Oil, anyone? Read this.

Macdonald Stainsby mstainsby at tao.ca
Wed Oct 3 01:40:39 PDT 2001

For reasons that will become painedly obvious to those who know him, I dedicate the following post to Mark Jones. The source is as interesting as the content: The National Post weekly supplementary Business Magazine. This is usually a magazine insert worth throwing away after you glance at the headlines, often about new internet technology and how this is part of the bubble, etc. etc....However this is altogether different. This is "them" saying it.

Note the comments on Iraqi oil being all that is left to tap. This "new war", whether touched off by terrorists or touched off by someone on "our side" is clearly going to be about re-invigorating what little is left of the world's oil supply. So grab a coffee and get comfortable: This post is something you must read if you must read anything.

Macdonald Stainsby ------ Rad-Green List: Radical anti-capitalist environmental discussion. http://lists.econ.utah.edu/mailman/listinfo/rad-green ----


Oil and gas prices are going up because the world's producers aren't finding enough new supplies to keep up with demand. Outside of OPEC, there's only one country with huge unexploited reserves: Canada


For North Americans this year, filling up at the gas station has been like playing a slot machine: you never know what price is going to come up. A year ago, the average price of a gallon of gasoline in the U.S. was $1.56 (all prices in US$). In the first quarter this year, it dropped to an average of $1.47 and then it spiked to $1.66 in the second. For the current quarter, the U.S. government's Energy Information Administration expects the average price will slip back to $1.42.

The same holds true for other fossil fuels. A year ago, the long-term outlook for North American natural gas reserves was grim and the average residential price in the U.S. had peaked at an average of $10.07 per thousand cubic feet (mcf). The average price tailed off to $8.70 for the fourth quarter and bounced back to $10.33 in the second quarter this year. The EIA's call for this quarter? $7.73.

It will likely be more. Reports of higher prices and tighter supplies are not isolated events; they foreshadow what we're about to experience. Supplies of world oil and North American natural gas are going to become far more limited. For years, we've aggressively exploited known resources to fuel rapid economic growth, pumping it out of the ground at unprecedented rates even when prices were depressed. But the easily recoverable resources are running out. It also happens that the countries sitting on the biggest proven reserves, the members of the Organization of Petroleum Exporting Countries (OPEC), have figured out how to manage their production so that they get the highest possible price at any given time. The conclusion from all this is inescapable: we're going to pay more for energy until our consumption shrinks to match declining world supplies.

It would be folly to labour under the illusion that overall oil and gas supplies are going to grow. Nor should we succumb to the popular notion that we can find enough oil and gas to meet any level of potential demand simply by pouring capital into exploration and development. In classic supply/demand theory, when supply gets tight and demand remains strong, prices rise. If you're talking about widgets, the solution to the problem is automatic. Manufacturers, enticed by opportunities for profit, spend the money to gear up and make more of them, bringing supply back into balance with demand, moderating prices. But oil and gas exploration isn't like widget making; investment doesn't necessarily increase supply. It's really an exercise governed by the law of diminishing returns. The largest oil and gas deposits are always exploited first, because they're the easiest to find and the most profitable. Every field, every region, ultimately has the same production history. Production rises quickly after the initial, large discoveries are made. Then it peaks and begins a natural decline that's partially offset by smaller, secondary discoveries. Eventually, though, production goes into an irreversible, long-term decline, and that is where the world is clearly headed now.

We've been spoiled in the past. World oil output and consumption grew at an extraordinary rate during the first 25 years after World War II, rising to 47 million barrels a day from seven million. Oil played a huge role in the golden era of postwar economic growth. It was cheap, available in apparently limitless quantities and, with the development of large tankers, deliverable everywhere at low cost.

Obviously, we weren't going to be able to keep finding oil fast enough to maintain such a high compound economic growth rate. Once that became clear in the early 1970s, prices increased substantially, something that would have happened regardless of OPEC's actions. But prices moved too high, too fast. Consumption fell and prices declined in real terms. Lower prices re-stimulated demand, but the subsequent doubling of oil prices after the Iranian revolution in the late 1970s led to a further sharp drop in consumption. Prices collapsed and stayed in the range of $15 to $20 a barrel for 14 years before demand recovered.

After several years of extraordinary economic growth in the West, we've reached the point where we can no longer find enough new oil to meet demand. That's why it's costing more at the gas pump, and why it's going to cost more to heat and light our homes and offices. So far, prices haven't risen sharply enough to really curtail consumption, but that's about to change.

Such a dire prediction may seem extreme in light of the fact that U.S. consumption is still below the all-time high it reached in 1977, and European consumption is even further below its peak. But the big industrial economies aren't the problem. For 20 years, energy consumption growth has largely come from the developing world, for the simple reason that transportation fuel-demand drives increased oil consumption. When a developing country's economy reaches the take-off point, the first thing that everyone wants is mechanized transportation. The more vehicles there are on the road, the more oil consumption rises.

We seem to have little difficulty making additional cars and trucks, but it has become much harder to find large deposits of oil to replenish our reserves. Over the past 30 years, world oil output - from OPEC and non-OPEC countries - has grown phenomenally. (See chart on page 60.) Throughout this period, however, the search for major new quantities of non-OPEC oil produced very disappointing results, despite the fact that, at times, oil was $40 a barrel and was expected to go as high as $70 a barrel.

Since 1970, the three largest non-OPEC oil discoveries, all enormously costly, were under water: the deepwater U.S. Gulf of Mexico, the deepwater off Brazil and the waters off Mexico. Peak production from each of these discoveries is estimated to be about one million barrels a day, an impressive number - until you consider that the world is consuming non-OPEC oil at a rate of about a billion barrels every three weeks. We aren't finding a billion barrels of new oil reserves every three weeks.

The long-term trend of crude oil production in the U.S., the largest non-OPEC producer, illustrates our predicament. Between 1945 and 1970, production doubled to a peak of about 10 million barrels per day. This was followed by an irreversible, long-term decline, despite significant price increases and continually improving exploration and development technology. The only major find of note in the postwar period was the Alaskan North Slope discoveries that the U.S. began to exploit in the late 1970s. These reserves had actually been discovered earlier, and if it hadn't been for the second oil-price shock, they might have remained a geological curiosity.

The same wasting profile - with the same intimation of higher prices - applies to the other major non-OPEC oil producers. In the North Sea, the second-largest non-OPEC production area, output has either peaked or is about to peak, and will then enter a long-term decline. China, the third-largest producer, has peaked and is beginning its decline. Mexico, the fourth-largest, has had declining conventional on-shore production since the early 1980s. Despite newer offshore discoveries, the country's total production has resumed its decline.

As disappointing as the search for new oil reserves has been, booming economic growth has led to the increasingly rapid exploitation of the resources we've already found. Nowhere is this clearer than in the pattern of Alaskan crude oil production, which rose very rapidly in the late 1970s to two million barrels a day, peaked and has since declined by 50%. Considerable money has been spent to prolong production, but the decline has nevertheless been fairly rapid.

The situation has been much the same in other non-OPEC countries. Before the political collapse of the USSR, Eastern Europe suffered an initial production decline for the same reasons as in other non-OPEC countries. In response, Soviet President Mikhail Gorbachev committed major new investment to the oil industry, in large part because he needed oil production for export in order to earn hard currency. Despite his efforts, production peaked and a decline set in, only to accelerate after the USSR's collapse. Of course, consumption fell even faster because the economy imploded. Developments in the Caspian region over the next 10 years could increase the former Soviet Union's net production by as much as two or three million barrels a day. Russia could then increase its net exports to the rest of the world by a couple of a million barrels a day. This, however, is a very optimistic forecast because it assumes that all the required capital and services will be provided and that the country will actually have the means to transport the oil.

Nor can we look to OPEC for a surge in supply that would bring price relief. The venerable cartel has the reserves to pump more than 32 million barrels per day by the end of the decade, roughly equivalent to its peak production levels of the 1970s. But that isn't going to be enough to offset the decline in production from non-OPEC countries. Almost equally important, OPEC is meting out its resource, in effect acting as the world's swing oil producer to balance world supply and demand. In doing so, it has become adept at managing its production levels to achieve the highest possible price at any given time.

Since the late 1970s, there have been numerous gyrations by individual OPEC members as the cartel worked toward a viable production quota system that would allow members to sustain comfortable levels of output while maintaining international market share. There have been significant disturbances along the way, the largest being the Gulf War of 1990-'91 that resulted in a total Western embargo on Iraqi oil that lasted six years. There has also been considerable infighting among OPEC members, notably several years ago when Venezuela announced it was going to expand its capacity to five or six million barrels a day and become the largest supplier to the U.S. This annoyed the Saudis and fuelled an ongoing market-share battle.

Despite such upsets, OPEC's quota system has gradually become more stable. And the cartel's position will further improve when the embargo against Iraq is removed completely, leaving that country as the only member of OPEC with the unexploited resource base to be the significant incremental supplier of oil to the world. Potentially, Iraq can sustain a long-term production capacity of about six million barrels a day, roughly double its current output.

Iraq will also join Saudi Arabia in making OPEC a truly rational cartel. OPEC's historical inspiration is the Texas Railroad Commission that allowed the state to serve as the incremental supplier of oil to the world for almost 40 years after the huge discoveries in the East Texas field in the early 1930s. To stabilize world oil markets, the commission developed a system whereby it was assumed that other producers in the world would operate at capacity and that Texas would serve as the swing producer.

The commission's method was simple, but effective. It held monthly meetings at which U.S. and international refiners provided estimates of their oil requirements for the next month. The commission then set Texas production to meet the difference between all other production at capacity and the market demand for oil. Seasonal variations in consumption make it difficult to forecast oil demand, but with monthly production adjustments, mistakes can be corrected easily. The Saudis are moving toward this model in order to manage production so that it generates the highest possible revenue. They're now close to having an efficient management system. Last year, the Saudis, either in unison with OPEC or unilaterally, adjusted production five times. They announced a target price and usually managed to achieve it. And as they've become more comfortable with continuing high consumption rates, the Saudis have gradually raised their target price in order to increase revenue.

But what about oil's cleaner, (sometimes) cheaper and increasingly popular cousin, natural gas? Natural-gas production in the U.S. alone is greater in total energy output than the oil production of the world's largest producer, Saudi Arabia. But the North American gas industry is confronting a unique and profound combination of events that has a major implication for prices. The gas industry is facing the first true shortage of deliverable reserves in its history at a time when the American electric-power generation industry has decided that every major expansion project on the boards should be fired by natural gas.

Natural gas supplies have looked tenuous in the past. We thought we were running low in the 1970s, but that was primarily because Canadian and U.S. government policies dictated that sales contracts be supported by 20-year reserves. Since then, of course, finding-rates have declined, the industry has been deregulated and we've had an economic boom. Producers have been running at capacity and selling every cubic foot of gas they can produce.

Economic growth has been accompanied by a boom in electric power consumption. As a result, a major capacity expansion is underway, with natural gas the fuel of choice. This is based, in large measure, on dubious U.S. government-sponsored studies that have concluded that U.S. gas supplies can be increased by approximately 50% during this decade at moderate prices, thanks to continually improving technology. As is the case with oil supplies, such optimism is misplaced.

In some respects, the postwar history of natural gas parallels that of oil. There was a dramatic expansion of North American production in the 25 years after 1945. Output almost quintupled, and there was a huge expansion of pipelines and gas-intensive industries. It was also a golden era for exploration; although vast amounts of gas were consumed, enough new finds were made that reserves almost doubled. The turning point was 1967, the last year discoveries exceeded consumption. Since then, the U.S. has been living off its reserves, and now it has run out of the ability even to do that.

The industry also demonstrates what happens when the irresistible force of demand meets the immovable object of diminished supply. With the decline in new discoveries, the industry couldn't maintain 20-year reserves. Prices rose rapidly and consumption declined by approximately 25%, creating what is known as the "gas bubble."

Since the late 1980s, the gap between U.S. production and demand has grown rapidly, peaking at about nine billion cubic feet a day, roughly 15% of the country's requirements. This has meant that increasing amounts of natural gas have had to be imported from Canada. If Canada hadn't had the surplus producing capacity and the willingness to supply the U.S. market, there would have been a natural-gas supply crisis many years ago. The problem now is that Canada has reached its production capacity. So while we'll see continued price volatility because of weather-related changes in demand, we'll also require generally higher prices to restrain consumption to meet the available supply.

And everywhere you look, there are signs that supplies of natural gas are shrinking. The rate of production decline over the first year of life for new North American gas wells has accelerated dramatically. On-shore, Texas has gone from 32% decline rates to about 56%; the Gulf of Mexico from about 27% to just over 40%; and Western Canada from an average of about 12% to more than 30%. The reason is clear: in order to replace declining overall production, each well that is drilled has to be depleted more rapidly.

How hard is it to replace existing gas reserves, given current levels of demand and production? To maintain total North American gas production would require the development of new production each year that roughly equalled today's total production from the Gulf of Mexico. It's worth pointing out, however, that it took 45 years to achieve current levels of Gulf output.

The supply and price prognosis may be harsh news for North American consumers, but for the Canadian oil and gas industry, the new world energy order is going to be a huge blessing. Canada has relatively large, unexploited oil and gas reserves and a next-door neighbour with the world's most voracious appetite for fossil fuels. The U.S., which consumes 26% of the world's oil supplies, now imports more than 50% of its requirements. Proximity and politics tell you that a growing share of that is going to come from Canada. The U.S. also consumes 30% of the world's natural-gas production, with rapidly growing imports from Canada now representing 15% of its total usage.

The U.S. energy scene is complex and charged with politics. Today, a great deal of debate surrounds the economic and environmental desirability of various fuels. As supplies of natural gas diminish, for example, there's a prospect that more coal will be used in industrial and power applications, albeit employing much cleaner technology than in the past. Nuclear power is being reconsidered in the wake of re-regulation and the consolidation of the industry. There's also much interest in expanding liquified natural gas imports and in developing new hydroelectric projects, as well as expanding wind-powered generation and increasing research into solar energy. In short, Canadian resources will be competing in a complex and turbulent market. Nevertheless, when you make allowances for all the heated debate, not to mention the swings in demand that accompany economic cycles, it only makes sense that Canada's share of the U.S. oil and gas market will rise.

Canada's conventional oil production peaked about the same time as that of the U.S., but then Canada began the long, slow development of its heavy oil and tar sands. Thanks to these enormous resources, Canada will likely be the only major non-OPEC producer whose production continues to rise. Oil production is expected to increase by 50% this decade, and if the present trend holds, Canada will move from fifth place to first among non-OPEC oil producers sometime before 2015.

There will be continued major activity involving conventional and heavy oil in Western Canada, and large production increases off the East Coast and in the tar sands in Northern Alberta, where Syncrude and Suncor have begun major expansions. Shell, ExxonMobil and Gulf Canada have all announced firm commitments to build new tar sands plants and mines to supply them, and additional projects are anticipated. The tar sands resource is huge, and total production costs have declined significantly.

The U.S., which is committed to using natural gas to expand electric-power generation, represents an almost insatiable market for Canadian natural gas. Now that Canada's export pipeline system capacity has been expanded, the only question that remains is the amount of gas the country can manage to ship. There have been major discoveries on the East Coast, for which a new export pipeline system is now in operation, and in the Northwest Territories, which are dependent on long-term pipeline projects. In the long term, though, the volume of Canadian gas exports will depend on exploration success from new, deeper drilling in more remote areas.

Under the circumstances, it's hardly surprising that American companies have greatly increased their participation in the Canadian oil and gas industry. Investment activity and profitability have risen dramatically because all of the fundamentals support a prolonged, strong expansion. Calgary's skyline has an alluring golden aura these days.

In the contradiction lies the hope.

--Bertholt Brecht

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