New Discoveries Insufficient to Avoid Peak Oil

The key point of Peak Oil isn’t about how much oil there is in the ground, or reserves, but the potential imbalance in extractive flows, or how much you can bring out of the ground at any one time. As a consequence, the world is facing falling production that will be hard to replace in the foreseeable future. Words: 2032

In further edited excerpts from the original article* Cam Hui (www.qwestfunds.com) goes on to say:

New Discoveries Insufficient to Avoid Peak Oil
To illustrate the concept of flows versus reserves, imagine that you had $1 billion in the bank but you could only take out $1 a year. You have lots of wealth (reserves), but you are short on usable cash (or extractive) flows. The International Energy Agency’s (EIA) 2008 outlook estimates that the world needs to replace production equivalent to six Saudi Arabias by 2030. Even if we were to assume that oil consumption stays flat to 2030, we would then need to replace four Saudi Arabias of production (instead of six). While these new discoveries do help alleviate future potential shortages, they are, to excuse the pun, a drop in the bucket in efforts to offset future production declines.

The Theory Behind Peak Oil
The theory behind what is commonly known as “Peak Oil” is that global oil production capacity cannot meet rising global demand. In fact, production capacity is expected to peak and begin to fall in the near future. When that happens, oil shortages will develop. The world is not running out of oil, but running into the Malthusian limits of extraction and production capacity.

An important assumption behind Peak Oil is that we are about to use up half of all of the extractable oil that there is in the ground. Once we hit that peak, production starts to fall. Meanwhile, world demand continues to rise, driven by industrialization and rising affluence in the developing world. When rising demand and falling supply meet, you get an energy shortage and rising prices. The realization that there are limits to production growth would highlight to investors the scarcity of oil as an energy source, as well as create constraints on world growth.

A Profile of Falling Oil Production
You turn on the taps and get a big ramp up in production, which is followed by a plateau and eventually by a slow decline until it is no longer profitable to keep the field running. What many analysts have done is aggregate the data for all oil fields around the world and create a global cumulative oil production profile. The depletion rates come to 4-6% when you come to the down slope, and the figures are corroborated by various sources like the IEA. That means a minimum of three million barrels of daily output is disappearing a year due to old age. In the meantime, announced finds that are due to come on stream can’t keep pace with lost production.

Putting Three Million Barrels a Day into Perspective
To understand what three million barrels a day really mean, the oil industry has gotten very excited about big finds such as Atlantis (Gulf of Mexico) and Plutonio (Angola). However such fields are only expected to produce 220,000-240,000 barrels per day. For another perspective, consider that the mammoth Ghawar field in Saudi Arabia produces 5 million barrels per day. We need six Saudi Arabias… Even if we assumed flat demand growth to 2030, we need to replace production equivalent to four Saudi Arabias.

When global oil production peaks or when the investing public gets a whiff of the prospect of a production peak, the markets will panic and energy prices will skyrocket. So for investors the question is “when is the peak?” The IEA estimates that the peak would be in 2020 under certain optimistic assumptions. Fatih Birol, chief economist of the IEA, stated a year ago:

“In terms of non-Opec we are expecting that in three, four years’ time the production of conventional oil will come to a plateau, and start to decline. In terms of the global picture, assuming that Opec will invest in a timely manner, global conventional oil can still continue, but we still expect that it will come around 2020 to a plateau as well, which is, of course, not good news from a global oil-supply point of view.”

Wow! Non-Opec production is forecast to peak in three to four years time (2012). Peak in world production by 2020, but only if Opec (massively) invests in its infrastructure in a timely manner. The world is currently gripped by a global recession. With oil well off its $147 high and prices volatile, who is willing to invest in significant new capacity under these conditions? The answer also depends on your definition of “oil”. Commonly cited statistics lump oil output with other liquids (condensates and natural gas liquids). As Qwest Investment Management president Maurice Levesque pointed out we may have seen the peak in crude oil production in 2005.

The Politics of Oil
The IEA forecast is dependent on a lot of things going right.
1. there has to be enough large discoveries and sufficient capital invested to raise output.
2. that demand and supply are market driven and supply is not affected by political considerations.

In reference to the aforementioned, if and when the public believes that a global production peak is around the corner, there will be tremendous pressures for resource nationalism. Oil exporting countries will be tempted to enact legislation “to keep the oil for ourselves”, or to use oil as a weapon. The blogger Fabius Maximus calls this process “political peaking”. Remember Canada’s National Energy Program in the early 1980s? That was an example of political peaking, albeit a few decades early.

Today, we are seeing another example of political peaking and resource nationalism in Brazil, where legislation is being enacted to “include additional measures to give Petrobras the upper hand in future rounds of bidding for the deep-sea deposits”. For an example of the use of energy for geopolitical gain, consider what Russia did with gas supplies to the Ukraine and Europe in January 2006. The dispute flared up again in January 2009. Both incidents not only affected natural gas supplies to the Ukraine, but curtailed supplies to the EU as well. Now think about what Russia might do if there were widespread concerns about Peak Oil. Moving to the Middle East, what might a new government’s policy be should the House of Saud fall?

Industrialization = More Energy Demand
Energy demand is being driven inexorably higher by growth in the developing world. As countries industrialize and become more affluent, higher living standards are contributing to increased energy consumption. In addition, high energy consumer appliances have become cheaper and more readily available. Many of the developed world’s lifestyle advantages are now within reach of more and more people in the developing world.

The Energy Information Administration (EIA) of the US Department of Energy’s 2009 outlook shows that most of the demand increase is coming from non-OECD (developing) countries. In fact, 63% of the projected demand increase is coming from the BRIC (Brazil, Russia, India and China) countries. Most of the remaining demand growth is coming from other non-OECD, or developing, countries.

What About Alternative Energy?
The Obama Administration has made it clear it wants to encourage the development of alternative and renewable energy. Will a migration to alternative energy be able to save us from impending energy shortages? Frankly, you need oil to get from A to B. There aren’t many good alternatives to petroleum based fuels for transportation. The last time I looked there weren’t any solar or wind-powered cars, electric ships or nuclear airplanes in production or on the drawing board.

Adoption times for new technologies are also an issue. Robert Hirsch’s best case analysis of how long a Peak Oil mitigation program might take finds that even after a 20-year “crash program” an aggregate output increase of about 35 million barrels of oil equivalent a day. That figure is roughly equal to the production of four Saudi Arabias, which would be not enough to alleviate shortages in the IEA’s forecast to 2030.

What About all the Big Discoveries?
There has been a flurry of large oil finds lately. Won’t they change the outlook? BP announced a “giant” discovery at its Gulf of Mexico Tiber field. Iran also announced some large finds over the summer. These headlines are a ray of sunshine after years of gloom about diminishing reserves. To understand the impact of the recent discoveries, let’s go beyond the headlines and look at the numbers.

Analyzing BP’s Gulf of Mexico Discovery
BP did not release an estimate of the size of the field, but major integrated companies do not use the term “giant discovery” lightly. It is said that BP hopes that Tiber will be on par with its crown jewel, the Thunder Horse development. Thunder Horse produces about 300,000 barrels of oil equivalent per day, which is about one-half of Alaska’s North Slope daily output. Even after a 20-year “crash program” to mitigate Peak Oil, Hirsch projects an aggregate increase equivalent to about four Saudi Arabias, which would not be enough to alleviate shortages in the IEA’s base case scenario forecast to 2030.

Iran: Technology, Capital and Politics
The Iranian finds are problematical in other ways. While the new discoveries affirm Iran’s position as a major oil supplier for decades to come, its infrastructure is aging, its technology lagging and the country has demonstrated a suspicion of foreign investors in its petroleum industry. Consequently, the country’s oil production capacity has remained flat despite a number of new discoveries in the past decade. The Iranian oil ministry spends about $3 billion a year just to maintain
production but they are currently having problems sustaining their current output because of a lack of technology. Given the size of the projects, significant capital and technology are needed to exploit the new discoveries. Without foreign involvement, production increases are highly unlikely.

Then there is the geopolitical dimension to development. Iran has yet to find an investor for its giant Azadegan field, which contains an astounding 26 billion barrels of oil equivalent. During the summer, a consortium of Japanese companies backed off a $2 billion contract with the Iranian oil ministry under US pressure. Iran’s infrastructure is aging and the country can’t get the capital to upgrade its technology. Iran’s oil production capacity has remained flat despite new discoveries in the past decade.

Peak Oil = Peak in Flows
There are several points to keep in mind about threat posed by Peak Oil:

 It’s about how much you can take out (flows), not how much you have (reserves); and the world is running short of flows.

 The IEA forecasts that the world needs to replace production equal to six Saudi Arabias by 2030. While these new discoveries are a welcome respite from the threat of an imminent collapse in oil production, these finds are not game-changers in big picture terms.

Today, the world is gripped by the Great Recession, which serves as a temporary reprieve as it has the effect of dampening demand growth. Global demand should begin its inexorable rise again as soon as economic recovery takes hold.

A century ago the world migrated from coal to petroleum as an energy source. Hopefully it can smoothly transition to new energy sources in a way that does not significantly disrupt the global economy. I expect that the transition period to be extremely bumpy.

The imbalance between oil demand and supply is likely to result in a decade long upward trajectory in energy prices, marked by volatility. The world is going to be running short of oil production in the not too distant future and these new discoveries don’t change that reality.

*http://www.qwestfunds.com/publications/newsletters_pdf/newsletter_october_2009.pdf

Editor’s Note:
- The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
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