Peak Oil News: Really, Really Bad News About Oil

Wednesday, June 04, 2008

Really, Really Bad News About Oil

Seeking Alpha


By Ferdinand E. Banks


Some years ago I wrote a paper called ‘A ‘New’ World Oil Market’ (2004), which I presented at a conference somewhere. The intention of that paper was to argue that the world oil market was in the process of a rapid transition, and the combination of resource scarcity and accelerating demand (relative to supply) would cause a fundamental shift in the market. I said in that paper essentially what I am going to say here, only at that time I couldn’t prove a few of the things that needed proving. All that has changed: it changed when the price of oil reached $100/b and continued to rise, because with that price and the present movements of global oil supply and demand, proofs are no longer necessary. This time the wolf is here!

In the American Navy there was once a saying that ‘On every ship there is someone who doesn’t get the message’, however on this ship everyone is finally getting the message, where everyone includes a former head of the Petroleum Industry Research Foundation in New York, who once claimed that OPEC is “on its way into a stagnant volume environment at best”. This misleading statement can be translated as ‘OPEC’s oil is increasingly unimportant’.

For me OPEC is – and has always been – the oil producing countries of the Middle East. I’ve never concerned myself with the others because, as Matt Damon said in the film Syriana: “It” – meaning oil – “is running out, and most of what is left is in the Middle East”. As I never tire of pointing out in my seminars, some people find this difficult to accept, because some people specialize in being wrong. The Cambridge Energy Research Associates [CERA] once said that OPEC’s fate was not in its own hands, although the truth is that it has always been in its own hands, with the difference being that now that organization is fully aware of this very dramatic fact.

Unfortunately, or fortunately as the case may be, dealing with Middle Eastern energy resources also involves issues far outside that part of the world, because it happens to be true that it is no longer advisable to discuss Middle Eastern prospects without considering the actions and/or goals of other energy producers, and vice versa. Here we have a perfect example of what in game theory is called ‘strategic interaction’.

Hopefully this will become at least partially clear in the sequel, but to begin I want to offer an extremely valuable insight into one phenomenon that will characterize the future oil market, which I will provide now, because it should be confronted and thought about as soon as possible. Regardless of what you have heard or will hear, read or will read, thought or will think and regardless of the assurances that the oil and gas exporters in the Middle East give or will give, it is doubtful whether those exporters are able or for that matter willing to provide the energy resources that their customers desire or will come to desire, at prices resembling those of the recent past.

And here I ask my favorite question: would you supply these resources if you were in their place?

A BIT OF OIL HISTORY AND ECONOMICS

The agenda of the foreign producers (i.e. Big Oil or the ‘Seven Sisters’) in Saudi Arabia ostensibly featured a progressive raising of oil production to twenty million barrels of oil per day (= 20mb/d), and keeping it there as long as it made economic sense – i.e. was profitable. The thing to be understood is that the strategy underlying this production profile turned on maximizing profits over a limited time horizon, and here I want to emphasize that the choice of a time horizon was as important or even more important than other components of their production strategy, which is an observation that you did not encounter in Economics 101. You didn’t encounter it because the teachers of Economics 101 do not know how to handle the production of exhaustible resources like oil. However after the October War (of 1973), when the assets of these companies were confiscated by their previous hosts, a very different agenda was introduced

The goal of the confiscating governments, and especially Saudi Arabia, also turned on maximizing profits, although over a much longer time horizon. In addition, when the opportunity presented itself, these profits were to be used to diversify their economies in such a way that the main source of prosperity would be reproducible capital – i.e. structures and machines – rather than exhaustible natural resources such as oil and gas. The opportunity arrived in full bloom when the price of oil suddenly exceeded 40 or 50 dollars per barrel, because those prices gave the governments of many oil producing countries the kind of freedom that President Bush and his colleagues believe only comes about by living or trying to live the American Dream. Everyone who has watched CNN or the U.S. program ‘60 Minutes’ has probably seen a brilliant example of this process in that lucky and superbly managed country Dubai. Returning to the agenda for Saudi Arabia, ‘sustainable’ oil production over an indefinite future was envisaged at about 10 mb/d, or less, while an additional 1-2 million barrels per day were to constitute surge capacity (which is capacity intended for use over a short period).

Notice the or less in the above, because the present King Abdullah of Saudi Arabia recently said that the world cannot count on large increases in the output of his country after 2010, which is interesting because some observers think that today’s oil production is less than Saudi production a year ago.

Needless to say, this kind of thinking and acting on the part of Middle Eastern governments did not win approval everywhere. For instance, the position taken by an outspoken Nobel (Prize) Laureate, the late Professor Milton Friedman of the University of Chicago, was that the general welfare was always best served by unambiguous profit maximizing behavior, supervised by hard-core capitalists. When the assets of the short-run profit maximizers throughout the Middle East were confiscated, and formal production quotas for oil established by OPEC, Friedman predicted that the price of oil would collapse and OPEC would fall apart. Friedman’s irrational forecast is best forgotten, but even so I want to present and comment on a similar vision of the Middle East oil scene that was put together by another University of Chicago Nobel Prize Winner, Professor Gary Becker. Writing in Business Week (March 17, 2003) he presented his audience with the following soap-opera:

Middle Eastern nations are far less important to world oil production than they were immediately after the formation of OPEC. Their share of world oil production has fallen from almost 40% to less than 30% now. In order to raise the global price of oil the OPEC cartel, led by Saudi Arabia, had to restrict its members’ production. This raised prices, encouraging non-OPEC nations, including Russia, to expand production. Also, oil companies have made greater efforts to find new deposits deep in ocean waters, in the frozen tundra of Siberia, and in China and elsewhere.

This statement is completely without any scientific value, but it deserves some attention. Becker’s twisted faith in deep water deposits, as well as large new deposits becoming available in Russia and China is best described as bizarre. Although a few years ago the best energy economist in Russia said that his country could raise its oil production to 30 mb/d of oil and keep it there, the truth is that oil production in Russia has now roughly flattened at about 10 mb/d. According to Leonid Fedun, vice-president of the largest independent company in the Russian oil sector, it is unlikely that output will ever exceed that amount. He could be slightly wrong of course, but it would hardly increase by enough to result in Professor Becker being nominated for another Nobel. Something that needs to be appreciated by all oil importers is that Russia is potentially a very rich country, and an increasing fraction of Russian energy production is going to be consumed domestically.

China is already a country with a large oil deficit, and where the growth in oil consumption is much larger than the growth in domestic supply. These deficiencies are probably increasing faster than anywhere else in the world, to include the United States. Oil companies are making great efforts to find new deposits “deep in ocean waters”, are drilling boreholes everywhere, exploiting deposits in remote locations in the far north of Alaska, and perhaps far up in the Arctic Ocean, and desire greater access to coastal waters. Regardless of how much desiring and drilling and exploiting they do however, it will not suffice to replace Middle Eastern resources, nor greatly depress the oil price. Only a new energy technology in conjunction with a reduction in demand growth for conventional oil is likely to do that! This unpleasant truth has escaped Professor Becker, but it is well known in the executive suites of both ‘Big and Little Oil’.

Finally, attention can be directed to the decline in OPEC production that was mentioned by Becker, and which that scholar interpreted as a misfortune for those nations. The earlier decline in OPEC production, and its present slow increase, is the key source of the new economic strength of the Middle East, as well as some of the other OPEC countries. If they had maintained their output at 40% of the total, they might still be trying to raise the price of oil to $28/b.

IRAQ AND OIL

Alan Greenspan is not my favorite economist, but I am sure that he is highly talented professionally and socially, completely at home in the great world of banking and finance; and despite accusations of late that his judgement was occasionally unsound when he was chairman of the U.S. Federal Reserve System (where he was frequently described as the second most important man in the United States), I think that very often he had information to offer about energy matters that should have been given a maximum amount of attention.

His latest contribution – apparently surfacing in his recently published memoirs – is that although not usually discussed in public, everybody knew that the war in Iraq was about oil. By everybody he didn’t mean people like me, but people like himself: serious insiders with important places to visit and important things to do after they arrive. People who are relaxed when in the presence of minds that move the world – as they are called on CNN. Minds that were and perhaps still are at the disposal of Sir Alan, both in elegant conference rooms, and at tasteful dinner parties where high-level gossip is circulated with the same nonchalance as coffee and brandy.

In one way or another Mr Greenspan has been told, and probably a number of times after the cognac has gone around the table, the same thing that Matt Damon told viewers of the film Syriana, and that being the case, some of the decision makers in his network pondering the bad news about the availability of motor fuel have almost certainly found themselves thinking or suggesting or implying or insisting that extraordinary measures might someday be necessary to keep the wheels of economic progress spinning in the oil importing countries.

Everything considered, I feel it necessary to ask another question at this point: if you can’t believe Alan Greenspan on this issue, then who can you believe.

Having once inspected at great length a map originating with the U.S. Government Printing Office (in Washington D.C.), which indicated landing zones in the Gulf for paratroopers and marines, and having heard Alan Greenspan say aloud and in English what he believes is the reason for the Iraq war, and knowing that in the widely read Time Magazine Henry Kissinger once broached a military option, it has lately become easy for me to accept that the United States and others might be prepared to go to war to ensure the future obtainability of oil. Put another way, a short and successful war might have been considered by somebody to be the optimal move to put OPEC in its place, where by somebody I do not mean somebody in the South Bronx or Watts.

Moreover, in a class or seminar room I might be prone to claim that the oil resources of Iraq are not only large but, in theory, large enough to buy the time needed to establish the new energy economy referred to above, and which – unless they are comatose or irresponsible – every upper echelon politician and civil servant in the energy importing countries knows will have to be established sooner or later – although like myself they do not know how.

Some numbers might be informative to curious readers. According to last year’s BP Statistical Review of World Energy, Iraq has 115 billion barrels of proved oil reserves, as compared to 264 billion barrels for Saudi Arabia. Current sustainable output for Iraq is probably less than 3 mb/d, while before the present war the maximum output was close to 3.5 mb/d. More important though, of Iraq’s discovered and evaluated oil resources, a sizable fraction may still be unexploited. One of the most important observers of both Iraqi (and Middle Eastern) oil is Dr. Mamdouh G. Salameh (2004), who points out that in many respects the oil resources of that country are more impressive than those of Saudi Arabia.

Consequently, some influential and not so influential people think that Iraq can and should raise its production to 6 mb/d, and there has even been some talk of getting it up to 8 mb/d. According to a former Iraqi oil minister or decision maker though, output in this range would create the greatest problem ever faced by OPEC, which is the reason why they are not going to abandon OPEC quotas. Why should they, when they see what is happening in a neighboring country.

Five or six years ago, the price of oil was $22/b, predictions were that it would fall under $20/b, and OPEC was desperately trying to get the oil price up to a sustainable $28/b. So let’s think in terms of the latter figure, and round off U.S. oil imports both at that time and today to 10 mb/d of oil. If for computational purposes we take the present price of oil to be $130/b, then the U.S. is paying almost a billion dollars a day more for imported oil than they were paying six or seven years ago, which is about the increase in the amount received by exporters to the U.S.

Now think about Saudi Arabia, which might be exporting about 9 mb/d of oil. A movement of the oil price from the desired $28/b to $130/b means an increase in daily income of about a billion dollars when various expenses are taken into consideration. In these circumstances it is easy to understand how Saudi Arabia plans to finance the establishment of four new economic zones that will include state-of-the-art manufacturing facilities, and also to understand why that country feels it unwise to invest in additional oil producing capacity. Why should they or any other country in the Middle East invest? Why contribute to or initiate a decrease in the price of an exhaustible resource?

FINAL STATEMENT: PEAK OIL

Last year I taught the course on oil and gas economics at the Asian Institute of Technology (Bangkok), and at some point I asked one of my students what he thought of my discussion of the ‘peak oil’ theory. He had no problem with it, he said, but the director of the oil company for which he worked thought that it was nonsense. I also received that judgement from a gentleman who published one of my short papers on oil. He published it, he said, in the interest of fairness, because he did not believe in the peaking of the global oil supply, which struck me as odd, since he and his friends and his network must have been even more aware than I am that a large majority of the world’s giant deposits have peaked or reached a plateau, and the same applies of course to smaller deposits.

I mentioned earlier the published opinion of a man that I call “the best energy economist” in Russia on the oil supply of that country, and perhaps I should note that the oil minister of Saudi Arabia once said that his country could raise its production to 15 mb/d of oil, and maintain it there indefinitely. If these things were really true, and Professor Becker was just partially correct in his evaluation of the world oil scene, then nobody has to worry about a peaking in the near future of the global oil supply and what that could mean for an oil price that is already too high. At present one hears as much about the detrimental effect of increasing food prices as the danger posed by escalating oil prices, but the former is partially dependent on the latter, because of the high energy intensity of modern agriculture.

The position taken in this exposition is that none of the optimism that may be circulating about the oil future is justified. The statement by the Russian gentleman, given his competence, was probably a simple mistake, and the Saudi oil minister later suggested that his remarks were misinterpreted, and if he hadn’t suggested it the position of the present King (Abdullah) of Saudi Arabia was quite clear. In other words, the declaration thirty-five years ago by the Saudi head of state that the oil of his country was to be placed at the disposal of both present and future generations of Saudi citizens and not motorists in the oil importing countries was the real deal and not idle chatter.

What about the director of the oil company where my student was employed, or for that matter a similar contention by the directors of Exxon (XOM) – the largest and most profitable oil company in the world – who have repeatedly rejected the idea of peak oil, or the gentleman in New York who published my paper, although he didn’t believe in peak oil, or the people in the U.S. Department of Energy [USDOE] and the International Energy Agency whose forecasts of the global oil production in 2030 are (or were) masterpieces of absurdity, or the well known consulting company Cambridge Energy Research Associate [CERA], with offices in North America and Europe and probably elsewhere, and a Pulitzer Prize winning oil expert as its chief, which has come to the goofy conclusion that while there might be a peak, it will be an undulating peak. What is going through the heads of the people involved here?

""It’s called money, Virginia”, to use some of that beautiful Wall Street terminology."

As a result, it is perfectly logical for the boss of my student to want to give the impression that in reality there is a very large amount of oil in the crust of the earth, and so present or future technology will have no problem with its discovery or extraction, and therefore a resort to unconventional energy sources is unnecessary. Whether he or his colleagues at Exxon and a few other major oil firms, or the present oil minister of Saudi Arabia, and oil ministers and tycoons elsewhere, actually believe this song-and-dance in their heart of hearts is completely irrelevant. They know, even better than I do, that discovery in the Middle East has peaked, and it is only a matter of time before output from the largest deposits peak. Of course, in one sense it doesn’t make any difference whether Middle Eastern and other deposits peak or not, because the relatively small increases in their output will not be able to match the dynamic growth of demand in China and India: this unambiguous process can be reduced to the supply and demand curves in Econ 101.

Let me also note that if the Saudi King is serious about not raising production, then the largest producing country in the world might already be in the process of peaking. You can interpret for yourself what that means, but the billionaire investor T. Boone Pickens interprets it to mean that global peaking is already taking place.

The important thing for me where this topic is concerned was or is informing students and others how they should study the subject. The approach here is simple, and not a single one of my students at the Asian Institute of Technology had a problem with it. What it involves is examining in detail the peaking of oil in the United States, which is often labeled the richest country in the world, and thus able and willing to mobilize the absolute latest and most sophisticated technology, as well as employ the best managerial and scientific and engineering talent in the world to supervise and upgrade that technology.

The peak oil drama in the U.S. can be reduced to the following. The peaking of oil discovery in the U.S. took place in the early l930s. The peaking of production in what is called the lower 48 – i.e. the U.S. minus Alaska and Hawaii – took place in late l970, or about 40 years later. Furthermore, the giant Prudhoe oil structure in Alaska came on stream after the peaking of production in the lower 48, and as a result output in the (entire) U.S. turned up, but even so it never reached the 1970 peak – which mathematicians would therefore call the global peak for that country. One more item belongs here. Even though output in the U.S. peaked in l970, today the U.S. is producing about 5.5 million barrels of oil per day, or more than any country except Saudi Arabia and Russia.

This indicates that the peaking of production in the U.S., or in the British and Norwegian North Sea, or in Russia, or the peaking that will eventually take place in the Middle East, is an economic and not a geological phenomenon. But certain phenomena that involve both economics and geology are worth emphasizing, especially the reality that if discovery peaks, then eventually output will peak. Global discovery peaked about 1965, and according to the present Vice President of the U.S. in a talk that he once gave – but his conservative friends choose not to remember – the peaking of the world oil output cannot be avoided, and he thought that it could take place as early as 2008. This is probably not correct, but Mr Cheney is an insider in the oil world, which means that he is not in the habit of saying things that would offend his friends and neighbors.

Moreover, global oil consumption exceeded global discovery for the first time (in modern times) in 1980, and for every barrel of oil discovered, about three are consumed. These factors help to explain why the oil price is so high, along with the fact that almost all oil producers understand that it is a mistake to produce oil today that could be produced and sold later at a much higher price.

If enough producers feel that way, then it is almost guaranteed that the higher price will come about. And it has come about, and not only that it may have come to stay.

REFERENCES
Banks, Ferdinand E. (2008). ‘OPEC and oil’. Petromin.
______ (2007). The Political Economy of World Energy: An Introductory Textbook. London and Singapore: World Scientific.
______ (2004). ‘A new world oil market’. Geopolitics of Energy (December).
Crandall, Maureen S. (2006). Energy, Economics and Dreams in the Caspian Region. Westport, Connecticut: Praeger.
Robelius, Fredrik (2006). ‘Oljefyndet är en bluff’. PsX Press
Salameh, Mamdouh G. (2004). Over a barrel. Salameh: Surrey England


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