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May 27th, 2008

Oil Production, Oil Price

They finally got my full attention: Last week I paid $100.96 for a tank of gasoline. It wasn't the most expensive grade of gas; it wasn't at the highest-price filling station in San Diego. The crisis reached into my wallet and it hurts.

In 2005, world oil production stopped growing and oil prices shot up uncontrollably. My graph of production versus price is now two weeks old and the price is already off the top of the paper. This morning, West Texas Intermediate is $130 per barrel. In Econ 101, they taught us that increasing prices would enlarge the supply. The economists may have envisioned a large inventory of oil wells, temporarily shut down because of low oil prices.

Value of World Oil Production
(Please click on the chart to view a larger version.)

What happened? We hit "peak oil" – also called "Hubbert's peak," – a geological limitation to the oil supply in the ground. With no additional supplies, a bidding war began in 2005 over the remaining oil in the ground. This is not a news story that goes away after a month.

The news media are only partially addressing the story. Two different friends e-mailed me about Paul Krugman's op-ed column in the New York Times of May 12, 2008. Krugman's primary conclusion was that today's high current oil prices are not simply a speculative bubble. However, his preferred explanation came down to a single phrase, " . . . mainly the growing difficulty of finding oil." Krugman does not distinguish between repairable and un-repairable difficulties. Repairable causes would include shortages of terrain open for drilling, of deep-water drilling rigs, of roughnecks, of geophysicists. The huge un-repairable shortage is undiscovered oil.

How big is the problem? Multiplying production (barrels per year) times the oil price (dollars per barrel) gives a total cost in dollars per year. It's an enormous number; tens of trillions of dollars per year. To put a scale on it, the three thin curves on the graph show the oil cost in contrast to the total world domestic product; the annual value the goods and services added up for all the world's countries. The three curves show the oil cost at one percent, two and a half percent, and five percent of the total world economic output. At $130 this morning, we are at six and a half percent.

If we see oil at $300 per barrel, we will be looking out over the smoldering ruins of the world's economy.

Oil production obviously cannot consume 100 percent of the world's income. My intuitive, uninformed guess is that it cannot go above 15 percent. If we see oil at $300 per barrel, we will be looking out over the smoldering ruins of the world's economy.

The raw numbers aren't deep, dark secrets. The oil production and oil prices are posted by the US Energy Information Agency. The EIA keeps two sets of books on oil production. I used the smaller one that includes conventional oil (and gas condensate) but does not include synthetic fuels. For the 2007 world economic output, almost identical numbers come from the International Monetary Fund and the CIA.

The scales on the graph are simple linear scales. Prices have not been adjusted for inflation. (I claim that correcting oil prices for inflation is circular; inflation is often driven by energy prices.) The prices and production are as-is, without being converted to a year-on-year basis.

So what about the experts and the oil companies who assure us that peak oil won't happen anytime soon? They have plenty of stories to tell:

• The USA is now a service economy; we don't need as much oil as before.
• Energy and food prices are too volatile to be included in the "core price index."
• Oil prices have gone up, but we are still surviving, sort of.
• Oil companies could find plenty of oil if they were allowed access for drilling.
• Alternative energy sources will appear that replace conventional oil.

An additional message says that the 1930s lessons from the Great Depression taught us how to stabilize our economic system. Big Ben Bernanke has pushed large piles of chips into the middle of the table. He placed his bets to prevent a major depression, but unfortunately he has a finite pile of chips. I fervently hope that he wins. (This is a collegial matter: Bernanke was a professor of economics for 20 years at Princeton; I was a professor of geology at Princeton for 30 years.)

Despite the all the arguing, the oil problem really does matter.

• Been to the grocery store lately? Agriculture is a heavy user of energy.
• Ford and General Motors are having difficulty selling big SUVs.
• By my count, seven passenger airlines have flown to that great airport in the sky.
• After many consumers pay for gasoline and food; they don't have money left to make their mortgage payments.

One remaining sweet spot in the economy involves companies like Google, Intel, and IBM. Notice that they are all pushing around bits of information. The other major sweet spot is the producers of oil and other basic commodities.

Although there apparently has been some good news out of the oil patch recently, it may not be big enough, or soon enough, to solve our oil-supply problem. For instance, the government of Brazil, and their national oil company Petrobras, announced a major offshore discovery. Various numbers from 10 billion barrels to 30 billion barrels have been tossed around. Give it your wildest dreams and call it 30 billion barrels. That would postpone the world oil problem for just one year. Further, there are only a dozen drilling rigs in the world with the capacity to work in 6000 foot water depth and handle 20,000 feet of drill pipe. Before their discovery announcement, Petrobras signed contracts for additional drilling rigs. One published account said that 80 percent of all the deep-water drilling rigs in the world are now under contract to Petrobras. (I have to confess that I bought a modest block Petrobras stock on February 20, 2008. It wasn't insider trading; Petrobras had rather large oil and gas reserves compared to its market cap. In the first month after I bought it, Petrobras stock lost 20 percent of its value. It's OK now; buy-and-hold investors have thick skins.)

What do we do? First – admit that there is a problem . . . It's the oil supply, stupid.

What do we do? First – admit that there is a problem. Several analysts are still in the initial denial stage: Jad Mouawad, Michael Lynch, Daniel Yergin, and ExxonMobil. You can cheer up a little by looking at www.CafePress.com. They sell 273 different items indexed under "peak oil." However, you may not want to carry a book bag that reads, "When you say 'cannibal' you make it sound like something bad." During the upcoming presidential campaign, let the candidates know that peak oil is the issue of overwhelming importance. A modest tax write off for wind energy is too little and too late. It's the oil supply, stupid.

You will find that there is a duality. What is best for you may not be the best for the world. I buy oil stocks because I am trying to protect the value of my savings. For the world, I've been writing and talking for six years telling people that "Houston, we have a problem."