Why the Wild Descent of Oil Is Cause for Concern

February 9, 2016

NOTE: Images in this archived article have been removed.

Image Removed

Oil photo via shutterstock. Reproduced on Resilience.org with permission.

The signs of oil’s madcap price collapse are everywhere.

Global markets now behave like digital roller-coasters from China to Europe.

Schlumberger, the largest oil field service firm, cut 10,000 jobs in 2016 and another 20,000 jobs last year. The champion of hydraulic fracturing posted a loss of $1 billion, too.

Throughout the world’s financial pages, economists have adopted a new noun: stagnation, stagnation and stagnation.

In Aberdeen, Scotland, former oil workers line up at food banks.

In Fort McMurray, Canada’s oilsands mining centre, Nexen shut down a 50,000 barrel a day facility — a dramatic first. Dogged by wonky technology and a recent explosion, the Long Lake steam plant consistently failed to reach production targets (70,000 a day). It extracted some of the world’s dirtiest oil.

Walmart, a conglomerate founded on the assumption that cheap energy will last forever, is closing more than 200 stores in the United States and Brazil, where the economy has gone south.

In the U.S., scores of energy companies dependent on fracking have gone bankrupt.

Every continental petro-state — Alaska, Alberta, Colorado, Wyoming, Texas and Louisiana, North Dakota and many others — has now declared extreme budgetary shortfalls due to huge drops in oil and gas revenue.

The International Energy Agency predicts "the oil market could drown in oversupply" in 2016.

And so, the descent of oil has become a sort of Sherman’s March on globalization.

The status-quo pundits say don’t worry. The world is awash in oil due to the brute force of fracking and Alberta’s faltering bitumen boom.

Markets are just experiencing another wacky correction in supply and demand, and business as usual will continue. Relax, add the pundits — lower energy prices tend to revive economies by putting more money in the hands of consumers, and all will be well.

But the global economy is now confounding academic theorists. Falling gasoline prices haven’t propped up the economy, or stimulated growth for that matter. In fact, global finance appears to be driving into another recession while debt grows, innovation disappears, capital investment recedes and wages stagnate.

So there must be another story.

A monster called ‘diminishing returns’

There is, and it’s a rather grim energy fairy tale. This one shows how the world’s economy depends on the quality of energy burned, and not the amount of money spent. When economies spend cheap oil, GDP rises; when they switch to costly and unconventional stuff, growth comes to a screeching halt.

In this unfolding story, cheap credit played a big role. It allowed an industry to carelessly borrow trillions to chase ultra-expensive and risky resources such as bitumen and shale oil.

An energy industry laden with toxic debt is now earning less money than what it costs to shovel bitumen or frack shale. And this kind of debt is not going to end well for financial markets. Or for ordinary people.

But the darkest character in this fairy tale is the monster called diminishing returns.

On a diet of cheap oil, the world financial system grew on energy surpluses like a wildfire dines on trees in a forest.

But no more. The cheap stuff is gone, and companies are now frantically fracking North Dakota at a cost of $60 a barrel or mining northern Alberta’s heavy bitumen at costs as high as $80 a barrel. With oil at $30 a barrel, many companies are, as respected Houston analyst Art Berman recently put it, "losing their asses."

Diminishing returns explain why. Imagine a 20-year-old vehicle that now costs more money to maintain than it does to drive. Every time the owner pours more cash and energy into the clunker, the benefits and rewards keep shrinking. An old car can be a treadmill into poverty.

In a 2014 paper for the Philosophical Transactions of the Royal Society, David Murphy, an energy expert at St. Lawrence University, chronicles what diminishing returns really mean in energy terms.

For every barrel of energy invested in global oil production, 17 are now extracted and turned into wealth. (Nearly 100 years ago, one barrel of investment yielded 100 barrels more, a cornucopia that built the global economy.)

But the industry must now drill deeper and deeper into ugly reservoirs and then fracture them apart to capture molecules of gas or oil. As a consequence, U.S. oil production yields only 11 barrels for every barrel invested, and that number is fast declining. Ultra-heavy bitumen and other unconventional hydrocarbons capture returns of less than 10 and in many cases as low as three.

Energy resources that deliver such paltry returns are civilization shrinkers. They cannibalize other resources and offer no energy surplus.

An investor’s nightmare

As Murphy notes, and as The Tyee has documented over the years, unconventional hydrocarbons require more capital, water and energy to extract. They destroy more land and deliver poorer energy returns. They are an investor’s nightmare and represent the end of business as usual.

Take fracking for example. The unpredictable technology now accounts for 25 to 50 per cent of a well’s drilling costs. It requires extensive real estate and lots of fresh water. Injecting fluids to crack rock underground not only creates earthquake hazards but also aggravates the billion-dollar liability of leaky wellbores. Furthermore, the industry admits that frack jobs don’t even work or hit the target zone about 60 per cent of the time.

One analyst recently noted that "this method of extracting petroleum is like grocery shopping in the supermarket with a backhoe. Yes, you did indeed scoop a lot of eggs into your cart, but look behind you. It’s a totally ham-fisted way to extract finite resources, unless the only goal is short-term maximization of production."

Diminishing returns also dog forms of renewable energy. You can only build so many wind farms, for example, before those turbines remove more and more of the energy from atmospheric motion and eventually reduce wind speeds. At that point, wind energy becomes a model of inefficiency, looking more like an Alberta steam injection well where industry boils water with methane to melt cold bitumen out of the ground.

The implications of diminishing returns for oil are stark: the more society invests in unconventional hydrocarbons, warns Murphy, the more "growth will become harder to achieve and come at an increasingly higher financial, energetic and environmental cost."

As society switches to energy resources of lower and lower quality, simply maintaining the flow of net energy to society will require that companies and nations accrue more debt to spend a proportionally larger amount of capital on gross energy extraction that comes with dirtier environmental impacts, such as carbon-spewing bitumen.

Diminishing returns from oil production "indicate that we should expect the economic growth rates of the next 100 years to look nothing like those of the last 100 years," writes Murphy.

Growing toxic debt load

That reality now seems to be unfolding on a global scale. The trouble really became apparent when oil prices leapt beyond $90 a barrel in 2010 and remained at unprecedented highs for four years. These high prices, in turn, put recessionary pressures on the global economy. Costly oil forced people, nations and firms to scale back and put on the brakes.

Meanwhile, Big Oil continued to borrow billions to extract difficult and unconventional hydrocarbons such as deep-sea oil, bitumen and shale oil. All required more capital and more energy to pull out of the ground.

In 2000, companies spent $400 billion a year chasing hydrocarbons. But by 2013 they were spending nearly $900 billion with little change in production.

The lenders and banks ignored the toxic debt and pretended it was business as usual. They poured money into shale gas and bitumen mining like gamblers at a casino.

Goldman Sachs now reckons more than half of the oil companies listed on the stock market spend five times more than what they did a decade ago chasing extreme hydrocarbons. As a consequence, they need an oil price of $120 a barrel to remain cash neutral in the future. In the process, they drove down the price of oil to $30.

In 2014, federal energy bean counters in the U.S. revealed that the energy industry was actually spending more than it was earning. The U.S. Energy Administration reported 127 of the largest oil and gas firms generated $568 billion in cash from their operations during 2013-2014, while their expenses totaled $677 billion. To cover the difference of $110 billion, the energy giants increased their debt load or sold off assets.

Given that the gap between earned cash and spending stood at a modest $10 billion in 2010, that’s a significant change for the industry as well as the global economy it fuels. Since then, the toxic debt load has grown larger.

Wood Mackenzie, an oil consultancy, now estimates that 2.2 million barrels a day of Canadian production is unprofitable with oil at US$35 a barrel, and most of that debt-inviting extraction is coming from the high cost and complex oilsands.

According to Berman, a consummate oilman and analyst, the shale and bitumen fairy tale is ending badly: "Cheap stupid money, because of artificially low interest rates, resulted in over-investment in oil as well as lots of other commodities.

"Over-investment led to over-production and eventually over-production swamped the market with too much supply and the price has to go down until we work our way through the excess supply."

Today, the majority of shale oil extractors in the U.S. and bitumen miners in Alberta are losing money. "Nobody can break even at less than about $45 a barrel, and that’s just reality," Berman says. "But everyone keeps on producing to generate some income to pay back their lenders."

And so oil prices stay in the doldrums, as companies pump costly, unconventional oil to service their debt.

‘All economies have finite lifetimes’

The recent collapse of oil prices has also turned economic theory on its head. After oil prices rise, economies tend to shrink and go into recession. But when they fall, economies are supposed to roar again as things get cheaper and wages go farther.

That’s not happening this time. The global economy is stagnating or shrinking, and energy demand, a big determinant of commerce and GDP, is slowing or going nowhere. In previous price downfalls, cheap oil has pumped up demand. That’s not happening now.

Gail Tverberg, an accountant and energy blogger, has an interesting theory about all this.

She believes that "all economies have finite lifetimes, just as humans, animals, plants and hurricanes do." She thinks that we may be "in the unfortunate position of observing the end of our economy’s lifetime."

A senior Ikea executive, Steve Howard, recently acknowledged the possibility: "If we look on a global basis, in the West we have probably hit peak stuff. We talk about peak oil. I’d say we’ve hit peak red meat, peak sugar, peak stuff… peak home furnishings."

Economists used to believe that when societies peaked, prices would rise, and energy products would become scarce. But Tverberg reckons the networked economy won’t necessarily behave that way. "High energy prices tend to lead to recession, bringing down prices. Low wages and slow growth in debt also tend to bring down prices. A networked economy can work in ways that does not match our intuition; this is why many researchers fail to understand the nature of the problem we are facing."

She adds that high oil prices expertly disguised the brutal reality of diminishing returns. Whenever an industry or society blows up the principles of efficiency by getting on a treadmill with no efficiency or gain in energy returns, there is no growth. But there is stagnation and political unrest.

Tverberg worries about toxic debt loads, too. As energy gets more expensive (and renewables are expensive and fossil fuel dependent, too), society has to borrow more money to keep a global clunker on the road. Tverberg notes that you can only dial up the debt for so long before you "discover that debt growth has a lot of adverse effects. And one of the big ones is that it tends to funnel money to the wealthier class and take money away from the poor members of society."

A peak world and complex society faces a conundrum: high oil prices shrink the economy while low oil prices destabilize it due to diminishing energy returns.

There may be some temporary solutions, but they involve ending cheap credit, shutting in at least a million barrels of oil, and regulating the price of oil as the Railroad Commission did in the 1930s. But our politicians cling to the myth of constant growth and have no idea what the real problem is.

"Things aren’t working out the way we had hoped," explains Tverberg in one of her insightful blogs. "We can’t seem to get oil supply and demand in balance. If prices are high, oil companies can extract a lot of oil, but consumers can’t afford the products that use it, such as homes and cars; if oil prices are low, oil companies try to continue to extract oil, but soon develop financial problems." The lesson? Expect more volatility not just in oil prices, but financial markets and political institutions. Expect more debt and economic contraction. The commodity that destabilized the climate will not let go of its grip on the global economy without many convulsions. We are in full energy transition without a guide.

Diminishing returns, just like rising expectations, do not bring out the best in people: expect violent reactions and revolutions in petro-states and indebted nations. Expect the unexpected and a narrative of volatility.

"Unfortunately, what we are facing now is a predicament, rather than a problem," reflects Tverberg. "There is quite likely no good solution. This is a worry."

Andrew Nikiforuk

Andrew Nikiforuk has been writing about the oil and gas industry for nearly 20 years and cares deeply about accuracy, government accountability, and cumulative impacts. He has won seven National Magazine Awards for his journalism since 1989 and top honours for investigative writing from the Association of Canadian Journalists.

Andrew has also published several books. The dramatic, Alberta-based Saboteurs: Wiebo Ludwig’s War Against Big Oil, won the Governor General's Award for Non-Fiction in 2002. Pandemonium, which examines the impact of global trade on disease exchanges, received widespread national acclaim. The Tar Sands: Dirty Oil and the Future of the Continent, which considers the world’s largest energy project, was a national bestseller and won the 2009 Rachel Carson Environment Book Award and was listed as a finalist for the Grantham Prize for Excellence In Reporting on the Environment. Andrew's latest book, Empire of the Beetle, a startling look at pine beetles and the world’s most powerful landscape changer, was nominated for the Governor General’s award for Non-Fiction in 2011.