Thursday, August 8, 2013

Peak Oil is Dead?


The world’s press has been effusively promoting a new story line about energy: the Peak Oil theory is dead. The shale revolution killed it. North American production of liquid fuels is growing again, and soon enough, the US will be a net exporter. OPEC is in trouble as oil prices are about to fall, and members’ subsidized supply and generous social programs are at risk. National deficits and social unrest may follow.

In addition to the shale story, there are several other components to this new worldview:

·         For the fourth straight year, demand for crude oil in OECD countries has fallen

·         Renewable power generation has increased significantly, led by new hydropower in China, wind in North America and solar in Germany

I don’t buy it.

First of all, those who claim that we have entered a happy new world of energy abundance have to account for the fact that energy is now more expensive than ever. To the right is a chart of the price of a barrel of oil since we first started pumping it out of the ground in Pennsylvania 150 years ago.





If oil is flowing so freely, why is it so damn expensive? Greedy speculators are not the answer. Speculators don’t care whether the price of oil goes up or down – they make money either way. Did they cause oil to briefly drop to $30 at the end of 2008? Furthermore, if oil prices are too high by $40 or $50, as some people suggest, then where the heck is all that profit going? The world consumes 80 million barrels per day. That would equate to $1,500 billion in annual excess profits. Where is it? That’s 210 times the profits of Goldman Sachs last year. Commodities traders make up only a tiny fraction of their profits. Oil companies don’t have that kind of money either – look at their cash flow statements and you’ll see that most of their money is being spent on operating costs or development.

 Furthermore, the causes of this supposed new reality are simply window dressing. The much larger macroeconomic drivers which fueled Peak Oil theory are still intractably at work. Let’s take them in order:

Growing North American supply: promoters of this story point out that North American production has recently increased by approximately one million barrels per day (bpd). While this is true, it is partly a gimmick: the conversation is now about total liquid production, instead of crude oil production. The lions’ share of this gain has come from increased natural gas liquids and refinery gain. You can’t run your car on natural gas liquids, and refinery gain is being generated because we’re using heavier oil, which is also more expensive to transport and refine. In addition, as mentioned previously, the world consumes 80 million bpd. Even if all of the increase is refined and consumed, that increase equates to a whopping 1.25% of global demand. This hardly seems like a change which would cause us to utterly alter our worldview. Finally, and most importantly, depletion rates for fracked shale wells are considerably higher than for conventional wells. As conventional production is replaced by shale production, the supply problem might be getting worse, not better.

 
Declining OECD demand: It is also true that crude oil consumption in developed economies has declined recently. We’re insulating our houses better and driving more fuel efficient cars. This is all good. But did anyone notice that the world’s developed economies have been in the doldrums for about four years, too? Is it possible that these two phenomena are linked? As far as I can tell, nobody has rebutted the seemingly ironclad relationship between wealth and energy consumption (see here). We’re driving Priuses but we’re also consuming less oil because we’re not taking vacations to Hawaii like we did in 2007.
 
And in a subtly different but related point, isn’t it possible that this declining oil consumption is also due in part to high energy prices? And yet now we’re celebrating this wonderful new fuel efficiency because it’s going to lead to much lower energy prices. Frankly, I find the argument bizarre.

Finally, and most importantly, the residents of OECD countries are already rich, and already consume massive amounts of energy. But the residents of OECD countries are only 18% of the world’s population. The benefit of a small marginal decrease in their consumption will be absolutely swamped by the increase of consumption by residents of the third world as they move into the middle class. There are 700 million peasants in China who would like to live like Americans. Getting them there will make all of our Prius driving irrelevant when it comes to Peak Oil math.

The rise of renewables: There is more confusion and misunderstanding about this issue than any other in the current energy debate. The sad fact is that, even after hundreds of billions of dollars of investment, wind and solar power combined generate only 3% of our total energy supply in the United States. Hydropower generates a considerably greater percentage, but we are essentially at the limit of that resource. We’ve already dammed the most obvious rivers. Environmental and transportation concerns preclude significant new hydro resources. As much as I hate for it to be true, we will bankrupt ourselves if we attempt to replace liquid fuels with renewables over anything but the very, very long run.

 
The reality is that the macroeconomic conditions which caused people to be concerned about our hydrocarbon resources have not changed. If anything, they have gotten worse in the last ten to fifteen years as economic development in China and India have proceeded at a pace greater than anyone ever thought possible.

 Part of the confusion, I think, lies in the fact that most people are unaware of the subtleties of Peak Oil theories. Peak Oil is popularly described as a theory which says that we are running out of crude oil, and that once the death spiral starts, the world will be plunged into a Road Warrior-like dystopia. While there are indeed believers in this bleak future, most thoughtful Peak Oilers describe a more extended version of the slide, where the initial signs of Peak Oil are primarily reflected in high prices and a gentle plateauing of energy production. Gains in prices are met with capital investment to reap higher profits, but also cause economic shocks. The world slips in and out of recession as economies adjust to new, higher energy prices. The world will never actually run out of oil, it’s just that the marginal cost of new barrels will rise so high that it’s quite irrelevant.

 Does this scenario sound familiar? (See my post of January, 2009 (!) for my own prognostications on the issue). Eventually, even these more optimistic Peak Oilers believe that production will eventually slide downward with ever more devastating effects. How long that takes depends on who you’re talking to.

Another reason why I think people have misunderstood the dynamic of crude markets is that they are using an incorrect definition of marginal cost. In traditional economic parlance, marginal cost relates solely to Cost of Goods Sold – the true operating costs of extracting oil from the ground: depreciation of the well capital investment; labor for the rig workers; variable costs at the plant like fracking water and chemicals. But the oil world has changed. Extracting oil from the ground is not quite as simple as poking a hole in the ground and conjuring up a gusher.

 The world rejoiced a few years ago when Petrobras confirmed the existence of approximately 7.5 billion barrels of light, sweet crude off the Brazilian coast. Everyone said, “See? We’ve got plenty of oil!” Unfortunately, the oil is located in a spot where the ocean floor is 1.2 miles below the surface, and, once there, the drill has to venture through another 3.0 miles of almost impenetrable salt, sand and rock. Getting all those barrels out of the ground will cost staggering amounts of money. What is marginal cost in that case? The cost of the rig, labor and consumables are only a part of it. Just to start a program like that requires tens of billions of dollars in overhead: engineers; consultants; lobbyists; bureaucrats; and specialists of every sort, not to mention the costs of safety, insurance and environmental protection. In effect, the marginal cost of that oil becomes the entire cost side of the Petrobras P&L. And for what? 7.5 billion barrels of oil is about three months of global demand. Big whoop.

Now, I’m not saying that the price of oil will never go down again. Like the stock market, the price of oil will go up, and it will go down. But I truly believe that the medium and long term trend is only up, and maybe substantially. Further, if price does go materially down, it’s not because we’re driving yet more Priuses or Teslas, it’s because the world economies have taken it on the chin again like 2008.

 
If it sounds like I am pessimistic, it’s because I am. However, I am also a true believer in the power of human spirit and ingenuity. I believe we’ll muddle through the problem, but it’s going to be rocky. Ironically, if you’re worried about climate change, Peak Oil is actually a good thing. Here were Obama and Steven Chu wanting to furtively increase the price of oil to choke off demand. If I’m right, it turns out they can just sit back and watch Mother Nature and the laws of economics do their work for them.