An Applicable Update on the World Oil Market
Professor Ferdinand E. Banks
Applicable how? Applicable in the sense that one of the cardinal rules of physics has traditionally been that the introduction of new concepts was not more important than abandoning some of the mistaken notions that often find their way into widespread circulation. This is why I offer the present update, instead of upgrading one of my earlier contributions, or for that matter reworking a portion of the chapters on oil in my forthcoming energy economics textbook (2007). Those materials are not yesterday's news, but things move fast in the great world of oil, and unfortunately new events do not always receive what I regard as an appropriate interpretation. For instance, in the section below titled 'The Logic of Peak Oil', I am essentially inquiring how a new author, Mr Duncan Clarke (2007), could possibly come to the conclusion that the flaw in the peak oil argument is that it ignores the basic rules of economic theory, which to his way of thinking stipulates that when the price of something goes up, it is always the case that either supply increases or demand falls or both. When a student of economics makes this claim about a non-renewable resource, I usually call it a misunderstanding. Originating with someone who enjoys a background in economics as well as three decades of rubbing elbows with oil company executives and experts, it shows a disturbing lack of perception.
As Professor Julie Urban pointed out (2006), economists are wrong by continuing to believe that price increases can locate resources that do not exist in the quantities required. As for a fall in the demand for oil, this is an issue that might have some traumatic macroeconomic overtones, as will be noted later in this introductory section. A slender bundle of pseudo-scientific hand-me-downs has also been served up by two authors under the sponsorship of a Washington DC 'think tank', the Cato Institute, whose energy and climate delusions are financed to a certain extent by the largest oil company in the world, ExxonMobil. The gentlemen in question are not in the oil business, nor are they economists, but are respectively professors of government and public affairs, which means where this topic is concerned that they have little more to provide than rappers or do-ah choristers.
It has now become clear to a large number of concerned observers that October, 1973, was a turning point in modern economic history. Aside from the near panic that accompanied the first oil price escalation (or 'shock' as it is sometimes called), my most vivid recollection of that dramatic period was the general failure by economists and politicians to comprehend the character and significance of OPEC, and what the logical and legitimate ambitions of certain key OPEC countries could or would eventually mean for the politics, philosophy and economics of virtually every country in the world, regardless of their access to oil or other energy resources.
Somewhat earlier, Enrico Mattei had coined the phrase "the Seven Sisters" to describe the petroleum world's movers and shakers. The Seven have now morphed into Four - ExxonMobile and Chevron of the US, and Europe's British Petroleum (BP) and Royal Dutch Shell. According to a recent article in the Financial Times (March 12, 2007), there is a new Seven that deserves at least a modicum of attention: Saudi Aramco, Russia's Gazprom, CNPC of China, NIOC of Iran, Venezuela's PDVSA, Brazil's Petrobras and Petronas of Malaysia. These are important enterprises, and CNPC and Petronas are particularly aggressive, but with the exception of Aramco and Gazprom, not yet in the 'class' with the above four. For instance, Iran has 11% of world oil reserves, and after Russia is the most important natural gas nation, but unfortunately there is some evidence that it will not be able to make the kind of contribution to the global energy supply that will be necessary to keep the oil wolf away from the door.
According to Roger Stern (2006), Iran could stop exporting oil as early as 2014 - presumably because of a greatly increased demand for transportation fuels in that country and adjacent regions. This does not sound completely right to me, even if it is possible to accept the suggestion that Iranian export capacity may develop in a manner that will be well under that predicted by e.g. the International Energy Agency (IEA). Professor A.F.Alhajii, for instance, contends that Iran can increase production to 4.8 mb/d, and maintain it at that level for than 20 years if they desire (2007). Regardless of Iran's capabilities however, one thing deserves emphasis: if Iran's contribution to global supplies turns out to be less than desired, it is not because of any technical or managerial shortcomings on the part of Iranians that would be ameliorated by inviting foreigners to explore for and extract oil and gas in their country.
According to the IEA, ninety percent of new oil supplies in the next 40 years will come from developing countries. Ordinarily this could be regarded as a cheerful piece of news, however I am so accustomed to flawed IEA prognoses that I am unable to take it as a given. For example, it appears that Saudi Arabia (with 22% of world reserves) has convinced that organization and a few others that they will boost production capacity to 15 mb/d, or thereabouts, in the not too distant future. This will almost certainly not happen, however if it did it would not make the forecasts of the IEA and the United States Department of Energy (USDOE) more palatable. For that Saudi production must eventually rise to 20 mb/d of the predicted 121 mb/d that has been forecast by those two organizations for 2030, and this is completely out of the question. In the executive suites of Big Oil, a sustainable output of 121 mb/d at any time in the future is generally regarded as being without any economic or geological feasibility, regardless of what the directors of the 'Big Four' say when the TV cameras are turned in their direction.
I utilize a small portion of my new textbook to examine the above predictions, and also to argue that more attention should be paid the macroeconomic and political situations that could unfold in the event of explosive price rises that could accompany or even precede a peaking of the world oil output. The price of oil determines the price of most energy resources, and definitely the other fossil fuels - gas and coal. An abrupt energy price escalation could therefore have a sharp impact on productivity, which in turn would have a negative effect on employment and the remuneration of employees. It might also lead to a decision by large numbers of voters in the energy importing world that military action launched to obtain energy supplies is preferable to even a mild decline in their living standards that has the possibility of being irreversible.
Something else that it could mean is an additional resort to coal that would cancel out all the fine theories and intentions expressed in the Kyoto Protocol and its spinoffs. The USDOE has estimated that electricity demand in the US will increase by 45% between now and 2030. Coal usage is scheduled to grow from 51% to 57% because of its availability and price, but a sustained escalation of the oil price would be certain to boost the price of gas, which according to a study by Sanford C. Bernstein & Co., already costs 30% more than coal on the US electricity generation front, even if a very high price for the suppression of carbon emissions is assumed. Coal might then attain more than 60% of the energy mix, with 'clean coal' playing only a minor role. As for the kind of coal-burning plant called FutureGen, which would trap carbon dioxide before it reaches the atmosphere and bury it below ground, if it corresponds to the efforts in that direction by the large Swedish firm Vattenfall, it is strictly a play for the gallery.
The principal theme in what follows has to do with the return of OPEC to the oil market driver's seat, the genuine shortage of energy materials in terms of the amounts that are desired, and the growing ability of formerly monolithic state oil companies to alter the competitive landscape in oil, oil products, and petrochemicals.
I. GAME THEORY AND UNCONVENTIONAL OIL
Before continuing, it might be a good idea to introduce the word 'game' into the present discussion. In the Hollywood travesty of the book A Beautiful Mind (1997), game theory was presented as an authentic scientific pursuit rather than the description applied to it by Professor Erich Röpke, which was "Viennese coffee-house gossip". Actually it is a combination of both, in the ratio of about one-in-five, and this is despite its prominence in esteemed (though largely unread) journals of quantitative economics, as well as the widely circulated opinion that "it is impossible to understand modern economic thought without a grounding in game theory." On the whole game theory has failed to deliver, although it was introduced into the modern economics literature by a man often credited with the best brain of the 20th century, John von Neumann.
At the same time it can be admitted that there are certain things that game theory has spotlighted that are of considerable value in analyses of the present type. People sometimes act irrationally but are also capable of thinking strategically, and skilled players more often than not consider all possible outcomes, and constantly attempt to evaluate the meaning and possible evolution of alternative payoffs. What John Nash - the proud owner of A Beautiful Mind - ostensibly did was to carefully formulate a theory in which equilibrium means that each player cannot improve his or her position by making an alternative choice. What actually happened was that Nash took a few minutes to recast a notion that had been published at least a hundred years earlier by Antoine Cournot, and for which he was eventually awarded a Nobel Prize in economics.
In my lectures I have used game theoretical concepts to discuss unconventional oil, and also oil found in unfamiliar locales, such as the Caspian region. The basic issue here is not an 'equilibrium', but the astounding quantity of misinformation and misunderstandings put into circulation by 'players' with interests in these locales, as well as their official and unofficial propagandists. For instance, one of the best introductions to oil from Canadian tar sands, and heavy oil (from Venezuela) can be found a recent OPEC Bulletin (March, 2007). It happens though that oil from these two sources is a growing competitor of conventional oil (from e.g. OPEC countries), and so a question must be asked about the enthusiasm shown unconventional oil by an OPEC publication. The reason quite simply is to give the impression that despite the warnings circulated by persons like myself, both governments (and perhaps consumers) in the oil importing countries should come to accept that there will be plenty of oil available in the distant as well as the near future, and very likely at prices that they find reasonable.
Saudi Arabia enjoys a special position where conventional oil resources and production are concerned, but now we often hear that Saudi reserves may not be in the same class as those found in Northern Alberta (Canada). Furthermore, the latter might be overshadowed by the resources of the Orinoco Oil Belt in Venezuela: the OPEC discussion cites estimates of Petroleos de Venezuelas, which puts the present estimated content of the Belt at 235 billion barrels of heavy crude, which with likely additions should eventually be sufficient to cause it to be labelled the largest petroleum reserve in existence.
The question must then be put as to the cost of exploiting tar sands and heavy oil. Forty dollars per barrel is the highest figure that I have ever seen, which would suggest that with an oil price unlikely to fall below fifty dollars per barrel ($50/b), an oil shortage during the present century is a physical impossibility, and the Schwartzenegger/California type of initiative featuring ethanol and/or hydrogen is unnecessary. Actually, as an 'insurance' against oil price spikes, it is essential, although there is no need to launch an undertaking of Manhattan Project size until the technology for these departures is further developed. Furthermore, according to the Toronto Star (Wednesday, 25 April, 2007), the supplies of easily exploitable Canadian oil have almost run out, and so conventional oil royalties are only one-third of those obtained two years ago. Oil sands royalties are also declining, apparently because of a lower rate of growth of tar-sand output: perhaps only 3 mb/d in 2020 as compared to 1 mb/d at present. If this figure is anywhere near the truth, tar sands are not going to save the day for North American consumers, regardless of the huge reserve figures that we constantly hear so much about. For example, when Shell Oil states that they might have access to an impressive slice of the 2 trillion barrels of oil reserves that they believe could eventually be located in Canada, they are sending a message to present and potential investors in their shares that great things are ahead, despite any disappointments or negative press that they might have been exposed to over the past few years.
As for heavy-oil in Venezuela, Major Chavez obviously intends to make sure that if he has the option, its output will be such that it does not spoil the market. Although it may appear that he has even less respect for Adam Smith's "invisible hand" than his famous friend in Cuba, the simple fact of the matter is that like Mr Smith and his disciples in the executive suites of Big Oil, he prefers more money to less. The last foreign controlled oil field in his country - in the Orinoco Belt - has been nominally nationalised, which means that the Venezuelan government will assume majority control of four heavy oil projects, and thus reduce the stakes of ConocoPhillips, Chevron, Exxon Mobil, Total, BP and Statoil by a few billions of dollars, but as far as I can tell there will still be a foreign presence in the Venezuelan energy industry.
Given that Canada and Venezuela are the flagships of tar-sand and heavy oil hopes and dreams, the future of non-conventional resources may not be as bright as many persons in the main oil importing countries have come to believe, in that these resources will not be available in the near future in sufficient amounts to relieve some of the demand pressure on conventional resources. Of course there is still shale oil, in which the US appears to be the world leader, however in my opinion the touting of shale oil is perhaps the biggest scam yet.
Now we see what game theory is largely about outside the seminar room and learned journals. Not "beautiful mind games" that provides academics and policy makers with an important new analytical means to study human behaviour, but to an embarrassing extent a refined and overpraised outlet for the presentation of untruths and misunderstandings.
2. THE LOGIC OF PEAK OIL
One often exploited origin of non-peak arguments turns on assuming that unconventional oil of the kind discussed in the previous section is in reality conventional. On the basis of the discussion in that section however, this would not change very much. Unconventional oil at the present time is about reserves and not production! The presence of hundreds of billions or even trillions of barrels of reserves of unconventional oil in Canada and South America may not have a sizable effect on the date of the global peaking of production, even though a great deal of unconventional oil is going to be produced in the years to come, and under certain circumstances could push the peaking of conventional oil into the future by a few years. It is not peaking but the effect of actual or putative peaking on the price of oil that is the main issue here.
For what it is worth, drawing on the contributions of others, I estimate that a peak for all oil (i.e. conventional and unconventional) will take place between 2015 and 2020. Most independent observers and energy professionals with a deep interest in oil would probably be able to go along with this, although the estimated time to the peak appears - on the average - to decrease every year, and there are even claims that the peak for conventional oil has already taken place. On the other hand, Shell sees a peak coming after 2025, while the United States Energy Information Administration (USEIA) and United States Department of Energy (USDOE) think that a peaking can be delayed until after 2030. The important consultancy Cambridge Energy Research Associates (CERA) thinks that there will be an undulating peak instead of a distinct peak. In my course at the Asian Institute of Technology I described this prediction as a touch looney, although it might make sense in an elementary economics class at some storefront university in Boston or New York.
ExxonMobil sees no peak at any time, and the often quoted Michael Lynch is also unable to discern a peak: his clients have been duly informed that they should find something else to be concerned about than an explosive oil price escalation. Before the recent price run-up, Doctor Lynch argued that the price of oil would decline to about $25/b. OPEC also denies the presence of a peak, but like Big Oil they find it sensible to try to convince the persons and firms on the buy side of the oil market that any apprehensions they may have about the future availability of oil are ill-considered. The energy director of the European Union has called the discussion about peak oil just another theory among many. He has a similar belief about the obvious failure of electric deregulation, which leads me to believe that the extent of his knowledge about these (and probably many other) topics is best not discussed in a public forum.
In my lectures I always deal with this problem in terms of the history of oil in the US, viewed in the light of a variant of (Albert) Einstein's equivalence theorem (which is explained in some detail in my international finance book). What I do with this subject is to start with the equivalence of the laws of oil production in the US and elsewhere, and argue that the peaking of oil output in the US is a microcosm - or was a preview - of global peaking. Once I have the bottom line, I explore some of the details. Oil was discovered in Pennsylvania just before the US Civil war, and later was produced in appreciable amounts in that state and a dozen others. It was the discoveries in Oklahoma and California, and in particular East Texas that made the US an oil superpower. Oil discovery peaked in 1930, while in late l970, to the surprise of oil scholars everywhere, production peaked in the 'lower 48'. The oil output story for the entire country (i.e. 50 states) changed however when the huge Prudhoe field in Alaska came on stream, which meant that the oil production curve for the US turned up. But even given the magnitude of that field, production never achieved the l970 level.
What about technology riding to the rescue, as President George W. Bush has predicted that it will. No country in human history has had the access to scientific and engineering knowledge that is enjoyed by the United States of America, but all attempts to reverse the ongoing depletion of oil, whether onshore or offshore, have been in vain.
As things now stand the US consumption is approaching 22 mb/d of oil, of which about 60% is imported, according to the important and reliable Oil Depletion Analysis Centre (ODAC), whose publications and bulletins can be examined via GOOGLE. Nobody really expects a change for the better in this situation, although for the time being the depreciation of the US dollar has taken some of the stress off the US financial system. But in the long run this depreciation could lead to inflationary pressures that raise US interest rates, which would exacerbate the present unfavourable development that seems to be taking place in the housing market. My macroeconomic knowledge is not as up-to-date as I would like for it to be, but unless I am very mistaken, the housing market could be the weakest link in the US economy at the present time. But even if the housing market does not go sour, something will have to give. It cannot be so that the US can import hundreds of millions of dollars of oil every day of the year, as well as fight an expensive war, and the welfare of its citizens is not influenced in a negative manner.
An even more bleak story is available for the UK. The first exploration licences for North Sea oil were awarded in l964, and oil production peaked at 2.7 million barrels in l999 (or 2.9 mb/d if natural gas liquids are included). The interesting thing here is that in l991 there were 100 fields in production, while in l997 there were 186 offshore fields in production. Moreover, although in the early years of this century the UK government talked of 300 discoveries awaiting development, exploration levels in e.g. 2002 were the lowest since 1970 (according to Dan Roberts and Carola Hoyos of the Financial Times). Several insiders have claimed that oil prices were not high enough to go after the oil remaining in the UK North Sea, but this situation has not changed to any great extent as a result of the oil price moving to record levels. Like many regions in the world, the North Sea no longer contains any easily exploitable reserves. This should have been obvious when Sir John Browne announced that in the future BP would concentrate on profitability rather than property.
Optimists are not particularly concerned with the way things have gone in North America and the North Sea because of the access that they believe the oil importing nations will soon have to unconventional oil and/or motor fuels, and they are also enthusiastic about the Caspian region. According to Professor Maureen Crandall of the US National Defence University, however, most of the talk about the Caspian is "hype". I believe this too, however perhaps it does not make a great deal of difference, because given the macroeconomic growth of China and India, and perhaps elsewhere in Asia and South America, every additional barrel of oil is going to be valuable. There is also a great deal of talk about the relief that will be brought to the global oil market by new developments in Africa and increased output in Saudi Arabia.
The opinion here is that much of the talk about the increase in output in Saudi Arabia is self delusion: the government of that country has finally discovered that the correct development strategy is to minimize the increase in oil production, taking into consideration certain political constraints, while the national oil company Saudi Aramco has said that increasing production too fast could run down reserves faster than the country would like. This can be put another way. According to Jim Mulva, CEO of ConocoPhillips, the national oil companies of countries like Saudi Arabia "may have other strategic objectives, which may limit the speed by which they develop their resources". It so happens that the chief other strategic objective is development! The director of the important consultancy PFC Energy, Robin West, has brilliantly summed up this situation by saying that "the full impact of the nationalisations that took place in the l960s and l970s are taking effect now."
Analysts at PFC have also stated that the scale of increases in output in Kazakhstan, Angola, Nigeria and Brazil are limited, and that production in these countries will also peak in the not too distant future. If this turns out to be the case for Nigeria and Angola, then all of Africa south of the Sahara can soon be written off where oil is concerned.
Five years ago a theory was offered by the chief oil analyst of a major financial company that oil prices would drop as low as $18/b by the following year, and they would stay there. He argued that the only time in the previous 60 years that the oil price was above $17/b was when there was a war involving at least one OPEC country, or a member facing political difficulties or embargoes. The possibility that OPEC had or would become more sophisticated in that it examined global demand and supply trends and possibilities and reacted accordingly was dismissed. Perhaps one of the reasons for this 'optimism' was that the futures market predicted lower prices the following year, and recently even the new director of the US Federal Reserve System referred to the futures market in such a way as to suggest that it had something to offer when it came to forecasting future oil prices. In point of truth the futures market has been a very poor predictor of the actual price of oil since the beginning of the present century, and most of the time in the 20th century.. On this topic I think it best to pay attention to something that Matthew Simmons of Simmons & Co - a Houston-based investment firm specializing in oil - once said: "Too many people are looking at OPEC through the rear-view mirror. There's a resolve in their eyes never to go back to the days of cheap oil". Not just in OPEC's eyes but in their investment policies, which make it clear that they feel that it is in their best interests to refrain from bringing too much additional oil to market. This is a good place to ask one of my favourite questions: would you if you were in their place?
Accordingly, the optimal development strategy for a country like Saudi Arabia is to pay more attention to the refining of oil, and the production of petrochemicals. There are not only enormous economic possibilities here, but they have finally been understood and are very likely to be exploited. It is for this reason that I am positive to a rapid but limited increase in the capability to produce larger quantities of e.g. ethanol and biodiesel, because even if much larger quantities are not needed, they are a valuable insurance in the event of a sudden decline in the supply of conventional fuels. Here it should be remembered that on the basis of some misunderstanding with Iran about a month ago, the price of oil suddenly spiked by 5 dollars a barrel.
3. CONCLUSION: THE OIL PRICE AND THE WISDOM OF BILL O'REILLY
I have a serious set of issues however with his beliefs about the oil price. To his way of thinking the increase in and volatility of the oil price is due to the machinations of speculators in e.g. Las Vegas. Without these "little guys", to use his terminology, or "masters of the universe", as Tom Wolfe called them - and occasionally they call themselves - we would have no problem obtaining the oil that we need, and at prices that we would feel comfortable paying.
What Mr O'Reilly is alluding to are hedge funds, which are also mentioned quite often in the financial press. I say a few things about hedge funds in my finance book and my lectures, and I was even given a lecture on these establishments by a hedge fund hustler just before taking up a visiting professorship in Hong Kong. The truth of hedge funds is similar to the truth of operations like the Nordic Electricity Exchange (NORDPOOL). Their strength is in the laziness of their clients. There are approximately 8500 hedge funds in the world, and every year about l000 either go out of business or are close to shutting their doors. It also happens to be the case that the yield on a large majority of those remaining does not come up to the yield on imaginable unmanaged funds of one type or another, assuming that it was possible to buy these unmanaged assets. There are superstars in the ranks of hedge fund managers, but mostly they busy themselves with the likes of the wealthy Mr O'Reilly, and as the Efficient Market Hypothesis tells us, most of these superstars are brought down to earth sooner or later, although when that happens they still have their condos in Aspen or Monte Carlo.
Despite what O'Reilly and others may think, the long run (or trend) oil price is determined by supply and demand, and the short run price can be described by a stock-flow model of the type explained at considerable length in my forthcoming energy economics textbook. Do hedge funds or "little guys in Las Vegas" have anything to do with this price? Not much, but probably some if we consider the following diagram.
Hedge funds and futures markets may influence the expected price, and as a result the desired stocks (i.e. inventories). If, for example DI > AI because it is expected that price will increase, then price will increase as an attempt is made to increase stocks. Readers who are interested in the real world oil market would do well to examine this diagram and the explanation of its functioning in my textbook. Nowhere in economics is there a greater discrepancy between fact and fiction than in the attempt to explain the mechanics of natural resource markets by esoteric models without the slightest virtue except that the people who use them find them easier to understand than the real deal.
At the present time I am working on a paper called 'The architecture of world oil', in which some items that could have been included in this paper will be taken up. Among these will be a more extensive discussion of OPEC, and oil products and petrochemicals. Hopefully readers will find it interesting and useful, and it would certainly be nice if other persons - to include students - would take a more intense interest in oil products and petrochemicals, because the economics literature on these is very inadequate.
Professor Ferdinand E. Banks
REFERENCES Alhajii, A.F. (2007). 'The impact of Iran's nuclear standoff on world energy security'. Energy and Environment (Forthcoming).
Banks, Ferdinand E. (2007). The Political Economy of Energy: An Introductory Textbook. London, New York and Singapore: World Scientific.
______. (2004). 'Beautiful and not so beautiful minds: an introductory essay on economic theory and the supply of oil'. The OPEC Review (March).
______. (2001) Global Finance and Financial Markets: A Modern Approach. London, New York and Singapore: World Scientific.
______. (2000) Energy Economics: A Modern Introduction. Boston and Dordrecht: Kluwer Academic.
______. (1991) 'Paper oil, real oil, and the price of oil'. Energy Policy (July/August).
______. (1987) 'The reserve-production ratio'. The Energy Journal (April)
Clarke, Duncan (2007). The Battle for Barrels: Peak Oil and World Oil Futures. London: Profile Books.
Nasar, Sylvia (1997). A Beautiful Mind. New York: Simon and Schuster Stern, Roger (2006). 'The Iranian petroleum crisis and United States national security. Proceedings of the National Academy of Sciences.
Urban, Julie A. (2006). 'New age natural gas pricing'. Journal of Energy and Devopment. Volume 31(1).
Yamaguchi, Nancy (2007). 'Middle East petroleum sector growing in all directions. Petromin (March).
Von Neuman, John and Oscar Morgenstern (1944). Theory of Games and Economic Behavior. Princeton, New Jersey: Princeton University Press.
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June 28th, 2022
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