Special Report: Peak Oil

The Challenging Incongruity of Cheap Oil

Expecting or wanting oil prices to be "low or moderate" is at best incongruous, and at worst naive in the current economic, financial and political context.

By Andrew McKillop
Published October 05, 2009

Oil Prices And The Economy

Concerning the interrelated subjects of oil demand, oil production, oil prices and the economy, Fred Banks says, in his new book Energy, Environment and Economic Theory:

[A]s things stand at the present time, we will be extremely lucky not to confront an oil price of $100/b again before the end of 2010 or 2011, which might have the effect of reintroducing or reinforcing a number of macroeconomic discomforts. Think about it: the oil price racing past $100/b again, and perhaps not stopping until it reaches the $200/b level predicted by people like Matthew Simmons (the investment banker and former adviser of President Bush), and the billionaire investor and energy buff T. Boone Pickens, while Alexei Miller of Gazprom begins talking again about a price of $250/b)! Isn't this the kind of situation that starts oil importers wondering if the end of the world is approaching?

No one less than Ben Bernanke, speaking at Jackson Hole (Wyoming) in late August 2009 expressed his own worries. He referred to very high oil prices as related to or deriving from "speculative trades". Adding that $100/b oil would compromise the economic recovery, he hinted that oil at $100/b might force him to raise interest rates. This would mightily compromise the recovery, we do not need to add!

In his own words: "Last year, oil at $145 a barrel was a tipping point for the global economy as it created negative terms of trade and a disposable income shock for oil-importing economies." And: "The global economy could not withstand another contractionary shock if similar speculation drives oil rapidly toward $100 a barrel."

Expensive Oil And Keynesian Recovery

The process of what I call 'Petro Keynesian Growth' operated strongly through 2004-2007, as the global economy surged to the highest annual levels of economic growth for over a decade. Constantly rising oil prices, and prices for other commodities helped lever up this growth, notably through tranferring resources to generally lower-income commodity exporter countries with high marginal propensities to spend and consume.

By 2008, however, this 'Petro Keynesian Growth' peaked out, as very high oil prices impacted food prices, reducing disposable income not only in lower-income countries, but also in OECD countries. In addition, of course, the debt-driven nature of consumer-led economic growth in most OECD countries, and the excesses of financial trading and 'engineering' contributed to the 2008-2009 crisis starting in the bank, finance and insurance sector.

This crisis has been responded to by another type of Keynesian spending, that is state-backed 'injections' of massive amounts of public cash in the now fragile and 'financiarized' economic systems of the OECD countries.

Concerning oil and energy prices, and as we will see a little later on, investment spending or capital expenditure needs in the world oil and gas industry are forecast, by the IEA among others, as expanding very fast to very high levels.

This itself makes cheap oil, which we could define as price levels of about $30/b or $40/b, almost impossible without very grave economic and financial problems for the industry, including risk of multiple bankruptcies or abandonment of many project. This itself would surely lead to oil shortage in a predictable future, if economic recovery was sustained.

Particularly concerning the USA however, which Professor Banks explains imports almost exactly 25 percent of world traded oil exports (about 25 percent of around 51 to 53 Mbd, US oil imports in 2009 being close to 12.5 Mbd), the deficit on its oil trade or the "oil bill" is only one of Ben Bernanke's financial and economic concerns. The intensity and size of the 2008-2009 bank, finance and insurance sector crisis, and its spillover to the 'real economy' has created extreme public finance challenges, which dwarf the question of the USA's oil bill.

The US oil account is, of course, in deficit. The oil balance is set by imports, mostly of crude, versus exports, which are mostly finished products. The deficit in cash terms runs at a level that is mainly determined by oil prices, while the net import volume is set by oil demand, US exports of finished products, and oil stocks within the US economy.

Price-influencing factors such as stocks at any one moment in time, and their weekly change are of course religiously studied by the oil trading fraternity. Oil traders were criticized by Bernanke as over-oriented towards "speculative trades", but oil traders are perfectly able to rapidly talk down prices, as well as rapidly talk up prices. Natural gas traders in the US, and in other markets, have radically bet on cheap gas, so far this year, talking down prices to less than $5 per million BTU, equivalent in energy terms to oil at less than $30/b.

To be fair, the same administration which employs Bernanke has also criticized reckless speculative trading on financial markets, in part responsible for the 2007-2008-2009 financial crisis or "meltdown", which has necessitated truly fantastic Keynesian-type financial support. Comparing this with the US oil import bill is quite edifying.

According to Bloomberg.com, giving estimates for this state-initiated and mostly state-funded financial support and intervention in the markets and the economy to late September 2009, the US federal government in 2008-2009 has lent, spent, borrowed and guaranteed a total of about $11.5 trillion. Some of these guarantees, we can note extend well into 2010, thus actual financing for 2008-2009 is less, but is nevertheless probably well above $7.5 trillion, only for the USA.

The most-recent record year for US oil import spending (the "oil bill") was 2007 at about $327 billion. Early forecasts in 2008, when oil prices were moving towards their summits, that the year 2008 would exceed this, at perhaps $400 to $450 billion were proven completely erroneous.

For the full year 2009, due both to lower average oil prices and to declining US oil import demand (its decline of demand being bigger than falling US domestic oil production), the US "oil bill" will probably be less than $225 billion.

The Us Oil Bill Is 'small Beer'

Obviously, therefore, the US oil import bill, even with oil prices in 2008 moving towards $125 to $150 a barrel, is rather small beer. Keynesian deficit spending for the 2008-2010 period, by the US government, would cover approximately 25 or 30 years of US oil imports at current 2009 volume rates, around 12.5 Mbd, but with the oil price averaging well above $100 a barrel, the "panic price" identified by Bernanke in August 2009.

We can argue with others that reducing the US trade deficit, on oil among other things, would contribute to global economic and mentary stability, but recent Keneysian excesses of deficit spending reduce the US oil bill to rather small beer.

Relative to the extreme losses generated by unregulated trading in all financial paper, particularly interest rate futures, currency derivatives, and similar complex and opaque securities, which tended to exhibit 'zero sum game' net results when confidence suddenly ebbed, importing oil even at "extreme high" barrel prices is paled almost into insignificance by deficit financed 'Keynesian recovery' state spending.

At the level of the G20 countries, this deficit-funded spending may attain up to $15 trillion for the years 2008-2010, depending on what extent there is "real economy' recovery. World total GDP in 2008, according to the IMF, was about $63 000 billion.

Using incongruous arguments regarding oil and the oil price, I can suggest, is not limited to Milton Friedman and his pet theory that "the OPEC cartel must fall apart" when oil prices are high, a theory that is well exploded by Professor Banks in his book. The implicit theory of Ben Bernanke, and many others, that high priced oil spells crisis and confusion for the world economy, is at least as incongruous! Up to about $90/b, higher priced oil tends to reinforce and bolster global economic growth.

The 75-Dollar Limit

We must note that the IEA and some other energy watching entities, groups and specialists claim that the world oil and gas industry will quite soon embark on massive investing. This huge spending must be amortized one way or another. For the oil industry that means relatively high and relatively stable oil prices, or serious problems for the oil and gas industry.

This spending will be needed to fight depletion, or if the word "depletion" cannot be mentioned, then this massive investing will be needed for a host of mentionable factors.

These mentionable or politically correct reasons why spending has to jump include more difficult or "hostile" operating environments, much more deep sea oil extraction and production, increased tarsand oil production in Canada and perhaps soon in Venezuela, much more gas liquids and condensates separation and extraction, replacement of outdated (and often oversized) refineries, storage tanks and pipelines, many new oil and gas pipelines, possible increased production of GTL and CTL, greater needs to protect the environment or limit environmental damage, very large increases in world LNG infrastructures and shipping, and so on.

The "so on" already includes quite large spending by the oil and gas industry, and some oil and gas exporting countries in "After Oil" activities such as developing alternate and renewable energy and "decarbonizing" the economy, which in the case of BP is called "Beyond Petroleum".

The IEA estimates that the world oil and gas industry, outside the national oil companies of the OPEC group, will or may attain a yearly capital expenditure rate of $1 trillion by 2016, compared with about $350 - $375 billion in 2009. IEA published views on the question as to whether this "round sum" of about $1 trillion-a-year by 2016 includes, or does not include OPEC NOC's capital spending needs is in fact unclear, that is sometimes yes, and sometimes no.

However, whether the OPEC NOCs are included or not, capex in world oil and gas is forecast to radically increase. Regarding OPEC NOC capex, we can note that the IEA assumes at least 60 percent of all incremental world oil supply to 2030 (perhaps + 20 Mbd) as coming from these companies, almost all in the shape of gas liquids and condensates, where capital costs per unit barrel-per-day oil equivalent of capacity are rather high.

This level of spending, perhaps $1 trillion-a-year by 2016, will rather obviously and heavily militate against oil prices below about $60 to $75/b. Major oil and gas companies tend not publish any price forecasts, but when they do, they are now rarely below about $60/b for the 2010-2020 period.

From Summer 2008 to date, as oil prices gyrated, losing about 75 percent in day trading on major markets and falling to below $35/b, then recovering to around $70/b at the time of Bernanke's statements at Jackson Hole, major producers including Russia and Saudi Arabia let it be known that $75/b would be entirely satisfactory to them, but less than about that price would not.

One very simple reason is oil and gas industry capex needs. This basic 'driver' for prices of around $75/b right through the period 2010-2020, with a floor price not less than $60/b is often simply ignored by media. This is usually more concerned with this week's developments in the Iranian nuclear saga, Nigerian domestic political struggles, or other (geo)political themes.

The Green Energy Explosion

Enter the subject of radically accelerating the development of all non-fossil energy supply sources and systems, energy saving, rational energy utilisation, and so on, for a number of key policy and economic goals. These include mitigating climate change by limiting the growth of CO2 emissions and other GHG emissions, improving energy supply security, reducing energy waste in industry, farming and housing, creating new employment and new economic activities, and other goals.

One of these, we can note, is the fond belief that many, or even most of the "green energy" alternatives will provide lower cost energy than oil at say $75/b, natural gas at about $5 a million BTU, or energy coal at $65 or $75 a ton (in thermal energy terms equivalent to about 5 barrels of oil).

Through 2009, and in the run-up to the COP-15 "climate summit" in Copenhagen, in December, estimates and forecasts of needed spending to pursue these goals has constantly grown. Forecasts for spending needed to develop non-hydro renewables, as well as hydropower, and nuclear energy (in some countries), the massive development of electric cars and vehicles, as well as what is called "clean coal and sequestration of carbon", have also continually grown because the scope and goals of this "energy transition" programme, or quest are constantly expanded.

A report to the 2009 Davos Forum gave a surprisingly precise estimate of a yearly average of $515 billion being needed over 2010-2020, ie. a total of around $5 150 billion by 2020. To be sure, this large total would include a significant percentage of "financial operations" such as increased CO2 and other emissions trading, offsets due to the CDM or Clean Development Mechanism, to pursue or accelerate alternate energy and climate change mitigating investment in non-OECD countries, and many other activities not necessarily directly resulting in expanded output from non-hydro renewable energy sources.

Adding complexity to the goals and scope of this "green energy revolution", in most countries "alternate energy" development is considered as targeting increased investment in 'conventional' or large-scale hydropower as well as nuclear energy.

We can assume, but with difficulty, that the world oil and gas industry will probably be able to muster capital investment financing at a rate of $1 trillion-a-year by 2016, which will need a rather high oil price and related natural gas price, we can note, but finding $515 billion-a-year for "alternate energy" may be difficult. It will be doubly difficult if both fossil and alternate energy goals are pursued: annual energy sector spending needs in this case could attain perhaps $1 500 billion-a-year by about 2016.

We can add a third strong doubt on achieving this level of spending in either oil and gas, and even more so in "alternate energy", by including the risk that global economic growth does not at all "bounce" or rebound vigorously. Without rather strong and sustained economic growth, at least 3.5 percent per year at the world level, sustained for several years, even the IEA's now very modest forecasts of world oil and gas energy demand growth to 2030, of about 1.6 percent a year (and about 7 percent a year for non-hydro renewables) would no longer be realistic. As we saw in 2008-2009, when world oil demand fell by a total of about 3.5 percent (about 2.75 Mbd) year-on-year in the first and second quarters of 2009, oil prices fell by over 70 percent.

Anyone doubting the extremity, and fragility of forecasts that combined oil and gas, and green energy spending could or might reach $1.5 trillion-a-year by around 2016 should simply look at OPEC revenues in the event of two assumptions:

Under these two assumptions, OPEC revenues would total about $1.05 trillion-a-year. This is far less than the combined onslaught of energy sector investment, to produce more oil and gas and push back depletion impacts on output, among other things, joined with the sudden new desire of G20 leaderships to radically accelerate the development of "alternate energy".

One thing is sure, regarding the possible, or even probable boom in alternate and renewable energy spending. Unlike the huge forecast increase in oil and gas spending, it is very unlikely to spontaneously "ramp up", or increase in stepwise fashion, from current world average spending of well below $70 billion-a-year, to more than $500 billion.

Without government directives, legislation, and state-backed loans and financing, vastly greater than the product of current "carbon taxes", where they are levied, any rational expectation of growth in green energy spending can only be much lower.

Cheap Oil and Expensive Green Energy

Oil prices at around $60 to $75/b could in fact be considered low or perhaps extremely low, given what is said above. It may be incongruous or naive, at the least, to imagine oil prices will stay at even Bernanke's "preferred price", of about $75/b. The CEO of Total SA, de Margerie, has for example recently forecast oil prices at $145/b "by 2014".

While wind electricity is undoubtedly quite cheap to develop, with capital costs which are relatively low and decreasing, and world windpower capacity expanding rapidly to now stand at about 150 GW, it does not replace or save much oil. Other than wind electricity, most of the non-hydro renewables are much more expensive than windpower, but like it tend to deliver only electricity, and do not save or replace much oil.

Many examples could be given, not necessarily including the fiasco of maize-based bioethanol fuel production in the USA (and beet sugar or maize-based bioethanol in Europe), or edible vegetable oil-based biodiesel fuel production. In these cases - "first generation" biofuels using food crops - the breakeven price relative to oil is often in the range of $80 to $125/b. The land resource and water needs for "ramping up" fuel ethanol and biodiesel production to seriously rival world petroleum, would be immense.

In many cases, renewable energy sources and systems, for spontaneous market-driven investment and growth without legislative intervention, carbon taxation, preferential tariffs, state grants and state-backed low interest financing, and so on, require high and stable oil and fossil energy prices.

Many of the methane producing processes and systems included within "alternate energy", for example landfill and municipal waste methane recovery, industrial waste-based biogas, and even certain more complicated technologies for coalbed methane extraction require gas prices nearer $10 per million BTU, than current world pipeline gas and LNG prices at or below $5, to be feasible without subsidies.

Few precise or well analysed figures are available on green energy spending plans, or hoped-for amounts of capital expenditure, relative to the oil saving that may be achieved. We can, however, take the European Union's "20-20-20" plan, announced in December 2008, aiming for a 20 percent replacement of current energy consumption by renewable energy by 2020, among other targets.

This plan would imply the saving and/or replacement of about one-fifth of current EU27 oil consumption by renewables, that is about 20 percent of 14.57 Mbd according to CIA Factbook data on 2008 oil demand, or nearer 14.25 Mbd using Eurostat data. 20 percent replacement of EU27 oil demand by green energy sets a target of achieving 2.8 Mbdoe of green energy supply by the year 2020.

For the oil part of the program, this would demand (according to very approximate data given by different European Commission directorates and other sources) roughly $100 to $150 billion a year average spending.

This is therefore a total not exceeding $1 500 billion through 2010-2020, to save about 2.8 Mbd of oil (natural gas and coal energy saving being treated by other parts of "20-20-20"). IEA figures for world oil & gas industry spending are perhaps 4 or 5 times more in the same period, but the amount of new or maintained oil production capacity yielded by world oil & gas industry capex at this rate would probably be 7 or 8 times more than the 2.8 Mbd of EU27 oil demand replaced by green energy./p>

Electric Car Nirvana

Electric cars appear, to some, to be assured of rapid consumer acceptance (despite all indications to the contrary, to date), because typical electricity consumption of larger-sized electric saloon cars, for example Chevrolet or BYD electric cars priced at around $25 000 to $40 000 each, are no more than about 16 kWh for 100 kms. This performance is used to present such cars as "equivalent to a gasoline fuelled car that does 250 miles per US gallon".

To energy policy makers, of course, electric cars seem to offer a route to rapid and large cuts in national oil dependence and consumption, explaining the large state subsidies, grants and low-cost loans provided by governments, to the car industry and electric vehicle R&D, battery technology research, and so on.

The question of electric power plant capacity needs, for charging electric vehicles, is however almost ignored at present. The simplest back-of-envelope calculation of power plant capacity needs to recharge even a few percent (say 15 percent) of the current world car fleet, of about 900 million car-equivalent units (cars plus vans, minibuses, light trucks), growing at about 55 million units a year, shows that grave electric power sector problems, and very high investment costs, would result.

Assuming each car would need recharging at 4 kW to enable its lithium-based batteries to be recharged and run its neodymium-dependent motors a few hours, the 5-hour charge storing about 18 kWh, after losses, would provide about 120 kms of travel. We can then look at a world car-equivalent fleet well beyond 1 billion units, of which only 15 percent are all-electric, or electricity-dominant PHEVs (plug-in hybrids).

This would give a need to supply up to 400 or 500 million kW of electricity, if or when a large proportion of these 150 million cars were plugged-in simultaneously - showing the great interest, as well as need for so-called "smart grids" that can better ration and apportion limited electricity supplies and draw in the most-possible quantity of variable supply, renewable-based electricity.

400 or 500 GW of new, dedicated electric power capacity to handle the charging needs of 15 percent of the world car fleet is a rather spectacular new challenge not only to existing, mostly coal, nuclear and natural gas-fuelled electricity production, but also to the fond hopes of green energy. Putting this in perspective, it is roughly three times India's current total electric power production capacity and 3 times total present global windpower capacity.

Costing this implied massive program to build new electric power plant capacity, whether green or black or brown, is relatively easy - and results in needs to ensure electric car drivers do not obtain a free ride.

Beyond the 'upstream' new power plant capacity needs implied by even a 15 percent replacement of the world car and light vehicle fleet by all-electric vehicles, we also have major challenges for urban electric power infrastructures. The understandable desire of private car owners to "recharge anywhere" implies cabling city centers with huge numbers of power outlets able to deliver 4 kW or 5 kW, each, as well as building the power plants 'upstream' to deliver this huge new power demand. Estimated costs of this are as yet very fluid, but can be calculated, and are very large.

A Few Conclusions

Rather like the sudden and massive, unplanned and confused reaction of G20 leaderships and their finance ministers, and central bankers to the 2007-2008-2009 financial and economic crisis, the drive for "green energy" is ceaselessly growing in political and economic importance. The large role of the state in financing this "energy transition" is hard to doubt, given the actual and current spending on alternate and renewable energy, versus estimates and forecasts from many sources, including the World Bank, UN agencies including UN IPCC, the European Commission, and so on.

At the same time, world oil and gas industry spending plans, and needs are likely to grow very fast, to very high levels. As we know, most of the non-hydro renewables are still in their technological infancy, face basic resource problems (energy intensity/unit area, for example), are difficult to scale up, require quite complex integration with existing energy economic systems, and so on. This makes their unit cost in barrel-day equivalent high, or very high.

In turn this means government subsidies and state intervention, if G20 leaderships and their public opinions want "green energy" to grow very fast, and effectively substitute a significant part of current fossil energy sources and systems, by 2025 or 2030. This target may have to be as low, and as reasonable as 10 percent from non-hydro renewables, to have any chance of success. Energy saving will in fact be a much more feasible energy economic option in most, or all OECD countries.

Expecting or wanting oil prices to be "low or moderate" is at best incongruous, and at worst naive in this economic, financial and political context. The near-term future, starting with the COP-15 "climate summit", as well as oil price movements at the time of this conference and its aftermath, will tend to show us what we may be able to expect. One of the most rational expectations is very clear: oil prices will likely stay close $75/b for some while, and will tend to increase in 2010, if there is no "double dip" recession.

Accelerated "green energy" transition will, if anything, tend to bolster and reinforce what Bernanke calls high, or dangerous oil prices. This is due to the simple fact that only high oil prices give any economic credibility to most of the non-hydro renewable energy sources and systems. Whether or not oil prices behave as they did in 2008, and "peak out" to extreme high levels, then collapse, will depend on several factors.

These notably include the trend of economic recovery, the value of the US dollar, and world interest rates. Oil prices rising even to $90/b can be "absorbed" by the world economy given recent experience, although much higher prices, beyond about $125/b will not be possible to support and sustain.

Andrew McKillop is a writer and consultant on oil and energy economics. Since 1975 he has worked in energy, economic and scientific organizations in Europe, Asia, the Middle East, and North America. These include the Canada Science Council, the ILO, European Commission, Organization of Arab Petroleum Exporting Countries, the UN Economic and Social Commission for Asia and South Pacific, and the World Bank. He is a founding member of the Asian chapter of the International Association of Energy Economics. He is also the editor, with Sheila Newman, of The Final Energy Crisis (Pluto Press, 2005).


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By A Smith (anonymous) | Posted October 05, 2009 at 14:19:53

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By Andy (anonymous) | Posted October 05, 2009 at 21:19:20

Got any spare change?

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By Andy (anonymous) | Posted October 05, 2009 at 21:26:51

I agree, we don't need any more slime downtown,uptown,in town.
It's pretty bad when you can't even walk down town without some crack head asking for money to pay for a bus ride to the meth clinic.

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