Peak Oil Economics

Oil prices, US oil independence and basic economics

I just listened to the another politician screaming about opening up ANWR for oil development. These politicians claim our recent sky high oil prices are due to lack of new supply here in the US. As an economist, and an energy user, this view really annoys me You can't dig yourself out of this scarce resource pricing issue. One needs to let economics work: prices need to continue to rise, until demand falls and alternatives are properly funded.

These same politicians also claim that the US economy will crash due to the high cost of hydrocarbons. Actually, I believe the opposite is true. The US oil fueled economy is old and tired. A new vibrant US economy is coming - if we start real investing in all the oil alternative technologies.

US oil independence and ANWR

Let's be very open and clear. If you want the US to be independent from middle eastern oil, the price to the end users needs to continue to rise. While the US should continue to drill in all our current developed areas (US land, GOM up to 2 miles of coastline, deep water, etc.), there is no economic reason to drill in ANWR.

An Energy Information Administration analysis in 2004 concluded that "by 2025 ANWR is projected to reach .9M barrels a day". This report further states that it would take about 12 years for the US to receive any hydrocarbon from ANWR. So, if ANWR were approved today, the US would get its first barrels of oil in 2020. Of course, between now and 2020, there would need to be a huge increase in infrastructure and construction activity to develop ANWR. This activity needs energy, specifically diesel fuel for all this construction. The US would have a further rise in oil demand while this project is being built-out, increasing fuel cost for all Americans.

With this above time-frame in mind, it appears some politicians feel we will still be highly dependent on oil in 2020-2040. We could just build cars that don't use oil, would this not be more logical? My view is to just let economics work. Gas at the pump at 5-10 dollars a gallon would make the manufacturing of the combustion engine vehicle a big ole dodo bird.

Even better, the US does not need any technological breakthrough to make the current vehicle engine extinct. Coal liquification into diesel fuel has been done on a large scale since WWII. Can the CTL technology be clean? Well, yes it could, but not at 3 bucks a gallon. The diesel engine is 30% more efficient than a combustion engine, so if we use coal vs oil, this one component change would make the US independent from middle eastern oil.

We also have natural gas powered cars, fuel cell and electric cars. These technologies are here today, and will continue to improve every year if we allow natural economics to continue.

Peak oil theory

This is a very misunderstood concept. Peak oil has very little to do with actual oil reserves. Let's assume that the world has 100 years of oil reserves; hell for argument's sake, let's just bump that figure up to 2,000 year's supply of oil reserves. So with 2,000 years of oil left, how does the peak oil theory stand up? Actually, very well. One needs to understand economics and infrastructure.

Peak oil has nothing to do with reserves, but instead with the rate of extraction, distribution, and refinement. Wiki gives a concise view:

Peak oil is the point in time when the maximum rate of global petroleum production is reached, after which the rate of production enters its terminal decline.

Currently, world oil extraction and distribution is about 85 million barrels a day. Is this the peak? Hard to say, but we can say based on economics that the world is either at the peak or within 5-10% of a possible peak. Current actual demand is estimated to be around 87 million barrels a day, so it's obvious that prices will continue to rise until demand is brought back in balance. Here is Boone Picken's current view:

Eighty-five million barrels of oil a day is all the world can produce, and the demand is 87 million," he said. "It's just that simple. It doesn't have anything to do with the value of the dollar.

Of course we need assumptions. An economist can't get through the day without a few assumptions! Here are my world oil economic assumptions.

1. World-wide demand for energy and transportation energy will continue to increase between 1-3% per annum.
2. Supply and distribution of oil will be between 85-87 million barrels a day.
3. World-wide pollution taxes, or cap and trade programs, to increase dramatically over the next 10 years, the effect of which is a 10-20% tax on polluting sources of energy (oil and coal).

So if the world is currently capped at about 85M barrels a day of extraction and distribution, but demand for oil rises 3% per annum, what happens next? Since the demand curve for oil is very inelastic, this means that the price of oil can rise very sharply in the short term. This is what we have seen during the past 3-4 years.

For me, as an economist, I am very interested in the next question: What about the pricing dynamics for oil in the long term? This is also the most important question for any decision on ANWR, since consumers will not see any significant oil from ANWR until 2025.

Long term oil economics

This is more complex than it appears. As stated above, the short term economics indicate much higher oil related energy prices given the above assumptions. Governments and investors all over the world are very interested in this topic. We all see that it is transportation - vehicles - that drive the demand and price for oil. For the first time, it is clear that alternative vehicles will be competitive long term.

In order for current oil extraction and distribution to even stay at 85M a day, or to increase this amount, oil infrastructure investment must increase. For future extraction, the world needs new oil platforms and deep sea oil rigs. For transportation, the world needs VLCCs. Once transported, we need large refineries to create the distillates. After refining, we need miles of steel pipelines, trucks, etc.

The cost of the above infrastructure is huge. Building a VLCC takes years, at a cost of over 120 million. This cost has risen over 50% in just a few years. As fuel costs rise, the cost to make everything also rises - steel plates, large diesel engines, precision tolls,etc. This economic dynamic is the same for the very expensive new rigs, refining capacity and transportation pipelines and vehicles.

Here comes the crux. CEOs of firms in the oil industry must always do a financial cost benefit analysis of these new large infrastructure purchases. With the current high cost of gas and diesel ($4-5 dollars a gallon), and pollution taxes in the future increasing this price to over $5 a gallon for the foreseeable future, alternative natural gas engines (1-3 dollars a gallon), electric vehicle engines (under $1 a gallon) and coal to diesel fuel (4 dollars a gallon) are all economically preferred.

With the much higher differential in the cost of powering the current oil based vehicle engines, the world will quickly adopt natural gas, battery and fuel cell powered vehicles over the next 10 years. So why invest 120 million dollars in a large crude carrier when it could be obsolete in 10 years? The same thinking applies to large oil rigs, new refineries, etc. And again, why waste money money drilling in ANWR - by the time the US gets the oil, we probably will not even need it.

As in investing and life, timing is everything. When will firms stop ordering all this expensive oil infrastructure equipment? If they were prudent, I would expect a drop-off in oil infrastructure demand over the next 3-5 years.

What will happen with oil prices?

As stated above, oil prices will continue to stay high in the short run, but at some point in the next few years, I predict a downturn in oil prices, as alternative power sources are used in vehicles. This is how economics should work. I am surprised that this shift has taken 100 years. As an investor, this changes how I value many energy firms.

Firms that are 100% levered to the extraction and distribution of oil will have falling cash flows after 2013-2015, in my humble opinion. Individuals and businesses change their vehicles quite often - every 3-5 years - so one can see how the technological changes in the transportation area can impact the demand for oil fairly quickly. As for the electric generation, this timing is different. We don't change our power plants out every 5 years, so the demand for coal and natural gas will remain strong at least 10 years out.

As I have written before, firms that are in the natural gas business will outperform the oil related firms in the future. Also, firms in battery and fuel cell technology should outperform. These changes will invigorate the US economy - if the government stays out of the way. Current ethanol mandates and ANWR drilling plans all have one effect - to slow down the natural economic change from oil to all its alternatives.

Authors note:

I first published this article on Seeking Alpha on May 22nd, 2008. As one can see, my prediction of oil prices coming down has happened even faster than I predicted. Obviously the current economic recession has much to do with this sudden price drop, but the fear of a Boone Pickens type shift to natural gas vehicles may play a major role in future oil demand dynamics.