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The perfect storm

No question is so difficult to answer as that to which the answer is obvious.
     —George Bernard Shaw

In a revealing interview with journalist David Strahan at this year's Oil & Money Conference, former head of Saudi Arabian exploration & production Sadad Al-Husseini told the world that he now believes that the current level of world oil production will likely never be exceeded. Al-Husseini's view coincides with that of T. Boone Pickens, who stated at ASPO-USA's Houston conference that the world oil production peaked in 2006. The 85 million barrels per day of liquids available to the markets now is all we're ever going to get if these oil industry veterans are correct.

Oil Prices Since 1994With demand rising and supply flat, prices must rise. Accordingly, Al-Husseini believes that oil prices will rise by $12 per barrel per year from here on out, assuming a "base" price level of about $70 in 2007. The nominal price is now just above $92/barrel, so the difference must be due to the usual suspects cited by the mainstream media, including speculators, the weak dollar, rising Asian demand, resource nationalism, geopolitics in the Middle East, disruptions in Nigeria, and Iraq. As always, we must add in the reason du jour, which last week was a possible Turkish incursion into northern Iraq to combat the PKK and other Kurdish separatists, a move that prompted an Iraqi threat to close down the Ceyhan pipeline. This week, stormy weather in the Gulf of Mexico has shut-in 600,000 barrels per day of Mexico's production. Problems with the long-term oil supply are rarely mentioned.

As noted in last week's peak oil Progress Report, the Nymex light sweet crude nominal prices have been rising for 8 years now, and especially since 2003 (graph above left). Each new price surge is seen as a fresh event, disconnected from the clear trend. Most news stories about the oil price make sure to note that the new nominal highs still fall short of the April, 1980 inflation-adjust price of $101.70. The real price is a moving target, so no matter how high the prices goes, the new highs never seem to match the 1980 record. But someday they will, and the comfort afforded to some by that observation will evaporate.

The Facts of Life

Peak oil is not an event that happens all of a sudden. You have to watch the supply numbers and oil prices over several years. If supply is flat or declining, demand remains strong and prices inevitably rise, then all the indicators of a peak in the oil supply are present. There is always the possibility that supply will rebound as prices spur greater investment, which would indicate a hiatus, not a peak, in the oil supply when seen in retrospect. However, if the supply-side is not responsive to strong price signals —i.e. the price elasticity of supply remains low—over a number of years, then a flat production curve provides stronger evidence that a peak, not a pause, is indicated as time goes on. If prices rise too high, too quickly, short-term demand will subside, thus temporarily masking the supply trends.

According to the EIA data, the world's all liquids monthly tally has stayed between 84 and 85.5 million barrels per day since January of 2005 after leaping an average of 3.509 million barrels per day in 2004 over the previous year. Al-Husseini joins a growing chorus of analysts who are convinced the current plateau signals that new oil provided to the market will not outstrip declining production stemming from depletion in the existing project base. It is even more disturbing that Al-Husseini expressed a negative view about the world's proved oil reserves

“[World] reserves are confused and in fact inflated. Many of the so called reserves are in fact resources. They’re not delineated, they’re not accessible, they’re not available for production”. By [Al-Husseini's] estimate 300 billion of the world’s 1200 [billion] barrels of proved reserves should be recategorized as speculative resources. [emphasis added]

Overstated reserves claims are "mainly in the OPEC countries." The world had used about 1.1 trillion barrels of liquids at year-end 2006. (See On the Likelihood of Peak Oil, ASPO-USA, May 30, 2007.) The world has produced about 25.3 billion barrels (all liquids) in 2007 so far. If Al-Husseini's proved reserves conjecture is correct, the world has now consumed well over 50% of its oil endowment as things stand right now, depending on the remaining reserves of natural gas liquids, and further assuming that the discoveries trend continues, and additions from unconventional sources (e.g. the tar sands) and biofuels will remain small. Al-Husseini told Strahan that he expects increasing oil prices to support the current production plateau for another 10 to 15 years, but beyond that, at a time when the world's oil fields will be severely depleted, it is hard to predict what will happen.

Al-Husseini thus predicts that the world may be able to produce as much oil as it does now in 2015, but the market-driven price for a barrel of that oil will be $166. But of course that will not be the actual price of a barrel of oil. The price is likely to be much higher than $166, even if the current plateau is sustained, due to numerous random variables affecting the oil supply in a volatile, tight market accompanying strong demand. That's what is happening now.

The real oil price will presumably surpass the 1980 high water mark well before 2015, assuming that the inflation rate does not outpace growth in the oil price. If it does, then rising capital costs in the oil industry will erode investment in new production capacity, further lowering the price elasticity of supply. (See Upstream Economics and the Future Oil Supply, ASPO-USA, August 8, 2007.) Tripling of the oil price since 2003 has not spurred greater production levels since 2004. Al-Husseini's assumption that steadily rising oil prices will work to keep production flat for 10 or 15 years may be overly optimistic.

What about the demand side? Al-Husseini notes that "demand destruction" is happening now, and will continue in the future as poorer oil buyers get priced out of the market. (See What About the Poor?, ASPO-USA, August 1, 2007.) The rate of demand growth in the OECD nations has slowed, while China and India continue to consume more oil each year like there's no tomorrow. Here is what Why oil prices are at a record high (Reuters, October 29, 2007) had to say about it—

While previous price spikes have been triggered by supply disruptions, demand from top consumers the United States and China is a driver of the current rally.

Global demand growth has slowed after a surge in 2004 but is still rising and higher prices have so far had a very limited effect on economic growth.

Analysts say the world is coping well with high nominal prices because, adjusted for exchange rates and inflation, they are lower than during previous price spikes and some economies have become less energy intensive.

Note that Reuters does not acknowledge any "supply disruption," despite flat production levels for the last 34 months. In fact, there are a number of disruptions to supply due to geological factors, geopoltical fiascos, et. al. What is missing is a single overwhelming rupture in the oil supply that explains rising oil prices.

The world—excluding the poor, who are always invisible—is "coping well" with high oil prices, so at least for the wealthy or industrializing economies, prices are not yet high enough to make a significant dent in demand. Perhaps oil will have to be priced at $120/barrel, or higher, to effect real changes in consumption patterns. This will happen in the 2010-2012 period according to Al-Husseini's scenario. Will the booming Asian or Persian Gulf economies be slowed by higher prices? It appears that no oil price is high enough to dampen subsidized demand in the oil producers. In China and elsewhere in Asia, rising oil consumption supports new industries that were "outsourced" from the OECD nations. Lower demand growth in the United States is an illusion: the demand was merely shifted elsewhere—see Wal-Mart.

Human Nature Weighs In

If the world is easily adjusting to higher oil prices, this is not good news. Complacency is explained by three related aspects of human nature—

  1. People react swiftly to immediate obvious threats to their well-being, not long, drawn-out historical events like peak oil, e.g. the Iranian revolution in 1979 as opposed to the situation today.
  2. Markets overvalue the present, ignoring what the past trends are telling them and discounting the future, which presumably will take care of itself, e.g. substitutes for oil will be available as needed. The inherent bias is toward a positive future which is never presumed to be worse than the past.
  3. Self-interest creates positive bias automatically, e.g. official statements from Saudi Arabia or international oil companies will never devalue their own future contributions to oil production.

All of the observations made here about supply & demand, as these relate to peak oil, can be explained by the interactions of these three "laws" of nature. Al-Husseini's statements are startling because his analysis runs counter to natural expectations. A former high-ranking official in Saudi Arabia's petroleum industry has essentially told the Oil & Money Conference that the oil supply will remain flat forever. Do not expect this revelation to roil the markets. On the same day Al-Husseini's analysis was published, oil prices went down about $3/barrel due to profit taking on the advice of Goldman-Sachs, who are usually bullish.

The Perfect Storm

The Perfect Storm Although it is impossible to predict the future, extrapolating present trends1 (strong demand, flat supply, ever rising prices) leads to "The Perfect Storm" sometime in the next decade. At the tipping point, oil prices exceed the pain tolerance of a sufficient number of global consumers, causing economies to roll over into severe recession. Complacency during the run-up has discouraged the development of substitutes for oil, so alternatives do not exist when crude becomes prohibitively expensive. Crippled economies and inflationary pressures will make it very difficult, if not impossible, to provide the capital expenditures necessary to create a new transportation system. Unlike the period following the crises of the 1970's and early 80's, the Phoenix does not rise from the ashes ever again. This scenario, which is based on al-Husseini's views, describes the end of the road we're traveling.

Sadad Al-Husseini has added a strong voice to those concerned about the peak oil issues. His analysis should not be taken lightly. Human nature is not on our side because there is no perceived crisis yet. Nonetheless, the world has a clear choice: act now before it's too late, or suffer the consequences. It's that simple.

Contact the author at [the original article at ASPO-USA]

1. From the Warner Brothers movie of the same name.

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