7 reasons to doubt the oil optimists

Recently I wrote about "Trough Oil": the idea gaining  ground that Peak Oil pessimists were wrong and that oil going to become abundant and cheap in the coming decades.

I laid out the causes for such optimism in the original article but in this follow up piece I am focusing on the counter-arguments: why increasingly hard to satisfy oil demand will continue to keep oil prices high for decades.

1.  The current oil price

If new sources of supply are coming and demand is set to fall, why is the oil price so high?  Even with a hard landing in China, crisis in the Eurozone and world trade volumes crashing the oil price is stuck well over $100 a barrel for Brent crude.  Most oil traders expect it to remain so for the next couple of years at least - forecast.  By comparison weak demand conditions have ushered in $20 or even $10 oil in the past. These market insiders are telling us that the oil market fundamentals are still tight.

2.  Maybe production did peak in 2005

Oil production has actually risen in recent years but look behind the numbers and there have been changes since the middle of the last decade.  Production growth has slowed despite trillions of dollars of investment and Saudi Arabia, long seen as the world's "swing" producer, pumping at record levels.  See chart here:  world oil supply is not growing very much.

Secondly the proportion of oil output that isn't actually oil has increased.  Natural gas liquids are the main alternative to crude but have about 70% of the energy value which is why they sell for less.  Others include ethanol which is only viable thanks to what I would argue are crazy and damaging government mandates which are becoming increasingly controversial as food prices rise.

3. Production costs put a floor under the price

All the new sources of supply people are talking about come at a price and it is not much lower than $100 in many cases.  For example the Canadian tar sands oil extraction process uses a lot of water and energy to make something usable and this can cost $60-80 a barrel.  Approximately 2 million bpd now comes from this source so it's not small beer.

Other new sources such as US shale production, including 0.5 million bpd from the Bakken fields on the US/Canadian border, are cheaper but they still use a lot of water and energy and exact an environmental price critics say.

It is the marginal cost of the last couple of a million bpd that matters when it comes to setting a minimum oil price and that cost is rising.

Peak oil was never about oil "running out" - it's more that the big (easy) fields are declining faster than new sources can be economically developed.  That assumption still looks to hold and preludes the possibility of the oil price ever returning to much below 80$ whatever the economic conditions.

4.  Technical challenges are growing

This is a similar point to 3. but is about the difficulty and danger of extracting new reserves rather than the cost, particularly when it comes to deep sea drilling.  The Horizon disaster vividly illustrated what can go wrong with deep sea drilling but perhaps even more pertinent is to look at the reserves Brazil intends to exploit off its Atlantic coast.

These are so large (50-100 billion barrels or even more) that they alone count as one of the major reasons for Trough Oil optimism.  To put that number in context that is perhaps 1/3 of another Saudi Arabia.  But the catch is there are thousands of feet of salt rock between the ocean floor and the oil trapped beneath it.  Much of the oil is beyond a depth that even "ultra-deep" rigs are currently able to go (7,500m to about 10,000m) and the deeper you go, the more pressure and the more risk.  The Horizon disaster happened at just 1,500m.  New techniques and perhaps a $1 trillion may be required.

None of this suggests the fight to keep the world's thirst for oil satisfied is going to be either cheap or easy.

5. Declining consumption in the West will be more than offset

One of the main focuses of optimism on the demand side is that  oil consumption in the West is on a declining trend even allowing for the effects of the economic crisis.  It is true that high prices, recession and more efficient cars have combined to reduce oil consumption slightly in the US and other developed markets (but by less than 1% between 2000 and 2010 according to one chart I saw).  But this has been more than offset by rising demand from China and other fast-growing countries and I expect this to continue.

In the short term I am a China bear and I think the troubles that afflict that country will have big knock-on impacts through places like Brazil and Indonesia.  However long term there is nothing that will prevent the economic rise of the developing world and the consequent increase in competition for scarce resources.

It might be a bumpy ride but the big picture is still one of hundreds of millions of people emerging from relative poverty to something approximating a middle class lifestyle with its attendant consumption patterns: a richer diet, more travel and especially buying a car.

6. Oil producers keep more of their own oil

One of the key warnings of Peak Oil pessimists is that the problem of declining output by traditional producers is that they will increasingly consume more of their oil domestically leaving less for export. This was one of the main arguments convincing me that from now on oil prices would stay high and it would get tougher and tougher to supply demand.

And it's playing out just the way the doomsayers predicted.  Middle Eastern consumption of oil rose by 55% during the first decade of the millennium more than cancelling out the small declines in the West.  Saudi Arabia, which burns oil to generate electricity to power air-conditioning units and water desalination plants, now consumes 3 million of it's 11 million b/d total output.

7. Carry on guzzling

Transport, including aviation, accounts for about 75% of oil demand.  Despite gently declining car use in the West and more efficient vehicles being mandated by governments, demands for oil to fuel transport globally is almost certainly going to rise in the coming decades as it has done for decades past.

We have already discussed the essential reason for this - the growing size and power of the middle classes in the developing world.   The only thing that could prevent a remorseless rise in underlying oil demand - apart from the BRICs and other fast-growing countries going into rapid economic decline which seems unlikely - is a switch from petrol/diesel to something else.

Oil optimists point to clear signs that governments and  leading major manufacturers are getting behind electric cars.  Other alternatives to oil are natural gas, hydrogen and even liquid air.

But the odds are that they will all remain a niche for the relatively well off or environmentally-concerned.  This is not because there won't be technical advances in, for example, batteries but because the petrol car economy is so embedded (at such a vast sunk cost) that even a superior form of automobile technology would face a massive struggle to overturn it.

Consider vehicles powered by liquified natural gas which have been around for decades.  They do not require any great leaps forward in technology, new refueling infrastructure (many filling stations already sell it) or a new fleet of cars (petrol cars can be converted quite cheaply).  And gas - in the US at least - is 1/7th the price of oil.  But only a tiny fraction of the US vehicle fleet is powered by gas.

In summary - the global petrol engine population will continue to faster than the increase in fuel efficiency; oil supply from the "easy" sources of the past will continue to dwindle and prices will stay high.  This has important investment implications but that will be for another post.

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Trough oil?

After decades of "Peak Oil" talk and warnings about  a global energy crisis, it has become fashionable to claim the opposite: we are awash with the stuff and a  supply crunch has been postponed indefinitely.

This is especially interesting to me as an investor because I largely bought into the Peak Oil theory.  Permanently high oil prices and the knock-on effects of depleting oil supplies have been something of a cornerstone of my thinking about the economic future.  It's why I made what has so far turned out to be a great call on Shell shares last year - How to ease the pain of high fuel prices.

Roughly speaking the Peak Oilers claimed that oil production would peak at 85 million barrels a day (bpd) around the middle of the last decade as production rates from big fields declined.

There is no shortage of oil left in the ground but most of the big easy discoveries have been exploited and it would be increasingly hard and expensive to keep up production levels.  With demand from the developing world, especially China, growing fast a crunch loomed and prices would sky rocket.

As we all know this happened to some extent.  Chinese consumption alone rose by 4 mbd in the 2000s and the world's oil producers struggled to keep up which culminated in $147 a barrel oil in 2008 and $100+ prices most of the time since despite the economic crisis.

The 90s when oil went down as low as $10 and rarely exceeded $10 seem like another era and one that will never be repeated.

But crucially producers have responded and oil production has increased. The high prices have attracted trillions of dollars in investment in traditional oil producing countries (Saudi Arabia is producing record amounts), new frontiers (e.g. in Africa),  and in deepwater drilling.

Throw in a recovery in production from Iraq, which recently became the second biggest producer in OPEC, increased production of "non-conventional" oil extracted from tar sands and new techniques to  increase recovery rates from old fields and you can see why production has continued to increase.

A lot of the "trough oil" talk has been driven by the view from the US where exploitation of shale gas and oil has been something of a game-changer.  US oil production peaked at 10 mbd in the early 70s and had been in steady decline to about 5mbd until recently when output started growing again.  Imports have been reduced by a third and there is talk of the US being self-sufficient in a few years.

But supply is only one side of the price equation; what of demand and especially this insatiable demand from the developing world?  Even on this front optimists see trends that could make oil abundant and cheap again.

I have even seen one article in the New Scientist predicting that, by 2020, oil production will start to fall not because of a lack of accessible reserves but because demand will be declining.  That's a radical claim: an oil crunch will be avoided not because we will find new sources of supply but because the world will - in their words - "dump the pump".

Two reasons are offered:  increasingly fuel-efficient cars, either because of regulations or through consumer choice, and the rise of the electric car.

Developed world oil demand has started falling already including in the US.  Partly that is due to the economic crisis but a trend towards fuel efficiency is a factor and is set to become even more significant as new laws take effect.

Consider US CAFE standards which mandate the average fuel efficiency of cars sold as measured by miles per gallon (mpg).  When CAFE first came in during the 70s the requirement was 18 mpg and this was increased gradually to 27.5 mpg by the 2000s although Bush refused to raise this not very demanding target higher.

Obama has not been so lenient on the car industry and the next target (due 2016) is 35.5 mpg.  Even stricter CAFE laws will bite from 2017 leading to cars with an average 54.5 mpg and a forecast decline of 11% in US oil demand.  The EU has passed similar laws focused on average CO2 emissions across manufacturers' fleets.

So that's how Peak Oil could become Trough Oil - multiple increases in supply meets dwindling demand.  Well that's the theory.  But should we buy into it and, for example, sell oil stocks which would surely tank in a world of Trough Oil?  While there are some undeniably interesting facets of the argument I am sceptical but I'll set out the reasons why in another post.

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