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Economic Theory and Some Oil Market Realities
Ferdinand E. Banks
May 29th, 2005

Not too long ago I had the great pleasure of giving a long lecture on oil at the Royal Institute of Technology in Stockholm, where I once studied mathematics in a building that is still known as ‘Sing-Sing’ (after the US prison of the same name.) And once again I discovered, to my great surprise, that even at this late date the realities of the present world oil market have not been absorbed by the future engineering elite to a desirable extent.

The major dilemma is simple and widespread, and cannot be referred to often enough: Mr and Ms consumer are still unable to comprehend that we are moving toward a world in which we are not going to have access to the inexpensive oil to which we believe we are entitled. Eleven years ago the Energy Journal presented a special issue called ‘The Changing World Petroleum Market’ (1994) in which the future oil and gas scene was systematically misrepresented by a number of prestigious energy economists. In their vision of the 21st century, not only was oil “plentiful”, but OPEC was a fragile construction due to the enormous amount of oil and gas that could or would eventually be discovered in the unexplored or only partially explored regions of the globe. In terms of mainstream geology, this kind of thinking hardly deserved to be labeled bizarre, but even so it attracted a sympathetic audience.

A basic difficulty was and is the inability of many observers to accept that technology cannot discover or produce oil that does not exist; and where it does exist, it may not be what many students of this subject think that it is. A perfect example here is the tar sands of Northern Canada, whose resources have now been officially added to proved Canadian reserves of oil, thereby turning that country into a rival to Saudi Arabia in the oil reserves league.

Professor Douglas Reynolds has examined the realities of Canadian tar sands in the latest issue of the OPEC Review (2005). As he makes clear, “Physics, economics and engineering management all point to one thing – oil sand is not the same as crude oil. By defining oil sand bitumen as proven reserved of crude oil, we are setting up the oil and energy markets for a large price spike – a shock.” A version of this comment could probably be applied to the heavy oil of Venezuela, along with a reminder that from a thermodynamic point of view, both heavy oil and oil from tar sands do not have a great deal to offer.

Another important issue in these matters concerns attracting investment dollars to non-profitable undertakings, which is something that I touched on in my energy economics textbook (2000) and several recent papers, but which apparently was not appreciated by a number of influential readers. However Professor Maureen S. Crandall of the United States National Defense University, in a discussion of the huge resources that ostensibly will be made available by extensive exploitation of the Caspian region (2005), makes the following unwelcome observation: “But this producing region as a whole, while accounting for billions of dollars in investments, is unlikely to be a large and sustained future producer and contributor to the world’s energy supplies, and cannot be considered of strategic energy importance to the US.”

The same judgement applies to other ‘oil producing regions of great promise’, but it is best at this time to sum up the situation introduced above with a quote from Craig Bond Hatfield (1997). “The coming era of permanent decline in oil-production rate and the economic and social implications of this phenomenon demand serious planning by the world’s governments.” This decline is not certain, but it might be useful to remember that the major part of today’s oil production – at least 70% – comes from deposits discovered before 1970. This is hardly worth pondering, given that global oil discovery peaked about 1965. Similarly, rumors have started making the rounds that the relatively new discoveries in Russia and West Africa may not live up to expectations.

Some Basic Economics

Recently the International Energy Agency (IEA) published its latest ‘World Energy Outlook’, in which the conclusion was advanced that the availability of oil in terms of reserves and production will not be a problem as long as a few trillion dollars can be mobilized to finance new wells and pipelines, as well as capital intensive items such as refineries and tankers.

In addition, that organization has postulated an increase in the world oil demand from the present 84 mb/d to 121 mb/d in 2030. Normally, I would express some curiosity as to the scientific background for that estimate, however I have heard it a number of times, and it is almost the same as a recent estimate of the United States Department of Energy (USDOE). At the time when this 121 mb/d is supposed to be produced, OPEC is pictured as being responsible for about one-half (as compared to approximately 38% just now). This suggests an OPEC production of approximately 60 mb/d. At the present time Saudi Arabia supplies almost a third of OPEC oil, and given their reserve situation relative to the other OPEC (and non-OPEC) countries, this fraction will hardly decrease. (Saudi Arabia has proven reserves of 260 billion barrels, while second place Iraq has 120 billion barrels.) Accordingly, it seems that IEA experts believe that Saudi Arabia will supply about 20 mb/d in 2030.

It will not be easy for Saudi Arabia to supply 20 mb/d in 2030, or at any other time in the near or distant future. A high-ranking Saudi official recently stated that 15 mb/d should be possible, which undoubtedly sounded lovely to motorists in the large oil importing countries – if they were listening; but although my knowledge of geology is limited, the energy economics that I have taught left me with the belief that the 12.5 mb/d recently promised by the Saudi Arabian king to President George Bush is a more realistic goal. This particular output is supposed to become available by 2010.

There is also some question as to what OPEC as a whole will be able to achieve. A report from the consulting firm PFC Energy (as mentioned in the Petroleum Economist, October 2004) states that OPEC is producing about 8 billion barrels a year more than it has been finding. This situation might change if e.g. Libya and Iraq intensify their exploration activities, however there is little or no reason to believe that this will be of other than marginal significance for the IEA and DOE targets mentioned above.

During the question and comment phase of the lecture mentioned in the first paragraph of this paper, I was cheerfully informed that OPEC producers are increasingly aware that erratic behavior on their part might result in their being confronted by a deluge of synthetic liquids, with natural gas being the most popular input. This kind of situation sounds consistent with the approach taken in a mainstream intermediate microeconomics textbook – assuming that you and your teacher did not confine your reading to the first few chapters – but even so it has no basis in reality: there is not enough natural gas to bring this about except in the fantasies of journalists, and for various reasons coal is no longer a contender. Of course, even if it were possible, the producers of onventional oil might – in theory – merely dump their prices when the new oil comes on the market, and therefore wipe out the profit of the intruders. I can also note that your favorite book on game theory probably suggests that the mere threat of dumping prices should suffice to keep potential suppliers of unconventional oil from listening to advice from economics professors with a deficient knowledge of what Ernest Hemingway would call “their craft”.

Almost thirty years ago Crown Prince Fahd of Saudi Arabia informed the large oil importing countries that their best strategy was to moderate their consumption of oil, while introducing as rapidly as possible alternative sources of energy. (Similar thoughts were expressed by the very visible and highly respected oil minister of Saudi Arabia, Sheikh Zaki Yamani.) Prince Fahd also emphasized the need to preserve his country’s petroleum wealth for future generations, and made it clear – by actions as well as words – that Saudi Arabia recognized its position as a critical component in the global oil supply nexus – both present and future – and would do everything possible to maintain an adequate margin of spare capacity that could be used in the event of an unforseen escalation in global demand. A large part of this is forgotten or overlooked by many journalists and pseudo-scholars in the consuming countries, however it is an undeniable part of the history of the past thirty or forty years.

The Iron Laws of Glamour

One of the experts mention in the Energy Journal survey, Professor Morris Adelman, began his contribution by informing us that “Glamour robs people of their common sense.” This is not completely certain, because the German megastar, Marlene Dietrich, once noted that glamour is the thing that makes us equal to the occasion.

The lapse in common sense that is relevant here involves what Adelman identifies as a “mistake”, by which he specifically means the OPEC countries assuming control of the oil in their countries. Instead of showing foreign enterprises the door, the professor believed that the host countries should have “left the companies in place, to invest and produce efficiently, and to compete on the narrow margins left to them.” I have heard this kind of thing at a number of energy conferences during the last few years, and in its ad-hoc versions it sounds even more looney-tune than coming from a leading academic oil economist. As one of the most astute observers of the 20th century energy picture – the petroleum scientist and executive Donald E. Carr – remarked, Aramco (i.e. the foreign company exploiting Saudi Arabian resources) had a “fond” idea of producing 20 mb/d, which for reasons given in my textbook and elsewhere is not the kind of ambition that could be associated with the most common use of the term ‘efficiency’.

Last year the French oil company Total, and Shell, were awarded the first oil exploration contract in Saudi Arabia since l974, however this was limited to gas. As Business Week (October 25, 2004) pointed out, it gave those enterprises “a foothold in the world’s richest oil patch”, but even so it is dubious that they are there as major players, because the simple truth is that they are not needed. They are needed even less than the foreign owners, bureaucrats, propagandists and busybodies who are gradually taking control of the Swedish economy.

In the last few years, Sheikh Yamani (who was mentioned above) has become a favorite with the oil optimists – or ‘flat-earth economists, as they are sometimes labeled. Sheikh Yamani has gained a considerable following by comparing oil to the stones of the Stone Age, saying that there were plenty of stones remaining when the Stone Age came to an end. The point here, I suppose, is that it would not be a good thing for a major oil producer to have large reserves of oil remaining when the oil age is over (and, e.g. the hydrogen age was moving into high gear).

With all due respect, I am afraid that the kind of economics and finance that I teach prevents me from understanding this kind of reasoning. Oil age or no oil age, the resources of the large oil exporters will continue to be valuable as an input for the energy intensive industries that are being constructed or could be constructed in e.g. the Middle East. Saudi Arabia, for instance, should eventually be able to construct a petrochemical industry of the absolute top rank. If a country like South Korea could build a viable petrochemical export industry although it lacks domestic petrochemical feedstocks, or perhaps more important, inexpensive energy for running these facilities, then a country like Saudi Arabia should have an unbeatable competitive advantage. Moreover, something that is seldom appreciated is the value of petrochemicals in modern life. Preserving oil for this purpose is one of the reasons why the price of oil should not be allowed to fall to the level where persons like Professor Adelman and his Greek chorous once wanted to see it.

Although not remembered any longer, there was a time when Sheikh Yamani had a very different point of view where Saudi oil is concerned. He presented this at the Stockholm meeting of OPEC in l977, although only a few people bothered to listen to him, and many of those who did failed to comprehend his meaning.

What he said was that if consumption and reserve augmentation trends continued to hold, then the market and not OPEC would determine the price of oil, and that price could rise to a very high level. Furthermore, even consumer friendly OPEC members like Saudi Arabia would be unable to interfere to an extent that would depress the price. This is precisely what has happened, with the OPEC Secretary General, Pumomo Yusgiantoro, calling present oil prices “crazy”, while admitting that it was the market rather than OPEC which is responsible for this situation. Yamani’s superb presentation was intellectually far ahead of the kind of thing that we were receiving at that time from the Nobel Prize winner Milton Friedman, who assured his adoring audience that OPEC would collapse, and the price of oil would end up well under ten dollars a barrel.

Conclusion: Genius at Work

Recent estimates of limited oil resources as constituting a constraint on the future of oil, lack validity. The issue unimportant for the oil market for 50 years. Similarly, of annual additions to reserves are unfounded: the world is running into oil, not out of it. Peter R. Odell (1994)

The above statement by Professor Odell was repeated many times later, in many countries, to include Sweden, where it was warmly appreciated by the local movers and shakers, as well as anyone else to whom the words of Samuel Johnson apply: “The mind that has feasted on the luxurious wonders of fiction has no taste for the insipity of truth.”

The most important question to ask then is how could anyone repeatedly make this kind of mistake, because the scarcity of oil was crystal clear long before the above lines were written. In every corner of the globe bell shaped production curves could be drawn for very large oil deposits, and from these curves and the geological and economic explanations for their appearance, it should have been possible to understand that the oil optimists were (and are) working the wrong side of the street.

Unfortunately, in the soap opera about oil that featured Professor Odell’s words, there were other prophets. Professor Adelman has already been mentioned, and now Professor James M. Griffin of Texas A & M University deserves some attention. Professor Griffin is a conspiracy theorist who constantly talks of cheating by OPEC members, and whose knowledge of game theory leans heavily on what is known as a tit-for-tat strategy which, to his way of thinking, has something to offer for “deterring cheating”. This probably is true in theory, but dubious and irrelevant in fact, because the “enormous OPEC reserve base” that Griffin (like Odell) attributes to OPEC has actually not existed for many decades: given the actual and potential economic growth in the world economy, there is no such thing as an enormous reserve base!

There is instead a limited amount of oil in the crust of the earth that it is in the interest of both buyers and sellers to preserve for many more years in both the stock and flow sense – that is, not just as petroleum in the ground, but available as inputs for the durable items that were purchased by consumers and producers in the belief that they would not be kept from using them because of the lack or extremely high price of a critical input, where by “critical input” I mean what George Monbiot calls “the resource on which our lives are built”.

One final point. Professor Griffin makes heavy weather of what is known as the ‘backstop fuel’, by which it is meant ‘a higher priced fuel with high availability that can replace current popular fuels when they run out or become too expensive.’ I displayed the same naiveté when I began to teach energy economics, but eventually I found out that this famous ‘backstop’ is one of the most useless concepts every introduced into a class or seminar room, and probably one of the reasons why economists from some of the leading academic and financial institutions in the world once allowed themselves to believe that no harm could come to the international macroeconomy if the price of oil fell to the level of that of bottled water, and remained at that level indefinitely.

Ferdinand E. Banks
May 29th, 2005

References

Adelman, M.A. (1994). ‘The world oil market: past and future’. The Energy Journal.

Banks, Ferdinand E. (2005). ‘Logic and the Oil Future’. (Forthcoming)

______. (2004). ‘A new world oil market’. Geopolitics of Energy (December).

______. (2000). Energy Economics: A Modern Introduction. Dordrecht and Boston: Kluwer.

______. (1998). ‘World energy and the 21st Century’. The OPEC Bulletin (July).

Carr, Donald E. (1978). Energy and the Earth Machine. London: Abacus.

Crandall, Maureen (2005). ‘Realism on Caspian Energy’. IAEE Newsletter (Spring).

Griffin, James M. and Lawrence Vielhaber (1994). ‘OPEC production’. The Energy Journal.

Hatfield, Craig Bond (1997). ‘Oil back on the global agenda’. Nature (May).

Odell, Peter R. (1994). ’World oil resources: reserves and production.’ The Energy Journal.

Reynolds, Douglas (1995). ‘The economics of oil definitions’. OPEC Review (March).