is oil still oil

By Chris Caton Chief Economist BT

Has oil production passed its peak?
The prolonged spike in oil prices, the strong growth in demand for oil in recent years, and the realisation that the energy needs of the developing world are likely to continue to grow have all led to increased focus on the concept of peak oil production. That is to say that, no matter how much oil there may still be in the ground, we are getting close to the point where it will simply be impossible to extract the oil at an ever-faster rate, so oil production will hit a peak.

Some adherents to this view believe that we are already close to this point. Indeed they can point to more than 50 oil-producing countries, including the US, that are already producing less oil than they used to, indicating that they have already reached, and passed, their peaks.

A world of change

If this view is correct, then you ain't seen nothing yet as far as energy prices are concerned. Prices will have to rise much further just to ration the available (limited) supply. And it isn't difficult to paint a picture where there is conflict for access to the limited supply, and where certain activities, such as air travel, simply become impossibly uneconomic. The world will have to settle for a far simpler way of life. Our grandchildren will be far worse off than we are.

Investment markets haven't factored this world into their thinking. Today's corporate world exists on the assumption of continued cheap (and available) energy, and is valued accordingly. So when it is realised that the assumption is wrong, capital markets will collapse.

How long till we hit the panic button?

Not so fast. It is true that there is only a finite quantity of oil still in the ground but, as Dr Greenspan and others have reminded us, there are more known recoverable reserves still in the ground than there were 10 years ago, despite all the oil consumed in that 10-year period. It is estimated that the OPEC nations could continue to extract oil at their current rate for another 80 years, even if they don't find any more.

It is true that it has been decades since a large new oil field was discovered, but most of the increase in recoverable reserves comes from already-existing fields.

$180 a barrel?

One of the reasons "peak oil" adherents have difficulty selling their view is that we've heard all this before. From the Club of Rome days in the early 1970s, we have been warned that the world will run out of oil and other commodities, and that prices will climb to very high levels. Indeed, I am told that the first forecast that the world will run out of oil was made prior to the first well coming online in the US, sometime in the middle of the 19th century.

In a previous existence, I ran a model-based long-run forecasting service in the United States. We produced predictions of economic activity, industrial production, inflation etc with a 25-year horizon (Americans are a gullible lot). For my macroeconomic forecasts, I took input from other sources within the same consulting company, including an Energy Group. In 1980, that group forecast an oil price of $180 per barrel by 2000.

It's all supply ...

Of course, in the fable about the boy who cried wolf, there was eventually a wolf. Just because it hasn't happened yet doesn't mean that it can't. True, but it is also true that economics works. One of the reasons why the pace of oil discovery has slowed in the past twenty years is because the price was so low that the return to the capital spending necessary to find and deliver more oil simply wasn't high enough. With the price where it is now, that should and will change. We will find new ways to extract oil from existing fields; unconventional sources such as tar sands and shale oil will become progressively more economic; and still largely-untapped and fecund areas, such as Russia and Africa, will become more and more important.

... and demand

Meanwhile, the relatively high price of oil will work on the demand side also. The world already uses about a third less energy per unit of output than it did 30 years ago. The capital stock (including cars) is far more energy-efficient, and as the developed world grows, it shifts its output towards services and away from goods, which tends to drive down the demand for energy. These days, of course, much of the world's growth comes from the developing world where different considerations apply. The car fleets in China and India, for example, will obviously continue to grow rapidly for a long time. True, but the developing world is remarkably inefficient in its use of energy, and there is considerable scope for demand growth to be limited by increased efficiency.

Short term outlook: oils ain't oils

The kernel of truth behind the "peak oil" view is that oil is likely to remain expensive for a long time. This will bring forth new supply, and limit demand. We will pay more to cool our homes and to drive our cars, but we will still be able to do it. The high price will lead to continued searching for new technologies to replace the black gold.

There is a quote variously attributed to Sheik Yamani, the OPEC oil minister in the 1970s, or to The Economist magazine, as follows: "The Stone Age didn't end because the world ran out of stones, and the fossil fuel age won't end because we run out", but don't be surprised if oil is never cheap again.