Ladies and gentlemen, boys and girls... Dying time's here.
Mad Max Beyond Thunderdome
I have seen more fear in the articles discussing oil scarcity than I have in those proclaiming the economic Armageddon is around the corner. While I think we are setup for an economic crash, I am not convinced the end of cheap oil is the end of civilization as we know it. Rather, I think it is the beginning of a new phase of energy usage that will simply change how we value energy and use it in our daily lives.
Instead of shoveling pig dung for methane-based fuel energy as depicted in Mad Max, we will more likely adopt natural gas and hybrid cars for transportation, while using cheap and safe LFTR-based thorium as a very cheap grid energy solution. Transportation will be more expensive, but grid energy will be much cheaper and more plentiful. In the end, we will adjust our energy usage patterns to match technological innovations and supply patterns. But I doubt the earth will turn into a giant dust bowl due to a shortage in cheap crude.
Let us get into some facts about current oil demand and supply and then explore how our oil supply issues affect our energy demands in the future.
To start the discussion, the most famous oil prognosticators have predicted that by our current date, we'd be in a much more dire oil shortage than we are. The thinking went, that by previous supply metrics and the increasing rate of usage due to population growth in emerging markets driving increasing rates of change, something had to give and give fast. The problem with this argument is two-fold. First, the estimates on future supply have proved to be incorrect. And the prognostications tended to ignore technological advances that have, so far, allowed oil supply to just barely keep up with oil demand while keeping prices from going straight north.
US Energy Information Administration
Non-OECD oil demand, including gasoil, oil, and gasoline has grown steadily since 1996 and this trend is expected to continue. OECD oil demand has remained almost the same over that time span, with strong reduction in gasoil and slight increase in gasoline demand. Non-OECD demand increases are lead by Asia, the Middle East, and then the Russian bloc.
US and European oil demand has remained relatively stable since the mid-1980s, while the biggest area of growth has been the Asia Pacific region emerging markets.
Source: International Energy Agency
Transportation fuels drive the large increases in non-OECD demand. Indian demand is rising by about 3.5%. Russian demand is rising by 3.4% over 2011 so far. Japanese demand is up owing to the recent shutdown in nuclear energy supply, but this may be relatively short term in nature as alternatives are explored that are cheaper than burning oil for grid power.
Chinese demand is rising but has slowed by recent economic developments. This may be one of the main reasons the price of gasoline in the US has actually fallen to the $3 per gallon level recently. The larger nations are demanding less oil within the last few months due to the economic slowdown, which has eased the price of gas. And note that while Asia's thirst for oil had increased dramatically, OPEC's has shown the ability to provide that oil.
As noted in two above graphs, the Middle Eastern supply of oil has kept up with aggregate demand increases in Asia. Interestingly, Europe and the US, while large demanders of oil, have not significantly increased their demand for crude in quite some time.
Let's take a look at current oil production graphed against the historical supply growth rate. Production has recently fallen off the 30 year trend, but not as dramatically as originally predicted.
Source: Our Finite World
Most supply increase has come from OPEC nations, with US production at 13 year highs owing to hydraulic fracking in shale and carbonate plays. Canadian supply is down slightly. Brazillian supply is down. African supply is down sharply mainly due to conflicts in Sudan.
The outlook assumes that substantial production stoppages affecting the Sudans, Syria and Yemen persist for much of 2012. (International Energy Agency, May 2012 update)
Source: International Energy Agency
The demand and supply discussion is not complete, however, without examining overall costs of production and subsequent energy returns on investment.
Costs and EROI
Getting oil out of the ground costs us money. Costs have been rising over time to produce a barrel of oil, and hence the price of oil has increased in unison.
Break-even costs for extracting oil have been rising.
Not all oil is equal; costs of production versus market price gives some producers an advantage. The thought is that when price rises high enough above costs, then production will increase in some of the more expensive, smaller plays.
But the real question should be, are costs rising because the plays are more expensive, or because prices are rising in general due to inflation? One way to remove inflation from the cost picture is to plot the price of gold to the price of oil. Since gold tends to follow inflation closely, the ratio gives us an idea of whether oil is relatively more expensive or less expensive, sans inflation.
Note: I would use CPI to estimate inflation, but my contention for the last 2 years has been that government manipulation of CPI measurement has made the statistic basically meaningless. Gold has been a more consistent measure of inflation for thousands of years and the gold/oil ratio has consistently been used as a measure of the relative price of oil for a long time.
Source: Incredible Charts
As we can see from the chart, the ratio has fallen substantially in the last 10 years, even during gold's miraculous bull run, suggesting that the 10 year costs of extracting oil have been substantially higher than the overall inflation rate noted in the economy.
Analysts have long noted the EROI (aka EROEI) statistic as a rate of return on energy invested per barrel of oil. EROI is a scary statistic at first, but with further examination the panic level tends to fall a bit.
It is plainly obvious that the energy return on investment for oil has sharply fallen in the US since the beginning of the oil boom age. This is true everywhere. Common EROI values for major forms of energy are shown next.
Source: Oil Drum
Just looking at the first EROI graph creates panic that the world as we know it is about to end. But EROI as traditionally presented is a bit of a math trick. EROI is the ratio of the amount of oil we get for each equivalent barrel of oil energy used in extraction. So a 20:1 return implies that for every barrel of oil energy equivalent expended, we get 20 barrels of oil energy in return. As the number falls to 7:1 for most oil sands projects in Canada, it is easy to imagine where gasoline prices should triple in short order. But that hasn't quite happened.
If you flip the numerator and denominator in the EROI calculation, you get a 5% cost of energy extraction in the 20:1 scenario, and a 15% cost of energy extraction in the 7:1 scenario. Costs have tripled, but the energy provided by oil sands projects is still quite profitable in energy terms and worthwhile to pursue for global production. An decrease in 10% of oil energy available doesn't spell the immediate end of the world, just reasonably higher gas prices. And that is what has happened.
The rest of the rise in gas prices the last few years can probably be attributed to other factors, such as monetary inflation which has significantly raised the prices of other goods in general. So it's important to note that while oil is getting costlier, we aren't at Defcon 5 just yet.
Future oil production and supplies are what interests most economists and investors looking to make decisions on what to do next with oil. It is interesting to note that world proved reserves have increased quite substantially in the past 20 years.
South and Central America have contributed greatly to the rise in oil reserves. That's a good sign. However, not all oil is the same and reserves are increasingly being found in more expensive plays such as deep water and oil sands that ensure costs of production will remain high for the future.
Heavy oil, which is harder to process, and oil sands bitumen make up a significant portion of reserves. In addition, the growing gap of new oil discoveries shows that we aren't going to see cheaper oil in our lifetime, unless an astounding breakthrough in mining technologies drives costs of more difficult oil extraction lower. The reasonable expectation here is that innovation in drilling oil will keep prices from rising exponentially in the near term, but not keep them from rising faster than the general level of economic inflation we see in other commodity prices or in gold. Oil is just going to get more and more expensive to gather.
Other Things to Consider
There have been some interesting developments in regards to US oil availability. Heavy oil from Canada is trickling down to the refineries in the coastal regions of the US. But, because the oil supply generally flowed the other way, there are not enough open pipelines to carry this heavy oil down to the Gulf region where refiners can process it. Hence, the refinery rates have fallen a bit.
We have plenty of refinery capacity, but it cannot be used until we can transport the heavy oil where it needs to go for processing. This, in addition to global slowdown, is contributing to the slight fall in heavy oil prices. We can expect this to continue as long as the heavy oil supply to the US is bottle-necked to the refineries and cannot make it into world supply to lower overall world oil and gas prices.
In addition, EROI is calculated using current grid energy prices. For oil projects fed by grid power, any technological advancement in grid energy production, such as the Thorium LFTR project advanced by Flibe Energy and overall Thorium energy revolution taking place, will significantly lower costs of production and boost EROI for oil.
In addition, technological advancements in extracting shale oil, such as the one that powered the vast increase in natural gas supply in the US which sharply dropped market prices, may also lead to an increased EROI number. We simply cannot count out advances in technology and their effect in the costs of extracting oil in the future of some of the oil sands and other expensive oil projects.
There are some substitutes to oil as a transportation fuel. One of those is natural gas, which has witnessed an outstanding boom in recent years. As the ability to transport NGLs overseas is increased by investment in the shipping industry for such vessels, natural gas will be made more available as a substitute transportation energy. Natural gas cannot by current reserves make up for oil's 33% role in the global energy economy, but it can make a substantial dent and buy us more time to develop a true, long term substitute for oil as a transportation energy source.
At the end of the day, we are running out of cheap oil. But several factors will mitigate how much damage is done by this, and how quickly. If we act on the several profitable energy projects available to us, and intelligently shift usage of other transportation energy substitutes, we can mitigate the impact of the coming oil drain will have on our way of life. And perhaps we can stop spending $1.2 trillion on oil wars and realize THAT money could have been much better spent proactively planning for the changes in our energy futures.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.