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November 19th, 2017

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Economics, Economists and the Oil and Gas Future

Professor Ferdinand E. Banks
ferdinand.banks@telia.com
May 27th, 2010

"Most discussions of the earth's energy resources and their use by modern societies betray a widespread lack of scientific literacy, and abound in misinformation, biases, and proffers of dubious solutions driven by various special-interest agendas." -Professor Vaclav Smil
1. ECONOMICS

That was an interesting and valuable observation by Professor Smil, but personally I am fond of one that seems equally as relevant, and is much easier to remember: "All theory should begin with facts". This contribution contains some facts about oil and gas that my energy economics students at the Asian Institute of Technology (AIT) were kindly asked to learn perfectly. They were also informed - mostly in non-academic language - that not doing so would mean a failing rather than a passing grade.

The output of oil in the U.S. peaked at the end of l970 at about 9.5 million barrels per day (= 9.5mb/d) - which is approximately the current output of both Saudi Arabia and Russia, the largest producers (and exporters) of oil in the world. When that peaking took place there was still an enormous amount of oil onshore or directly offshore the United States. Production then gradually declined to 7.5 mb/d, but when the giant Prudhoe Bay field in Alaska came on stream, the total output in the U.S. turned up. As things turned out however, the previous peak was never attained. Instead, total U.S. production stopped short of that peak and once again began to decline. Today U.S. output is approximately 5.7 mb/d, and although statistics seem to indicate that the first sustained output in decades began in 2008, it is virtually certain that - given present production and its rate of growth - it will not be until 2015 that production will reach the 6 mb/d that was experienced in 2005. Of course, it may never reach that level.

In the latest forecast by the Energy Information Agency (EIA) of the United States Department of Energy, which is discussed by Rapier (2010), the global consumption of oil is shown climbing to 105 mb/d by 2030, of which production accounted for by projects that are identified at the present time is only 45 mb/d. The gap is therefore 60 mb/d, and in the most favourable of circumstances is supposed to be closed by output from "unidentified" projects. These numbers do not appear to be completely correct to me, but even so they give an indication of the problems that oil importers might face in the coming 20 years. More important, the United States Department of Defence ('The Pentagon') has just released a statement indicating that very bad news about the global production of oil might be reaching the newspapers and airwaves by 2015, and explicitly stated that this in turn could impact negatively on the macro-economy of that country..

On a number of occasions I have discussed at great length the forecasts of the EIA and the International Energy Agency (IEA). While in Bangkok I concentrated on the predicted global production for 2030, which for both the IEA and EIA was a completely unrealistic 121mb/d. After mentioning that I had picked up some information in Paris which indicated a global production peak in 2013, I informed my students that, on the basis of estimated reserves of oil, it was virtually impossible for global output to continue increasing past 2020, and perhaps a distinct peak would appear as early as 2015. I also made heavy weather of the forecast of the director of the French oil 'major' TOTAL, which was that global production would never exceed 100 mb/d.

Let me sum up the above by saying that the U.S. oil production experience is a model (or paradigm) for what will take place on the global level. It is a model whose rudimentary details - as expressed in this paper - should be learned perfectly by everyone interested in oil, and in addition they should be able to repeat these particulars day or night, because in one way or another they apply almost everywhere. Moreover, it needs to be especially appreciated that production is not explained by geology - geology is a constraint, in that oil is either present in a given plot of land, or it is not. Production is explained by what in intermediate economic theory is called intertemporal profit maximization: for individual deposits as well as regions, production will continue to increase as long as an increase is deemed profitable in the intertemporal sense - i.e. taking into consideration the future as well as the present. Otherwise, theoretically, the slope of the production (frequency) curve will 'flatten', regardless of the size of oil reserves that are still available.

Something that should be added here is that while it may not be true elsewhere, there is no evidence that, in the future, drilling for oil offshore the U.S. will turn out to be especially rewarding in a 'social' sense, even though a few firms are likely to realize large profits. The same is true if extensive drilling is permitted in the Arctic National Wildlife Refuge. ("Rewarding" in a social sense implies e.g. making the dreams of American motorists come true.)

Charles Maxwell, who according to Roben Farzad (2008) was ranked by Institutional Investor as the No.1. oil analyst, once condemned the CEO of ExxonMobil for "irresponsibly advertising" plentiful supplies of oil. According to Farzad, Maxwell said that "It really does Rex Tillerson no good to keep denying that oil production will be peaking." That was in 2008, and here I would like to say that if the oil price approaches $150/b again, as it was doing about that time, then in makes little or no difference whether production peaks or not: the oil wolf is at the door. I can also stress that in my opinion, peak oil is not about the future. It is about the past, and the geopolitical peak that came about 2003-04 when OPEC finally discovered the advantage it held in what has sometimes been called the 'great oil game'.

A supposed peak oil sceptic at an influential consulting firm has employed the picturesque word "garbage" to describe the efforts of peak-oil believers. I am not sure that this terminology is completely suitable, but if you encounter that gentleman some fine day, remind him that the output of the U.S. has peaked, as has production in the UK and Norwegian North Sea. It also appears that non-OPEC output - which is about 60 percent of global output - has also culminated, as explained in the work of Gregor MacDonald (2010) and others. Given the opportunity you can also mention that what was the second largest field in the world just a few years ago - the Cantarell field in Mexico - is declining at a startling rate. Hopefully he will take this information seriously, though there is a possibility that none of this will upset him. After all, his organization once claimed that the production of oil will reach 115 mb/d by 2030, and moreover will remain at that level through 2050.

Not only did Christophe de Margerie, the chief executive of Total, say that global oil production would never exceed 100 mb/d, but he offered to discuss this estimate with any decision maker, at any time, and publicly. This is the kind of invitation that concentrates minds! Recently though, someone in his organization seems to have had some second thoughts, because a number being passed around on the Paris grapevine was 95 mb/d, the last time I visited that charming metropolis. This also implies a global peak before 2020, and if the bad macroeconomic news now being experienced blows over, and global economic growth rate attains its average for the last decade, the peak might arrive in the vicinity of 2015.

The Russian output may be close to peaking, and a director of one of the largest Russian firms says that his country will never produce more than 10 mb/d. This may or may not be correct, but in any case Russian exporters will do an increasing amount of business (in oil and gas) in Asia, to the detriment of European importers. The governments of oil importing countries everywhere though can consider the following. The discovery of conventional oil peaked in l965. Somewhere in the first half of the l980s the annual consumption of oil became larger than the annual discovery (although Charles Maxwell puts this in 1988), and at the present time only about 1 barrel of (conventional or near-conventional) oil is discovered for every 3 consumed (which is approximately the ratio mentioned by Maxwell.). According to a British Petroleum (BP) document, of 54 producing nations only 14 still show increasing production. 30 are past peak output, while output rates are declining in 10. To claim that all this does not imply an eventual physical peaking (and oil price escalation), is the same as implying that the (oil) whole is less than the sum of the parts, which is a myth that no intelligent observer would rush to endorse.

One more thing needs to be mentioned here: regardless of the level of oil production, there will be a downward pressure on exports, as OPEC countries 'consume' larger amounts of their oil output in both consumption and investment activities. Domestic consumption by oil producing countries has become one of the most popular topics in the business press. Moreover, the following should be digested by all neophyte oil forecasters and experts: OPEC has not only learned how to play the oil game, they have learned how to play it so that they are unlikely to lose! They are playing it the way that you would if given the opportunity, and the bottom line for their strategy - whether they know it or not - is to produce as little oil as possible, and invest as little money as possible in additional oil production facilities.

2. ECONOMISTS AND OIL

Professor Earl Cook, the late professor of geosciences at Texas A & E University, wrote a book that deserves a place on the reading list of every course in energy economics in every university in the world where that subject is taught. He makes the following important observation (1976): The (long run) recovery prospects for oil are such that that they "may unbridle the technological optimist, and allow estimates that put extreme demands on the technological cavalry to come riding over the hill in the nick of time to rescue the nation from scarcity".

By nation he meant the United States, but this observation holds for almost every country in the world, and conceivably less for the U.S. than many of the others. For what it is worth though, it will not unbridle many of the colleagues in the faculties of economics in any country, because their insensitivity to this and various other issues that are crucial for the future of civilisation is one of the reasons why the scientific integrity of economics is constantly questioned. For instance, the superstar physicist Murray Gell-Mann thought that winners of the (ersatz) 'Nobel Prize' that is sponsored by the Swedish Central Bank (The Riksbank) to reward economists for their contributions to applied and theoretical economics, should be discriminated against by being seated separately from the other laureates in the Nobel awards ceremonies at Stockholm's Concert House. He apparently concluded that since economics may not even be worthy of the status of a grandiose pseudo-science, this might be one of those exceptions in which apartheid was justified.

I have a problem believing that this is true, especially at the present time. Even if the most important American economist since the founding of the Republic, the late Professor Paul Samuelson, as well as colleagues (such as Barbara Bergman), occasionally referred to the precious advice of economists as crank, moonshine and snake oil , I think it could be argued that economists (and engineers and managers, etc) have as much to offer in describing and solving the supremely important energy quandaries that we are facing at the present time as physicists. The problem is that economists seldom deliver. Although economists read and teach from brilliant microeconomics textbook, virtually every student of energy economics in the world has been told that the interest rate is the key variable in determining intertemporal oil production, although in reality this role is taken by reservoir pressure (and its influence on extraction cost). Even Jack Nicholson probably came to understand this while making the film 'Five Easy Pieces', because pressure declines were the reason his 'character' had to spend so much valuable time in oil fields, attempting to maintain the flow rate of that liquid.

3. A PERSPECTIVE ON NATURAL GAS

The story of oil is simple, and so in my energy economics courses I tend to have little patience with students who cannot comprehend its main features. Gas was the same until recently, but now gas issues have been complicated by a widening and deepening of natural gas markets (due e.g. to the impressive economic growth taking place in China and India), and also talk about shale gas. There are many mistakes that are repeatedly made in the analysis of natural gas markets, and given the widespread circulation of what Professor Smil calls misinformation and biases, it should be recognized many more are going to be made in the very near future.

Among other things, my excursions in the blogosphere have convinced me that certain people are hard at work to convince the television and 'blog' audiences in the U.S. that their energy troubles are almost over because of the huge amounts of shale gas that - ostensibly - can be economically extracted in various parts of that country. Moreover, if this turns out to be true, then it is likely that the same could apply to many other parts of the world, since the shale gas phenomenon is largely a matter of technological improvements that can be easily transferred between countries or continents. At the same time it should never be forgotten that what some observers call the shale gas 'revolution' might turn out to be no more than be one of those mammoth 'spin' jobs that are mainly concerned with increasing somebody's money and power. Personally, for reasons given below, I remain sceptical to a large part of the shale gas song-and-dance, but admittedly I could be completely wrong. We will just have to wait and carefully examine the evidence before we can forecast how this issue might play out.

In the meantime it might be useful to put some basic information about natural gas into the hands (or on the screens) of interested parties. According to the British Petroleum Statistical Review for 2009, the natural gas share of the world's primary energy consumption was 21%, which amounted to 2.945 trillion cubic meters of gas. It happens to be true however that cubic feet are more useful than cubic meters, and so that number can be multiplied by 35.3 (cubic-feet per cubic-meter). In addition I can mention that in my energy economics textbooks (2000, 2007), I predicted that gas' share in the global energy picture will climb to 24%,

The power sector accounted for 39% of global natural gas consumption in 2007, while industrial, residential, service and agricultural sectors consumed about 50%. 'About' because transportation was a small consumer. According to the International Energy Agency (IEA), 11% of global gas consumption can be associated with petrochemicals (and fertilizers), where natural gas is a production input (or feedstock), and also provides the energy for driving these activities. The IEA has predicted that the global demand for natural gas will increase by 52% between 2006 and 2030, largely because of the increase in electricity generation. I discussed forecasts of this nature in my book on natural gas (1987), and came to the conclusion that a consumption growth of that nature was impossible. However, if massive shale gas supplies are real, and not a fantasy, then it might be possible to provide that amount of gas without the gas price going into orbit, although it is definitely not certain. Why the reference to an escalating gas price? It is because by 2030 traditional sources of gas supply might be rapidly decreasing, either for geological or geopolitical (= geo-economical) reasons.

A somewhat more exotic use for gas based equipment is as a back-up for intermittent generation, such as that dependent on wind and solar. As far as I know, the economic theory of this matter has never been adequately investigated, although the limited insight provided by some elementary algebra in one of my textbooks (2000) indicates that wind and solar installations with natural gas backups may not be inexpensive. The average capacity factor for wind in Germany (and Denmark) might have reached 22%, and thus were it not for the ability to obtain power from other countries, very substantial investments would have to be made in something like gas burning equipment - as well as the natural gas itself - to ensure that lights stay on and houses are heated in those two countries when the wind is not blowing and/or the sun is not shining.

Some years ago Professor Douglas Reynolds of the University of Alaska summed up the oil situation in an important paper in the OPEC Review (2000) by saying: "Oil supply is tight, demand is growing, and there are no viable substitutes". If it turns out that massive quantities of shale gas are not available, the same conclusion could and should be repeated for natural gas, and repeated day and night everywhere that gas is an important source of energy, and plans are being made to increase it utilization. It is in this context that correctly evaluating the availability of shale gas is essential, and governments should play a major role in this project, because some shale enthusiasts with access to the media have increased projections of shale gas reserves from 30 years at current usage rates to 100 years, and these projections can be encountered everywhere. One reason for projections of this nature is to increase the value of properties that might contain this gas.

According to David Rotman (2009), the editor of the Technology Review, shale gas is capable of dramatically changing the global energy map. This may be true, but if not then certain investments that should be made in other energy resources and alternatives may not be made, and thus when existing energy strategies and efforts are more carefully examined, and perhaps judged sub-optimal, very expensive alterations may be necessary. This kind of thinking is nothing more than an appendage to Richard Bellman's 'Principle of Optimality', which is based on the mathematical notion of recursion, and suggests that excessive haste can be a mistake, while more attention should be paid to obtaining superior forecasts.

The consultant Henry Groppe has claimed that shale gas will not provide the boost in reserves often claimed, citing a 'natural depreciation' of shale gas deposits that often attains 45 percent in the first year of exploitation. If he is correct, a small amount of integral calculus, in conjunction with a concept know in capital theory as 'depreciation by evaporation', will show that many persons intent on waltzing into the upper-income bracket by acquiring shale properties should be very careful.

As some of us know, in evaluating a difference in opinion of the above nature, specific professional credentials should play a crucial role. If we return to the individuals mentioned in the previous paragraphs, on one hand we have a gentleman who edits an important technical publication, and presumably has some scientific background, while on the other we have a world-class expert on petroleum matters, Henry Groppe, who is a graduate engineer and former officer in the United States Navy, with 40 years of experience as a petroleum consultant.

I can also refer to a brilliant article by Puru Saxena in '321 Energy' (2010) for a thorough insight into this question. In the process of summing up a long and valuable discussion, he expressed some reservations concerning shale gas prospects. One of the people who should read and attempt to understand this article is Amy Myers Jaffe, whose performance some years ago at the Rome conference of the International Association of Energy Economics left me reaching for the aspirin. Then it was oil, but now it is shale gas, and the article she published in the Wall Street Journal (2010) is at best a clumsy attempt to take advantage of the lack of scientific depth that permeates the world of academic energy economics, and which is partially responsible for the failure of voters and politicians to recognize and measure the energy security threats they are facing, and which will likely not go away if a few shale gas deposits are exploited.

To reiterate, it will take more than a few articles and interviews before we know the precise scope of this resource (which, incidentally, has been exploited to a limited extent for a great many years), but I regard the most important observation thus far about shale gas to be that of the CEO of the oil major Chevron, John Watson, in which he confesses that he will avoid investing in that sector. Mr Watson flatly declared that the price of shale assets is too high relative to expected returns to justify a large scale commitment by his firm. Put another way, he does not believe that shale gas has lived up to its publicity, and as a result he will not join many of his esteemed colleagues in investing millions or billions in that commodity - at least at the present time. For instance, in December of last year, ExxonMobile bought XTO Energy because, ostensibly, of its strong position in shale gas. The cost was $31 billion in stock and $10 billion in XTO debt, which incited several long and highly critical discussions in the blogosphere.

Among the observers of the gas scene who chose to go public with their apprehensions a few years ago was the former Chairman of the U.S. Federal Reserve (or Central Bank), Alan Greenspan. On several occasions he warned of possible traumatic spikes in the price of gas that could have very disagreeable macroeconomic consequences. In fact he went so far as to say that North America will forever be condemned to a volatile and inefficient gas market unless it can secure unlimited access to the vast world reserves of gas.

"Unlimited access" suggests that Dr Greenspan may have gone too far in his evaluation of the gas futures, however according to Vicky A. Bailey, Assistant Secretary for Policy and International Affairs in the U.S. Department of Energy, "We will be hard pressed to meet demand that might represent a 50 percent growth in eight years, unless we can manage to locate and develop far greater domestic reserves than currently exist." That was seven years ago, as was the last remark I heard on this subject by Alan Greenspan, but it is very definitely applicable today if shale gas is incapable making more than a marginal contribution to the global natural gas supply.

Some years ago a well known professor of energy economics flatly stated that there was plenty of oil and gas in the world, and fortunately in regions where its owners would make these items available should buyers and potential buyers come forward with sufficient cash. In other words, if the owners of these resources did not have any plans to restrict supply, which happened with the chief executive of an important gas exporting nation, who announced that a large share of the gas in his country belongs to future generations, and so he was extending its lifetime by producing less. At the same time, various claims were made about the efficiency of a complete 'liberalisation' (or restructuring) of natural gas markets, which is an even more grotesque proposition than the electric deregulations that were so harmful in places like California and Brazil and elsewhere.

Fortunately I had the opportunity to examine electric deregulation at great length during my tour at the Hong Kong Energy Research Institute, and in the course of my lectures there made it clear in language that could not be misinterpreted that the main failure with that illogical and unnecessary experiment was not due to politicians and industry executives, but academic economists who insisted on not understanding the lessons of both economic history and theory, but even so to express themselves in such a way as to make a gratuitous contribution to a colossal waste of material and human resources. You do not have to look very hard to see similar abberations at the present time, and not just about gas. The so called efficacy of 'carbon capture and storage' has been greatly misunderstood, and everybody reading this should attempt to comprehend the enormous demand for all energy resources that will take place because of population increases.

4. FINAL REMARKS
The OPEC price increases, for example, are largely motivated by the desired to be paid enough for a wasting asset so that it can be replaced by other types of assets. They are only marginally concerned with increasing the production from existing facilities, or with making a search for additional oil profitable.

-Ferdinand E. Banks (1977)
What I would like to claim is that this observation was mine and mine alone, however after teaching at the African Institute for Economic and Development Planning (Dakar, Senegal), I was forced to conclude that it was completely obvious to most of my colleagues and students, as well as myself, because it was the only development strategy that made any kind of (theoretical) economic sense.

Moreover, it especially makes sense for countries with large reserves of oil and gas, because oil can easily be refined and sold in the form of oil products, while some of these oil products can serve as inputs in the production of petrochemicals. Among the economists who discussed this were professors Morris Adelman of MIT and Hollis Chenery of Harvard, both of whom should have received Nobel Prizes, and whose chairs at the awards ceremony in Stockholm's Concert House should have been placed with those good persons whom Professor Gell-Mann thought of as 'real scientists'. Unfortunately professors Adelman and Chenery did not receive the opportunity they deserved to impress academic movers and shakers, insiders, shot-callers, and decision makers with their knowledge, because when they were most productive, a barrel of oil was sometimes less expensive than a barrel of coca-cola, and it was commonly thought that large deposits of conventional oil would eventually be discovered in favourable locations. Put another way, so-called insiders believed that OPEC would never morph into a genuine cartel, and was likely to remain a bit player on the oil stage for many years, and perhaps forever.

Such is no longer the case. The bottom line for OPEC today is to produce as little oil as possible, which is hardly a secret to anyone who has read more than the first half of an intermediate microeconomics textbook, or for that matter is familiar with the international financial press. Unless I am mistaken, many - though far from all - of our political masters have digested or are digesting the oil message, because the interest now shown nuclear energy by the political leadership of many countries possibly results from a comprehension by those ladies and gentlemen that without nuclear, voters are going to find themselves somewhere that they do not want to be, and might react accordingly when they go to the polls on election day.

According to Charles Maxwell, the lessons of the past 150 years barely provide an inkling of what the oil future will bring. This is not to deny that supply and demand tell the main long-term story, but in my research on oil I am more and more tempted to concentrate on the dominant position now held by OPEC on the supply side of the oil market. Here I can note that, a few months ago, I was abruptly informed that a GASPEC was impossible. Normally I would have ignored this contention, but the gentleman responsible for it has considerable access to the energy media. In case he has not changed his mind, let me say that a GASPEC might be right around the corner if the gas price does not recover, and so instead of dealing in wishful thinking, he should make it clear to the television audience that an OPEC and a GASPEC are not very good news at this point in history.

Before finishing this paper, I want to say something about my particular view of the energy future. The curtain will very likely come down on the oil and gas drama well before the end of this century. What about coal? I prefer not to make any predictions about how long this resource is going to last, but I would like to cite the belief of Jeffry Michel, an MIT engineer living in Germany, that the process that is supposed to increase the attraction for coal - carbon capture and storage - is a "thermodynamic travesty". The best translation of that term is economic travesty, because 'capturing' and 'storing' carbon is enormously expensive. Something else that is eventually going to be judged enormously expensive is the cap-and-trade nonsense being promoted for dealing with carbon dioxide emissions.

According to Jon Hilsenrath (2009), even the economic theorists who designed cap-and-trade now condemn it, however unfortunately the members of the great financial community, along with many academic economists, judge it favourably. Needless to say, for the former, the reason that cap-and-trade has been granted their faith has to do with cash, and not carbon. Anyone who can add, subtract and multiply should be able to understand that being an intermediary in the buying and selling of CO2 emission permits is a lovely career option

That leaves nuclear. My energy future for the two countries I know best - Sweden and the United States - amounts to the following: 'somewhat' more nuclear, and a lot more renewables and alternatives. Moreover, and this is especially important, without the additional nuclear, the renewables and alternatives will underperform economically. In one way or another, most intelligent observers know this, but for economic and/or social reasons prefer to keep it to themselves..

REFERENCES

Adelman, Morris A. and Martin B. Zimmerman (1974). 'Prices and profits in Petrochemicals'. The Journal of Industrial Economics (June).

Hilsenrath, Jon (2009). 'Cap-and-trade's unlikely critics: its creators'. Wall Street Journal (August 13).

Banks, Ferdinand E (2008).'The sum of many hopes and fears about the energy resources of the Middle East'. Lecture given at the Ecole Normale Superieure (Paris), May 20, 2008

______ (2007). The Political Economy of World Energy: An Introductory Textbook. London and Singapore: World Scientific.

______. (2000). Energy Economics: A Modern Introduction. Dor Boston: Kluwer Academic.

______. (1991). 'Paper oil, real oil, and the price of oil'. Energy Policy (July).

______. (1987). The Political Economy of Natural Gas'. London and Sydney: Croom-Helm.

______. (1980). The Political Economy of Oil. Lexington and Toronto: D.C. Heath.

______ (1977) Scarcity, Energy and Economic Progress. Lexington and Toronto: D.C. Heath.

Chenery, Hollis B. and Paul G.Clarke (1962). Interindustry Economics. New York: Wiley

Cook, Earl (1976). Man, Energy, Society. San Francisco: W.H. Freeman & Co.

Farzad, Roben (2008). 'The oracle of oil speaks'. Business Week, (July 7).

Jaffe, Amy M.(2010).'Shale gas will rock the world'.Wall Street Journal ( May 10).

MacDonald, Gregor (2010). 'Officially, peak non-OPEC in 2010. Really? Seeking Alpha (January 15).

Eltony, Mohamed Nagy (2009). Oil dependence and economic development: the tale of Kuwait. Geopolitics of Energy (May).

Rapier, Robert (2010). 'EIA's Energy Outlook for 2010 reveals disturbing figures'. OilPrice.Com.

Reynolds, Douglas B. (2000). 'The case for conserving oil resources: the fundamentals of supply and demand'. OPEC Review (June).

Rotman, David (2010). 'Natural gas changes the Energy Map'. Technology Review

Saxena, Puru (2010). 'Shale gas - miracle pill or empty promise'. 321 Energy (May, 5).



Professor Ferdinand E. Banks
May 27th, 2010
ferdinand.banks@telia.com




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