Can Triumph Over Peak Oil Continue In A Post-Monetary Stimulus World?

by: Zoltan Ban

It has become an increasingly universally accepted hypothesis, that given the increase in oil prices from the long-term historical norm of about $20 a barrel, to about $100 in the past few years, peak oil is no longer something we have to worry about. Even many of the people involved in trying to spread the knowledge about the subject, such as the popular website "The Oil Drum" recently announced their intention to stop publishing new material. The avalanche of claims of peak oil theory's demise, backed by more and more proof that at $100 oil we can expect to have a large volume of unconventional resources come on the market, seem to have won the day.

I have to admit that I took for granted the long-term viability of $100 + a barrel oil myself, and even though I figured that it will take a 1% bite into long-term global economic growth potential, I also figured it will be a manageable decline from the growth trend we witnessed in the years prior to 2008. Given that average oil prices have been hovering in the $100 a barrel range for a few years now, and we seem to be able to handle the pain relatively well, I think almost everyone has taken the viability of this price range for granted. Therefore, the expectation that we have hundreds of billions or even trillions of barrels in new potential supplies has become the new accepted paradigm.

It seems, we have all forgotten the very important detail that has been part of the global economic reality since 2008, and that is that we have been on life-support ever since the financial meltdown. The US Federal Reserve purchasing as much as $85 billion a month in debt assets, cannot but have a huge distorting effect on all economic activities and prices. Now that we are starting to discuss a gradual removal of the life-support apparatus, the market is scrambling to re-price everything ranging from the value of money (interest charged for lending), to the value of commodities. This process will be completed once the monetary stimulus measures implemented since 2008 will be fully removed from the economy, and then we shall see the real level of oil's long-term price viability.

Back to basic supply/demand issues.

We have no way of knowing what will be the new long-term acceptable price level for crude in the post-monetary stimulus future. I think however, it is worth taking a moment to go through an exercise of our imagination. We should think what the global oil industry would look like at $75 per barrel oil. Given the drastic changes we have seen in production patterns in the past decade, as well as the shape of the consumer sitting on the demand side of the equation, I believe the overall picture would end up looking more like the peak oil scenario envisioned by those who believe in it. At the same time, it would start moving away from the "we are forever saved thanks to technology accessing previously un-viable resources" crowd's vision, which was argued for very successfully in the past few years.

On the supply side, we have millions of barrels in present and future additions to global production capacity, which stem from projects or fields which are viable at $100 a barrel, but not at $75. Just to name a few, the Eagle Ford shale oil and gas field, which given the information currently available in regards to reserves and investments, I made a crude estimation that we need to see oil in the $90 and gas in the $6 range in order for the collective firms operating in the field to break even. By 2015, collective investment into that field will be $150 billion dollars, with much more needed to be spent afterwards to continue to grow and keep production going. Oil reserves are estimated in the three billion barrel range. If oil prices were to settle at a new lower post-stimulus average of $75 dollars a barrel, the value of the current reserves at that price would be $225 billion. In this case, it does not take a well-by-well analysis and endless arguments over expected decline rates, in order for us to realize that many projects in this field would have to be shelved in the absence of the current price level supporting the development of the field. All we have to do is subtract $150 billion from $225 billion in order to realize that if prices were to drop significantly, companies that already invested all that money, will in fact lose billions of dollars on their investments.

Many other projects around the world, including most of the giant fields discovered in the past years in deepwater, off the coast of Brazil, Africa and North America also need the current price range, given the already known high cost of field development as well as the high level of uncertainty involved in deepwater oil exploitation (click for more info). These deepwater projects alone, if we were to lose them from the production schedule, would cut our potential expected level of production for the next few decades by a few million barrels per day.

Another major expected contributor to the expected global oil supply for the next few decades is enhanced recovery from aging conventional fields. Going after relatively small pools of oil bypassed by current conventional primary and secondary production methods, can often add significantly to the field's ultimate rate of recovery from the total oil originally in place, but it is often expensive to do so. Recovery rates for conventional fields have gone from 15-20% many decades ago, to about 40% currently, by using secondary recovery methods such as water injection into the field, in order to help maintain the field's pressure. Many experts in the field believe that ultimately, we will see 60% recovery rates, and I do believe it is technically possible to achieve it. I do question however, whether we can sustain the average price level needed to make it happen.

Click to enlarge

EIA consumption data

Index mundi global oil price data

Note: As we can see in the graph, as the price of oil went above $110 a barrel, OECD consumption reacted negatively, which indicates our current level of tolerance for price increases, given that we are in a period of monetary stimulus.

We should also keep in mind that oil producers fund their projects in large part through accessing credit. With central banks around the world having to pull back on stimulative monetary policy, the price of money will increase, and so will the added cost to oil production, as companies will have to pay more interest on their debt. Therefore, as tightening monetary policy will push oil prices down, it will also push the cost to produce it up at the same time.

On the demand side of the equation, we have to remember that the current consumer is taking advantage of historically low interest rates, in order to be able to maintain the consuming patterns developed over many decades. Growth in real wages has been stagnant in the western world, as well as in many other places since 2000, yet consumption per capita has been increasing. With competition for investment being more and more fierce on a global scale, it is hard to see how we can ever hope to engineer a new era of real wage growth in the developed world. If anything, we can expect real wages to decline, given that growing youth unemployment worldwide is an increasingly widespread phenomenon.

If the monetary stimulus introduced by major central banks since 2008 will be removed from the system, we can expect new pressures to appear on the average household budget. A rise in interest rates will squeeze the ability of the consumer to afford other goods, and thus we will most likely see downward pressure on oil prices, even as the oil industry seems to rely on growing real prices (adjusted for inflation) to keep the peak oil monster away. It is therefore, I believe fair to conclude that peak oil is a myth, fiction, a scare tactic, and a host of other things that the other side labeled it, only and only if the monetary stimulus we see being injected in the global economy will continue to flow. If and when, for any reason, the monetary stimulus is removed, all bets are off.

Looking ahead, if I happen to be right and the current price range for crude oil will not be viable in a post-monetary stimulus world, it seems our choices are as follows: We can choose to continue with the current path of cheap and plentiful money supplies around the world, with consequences, which we cannot be entirely certain off, or we can face stagnating or even declining global oil supplies. It is hard to guess which path our elites would prefer, but my guess is that cheap money is here to stay, even if sometimes we will witness attempts to end it in the coming years and decades.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.