Peak Watch

The BTC, Oil Prices and A War in the Caucasus

The direct use of force is such a poor solution to any problem, it is generally employed only by small children and large nations.
     —David Friedman

Recent events in the Caucasus and Turkey remind us that choke points in world oil transit are subject to geopolitical disruption. Operator British Petroleum (BP) was forced to shut down the Baku-Tbilisi-Ceyhan (BTC) pipeline after a terrorist attack in Turkey that occurred 2 days before the Russian military incursion into Abkhazia, South Ossetia and Georgia (hurriyet.com.tr).

The BTC has a capacity of 1 million barrels per day (b/d) and carries Azerbaijani oil destined for Europe from Baku to the port of Ceyhan on the Mediterranean Sea (map below). The BTC is used to deliver light crude oil from the large Azeri-Chirag-Gunashli field in the Caspian Sea.

Two insights arise from this disruption of Caspian oil supplies. I'll discuss each one below.

Oil Price Movements

It is amazing that the BTC shutdown had little discernible effect on oil prices, which have been falling precipitously for over a month now.

Despite the disruption to global oil supplies, the price of sweet light crude dropped yesterday [August 11] by 75 cents to $113.70 a barrel.

Julian Lee, senior energy analyst with the Centre for Global Energy Studies, said: “It is quite remarkable that the world has lost one million barrels [per day] but the market has not really been bothered. It shows a fundamental shift in market perceptions.”

What it shows, Julian, is that an irrational herd mentality has seized the oil markets and no temporary event affecting supply & demand fundamentals can dent bearish sentiments at this time. Even oil inventories, which are in the lower part of their historical range, have not persuaded traders to bid up oil. All of this is quite the opposite of an equally irrational bullish sentiment that seized the markets in the run-up to $147/barrel. If the BTC had been shut down during the bulllish phase, prices could easily have jumped up $10 or more in a single day.

Other factors have lowered the price, including the latest dollar rally and the mysterious end of speculation by Morgan Stanley, Goldman Sachs and others, who were investing in oil futures at the same time that they were also forecasting higher prices, which had the desired effect of further driving up those prices. Actually, the speculation is simply going in a different direction; bearish traders are selling oil short now betting that the price will fall.¹ And of course, large volumes of shut-in oil count for nothing when you've got put options (The Australian, August 14, 2008)—

The market may have limited upside, however. As futures plunged, many traders took out puts, or options to sell, when oil hit various prices between $US120 and $US100 a barrel. Those options expire later this week [ending today], creating a natural resistance in the market to moving much higher than its latest settlement.

Oil price movements show meaningful trends over periods counted in years, not days or weeks or even a few months. Here's the latest version of what is rapidly becoming my favorite graph—I have finally learned that effective information marketing requires constant repetition.

               5-year Trend Line is shown in Gray; Also shown are the previous over-correction
                            and a possible over-correction in the coming weeks or months

The gray trend line reflects the supply & demand fundamentals over a 5 year period. Lately, those fundamentals seem to be undergoing a small but significant shift because world oil demand appears to have fallen a bit as a result of the exuberant price run-up—oil traders are presently sold on this shift. Unfortunately, the data, outside of weekly EIA reports, is too sketchy to allow us to draw any definite conclusions. The China demand data is clouded by preparations for the Olympics, and European total oil products demand appears to be flat (IEA).

If a significant demand shift has indeed occurred, this might imply a slight flattening of the 5-year supply & demand trend, assuming OPEC continues to pump oil at record rates. That's a big IF. Should oil fall below $100/barrel, it is likely OPEC will start cutting production. Thus we will likely re-live the skyrocketing price nightmare we saw earlier in 2008 sometime later this year or in 2009. So it goes.

In the past I have tried to emphasize that the harmful effects of peak oil will take many years to unfold. For those predicting oil prices falling back to $50/barrel (Barrons) or those saying prices of $500/barrel are possible in 3 to 5 years (Robert Hirsch), I would suggest that the truth lies somewhere in the middle. If I'm right, extrapolate the gray trend line (graph above) to see where prices are headed in coming years.

The Barrons view is based on an unrealistic view of supply and a misapplication of historical price cycles which no longer pertain in the peak oil era, while the Hirsch view is based on an unrealistic view of demand, which would be utterly "destroyed" long before oil reached $500/barrel or even $300. My own view is laid out in The Prognosis for the United States (ASPO-USA, June 25, 2008).

Russian Hegemony and the BTC

There is some scary talk coming out of Russia concerning the autonomy of Georgia and the fate of the BTC pipeline (hurriyet link op. cit.).

An adviser to the Russian parliament also claimed the closed pipeline would not be opened again and declared the line is "dead".

"The world and countries in the region have seen that not NATO, but Russia is the only one who could secure the energy routes," Alexander Dugin, international politics advisor to the Russia's Duma, told Turkish Cumhuriyet daily. "In this context, regarding Turkey's energy politics, it should be said that the BTC is not running at the moment and it will not run again."

Actually, the BTC will likely re-open next week but if it does not, one would hope that NYMEX oil traders will take note that as much as 850,000 b/d has been physically removed from the world market—this is far more oil than the recent U.S. consumption cuts. Russian troops "shelled" the BTC this week. The Wall Street Journal reports that "a neat row of large craters in a field in southern Georgia strongly suggests that Russia dropped bombs near oil and gas pipelines bringing fuel to the West."

Georgian officials say Russian warplanes dropped bombs in an early Saturday raid close to the Baku-Tbilisi-Ceyhan pipeline, which pumps some 850,000 barrels of crude a day -- or 1% of total global oil demand -- from Azerbaijan to the Mediterranean. The bombs narrowly missed the line, but one exploded just 10 feet away from it.

You don't always have to hit the target to make your point.

Russia's (Putin's) re-assertion of their traditional hegemony in the Caucasus may signal that Caspian oil is at risk not only now, but in all the years to come. This is bad news because Caspian oil is one of the few sources outside of OPEC that can provide steady or increased production in future years.

But after the mauling Georgia got, "any chance of a new non-Russian pipeline out of Central Asia and into Europe is pretty much dead," says Chris Ruppel, an energy analyst at Execution, a brokerage in Greenwich, Conn. The risk of building a pipeline through countries vulnerable to the wrath of Russia is just too high.

Putin runs a large risk if he attempts to shut down the BTC permanently, an action that would throw the oil markets into chaos. Russia has already demonstrated that they are an irresponsible actor in the natural gas markets, but the oil markets have been exempt up to now. Ruppel is no doubt correct when he says that additional pipelines carrying Caspian oil outside of Russian control are no longer an option. 

As crude oil gets more and more precious in upcoming years, strategic geopolitical moves to control a larger share of that oil will become more frequent. Putin (pictured left) has forcefully made his point about who will control the Caucasus. But before President George W. Bush further condemns Russia for invading Georgia, he would be well advised to ask himself who invaded Iraq. Small children and big nations—they tend to act alike.

Contact the author at [email protected]

Notes

1. In the case of stock, "short sellers borrow stock and sell it, betting the price will drop. If their bet is correct, they can buy new shares later at a lower price, repay the borrowed stock, and pocket the difference between the sale price and the repurchase price."

Growing Pains -- Climate and Peak Oil

You've got to be very careful if you don't know where you're going, because you might not get there.
I knew I was going to take the wrong train, so I left early.
If you come to a fork in the road, take it
     —Yogi Berra

The impending peak of world oil production is a tangible limit on liquid fuels growth, and a signpost pointing to other ceilings on natural resources. While there is some debate about whether coal supplies are similarly constrained, there is little doubt that anthropogenic climate change imposes a practical limit on how much coal humankind should burn. Similar difficulties will arise with natural gas production in the 2020s, with impacts coming sooner in the North American market.

The economic theory of non-renewable resources like oil and coal confidently states that as the price of these commodities rises, substitutes become affordable, eventually replacing the increasingly scarce originals. Thus we will substitute electricity (via plug-in hybrids as currently envisioned) for oil, and generate the electricity from a diverse number of sources—nuclear, fossil fuels, wind, solar, geothermal and hydroelectric. Another story says that we will partially replace oil with biofuels or coal-to-liquids (CTL) conversions. Matters get complicated in a hurry as we find ourselves scrambling to define the multitude of technofixes and efficiency measures necessary to replace the "simple" fossil fuels world we are accustomed to.

Consider this reference case graph from the EIA's Annual Energy Outlook in 2008.

I would like to call your attention to two aspects of this graph: 1) U.S. electricity consumption has been growing steadily since 1980, with most of that growth coming from coal-fired generation and natural gas; and 2) the projected share from all sources other than coal is just slightly higher in 2030 than it was in 2006, with renewables rising but natural gas, for which the share has been overestimated, falling. Thus, most future growth comes from coal.

I can already hear the strenuous objections! The renewables share is far too low in 2030, and perhaps the nuclear share as well, depending on who you talk to. The renewables line will rise as the coal line does, or to hear some tell the story, the renewables share will replace most of the coal-fired power generation. I will not be debating this point today. My story Al Gore's Fantasy Energy Challenge addresses some but not nearly all of the issues concerning how far and how fast renewables will replace fossil fuels.

The EIA's renewables projection appears to be a reasonable "ballpark estimate" of what the actual output (mostly from wind or solar thermal) will be in 2030, which is a scant 22 years from now. The problem lies with the EIA's assumption of growth in coal consumption (see below). Thus it is hard to assess what the renewables share will be because total consumption is a moving target.

Some people seem to think that I am against growing renewables because I have pointed out constraints on that growth. Nothing could be further from the truth. The burden of proof lies with those who argue that solar, wind, and the rest can replace all (or 90% or 50%) of the power generation from fossil fuels within a decade or even by 2030. The U.S. consumed 3814 billion kilowatt-hours of electricity (graph above) in 2006. I'm from Missouri—show me!

Another Look At Coal

It is entirely possible—some would say likely—that the United States, China, the EU, India, et. al. will lack the spirit of cooperation and political will necessary to reduce CO₂ emissions to combat global warming. This outcome places us in the "business as usual" (BAU) scenario (graph left from Hansen and Kharecha). Indeed, we are still on the BAU path in 2008 despite all the hand-wringing about climate change.

Once oil peaks, followed by natural gas in the 2020s, the Intergovernmental Panel on Climate Change (IPCC) and many others assume that humankind will burn huge amounts of coal thereafter. Jørgen Ørstrøm Møller's The Return of Malthus (The American Interest, July-August, 2008) puts it this way.

In the slightly longer run, the issue will not be so much the price of oil but the overall composition of energy sources. Substitution from oil and gas into other energy sources will occur, but more likely than a major shift to renewable sources such as wind energy or solar energy will be a switch to coal and perhaps nuclear power. If coal plays the major role, the global economy's dependence on fossil fuels will be basically unchanged. Here, too, prices for energy will rise because of the need for large investments in infrastructure...

Møller's viewpoint assumes that at least one of the pathways in the simplified diagram below scales up to a level which mostly replaces liquid fuels refined from oil over the long term.

What if neither direct coal-to-liquids conversion (e.g. via Fisher/Tropsch) or mass production of electric transport can scale up to the desired levels? For the moment, accept the premise that both technologies fall far short of the required scale. I am not going to argue this crucial point today, I just want to engage you in a thought experiment. I am also going to assume that CTL replaces less than 5% of oil products over the long term, which I regard as insignificant (graph left).

In the diagram, you could substitute renewables or nuclear for coal in the electric transport pathway, but I am concerned about coal for now.

In a world with a diminishing oil supply over the long term, and given the fact that biofuels production is largely constrained by our ability to tap the Earth's net primary productivity for this purpose, I fail to see how future economies can thrive & grow in the absence of a robust transportation system which remains largely dependent on liquid fuels in our hypothetical scenario.

If coal does not substitute for oil, oil prices are very high, and our ability to move commodities or manufactured goods around from place to place must therefore diminish in the future, and GDP levels in the world's economies are not growing (or falling) as a result, I fail to see how coal consumption would grow to the levels assumed in "business as usual" (or most other IPCC) scenarios.

I assume, as the EIA and no doubt the IPCC do, that coal consumption is generally a function of economic growth. Future CO₂ emissions from coal would thus fall well below levels assumed by the IPCC whether or not the Earth contains sufficient recoverable coal reserves to support IPCC emissions estimates over the long term.

If you accept this hypothetical argument wholly or mostly, you can easily see that the peak of world oil production has dramatic effects on future climate change scenarios if coal does not replace liquid fuels. And if the electric transport pathway does not scale, then it doesn't matter if you replace coal with renewables or nuclear. It is for this reason that I consider the substitution of electricity for liquids in transportation to be the key energy issue of our time.

A modified scenario in which we successfully electrify railroads, light rail, trolleys, lots of buses, etc. but do not (and can not) build hundreds of millions of privately owned plug-in hybrid vehicles presents a possible compromise solution. The problem in this scenario revolves around our ability to build the required infrastructure to support massive public transportation systems under sub-optimal economic conditions. This "middle way" scenario may be our best bet if electric transport only partially scales up, but it also requires us to mostly forego privately owned automobiles and light trucks.

If this scenario is completely wrong and happy motoring continues by other means, and renewables or nuclear can not replace coal, then the climate change argument limits future coal consumption. If we "solve" the peak oil problem in the transportation sector via electricity and do not have the wisdom to limit coal emissions, then it behooves us to determine how much recoverable coal there is left to burn. This estimate is important in all cases, but is especially important if electrified transport scales up and coal consumption is not curtailed.

I can not envision any pathway in which total U.S. energy consumption continues to grow (graph left) if humankind is going to address both peak oil and global warming. (Take the EIA liquids numbers with a grain of salt.) After peak oil, the end of energy growth is now here if we do the right thing about the climate.

A Tough Situation

We clearly have a tough situation on our hands. To prevent runaway CO₂ emissions, we should not burn any more coal than we do now. Preferably, we should phase out coal consumption by some percentage each year. Thus under reasonable assumptions about scaling up renewables or nuclear, U.S. electricity consumption, as with oil, must remain below present levels from now on. This conclusion seems inescapable to me—all contrary conclusions appear to be based on some sort of techno-optimist fantasy.

Crazy theories like "abiotic oil" concoct a story to justify our governing growth paradigm for petroleum. Less crazy electricity "growth" stories that strike me as being implausible include—

• very-large-scale carbon capture & sequestration (CCS) at coal-burning plants worldwide
• nuclear fusion, which is 30 years away and always will be
• very-large-scale storage of energy (e.g. via dammed water or molten salt) from intermittent power sources (wind, solar)
• a global power grid as proposed in Project Genesis (Global Energy Network Equipped With Solar Cells and International Superconductor Grids), or the lesser Solar Grand Plan  by which "solar power plants could supply 69 percent of the U.S.'s electricity and 35 percent of its total energy by 2050" (Scientific American, January, 2008).

Each of these stories attempts to buttress the flawed assumption of endless growth in human energy consumption even as we solve the peak oil and climate change problems. You can't have your cake and eat it too.

While it's true that we can wring a very large amount of efficiency out of our residential and commercial electricity consumption, perhaps enough "to offset almost all of the projected [new] demand for electricity in 2030 and largely negate the need for new coal-fired power plants," the unavoidable message remains the same—no more growth for you!

It is ironic that an environmental externality—climate change—may be the final straw (after peak oil) driving the end of growth in fossil fuels consumption, and thus put the breaks on total energy consumption growth generally in the 21st century. Thomas Malthus could not have imagined that.

Signing Off

I resigned from ASPO-USA a few weeks ago, so this is my last weekly column. I've tried to call things the way I see them since I started writing here in April, 2007. I've consistently tried to decide the questions I've written about with the best evidence I could find.

I never intended to be a futurist and admit freely that I can not predict long term outcomes with much certainty. On the other hand, the world is facing some huge problems, many of which I've never written about: degradation of the oceans, deteriorating soil quality, aquifer depletion, fresh water shortages, population growth, the current mass extinction, peak fish, and on and on—it's a long list.

I follow the rule of thumb that says strive for the best but prepare for the worst. I am a skeptic, but the world needs optimists, too. However, I can not abide a religious faith that things will just "work out" or an equally religious stance that the end of the world is nigh and we are all doomed. I still believe that Carl Sagan was right when he said that science is a "candle in the dark." We certainly need some candles, because there sure is a lot of darkness out here that needs to be lit up.

Thanks to ASPO-USA for giving me the opportunity to write this column. With that, I'll end today's story and my tenure here. Good luck.

Contact the author at [email protected]

 

Al Gore's Fantasy Energy Challenge

A little Learning is a dang'rous Thing;
Drink deep, or taste not the Pierian Spring
     —Alexander Pope's An Essay on Criticism (1709)

Recovering politician and Nobel Prize winner Al Gore gave a rousing speech last week urging America to move to renewables to power the grid by 2018.

Today I challenge our nation to commit to producing 100 percent of our electricity from renewable energy and truly clean carbon-free sources within 10 years. This goal is achievable, affordable and transformative. It represents a challenge to all Americans – in every walk of life: to our political leaders, entrepreneurs, innovators, engineers, and to every citizen...

Of course there are those who will tell us this can’t be done...

To those who say 10 years is not enough time, I respectfully ask them to consider what the world’s scientists are telling us about the risks we face if we don’t act in 10 years...

To be sure, reaching the goal of 100 percent renewable and truly clean electricity within 10 years will require us to overcome many obstacles. At present, for example, we do not have a unified national grid that is sufficiently advanced to link the areas where the sun shines and the wind blows to the cities in the East and the West that need the electricity [map left]

Gore's speech was not well received in many quarters because knowledgeable people don't believe his 100% goal is even remotely achievable. The former vice-president is no longer holds office, so he is not accountable to voters. Gore is more like Moses, who has gone to the mountaintop to receive God's 11th commandment that thou shalt not burn fossil fuels. Unfortunately, our civilization was founded on the abundant energy fossil fuels offer. We can not simply undo that dependency in a decade as we near the top of a growth curve that was made possible by burning coal, oil and natural gas.

Gore is motivated by the dangers of anthropogenic climate change. Some of these dangers are real, but unlike Dr. James Hansen, who has started to realize that IPCC doomsday carbon emissions scenarios are built upon unrealistically high estimates for remaining recoverable fossil fuels (perhaps including coal), Gore does not acknowledge any limit to the disaster that humankind faces as the Earth warms. Gore's undebatable assumption is that we will experience the Cretaceous "hot house" all over again. In energy matters, the former Vice President does not feel obliged to understand the issues. He just knows that burning fossil fuels is a bad thing.

The recent Nobel Prize winner has painted us all into a corner. Those of us who say "this can't be done" are naysayers, or to use a quaint phrase of an earlier era, nattering nabobs of negativism. I think setting an ambitious goal of a 15% conversion of the grid to wind, solar, and the rest by 2020 would have spurred us all to action. The feasibility of a 20% wind powered grid was vouched for in the Department of Energy's 20% Wind Energy By 2030.

After Gore's speech, suggesting a more modest goal will be regarded as timid or worse—defending reality will be portrayed as cynical corporate self-interest by climate extremists. And it is self-interest, for almost every single one of us is invested in an electricity grid that meets our demands, not just coal or natural gas companies. Those few who say otherwise must enjoy living in the dark or off the grid in solar/wood powered houses. Well-compensated climate change activists drive their cars and live on the grid, so there is a large element of hypocrisy at work here which is justified by elaborate fantasies about replacing fossil fuels.

Real Sacrifices

There are two general philosophies about solving our energy problems. You can grow you way out, or you can shrink your way out. These alternatives are not mutually exclusive, but do define two complementary approaches to the problem. Al Gore is exclusively a growth guy.

Think about steel. You can see the exponential price increase occurring in 2008 (graph left). The phenomenon is described in Lofty Steel Prices Could Keep Rising (IHT, May 19, 2008).

Steel prices have soared almost 50 percent this year and could rise even higher as the cost of raw materials keeps climbing and global demand shows little sign of abating.

Steel makers have been steadily raising prices to benefit from a strong market after years of decline in the industry and also to pass along to customers the spiraling costs of iron ore and scrap metal, two major components for making steel.

Others have regularly added a surcharge to shipments to cover the extra costs of making steel, which is in huge demand in China, India and other countries building up their economies.

What are wind turbines made of?

The contract signed by Bluewater Wind and Delmarva Power came with a clause that allows Bluewater to walk away without penalty if the project doesn’t look economically feasible within the next two years. Monday’s $800 million, 25-year contract is for a wind farm planned a dozen miles offshore of Rehoboth Beach...

Bluewater officials said the viability of the project also remains at the mercy of costs that still are estimates. The company will be moving forward with detailed engineering that will help pin down what it will cost to build the wind turbine farm, move the electricity to shore and connect it to the power grid through a substation.

Nathaniel Bullard, a Washington-based senior analyst with New Energy Finance of London, said one critical factor will be the the price of steel. “Everything in a wind turbine is steel: the tower, the gears, the control systems,” Bullard said.

The price of iron ore, a key ingredient in steel, has risen roughly 80 percent since last year. [Bluewater spokesman Jim] Lanard said Bluewater can build the project even if the price of steel increases...

The world may be facing steel shortages soon.

ArcelorMittal Chief Executive Officer Lakshmi Mittal said the world may be facing its first steel shortage in decades because of accelerating demand and a lack of investment when the metal was trading at lower prices.

"There is short supply; all steel companies are running at full capacity," Mittal said last week in an interview in New York. "We're facing for the first time in decades a potential shortage of steel."

Once shortages develop, price rises will be steeper than we've already seen, and projects will be delayed or canceled until the market comes into a new balance which could take many years to achieve. Some of those delayed or canceled projects will be wind farms. The DOE 20% Wind Energy report explains why wind energy prices have been rising since 2002.

• Shortages of turbines and components resulting from the dramatic recent growth of the wind industry in the United States and Europe
• The weakening U.S. dollar relative to the euro (many major turbine components are imported from Europe and there are relatively few wind turbine component manufacturers in the United States)
• A significant rise in material costs such as steel and copper as well as transportation fuels over the last three years

Even the recent vigorous growth in wind energy from a fairly small installed base has caused turbine shortages. "Randall Swisher, Executive Director of AWEA [American Wind Energy Association], told workshop attendees that if one ordered a new wind turbine generator today, one would have to place a sizable deposit in cash, and wait at least two years for delivery. This observation was confirmed by a number of other speakers."

Gore is calling for runaway growth in implementing renewable energy. Such "overheating" always leads to inefficiencies, inflation and shortages in economies. Pointing out that runaway growth causes all sorts of problems is not naysaying—this is just the way things work. Not every problem is a climate change problem, Al.

I chose one example (steel costs & availability) among many to illustrate the dangers of growing your way out of a problem. Another example would be the mass production of plug-in hybrid vehicles. No one really knows if this can be done. If the vehicles use lithium Ion batteries, can we extract lithium at the required rate? Some people think the answer is no. If the answer is no, then changing over the grid does nothing at all to solve our oil dilemma. If the answer is maybe, or a qualified yes, then 15 years is the absolute minimum time required to change over our vehicle fleet if we act aggressively.

There were 250,851,833 registered vehicles in the United States in 2006. That's an intimidating number. We'll have to move forward one plug-in at a time.

What about shrinking your way out of a problem? The former vice president could have suggested that we make a permanent 10% reduction in our electricity consumption in the United States within a decade while adding renewable sources to the grid at a reasonable but aggressive pace, phasing out coal as we go along.

You say you can't live in the desert without air conditioning? OK, don't live in the desert.¹ The taboo associated with partly shrinking our way out of the fossil fuels problem is so strong that Gore would rather scare the bejesus out of us and advocate a fantasy growth plan rather than tell people to turn out the lights and shut off the air conditioner. Sorry, Al, real sacrifices will have to be made if you want to solve the climate and peak oil problems.

Afterword

The world has become a crazy place. Honestly, I don't know if the world changed or I did—maybe it's always been a crazy place and it took me much of the last 15 years to figure it out. But the craziness does seem to be growing worse.

One major cause of all the craziness is the magnitude and apparent unsolvability of the climate & environmental problems, and the oil & other resource problems. We've dug ourselves into a very deep hole, and nobody knows how we're going to climb out of it while managing to avoid undue human suffering.

I define insanity as "disconnected from reality." In an insane world, human all-stars like Al Gore get to make crazy policy statements which then get taken seriously and undergo critical analysis as in this column. He states that his 100% goal is "achievable, affordable and transformative." No, it's neither "achievable" or "affordable." Such proposals for "solving" our climate or oil problems are akin to fantasies like Disneyland or Batman. For the record, Disneyland is a theme park and Batman was a comic book that spawned a series of movies.

Such are the times we live in. So, take this column with a grain of salt. I was merely pointing that Gore's premise is not connected to reality. I am appreciative of the efforts the man who won the 2000 presidential election has made in the past. Gore could be more helpful now if he tempered his goals to put us on a navigable road.

Contact the author at [email protected]

Notes

1. According to Andrew Revkin at the New York Times, Gore is "sticking with his preference for taxing sources of emissions and limiting costs for citizens...."

Peak Oil Is A Done Deal

It ain't over 'til the fat lady sings
    — anonymous

The fat lady is warming up
    — anonymous

I now believe that the hypothesis of a near or medium-term peak in the world's oil supply is confirmed beyond any reasonable doubt. A shift in emphasis that speaks to reducing our demand for oil and examining alternatives to oil is now required. I will be taking that road in the future, leaving specific concerns about the oil supply behind.

Today's story briefly summarizes why I believe "peak oil" is a done deal. This forecast¹ reflects my own views. This analysis does not necessarily reflect the view of ASPO-USA.

Global oil (crude + condensate) production will peak at 76.5 ± 0.5 million barrels per day (b/d) in 2011, ± 1 year, with a probability of 80%. There is a 20% likelihood that output will peak at another level—not 76-77 million b/d—between 2009 and 2013.

This estimate intentionally says nothing about the shape of the production curve after the peak. I stand by this forecast and will not be revising it in the future. A "peak oil" forecast examines the supply-side of the oil market, but reality dictates that high prices will affect demand. My estimate can thus be viewed as a "low price" or "reference" case that ignores the effects of rising prices. See the Summary for a brief discussion.

Saudi Aramco Update

Business Week published Saudi Oil: A Crude Awakening on Supply? on July 10, 2008. Steve LeVine's story should leave us with no doubt about what to expect from the Kingdom in coming years. Mysteriously, this story was not Front Page News in every media outlet all over the world.

Business Week received a  "detailed document obtained from a person with access to Saudi oil officials." The new information simply confirms what I already knew, but independent confirmation helps us reach firm conclusions. PFC's Roger Diwan, a respected oil analyst, vetted the Business Week document.

The data describes Saudi maximum sustainable capacity (table above). Capacity remains around 12 million barrels per day (b/d) for the next 5 years. An important shift occurs which should give us all pause.

One dramatic part of the data concerns a site called Ghawar, which has been the kingdom's workhorse field for decades. It shows the field producing 5.4 million barrels a day next year, but the volume then falling off rapidly, to 4.475 million daily barrels in 2013. "That's why Khurais is so important—to make up for that decrease," said the oil industry executive who released the data.

The long anticipated decline ("twilight") of Ghawar, the world's largest oil field, is reflected in the Saudi Light data (blue circle). If these numbers are accurate, Ghawar output declines 17% between 2009 and 2013. This works out to about 4%/year for each of the next 5 years. Production of "good oil"—not Manifa heavy sour oil (gray circle)—to offset these declines is supposed to come from Shaybah.

Though 2014 is not included in the data, one of the fields listed—Shaybah—is to have a volume increase to 1 million barrels a day that year, from 750,000 barrels a day from 2009 to 2013, according to the oil executive.

Simple arithmetic tells us that additions from Shaybah after 2013 will not offset Ghawar declines for more than one year. Business Week's source indicates that 10.4 million b/d is Saudi Arabia's maximum production level between 2009-2013.  This number confirms what I wrote in The Saudis Are Blowing Smoke Again (ASPO-USA, March 12, 2008). Whether the Kingdom will actually produce at their maximum sustainable capacity is another question. See Sleepwalking Toward the Oil Precipice to learn about setting correct expectations about OPEC production in the coming decade (ASPO-USA, April 30, 2008).

Khurais and Manifa are very likely the last large (≅ 1 million b/d) increments that Saudi Arabia will be able to put on-stream—ever.  A "paradigm shift" means the Kingdom is not going to knock itself out raising crude oil production to (best case) levels beyond 10.5 million b/d in the medium term out to 2012 or so, and will likely not be able to do so thereafter—Ghawar will not last forever, despite what Mr. al-Naimi or CERA think. Investment in additional capacity available after 2011 would have to be on the drawing board now, but there is no indication that Saudi Arabia has thought that far ahead.

[I should add now that Khurais and Manifa must meet capacity expectations for the Business Week scenario to come true. Also, most Manifa oil will likely be refined in Saudi Arabia, not exported.]

The Saudi peak is now in sight. Saudi Arabia is the only OPEC member that can raise production by any significant amount in the medium-term to 2013. The longstanding argument about the Saudis is over. 

The Non-OPEC Peak Is Assured

Oil supply growth outside of OPEC has slowed considerably in recent years despite a long list of new projects. Unfortunately, the amount of new oil coming on-stream looks better on paper than it does in actuality.

In February of this year, the EIA released its Outlook For Non-OPEC Oil Supply Growth in 2008-2009. The forecast boldly stated that the oil supply coming from outside the OPEC cartel would be 2.4 million b/d. The EIA has now revised their forecast as shown below (STEO, June 8, 2008). The revised numbers are shown in red.

In my now inaptly titled These Are The Good Years, I shaved 1 million b/d off the EIA's numbers (ASPO-USA, February 20. 2008). Even this downward revision was insufficient. The EIA now puts growth at 1.06 million b/d for both years combined. Apparently I was overly impressed with paper barrels. It is not a mistake I intend to repeat. Predictably, the EIA has pushed most of the growth into next year. They are still playing the pollyanna game.

In my Good Years column, I reviewed all the reasons why the EIA and other analysts have been overly optimistic about non-OPEC output. Delays are one factor, but the main reason for lowering forecasts is the overall non-OPEC production decline rate, and underlying rates for particular countries like Brazil or Norway. Now comes news that the International Energy Agency (IEA) has recalculated the global decline rate.

Project delays averaging 12 months, coupled with global average decline of 5.2% - up from 4% last year – are the factors behind these revisions. Over 3.5 mb/d of new production will be needed each year just to hold global production steady. “Our findings highlight again the need for sustained, and indeed, increased investment both upstream and downstream -- to assure that the market is adequately supplied,” stated [Nobuo Tanaka, IEA Executive Director].

It is crucial to understand that the decline rate outside of OPEC is higher than that within the cartel because non-OPEC oil includes the United States, the North Sea, Mexico, and other countries on the downslope of their production curves.  Thus, the IEA revision can only mean one thing: non-OPEC declines are accelerating. This is the main reason behind the EIA revision.

I am now going to switch gears and look at some data from the IEA's 2008 medium-term report covering the years 2008-2013.

 

You can plainly see why I called my review of the EIA's forecast These Are The Good Years in the IEA's data (click to enlarge, look left). The data also reflect the peak of Russian oil production, for no "key non-OPEC increment" is listed for the world's largest producer outside Saudi Arabia. I also believe the addition from the Canadian tar sands (ASPO-USA, January 2, 2008) has been overstated—it is the largest addition!

I am going to revise the IEA's forecast. First, I'm going to toss out their prediction for 2013. If we can't estimate next year's non-OPEC additions, how can we make a specific forecast for 5 years from now? Taking a closer look at the data, we see that OECD declines are minimal in 2009 and 2013. The 2009 estimate is understandable in light of the fact that both Atlantis and Thunder Horse are now on-stream in the Gulf of Mexico. Both fields will hit their maximum capacity (450,000 b/d combined) later this year or next year.

The 2013 estimate can not be trusted, however. Even if there are scheduled additions in the Gulf of Mexico in that year that compensate for OECD declines, we should keep in mind that both Atlantis and Thunder Horse were subject to 3-year delays beyond their initial start-up dates. The 2013 addition is suspect, and does not affect my peak estimate in any case.

Second, I am talking about crude + condensate, so I will toss out the ethanol, natural gas liquids (NGL) and refinery processing gains included by the IEA.

After revisions, I believe the net addition is approximately 500,000 b/d for the medium-term. If 2008-2009 are not the good years, and apparently they are not, then no amount of highly profitable light sweet crude from places like Ghana will save us. The non-OPEC crude + condensate peak in 2010 is all but assured.

The Rest of OPEC

We have figured out what to expect from the non-OPEC countries, and we know what to expect from Saudi Arabia. It is now a simple matter to figure out what the contribution from the rest of OPEC will be, add up all the increments, and make our "peak oil" prediction.

The next graphic shows the IEA's take on OPEC growth in the medium-term (below, click to enlarge).

 

The IEA's data shows that OPEC capacity rises 2.5 million b/d in 2008-2013, but we must revise that number based on the new Saudi data. In its June Oil Market Report, the IEA puts Saudi capacity at 10.65 million b/d. If we add 1.78 million b/d to this number (graph above), we get 12.43 million b/d. But we know that Saudi capacity never exceeds 12 million b/d in the medium-term, so the IEA has overstated that capacity addition by 0.43 million b/d. If the total OPEC addition is 2.5 million b/d, then the revised number is now 2.07 million b/d and the Saudi addition is 1.35 million b/d.

Regardless of the Saudi contribution, the "rest of OPEC" contributes 0.72 million b/d of new production capacity in 2008-2013. In the IEA's pie chart (graph above, right), the numbers do not add up to the supposed total addition of 2.5 million b/d. This "miscalculation" is understandable in view of the impossibility of assessing future additions from Iraq or Nigeria.

Now is not the time to get into a tortured discussion about whether "peace will break out" in Iraq or Nigeria allowing some production increases. I am going to accept the IEA's number of an addition of 0.72 million b/d outside of Saudi Arabia.

In Summary...

I am now in a position to add up the production numbers arrived at above, but first I need to establish a baseline. I will use the EIA's data (here and here) for May, 2008. The EIA's 4-month average for 2008 is 74.325 million b/d. Saudi production in May was 9.4 million b/d, up 300,000 b/d from April. I will add those barrels to the 4-month average to obtain a baseline of 74.625 million b/d.

We can now add our additions to the baseline. The non-OPEC increment is 0.5 million b/d, the Saudi increment is 1 million b/d, and the rest of OPEC increment is 0.72 million b/d. Together, these yield 2.22 million b/d. Adding this to the baseline, we get 76.845 million b/d. If you look back at both of the IEA charts, you will see that OPEC capacity additions fall off considerably in 2011, while non-OPEC additions drop after 2009. My view is that after 2011, we will never surpass production levels achieved that year.

The oil price is rising quickly. The higher prices preceding the peak are now dampening demand in the United States and elsewhere in the OECD. However, subsidized consumption growth outside the OECD (China, etc.) is still soaking up demand reductions elsewhere. I can not predict future oil prices with any certainty, and I can not predict future oil demand with any certainty, although I have discussed these subjects at length in other columns.

Obviously, I can not predict the exact shape of the world oil production curve in the next 5 years. What I can do, however, is establish a ceiling for world oil production should demand remain strong going forward. That ceiling, now and forever, occurs in 2011 somewhere between 76 and 77 million b/d.

We are so close to the peak now that quibbles about the numbers cited here do not matter. My familiarity with the oil industry justifies many of the "hidden assumptions" I've made and did not have time to discuss here. If you remain unconvinced that a peak of world crude oil production is not almost upon us, nothing I could say further will persuade you in any case.

As I said at the top, this is my official forecast and I will not revise it in the future. I will note for the record that in 2008, few Americans have come to grips with the implications of a permanent peak in the world's oil supply. I have done all I could over the last years to warn everyone about what's coming. My conscience is clear even as my concern remains high.

For me, the time has come to examine measures we might take in the post-peak world.

Contact the author at [email protected]

Beware Those Evil Speculators

He'll cheat without scruple, who can without fear
    —Benjamin Franklin

Charles Dingell (U.S. House of Representatives, D, Mich), Michael Masters (Masters Capital Management), and Abdullah bin Abdul Aziz Al Saud (the King of Saudi Arabia) all agree on one thing: greedy speculators playing a rigged game are behind the steeply rising oil price. This rare, exquisite consensus is described in Gas could fall to $2 if Congress acts, analysts say.

Testifying to the House Energy and Commerce Committee, Michael Masters of Masters Capital Management said that the price of oil would quickly drop closer to its marginal cost of around $65 to $75 a barrel, about half the current $135.

Fadel Gheit of Oppenheimer & Co., Edward Krapels of Energy Security Analysis and Roger Diwan of PFC Energy Consultants agreed with Masters' assessment at a hearing on proposed legislation to limit speculation in futures markets.

Krapels said that it wouldn't even take 30 days to drive prices lower, as fund managers quickly liquidated their positions in futures markets.

"Record oil prices are inflated by speculation and not justified by market fundamentals," according to Gheit. "Based on supply and demand fundamentals, crude-oil prices should not be above $60 per barrel." [emphasis added]

I've refrained up to now on commenting on the "speculators" theory in so far as I mainly believe that it merely represents another form of denial about the alarming oil market fundamentals. But with Congress ready to act to further regulate futures trading on the NYMEX, it's time to look at the situation more closely.

It's Mostly About the Fundamentals

Let's get the obvious out of the way. First, I am a "peak oil" writer. There is ample data to support the proposition that no or slow growth in the oil supply has caused production to fall behind burgeoning subsidized demand growth outside the OECD (in China, Russia, India, the Middle East). The supply & demand imbalance has caused the oil price to rise steadily (with one exceptional period) since the beginning of 2003. This is my "bias" in this discussion—it's mostly about the fundamentals.

Much of the exponential price rise we've seen in 2008 is not due to the market fundamentals, however. While it's true that the supply & demand imbalance is has become decidedly worse in 2008 due to stagnant oil supply growth outside of OPEC, there are substantial feedbacks between the weak dollar and the price of a commodity that is traded in dollars (Black Friday, ASPO-USA, June 11, 2008). Moreover, a bullish herd mentality now influences oil traders. Paul Roberts, author of The End of Oil, called it the oil speculator premium (Los Angeles Times, December 10, 2007).

Oil is, in other words, an inherently volatile commodity, and thus highly attractive to traders, who profit by betting on the daily and even hourly fluctuations in price. And while there's nothing criminal about betting on price, it is a problem when the bets themselves influence the price. If enough traders gamble that oil prices will rise over, say, the next 30 days, then the price of 30-day oil futures contracts will rise, which will eventually pull up the current, or spot, price of oil -- the classic self-fulfilling prophecy. And because traders are always looking for anything that might warrant a price increase (and thus, the placing of a bet), the smallest events -- unrest in Nigeria, for example, or even upbeat economic news (which implies greater oil demand), become potential catalysts for a price rise.

None of this would be happening if the oil market weren't as tight as a drum. There's hardly any surplus supply capacity. High oil prices since 2003 have failed to stimulate supply. Few believe that new oil coming on-stream will alleviate the situation. So the oil market is mostly working the way markets are supposed to work—lots of investors are betting the price will continue to rise because that's what the fundamentals tell them.

Yes, some of this is a "self-fulfilling prophecy" because higher futures prices do push up spot prices. But how much of the oil price rise is due to the influx of speculative money betting on higher oil prices? This is where things get hairy.

What's Going On at the CFTC and the NYMEX?

The image in the public mind depicts hordes of evil speculators who driving up oil prices by throwing scads of money into the buy side of the equation. Ronald Ripple, an economist Macquarie University in Sydney, recently made some comments on futures trading in the Oil & Gas Journal concerning the role of speculators myth (June 9, 2008, subscription required).

The open interest on [oil] futures contracts represents the number of contracts, and therefore the volumes of the underlying commodity, that are active and still constitute obligations on the part of buyers and sellers.

According to NYMEX, “The exchange’s core energy contracts ... stipulate physical delivery, although deliveries usually represent only a minuscule share of trading volume—less than 1% for energy—overall.” That a very small share of the traded volumes goes to delivery is not indicative of speculation. The majority of contracts (i.e., open interest) are held by commercial traders who are likely hedging the price risk they face on the physical units bought or sold in separate transactions... [graph left]

Commercial traders are those deemed to have an interest in actually acquiring the physical commodity, while noncommercial traders do not have such an interest. Historically, commercials have been associated with hedgers, while noncommercials have been associated with speculators.

Clearly, however, commercial traders have dominated, even in the recent past associated with the run-up in prices. For 2000-08, as much as 53% of the increase in long positions is attributable to commercial traders. So, more than half of the growth on the long side—the side typically associated with pushing prices higher—has been from commercial traders rather than noncommercials. [emphasis added]

According to Ripple, the bulk of the growth of "open interest" in NYMEX contracts results from hedging by commercial traders who are interested in acquiring physical oil, not non-commercial speculators buying and selling paper. It makes sense that commercial traders would want to hedge their bets as far as possible to mitigate risk in a highly volatile market driven by important but imperfect information about the shaky world oil situation.

Michael Masters and Michael Greenberger dispute Ripple's view. Greenberger is a professor of law at the University of Maryland and served "as the Director of the Division of Trading and Markets (T&M) at the Commodity Futures Trading Commission (CFTC) from September 1997 to September 1999." Greenberger testified before the Senate on June 3, 2008. Here's what he had to say about the distinction between commercial and non-commercial traders on the NYMEX. Futures trading is regulated by the CFTC. It's necessary to quote some passages from pp. 17-18 at some length.

Senator Lieberman‘s and other legislative conclusions about the adverse impact of speculation were doubtless driven by the testimony of Michael  W. Masters, Managing Member of Masters Capital Management, LLC, at the May 20 hearing. Mr. Masters showed that investment banks and hedge funds, for example, who were "hedging" their off exchange bets on energy prices on regulated exchanges were quite remarkably and inexplicably being treated by NYMEX, for example, and the CFTC as "commercial interests," rather than as the speculators they self evidently are. By lumping these investment banks and hedge funds with traditional commercial oil dealers, even U.S. fully regulated exchanges were not applying traditional speculation limits to the transactions engaged in by these speculative interests. Mr. Masters demonstrated beyond all doubt that a huge percentage of the trades in WTI futures, for example, were controlled by non-commercial interests. It is now clear that the CFTC in its pre-May 29 assurances had never before examined the positions of these "swaps dealers", because in that release it required these banks and hedge funds to report their trades to the CFTC and the CFTC committed "to review whether classification of these types of traders can be improved for regulatory and reporting purposes"...

Indeed, Senator Bingaman, Chairman of the Senate Energy Committee and Natural Resources Committee in a May 27, 2008 letter to Acting Chairman Lukken [of the CFCT], stated: "[I] remain concerned that the Commission‘s assertions to date—discounting the potential role of speculation in driving up oil prices—have been based on a glaringly incomplete set of data." Senator Bingaman referenced not only the likelihood of the CFTC not having adequate data on foreign boards of trade who do business in the U.S. or the over-the-counter unregulated futures markets, but the CFTC‘s sanctioned practice of "classify[ing] so-called  'swaps dealers'—including large investment banks [--] as 'commercial' market participants, alongside physical hedgers such as oil companies and airlines, rather than as non-commercial participants," the latter of whom would be subject to speculation limits. In other words, Senator Bingaman realized that when Messrs. Lukken and Harris [of the CFCT] had been assuring the Senate Energy and Natural Resources Committee that speculators played no role is the oil prices run up, they were not counting certain investment banks and hedge funds, for example, as speculators! [emphasis added]

The CFTC thus counts investment banks and hedge funds as "commercial interests," not speculators, so Ripple's data (graph above) is misleading. This regulatory debacle is further complicated by unregulated trading on the NYMEX in foreign exchanges, e.g. the London-Dubai Loophole or other unregulated exchanges like The ICE. We can therefore conclude that huge amounts of speculative money has flooded into the NYMEX as the "big money boys" bet that the oil price will rise, and helping it along as they do so.

The Heart of the Speculators Question

The heart of the speculators question concerns whether this huge influx of non-commercial money (liquidity) in the oil market has distorted the price beyond all reasonable recognition, or whether the influx of capital is the signature of a healthy market predicting higher prices based on the fundamentals, and thus driving up those prices.

The answer can not be black or white, for as Greenberger notes, "even U.S. fully regulated exchanges [NYMEX] [are] not applying traditional speculation limits to the transactions engaged in by these speculative interests." I am not sure what "traditional speculation limits" are, but if NYMEX futures transactions are not being regulated as they normally would be according to historical precedent, then we have a problem that has to be fixed.

On the other hand, the worsening market supply & demand fundamentals are crystal clear to anyone who has looked at the data. It is inconceivable that 50% of the oil price is due to speculation as Masters claims. Here's what Scott Nations of Fortress Trading had to say in the CNBC video below.

The [oil] price is what the price is... And it seems to me that the first part of a cure is to understand that you have a problem. If this is the discussion that we're having [about speculators], then the stock market is not even ready to admit that oil is a problem right now.

[Click on the picture to watch the video. CNBC's Rick Santelli notes that when the "front month" contract expires, there is no large sell-off of speculative paper contracts. He regards this as strong evidence that speculation is not driving the oil price.]

I incline to Scott Nations' view. Analysts who say speculation alone is responsible for 50% of the oil price, implying that the oil market fundamentals are sound, are a bit like alcoholics who need to join a 12-Steps program. So, Michael Masters, repeat after me:

Step 1. We admitted we were powerless over oil; that our lives had become unmanageable.

Onions, Oil and Stable Markets

The House of Representatives has "directed the CFTC to use all its authority, including the agency's emergency powers, to 'curb immediately' the role of excessive speculation in energy futures markets." The legislation passed by a vote of 402 to 19. A number of new bills are in the works which would create barriers to entry in the U.S. oil exchanges.

Fixes in the works on Capitol Hill range from new constraints on speculators — including a 50 percent margin requirement on financial speculators, full disclosure of all trading by investment banks in all markets, and prohibiting investment banks from holding energy assets — to a bigger role for the Commodity Futures Trading Commission.

It is clear that more regulation is required, but care must be taken to insure that over-regulation does not distort markets in a different way.

What can onions teach us about oil prices? Fortune Magazine notes that "the bulbous root is the only commodity for which futures trading is banned." And what has been the result? Huge volatility, much greater than that seen in the daily oil price fluctuations. The wild price swings (graph above left, cwt abbreviates hundredweight) "have reinforced academics' belief that futures trading diminishes extreme price swings." See the Economics of Oil Futures Trading for a discussion of how a well-functioning futures market smooths price changes and creates accurate price signals.

No proposal now on the table will actually abolish the oil futures market in the U.S, but Congress may do more damage than they know by severely curtailing futures transactions on the NYMEX. Tremendous price swings in a commodity like oil as seen for onions would make future planning impossible for everybody with a vested interest in the commodity (everybody). The mixed signals would confuse the supply & demand further, thus making reasonable demand responses to high (low) prices impossible.

What Changed in 2008?

For what it's worth, here's what I think happened in the oil markets this year: the long-term expectations about the future oil supply affecting the market balance going forward became more pessimistic.

Look at the EIA's forecasts for their high price case over the last 5 years (graph left, courtesy of George Asebius). World oil production now goes down in the high price case due to decreased demand. As Asebius pointed out to me, the EIA now regards its high price scenario as the most likely outcome. "Given current market conditions, it appears that world oil prices are on a path that more closely resembles the projection in the high price case than in the reference case." The International Energy Agency (IEA) has put out similar views over the last few years.

As "official" forecasts come more into line with "peak oil" views, the expectations of oil traders have changed to reflect the new reality. Naturally, non-commercial speculators want a part of the action. The oil market is mostly healthy even if it requires more regulation to prevent overheating at the moment On this view, changing market fundamentals drive the increase in speculative investments. They're not called fundamentals for nothing.

I believe¹ the effects of the weak dollar and the "speculator premium" account for about 20% of the current NYMEX price. A price "tumble" down to $110-$115/barrel would not surprise me at all Oil prices have dropped almost $10/barrel in the last two days. I believe that prices in this range are nearer to what the fundamentals dictate at this time. The oil price could stay at this relatively "low" level for a short while before resuming its inevitable rise. But a price slide to $60-$75/barrel is impossible because continuing tightness in the market precludes it. The soaring demand for middle distillates combined with the relative scarcity of light sweet crude oil does not permit such a market "correction."

Finally, oil could never drop to $60-$75/barrel because OPEC would cut production sharply to defend a floor price well above this level at $100/barrel or more, especially in light of the weak dollar. This would happen so fast that it would make your head spin, Mr. Dingell. Tell that to your Michigan constituents.

If you think speculators are entirely responsible for rising oil prices over the last 3 years, nothing I could
say will persuade you otherwise. Future events, however, will bear out the view that an irreversible historical shift has occurred in the oil markets. The "speculators" craze of 2008 will wither away as all insignificant twists and turns eventually do. Much of this talk just distracts us from the important tasks at hand.

Contact the author at [email protected]

Notes

1. Look at chart of the monthly average price for WTI crude.

I've added two rough curve fits. Do you believe the red line? Or do you believe the gray line? I believe the longer term trend is more reliable than the steep run up. So, I think the "fundamentals" price is about $110-$115/barrel, above where the gray line points due to changing expectations about the future oil supply. Do I know that I'm right? Not at all. Does anybody? No.

As Good As It Gets

A lie may take care of the present, but it has no future
    —anonymous

Deceptive statements now dominate the discourse on America's oil dependency in the 2008 presidential campaign. The confused debate about Republican supply-side measures versus Democratic demand-side measures entirely misses the central point: domestic oil production is about to experience a mini-peak in the years 2010-11 and then resume its inevitable decline.

Today I review the increasingly alarming domestic oil supply situation and the recent talk about drilling on America's outer continental shelves (the OCS). McCain now advocates this "solution" to the oil crisis. Previously I examined the inadequacy of Obama's energy policy in The Sierra Club Solution (ASPO-USA, January 30, 2008). This "solution" requires that Americans wait for cellulosic ethanol and plug-in hybrids, neither of which are ready for prime time, and neither of which will make a significant impact on our oil demand before 2020. Another column discussed why ANWR Is Not the Answer (ASPO-USA, June 4, 2008).

As Good As It Gets

Figure 1 shows the most likely outcome for American oil production out to 2025.

             Figure 1 — US Domestic Oil Production (crude oil + condensate) from 1990-2025
             Calculated with a 2% increase in 2009-2011 and a 1% yearly decrease thereafter

Outside the Bakken play in Montana and North Dakota, new domestic oil comes from the Gulf of Mexico deepwater. (This is called ultra-deepwater in water depths ≥ 3000 feet.) In the last 6 months, the two biggest deepwater projects scheduled in the Gulf after 2007 and for the next 5 to 7 years have already come on-stream—Atlantis (200,000 b/d maximum capacity) and Thunder Horse (250,000 b/d).

Both projects are operated by British Petroleum, and both projects were delayed approximately 3 years from their first announced start-up dates. These developments give Americans the slight "deepwater bump" shown in Figure 1. After 2011, the most likely outcome is that scheduled new deepwater projects do not add enough oil to offset Lower-48 declines. (Oil & Gas Journal, June 9, 2008).

The next few years are as good as it gets for American domestic oil production.

We have thus run out of time to debate implementation of proposed supply measures that won't take effect until after 2020 (Figure 1, link to Christian Science Monitor, June 30, 2008). As I argued in The Prognosis for the United States, Americans must start reducing their oil demand by about 300,000 barrels per day each year for the next 7 years (ASPO-USA, June 25, 2008). Even this cut may not be adequate to prevent economic chaos because the oil price is over $140/barrel now and rising fast.

An Offshore Drilling Guide for the Perplexed

How bad is the political discourse on boosting America's domestic oil production by drilling on the OCS?  Let's try to answer this question. President George W. Bush weighed in on offshore drilling June 18, 2008.

First, we should expand American oil production by increasing access to the Outer Continental Shelf, or OCS. Experts believe that the OCS could produce about 18 billion barrels of oil. That would be enough to match America’s current oil production for almost ten years. The problem is that Congress has restricted access to key parts of the OCS since the early 1980s...

What does "increasing access" mean? And who are the experts who "believe" that we can produce 18 billion barrels of oil? This sounds like a lot of untapped oil to voters who are uninformed about energy issues.

The "experts" in question dwell within the Mineral Management Service (MMS) of the U.S. Department of the Interior. Bush is referring to page 72 of the MMS report Comprehensive Inventory of US OCS Oil and Gas Resources, which formed part of the Energy Policy Act of 2005. The table taken from the MMS report (left) gives a "mean estimate" for "undiscovered technically recoverable resources" of 18.92 billion barrels of oil in the restricted offshore areas. Bush rounded down, not up.

What Bush does not say is that the total "endowment" of undiscovered resources in the OCS is 85.88 billion barrels of oil (2nd table left) according to the MMS. Bear in mind that these resources are undiscovered, meaning that this oil does not effectively exist until some oil company operator actually finds enough oil to make development commercially viable. Once the offshore leases are obtained, an operator must carry out actual exploration (using 3-D seismic surveys) and then drill some test wells to measure oil flows in areas that look promising, or prospective in industry parlance.

If we do the arithmetic using the imaginary numbers provided by the MMS, 85.88 − 18.92 = 66.96 billion barrels of hypothetical oil outside the environmentally restricted areas.

The Democrats seized on the opportunity presented by the imaginary 66.96 billion unexploited barrels in the unrestricted acreage. Jason Altmire (D, PA) carried some water for his party.

Let me be clear: I support domestic drilling and believe that the oil companies should immediately start developing the 68 million acres of federal land currently leased to them,” Altmire said. “It is estimated that this land could yield an additional 4.8 million barrels of oil each day, which would nearly double the U.S.’s oil production.

Additional confusion arises in Altmire's remarks. Where did these 4.8 million barrels "each day" come from? The number is not cited in the MMS report, which only estimates undiscovered resources in the offshore areas. Nancy Pelosi repeated the talking point the day Bush made his remarks (Environmental News Service, June 18, 2008).

If oil companies tapped the 68 million federal acres of leased land it would generate an estimated 4.8 million barrels of oil a day - six times what the Arctic National Wildlife Refuge [ANWR] would produce at its peak, Pelosi said.

"The fact is 80 percent of the oil available on the Outer Continental Shelf is in regions that are already open to leasing, but the oil companies haven't decided it's worth their time to drill there," the speaker said.

If we extrapolate from today's production rates on federal land and waters, we can estimate that the 68 million acres of leased but currently inactive federal land and waters could produce an additional 4.8 million barrels of oil and 44.7 billion cubic feet of natural gas each day. [this last paragraph is from Pelosi's website]

Six times what ANWR would produce at its peak. We are now comparing one imaginary oil flow to another, a breathtaking maneuver! Only extraordinarily skilled politicians can pull off this kind of deception. Don't try this at home.

Pelosi, McCain and others seem blissfully unaware that there is an Earth Sciences discipline called geology, and that within this field of study there is a specialty called petroleum geology. On what basis could you extrapolate future production from today's production rates? You can't, there is no basis. Some areas are geologically prospective, others are not. It is a matter of exploration & production. No doubt the most promising or most easily-accessed areas have been developed first.

The oil companies "haven't decided it's worth their time to drill [in lots of offshore acreage]" because geology tells them that no commercial oil exists there, or they haven't yet gotten around to exploring some of the prospective acreage. In the latter case, it is a matter of leasing scarce drilling rigs that have been designed to operate in the ultra-deepwater. Multi-year delays are common. Chevron must wait to obtain a drilling rig which allows them to drill another test well in the Jack/St.Malo Walker Ridge in the Gulf (Bloomberg, June 13, 2007). The new appraisal well must be drilled before a development decision can be made.

These constraints on drilling in "untapped" OCS exploration parcels (blocks) apply equally to the protected and the unrestricted areas.

It is part of the mission of the Energy Information Administration (EIA) section of the Department of Energy to estimate oil flows i.e. actual domestic oil production going forward. Their estimate of the  Impacts of Increased Access to Oil and Natural Gas Resources in the Lower 48 Federal Outer Continental Shelf (excluding Alaska) is shown in the graph (left).

Three data points stand out: 1) OCS production never reaches 2.5 million barrels per day; 2) including restricted areas on the downside of the curve does not alter the offshore production peak and 3) no production in restricted areas occurs until 2018, a decade from now. So much for Nancy Pelosi's extrapolation.

So, how bad is the political discourse? Opening up the protected areas is a red herring (the Republicans). Talk of boosting production in the unrestricted areas is a red herring (Democrats). Politicians are talking about producing hypothetical oil in a hypothetical future which everyone, including the EIA, agrees is at least 10 years down the road. This is as bad as it gets.

What About Conservation?

The 19th century German politician Otto Von Bismarck said "Politics is the art of the possible." In 21st century America, politics has become the art of impossible dreams. National Public Radio ran a very interesting segment the other day which asked the question Why Aren't Candidates Talking Conservation? (June 30, 2008). Day to Day reporter Madeleine Brand asked Jodi Powell, Jimmy Carter's press secretary, why the presidential contenders are not willing to stand up, as Carter did, and tell Americans the straight story on why they must cut their oil consumption.

Brand pressed the point that such a stand would be politically unpopular, but Powell argued against this interpretation, saying that Carter's speech in 1979 was well received among voters. In any case, don't expect either Obama or McCain to take such a stand while they are running for president. Telling people to use less is perceived, rightly or wrongly, as an unpopular message which will prevent election.

Powell did make an important point, however. He said that "we've fallen into a pattern of treating the American people ... almost with contempt." Transparent deceptions about hypothetical futures don't cut the mustard, they are insulting. As a friend of mine said, addressing what Americans must do now is the "price of admission to this [energy] debate."

It's time to call out McCain and Obama, demanding that they tell us what Federal policies they would enact to help us in the next few years, not in a far-off imaginary future. If the answers are unsatisfactory, as they no doubt would be, at least we can face the future honestly with our eyes wide open. Jodi Powell called America's lack of preparedness a "huge tragedy." He is certainly right.

Contact the author at [email protected]

 

The Prognosis for the United States

Procrastination is the art of keeping up with yesterday
     —the late George Carlin

The oil crisis is upon us. I hope to convince you that sharply curtailing our oil demand is the only and best way for Americans to negotiate the coming decade (2008-2018). To that end, I will construct three scenarios for you to consider in contemplating your future energy consumption.

High oil prices are starting to work the way economists think they should. A recent CERA report argues that U.S. gasoline demand peaked in 2007. It appears that vehicle miles traveled has also peaked. Despite these welcome trends, changes forced upon us by the unavoidable workings of the dismal science are likely to be inadequate to task ahead. The Econ 101 solution becomes harsher as time goes on as the phrase "demand destruction" implies.

The simple scenarios laid out below might persuade you that taking the initiative to reduce your liquid fuels usage will be necessary to maintain our collective prosperity. Early adapters of measures that reduce their oil consumption will be rewarded, for the race is to the swift. Vulnerable Americans who do nothing will pay the piper as the coming decade unfolds. (See NPR's More Workers Telecommuting, Seeking Closer Jobs, June 18, 2008).

Some Assumptions About the Oil Market

The downward "corrections" in world oil demand that accompanied the supply shocks of 1973-75 and 1979-83 (graph left) are unlikely to be repeated this time around. Back in 1970, demand in the more advanced OECD economies made up an astonishing 74% of global oil demand. In 2007, OCED consumption made up only 57% of the total. This rebalancing trend is set to continue.

Slow or no growth in the oil supply has combined with a demand shock from outside the OECD (Russia, China, India, Brazil, Venezuela, the Persian Gulf countries) to create soaring oil prices over the last 5 years. This demand shock will not abate any time soon, or at least not in time to save our bacon unless we take immediate remedial actions. New oil production will provide only limited relief. It is thus incumbent upon consumers in the OECD countries to be very aggressive in cutting their demand for refined products made from oil to reduce global competition for this precious resource.

The scenarios laid out below depend on three assumptions about future oil market fundamentals. I think these assumptions are reasonable although some pollyannas will disagree.

1. Oil consumption outside the OECD grew by 5.42 million barrels per day (b/d) in the period 2003-2007 (graph left). I assume that this trend will continue, with demand rising approximately 1 million b/d per year over the next five years. Growth may slow after that. If you look upon this assumption as overly aggressive, I would argue that fuel subsidies, especially in the oil exporters (Russia, the Middle East), will continue to drive this phenomenal growth. It is always wise to err on the side of caution. Subsidies never pay off in the long term, but I am not talking about the long term (a decade of more). Every country wants a large share of what promises to be a diminishing oil pie in the long run.

2. China is the main driver of non-OECD demand growth, so I want to emphasize that our expectations about their consumption should be in line with point #1. I assume the steep upward trend (graph left) will continue, despite China's recent move that raised state-controlled gasoline prices by 15.8% and diesel prices by 17.8%. The Chinese leadership is very worried about the country's 8% inflation rate, which will no doubt be exacerbated by partially lifting fuel subsidies. To tame inflation, China will continue to subsidize its oil demand.

3. I will make a "peak oil" assumption which goes as follows: oil (crude + condensate only) will top out at about 76.5 million b/d within the next 5 years. (The latest EIA March number puts it at 74.494 million b/d before the lastest Saudi increases.) This assumption, which may turn out to be generous, results in an average increase of 285,000 b/d per year over 7 years, but the supply growth likely won't gradual. The oil supply, when it can rise at all, tends to go up by fits and spurts, as it has this year after being flat for 3 years, and as it did in 2004. Addition assumptions are made concerning other liquids, not just crude + condensate.

   1. Natural gas liquids are plentiful, but do not affect the transportation or industrial sectors (outside petrochemicals) where most oil consumption occurs.
   2. So-called "1st Generation" biofuels production—made from the corn, not the stalk—peaks within a few years. I am including biodiesel from palm oil or other feedstocks and ethanol from sugarcane.

   We are mainly interested in the global supply of middle distillates (diesel, heating oils, jet fuels) and gasoline i.e. the high quality products made from crude oil. I am agnostic about whether the oil supply starts to decline or remains in a plateau after it peaks, at least for the purposes of this analysis. Supply will will be tight in any case. My supply-side assumptions depend on the probable OPEC production scenarios discussed in Sleepwalking Toward the Oil Precipice (ASPO-USA, April 30, 2008).

Three Simple Scenarios

Conceptually, each of the 7-year scenarios below is very simple. It is a matter of making compensatory demand decreases. For example, if non-OECD demand rises 1 million barrels per day in a year's time, and the crude + condensate oil supply increases 285,000 barrels per day, then OECD demand must fall by 715,000 barrels per day during that year to keep the oil market in approximately the same balance as it is today.

It is the ability or failure to achieve the necessary offsets that makes for relative reward or punishment in the OECD economies. It will take 7 to 10 years (or more) to make significant structural changes that decrease OECD (and America's) oil demand. Such changes include significant market penetration for gas-electric hybrids or plug-in hybrids, some "2nd generation" biofuels from cellulosic feedstocks, more ultra-deepwater oil production, building extensive light-rail transit systems, expanding the railroad system (in the U.S.), and restructuring the geography of work & living patterns to encourage fuel conservation.

American oil demand makes up 40.6% of total OECD demand (EIA data, two-month average for 2008). I will assume that U.S. oil consumption stays constant as a percentage of OECD demand in future years. The price elasticity of demand measures the sensitivity of consumption to price. Low elasticity implies that demand does not decrease much as the price rises.

• Scenario 1 — Buy Some Time
  Yellow Alert

  This scenario assumes a high price elasticity of OECD oil demand. Americans, Europeans, the Japanese, the Koreans and others are highly motivated to cut their demand sharply in the medium-term. The OECD countries achieve a 10% consumption cut over 7 years while keeping the economic performance stable at current GDP levels. The decreased consumption offsets non-OECD demand growth and sluggish oil supply growth, thus buying us some of the time necessary to implement significant structural changes. OECD consumers adapt well to high oil prices, which remain more or less at their current level. After 7 years, American oil demand comes in just below 18 million barrels per day. This is the "best case" scenario.

• Scenario 2 — Close But No Cigar
  Orange Alert

  This scenario assumes a medium-to-low price elasticity of OECD oil demand. The developed economies achieve only a 5% consumption cut after 7 years. Competition for oil (exports) goes up because non-OECD demand growth is not offset, resulting in an ever-rising floor price for crude oil. Americans are slow to make adjustments, or find it too difficult to do in an anemic economy with sharply declining home prices. The real price of oil (in 2008 dollars) rises above $150, a price level which is sustained for years at a time. The housing market never recovers.The economy is slowly strangled by an ever-tightening stagflation noose. The economy is intact, but just barely. School districts, city & county services, businesses, et. al. are hit hard but do not shut down.

• Scenario 3 — It's All Over Now, Baby Blue
  Red Alert

  This scenario assumes a very low price elasticity of OECD oil demand. The OECD nations achieve only a minuscule consumption cut in the next few years. Non-OECD demand growth and inadequate global supply are only slightly offset. Actually, a much larger consumption cut is "achieved" after 2010 because the economy is in a tailspin. Sustained prices of $200/barrel lead to the economic collapse. Demand takes a nosedive as duress causes the loss of many jobs when businesses (or public services) are forced to shut down. Home mortgage defaults are common. Driving becomes a luxury for many. Conditions are akin to the Great Depression for many Americans. Our quality of life deteriorates rapidly. This is the worst case.

Can We Buy Some Time?

I'd like to think we can buy some time, but my money is on Close But No Cigar. I'd also like to think that I'm the Answer Man, but I'm not. We're in terra incognita in 2008 and beyond. I've got a pretty good track record up to now, but prediction is notoriously difficult, especially if it's about the future (Niels Bohr).

The scenarios outlined here are not black or white. Instead, they are meant to delimit the range of possibilities as we think about the coming decade. The prognosis for the United States likely lies somewhere in this range but let's face it, all sorts of bad stuff could happen in the next five years in places like the Gulf of Mexico or the Middle East. Conversely, miracles are rare.

There are signs that the early adapters are busy making changes right now. Here's a partial list.

• looking for housing closer to work
• telecommuting and 4-day work weeks
• buying more fuel efficient cars or riding the bus
• shipping goods by rail

I would urge all Americans to start making changes now. Even if you are not feeling the pinch of higher fuel costs now, there is no guarantee that you are immune to future price hikes. You must think in terms of $5-6/gallon for gasoline or $6-7/gallon for diesel. The danger is that complacency will settle in if prices fall for a few months.

A major problem is that the structure of American society makes it difficult for everyone to make the necessary changes. There are just so many houses near useful public transit to go around. Inevitably, not all people will succeed. Those who are slow to move or unfortunate will be left behind.

The warning signs are there for everyone to see. It is hard to miss the stress in the trucking industry, the airlines, suburban school districts and other enterprises that are heavily dependent on liquid fuels. I have argued that cutting our oil consumption is the only sensible thing to do. If we achieve a 10% cut in the next 7 years, we'll buy some time to implement the structural changes necessary to meet the crisis.

On the other hand, if we insist on having senseless arguments about opening up ANWR and the outer continental shelves for oil exploration, then It's All Over Now, Baby Blue.

Contact the author at [email protected]

Saudi Arabia Rides to the Rescue?

We won't be fooled again.
     —The Who

With no oil price relief in sight, Saudi Arabia has promised to raise its production in July. Initial reports like the New York Times' Plan would lift Saudi output, claimed that the Kingdom would raise supply "by about half-a-million barrels per day [in July] ..., an increase [which] could bring Saudi output to a production level of 10 million barrels a day, which, if sustained, would be the kingdom’s highest ever."

These early reports proved to be overly optimistic. Saudi Oil Minister Ali Al-Naimi clarified the initial rumors in his meeting with Ban Ki-moon (AFP, June 16, 2008).

UN Secretary General Ban Ki-moon, after a weekend visit to Saudi Arabia, said Saudi Oil Minister Ali al-Nuaimi told him Riyadh would raise production by 200,000 barrels a day in July on top of a hike of 300,000 barrels made in June [together = 500,000 b/d]

"They will respond positively whenever there is a request from their customers, so there is no shortage," Ban said. "They don't want to be blamed."

Oil analysts give various numbers for Saudi Arabia's May production level. The EIA comes in at 9.40 million barrels per day (b/d), while Platts says 9.24 million b/d. The graph (left) shows the data series for 2007-2008 (through May) according to the EIA.  I prefer OPEC's numbers, even if they are based on "secondary sources" like the others.

OPEC's June Oil Market Report lists the Kingdom's May output at 9.134 million b/d (Table 14). The July increase would put Saudi Arabia's daily production at 9.634 million b/d in July. If Saudi Arabia achieves their stated goal, the total increase amounts to 1.05 million b/d above their average daily production in the 3rd quarter of 2007 (8.584 million b/d).

If the EIA's latest official number for world crude + condensate production (74.472 million b/d) in the 1st quarter of  2008 is correct, and Saudi Arabia makes the promised increases, and all else remains the same, then the world will be close to 75 million b/d in July. This tally would shatter the February, 2008 record (74.628 million b/d).

Assuming these production gains come to pass, it follows that reports of a peak in world oil production back in 2005, and the hypothetical demise of Saudi Arabia's ability to raise output, were, like rumors or Mark Twain's death, premature. Now that we've got the dreary numbers out of the way, it's time to look at the Bigger Picture.

OPEC Changes the Rules

Only a single American press report (that I could find) included the most important oil supply news so far this year. The new information comes from a Fox Business reprint of a PR Newswire Europe story on the latest Platts survey published on June 11, 2008.

The survey shows the OPEC-12 exceeding their 29.673 million b/d target by 77,000 b/d. A senior OPEC delegate said Monday that OPEC ceilings and quotas had become largely irrelevant and that OPEC had a "tacit" understanding that those members capable of boosting crude production should supply as much oil as world oil markets needed.

OPEC has suspended, at least temporarily, its function as cartel. The exporting countries are free to pump flat out. If we reach the 75 million barrels per day mark in July, that's likely to be very close to the maximum useful capacity the world has at this time. This is a scary thought because we are only one Gulf of Mexico hurricane away from an economy-wrecking price spike.

The Texas Railroad Commission (TRC) ended prorationing in 1973. Why is this relevant? This quote from A Brief History of the Oil and Gas Practice in Texas explains the connection.

With literally thousands of wells in open flow, the Texas Legislature recognized that the oil patch needed to be regulated to deal with the problems associated with unbridled drilling and production. The Texas Railroad Commission was the best-organized regulatory agency in the state at the time, so responsibility for oil field regulation was passed to the commission. The legendary Ernest Thompson led the commission in the enforcement of correlative rights and the application of field rules to assure orderly production activities.

The Railroad Commission succeeded in curbing the chaos in the East Texas Field. In order  to establish a floor on the price of crude oil, the commission introduced a system of prorationing. During that era, Texas was the swing state in oil production in the United States. By limiting the amount of production in Texas, a stable price for oil was established. The Texas Railroad Commission is reputed to be the model on which the OPEC oil cartel was based.

The TRC opened and closed Texas' [oil production] capacity between 1935 and 1973 to damp the boom and bust cycle in oil production and prices (Kaufmann & Cleveland, The Energy Journal, 2001). After U.S. production peaked in 1970, it was no longer necessary to regulate production to maintain a floor price for oil.

Like the Texas Railroad Commisson back in the day, OPEC has functioned in recent years to defend a floor price for oil. By lifting quotas, the cartel has acknowledged that rising prices are out of control and maintaining a floor price for oil is no longer an issue. OPEC now believes that very high prices may severely curtail oil demand eventually, as they did in the 1970s, causing a severe global recession which hurts the longer term outlook for the OPEC countries who want to sell us oil.

OPEC is intervening to drive down the oil price, but the damage has been done, its too late. Allow me to quote from my The Saudis Are Blowing Smoke Again (ASPO-USA, March 12, 2008).

If you want to point to a single factor that has contributed the most to oil's steep price rise since the 1st quarter of 2007, you needn't look further than this—the Saudis and the other OPEC countries kept oil off the market that winter to prevent an irrational price slide below $50/barrel just as production in the OECD nations continued its steep decline and other countries, like Russia, struggled to maintain production levels or put small new increments on-stream. Global supply fell further short of demand with each passing month and the volatile oil price has gone up ever since.

[See my ANWR Is Not the Answer for an explanation of the "irrational price slide below $50/barrel" that occurred between August, 2006 and January, 2007, ASPO-USA, June 4, 2008]

Given their production increases since August, 2007, it is now obvious that Saudi Arabia responded far too late to steeply rising oil prices in the 3rd quarter of that year. Saudi Arabia can no longer put enough oil on the market to lower the oil price much, or slow its rise much, although they might have been able to do so last summer.

Do Refiners Want More Saudi Crude?

Saudi Arabia is offering greater volumes of Arab Light (33.4° API, Sulfur 1.77%) and Arab Extra-light (37.2° API, Sulfur 1.15%) in the June/July production hike. Arab Light crude is called "sour" because of its high sulfur content. Refiners who can process this oil will take it only if Saudi Arabia lowers the asking price. US refiners see extra Saudi oil offer [as] too pricey tells the story (Reuters, June 16, 2008).

"They [the Saudis] can offer all the oil they want. The fact is they want too much for it. There's cheaper oil out there right now," said a trader with an independent U.S. oil refiner.

Saudi official selling prices for the United States currently list Arab Light ARL-OSP-N at a nearly $3 per barrel premium to comparable U.S. domestic crude grades like Mars MRS- -- even before the cost of shipping oil from Saudi Arabia is taken into account.

Traders said they would be willing to increase purchases of Saudi crude, if prices were lowered.

Asian refiners like China's Sinopec, who are operating at a loss, are "choosy" about the the oil they buy in order to keep their costs down (Reuters, June 16, 2008). Many "simple" refiners in Asia would prefer a crude mix that includes more medium or heavy oil, not the pricey Arab light Saudi Arabia is offering. They also want these lower quality grades at a reasonable price.

Although margins for processing the kingdom's heavier grades have plummeted, Aramco has also cut the discounts it offers on these grades to their lowest levels this decade, while keeping prices of its lighter grades at relatively high levels. [emphasis added]

In addition to keeping oil off the market in 2007, the Saudis have raised prices on all of their crude grades beyond what the refining market could bear. The Kingdom obviously cares deeply about the detrimental effects on global economies of the 2008 oil price shock.

A "Summit" on High Oil Prices

Along with the ½-a-million barrel increment the Kingdom the putting on-stream in June and July, the Saudi King has planned a handwringing festival to be held in Jeddah on June 22nd, where Mr. al-Naimi can blame speculators—certainly not himself—for intractable high oil prices.

The key part of the AFP story quoted above is Ban Ki-moon's startlingly honest statement that "[the Saudis] don't want to be blamed" for soaring oil prices. (This just goes to show that the Secretary General is new to oil industry politics, and does not understand the fine art of spin.) Avoiding blame appears to be Saudi Arabia's main reason for holding the summit.

Traders will be watching for the outcome of a June 22 meeting of oil producing and consuming nations in Jeddah, called by the Saudis.

"As we look ahead to this week, all eyes will be on Sundays 'oil price summit' in Jeddah," said analyst and trader Stephen Schork, in his Schork Report. "If the Saudis do not succeed in popping the balloon here, then off to $150 we go."

I've got a tip for you Stephen—it's likely to be "off to $150 we go." How exactly are the Saudis going to pop the balloon? Can they roll back fuel subsidies in growing China? No. Can they put ½-a-million barrels of light sweet crude on the world market? No. Can they buttress the sliding dollar? No.

This is not to say that there won't be a small price slide after the Jeddah summit. I expect that some very important people—everyone who is anyone is attending to show us how much they care—will raise the art of bloviation to new, unprecedented levels. This empty talk may move the markets lower for a few days. One can only hope that the Saudis will lower their prices to accommodate struggling oil refiners. This move, at least, would not be a token gesture.

The truth is that the Saudis know all this—no significant price relief is possible on the supply-side alone. After the Saudi increases, oil production near 75 million b/d will be close to the world's maximum output. It will take months for these Saudi increases to affect the markets, and by the time they do a few hundreds of thousands of barrels per day will amount to a small ripple in a big pond. We are living on a knife's edge.

The duplicity of Saudi Arabian officials in oil-related matters seems endless. It is suspicious that they have not been willing (or able?) to raise production until new Arab Light crude came on-stream from the Khursaniyah field. Saudi made too little investment in new oil fields earlier in this decade, and raising production now comes too late to alleviate the 2007-2008 oil price shock, a behavior pattern we will no doubt see repeated over and over again in coming years. They take no responsibility for their decisions. They insist, contrary to reality, that the oil markets are "in balance" and the price shock is merely a result of speculation.

There is a growing recognition that the oil crisis is not going away anytime soon. You wouldn't know that from listening to the Saudis. Here's my advice: Tune them out. We won't be fooled again.

Contact the author at [email protected]

Black Friday

I couldn't repair your brakes, so I made your horn louder
     —Stephen Wright

I don't know why the oil markets chose June 6th, 2008, to freak out¹. The upward price movement started the day before, but Thursday's rise was within the bounds of "normal" single-day volatility lately. On Black Friday, the NYMEX WTI price jumped up nearly $11/barrel during the call-out trading session between 9:30 AM and 2:30 PM EST.

A spate of bad news appears to have "caused" the price hike, but can we honestly say that any of these concerns, or even all of them put together, was extraordinary? Was there a profound shift in the market fundamentals? The answer is "no"—anxieties in the skittish market turned to full-blown panic. The fear-driven stampede reflects the high degree of uncertainty in the markets about the continuing devaluation of the dollar, conflict in the Middle East, unfettered oil demand growth in China and the Middle East, lagging supply growth, and last but not least, the poor health of the American economy.

Worries about America's Stagflation Show include soaring (and understated) inflation, future Fed interest rate policy, rising unemployment, the reeling housing market, huge write-downs in the financial community, soaring trade & federal deficits, and the price of corn.

Nobody can find solid ground to stand on, the magical price point that brings supply & demand into balance. Can this oil price spike go on? Yes, indeed it can. Is oil in a speculative bubble? Mostly not, but there may be a downward market "correction" at some point.

The only thing I can think of that would dampen the oil price at this point would be a a few large hikes in the Fed funds rate to deprive the economy of all the inflationary oxygen making oil traders giddy. (It might also help to close the Enron "loophole" as George Soros wants to discourage market speculation.)

Rate increases would curtail loans (and thus investment) in an already recessionary economy, thereby defending the dollar and taking some of the bite out of inflation by reigning in growth in the M3 money supply (St. Louis Fed). The current M3 number is unavailable because this data series has been

** DISCONTINUED **

An even slower economy would eventually put a large dent in American oil demand, an "involuntary" decrease dictated by ruthless "free" market principles. Our beloved Fed Chairman, "Helicopter Ben" Bernanke, is now hinting that inflation and the dollar are a concern. But this is an election year, and the fallout (joblessness, business failures) from raising interest rates would no doubt be severe.

The oil market fundamentals still predominate over other factors affecting the oil price. Among the other detrimental things driving up the price, untangling the relationship between the oil price and the declining dollar seemed most important because understanding this issue yields the most bang for the buck (least?) in terms of understanding why we are oppressed by soaring oil prices.

The Dollar Devaluation/Oil Price Death Spiral

If the relative value of the dollar falls X% and oil is denominated in dollars on the world market, the oil price must rise X% to keep its value. This is the simple numéraire interpretation of what is driving the oil price upward as argued, for example, in What's Going on in the Oil Market? (Daily Kos, June 7th, 2008). Econbrowser's Menzie Chinn discusses the issue in Does Dollar Weakness 'Cause' High Oil Prices? (October 31, 2007).

A causal flow is imputed in this discussion: namely dollar weakness causes the price of oil to rise, because oil is denominated in dollars. In the face of a declining dollar, with the relative price of oil being set in equilibrium, the dollar price of oil must rise...

The Dallas Fed's energy update for the 2nd quarter shows that the dollar has continued to slide, "propping up ... oil prices even further" (graph left).

The price differential between the euro and the dollar is dramatic. Only 75 euros (€ 75) were required to purchase a barrel of oil when this snapshot was taken, whereas the U.S. dollar price was $119/barrel.

All things being equal, if the dollar's value declines, the oil price will rise. But not all things are equal. Menzie Chinn created a similar, updated graph to put the price issue in perspective (Econbrowser, June 6, 2008).

One way of taking out some of the numéraire issue is to see how a price of a barrel of oil would be, expressed in other currencies. In the figure below, I compare the dollar price against that in euros, and against that in the Special Drawing Rights (SDR)...

What [Chinn's figure, like the one above] highlights is that while USD weakness is associated with higher dollar prices for oil, upward trends in all prices are evident...

The oil price expressed in euros has also risen sharply since the beginning of 2007, but not nearly so quickly as the dollar price in 2008. Another look the graph above reveals that a strong inverse correlation between the dollar's relative value and the oil price is only apparent since the 2nd quarter of 2007. The longer term relationship is not nearly so straightforward (See Chinn's "Dollar Weakness" article).

... the idea that it's just a numéraire issue -- weak dollar implies more dollars per barrel of oil -- does not seem to be consistent with a negative correlation between the real price of oil and the real value of the dollar, plotted in [the graph above left]

Other factors complicate the numéraire explanation. Chinn points out the two-way causality between the value of the dollar and the dollar price of a barrel of oil. "A higher relative price of oil should weaken a country's real exchange rate if it worsens the country's terms of trade." If a country is a large net importer of oil—like the United States—the trade gap worsens as the oil price rises (graph left). The U.S. News & World Report cites the increasing trade gap as a cause of the declining dollar (March 7, 2008).

The ongoing trade deficit for goods and services—which stood at more than $700 billion in 2007—has played a role as well. Although it has narrowed recently, the gap works to increase the supply of dollars in the global financial system, which pulls the currency lower.

If expenditures on imported petroleum exceed export gains due to a weaker dollar, the trade deficit grows worse. The Wall Street Journal's Oil Prices Pushes Trade Gap Wider updates the deteriorating situation (June 10, 2008).

The U.S. bill for crude oil imports in April increased. It totaled $29.34 billion, up from $25.03 billion in March. The average price per barrel increased by $6.96 to a record $96.81 from $89.85. Crude import volumes increased to 303.05 million barrels from 278.57 million.

The simple explanation put forward at the Daily Kos (and elsewhere) that the dollar devaluation is the primary cause of the oil price rise since the middle of 2006 is only part of the story. Dollars and oil are traded in separate markets which are not always mutually reinforcing, and causes are hard to separate from effects.

Nonetheless, the Dallas Fed's Crude Awakening estimates that "exchange rate movements accounted for roughly a third of the $60 increase in oil prices from 2003 to 2007." It's only in the last few months that matters have got out of hand as the devalued dollar/higher oil price dynamic spirals out of control.

The declining dollar has other detrimental macroeconomic effects on the oil markets according to the Dallas Fed.

A declining dollar makes oil cheaper for Europeans and other foreign consumers, propping up their demand. A weakening U.S. currency also reduces the dollar-denominated supply from foreign producers. Together, these two factors exert additional upward pressure on prices. Daniel Yergin, chairman of Cambridge Energy Research Associates, adds a third element in arguing that some investors have used oil as a hedge against the dollar’s decline.

It is indisputable that investors have used oil (and other commodities) "as a hedge against the dollar's decline", an obvious fact that we don't need Daniel Yergin to tell us. Moreover, speculation in the futures markets is playing a role, although on the last day of the trading period for the front month, you've got to sell or take delivery on the oil (CNBC video). Nobody appears to be hoarding oil, so the oil price on the last day of the front month contract is the market-determined price, speculators or not.

The Dallas Fed's other contentions are more doubtful. I am not aware of any country or oil company withholding oil from the market because the dollar's value is declining. Even within OPEC, little spare sellable oil capacity exists. Saudi Arabia and the rest of OPEC are following their own production policies as detailed in Sleepwalking Toward the Oil Precipice (ASPO-USA, April 30, 2008). Fuel protests in Europe  contradict the idea that the declining dollar is propping up demand there. Oil is not "cheaper" for Europeans, who must also bear heavy fuel taxes.

Consumers Caught in the Middle

The declining dollar/rising oil price death spiral leaves consumers subject to escalating prices for fuel, food, and just about everything else. Dow Chemical's across-the-board price increase of up to 20% on all of its products signals that inflation is now out of control. The dollar's devaluation means we must pay more for imported goods in addition to paying the higher costs engendered by rising oil prices. The spending outlook is bleak for the large majority of Americans caught in the middle of this price squeeze.

Will there be an oil price "correction" that brings relief to struggling Americans? When the price spikes as it did on Black Friday, the jump is not related to market fundamentals. At today's price of $133/barrel, the "bubbly" (non-fundamental) part of the current price may be as much as $25-$30/barrel, which puts the new "floor" price for oil in the $105-$110 per barrel range. However, no large price correction is possible unless at least two of the following three conditions are met—

1. the U.S. dollar regains much of its strength relative to the euro and the yen
2. the crude oil supply exceeds the modest gains it has made so far this year
3. subsidies on oil consumption are lifted in the Asian economies, especially China

I'll leave you to judge whether you think these conditions will be met any time soon. And remember this: any downward price "correction" that does occur is likely to be short-lived.

People concerned about "peak oil" usually give short-shrift to other economic considerations. Being essentially a (very) special-interest group, most of the attention goes to the lagging oil supply, and most of the supply discussion focuses on geology and depletion. It is important to remember that we are dealing with multiple failures regarding America's status in the global economy, although our perilous oil dependency will ultimately be foremost among them.

Contact the author at [email protected]

Notes

The term "Black Friday" has been applied to various single-day economic panics in American history. For example, the Fisk-Gould scandal in 1869. Only recently has been the term been debased to refer to the shopping binge on the day after Thanksgiving.

ANWR is Not The Answer

Surely some revelation is at hand;
Surely the Second Coming is at hand.
The Second Coming! Hardly are those words out
When a vast image out of Spiritus Mundi
Troubles my sight: somewhere in the sands of the desert...

And what rough beast, its hour come round at last,
Slouches towards Bethlehem to be born?
     — from The Second Coming, W. B. Yeats

Americans are easily misled about domestic "supply-side" solutions to rising oil prices and dwindling global exports. Their confusion is understandable. Oil company executives like Shell's John Hofmeister have called for opening up now restricted areas in Alaska or on the outer continental shelves, implying that salvation is only a few oil wells away.

The United States Geological Survey (USGS) or the Mineral Management Service (MMS) routinely assign huge reserves numbers to unexploited, presumably prospective, areas, but it is not clear to people that do not follow the oil industry that these agencies are talking about undiscovered oil.

The age of easy, cheap oil in the United States is over and done with (ASPO-USA, May 26, 2008). The Lower-48 peaked in 1970. The volatile shallow-water oil production in the Gulf of Mexico last peaked in 1998, forcing operators to move out to deeper and deeper water. The impressive development of Alaska's Prudhoe Bay in the 1970s will not be repeated elsewhere in Alaska onshore or off. Prudhoe Bay peaked in about 1989.

An Exemplary Story Never Told

Promoting supply-side solutions to America's oil crisis creates a dangerous delusion. Before turning to the Arctic National Wildlife Refuge (ANWR), I want to tell you an exemplary story because both time and memories are short. This article runs long as a result, but it's a good story.

I have marked up the NYMEX monthly oil price curve I used in The Age of Aquarius, where I explained the market fundamentals driving the oil price (ASPO-USA, May 14, 2008). Here is the new version.

The oil price took a downward turn in August, 2006. As you can see, the price had been volatile but rising from mid-2004 on. The August downturn could have been yet another price blip, but on September 5th, Chevron announced the successful Jack-#2 test well in the Walker Ridge area of the ultra-deepwater Gulf of Mexico. To a world starved for good news on the oil front, the Jack discovery was treated like the Second Coming.

I was writing for The Oil Drum (TOD) back then, and I duly penned (after consulting with oil industry insider "Bubba") Jack-2 and the Lower Tertiary of the Deepwater Gulf of Mexico on September 11th. I did not think Jack would have a significant impact on domestic supply in 2006 and I have not changed my mind in 2008.

The media repeated the claim of Chevron's geologists that there was between 4 and 8 billion recoverable barrels in the Gulf lower tertiary play. An energy illiterate public thought that sounded like a lot of oil. We could all continue to cruise to Wal-Mart in our GMC Yukons to buy cheap stuff made in China. No problemo.

The hype surrounding the Jack flow test was like a tsunami washing over peak oil people stranded on beaches all over the world. Business Week said there as plenty of oil, just drill deeper. Cambridge Energy Research Associates (CERA) played up the discovery, which was no surprise, asking whether this might be the biggest oil play in 38 years. Little did I know that CERA had some other tricks up their sleeve.

The dip in the oil price which had started in August became a nosedive as the Autumn progressed and the Jack discovery guided market sentiment on oil. CERA moved in for the kill, releasing their report Why the "Peak Oil" Theory Falls Down — Myths, Legends and the Future of Oil Resources on November 10,  2006. This was just what the world wanted to hear—these "peak oil" people are a bunch of nutters, we're all whackos. Soon we would be swimming in new oil, Adam Smith's free market having worked its magic once again. Daniel Yergin had a field day in the fall of 2006. CERA report sales were no doubt brisk.

Picking myself off the floor, and after consulting with Professor Goose and other Oil Drum editors, I sat down in a single marathon writing session to produce Does the Peak Oil "Myth" Just Fall Down? — Our Response to CERA, which was published at TOD on November 11, 2006. But the damage had been done. Take another look again at the annotated price graph.

The downward price momentum spurred on by the Jack discovery and the CERA report finally bottomed out in January, 2007 when the average monthly NYMEX price fell to $54.57/barrel. I have added a rough curve fit (dotted line) to the graph which shows that if the price had continued to rise on the trend since mid-2004, the oil price would be just about where it is today, about $124/barrel. The market fooled itself into thinking happy days were here again. Precious time required to address the oil crisis was wasted. Oil became, for a time, underpriced. Now, you can't even trade in the Yukon (Wall Street Journal, June 2, 2008).

And what of Jack? Chevron plans to drill another appraisal well sometime later this year. Commercial oil production is on hold pending the results and a development plan must be put together because the Walker Ridge is way out there in the Gulf many miles from nowhere—just like ANWR. And if BP's delayed Thunder Horse is any guide, don't get your hopes up for any oil from Jack (together with St. Malo) before 2014.

And what of CERA? Now they say oil has as reached a turning point—

What is now unfolding is an oil shock. The fact that the world could take $80 in its stride in the context of strong economic growth does not mean that a price that is 60 per cent higher at a time of a credit crunch will be so easily assimilated. The economic toll is mounting. Airlines are certainly in shock as they start charging for checked luggage to find a way to pass on their biggest cost. Carmakers are reeling. Retailers are tracking the shrinking wallets of their customers. The rising prices for food reflect, in part, the impact of higher energy costs.

My goodness, it's an oil shock! ἐδάκρυσεν ὁ ἰησοῦς—Jesus Wept (John's Gospel, 11:35).

The Jack story serves as a cautionary tale for those who believe supply-side solutions to America's oil supply problem are a magic bullet that will end our energy suffering. Let's turn now to ANWR to see what the future might hold for supply-side solutions there should the area be opened up for development.

ANWR Is Not The Answer

Realistic expectations about ANWR needn't come as any surprise to the media, oil company executives, elected officials or anyone else. The Energy Information Administration updated their 2004 report on the ANWR 10-02 area in May, 2008 (graph left). Their Analysis of Crude Oil Production in the Arctic National Wildlife Refuge is abundantly clear on what we can expect from ANWR.

The era of easy, cheap oil has come and gone. You don't have to take my word for it, just read what the EIA says about the timing of production at ANWR. I will only quote the highlights.  Look at page 3 of the EIA's report for the whole story. This section gets a bit technical. Sorry about that.

This analysis assumes that enactment of the legislation in 2008 would result in first production from the ANWR area in 10 years, i.e., 2018. The primary constraints to a rapid development of ANWR oil resources are the limited weather “windows” for collecting seismic data and drilling wells (a 3-to-4 month winter window) and for ocean barging of heavy infrastructure equipment to the well site (a 2-to-3 month summer window).

The assumption that ANWR oil production would begin 10 years after legislation approves the Federal oil and natural gas leasing in the 1002 Area is based on the following 8-to-12 year timeline:

• 2 to 3 years to obtain leases, including the development of a U.S. Bureau of Land Management (BLM) leasing program, which includes approval of an Environmental Impact Statement, the collection and analysis of seismic data, and the auction and award of leases.
• 2 to 3 years to drill a single exploratory well. Exploratory wells are slower to drill because geophysical data are collected during drilling, e.g., rock cores and well logs. Typically, Alaska North Slope exploration wells take two full winter seasons to reach the desired depth...
• 3 to 4 years to construct the feeder pipelines; to fabricate oil separation and treatment plants, and transport them up from the lower-48 States to the North Slope by ocean barge; construct drilling pads; drill to depth; and complete the wells...

[And so on]

In the mean resource case, ANWR production would commence in 2018 if all of these steps happened without delay. Production would ramp up slowly, culminating in a peak of 780,000 barrels per day in 2027. Production would then decline to 710,000 barrels per day by 2030.

As with Jack in the Gulf, the timing of this provides no help in an oil crisis that gets worse by the day. And this is the EIA making these predictions. The glass is never half empty for Department of Energy analysts.

What is the mean resource case? You need to know because this is the sticky point where the public gets mixed up. The EIA explains what the mean resource case, which is based on a 1998 USGS study, actually means.

In the mean [probability] oil resource case, the total volume of technically recoverable crude oil projected to be found within the coastal plain area is 10.4 billion barrels, compared to 5.7 billion barrels for the 95-percent probability estimate, and 16.0 billion barrels for the 5-percent probability estimate. Because the USGS 5-percent and 95-percent probability oil resource estimates are asymmetric around the mean estimate, the expected field size distribution and, in turn, the distribution of projected oil production are also asymmetric with respect to the mean estimate’s field sizes and projected production...

The mean probability estimate refers to a 1-in-2 chance of there being oil resources at least equal to the size of that estimate; the 95-percent probability estimate refers to a 19-in-20 chance of there being oil resources at least equal to the size of that estimate; and the 5-percent probability estimate refers to a 1-in-20 chance of there being oil resources at least equal to the size of that estimate.

The bottom line for ANWR, as for all the other unexplored protected areas in the U.S, is that we are talking about probabilities of how much recoverable oil will actually be discovered. The USGS presumes that there is a 95% probability of finding 5.7 billion recoverable barrels, and a 1 in 2 chance of finding 10.4 billion barrels. Other assumptions must be made as well. The mean resource case of 10.4 billion barrels is the supposed original-oil-in-place. How much of this imaginary oil does the USGS guess will be recovered?

The 1998 USGS ANWR assessment assumed an average recovery factor of 37 percent of the original-oil-in-place. This recovery factor is based on primary (pressure-driven) and secondary (water-injection) recovery techniques, but does not included tertiary (enhanced oil recovery) techniques, which can increase oil recovery by an additional 5 to 15 percentage points...

Between 2018 and 2030, cumulative additional oil production is 2.6 billion barrels for the mean oil resource case... [which is 67% of the  ultimately recoverable of 3.848 billion barrels]

Evaluating ANWR is a crapshoot¹ until you've drilled some test wells and assessed the oil flows, for "there is little direct knowledge regarding the petroleum geology of the ANWR region." That's why a significant part of the delay in developing ANWR comes from drilling these appraisal wells, as the EIA acknowledges.

It's still possible to drill a dry hole in the age of advanced 3-D seismic subsurface imaging, or drill a well which doesn't produce oil flows that justify commercial development. (Failed tests have occurred several times in the Gulf of Mexico.) One reason people got inordinately excited about Jack is that the #2 test well did indeed indicate commercial oil flows.

Press accounts, even fairly good ones like Arctic Drilling Wouldn't Cool High Oil Prices, assume that the 10.4 billion barrels is "the most likely scenario," parroting the EIA's production flows for the mean resource case (US News & World Report, May 23, 2008). I have described this kind of behavior before, where the media "treats a (probabilistic, geological) abstraction as if it had concrete or material existence." This is the definition of the verb to reify.

I could make similar remarks for other areas of Alaska, e.g. the Beaufort Sea, the NPR-A north slope area to the west of Prudhoe Bay, or the Chukchi Sea, where MMS leasing round #193 recently took place. At least Shell put their money where their mouth is, paying over $105.3 million for a single exploration block. The MMS believes "there is up to 15 billion barrels of recoverable oil reserves ... lie beneath the Chukchi Sea." Now you know how to evaluate this statement—see ANWR.

The Best Answers are on the Demand-Side

In the future we're going to throw every supply-side solution we've got at the energy scarcity problem, but the oil situation is special. Oil is so precious that we owe it to future generations to save some for their use. ANWR is a good case in point. We could start the development now and get some oil in the 2020s, or we can wait a little longer and see some oil some years later. I suspect our elected leaders will succumb to pressure within a few years and authorize development of the resource, but it will do nothing to alleviate our predicament in the next 10 years.

Americans have run through all the easily obtainable, cheap oil. Therefore, the best solutions are on the demand-side. We must consume less oil, that's all there is to it. Telecommuting, 4-day workweeks, car pooling, new mass transit systems, long-haul railroads to replace the airlines, you name it. All of this is a no-brainer. ANWR is not the answer.

Contact the author at [email protected]

Notes

1. The text continues: "The USGS oil resource estimates are based largely on the oil productivity of geologic formations that exist in the neighboring State lands and which continue into ANWR. Consequently, there is considerable uncertainty regarding both the size and quality of the oil resources that exist in ANWR. Thus, the potential ultimate oil recovery and potential yearly production are highly uncertain." [emphasis added]