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Thursday, March 17, 2005

After Oil

"The best short discussion of why mainstream economists
don't get the significance of the peak of oil production".

by David Fleming

Prospect Magazine (November 2000)

Introduction by Prospect: The weightless economy still has dirty old oil pumping through its veins, as the recent fuel blockades demonstrated, says David Fleming. In the next ten years, the growing demand for oil will permanently overtake a shrinking supply - playing havoc with price. Why are western governments doing nothing to prepare?

Beneath the seabed off the coast of Saudi Arabia is an oil field called Manifa. It is giant, and its riches are almost untapped. There is, however, a snag. Its oil is heavy with vanadium and hydrogen sulphide, making it virtually unusable. One day the technology may be in place to remove these contaminants, but it will not be for a long time, and when, or if, it becomes possible, it will do no more than slightly reduce the rate at which the world's oil supplies slip away towards depletion. Even this field has one advantage over the massive reserves of oil which Middle East suppliers are said to hold, ready to secure the future of industrial civilisation. Unlike those fantasy fields, Manifa does actually exist.

In region after region, the story is of ageing fields, of the wrong sort of oil, of nitrogen being pumped into wells to keep up the flow, of new areas (such as east of Greenland) turning out to be dry. Britain's North Sea oil is at its peak now. The giant fields in Alaska, the former Soviet Union, Mexico, Venezuela and Norway are all past their peak. The US's own oil supplies have been declining since 1970 and now account for less than half its needs. There is a possibility of some big finds off the coast of west Africa, but their development is still years away, and they are not on a scale capable of making a difference. The only producers with an oil resource which may be capable of keeping oil flowing into the world market at a roughly constant level are the Middle East Opec five - Saudi Arabia, Iran, Iraq, Kuwait and the United Arab Emirates. And even in these countries, the closer you look, the less they have to offer.

Most of Saudi Arabia's reserves of oil are held in one huge field, the Ghawar. It has been pumped since 1948 and, not surprisingly, it is showing signs of exhaustion with its southern end now flooding with water. Saudi Arabia can keep its production roughly constant for another seven to ten years before it too has used up half its total oil resource and rolls over towards depletion. Then it will turn to smaller fields, producing smaller amounts, followed by poor-quality fields with real problems, such as Manifa.

Things are not much better in the other Gulf states. Iran, which used to be the young giant of the oil business, could not now sustain a higher output for long, and there are suspicions that some of the production credited to Iran is piped over the border from Iraq. Kuwait and one of the emirates, Abu Dhabi, could increase production and may well do so, but their reserves are small, relative to world demand.

Only one country has the potential for a serious increase in output, on a scale which could make a difference. The bad news is: that country is Iraq. Iraq's oil geology is not fully explored, but there are some well-informed guesses. One estimate is that there are 110 billion barrels there - equal to more than three British North Seas, or more than one third of the total resource once possessed by Saudi Arabia. This oil could not be made immediately available, but it is on a scale to keep world oil production rising for a few more years. It lies, however, in a country which is armed to the teeth, consumed by loathing of the west, and just waiting for a US armed intervention to make its day. Iraq was prevented from selling off its oil during the 1990s, when prices were lower than they will ever be again; it will soon be well placed to apply its own sanctions to the rest of the world by fine-tuning its output and naming its price.

This is not a happy story. But the most shocking thing about it is that it is not a new one, either. The essential problem has been known for a long time. It is a fact, written up exhaustively in the literature, that the period around the turn of the millennium marks the end of growth in the world production of oil, and the start of its long decline towards depletion. In 1956, the geologist King Hubbert accurately forecast that the US's oil production would peak in 1970. In 1970, Esso forecast that global production would peak in about 2000. In 1976, Britain's department of energy said that North Sea production would peak at about the end of the century - the same time as the peak in world oil production. For this reason, the report concluded, it would be a good idea to be ready with alternative supplies of energy.

Warnings have continued to flow. In November 1998, the International Energy Agency (IEA) showed that growth in world oil output could not be expected to continue beyond about 2001. And in the last few weeks, a member of the respected US Geological Survey has published on the internet his master-class on "the Big Rollover - When the Demand for Oil Outstrips the Capacity to Produce It". It concludes: "Hang on tight. If we don't recognise the problem soon and deal with it, it's going to be quite a ride!"

So it seems reasonable to conclude that the oil price rise of the past eighteen months could be just the start of something much bigger. Why then do the relevant authorities seem so complacent? The recent oil disorders have been discussed in terms of taxes and domestic politics, with occasional references to Opec trying out its strength, and to the powerful bargaining position which the US enjoys because of its strategic reserves. If the problem were really serious, surely - in this society rich in economists and experts - we would have been told?

Not necessarily. The economic principles, which explain how a market economy works, tend to break down when applied to natural resources such as oil.

There are four ways in which the principles of market economics do not apply in this case. The first arises from the fact that the price of oil today has virtually no influence on the rate at which it is discovered. In market economics, the rules of supply and demand hold good: if the price of something goes up, this gives a signal to someone to produce more of it; new producers will pile into the market until the price settles down again. In the oil market, price does not have this effect. In the early days, the best and biggest fields were quickly found, and were very cheap to pump. This fuel was very profitable; so the world's resources were prospected urgently and rapidly and, with the help of digital seismic technology, discovery of oil grew to a peak at about 1965.

This means that most of the oil we are using was discovered more than forty years ago. But that period of immense discoveries is over. There is no conceivable increase in prices which will bring it back. As we use up more of the fields which were discovered in the past, it is becoming more difficult to sustain the growth of production. Soon it, too, will decline.

A variant of the faith in prices is the faith that new technologies will increase the rate at which oil is discovered, and make it possible to extract more of the oil contained in a well. This confidence in "technological improvements relating to discovery and recovery rates" is expressed by Britain's energy minister, Helen Liddell, in her reply to a recent letter from Tim Yeo, shadow agriculture minister, one of the few British MPs to have taken an interest in the oil question. But the idea that technology will save the situation is without foundation. Digital seismic technology, which has been available for forty years, can speed up the finding of small fields, but it cannot bring into existence the giant new provinces that we would need to sustain the world's demand for energy. Ingenious ways of squeezing the last available barrels from each waning oil well can make no more than a few percentage points of difference on the downward slope after a field has passed its peak.

The second breakdown in the well-behaved thinking of market economics arises from a failure to grasp the significance of the peak in the oil supply. Standard economics deals happily with "quantities"; but, in the matter of providing the energy which underpins the global economy, there is a sense in which quantity is irrelevant. There is still a large quantity of oil in the ground; we are probably not even halfway through the total quantity of recoverable oil. What matters is not how much remains, but the turning point at which the flow of oil hits its peak and starts to turn down. It is here that what the market needs, and what the industry can produce, start to diverge.

When, after the turning-point, the flow of oil begins to decline, three things happen: some people have to go without; competition for the reduced supply of oil becomes fierce; and, quite suddenly, time is no longer on the side of good order in the market, as the oil supply declines at a rate which could be as much as three percent per year. A gap opens up between the need for oil and the reduced quantity actually flowing. Prices are set by the marginal barrel of oil sold to a market which cannot get enough.

The third way in which oil insults the received rules of economics is that it cannot usefully be discussed in abstract terms such as "reduced dependency" and "falling percentages". Recent commentary by the press and the government has persistently argued that the world's dependency on oil has declined during the last three decades, so that the market is much less vulnerable to price rises and disruptions affecting oil than it was in, say, 1973. Certainly, this is the British government's position: "People have substituted away from oil", wrote John Battle, the then energy minister, in 1998. This theme was taken up by Helen Liddell, for whom "the declining reliance of the world economy on oil" is another of the factors which "counterbalance fears regarding the peak in oil production". The Financial Times unflappably calculates the effect of high oil prices on corporate profits. At $40 a barrel, it would merely reduce corporate profit growth from thirteen percent to twelve percent. No problem. The FT says: "These projections reflect the fact that the corporate sector - and western economies as a whole - have become far less dependent on oil. As a proportion of output, OECD oil and gas imports were three and a half times higher in 1978 than they are now."

None of this makes sense. If oil accounted for just one percent of the total quantity of energy used, and that one percent provided the fuel for transport, then, as recent events confirm, disruptions to the supply of oil can close an economy down within days. Arcane calculations about the impact of oil prices on growth rates are irrelevant. While it is true that oil has declined as a percentage of all energy use in the UK since 1973 (from 45 percent to 33 percent), the volume of transport, which depends entirely on oil, has doubled. We are twice as dependent on transport as we were in 1973. Arguments about "reduced dependency" would be correct were it not for one problem: we do not fill up our cars with percentages.

The world as a whole uses thirty percent more oil now than it did in 1970, and the fact that its consumption of gas has risen many times over does not mean that it is less dependent on oil; it simply means that it has become dependent on gas, too. In Britain's case, the consumption of gas and oil combined has grown from fifty percent to seventy percent of energy consumption. Because, according to the most recent studies, the prospects for gas supplies in Europe are rather similar to those of oil there is no justification for arguing that we are less dependent on oil.

The fourth way in which normal economic analysis throws us off the scent of the oil shock is that it prefers to ignore time-lags. Specifically, it assumes that renewable sources of energy will come on stream just in time to take over from oil. All we need to do is wait for the "price signal" to kick in, so that when oil becomes more expensive, the alternatives will flood into our homes and cars and solve our problems. This is another piece of magic for which both the government and the press have fallen. What is really worrying the Opec countries, argues Anatole Kaletsky in The Times, is the danger of alternative energy sources bringing the demand for oil to a premature end. "The Saudis, in particular, realise that oil demand could collapse well before their kingdom has the chance to sell off its oil reserves". The British government agrees.

But the development of those alternative energy sources will take a long time. The government's own target for 2010 is that renewable energy sources should account for just 1.7 percent of the total quantity of energy now used in Britain. A detailed study of the switch to renewable energy was published by the LTI Research Group in Mannheim in 1998. It found that, if the development of renewable energy systems were supported by decisive, well-coordinated action by governments, in a sustained programme lasting for fifty years, renewable sources could provide 35 percent of the energy used at present.

If more efficient usage of energy and more compact ways of using land were developed at the same time, that 35 percent might conceivably give us all the energy we needed in fifty years time; and if it were given the highest possible priority, then, perhaps, it could be done in 25 years. We might therefore think of 25 years as the absolute minimum time it would take to rebuild Europe's energy economy on renewables. It follows that, if we wait in the approved economic manner for the market to give the "price signal" that renewable forms of energy should now be developed, we shall ensure that the job starts 25 years too late. Even if the shock were postponed for ten years, while an intensive programme to develop renewables began, it would still have started fifteen years too late to avoid a destabilising "energy gap".

So it does seem that one reason we find ourselves in this surreal situation, with devastating change unrecognised by the experts and dismissed by government, is that the problem falls outside the mind-set of market economics. Expertise, it seems, trumps common sense. Maybe, for a moment, we should stop thinking, and just feel the reality of energy famine. In the last few months, there are already people in the poorer countries who have found that the cost of paraffin for cooking is beyond their reach.

The economics of oil is now dominated by its close proximity to the output peak. The steep decline in the discovery of oil since 1965 means that production, too, must decline, and the turning-point is expected in 2005. Recent rises in oil prices suggest that the very high prices associated with a peak in 2005 are in their early stages. There may well be short-term fluctuations around more moderate prices, even below $30 a barrel; it is possible that, prompted by high prices, a crash programme of new production could hold prices down for some time. However, within the period 2001-2003, the tension between demand and the reduced growth in supply can be expected to raise prices further. When the market begins to believe that the price in the future will be higher than the price for delivery straight away, it will go into "contango": a rush to buy up short-term contracts will bid up prices, leading to a new equilibrium at a much higher level and persuading producers that the longer they leave the oil in the ground, the better the price they will get. A painful stand-off between high prices and flattened demand will persist for a period - five years, maybe - before supply collapses into its definitive decline.

None of that would necessarily matter very much if the world had spent the last 25 years urgently preparing alternative energies, conservation technologies and patterns of land-use with a much lower dependence on transport. As it is, however, the long-expected shock finds us unprepared.

And the consequences? Worldwide, the two main purposes for which oil is used are food and transport. Agriculture is entirely dependent on oil for cultivation and for pumping water, and on gas for its fertilisers. And for every calorie of energy used by agriculture itself, five more are used for processing, storage, and distribution. This dependency on oil and gas could be reduced if the industrial world switched to a more labour-intensive and localised form of food production, and to renewable sources of energy, such as solar and wind power, at various stages in the sequence from farm to shop, but that brings us again to the minimum transition period of 25 years. In other words, the part played by oil in the provision of food is non-negotiable; this dependency will force people to go on buying the oil they need, to the very limit of their resources.

The competition for oil to keep transport moving will be real and raw. The US will fight hard and dirty, for three reasons. First, its economy is organised around the assumption of cheap, long-distance transport. Second, it has a lot of money: it can afford to bid high. Third, the US has an additional problem: it is facing not just a shortfall in the supply of oil but, at the same time, a progressive reduction in the supply of gas; it already relies on gas imports from Canada, whose own reserves are now depleting rapidly. The timing is bad: just at the moment when the world's supply of oil begins to decline, the US will have a new and pressing incentive to increase its consumption.

By being able to afford high prices, the US will export oil scarcity to the rest of the world. At this point, a number of things begin to unravel. Poorer countries will be in deep trouble, with an energy famine affecting transport and spilling over even into food production and distribution. With daily lives locked into dependency on road transport, consumers will strain to cope with prices, but the scarcities themselves will persist. For substantial parts of the global economy, the travel and distribution on which they depend will not be an option. There will be economic destabilisation.

Governments are now in a dilemma. Is this analysis, with its appalling implications, to be taken seriously? Can it really be true that the institutional spokesmen on energy are united in error, and that for good information western governments must rely on the academic literature, on cautiously worded statements from official bodies, but above all on independent geologists and energy analysts, mainly working outside the institutional mainstream? Will governments, or indeed oppositions, be willing to recognise what the true situation is before the first consequences of an oil deficit hit the economy? Probably not: the barrier between rational thinking and institutional complacency is holding well, and there is no reason to believe that it is about to be breached.

When governments do eventually acknowledge the problem, the first step should be to establish a proper dialogue with their publics. The public needs to be told what the situation is, what the government is proposing to do about it, and that the effectiveness of any response depends on its cooperation. The public - which is now alert to the fear that something strange is happening - will want political leaders who manifestly know what they are doing.

Second, we need to find out quickly how food security will be affected by declining oil supplies. In Britain, which imports much of its food, its own farms could again become the main food suppliers.

Third, governments must organise the quest for alternative energy sources and conservation technologies. A renewables-based energy system will never provide the energy needed for transport on the present scale, but solar and wind technologies need to be applied urgently. (Contrary to popular belief, hydrogen-driven fuel cells are not an energy source.)

The coming clamour for nuclear power must be rejected. Its high capital costs would bleed funds out of the more cost-efficient renewable energy and energy-conservation technologies; its construction-times are long, its waste problem is still unsolved. In a destabilised economy with the prospect of unrest, it would be foolish to fill the landscape with nuclear power stations and uranium stores.

There may be a case, despite the climate change implications, for a return to coal mining. The problem is that we shall need an energy system, along with industry and transport, in order to be able to develop the energy alternatives of the future. The use of coal can help us buy time. Within a relatively short timescale of a few years, part of the transport system can be switched over to gas, and part of the electricity grid can be switched to coal. Coal could be the lesser evil for a limited period, and the increased emissions of carbon dioxide will be partly compensated for by a decline in emissions from oil.

Fourth, fuel rationing will have to be put in place. A design for electronic rationing, "domestic tradable quotas" (DTQs), which allows citizens to trade their electronic rations - buying additional rations or selling their surplus - already exists in outline and is ready for development.

The fifth area for government action is international. Here, too, there is a case for some form of tradable rationing system; the essential structure of a system of this kind has already been developed to reduce emissions of the global warming gases. The "Kyoto" structure for international rationing of emissions could be a useful model for handling oil scarcity.

When citizens are motivated and organised, they can get results. But we have to be ready for the economic consequences of what lies ahead. The prosperity of the twentieth century was built on cheap oil and gas. Very soon they will be neither cheap nor reliably available. Even at this late hour, imagination and leadership can still make a difference.

This article is reproduced here by permission of Prospect Magazine,

David Fleming is an independent policy analyst. His book, The Lean Economy, will be published in 2001.

The quotation at the beginning of this article is from "Oil Depletion" by David Delaney (May 2002, August 2002).

Bill Totten


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