Reading the Texas tea leaves

It's been a generation since oil prices tripled in 1973 because of the Arab embargo, and then quickly doubled again in 1979 when Iran's Shah was deposed.

The spikes focused a lot of attention on the possibility the world would run out of oil. Of course, few people noticed that it was international politics (along with the devaluation of the dollar), not geology, that caused the price run up; and domestic politics (in the form of price controls) that caused the shortages in the U.S. in the early '70s. In fact, in 1973, the world had yet to use seven-eighths of its total reserves of conventional oil (not counting tar sands and oil shale), and the North Sea and North Slope of Alaska fields were just starting to come on stream.

With the brief exception of the 1991 Gulf War (another political aberration) oil prices have been cheap for a long time now. And as recently as 1998, when crude dropped to $10 in the face of the Asian recession, it was about the cheapest, in real terms, it's ever been in history.

Right now the stuff is trading around $29, a relatively high level – but still a third of its real price in 1980. People ascribe that partly to an economic recovery in Asia, and partly to some unity in OPEC. But there may be something much more fundamental underpinning the high price this time: geological reality.

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Geology v. hysteria

As anyone with any sense knows, the talk about the world running out of oil is, from any practical viewpoint, nonsense and hysteria. Shortages will only appear in the case of major government intervention: war, price controls, embargo or quotas. That's because, in a free market, supply and demand are rationed by price. At $5, everyone would want more and production would cease; at $100, everyone would cut back and production would boom. That doesn't mean, however, that reserves of physical oil aren't constantly diminishing, despite vast improvements and efficiencies in finding and producing it.

My reading, in any given month, is about 50 percent science and 50 percent history and humanities. I try to avoid (with a few prominent exceptions) reading investment material, since most investment writers have surprisingly little knowledge of the world at large. Anyway, I'd rather go to the source, rather than have someone interpret what a third party thinks. For that reason, you may want to read an article entitled "The End of Cheap Oil," by Colin J. Campbell and Jean H. Laherr?re, in the March 1998 Scientific American.

Proved reserves

The authors, experienced petroleum geologists, make a compelling case that the next oil crunch will not be temporary or cyclical, but secular, which is surprising in view of the fact the industry reported worldwide proved reserves of 1,020 billion barrels of oil (GBO) at the start of 1998.

With current production running at about 25 GBO it would appear we have about 40 years worth of supply right now. And more oil is being found constantly. What could go wrong? I've always felt the oil supply was a non-problem, with the political caveats mentioned two paragraphs ago, albeit those are extraordinarily serious problems, in that the U.S. now imports most of its oil, and oil is the most political of all commodities. (U.S. oil production peaked at 11 million barrels per day (Mmb/d) in 1970; in 1998 production was 8 Mmb/d, with consumption running 19 Mmb/d, and imports of 11 Mmb/d making up the difference).

Most of the world's oil, and the only major fields that aren't now in decline, are in the Mideast – the very place (with the exception of Israel) the U.S. government seems most intent on antagonizing the indigenes. So I've always tended to be a bull on oil for political reasons, but a bear for geological/technological reasons. (See Chapter 23 of "Crisis Investing for the Rest of the Nineties.")

But Campbell, et al., have caused me to revise my thinking somewhat. They point out that 1) the reserve estimates everyone quotes are distorted, 2) consumption is not stable, but growing, and, most importantly, 3) that production inevitably declines from any field after about half the oil is pumped. They estimate that, including likely new discoveries, actual production will necessarily start declining before 2010.

Now that's in total contradiction to estimates by the likes of the U.S. Energy Information Agency, which, although it expects worldwide demand for crude oil to increase from 75 Mmb/d in 1998 to 112.4 Mmb/d in 2020, also expects lower world oil prices in 2020, for three reasons. First, higher near-term prices will stimulate drilling activity and increase production potential. Second, lower, long-term economic growth is projected for the Pacific Rim. Third, there will be higher non-OPEC production due to improved technology.

I can see the EIA's first point and third points, but their second point is bizarre. Right now China alone, with 20 percent the world's people, is using only 6 percent of its oil; India, with 17 percent of the world's people is using only 2.5 percent of the oil. By 2020 they'll both be on course to be vying with the U.S. and Europe for the top positions as users.

But Campbell goes much farther. He argues, compellingly, that world oil production is never going anywhere near 112 million barrels per day in 2020, because it's going to start declining for geological reasons (forget politics) in about 8 years. Indeed, it's never going above about 90 million, in any event, before it declines. In fact, Campbell now estimates the production peak will come around 2008, and from there drop about 3 percent per year. That's going to be a real disappointment to China and India, among others; it's going to mean, at some point, something like $5-10 gasoline for Americans. And that's not counting a lot of collateral effects.

The Hubbert Curve

This actually isn't new data, in that it was first published in 1956 by M. King Hubbert, who correctly predicted production from the lower 48 in the U.S. would peak around 1969, following a bell-shaped curve. The production curves of all other fields are equally predictable.

Figures show, as best as they can be put together, that about 800 GBO had been extracted from the ground from 1860 to the end of 1997 (not including the approximately 2 billion Sadaam burned in Kuwait), and about 1,000 GBO are still in the ground. Estimating reserves necessarily involves a degree of guesswork; geologists, therefore, assign probability numbers to them. For instance, if there is a 90 percent chance that the Oseberg field in Norway contains 700 million barrels of recoverable oil but only a 10 percent chance that it will yield 2,500 million more barrels, then the lower figure should be called the P90 estimate (P90 for "probability 90 percent"), and the higher figure the P10 estimate.

Unfortunately, however, when reserves are reported it's usually unknown whether they are P90 or P10, and the difference can easily be a factor of three or four. But it's a good bet the error is towards the more generous estimate, because when a company is making the estimate, it's better for the stock price, and a higher estimate offers a country a better bargaining position when oil is on the table for the purpose of quotas or loans. Campbell points out that, in the late '80s, six of the eleven OPEC members suddenly raised their reserve estimates by 300 billion barrels (140 percent of all the oil ever discovered in the U.S.) despite no major discoveries. Many reserves, worldwide, are political fictions. U.S. reserves are, however, all reported on a P90 basis even though P50 reserves, an average of the other two, tend to be the most realistic.

In any event, Campbell et al., using the best numbers they could assemble, and correcting for errors where possible, figure that the world's P50 reserves at the end of 1996 were approximately 850 GBO of conventional oil – about 15-20 percent less than accepted numbers. Most important, however, is the way the growth of oil reserves is figured. Most sources project the growth of reserves and production on a straight line at the same rate they've grown in the past. But with a finite, and determinable, amount of conventional oil left to pump, that doesn't make a lot of sense.

The argument is quite simple. Discovery peaked 30 years ago and has been falling since; 90 percent of the oil in existence has actually been located; and 80 percent of the fields in existence are now in decline, and decline curves are highly predictable. Despite huge advances in both exploration and production technology, discoveries in the 1990s averaged only 7 billion barrels a year. Last year production was close to 25 billion barrels, more than three times as much. And discoveries are dropping, while production is still rising. In essence, four barrels are now disappearing for every new one that appears. And there's no reason to believe spending more money will change the situation, since discoveries have continued dropping despite both vast improvements in technology, and the opening up of many countries that were previously closed to exploration after the collapse of the USSR.

The bright side

I'm a little chagrined with my acceptance of this argument, since it's reminiscent of the nonsense popularized by The Club of Rome/Jeremy Rifkin/Al Gore crowd, although their predictions of doom were made more from a psychological than a scientific basis. Still, there are several arguments, of varying quality, for optimism:

1. Giant new fields may be discovered in strange places not necessarily known for hosting deposits. Of course this hinges partly on the definition of "giant." A billion barrels is giant for any given company; but in a world consuming 25 billion barrels a year, it's not much. More importantly, advances in geochem and geophysics have pretty well ruled out major areas of the planet, such as true deepwater locations in the ocean. The Caspian Sea is probably worth about 50 GBO (about the size of the North Sea) not several hundreds of billions as sometimes reported in the media.
2. Higher recovery from existing fields. It's physically impossible, not to mention uneconomical, to extract the last barrel of oil from a field. In the 1960s 30 percent recovery was the rule; today it's more like 40 or 50 percent. Hopefully that number will keep growing. But it's a question of diminishing returns, and economics.
3. Reserve estimates are low. Although about 1,000 GBO is the accepted number, some authorities place recoverable conventional reserves at 1,500, or even 2,000 GBO. Certainly, doomsayers have been saying the world is going to run out of oil for nearly 100 years, and they've been hugely wrong. But there's reason to believe that estimates today are actually quite accurate. And even optimistic ones would seem to only move up the crossing of the supply/demand curve by 5-10 years at this point.

4. Tar Sand and Oil Shale. It's been known for decades that the Orinoco basin in Venezuela contains on the order of 1.2 trillion barrels of heavy oil. There are at least 600 billion barrels worth of oil shale in Colorado. And about 1.7 trillion more in the Athabasca oil sands in northern Alberta. And yet more in Russia. Perhaps a total of 10 to 15 trillion barrels of unconventional oil worldwide, enough for about 200 years almost any way you cut it. The problems are also well known: heavy metals, sulfur, huge water and energy consumption, immense capital costs and general environmental hysteria. And it's just not economical until oil goes much, much higher in price.

To my way of thinking, the best argument is that nanotechnology will both collapse oil consumption and make new oil production a non-problem in 10-20 years or so. I really don't think the long term is worth worrying about; and when I do think about it, I'm highly optimistic. But the problem of another oil shortage seems quite near at hand. And it's not just its political aspects, but real scientific ones that are confronting us.

Furthermore, since the only major fields in the world that aren't going into near term decline are owned by Iraq, Iran, Saudi, Kuwait and the UAE around the Persian Gulf, the scientific realities would appear to greatly complicate the political realities.

My conclusion is that we actually could see stunningly high oil prices over the next five years.