Peak Oil Primer

Off the keyboard of Monsta666

Discuss this article at the Energy Table inside the Diner

Peak Oil is an old topic for long time Doomers, but many Rookies in the Collapse Blogosphere are not that well versed in the ramifications of energy depletion issues. Here, Monsta666 gives a cogent overview of the Peak Oil situation as it stands now-RE


Peak Oil

Peak oil is not “running out of oil” as commonly depicted by critics in the mainstream press rather it is the time when total oil production reaches its maximum. After peak oil the total amount of oil production goes into terminal decline. It is really quite simple what peak oil is but people have a habit (not just with oil) of making the definition overly complicated.

A good example of peak oil can be seen in the graph below which shows that US oil production peaked at 9.6mbpd (million barrels per day) in 1970 and since then has gone into decline. There have been two recoveries with the first occurring in the late 1970s to late 1980s. This first recovery came about when the biggest oil field in the US (Prudhoe Bay) came online. There has also been a more recent recovery in production and this new recovery was mainly the result of the shale oil revolution in the late 2000s. None of these recoveries have exceeded the peak of 1970 however. This oil production profile is typical of most countries and perhaps the US is even slightly unusual in this aspect when compared to other countries as most countries do not experience a recovery periods.

Since peak oil is concerned with production rates it is about flow rates. That means it is not about reserve numbers as flow rates cannot be accurately determined by looking at reserve numbers in isolation. This point must be stressed particularly in light of recent years were a disproportionate amount of new oil comes from unconventional sources. As well as providing lower EROEI (Energy Return On Energy Invested) the flow rate from these sources tend to be lower relative to reserve size. This means that huge reserves number can be added but as they have low flow rates then these sources cannot offset the declines of conventional oil which incidentally are expected to decline by about 7% per annum according to the EIA (Energy Information Administration). Thus peak oil will be reached even though total reserves may increase substantially.

It should be noted that the dynamics of a global peak oil production will be quite different to the peak oil of an individual country. This is because unlike a single country, a change in the supply on a global scale will have a profound effect on the global price. An individual country on the other hand has a small influence on the world price (at least for the vast majority of countries). If the world supply of oil becomes constrained the price of oil will rise and this will either create a recession, bring more oil to the market or a combination of both. These factors will likely result in an extended plateau as more oil is brought online to offset declining fields while the high price will reduce demand keeping production from having to get too high. The graph below of world oil production demonstrates the trend described in this paragraph:

This plateau cannot be maintained indefinitely. As time progresses the amount of investment required to maintain production rates rises exponentially which means higher and higher price is required to maintain flow rates. At some point the global economy cannot support the costs required to maintain flow rates and as a result total oil production will decline. If the flow rates decline then the total supply in the market will decrease and if demand remains constant or worse rises, then oil prices must rise in tandem. Now the issue to bear in mind and this is a point that is often forgotten or overlooked even to people aware of peak oil, is the belief that oil prices will rise to infinity. I would say such a scenario is not going to happen, at least not within the foreseeable future..

It should be remembered that the price of oil has a profound effect on the world economy. If the price of a barrel of oil reaches a certain threshold it will send the economies that import oil into a recession. When a country enters a recession the demand for oil will decrease which will result in a price drop. We have seen two examples of this demand destruction in recent years; the first occurred in 2008 when oil reached $147 a barrel before the price fell dramatically due to the onset of the global financial crisis. The second more recent crash happened in March 2012 when oil reached $128 a barrel (Brent oil) and then subsequently fell to $90 a barrel. These high prices contributed to the ensuing recession in the major OECD countries particularly Europe and this demand destruction has been the chief contributor to the recent price decreases. We can therefore say there is a limit on how high oil prices can reach before it results in a recession and prices come down. The correlation between oil prices and recessions is strong with nearly all recessions in the last 50 years coincided with a recent rise in world prices as shown in the graph below:

Another important aspect to remember is when oil prices rise the economies of oil exporting nations grow leading to more internal consumption of its oil resource. In nearly all cases this internal consumption increase exceeds the rise in total production which results in less oil being exported. This rise in internal consumption is even more pronounced in Middle-Eastern countries were the price of oil is heavily subsidised and the culture for efficient use of petroleum is not widespread. Furthermore a significant amount of electrical energy, which is also heavily subsidised in the Middle-East, comes from oil which creates a strong downward pressure on the total amount of oil exported. As less oil is exported the price needed by these exporting countries to balance its books rises.

This issue of balancing the budget becomes even more acute if the exporting country needs to pay large fuel subsidies or/and social programs as these costs will be added on top of the increased investments required to maintain/increase oil production. These elevated costs are further exacerbated if the population is rising rapidly which is often the case in Middle-Eastern countries. If the price of oil were to fall below the break-even price for an extended period of time then the exporting country will reduce supply in an attempt to bolster prices. Thus there is a price floor for oil and since global net exports are decreasing this price floor will slowly rise over time. This decline in global net oil exports is clearly seen in the graph below:

Now with both those facts established we can see that there is a price ceiling which oil prices cannot exceed without creating a recession and there is also a price floor that oil will not stay below for long. Since the price floor will rise over time, there will come a time when the price floor meets the price ceiling and when that time arrives it is likely to create significant problems on the global economy.

This constraint supply and shifting price floors/price ceilings (which will come closer together over time) will also lead to another phenomenon. That is an increase volatility of oil prices. In fact a high volatility of price can be seen as indicator that the amount of spare capacity in the system is low. This increasing price volatility can easily be seen in this graph below:

As a result of this increasing price volatility it will become more difficult for consumers and suppliers of such oil to make long-term business plans which will raise costs indirectly as result as it becomes harder to maintain favourable long-term contracts. However what is more significant is since oil prices are so heavily connected to the state of the economy there is a good chance these bigger fluctuations will lead to greater volatility in growth rates (going from recession to growth and back again).

It should be noted that as stated earlier, there are limits to how high prices can rise and it is likely that coming oil crunch will not manifest itself initially as an oil crisis (with oil lines at the petrol station) but as a financial crisis with large numbers of bank insolvencies and other associated systemic risks that will stem from this initial crisis. It should also be noted that global economy is highly efficient and can produce goods and services at extremely low costs but this high efficiency comes at the price of low resilience. This is because many of the supply chains that supply our economies with goods/services are not only long spanning many countries but also operate on a JIT (Just-In-Time) basis. With the risk of various systemic failures what are the chances these low resilient supply lines can continue to operate in the midst of a financial AND liquid fuel crisis?

This distinction between and an energy crisis and a liquid fuel crisis is an important one because 90% of the energy for global transportation comes from oil. This transportation energy covers the most obvious examples such as cars, trucks, planes etc. but what should also not be forgotten is the machinery (and pesticides) necessary for agriculture and the mining of various metals that is needed for various goods including metals needed for the construction of renewable sources of energy. These sources, at this current time all depend on oil for these products are either transported or extracted using oil or oil itself is a basic input in the production of the said resource. In fact we can easily say that oil is an enabler of other vital resources so when we face an oil shortage it is likely we will also face a shortage in other resources. Again it is likely this scarcity will not initially manifest itself with the resource or good disappearing but merely that the price of the goods rises considerably.

While price rises and the accompanying demand destruction will serve to alleviate the constraint supply of oil for a time eventually higher prices can no longer manage a basic shortage. There will come a time when the price of oil rises creating a recession. However unlike previous cycles the next price rally will not generate a sufficient amount of income to overcome the existing decline rates from old fields. When this time comes not only will global oil production decline but more important, the rate of global oil exports will decline at an even greater rate. This decline will be higher than what developed countries can handle and adjust to so it is likely at that point that real oil shortages will occur.

Once the perception of an oil shortage begins to take hold then it is likely to induce not only higher prices but hoarding of the available resource. This behaviour occurs not only on a consumer level but also on an interstate level as exporting nations will begin hoarding their oil from the importing oil countries. The exporting nations will hoard oil as it will wish to save its remaining resources to itself as it will prioritise the needs of its citizens over the needs of foreign customers. This hoarding behaviour has been seen in the UK in two occasions when there was a perceived shortage of oil, first in 2000 and more recently in 2012 when an oil shortage induced consumers to panic buy and hoard the valued resource thus exacerbating an already difficult situation. It is likely that when a strong perception of shortage is felt then rationing will need to take place to avoid such irrational behaviour. In any case, when thinking about peak oil in its later stages, the physiological component cannot be forgotten as that will play a big part in how this situation unfolds. This last point cannot be understated as it is likely that once the problem of peak oil becomes apparent it is likely that other systems and conduits will be in a severely degraded state. What is more a shortage of oil is likely to compound any existing problems that are occurring.

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