On Oil Prices - or a Gentle Cough in Newsweek's direction

Newsweek has a story this week on why we should not be worried about the potential problems of peak oil. (One of the advantages of the Kindle is that I can read this early, one of the disadvantages of this being tax weekend is that I haven’t had time, so hat tip to Gail). Basically it is quoting chapter and verse of the Cornucopian Bible, and sadly it is riddled with misperceptions and the sort of blind faith in “someone who will take care of us” that it does a significant public disservice.

Let me explain the scale of the problem with a couple of examples, as I review parts of the article. To start there is this comment, noting that in real terms the price of oil has not gone up, but rather declined.

This long-term price decline is due mainly to the constant discovery of new fields and greater energy efficiency, making nonsense of the idea that the world is rapidly running out of oil.

To point out the fallacy of assuming this will continue, let me use John Grace’s excellent book on Russian Oil Supply. I use it because it geographically illustrates the point in a way that is more difficult with other countries. First you see the Russians could get all the oil that they needed from around Baku (in what is now Azerbaijan), and then when that proved insufficient, they moved North East and discovered the Volga-Ural Basin. Here, in the 1948 they discovered one of the great oilfields of the World, Romashkino, which held around 17 billion barrels of oil. Romashkino peaked in 1972, and the whole field peaked in 1976, at just under 4.5 mbd, and has been in decline since then. It was here that the technique of water flooding was perfected in Russia.

As Romashkino declined so the Russians moved further east, into Western Siberia, where they found the Samotlor field, Russia’s largest. By 1980 this field was producing 3.4 mbd but it too started to decline and by January 2003 had produced some 16.4 billion barrels and was down to a production of 300,000 bd. So where next? The Russians kept moving East and, at the same time tapped smaller fields, such as Fedorovskoye and Mamontovskoye, which are now running out. They reached Sakhalin Island and that is now in production, but Russian overall production is falling again, so where to move to next? Further East ? Er! Well there is this slight problem – Russia sold “further East”, AKA Alaska, in 1867. And so Alaska has already been put into production, and now is in decline. There are only so many places to look, and as Magellan showed, if you keep moving one way long enough finding new reserves, after a while you get back to where you started from, and you used those already. All the easy oil has now been just about found. The places we are left with to look are more expensive to look, and even more expensive to produce(such as the deep waters of the Gulf, and off Brazil).

There are three parts to the Newsweek argument:

Yet the fact is that the world has faced all these issues before, and for the past 200 years, commodity prices have been trending downwards, thanks to new technologies, greater efficiency in extraction and the substitution of one commodity for another (which explains the high correlation between commodities prices).

In themselves, and at certain levels of production of different items they each have validity, but in the current cycle they significantly ignore the factors of scale and time. Let me explain part of the this with another example. After Hurricane Katrina paid a visit to the Gulf there were a significant number of oil and gas wells that went out of production. Now the oil and gas remaining in those wells is still there, but it is not economic to go back and redrill the formations and restart production for the amount that is left. As the required technologies to generate production become more expensive, so the fields have to produce more to justify that investment.

A case in point here is the development of gas from the shale deposits around the country. With the development of horizontal well drilling, hydrofracing, slick-water hydrofracing, and now multi-stage hydrofracing the wells can produce up to 20 mcf/day. But the wells cost over $5 million and so the gas has to sell for a certain amount to justify that investment, and the fields decline in production at 60% the first year, so that initial number had better be high. At the start of these fields most of the wells are, though as they are finding out in the Haynesville, not all of them. And so where do you look for the next level of technology to find a better way of getting more out? There are some ideas out there (we filed a new patent last month, for example) but these take time to move from lab, to pilot to prototype to full production, and there are not that many ideas in the pipeline because there was, among other things, not that much investment.

We have just about run the gamut of the new technologies for now, and it will take a while to come up with more. Certainly injecting carbon dioxide for enhanced oil recovery can, in the right formations, give you an extra 10% or more, but there are only so many places that that can work, and the expense in getting the gas moved around, compressed etc is significant, and much of that logistic cost, when considered in the past, has been enough to restrict use of the technology.

And so we get to substitution of new fuels. And I guess the Newsweek reporters haven’t been paying attention, because ethanol and biodiesel are the likely candidates at the moment to replace liquid fuels. And neither are at a stage where they can be expanded to produce, for example, the 245,000 bd of oil production that is being lost as Cantarell declines. We are not talking about being able to wait the 10 – 15 years that it is going to take for the work on cellulosic ethanol to generate, economically, the fuel types that we need – these declines are happening, in real time, now!

Both scenarios ignore history, which shows that only one commodity rises in an inflationary environment: gold. Other commodity prices tend to bloom only during the mature stages of a boom when the global economy overheats and demand briefly exceeds supply. At the moment, supply for nearly all commodities far outweighs demand, and likely will decline for at least the next couple of years.

This assumes that there is enough oil, and substitute fuels that will be available, at a reasonable price, as demand resurges. To make that statement with confidence, you need to be able to say where that extra supply is coming from. Russia? It is falling back into decline, as is non-OPEC in general. Within OPEC, as was discussed last week at the EIA meeting, there is only so much additional production available (if in reality it is, and in some cases there are reasonable doubts that it is).

We have seen, in the last few months, as OPEC has cut back production, the matching of demand, in this time of global recession, with supply that is made available. The difference between flat-out production, which we had at times last year, and now, is in the neighborhood of 4 million barrels a day, over a total of about 80 million barrels. Expansion of the markets in China and India does not have to be that great, with a slight return of confidence in the rest of the world, and that cushion will be gone. When there is not enough supply to meet demand at a given price, what happens? Prices go up, and demand drops to meet the new price. But if the commodity is critical, and oil is an integral part of the world we live in, what happens when there is not enough at an acceptable price. What happens when you don't have the fields to open new reserves, when you don't have time to develop the new technology to extract more from existing fields, and when the substitute fuels aren't that ready for prime time?

What actually worries me more than the Newsweek story alone, is the feeling that this reflects the opinions of many in the new Administration, and if they don't realize the scale and imminence of the problems, then by the time that they learn, it will be too late.

And this is one of those predictions that will show results, either their way, or mine, within eighteen months.
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