the rate of power transfer, that is, how much energy is in the gasoline divided by the transfer rate when you fill up your car … it comes to something like 20 MegaWatts. That’s HUGE!!! To compare, while filling a tank takes a couple of minutes, recharging the batteries of an electric car takes hours.

So in conclusion, solar will be a solution somewhere, but it will not be a solution everywhere like oil has been.

4: Price Changes May Force Production and Consumption Changes

MMM: So my own theory on peak oil is that yes, crude oil production is near a peak, but the predictions of economic collapse fail to take into account thechanges that come with higher prices: alternative sources coming out of the woodwork, and behavior change. In fact, just like the effect of a dramatic increase in the price of cake on a couch-dwelling cake addict, peak oil might even trick the human race into replacing fossil fuels and reducing parasitic energy waste much sooner, removing a boat anchor we’ve had against economic efficiency.

I agree. The potential for efficiency increases mainly from lifestyle changes (not technological gadgets) are very large. At $1/gal people happily drive one hour to buy their favorite bag of doritos. At $5/gal they start shopping for high MPG cars. At $10/gal they’ll switch to scooters or bicycles. And similar in other fields. Since this happens slowly those who look beyond the next quarter or year can make strategic choices and reduce the impact to almost nothing. Hard it is for consumers to believe, the ones who believe that spending is proportional happiness, it’s just not true. We can live just as happily spending much less. Economic success should not necessarily be measured by the current standards which seem to equate success by how fast we can make stuff and put it back in a landfill. Those who resist or are too slow to adapt are going to get suckerpunched by a changing reality.

5: It’s too complicated to make Overly Dire Predictions

MMM: If my theory on why peak oil is not such a big deal were to be proven correct someday, I’d even put forward a second theory as to why it happened: I think it is because that the study involves many fields: geology, economics, electrical engineering, psychology, government policy, and various other things I don’t know about. The people who specialize in each of these fields seem to lack sufficient knowledge in the other areas to be able to predict the complete outcome. For example, the oil experts seem to neglect the natural gas supply, or assume that transportation cannot be made more efficient, or that electric cars will never exist, or assume that oil demand is inelastic to price. Things like that.

ERE: Absolutely! I remember seeing a few years ago how climate change models actually did not include any realistic components for the decline of oil use. Unbelievable! But I think this kind of ignorance is the primary weakness of the compartmentalized specialization focus on experts that our culture has fostered. It’s a big problem.

It’s also annoying how our usual way of doing business prevents us from making smart choices. A lot of the solutions are being cast as “buying green gadgets” because buying stuff is the only way consumers can imagine to solve any problem. However, that’s just not good enough because it’s not going to solve the fundamental problem that is “buying junk you don’t need in the first place”.

Mr. Money Mustache Concludes:

Ahh, I guess Jacob and I don’t disagree as much as I thought. It seems clear that fossil fuels are not infinite, and it does us harm to burn them anyway. So the real question is how painful will the adjustment be if these things get more expensive? If you design your life to be energy-efficient right now, you get the best of both worlds. Greater wealth immediately, and more insurance against energy price changes in the future.

Of course, the climate change we’re causing from all this burning is a whole separate issue and shall be told another time. But your personal solution remains the same: burn less, get richer.

You can read more from Jacob in his book called Early Retirement Extreme. Book Available here, my own little review here.

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More Notes on World Energy Supply:

The Economist: Shale Gas is Giving a Big Boost to America’s Economy

Cia Factbook: Oil Consumption by Country

BP’s estimates on world energy in the year 2030.

Scientific American on Solar Energy Price trends. (thanks to a reader for sharing this link!)

Here are the types of things energy traders look at when speculating on the short term price of energy. (Note that gas prices are not set by US oil companies, evil gas stations, or The President as is commonly assumed by the nation’s undecided voters).

A physicist speculates on the physical impossibility of permanent economic growth on a finite planet.