Friday, June 25, 2010

A Brief Revisiting of Peak Oil

For background on this subject go to this link:

Although discussed previously, the recent explosion of Deepwater Horizon and the resultant oil discharge into the Gulf of Mexico have some raising the issue of ‘Peak Oil’ as one of the hodgepodge of reasons to reduce the general reliance of oil in our society. The appropriate way to view ‘Peak Oil’ is the point where global oil production peaks and some believe that time as already occurred. Unfortunately others have expanded the peaking of production to signify a lack of available supply. Basically global production cannot reach the previous high because the total remaining supply of oil is insufficient. This distinction is not correct, for there are still large quantities of oil available.

Why can the statement be made that there are still large quantities of oil available? First, although it is true that most traditional existing wells are on the down-slope of their production curves, there are some remaining undeveloped traditional sites, mostly located in Iraq and Russia. In fact the prospective reserves in Western Iraq are thought to be especially large. Second, deepwater sites similar to Deepwater Horizon are still being explored and as technology continues to advance exploration of potential new sites will become more accurate and inexpensive. Most of the best deepwater sites are thought to be located off the Atlantic coast of South America and in the unfortunately fast-melting Arctic. Third, untraditional sources of oil have been identified (oil shale, oil sands, etc.) with very large deposits in Venezuela, Canada and even in the United States (Rocky Mountains). So with all of these additional acquisition opportunities around the world, not just in the Middle East why are there so many that believe the world has already entered the era of ‘Peak Oil’?

The simple answer is that each of these three types of resources have one major thing in common, oil extraction from these sources is more expensive than from current widespread traditional wells. Although many experts believe there are still large globally meaningful deposits that can be acquired through traditional wells, the countries that control the land containing this oil have been reluctant to allow foreign companies the opportunity to invest and conduct business under fair contracts. Thus, foreign companies do not view investment in these new undiscovered areas as profitable enough to warrant their time. Deepwater drilling has caught on in recent years as a viable alternative to unsuccessfully haggling with uncooperative foreign countries. However, as witnessed in the Deepwater Horizon disaster, deepwater drilling can be troublesome when things go wrong, environmentally and economically. Extraction from untraditional sources has been a hot topic in the petroleum industry for decades and as traditional sources become less and less available, the first serious wells are being developed, but mass production of these sources have stalled due to the high costs. Interestingly enough despite the belief of ‘Peak Oil’ it seems more likely than not that all three of these sources will be tapped to significant extent despite the significant cost obstacles because of the shear lack of alternatives and the necessity of oil in driving economic growth.

One of the chief elements to the cost obstacle is the classical volatility profile of oil prices. A general rule of thumb is that businesses love patterns and predictability. Some argue that the general volatility of oil price will keep petroleum companies from fully investing in these alternative sources types thus resulting in global production values that will fail to exceed current values. Basically a company needs to know if they are going to make profit on an investment a majority of the time and price volatility confuses the ability to make that prediction. Other potential unpredictability is what big consumption countries like the United States, China, India, etc. will do regarding carbon emission policy and how that new policy will influence oil price and consumption.

With falling ‘easy’ supply sources, future oil price volatility is somewhat reduced in that prices will steadily increase with few, if any, significant drop periods. Basically the future oil price curve will oscillate around a steadily increasing positive slope with the total period and amplitude of the oscillations dropping as the time progresses. An example of this concept is shown in below. The increase in oil price will eliminate a significant amount of trepidation for investment in more expensive sources. As long as a company can predict a profit to be made without a viable alternative, effort will be applied to make that profit.

Look at it this way: suppose you normally climb a 10 ft. tree to collect apples that you sell at a net profit of $30 per apple. Unfortunately almost all of the 10 ft. trees no longer have any applies available. However, there are 30 ft. trees will lots of apples, but the extra time and equipment required to collect apples from these higher trees will reduce the net profit per apple to $15. Some may question the will to continue to collect apples at half the profit, but if the individual cannot devote time to a more profitable venture (an option facing most oil companies) and people still want apples and can pay for them then apple collection will still occur. Right now the individual does not have the real viable option to sell oranges or some other fruit (biofuels) at $20 per unit, so apples it is.

Looking at possible environmental and energy regulations, some argue that changing dynamics in the United States will reduce demand for oil, thus reducing the total capacity for price increase thereby reducing investment incentive and total future supply. While it is true that average motor vehicle gas mileage will increase in the future with increasing design efficiencies of internal combustion engine driven vehicles along with further deployment of hybrid and 100% electric vehicles, there are some issues that are not addressed. While proponents are eager to mention these efficiency increases, they do not discuss the high probability of increasing fleet size. While motor vehicles will become more efficient, there will also be more of them on the road, which with the exception of 100% electric vehicles will increase oil demands. So when including changes in fleet size it is difficult to measure whether or not U.S. demand will actually drop and if it does, by what amount. Also increasing fleet size leading to increased oil demand is an especially large concern with developing countries such as China, India, Indonesia and Brazil that may not have the infrastructure to support electrical vehicles and develop cleaner use power sources. Side note: some people cite China having 100-125 million electrical bicycles as a good thing, funny that they fail to mention that those bicycles are being powered by coal.

A quick detour to explain the importance of market forces. The two chief reasons why some believe the era of ‘Peak Oil’ has begun are that official oil discoveries have been declining significantly over the last 40 decades (most believe that the discovery peak was reached in the late 60s – early 70s) and significantly rising prices starting in the middle of 2005 which only dropped due to the global recession and an inability of large consumers to buy oil. Many believe that this ‘catastrophic’ price increase was due to rising demand finally breaking through outpacing of supply, thus ‘peak oil’ must be close. Unfortunately there may be a problem with this logic. As the average price of oil rose from approximately $41 (a barrel to approximately $60 a barrel, global oil production was maintained at a consistent 85 million barrels a day.

A steady-state production level despite rising prices (almost a 50% increase) initially implies an inability to increase production because basic economic theory anticipates some level of increase in supply to maximize the profit potential from a price increase that is not accompanied by a demand decrease. However, when oil prices really jumped through the roof in late 2007 to mid 2008 (exceeding over $130 a barrel) global production did slightly increase which implies a greater sense of control over the production value over basic economics. Without understanding the mindset of those in control of the principle rates of production (OPEC provides upper 30 to lower 40%) it is difficult to identify whether or not there is any production supply significance to the size of the increase. Note that in this radical oil price time frame, oil production reached a new global peak when prices were around their own maximum. When prices began to fall due to the global recession, production dropped as well.

There are two possibilities regarding existing tapped oil supplies with respects to supply changes occurring in response to the radical price changes. First, oil supplies have become rather inelastic thus it is difficult for supply to increase significantly in accordance to a price increase like basic economic theory anticipates. Second, increasing oil supply is more difficult than economic theory predicts due to an existing set of rules created by OPEC. There is reason to believe that the dramatic price shift was caused in part by oil speculation in the free market due to the past free-flowing credit market where anyone could get credit even if he/she did not have the necessary assets. The entry of purchasers that previously would be unable to purchase oil could easily spike prices. Such price reaction, and even manipulation, may have been viewed as ‘short-term’ in the minds of the producers, thus the corresponding increase in production was slower than theoretically anticipated. Overall a combination of both of the reasons make-up the rationality behind the production response with a greater weight on the inelasticity issue.

In the United States further questions regarding the inability of possible buyers to acquire credit will reduce demand for oil in the United States not from lack of want, but from lack of ability to pay. However, regardless of the change in the U.S. it is almost impossible to consider a drop in global demand driven entirely by market forces, because of rapidly expanding demand in the developing world and a vast amount of available credit for purchase. Therefore, despite higher production costs petroleum companies should not be deterred due to questions about demand.

Although it appears that the future marketplace will not drive a decrease in global demand, new global environmental regulations and new widespread electrical grid design fostered by government law and/or directives could. Administration of a carbon tax, cap and trade system and/or streamlining grid construction would have a positive effect on lower oil demand by either adding cost to oil exploration and production or reducing the costs for oil alternatives allowing them to be more competitive in the marketplace. Unfortunately all of the large oil consuming countries appear to only be slowly advancing to adding additional costs to oil and other carbon sources, if moving at all, thus as it stands it appears that very little demand shift will come from the one element that could create a significant short-term shift.

Even though oil will still be required in the global community and this requirement will continue to drive investment and exploration, historical evidence and economic theory predict that dealing with higher oil prices will be financially difficult for most societies, especially the United States. Historical evidence set a magic price of $80-85 per barrel before the probability of financial recession in the United States increases significantly. In fact a majority of the time that oil has been in or above this price threshold the economy has been officially in a recession. The two most important industries that are influenced by oil prices are transportation and food production (harvesting equipment for large factory farms). Therefore, if the reality of more expensive oil is almost guaranteed then new strategies need to be executed to improve the ability to maintain quality of life in the United States and probably later in the developing world as well.

Unfortunately the development and deployment of oil alternatives do not appear ready in the near-future to play any significant substitution role for oil. The popular refrain for this deficiency is the claim of economics, but the real reason is scale. While algae and cellulous-based bio-fuels may eventually churn out 10-20 million barrels of oil a year by 2020 when the global demand is 80-100 million barrels of oil a day that amount is rather worthless regardless of how much it costs to produce that bio-fuel. If ethanol-based fuel ever even got close to the current demand for oil a vast majority of the population would starve because of the land use competition between bio-fuel and foodstuffs. With regards to electrical and hybrid vehicles, despite heavy optimism from proponents heavy deployment is unlikely. Even if such a revolution occurred, it remains to be seen if the evolution of the electrical grid would keep pace with the new demand or uncertainty and brownouts would become the norm. So without the ability to depend on the brute force of viable alternatives the global community as a whole needs to decide on a course of action.

For example consider global trade and its dependence on shipping. A higher oil price increases the overall costs associated with shipping requiring an increase in the price paid by the businesses importing the good, a cost that will later be passed on to customers. Eventually the oil price will increase to a point where the consumer will be unable to purchase the good, which will end trade of the particular good in that particular region. Therefore, a new strategy must be implemented in the transportation sector to counteract the negative effects of the oil price increase. Shipping in general is rather efficient in maximizing capacity in order to save money (ships are loaded to near full capacity), so the change must come on the propulsion end. Reverting back to ‘no active force’ (a.k.a. wind power) is not a suitable solution because of the wait times between departure and arrival, especially for perishable goods. The development of an electrical motor powerful enough for a ship of any reasonable size seems unlikely and inherently inefficient.

Realistically bio-fuels and nuclear are the two most plausible alternatives for ship travel where due to supply issues nuclear has the advantage. However, how safe would it be to have thousands of nuclear vessels transporting goods across the ocean on a daily basis? Such a ship-based population would be much larger and more exposed to danger than ‘proof-of-concept’ nuclear submarines.

Overall when discussing ‘Peak Oil’ it seems silly to discuss a lack of available oil or even a lack of drive to access oil in more expensive and/or difficult locations. Instead the most ironic feature of ‘Peak Oil’ is that government and individual decision-making will most likely bring on its occurrence. Reduction of demand through increasing efficiency or use and further development of alternatives are the only real ways to enter the ‘Peak Oil’ era in the short-term. Maybe it would be more appropriate for ‘Peak Oil’ converts to talk about entering the ‘Expensive Oil’ era or the end of ‘Cheap Oil’. Sadly the era of ‘Expensive Oil’ may be better than the era of ‘Peak Oil’, but not by much. If society is to effectively manage the era of ‘Expensive Oil’ significant changes need to be made with regards to travel and food production.

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