Thinking Seriously

Thinking Seriously

Mini Teaser: America's first energy secretary says we're running out of oil. It is a warning worth heeding.

by Author(s): James Schlesinger

THE RUN-UP in gasoline and other energy prices-with its impact on consumers' purchasing power-has captured the public's attention after two decades of relative quiescence. Though energy mavens argue energy issues endlessly, it is only a sharp rise in price that captures the public's attention. A perfect storm-a combination of the near-exhaustion of OPEC's spare capacity, serious infrastructure problems (most notably insufficient refining capacity) and the battering that Hurricanes Katrina and Rita inflicted on the Gulf Coast have driven up the prices of oil and oil products beyond what OPEC can control-and beyond what responsible members of the cartel prefer. They, too, see the potential for worldwide recession and recognize that it runs counter to their interests. But the impact is not limited to economic effects. Those rising domestic energy prices and the costs of fixing the damage caused by Katrina have weakened public support for the task of stabilizing Iraq, thereby potentially having a major impact on our foreign policy.

What is the cause of the run-up in energy prices? Is the cause short term (cyclical) or long term?Though the debate continues, the answer is both.

Clearly there have been substantial cyclical elements and "contradictions" at work. For several decades, there has been spare capacity in both oil production and refining. Volatile prices for oil and low margins in refining have discouraged investment. The International Energy Agency, which expresses confidence in the adequacy of oil reserves, urges substantially increased investment in new production capacity and has recently warned that, in the absence of such investment, oil prices will increase sharply.1 Such an increase in investment clearly would be desirable, but it is more easily said than done.

In the preceding period of low activity, both the personnel and the physical capacity in the oil service industry have diminished-and it will take time to recruit and train personnel, to restore capacity and to produce equipment. It is interesting to note that the capacity of OPEC itself has shrunk in this last quarter-century from 38 million barrels per day (BPD) to 31 million BPD. The bulk of the shrinkage occurred in Iran, Iraq and Libya, which have been the targets of both U.S. and international sanctions. Though knowledgeable people were aware of the shrinkage of spare capacity, it was still thought to be adequate-until the recent surge of demand, especially from China and the United States, brought us to the point that it was insufficient to satisfy the growing demand at prevailing prices.

Three additional points should be kept in mind. First, crude oil production capacity has not been wholly exhausted. The minister of petroleum of Saudi Arabia, Ali Naimi, points to the unutilized 1.5 million BPD in his country and states that he stands ready to serve additional buyers. The minister is making something of a rhetorical point: For the moment, that additional crude oil production capacity is unusable. There is a mismatch between the types of crude available and what refiners are able to process. For many decades there has been a marked excess of refining capacity-and very low margins in refining. There has been only a modest incentive to invest in additional capacity. With sufficient light crude apparently available, there has been little incentive to invest in capacity to process the heavy, sour crudes of the sort still available in Saudi Arabia. That is not to say, however, that there has been no investment. Here in the United States, far too much of the investment has been channeled into the capacity to produce the numerous boutique blends of gasoline, some thirty at last count-a foolishness mandated by the different state regulatory bodies.

Second, it is the international oil companies (IOCs) that have lots of cash. Their inclination has been to invest in new production capacity, counting only on prices being in the range of $20 to $30 per barrel-and not necessarily expecting the current high prices to be sustained. But while the IOCs have the cash, it is basically the national oil companies (NOCs) that have the reserves. The IOCs seek equity oil, and for the most part, equity investment in reserves controlled by NOCs has not been permitted. So, there exists another mismatch between those who have the resources to invest and the availability of suitable places to invest.

Third, when gasoline prices are rising, public anger rises at least correspondingly. Public anger immediately draws the attention of politicians-and here in the United States it elicits a special type of political syndrome: wishful thinking. It is notable that in the last election both candidates talked about "energy independence", a phrase that traces back to the presidency of Richard Nixon and the reaction to the Arab oil embargo. One should not be beguiled by this forlorn hope-and this brings us to the real problem for the foreseeable future. What is the prospect for oil production in the long term? How does it bear on the prospects for "energy independence"?

The Day of Reckoning Draws Nigh

AT THE end of World War II came the period of the opening-up and rapid development of Middle East oil, notably in the Arabian Peninsula. Both Europe and the United States embraced the shift from coal to oil as their principal energy source. The beginning of flush production in the Middle East coincided with and fostered the tremendous expansion of world oil consumption. In the 1950s and 1960s, oil production and consumption more than doubled in each decade. Annual growth rates in consumption of 8, 9 or 10 percent were typical.

By contrast, no one, not even the most optimistic observers, expects a doubling of production in the decades ahead. The present expectation is markedly different. In increasing numbers, now approaching a consensus, knowledgeable analysts believe that the world will, over the next several decades, reach a peak-or plateau-in conventional oil production.2 Timing varies among these observers, but generally there is agreement on the outcome.3

The implication is clear. Even present trends are unsustainable. Sometime in the decades ahead, the world will no longer be able to accommodate rising energy demand with increased production of conventional oil.

It should be emphasized that that would pose not a general "crisis in energy", but instead a "liquids crisis." Problems in energy other than oil are infrastructure problems, solvable through appropriate investment. To talk of a general "energy crisis" aside from oil is to divert attention from the central long-term problem. Advocating the construction of nuclear plants, for example, may be desirable, but it does not confront the critical issue of the liquids crisis. Basically, there is no inherent problem in generating and transmitting electric power, for which the resources are available. The intractable problem lies in liquid fuel for land, sea and air transportation.

We get clear indications regarding oil's future from those in the industry. Though the United States and other consuming nations seem to believe that Saudi Arabia can and should increase production as demand rises, when he was asked at a recent conference whether oil production would peak, Ali Naimi, the long-time head of Saudi Aramco, responded that it would reach a plateau. It is quite telling that when, in 2004, the Energy Information Administration (EIA) projected Saudi production in 2025 of some 25 million BPD to satisfy world demand, the Saudis demurred-and quite politely indicated that such figures were "unrealistic." The Saudis have never discussed a figure higher than 15 million BPD.

This is why David O'Reilly, CEO of Chevron, has stated that the "era of easy oil is over." Projections by Shell and BP put that plateau several decades out. BP now says that its initials stand for "Beyond Petroleum." Others, more pessimistic, suggest that the peak is much closer at hand-in the next decade. It is interesting to note, in light of the recent discussion of Chinese ambitions in acquiring oil assets, that the Chinese seem to believe that world production will reach a peak around 2012.4 So any indication of relative optimism is greeted with sighs of relief: The peak is not that near. For example, when Daniel Yergin of Cambridge Energy Research Associates recently stated that the peak will not come until after 2020, it was greeted with something approaching cries of elation: The threat is not that immediate!

What lies behind this now-changed view? In brief, most of the giant fields were found forty years or more ago. Only a few have been found since 1975. Even today the bulk of production comes from these old and now aging giant fields. The Ghawar oilfield in Saudi Arabia, discovered in the 1940s, is by itself still producing 7 percent of the world's oil. Would that there were more Ghawars, but, alas, that is probably not to be.

Moreover, the announcement by the Kuwait Oil Company in November that its Burgan field, the world's second largest, is now past its peak output caused considerable consternation. The field's optimal rate is now calculated at 1.7 million BPD, not the two million that had been forecast for decades ahead. In addition, that announcement has called into question the EIA's estimate in its reference case that Kuwait would be able to produce five million BPD; it now appears likely that the emirate will not be able to produce over three million BPD.

Essay Types: Essay