I am trying something different with this post. I below publish an edited version of an address by oil investment analyst John Dowd. It is available freely on the internet here. The address was given as testimony before the United States Senate Committee on Energy and Natural Resources on September 6 2005, and as such is in the public domain. It complements the post I wrote earlier this week, and provides further insight into the drivers of crude oil prices. Please leave a comment if you find it useful and would like other similar material published on Peak Oil Medicine in the future.
Mr Dowd: I would like to highlight five main points about our current oil predicament and what we can and can’t do about it:
1. The oil industry is inherently volatile in the sense that it is driven by a host of supply and demand factors which are largely beyond our control, at least in the short-run. That volatility becomes acute when spare production capacity is extremely tight. Under these circumstances, even a small disruption can produce large price spikes.
2. The primary reason that there is such limited spare capacity is because the record investment by the energy industry aimed at expanding oil production has not resulted in the expected supply response. Conventional wisdom holds that more investment will lead to more supply. In the case of global oil production, the validity of conventional wisdom does not appear to be certain. This uncertainty emanates from several sources:
- Global oil production growth rates outside of OPEC and the Former Soviet Union have slowed each decade over the past five, regardless of the level of investment.
- Investment in U.S. hydrocarbon production has doubled over the past decade but production has not grown. The record investment undertaken by the industry over the past five years has not been sufficient to cause global oil reserves outside of OPEC and Russia to expand. Furthermore, exploration success rates in deepwater basins have been substantially below initial expectations.
- Virtually every rig and every petroleum engineer in the world is already working. Materially increasing the level of activity beyond the current level is not feasible over the coming 3-5 years.
3. In the case of the refining industry, conventional wisdom regarding the effectiveness of additional investment does appear to be correct. We can and should build more refining capacity. Nonetheless, the industry today finds itself operating at a very high level of utilization due to the robust economic growth over the past decade, the slowdown in efficiency improvements in the auto fleet, more stringent environmental requirements, and the deteriorating quality of crude available to the industry.
4. This is not only a U.S. predicament. Gasoline prices this year have risen equally in Europe and the Far East. This is a global supply and demand issue. Important trends taking place overseas will likely exacerbate the situation. For instance, China has accounted for ¼ of the global increase in oil demand over the past decade. To date, this increase in demand from China has been entirely offset by accelerated production from the Former Soviet Union (FSU). What is alarming is that while Chinese demand continues to expand, Russian production stopped growing last September.
5. In the short run there are relatively few options for addressing a crisis beyond tapping the Strategic Petroleum Reserve. In the longer term, it is important to recognize that U.S. consumers and policymakers have far more control over long-term demand than they do over long-term supply. The demand side of the equation is where we have the most leverage and where we must focus our effort and resources.
High utilization is the cause of higher prices
With spare production and refinery capacity at the lowest levels they have been in decades—not just in the United States, but globally—it was only a matter of time before some disruption, somewhere, would have the dramatic impact on oil markets and on our economy that we saw as a result of Hurricane Katrina. Gasoline prices rose recently because rapidly growing global demand has outpaced the oil industry’s ability to bring new supplies to the market. This created a situation in which any disruption to existing supplies, even a relatively small one, would inevitably have an exaggerated impact on oil markets and on gasoline prices.
The growing susceptibility to a supply disruption like that caused by Katrina is rooted in a dramatic decline in spare production capacity as global demand for oil has grown more quickly than the ability to bring new supplies to market.
The market responds to the increased risk of future shortages by attaching a premium to the prices they would otherwise charge based on current inventories and current demand. This premium appears to be directly proportional to the amount of spare production capacity held in reserve.
For example: if there were 6 million barrels per day of idle capacity worldwide, no single terrorist act or natural catastrophe would be sufficient to cause a shortage. The risk premium would be low. At present, however, the world has only 1.4 million barrels per day of spare production capacity, or less than 2 percent of current global demand. This is only enough spare capacity to meet a little more than one year of expected demand growth and it leaves world oil markets at the mercy of political conditions in Venezuela, Nigeria, and Iraq, not to mention natural disasters and potential terrorist acts.
Why has supply growth lagged expectations?
In theory, the policy response to this situation is straightforward. If we can increase spare capacity—either by increasing world oil supplies or by reducing world demand—we will reduce the risk premium and crude oil prices will fall. In practice, accomplishing either is anything but straightforward.
On the supply-side, the primary concern stems from the apparent inability of non-OPEC producers to materially increase production in recent years despite increased investment and rising prices. The conventional wisdom within the energy industry for decades has been that the price of oil could not permanently move above $25 per barrel because if it did, this would invite a non-OPEC production response. High prices would attract more oil investment and production would rise.
Unfortunately, recent history suggests that the relationship between investment and output is not quite so simple, at least when it comes to this industry. The primary reason that capacity growth has been slower than expected is that the productivity of new basins has been substantially less than expected. In the United States, for example, capital investment by the oil and natural gas industry has doubled since 1994—yet natural gas production has not grown and oil production has actually fallen. This situation does not appear to be an aberration.
Deepwater reserves
A decade ago, the hope of the industry was that new reserves in the deepwater regions of the world would provide the next wave of global supply additions. The industry invested sizable sums in building new drilling equipment in order to tap the hoped-for reservoirs beyond the continental shelves in the Gulf of Mexico, Brazil, West Africa, and the North Sea. However, after an initial flurry of exploration success, discovery rates have been stable despite a jump in drilling activity.
While the deepwater basins are a source of supply growth, it is important to keep the size of this production growth in context. For instance, roughly 1/3 of the deepwater drilling equipment in the world is operating offshore Brazil, and has been for a decade. Nonetheless, Brazil is still a net importer of crude oil. Viewed more broadly, even with the opening of the deepwater basins to exploration, reserve discoveries outside of OPEC producing countries and the Former Soviet Union have not kept pace with production from those regions. Discovered oil reserves outside of OPEC and the Former Soviet Union peaked in 1997, despite the record investment by the oil industry since that time.
In fact, the same trend has occurred in all non-OPEC countries outside the former Soviet Union. Collectively, these countries have not only been unable to sustain production growth, they have witnessed a decline in production growth in each of the last five decades. During the 1970s, oil production in these countries grew by 3.1 percent annually. Over the past decade, production in these countries grew only 1.1 percent annually, despite considerably higher levels of investment.
Non-OPEC countries outside the former Soviet Union have experienced sub-par reserve discoveries despite an increase in exploratory drilling and the development of more sophisticated locating equipment. In fact, annual reserve discoveries in these countries have failed to substantially increase over the past 20 years. Worse, over the past four years the discovery of new reserves has fallen behind current production, resulting in a decline in total reserves for these countries.
Geologic reality
To some extent, these recent trends are explained by simple geologic reality. As reservoirs are gradually depleted, the remaining oil becomes harder and more expensive to extract. New discoveries must constantly be made just to compensate for the depletion of existing basins, let alone to meet a substantial new increment of global demand growth each year.
The world’s largest and most accessible reservoirs have already been tapped. As a result, we are now pursuing the less accessible and/or smaller reserves which typically cost more and experience more rapid production declines once they are developed. The U.S. experience with natural gas production provides a worrisome analogue in this regard.
We are also pursuing development of crude oil reserves that in prior times, under lower pricing scenarios, were considered to be of unacceptably poor quality. The implications are significant not only for the oil producing industry, but also for the oil refining industry. When lower-quality crude oil enters the refining system, it must be refined more intensively in order to yield the same amount of gasoline. This is one of the factors that has contributed to the high utilization of the refining system. The performance of the U.S. refining industry in particular has been impressive. The industry has been able to increase gasoline production by 10 percent over the past decade, despite a reduction in the absolute number of refineries, more stringent environmental requirements, and a slow but persistent deterioration in the quality of crude oil available to the market.
Lower quality oil
To grossly oversimplify the energy sector, the exploration industry is essentially the business of finding gasoline, while the refining industry is the business of making gasoline. It is not possible to analyse one without the other. One of the major reasons that the refining industry is tight today is because the lack of success of the exploration industry in finding new resources. Because we have not found substantial new deposits of light sweet crude oil, we have been forced to refine the barrels that we have found more intensively. Further deterioration in the quality of crude supplies will likely mitigate the benefits of future refining capacity additions.
Lack of drilling equipment
One major concern is that the lack of necessary equipment and expertise may limit the future supply response. For example, there are today only four competitive offshore drilling rigs that are idle available to go to work tomorrow (by contrast, some 422 offshore rigs are already working). While demand for offshore drilling equipment has recently spiked, supply is expected to rise by only 3 percent annually through 2008 based on already signed construction contracts. One difficulty in quickly expanding offshore production capacity is that building a modern drilling rig requires 3-5 years and costs between $150 million and $500 million, depending on the type of equipment. Another difficulty is that qualified labour in the oil industry is limited, and we are already running into shortages of skilled workers.
International issues
Much attention has recently focused on the impacts of China’s growth on world oil markets. In fact, all of the increase in Chinese oil demand over the last decade has been offset by increased exports from the former Soviet Union. This does not, however, appear likely going forward. The fact that production in Russia stopped growing last September is potentially a game-changing development that will further exacerbate the risks of a major supply crisis. Unforeseen changes on the demand side could equally accentuate these risks. For instance, if global oil consumption were to grow at a pace of 3.1 percent next year rather than current expectations of 2.1 percent, the forecast surplus global production capacity would be cut in half.
Geopolitical risk
Not only is the sensitivity of oil prices to supply disruptions heightened today because of the lack of spare capacity, the frequency of such disruptions is likely to increase because of where new oil producing facilities are being located. Throughout history, oil companies have taken a very rational approach to investment, weighing political risk against geologic risk when deciding where to explore and drill. As the world’s oil basins have matured and geologic risks have increased, the industry has demonstrated an increasing propensity to invest in politically risky areas. Today our attentions are understandably focused on the risks posed by nature, but any number of eminently plausible scenarios involving terrorism or political unrest could have similarly profound effects on world oil markets.
Conclusions/Recommendations
We may soon find out what our immediate options are for responding to a sustained supply crisis and how far those options will take us. At the moment it is still too soon to know whether recent events in the Gulf region constitute such a crisis. If they do I think we will find that our near-term options are limited. The President has called for releasing some oil from the Strategic Reserve and for voluntary conservation efforts, while other countries have indicated that they too will tap emergency reserves. The relaxation of environmental constraints in the refining industry should be a small positive for supply.
Conservation
I would recommend a stronger call for conservation. If, as a country, we were to obey speed limits for the next two months, we would probably conserve more fuel than will be lost by the refinery outages (from Hurricane Katrina). Reducing speeds from 70 mph to 60 mph, for example, improves fuel efficiency by 15 percent. If Americans want to know what they can do to limit gasoline price inflation, the answer is simple: slow down. I don’t think this is generally known, or believed, by the U.S. public, and it should be. That may be all we can do in the weeks and months ahead.
Longer-term of course, we must look for more fundamental ways to shift the current balance of supply and demand as a means of reducing our vulnerability to oil price shocks that we cannot control. Many will instinctively reach for supply-side solutions and for measures to increase U.S. oil output. For the reasons discussed above, however, it’s not clear that further incentives for expanded domestic production will do much good. And even if we succeeded in boosting domestic production for a time, our nation’s oil resources are simply too limited to make a lasting dent in the global market that determines the prices we all pay. Some of the provisions in the Energy Bill of 2005 will also help in the long run, especially those that seek to diversify the nation’s energy resources and promote efficiency, but most address the needs of the electricity industry, and not transportation fuels such as gasoline.
Transport
Our current predicament, simply put, is rooted in the near-total dependence of our transportation sector on petroleum fuels. Our nation possesses only 3 percent of the world’s estimated oil reserves but accounts for as much as 25 percent of global oil demand, the great bulk of it for use in our cars and trucks. When you look at these numbers it’s obvious that controlling our destiny in terms of oil security comes down to controlling the relentlessly growing demand of our transportation sector for gasoline and diesel fuel.
Fortunately, the potential for efficiency improvements in this sector is also substantial if the political obstacles can be overcome. The National Commission on Energy Policy found, for example, that a concerted effort to increase fuel economy standards, and promoting hybrid and advanced diesel vehicles, could substantially reduce future petroleum consumption by the U.S. transportation sector. We estimate that improving the average fuel efficiency of the entire U.S. vehicle fleet by 2 miles per gallon—an objective that can be readily achieved using already available, conventional vehicle technologies—would reduce total U.S.U.S. gasoline demand by roughly 1 million barrels per day. This amount is equivalent to all of the growth in gasoline consumption over the past eight years.
Of course, to matter at a global level, demand reductions must be significant, especially given the growth pressures we face in other parts of the world. And significant demand reductions cannot be realised overnight any more than significant supply enhancements or refinery expansions can be.
But it is reasonable to aim to achieve gradual yet steady progress that can yield substantial dividends over time. Gradually improving vehicle fuel economy through a combination of higher standards, manufacturer and consumer incentives, and other initiatives would essentially “buy us time” to develop the more advanced vehicle technologies and alternative fuels that will someday allow for a more decisive shift away from our current petroleum dependence.
Even in the short run, moreover, the benefits of any efficiency improvements introduced in the U.S. vehicle market would likely be amplified as a result of their diffusion to markets in other countries, most of which have as keen an interest as we do in slowing demand growth and blunting their exposure to future oil shocks.
Conclusion
We are probably all familiar with the well-worn homily about having the serenity to accept what you cannot change, the courage to change what you can, and the wisdom to know the difference. I don’t know that anyone would counsel serenity under current circumstances, but courage and wisdom are certainly called for. We can’t control hurricanes, terrorists, or the investment climate in foreign countries. We can’t stop international oil markets from adding a sizable risk premium to oil prices as long as worldwide spare production capacity remains dangerously low. What we can do is limit our future dependence on oil and our exposure to these risks through thoughtful, long-term policies aimed at promoting a greater supply and diversity of fuel options while at the same time significantly improving the efficiency of our nation’s vehicle fleet.
RSS
. For example, one author talks about a “terrorism premium” built into the