Living Economics

When oil was $10 a barrel in the late 90's, there was no need to look for alternative energy. But when oil price exceeds $60 per barrel recently, alternative energy sources suddenly look very attractive.

The $60 price does not mean the cost of producing oil has gone up to $60, it simply means that demand has increased faster than supply. The real cost of physical production might have gone up some, but most of the price increase simply reflects scarcity cost (Wilkinson). In other words, the higher price is needed to ration the available supply* and not to cover the production cost.

This higher price due to scarcity leaves enough headroom for alternative energy with higher production cost. Wind and solar power are obvious examples. But fossil fuels are still cheaper and represent some 86% of U.S.'s energy supply. Renewable sources of energy generate only 6%. Before the run up in oil price, solar energy cost about 25 cents per kilowatt hour. That's way down from a few decades ago, when it cost $2.50. But energy from the local utility company could be purchased for 8 or 9 cents per kwh (Business Week 9/20/2005).

Another alternative is to tap fossil fuels that are hard to tap but are more abundant. Oil companies now operate in 10,000 feet of water drilling wells that run five miles deep below the ocean bottom. When tar sands are mined, it takes 2 tons of sands to distill one barrel of crude oil (Washington Post). But 80% of the sands are too deep to be mined and have to be injected with steam to loosen the bitumen for extraction. As a result, oil from tar sands costs $7 to $8 per barrel, compared with $1 to $2 per barrel of Saudi Arabian oil (U.S. News & World Report 10/13/2003). Until recently, tar sands projects would be profitable if the price of crude was at least $25 per barrel (WSJ 9/15/2005). At $60, the profit could be quite fat.

So market prices are sending the right signals to exploit alternative sources of energy. But since these high prices do not reflect the environmental cost of fossils fuels and only current supply and demand conditions, they are still not high enough to substantially increase the R&D efforts into cleaner energy to hasten its cost competitiveness. At the current rate of funding and development, it will be at least 15 years until solar-powered homes or hydrogen-powered cars are ready for the mass market (Business Week).