Global Oil Production Peaking: What Happens Now?

Includes: PHO, PUW, PWB, USO, XLE
by: Carlton Kanner

One needs to note that the energy issues at hand are not purely economic. While the market will indeed force supply and demand into sink, the issue of petroleum reserves and exploration is not an economic issue but is rather an issue of geology.

While it is true that non-conventional sources, such as the synthetic oil from the tar sands, will provide additional reserves and production capacity, one needs to be cognizant of the decline rates of the super giant and giant fields. There are in excess of 40,000 oil producing fields in the world, but 94% of all known recoverable oil is concentrated in 1,500 giant and super giant fields. Of this 94% the majority can be found in the Middle East, and particularly in the “golden triangle of energy” as CEO of Simmons International, Matt Simmons calls it. This golden triangle can be viewed on the map below.


This triangle accounts for basically all the oil coming from the region. Saudi Arabia produces as astonishing 95% of its oil from only six fields! These fields are extremely old in comparison to other fields and their best know and largest field Ghawar, which has accounted for 60-65% of total oil production, is more than 50 years old. Ghawar has been resilient to less than stellar reserve management and massive water injection which has resulted in bacterial contamination of the field.

Peaking of Ghawar will occur sooner rather than later. Recent horizontal multi-lateral wells indicate the coming of a peak. Unlike vertical wells, which are able to capture the oil from its natural geologic pressure, horizontal wells are used to extract oil between the injected water and the gas cap which has formed above the oil column. This is an indicator of peaking. However, no field as large as Ghawar has been found so it is difficult to speculate the decline rates or how long a plateau can be maintained.

The other super giant fields around the world have already peaked, and are now well into decline. The North Sea and Mexico’s Cantarell field are both in irreversible decline as well as the US lower 48. Decline rates are usual in the proximity of 6-10% per year but can be as high as 20-30% as seen in Norway and Mexico. This can be misleading though. Cantarell’s decline rates are high on purpose because the field’s natural gas is being used to stimulate enhanced recovery with a neighboring field. This is why we haven’t seen as sharp of a decline rate from Mexico as a whole.

Overall global decline rates in a peaked world will most likely be in the proximity of 6-8%. Finding 6-8% of new capacity in the form of alternatives will be extremely difficult to do and most likely impossible. Even if we can find this 6-8% of lost oil production we will need more excess capacity to feed growth. Our growth based economy is entirely dependent upon cheap energy. This is where the true issue of peak oil comes into play. It isn’t about running out; it’s about exponentially increasing prices of energy.

Alternative energies are valued in a dollar figure when they should be valued in an energy figure. Energy returned on invested energy or EROIE, is a much better evaluation of an alternative’s viability. For the most part all of the alternatives that you read about in the news papers have terrible EROIE and thus are not viable as long term solutions to our energy needs.

Moreover, it is irresponsible to grow our energy. Having our food resources compete with our energy needs is not a sustainable solution to our energy demands. To replace the 20 million barrels we use each day, it is estimated that we would need to convert all of our farm land and empty meadow space into agriculture fields to grow the bio-diesel and ethanol required to supply us. In other words, we wouldn’t have any land left to farm our food on. With that being said, technology will help us to some degree. It will not, however, be the savior that the media portrays it as.

The best crops for bio-diesel and ethanol are typically subtropical plants which are high sugar yielding and high in lipid content. These plants need a rainforest-like climate to grow. North America’s climate is not conducive to these and thus the most promising and reasonable crops for wide scale use are soy beans and corn. These two crops have very low EROIE and can not be sustained without government subsidy. Because of this the ROI can be misleading. A crop with a high EROIE may have a low ROI or vice versa. Thus you need to look at both independently to get a good assessment of the viability of an energy crop.

Even the best energy crops, sun flowers, sugar cane and palm oil still have relatively low EROIE of about 6 to 1 in ideal conditions. For the most part, crops grown in the Midwest such as corn, have an EROIE of closer 1.16 to 1. While these numbers aren’t set in stone and with improvements in technology and advancements in the efficiency of the fermentation process we can hopefully see EROIE which are more attractive, but these alternative will frankly never replace a significant portion of our energy needs let alone give us the coveted “energy independence” that our politician love to throw around.

The only short term solution to an imminent peaking is the use of the Fischer-Tropsch process, which can be used to convert our abundant coal resources into a more valued liquid fuel. This buys some time and has been used in the past with much success. An example of its use was during WWII under Nazi Germany and in South Africa apartheid. Coal to Liquid is also currently used by the South African company Sasol Limited (NYSE:SSL). Coal to Liquid plants, much like nuclear plants, require huge capital cost, planning and development time. Estimates for a new coal to liquid plant will be on the order of about 10 years of development and building and billions of dollars.

Solar panels, both traditional, thin and String Ribbon, such as Ever Green Solar (ESLR) and solar concentrators such as those found in the California desert, provide little energy in the scheme of things. All of these technologies require significant natural resources as inputs and also a huge amount of skilled labor. The upfront cost of solar is the current limiting factor. The future of solar is vast but it will not solve our energy problems. It will, however, play an increasingly more important role as time goes on. I would not count on seeing more than 10% of our total energy ever coming form solar. It lacks scalability and is far too costly without government tax incentives. Solar is the perfect dream for everyone. It requires only the sun and produces no emissions; what could be better? Unfortunately our energy demands far exceed anything possible with solar.

Wind, like solar, requires a large upfront capital investment but provides us with free energy. Wind can not be used as base load power and, like solar, lacks massive scalability. There are a limited number of sites where wind energy can work and as we fill these high value spots we will find it harder to see large energy returns from the expensive turbines. When the wind isn’t blowing there won’t be power. This is a serious problem for a manufacturing based nation.

Water is perhaps our best alternative to oil and coal. It is a clean renewable energy and provides us with a good portion of our current energy needs. Again scalability is a major factor. In the USA we have used up almost all of the available places for these dams. These dams also have a large environmental footprint and have significant unintended consequences.

Geothermal, like hydro-eclectic, is a very viable option for large energy generation capacity. The Western US has a large amount of available geothermal sites which have yet to be exploited. Geothermal energy is clean for the most part, releasing only relatively small amounts of toxins and Co2 making it attractive. The only downside to geothermal power is the potential for earth quakes. About a month or two ago the Swiss government blamed a small earth quake, which I believe claimed the lives of several people, on a recently started geothermal plant. This plant had indivertibly pumped water to close to a geological fault causing an increase in pressure that resulted in a quake. Geothermal is, however, a viable energy source and should be exploited.

From an investing stand point there is the potential to make huge returns. The alternative energy companies trading today for the most part lack the basic value investing criteria and thus I will not discuss these in length. The large conglomerated oil companies such as Exxon Mobile (NYSE:XOM), Conoco Philips (NYSE:COP), etc are far too big and slow. These majors can only expand their reserves through mergers and acquisitions. Expect to see a large push in the near future to acquire Canada’s oil sand producing companies. I won’t speculate just yet which companies are primed for a take over. The Canadian tax law has recently changed and a particular issue regarding the handling of trust has changed and until I review this issue I can not speculate. Windfall taxes also present a future significant issue for these large mega cap corporations. When the American people are paying 4 dollars at the pumps and Exxon Mobile makes another record breaking year, it seems inevitable that some sort of windfall tax will fall on these companies.

The small, mid cap and a few independent large cap oil companies are far more attractive. These companies are trading at extremely low P/E ratios, have little debt and small downsides. I will leave a micro analysis of this sector for another post, but I would recommend almost anything in Canada that has a stake in the oil sands or significant untapped proven reserves. The Canadian currency should strengthen as we slip further into a commodities cycle (see Jimmy Rodger’s Hot Commodities for further information) which should help to increase profits these Canadian oil and gas producers.

The last issue I will discuss in this post is the price elasticity of demand for oil. History has proven that the slope of the demand curve is nearly vertical for oil, meaning that the global economy is willing to way 40, 60, 100 dollars for a barrel of oil. Often I hear the term demand destruction thrown around when talking about the price elasticity of demand of oil. And yes, I do agree that demand destruction will cause a reduction in demand, but let’s not beat around the bush and let’s just call it what it really is, a recession/depression. With anything short of recession/depression I see the chance to make a lot of money in the oil industry. I think this sums it up nicely, 65 dollars a barrel and the Dow Jones Industrial Average nearing a new record high.

Disclosure: none