Is the Peak Oil Theory Valid?

Includes: DBO, OIL, USO
by: Hard Assets Investor

First, a definition. If you're Paris Hilton, go here for your explanation, otherwise ...

The peak oil theory does not necessarily say that the world is running out of oil. That's actually an unstated fact. After all, nobody is actually making more.

What peak oil actually suggests is much simpler: At some point, global oil production will reach a peak, and then begin to decline. At that point, oil will become more expensive, because it will become increasingly expensive to discover and extract what oil there is left. As oil becomes more expensive, demand will go down. We'll never actually use the last drop of oil because it will be too expensive to buy.

According to peak oil theorists, the U.S. experienced its own peak in oil production in the 1970s. Globally, the estimates of when we reach peak oil production range from yesterday to 20 years to 50 years or more - take your pick.

New Resources Harder To Find, Harder To Tap

New crude oil discoveries are not coming fast and furious, though Brazil has had some luck in this area lately. Just last week, Brazil announced a major find 155 miles off the coast of Sao Paulo, near the Tupi oil field that was discovered in 2006. Petroleo Brasileiro SA (Petrobras) isn't discussing exactly how big they think the discovery is, but the Wall Street Journal reports that Petrobras is planning to lease another 40 deep-sea oil rigs in 2017 - this after it already has 80% of the world's deep-sea drilling vessels under lease.

New supply coming on line in Brazil is exciting news for the U.S. because more oil close to home would decrease our reliance on oil from the Middle East. Most likely, that oil instead would go to China and India.

But here's the problem - the technology, equipment and good old-fashioned know-how aren't necessarily up to the challenge these deep oil rigs require. Salt water corrosion, high oil temperatures, huge pressure changes and the depth of the drilling all pose problems the oil companies have to solve for those fields to be viable. And solving those will be higher-cost propositions. So, far from defeating the peak oil theory, these new and challenging finds in some ways support it.

Looking Forward

The Peak Oil theorists got a shot in the arm last week when the venerable International Energy Agency seemed to jump on board the Peak Oil theory. Here's what our Wall Street Journal said:

For several years, the IEA has predicted that supplies of crude and other liquid fuels will arc gently upward to keep pace with rising demand, topping 116 million barrels a day by 2030, up from around 87 million barrels a day currently. Now, the agency is worried that aging oil fields and diminished investment mean that companies could struggle to surpass 100 million barrels a day over the next two decades.

For a committed peakist, this was a big deal. A flat-out acknowledgment from one of the former skeptics that oil production is not guaranteed to continue to grow.

The International Energy Agency will be releasing a report in November that will, for the first time, evaluate the health of 400 of the largest oil fields in the world. Delving deep into the supply side of things is a departure from the IEA, which typically focuses on forecasting demand, assuming that OPEC countries will make up for any supply shortfall. By introducing a supply review, IEA seems to be raising the possibility that OPEC may not be able to meet that demand after all.

Of course, the fact that the IEA is focusing on supply is a natural signal (or plea) for OPEC to increase output. Considering that they already are pumping an extra 300,000 barrels a day and there has been no effect on crude prices, such a petition may fall on deaf ears. Additionally, the OPEC Secretary General Abdullah al-Badri seemed to refute the fears fanned by the Wall Street Journal's article in a report by Reuters saying "he was not worried about reports of faster-than-expected depletion in the world's biggest oil fields."

Mature Oil                       

Oil fields have a life span - in their youth they are plump, full and eager to please. But as they age, they become temperamental and stingy, the crazy Uncle Bob of the global energy supply. There is a natural rate of decline in production. Just what that rate of decline is can be a closely held secret, which makes finding information that much more fun. If you look through the U.S. Energy Information Administration's country reports, you can find depletion rates for some countries' resources. A few high spots:

  • In 2004, 20% of Russia's oil came from oil fields that were over 80% depleted. The post-peak fields are estimated to be declining between 1-5% per year.
  • Iran's rate of decline is estimated to be 8% for onshore wells and 10% for offshore wells.
  • Though the EIA has no hard facts for China, they do report that China's fields are mature and production is peaking.
  • In Saudi Arabia, Aramco states that the total average depletion for its oil fields is 29%. The largest Saudi field, Abqaiq, peaked in the ‘70s and is 74% depleted.

A more extensive report on 811 of the world's largest oil fields earlier this year by Cambridge Energy Research Associates put the average depletion rate at 4.5% a year. Even though that is lower than many peak oil theorists, it is still a whole lot of oil to make up each year through new fields or better extraction techniques.

Given how hard it can be to get good data, it will be interesting to see the IEA's report in November. Especially since it looks like China, Venezuela and Iran aren't cooperating, and getting specific field information from Saudi Arabia is next to impossible. One thing that might make IEA's analysts' jobs easier would be if China accepts the U.S.' invitation to join the IEA - but don't hold your breath. To do so, China would need to become a member of OECD - an organization whose members have open market economies and are committed to democratic pluralism.

And The Price Goes On

One thing is for sure: If the IEA report comes out in November with even worse news than the market is expecting, this curve will get a lot steeper and cries of "The Sky is Falling" will be heard loudly throughout the market.

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