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More Facts and Fictions About the World Oil Scene

Ferdinand E. Banks
October 30, 2006

A publication that I occasionally refer to as a compendium of London wine bar gossip recently offered a few choice observations about oil that deserve elaboration and a wider circulation. I place these observations in the category of facts, and use them to present a few comments on associated fictions. First and foremost it was noted that “Unfortunately for consumers, OPEC has little incentive to expand that ‘cushion’ in the short term. It would, in effect, be spending money to reduce its revenue, since the price of oil would undoubtedly fall if traders had no fear of future shortages” (The Economist, October 21, 2006).

The unforthcoming “cushion” that is being referred to above is sufficient production capacity to ensure at all times an excess of supply over the predicted demand for OPEC and/or world oil. This situation has been appearing in my work for the last five years, and is spelled out at some length in my forthcoming textbook (2007). I can add that since the major producers in OPEC have little or no reason to raise their output to the levels desired by the major oil consumers, they also have no need to indulge the fantasies of assorted experts and pseudo-experts by declaring themselves ready to welcome foreign executives and technicians in order to help them determine optimal extraction programs for their reserves of oil and gas. Students of the oil markets would do well to accept these realities.

Pointing things like this out appears to have increased my unpopularity in certain high-value circles in North America and Europe, however I am unable to understand why. As a teacher of economics and finance I am merely fulfilling my responsibility to inform interested parties what – in the light of mainstream economic logic – could conceivably take place as compared to what certain people want to happen, or think will happen, or even what will actually be experienced: the basic issue here is the optimum use of currently available information. Recognizing this, I feel perfectly comfortable saying that since without exception the OPEC countries now possess or have easy access to all the expertise that they require, and more important given the rapidly expanding market for their products, it can hardly be true that they are unable to function without the assistance of Big or Not-so-Big Oil.

According to the article cited above, Amy Jaffee of Rice University gratuitously declared that “most of the OPEC countries’ national oil companies have a dismal record on investment and expansion.” The reason for her disappointment can be ascertained from the following statement by the Economist’s energy experts: “Given all the uncertainties involved, a rational OPEC planner would probably resolve simply to maintain exports at today’s levels rather than add capacity.” With the exception of my own work, this is the first time that I have encountered this obvious but vital pronouncement.

The key word above is “rational”, while the phrase “given all uncertainties” is superfluous, because although there may be some uncertainties about the exact quantity of reserves at the disposal of various OPEC oil producers, there can hardly be any about the laws of supply and demand. According to the article being discussed, Saudi Arabia “has plans to pump a third more oil”, which sounds impressive but actually amounts to only an extra three and one half million barrels (= 3.5 mb/d) at the most, and thus means a total 12-12.5 mb/d, at some unspecified time in the future. For better or worse, this is not what President Bush and his advisers have been waiting to hear, assuming that they prefer lower oil prices to higher. The oil minister of Saudi Arabia once said that his country would be able to supply 15 mb/d in the foreseeable future, and in addition could maintain that amount indefinitely, but he could hardly have been serious. Something that is even more far-fetched is the contention by the International Energy Agency (IEA) that OPEC will be able to supply 57 mb/d of an expected 121mb/d of global requirements around 2030.

In my textbook I calculated the required OPEC output to be 60 mb/d at that point in time if the dreams of the IEA are to come true, but regardless of assumptions and mathematical slight-of-hand, neither 57 mb/d nor 60 mb/d has the slightest possibility of being realized. I think that it is best for all of us on the buy side of the oil market if our political masters understand this as soon as possible. I also have very serious doubts as to whether Saudi Arabia, for example, would be capable or willing under any circumstances to provide its share of the mythical 121 mb/d conjured up by the IEA, which comes to about 20 mb/d if a linear extrapolation is employed. This might also be the right occasion to note that according to an important French insider, Christophe de Margerie (director of exploration for Total), 121 mb/d is out of the question at any date in the future.

Before changing the subject, an issue that needs to be addressed is how a reduction in OPEC output would be managed if one were necessary in order to support an oil price floor of $60/b. The usual opinion is that most OPEC countries would object to making a cut in their production, but to me this implies that somebody in authority was asleep during the courses in development economics that he or she might have taken, because (ceteris paribus) they should be overjoyed for the opportunity to keep as much oil as possible in the ground, since a simple option of this nature would contribute to maintaining or increasing the oil price.

The difference between the oil market today and that market a decade ago is that certain sophisticated producers would be overjoyed. Any doubts that anyone may have on that score should be discarded as soon as possible. For example, one major OPEC country recently announced that instead of continuing to think in terms of a one generation time-horizon for the output of their natural gas, they now want this resource to provide them with a generous income for 100 years. It is a short step from expressing an intention of this nature about gas to adopting the same attitude for oil, although it happens to be true that the government of Saudi Arabia has been clear on this point since at least l973. Regardless of the promised or actual output of Saudi oil, high or low, it is patently unwise at the present time to believe that they will produce more than 12.5 mb/d.

Why should they? Would you if you were in their place?

Much attention is directed to OPEC’s attempt to impose a $60/b floor on the oil price, with comparisons frequently made to the $78/b ‘spike’ once enjoyed by all oil producers. The thing to notice here is that $78/b was really and truly a ‘spike’, which suggests that it was unsustainable. $60/b cannot be regarded as a spike, but the belief here is that it is also unsustainable, although not in the way envisioned by oil optimists such as Dr Michael Lynch. Having experienced a comparatively long stretch of $70/b oil, the OPEC countries are hardly in the mood to rejoice at having to accept a REDUCTION in their revenue of 27.5 x (70 – 60) = 275 million dollars a day for a long period of time. (Here 27.5 mb/d is the current OPEC output, while I take $70/d as a ‘putative’ sustainable price.) The ostensible floor that OPEC is gearing up to defend is $60/b, but it would be naïve to believe that OPEC’s goal at the present time is less than 65 or $70/b.

A basic position that I have always held is that oil is much scarcer than commonly realized. My textbook is filled with all sorts of numbers whose purpose is to support this belief, however recently I encountered some interesting work by Fredrik Robelius, a doctoral student of physics and petroleum engineering at Uppsala University. Robelius notes that 20 years ago 15 oil fields had the capacity to produce more than one million barrels of oil a day, while today there are only 4 fields. These are Ghawar in Saudi Arabia, Kirkuk in Iraq, Greater Burgan in Kuwait and Cantarell in Mexico. Cantarell is the most recent to be brought into operation, but due to its attraction for North American consumers, its output began falling last year. Burgan has also peaked. This is the kind of information that all students of the oil market need to keep in mind.

It has been said that Canterell’s deline will be more than compensated for by the large ‘strike’ in the Gulf of Mexico called ‘Jack’ (or Jack-2), but as has been pointed out by Robelius (2006) and Len Gould (2006), this allegation is a misunderstanding, or worse. Very likely any good news being circulated about that venture is another component of the ‘hype’ that is flooding the oil world, and mostly has to do with boosting share prices, as well as attracting some billions for exploration and production. As noted by Chris Screbowski, editor of the Petroleum Review, there are so many lies in circulation these days about oil that it is almost impossible to carry out a credible analysis.

There are still a few observers who disagree with the analysis provided above, but I have good reason to believe that their number diminishes every year: the oil spike referred to above concentrated a great many recalcitrant minds. I also believe that it is apparent now that the global macroeconomy will not find it easy to deal with an ‘early’ peaking of global oil production. Everything considered, an early peaking is something that should be be avoided at all costs if possible, and since it could involve serious losses of one sort or another to all players on the oil market, both OPEC and the major oil importing countries should turn to an interesting axiom from game theory which says that when cooperation is possible, it always – or almost always – pays to attempt to bring it about.

NOT THE REAL DEAL

Having made some favourable comments about a ‘piece’ in one of my least favoured publications, I would now like to make some unfriendly comments about a presentation in ‘Forbes’ , which to me ranks with ‘Fortune’ as an outstanding review.

Christopher Helman (2006) begins a discussion of the oil future by citing Michael C. Lynch’s claim that the oil price could fall to $45/b by mid 2007, and touch the 20s in 2008. According to Dr Lynch, the recent high oil price can be easily overcome. Since a great deal of Lynch’s optimism is based on new projects, this might be the place to cite a recent statement by Chris Screbowski: “The time lag between discovery and first oil production for a major project is currently averaging over 6 years. A few large projects are taking as little as 4 years, but many others are taking up to 10 years. This means there is now little or no chance of significantly altering the production outlook for 2010, while even that for 2012 is already largely determined”.

In a curious flight of fancy, Lynch has noted that the price of oil is is not rising but declining if expressed in grams of gold, which is an observation that is completely without any scientific relevance to anyone except possibly Steve Forbes – owner and publisher of Forbes – who wants the international monetary system reinvented to make gold the ‘reserve of last resort’ (2006). The last time I encountered a suggestion of this incongruity was during the Nobel Prize lecture at Uppsala University by Professor Robert Mundell, who suggested that Japan should adopt the U.S. dollar as its national currency. On that occasion I believe that I countered Professor Mundell’s advice with a favourite aphorism of Mr Forbes: “With all thy getting get understanding.” Needless to say, with a Nobel Prize safely in his possession, along with the prize money, he might have argued that a great deal of understanding was unnecessary on his part.

Apart from this show of respect for what has been called the most “noble” of all commodities, Dr Lynch envisages an ‘Oil Spring Busting Out All Over’, to slightly alter the title of an American musical comedy ‘hit’. Detail is unnecessary here, because almost everything Mr Helman chooses to cite is based on sheer delusion. For instance, India will soon be supplying an important part of its oil requirements from domestic resources, which is impossible, and the firm ‘Apache Energy’ is revitalizing a stretch of the UK North Sea with “new recovery techniques”. The latter claim can be classified as preposterous, because if there were substantial reserves to be obtained from the UK North Sea, they would be the object of exploitation by one or more of the oil majors with greater experience in the region. There was also a reference to the above mentioned activities of Chevron, Devon Energy and Statoil in the Gulf of Mexico, where the ‘Jack’ bonanza that they are advertising has been referred to as humbug by some very serious observers; however as Professor Kjell Aleklett recently mentioned, even if the claimed quantities of new oil did exist they would not substantially alter the world oil picture. Lynch also tells us that the ‘Twilight in the Desert’ that Matthew Simmons wrote about is actually a new dawn, and he apparently believes that ExxonMobil and BP are so discouraged by oil price prospects that they have started returning cash to shareholders rather than use it for exploration and production. The argument in my textbook is that they are passing out this money to shareholders because it makes more economic sense than using it to search for oil that does not exist – at least in the amounts that they consider to be worth extracting.

What we have with the ruminations of Dr Lynch and a few others is a soap opera that has been confected to support the crank conclusions of the IEA. Every decade for the last 40 years oil additions to global oil reserves have declined by fairly large volumes, while increments in consumption have been considerable, and in the coming years the gap between these could be greater than ever, particularly if present trends are maintained. Moreover, rumour has it that the IEA researchers do not have a great deal of faith in the projections they so grandly present their clients, however they feel compelled to offer them because more realistic estimates are not politically acceptable.

More realistic estimates are, fortunately, increasingly acceptable in the corridors and restaurants of power in Washington D.C., where the president of the U.S. has spoken of his country being hooked on oil. Doing something about this suggests, in the language of finance, that the time may have come for decision makers everywhere to go long on realism and short on nonsense.

In a recent article in EnergyPulse (2006), Alan Caruba insists that plenty of oil could be located in the Western Hemisphere if the search for it were more intensive, which may or may not be true, however he is correct when he states that it is better to put more effort into looking for and producing what oil is available, than to engage in á series of wars in order to assure access to various energy resources. Taking into consideration the fact that substitutes have been found for these resources, and clarifying for all concerned the relevant direct and indirect benefits, it may be time to begin thinking in terms of a Manhattan Project type effort that involves the large-scale production of e.g. biofuels and hydrogen. There have been many systematic and impressive arguments in EnergyPulse and elsewhere that this is an idea whose time has not arrived, but given the economic and political consequences of a too early peaking of the global oil output, it might turn out to be an optimal strategy.

Ferdinand E. Banks
October 30, 2006

References

Aleklett, Kjell (2006). Comment: oil production limits mean opportunities, conservation (Aug 21). Oil and Gas Journal (August 21).

Banks, Ferdinand E. (2007). The Political Economy of World Energy: An Introductory Textbook. Singapore, London and New York: World Scientific.

______ (2006). ‘Economic theories and oil market realities’. Energy and Environment (Forthcoming).

Beyer, Jim (2006). Comment on Reynolds. EnergyPulse (www.energypulse.net).

Caruba, Alan (2006). ‘Peak oil or lots of oil’. EnergyPulse (www.energypulse.net).

Forbes, Steve (2006). ‘Powerful Antiterror weapon – unused’. Forbes (October 16).

Gould, Len (2006). Comment on Caruba. EnergyPulse (www.energypulse.net)

Helman, Christopher (2006). ‘Really, really cheap oil.’ Forbes (October 2).

Reynolds, Warren (2006). ‘The next step: conversion to the solar-hydrogen economy (www.energypulse.net).

Robelius, Fredrik (2006). ‘Oljefyndet är en bluff’. Interview for PsXpress.