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Paying the Pumper

With the return of the highest oil prices since the energy crisis of the early 1980s, there are growing cries of alarm that the world is running out of oil. Some speculate that Saudi Arabia has reached maturity as a producing state and that its production will decline. Others cite the Hubbert curve, which postulates that once more than 50 percent of reserves are produced, output inevitably declines.

The world will not run out of oil soon, but there's still good reason for alarm. What the world is running short of is production capacity. There's plenty of oil -- we just can't get it out of the ground. It's important to understand some history to appreciate the problem.

Beginning in the 1960s and continuing through the energy crisis of the '80s, the oil industry was restructured. The Western international oil companies, which had controlled reserves and production just about everywhere except the Soviet Union and Mexico, had many of their largest assets nationalized by governments in such countries as Saudi Arabia, Kuwait, Iran, Iraq and Venezuela. These governments organized national oil companies to manage their resources. National companies are government agencies accountable to their governments first and the international markets second.

In response, competition among the international firms became intense as they focused on exploration in places where they were still permitted to invest: the United States, Canada, the North Sea and Australia. These companies diversified global oil production to the extent they could. With the development of sophisticated technology, they moved into deep-water production, notably in the Gulf of Mexico and off the coast of West Africa. Whenever a new petroleum province opened for investment, they tried to enter -- in Yemen, Colombia, the Caspian Sea and Russia. The technical and political risks were immense, and some large investments failed.

The indigenous oil industries in these countries, usually national companies, resist international foreign investment. They don't want the competition, nor do they wish to share the economic rent from the oil. When oil prices were low, and governments needed money, as in the 1990s, some foreign investment was permitted in certain countries, often over the objection of the national company. Substantial production growth resulted. Oil prices are now high, and most of the national oil companies are capable of meeting the financial requirements of their governments without foreign investment or interference.

The world economy is confronted with a situation in which there are large reserves -- more than in 1985 -- but in places where it is hard to tap them. The international oil industry is the only business in the world in which global capital cannot invest in the lowest-cost, most efficient production. National oil companies provide about 60 percent of the world's production but control 87 percent of the reserves, and their share will rise. Many commentators point out that a rising share of our oil will come from fewer countries, such as Saudi Arabia and Iraq. Should these countries continue to maintain their production, or even increase it, as we expect, there will remain the fundamental problem of increasing production capacity sufficiently to meet growing world demand. For example, sustained Saudi production is likely to grow by no more than 3 million barrels per day over the next 10 years, but worldwide demand, driven by the United States and China, is expected to grow by 15 million barrels per day.

The capabilities of the national oil companies vary widely. Some are as competent as the international firms, with excellent management and efficient operations. Others are deeply corrupt and lack the capital and skills to meet the sophisticated requirements of portfolio and reservoir management. Furthermore, exploration for new reserves can involve massive risks, which most governments are unwilling to underwrite, whereas the internationals, with huge balance sheets and diversified portfolios, are quite comfortable with these risks.

The thesis of the Hubbert curve is correct, but the conclusion that a fall in global oil production has inevitably begun is not. The Hubbert curve analysis applies where full commercial exploitation has taken place, but in many areas, other factors, including politics and policy, weigh in. It is true that production in most of the United States, Canada and the North Sea is in decline -- there, exploration and production have been exhaustive. But the most oil-rich areas, notably Mexico, Venezuela, Russia and the Middle East, have not been fully explored.

National oil companies may open up for investment if there are enough political and economic incentives. Production may also increase if there are changes in technology. This has happened many times before, most recently with the development of deep-water technology in the 1980s and '90s. One approach includes enhanced oil recovery from existing fields, where more than 60 percent of the oil often remains in place. Another breakthrough may come in efficient production from extra-heavy oil and tar sands, which is now very costly and capital-intensive. There are greater reserves of extra-heavy oil in Venezuela and Canada than in Saudi Arabia. Likewise, the industry has been seeking commercial breakthroughs in gas-to-liquids technology, converting natural gas reserves into ultra-clean diesel fuel.

Supply will increase if costs remain high long enough to justify the huge investments necessary. But oil markets have been cyclical for more than 120 years, and too much investment in capacity, as in the 1970s and '80s, inevitably leads to price crashes, followed by further commercial and political uncertainty.

Virtually every thoughtful policymaker knows that there is a serious problem in energy, but they are afraid to act. The U.S. government can do little to increase oil supply, but steps can be taken to reduce demand. Getting between Americans and their cars is the third rail of American politics. But if the American people refuse to accept some modest discomfort now, they will almost certainly be dealing with higher prices and serious economic disruption later. The obvious solution is for politicians to gather their courage and tackle demand.

The writer, a former assistant secretary of the interior, is chairman of PFC Energy, strategic advisers on international oil and gas.

© 2004 The Washington Post Company

Editorial Notes: "The most oil-rich areas, notably Mexico, Venezuela, Russia and the Middle East, have not been fully explored." No, but they have been extensively explored. Global discovery trends are on an undeniable down slope, and there is practically no hope that we can return to an era in which we are finding more oil than we are consuming. Some of the other assertions West makes are likewise, a bit misleading. Of course we can not predict technological advances, but we can understand some of the fundamental thermodynamic principles which make highly processed sources of energy unlikely to be able to provide us with as much energy as we are used to. There are other articles on this site which deal with reasons why shale oil and tar sands are not viable replacement fuels. Proponents of the Hubbert curve analysis, do not as West alludes, believe that it applies independent of politics. As many of the proponents point out, if it was not for the politically induced oil crises of the 1970s it is likely that oil would have peaked in the mid-1990s. The Hubbert curve is a guide, which serves much better than the 'fuel tank' model which states that oil will just suddenly run out without warning when we have finally used it up. -AF

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