Contrarian Wisdom Isn’t Necessarily Better Than Conventional Wisdom

For years, many observers (including myself) have argued that — from an environmental perspective — it is preferable for energy prices to be higher, so as to (1) discourage consumption of energy, mostly from fossil fuels which generates significant environmental impact, and (2) make various forms of energy efficiency and cleaner (if not zero-emission) alternative sources of energy more economically attractive to customers, which in turn will produce a virtuous cycle of further improvement in energy efficiency and alternative energy to penetrate markets in an ever-increasing fashion.

Recently, Carl Pope (formerly CEO and Chairman of the Sierra Club) penned an article that aims to turn this wisdom on its head.  In “The Road To Climate Heaven Is Paved With Ever Cheaper Oil”, Pope makes the point that the most environmentally-damaging forms of oil — such as the oil sands in Alberta — are intrinsically the most expensive to produce.  As a consequence, if oil prices were consistently at $70/barrel or less, production from these resources would be unprofitable and would relatively quickly cease, which in turn would (paraphrasing here) save the planet from future horrible devastation.

Pope notes that — of world oil demand at levels around 85 million barrels per day — about 80 million barrels per day can be sourced from relatively-clean conventional oil resources that are economically recoverable at much lower prices, rather than the dirty stuff which are economically viable only at higher prices.  In other words, the world supply curve for oil is pretty flat and low up to about 80 million barrels per day, and then goes vertical beyond that.

Assuming that his analysis of global oil supply is approximately accurate, Pope asserts that we just need the largest consumers of the world to somehow reduce demand levels by about 5 million barrels per day — permanently — and then the dangerous sources of marginal supply will be shut out of business.

It’s an interesting argument.  But I am not persuaded.

First of all, let’s consider how we got here:  World oil prices have consistently been hovering in the $80-120/barrel range since mid-2007 (except for a brief period in 2009 during the absolute trough of the global economic meltdown).  Why is this?  Except during the economic standstill, global oil demand has been robust at (as Pope says) around 85 million barrels per day — even in the face of high (and generally increasing) prices.  Note that U.S. demand has essentially been declining, so the rest of the world (especially China) has been picking up the slack.  (Imagine for a moment how much more demand there would have been had prices not increased so substantially!)

Put aside for a moment the question of how to achieve a demand reduction of 5 million barrels a day from the developed economies.  (Pope himself fudges on this point by stating that the developed economies could “encourage transportation efficiency and fuel diversity” in some unstated way.)  What would happen if Pope’s dream were somehow to be achieved?

At first, as Pope would hope, world oil prices would no doubt fall.  I don’t know if they’d fall by tens of dollars of barrel, but it’s possible.  If that were to happen, it almost certainly would cause a significant increase in demand within not-too-much time, which in turn would spur prices upward again.  Eventually, this force of increased demand would push prices back into the range that again makes viable production from the dreaded dirty marginal resources.

This is the notion of an equilibrium, central to free-market economic thought:  that any exogenous shock to the system will produce a response from the market that will tend to bring the system back into balance.

For Pope’s fantasy to play out, there would have to be not only an immediate reduction in developed-world demand for oil on the order of 5 million barrels per day (thus dropping oil prices to a significantly lower level), but an ongoing reduction from the developed-world to offset the faster growth in oil demand that would be generated by much lower oil prices that would somehow need to be maintained by ever-shrinking demands from the developed world.

I simply don’t see this happening.  Efficiency won’t be enough; it requires a massive shift off of oil for transportation — the “fuel diversity” for which Pope argues.  Low-cost natural gas (largely due to fracking, another environmental bete noire) for compressed natural gas vehicles and better (higher performance and lower cost) batteries for electric vehicles will help, but daunting investments in fueling/recharging infrastructure would be required for either (or especially both) to achieve mass-penetration — and I don’t see the money for these laying around.

With his recent article, Pope reaches for a similar conclusion, but coming from a different angle, as those who are seeking to forestall the construction of the Keystone XL pipeline to thwart access to markets for oil sands from Alberta and thereby prevent their development as a means of protecting the planet.  They share a supply-oriented mindset:  curtail supply by whatever means necessary (in Pope’s case, taking actions to depress market prices; for pipeline opponents, fighting legal/regulatory battles) to prevent consumption of a particular source of oil.

In my mind, this is not the way the modern economic world works.  In the market-oriented economy that generally prevails around the world, it is demand — not supply — that drives all the mechanisms.  World oil markets are fungible:  pushing down in one place will cause counterbalancing forces elsewhere, mostly negating the initial restriction.  Trying to control markets by somehow altering supply is futile, as the forces of demand will insidiously work around any inhibitions.

To see an example of this, look at the ineffectiveness of the so-called war on drugs:  demand may be lowered from unfettered levels but nevertheless remains abundant, against all social wishes.  The market is not destroyed; be assured, the market remains — it’s just been driven underground to all sorts of illegal and nefarious suppliers.

Similarly, the lack of a Keystone XL pipeline will not prevent the tapping of the Alberta oil sands (as long as oil prices are high enough).  Participants in the market are too nimble and inventive.  Oil sands output is already being shipped to the U.S. not only over existing pipelines, but as they approach capacity, by an increasing number of rail cars.  In addition, the Canadians may build their own pipelines to the Atlantic or the Pacific Coasts, allowing oil sands to reach world markets even with constrained access to the U.S. if Keystone XL is never built.  So the opposition to the pipeline will mainly have ended up being for naught — other than to drive up oil prices a little bit, due to the extra costs introduced into the market by denying an economically-attractive project from being built.

I respect Pope for all he has done in his career for the environment, building awareness of the critical issues our planet faces and generating urgency for action.  But, at least in his most recent writing, his unconventional economic wisdom does not ring true to me.  I’m often a contrarian myself, but in this case, I believe that Pope’s out-of-the-box thinking should probably be put back in the box.

The Geopolitics of Energy

“The Geopolitics of Energy”:  that was the title of a talk given at the Opportunity Crudes conference in Houston last week by Guy Caruso of the Center for Strategic and International Studies.  It’s an endlessly fascinating and urgent topic, as very few sectors of the economy shape the world in which we live as much as energy — and particularly, oil — does.

Highlights of Caruso’s presentation — many of which are not novel or unique, but are worth restating:

Oil is currently inseparable with transportation:  virtually 100% of mobility — whether by car, truck, rail, boat or plane — is fueled by petroleum-based products.  Demand is flat or even shrinking in the U.S. and Europe, but this is more than offset by explosive demand growth in the developing world — especially China, but also India, and the Middle East.  “The center of gravity of the oil industry is moving East.”

Most of the lowest-cost endowment of oil resources on the planet are concentrated in the Middle East, subject to great political instability.  A scary thought:  many leaders, especially in the lynchpin Saudi Arabia, are over 80 years old — what happens when they die?

Reliability of delivery is threatened by geogrpahic chokepoints.  For instance, over 15 million barrels per day — nearly 20% of world oil supply — passes through the Strait of Hormuz.  Although most of the oil passing through goes to Asia, the U.S. military remains the key protector of this vital trade route.

Meeting global demand growth in the face of declining conventional resources means two things:  a shift towards unconventional resources (which are more expensive to produce, and face significant environmental/technical challenges) and an almost insatiable need for ongoing additional capital investment.

Although technological leadership may remain with the “supermajors”,15 of the 20 biggest oil companies in the world (i.e., the ones with the most reserves/resources) are now state-owned enterprises, such as Saudi Aramco and PDVSA.  While some of these companies like Lukoil (LSE:  LKOD), PetroChina (NYSE: PTR) and Petrobras (NYSE: PBR) do have minority stakes that float on stock exchanges, make no mistake:  they are not being managed for the purposes of shareholder value maximization.  These companies trade on stock exchanges solely to access global capital markets so as to finance immense expansion programs.  Otherwise, their motivations are far different than profit-maximization as expressed so effectively by the supermajors:  these organizations are arms of nationalistic pursuits.  In other words, the oil game of the future will be driven less by money and more by geopolitical moves on the global chessboard.

There are more upward pressures on oil prices than downward pressures.  Note that the oil industry is running at over 95% of capacity — there’s almost no spare or excess capacity to cope with any perturbations.  Even so, most companies are using $60-80/bbl as the reference price in determining long-term capital investments:  big bets require conservative assumptions. 

Shale gas is a game-changer — not just in the U.S., but in many parts of the world.  More gas will be used for power generation, which will displace coal.  Indeed, without carbon capture and sequestration, coal will be under threat for both economic and environmental reasons in most places of the world.  (Exception:  China, which is growing so fast that it will build as much as possible in a true “all-of-the-above” energy strategy.)

Caruso closed by noting, humbly, that in his 40 years in forecasting the energy sector, there was a consistent tendency to underestimate the impact of technological advancement, which in turn renders long-term predictions subject to big errors.  Not only will the finer points of his analysis be inaccurate, but some of the overarching conclusions — which seem so obvious today — will no doubt be wildly off a few decades from now.  The key is figuring out which ones will be right and which ones will be wrong.  Black swans are hard to see when they haven’t yet flown to the horizon.

Oil: Releasing Reserves Means Increasing Market Pressures

On June 23, the head of the International Energy Agency (IEA) announced that IEA’s 28 member countries had agreed to release 60 million barrels of oil in the next month from their reserves “in response to the ongoing disruption of oil supplies from Libya.”

These extraordinary powers had been exercised only twice previously:  after Iraq’s invasion of Kuwait in 1990, and in the wake of Katrina in 2005.

What is odd, though, is that the prior two cases were invoked as oil prices spiked in the face of immediate unforecasted supply curtailments.  However, in this instance, the Libyan supplies have been off the market for months, and oil prices had been falling for several weeks in a row.  So, what gives?

I would like to think that there is a good reason for this action, but I can’t find it yet.  And, neither apparently can a lot of petroleum market analysts.  See, for instance, this blog.

Among others, a June 24 research report by Deutsche Bank (NYSE: DB) entitled “Emergency? What Emergency?” concludes that the move is politically-motivated primarily by the Obama Administration to drive down gasoline prices and improve voter sentiment as the peak summer driving season approaches.  Others have opined that the Obama Adminstration was targeting oil speculators as “bad guys”, and wanted to hurt them the most — in their wallets — by causing their trading positions to suddenly and dramatically turn negative.

Now, I don’t understand the way the IEA works.  I wouldn’t think that the U.S. would be particularly influential in a multi-lateral NGO based in Paris.  

And, if they powers-that-be are going to the well this summer to support political needs of the Obama Administration, won’t they have to do the same next summer too — right in the middle of the 2012 Presidential campaign?  Are they that stupid to think they’ll only have to shoot this bullet just once?

While it doesn’t seem that the “emergency” release of oil stocks is warranted by market conditions on their own merit, what we don’t know is what really happened at the last meeting of the Organization of Petroleum Exporting Countries (OPEC) on June 8, just two weeks in advance of the IEA’s surprise move.  By all accounts, the meeting was a debacle, with Saudi Arabia (long OPEC’s main player) seemingly losing control of the cartel.  Given that there was apparently a lot of communication between the IEA and Saudi Arabia and that Saudi Arabia was supportive of IEA’s move, the political aim of the oil release may be more to buttress the Saudi government than the U.S. government. 

Because, if the Saudi government falls, as others in this Arab Spring have, it is generally assumed that power will be assumed by Wahabbi forces that won’t have much reservations about shutting off the oil spigots — and the world economy will be in a world of hurt when Saudi oil supplies are withdrawn.

To the extent there’s any consensus among energy pundits, it’s that the release of strategic oil reserves is yet another indicator of a future of increasing oil prices.  With increased government meddling in the oil markets, producers will be reluctant to make major investments in marginal fields or breakthrough technologies to enable opening new production horizons.  This can only put upward pressures on oil prices and oil market volatility.

All in all, it seems to me that this release has little good long-term effect or benefit on the energy industry, with some considerable harm to it.  And, it may well be a harbinger of tougher times ahead. 

As Gregor Macdonald puts so well in his posting “The Dark Side of the OECD Oil Inventory Release”, the “release of inventory is confirmation that the era of permanently constrained supply is now very much with us. Because industrial economies are simply machines that convert energy inputs into useful work and services, [the] action is also a reminder that the dream of higher growth in conjunction with lower oil prices is now a backward looking view, a nostaglia for a past that’s no longer possible.”

To Boldly Go Where No-One Wants To Go

I am appalled at the state of the public discourse on oil and gasoline prices.

Between the newspapers and the talking heads, there is an increasing cacophony that the government should do something, just about anything, to halt the increase in oil and gasoline prices.

From the lefties:  Release stocks from the Strategic Petroleum Reserve!  Stop Big Oil from gouging customers!

From the wingnuts on the right:  Get the enviros out of the way and drill, baby, drill!  Cut gasoline taxes!

All of these steps are just re-arranging deck chairs on the Titanic.  The facts are simple, but they are discouraging, and they won’t be changed by wishful thinking or loudly-shouted populist mantras.  (It’s useful to remember, but often forgotten in today’s world, that just because the volume of your voice is higher doesn’t mean you’re more correct.)

In its territory, the U.S. possesses about 2% of the world’s proven oil reserves.  Yet, the U.S. economy consumes about 25% of the world’s annual oil production.  This blog post depicts the situation succinctly.

True, the U.S. share of global oil consumption will likely decline in the coming years — but that’s probably not because our demands for oil will decline.  Rather, it’s because China, India and the rest of the developing world are ravenously ramping up their demands for oil, with relatively little concern for the price.

With 727 million barrels according to the DOE, the Strategic Petroleum Reserve is only big enough to support U.S. consumption for a little over a month, so releasing even all of it doesn’t chnage the fundamental dynamics. 

There are balderdash claims floating across the Internet that there are hundreds of billions of barrels of oil resources in the U.S. (referring primarily to the Bakken Formation in the Dakotas) waiting to be tapped, if the bloody environmentalists would simply get out of the way.  Alas, as this blogger does so nicely, just a little bit of fact-checking easily exposes these claims as wildly-exaggerated

While there are about a trillion barrels of hydrocarbons in the Green River Formation in Colorado, Wyoming and Utah, this is not petroleum but rather oil shale  — which are not to be confused with the shale gas deposits that have yielded natural gas bonanzas in such places around the U.S. as the Barnett and the Marcellus.  Technologies in use today can’t produce the Green River oil shale resource, and while new technologies are being developed to pursue this compelling opportunity, they are being thwarted less by environmental constraints than by economic ones — more investment capital is required, and greater certainty of higher oil prices is required to attract that capital. 

Meanwhile, the biggest slug of known petroleum reserves on Earth lies in the Middle East.  Much of this is in Saudi Arabia — and as a set of cables released by Wikileaks a few weeks ago hints, it’s hardly certain that those reserves are as vast as have been widely-assumed.  If production starts to decline from Saudi Arabia — either because it’s become geologically over-tapped or due to internal political strife of the type we’ve seen of late in the Middle East — it’s hard to know where oil prices will crest.

Even so, at least currently, Saudi Arabia and the rest of OPEC continue to set the world price for oil — and while the privately-held oil majors profit handsomely when the price rises, it’s not like these guys have much of a say in the price of oil.  They’re the minority players in world oil production:  they merely go along for the ride, and take the money to the bank.

Moreover, the size of the planet’s endowment of fossil fuels is not increasing.  Old fossils aren’t being compressed into hydrocarbons at anywhere near the rate they’re being extracted from the ground.

Exploration and drilling technologies have improved dramatically over the past thirty years, and the oil industry has poked holes all over the planet — and in large swaths of the waters too.  We’ve explored most of the easy places, and we’ve sucked dry most of the cheap resources from the easy places.  What’s left is harder stuff to extract.  It’s more expensive.  Any as-yet-undiscovered reserves are generally going to be in harder places, or in smaller quantities.  There will be sizable finds here and there now and then — and they will be worth pursuing and utilizing in a responsible manner, but they won’t change the overall picture materially.

It’s damn-near impossible to consider this set of facts and conclude something other than oil prices — and therefore gasoline prices — are on an inexorable path upwards.  Perhaps with some downward blips along the way, but the upward trend seems inescapable.

And, yet, the vox populi is whining insistently that some miracle be performed by some mystical force to push the price trajectory downward!

Do something, anything!  These are the rants of a desperate society living paycheck-to-paycheck.  These are the cries of those who live in denial that we’ve painted ourselves into a corner with no clear escape. 

We Americans need to come to grips that we cannot continue to be held hostage to a damn-it-all mentality that continued economic well-being can only be achieved with permanently unfettered access to cheap oil and gasoline.  If we can’t ensure unlimited low-cost energy supplies — and I hope it’s becoming clearer to more people that we surely can’t — then the house of cards on which we’ve built our economy will fall.

Rather than turning the world on its head to keep alive a false promise that can scarcely any longer be extended, we need to turn our commitments towards building a more robust economic system that isn’t precariously dependent on one non-replenishable commodity.

This is not a popular line of thinking.  As the title of this post suggests, this is boldly going where no-one wants to go. 

I don’t want to argue whether or not it’s good for oil to be cheap or expensive.  I want a reasoned debate about what do we do when oil is expensive and we can’t do anything about it.

In his 2011 State of the Union speech, President Obama offered the theme that, as Americans, “We do big things.”  Moving our economy off of oil is a very big thing.  Alas, I’m not as sanguine as the President that we relish the challenge and have the appetite to do it proactively.  However, I am more hopeful about our future after considering Winston Churchill’s (hopefully timeless) observation:  “Americans can always be counted on to do the right thing…after they’ve exhausted all other possibilities.”