Seeking Alpha: Peak Oil is a Cost Issue

March 05, 2008

Jim Kingsdale: Bio & more articles

Underlying nearly all discussions of the oil price is a standard economic concept: supply and demand. It seems so elementary that there is no doubt of it. It says that demand has been growing more rapidly than supply recently and that at some point the world will reach Peak Oil and the price will zoom northwards.

But the reality is more complex. Peak oil is not just a point in time or even a plateau when oil supply becomes unable to expand to meet demand. We need a more nuanced model for oil prices that includes several other factors.

First, there is the role of speculators. OPEC officials often say the locals in New York are the culprits responsible for higher oil prices, an idea that often is dismissed as simply a way for OPEC to focus attention away from their own responsibility. But the fact is that prices are determined in the oil futures pit to a large extent and some speculators, like hedge funds, are represented in the pit. Speculation is not just a form of gambling or “playing” the weak dollar. It also serves to move forward the future supply and demand impacts on the oil price that speculators see coming.

Second, is the mindset of the oil exporting countries, including OPEC, which are increasing supply at a slower rate than they could. I call this hoarding but it is known more commonly as “resource nationalism.” It is abundantly clear that supply is being diminished by hoarding. I recommend to your attention the collection of examples that I have catalogued under that heading, on which you can click above.

In a sense, the speculators in New York and the oil exporters who are hoarding their supplies are thinking and doing the same thing. They are bringing forward in time a supply/demand crisis that they anticipate will happen some day in the future. Speculators do it in the futures markets. Exporters like Russia, certain OPEC countries and Mexico restrict production through various “resource nationalism” policies. Both act based on the expectation of higher future oil price with the impact of bringing such prices forward.

Third, and most complex are cost pressures. The paradigm example of costs reducing potential supply is the “oil shale” deposits in the American West and elsewhere. CERA, the ever-optimistic consulting firm that makes its money from companies and governments that have a stake in keeping oil prices low, likes to refer to the vast quantity of hydrocarbons still in the ground, a large percentage of which is oil shale. CERA points to such “reserves” as a reason to doubt the coming of peak oil. But the reality is that no economical means of producing oil from shale deposits has been discovered despite decades of government-financed work by big name companies. Oil shale is simply too expensive to process into oil for it to work at an oil price of $100 – or even at $200.

Thus, cost is translated into supply.

Underlying the poor economics of oil shale is the negative EROEI – that is, Energy Return on Energy Invested. It just takes too much energy to make crude out of oil shale. You spend more to make it than it creates. That means that as the oil price rises, so does the cost of the energy input needed to turn the shale into oil. So no price of oil is likely to liberate crude oil from oil shale deposits. The brilliant geologist Kenneth S. Deffeyes wrote in Beyond Oil that oil shale will probably not be developed until a very cheap source of solar power is available to supply the energy input. That is not likely to occur in scale until well beyond the advent of peak oil.

I use oil shale as a gross example of cost limits to oil production. But more subtle and current cost pressures are already at work. Such cost pressures reflect the shortage of an input needed to produce oil. Whether that input is deep sea drill rigs or trained personnel, the shortage restricts production.

A recent Wall Street Journal article highlighted the shortage of trained personnel throughout the energy sector. It refers to a 2005-2007 survey of top management and HR people which indicated that “More than 70% of energy companies expect their future operations to be hit by shortages of skilled personnel…” The shortage, resulting from a drought of recruiting in the 80’s combined with recently growing expansion needs, is captured by the following statistic: fully half the energy work force will retire within ten years.

Where production cost issues and supply constraint issues intersect most directly is in the cost of energy required to harvest new oil. When you go far offshore and drill very deep, when you mine oil sands using trucks as tall as three story houses, when you try to obtain oil from under the Caspian Sea during its hellish winter conditions, you use a lot more oil in the process. The higher that oil is priced, the more the cost of the oil you recover, as discussed in more detail here. So the cycle of high costs resulting in more limited oil production is self-reinforcing.

The way I think of it is like a plow preparing a field. It used to be that the field was flat and contained good soil. The plow would cruise right along. Now the field is on a hill and contains rocks. The only way to go in future years is higher and steeper with the rocks turning into boulders. Eventually, progress becomes extremely slow. That is what is happening to the production of oil.

In sum, higher costs of energy production are the mirror image of lower capacity to expand production. The two parts of the same whole problem mean that less oil is produced as it costs more. Less oil being produced is what leads “peak oil.” So are the higher costs of producing oil a result of “peak oil”…or are they an integral part of it?

We need to understand that the simple model of peak oil, expressed recently by an industry leader, as “when output growth stops the oil price will go through the roof,” is a vast oversimplification of reality. In fact, oil is already becoming scarce because of cost pressures, hoarding, and, sometimes, speculation. Of the three causes, cost pressures are the most constant and unrelenting and are causing the speculation and hoarding. Cost pressures are the economic evidence of physical factors that are restricting oil supply to levels that fail to meet global oil requirements. This concept was recently addressed by the president of Hess Corp, who said at the CERA conference, “The supply challenge is really not one of scarcity as some believe.” Rather, it is a cost issue.

http://seekingalpha.com/article/67204-peak-oil-is-a-cost-issue?source=d_email

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