High prices are here to stay
By Marshall Auerback
Concern that rising oil prices could harm the global economy dominated the recent meetings of world finance ministers and central bankers who gathered after Wall Street plunged to new lows for 2005. There were intense talks about the energy situation at both the meetings of the Group of Seven major industrialized countries and the policy-making committee of the 184-nation International Monetary Fund.
But is this yet another case of policymakers closing the barn door after the horse has bolted? After all, oil prices now look to drop below US$50 per barrel, having fallen several days in a row amid concerns of slowing global economic growth, falling stock markets and a further unwinding of the great reflation trade (which is engendering significant liquidation of the speculative long positions on the oil futures market).
To be sure, the recent sharp pullback in oil prices from new record highs is also the result of a quite understandable price-sticker shock. Oil and petrol prices are now five times as high as they were in 1998, when the world was looking for prices to plummet back to the lows last seen in the mid-1980s. It is also true that the psychological backdrop does not appear conducive to an ongoing bull market in the energy complex: today's news flow is comparable to that which arose in the wake of the conclusion of the Iraq war. Newspapers and brokers' reports write reams of material describing fatter inventories, and note that the transportation bottlenecks which had hitherto afflicted the oil industry have been largely been sorted out (if the recent decline in tanker rates is anything to go by).
Oil has twice pushed to the mid-50s range and sold off violently, leading many chartists to assume that a double top is forming. There are a lot more bulls than there were even three years ago, when we first started making the secular case for higher energy prices, and common sense tells one that no commodity can sustain such a rate of price increases indefinitely. And, as is often the case with any apparent speculative blow-off, there was the widespread publicity accorded to a Goldman Sachs report, in which the possibility of $100 oil was mooted for the first time.
So has oil been put in a conclusive top? Is all of this market chatter about "peak oil" simply a function of extreme bull market psychology?
Given the threats posed to global growth (in particular, consumption) by higher energy prices, there is clearly a vested interest in talking down the price of oil. But as market strategist Chris Sanders has noted, "Measured in relative terms, [oil] has not done that much compared to history. Nominal spot prices are only $5 or so as of this writing above their October 1979 peak at $44.60, and deflating spot oil by the US consumer price index ex-energy prices, we see a much different picture of its relative value against other goods and services. Looked at this way, it has barely retraced half of the 70s bull market run."
Add to this the simple dynamics of supply and demand, and it is easy to make the case that the recent weak price action in the energy complex is but a temporary downdraft, rather than indicative of a new, more bearish trend for oil, gas and coal prices. As always in such circumstances, it is best to go back to the basics: total new discoveries have been steadily declining for 40 years, and world consumption has outpaced newfound reserves for nearly a quarter of a century. The global economy today now uses more than four barrels of oil for every new one discovered.
In fact, according to a report by the industry consultants, IHS Energy, only 50% of the world's oil production has actually been replaced by new field discoveries. Annual discoveries have now fallen behind total consumption every year for the past 20 years. The consultants reported that all but three of the top-20 non-OPEC (Organization of the Petroleum Exporting Countries) oil-producing countries failed to replace their production with new discoveries. Russia and Mexico - the top-two non-OPEC producers, which together accounted for over 12 million barrels of daily production in 2003 - replaced just 11% and 10% respectively in the past 10 years. The report also shows that the percentage of discovered oil brought into production has steadily risen since 1975, which means that more and more of the legacy of past discoveries is being consumed. In 1975, about 65% of total discoveries were in production. Through the end of 2003 that figure had risen to 85% of all the oil ever discovered. In total, about 45% of all the oil found worldwide had been consumed by the end of 2003, according to the IHS data.
Worst of all, (from an American perspective at least), is that the largest new sources of petroleum are likely to emerge in countries with interests somewhat inimical to those of the US. This is not without historic precedent: in 1970, the seven major international oil companies thought they owned and thus had tied up the huge Middle East reserves beyond the turn of the century. Within five years, the nations there had taken ownership of their own oil - and prices had quadrupled.
Although the presence of 140,000 troops in Iraq makes a 1970s style nationalization a highly unlikely contingency, most of the major oil producing nations are close to full production capacity, notably Saudi Arabia (now producing oil at close to its maximum sustainable rate of about 10 million barrels per day). Both Henry Groppe and Matt Simmons, two of the world's leading independent energy analysts, forecast that in spite of current pledges to increase production and investment in infrastructure further, the Saudis are probably unable to raise their output significantly over the next 20 years while global demand, pushed by significantly higher consumption in the US, China, and India, is expected to rise by 50%. On the other hand, notes author Michael Klare, Iran has significant scope to increase its role as a major swing producer: "Iran has considerable growth potential: it is now producing about 4 million barrels per day, but is thought to be capable of boosting its output by another 3 million barrels or so. Few, if any, other countries possess this potential, so Iran's importance as a producer, already significant, is bound to grow in the years ahead."
Leaving aside such problematic geopolitical constraints to easier access to crude (at least from the perspective of the world's largest energy consumer, the US), one would also presuppose that higher prices would lead to improved returns on investment. But the very nature of depletion dynamics undercuts this assumption. According to energy consultants Wood Mackenzie, the value of new discoveries by the world's 10 largest oil companies fell well below the amount they have spent on exploration over the past three years, which creates a disincentive to increase investment further. A Financial Times report noted that companies were spending record levels on developing known fields to keep pace with the growing demand. But after 2008, according to Robert Plummer, corporate analyst at Wood Mackenzie, "They will need more discoveries to maintain growth ... the problem is exploration has not been generating returns."
Add to this the fact that the world is now losing more than a million barrels of oil a day to depletion - twice the rate of two years ago - according to a new analysis published in Petroleum Review, the oil and gas magazine of the Energy Institute in London. The analysis shows that output from 18 significant oil-producing countries, accounting for almost 29% of total world production, declined by 1.14 million barrels a day (mbd) in 2003. The annual rate of decline also appears to be accelerating, contrary to the widely held view that depletion progresses slowly. Combined expenditure of about $8 billion on exploration last year - down from $11 billion in 2001 - produced discoveries valued at less than half that amount.
As a consequence (based on data in the latest BP Statistical Review of World Energy), total OPEC production fell from a rate of 24.7mbd (recorded in 1997) and to 22.1mbd by the end of 2003. "It appears that depletion is now becoming a much more significant, though largely unrecognized, consideration in the supply-demand equation, and may be contributing to the rise in oil prices," said Chris Skrebowski, editor of Petroleum Review, who prepared the new analysis. Skrebowski noted, "Those producers still with expansion potential are having to work harder and harder just to make up for the accelerating losses of the large number that have clearly peaked and are now in continuous decline."
Global discoveries for oil peaked 35 years ago while demand has climbed inexorably higher. Obviously, there are still parts of the globe to be further exploited, whether in the deep ocean beds of the South China Sea, the west coast of Africa, or in the highly prospective Falkland Islands. But these regions are the exceptions, rather than the rule. As Sanders notes, "This cannot last forever, something has to give, and that something is production. There are variables: the business cycle, technology and politics; but these can only affect the date of the peak, not eliminate the peak itself." Especially when the date of that peak has been brought forward by the new demand variables of China and India; consider that for China and India to reach just a quarter of the level of US oil consumption, world oil output would have to rise by 44%. To get to half the US level, world production would need to nearly double. That is a virtual impossibility. The world's oil reserves are finite.
For all of the vaunted hopes imputed to new extraction techniques, it is worth noting that these processes are more likely to accelerate depletion rates, rather than expand supply. There quite simply are not enough new big oil projects coming on stream anymore to replace the old oil fields that are running low. It takes an average of six years from finding new oil to pumping it out, and the known new fields are not kept secret. In 2000, there were 16 major discoveries; in 2001 eight; in 2002 just three; and in 2003 zero. The writing is on the wall.
And the bad news is that there is no cheap, easy solution in sight: President Bush has publicly embraced hydrogen as a solution to the US's looming oil supply shortages. But, as Cal Tech Vice Provost and professor of physics David Goodstein has noted, there are only two commercially viable ways of making hydrogen. One is to make it out of methane, which is a fossil fuel. The other is to use fossil fuel to generate the electricity that is required to electrolyze water and get hydrogen. The economics of doing that are such that one ends up using the equivalent of six gallons of gasoline to make enough hydrogen to replace one gallon of gasoline. This "solution" , therefore, turns out to be no such thing.
Natural gas could be a very good substitute for oil. Cars that are not very different from those driven today can run on compressed natural gas, and it is a particularly clean-burning fuel. But if we turn to natural gas in a major way to replace diminishing supplies of oil, it will only be a temporary solution. The Hubbert Peak for natural gas is only a decade or so behind Hubbert's Peak for oil (in fact, in the US, natural gas production peaked in 1973).
And natural gas also puts Americans face to face again with the uncomfortable realities of the Iranian regime. According to Oil and Gas Journal, Iran has an estimated 940 trillion cubic feet of gas, or approximately 16% of total world reserves. (Only Russia, with 1,680 trillion cubic feet, has a larger supply.) As it takes approximately 6,000 cubic feet of gas to equal the energy content of one barrel of oil, Iran's gas reserves represent the equivalent of about 155 billion barrels of oil. This, in turn, means that its combined hydrocarbon reserves are the equivalent of some 280 billion barrels of oil, just slightly behind Saudi Arabia's combined supply. At present, Iran is producing only a small share of its gas reserves, about 2.7 trillion cubic feet per year. This means that Iran is one of the few countries potentially capable of supplying much larger amounts of natural gas in future, although presumably a pre-emptive attack in response to Iran's ongoing uranium enrichment activities could disrupt this supply (as well as any inconvenient and growing ties between Iran and America's leading competitors in the global energy market, China and India).
Wind and solar power are also being discussed as viable alternatives to oil. And they are, but only to a limited extent. Power generated from waves, windmills, and solar panels is weak, intermittent, and expensive - at least twice the cost of electricity produced from coal or gas. When it is cold or dark, solar panels don't produce energy; when it is calm, wind turbines don't turn. Moreover, in regions like northern Europe, where fossil fuels are very expensive and the wind is strong (and, hence, a viable alternative to rival hydroelectric power as a source of energy), other obstacles remain: places such as Scotland have been marked by protests developing over the "eyesore" wind farms being built over the pristine Highlands. Similar protests are emerging over plans to build Britain's biggest wind farm along the borders of the Lake District National Park on the grounds that it will destroy one of the country's most treasured and inspirational landscapes. Even allowing for resolution of these conflicts, there are relatively few places on earth, like northern Scotland or England's Lake District, where the wind blows strongly and steadily enough for it to be a dependable energy source, leaving aside the question of engendering political support to build these aesthetic monstrosities.
In recent years, the debate over nuclear power has revived, and to judge from the tremendous rally in the price of uranium and various uranium stocks, the market has already concluded that nuclear power is firmly back on the political agenda again. Nuclear power has undoubted attractions, as it would facilitate compliance with the Kyoto Treaty. But its replacement potential for oil is still limited. To produce enough nuclear power to equal the power derived from fossil fuels, would entail production of 10,000 of the largest possible nuclear power plants, according to Goodstein: "That's a huge, probably nonviable initiative, and at that burn rate, our known reserves of uranium would last only for 10 or 20 years."
Eventually, scientists, geologists and entrepreneurs may develop or discover entirely new sources of energy - for example, geothermal, biomass, or hydrogen-based systems - but at current rates of development, none of these alternatives will be available on a large enough scale to provide a cheap, affordable alternative to the 20th century's generally low prevailing energy prices. The recognition of oil's depletion dynamics neither means that oil is in imminent danger of running out, nor that no more will be discovered, that alternative technologies cannot be invented and deployed as substitutes.
It does mean that the single most important and chemically unique storehouse of energy on the Earth is finite and cannot be relied upon to deliver infinitely extended growth on its own, and the global economy will have to adjust to significantly higher energy inputs for the foreseeable future in spite of the recent price weakness recorded in the markets. This likely implies lower aggregate growth (and, by extension, corporate profits) and, from a geopolitical standpoint, a growing tension between the forces binding the world more tightly together into a global financial and production system and the forces competing to control the resources that fuel that production.