Scarcity: The Driving Force

Scarcity pricing serves to determine who gets it and who does not. Oil is starting to become scarce, which is why, as the world’s need for oil begins to exceed the world’s ability to produce it, the price of oil - instead of simply reflecting the costs of production - reflects a degree of scarcity value. Right now - late 2007 - it is a fairly mild degree of scarcity. But already we have seen nearly a tripling of oil prices over the past three years.

Natural gas is also in the process of becoming scarce but it operates differently from oil. There is a global market for oil. The price for a given grade of oil differs from one place in the world to another only by the fairly minor costs of shipping and handling. The markets for natural gas, however, are regional ones because it is difficult to ship overseas. To ship natural gas between continents generally requires an expensive and environmentally hazardous process of liquefaction at very low temperature. The resultant Liquid Natural Gas, LNG, is transported on special ships. At the destination it is re-gassified. Therefore, the cost of LNG can be high and the capacity to increase LNG in the short term, because it requires special infrastructure, is limited.

The long term price vectors for natural gas production in North America point toward growing scarcity. Gas is a cleaner burning fuel than oil, so is far more desireable from the increasingly important environmental perspective. And gas wells decline at much more rapid rates than oil wells. On the other hand, many analysts believe there is far more natural gas buried underground relative to our use of it than there is oil relative to its use.

For many years, the price of natural gas was in the range of $2 per million cubic feet (”mcf”) but it spiked to $14 after hurricane Katrina, and is now in a range of $6- $8. While a great deal of new U.S. exploration and development in recent years, based on the suddenly higher gas prices, has produced a bulge in U.S. natural gas production, this glut is expected to be temporary. The longer term supply problems include the fact that Canadian gas, which has been a large part of U.S. supplies, is declining rather steeply while the demand for gas in Canada to help produce oil from oil sands is increasing, as is demand in the U.S. for agricultural purposes and for the production of ethanol. Therefore, even if natural gas seems plentiful now and may seem even more so if weather patterns are benign in the near term, eventually North American natural gas will become quite scarce. That may well happen within the next few years.

Gas production is increasing in the Middle East and Central Europe and LNG imports to North American are increasing too. The U.S. has a great deal of spare LNG port capacity compared with current LNG imports but compared with our total natural gas usage our LNG port capacity is fairly limited. Plus we must bid against the Europeans and Asians for LNG, which can make it even more expensive compared with domestic production. So the likelihood is that as time goes on and North American natural gas production peaks and begins to decline in not-too-many years, the price of natural gas in North America is due for substantial increases.

A consequence of higher natural gas prices will be to increase the cost of electricity. To some degree the prices of all energy sourse are linked.

THE ENERGY FUTURE IS ACTUALLY FAIRLY OBVIOUS

Over the next fifty to one hundred years, oil and natural gas will become so scarce that they will be uneconomical for most purposes. In their place we will use some coal, but global warming considerations will limit coal use. So we will ultimately have to rely on renewable energy sources - wind, solar, hydro, and geothermal energy, all of which are used to produce electricity. And all of which, fortunately, are plentiful. Their use is currently limited only by our lack of technical knowledge, but clearly that will come with time. In short, we will trend from a mixed economy dependent on petroleum and electricity to one almost totally dependent on electricity, some of which might be used to manufacture liquid or hydrogen fuels.

During this transition process we will develop technologies allowing for vastly more efficient energy use so we can consume far less energy to accomplish the same tasks. For example, we’ll drive cars that get at least 100 miles per gallon of liquid fuel, probably within the next ten years. We can see the way to do that just by incorporating a hybrid diesel power train that is nearly available now and adding an electric plug. That is a five-times multiple of efficiency that will let us drive just as cheaply as we do today but with a gas price of about $15 per gallon and an oil price of about $250 per barrel.

The stable, green, renewable energy future will center on the all-electric automobile.   It will incorporate a battery technology that will be constantly improved upon until perhaps some day it is optimized.  The battery will be rechargeable at home or at public refueling and exchange stations that will be as ubiquitous as parking meters and gas stations - and perhaps will be incorporated into both.  Initially, it will be a “city car” because the battery exchange/recharge infrastructure can most cheaply be deployed in a city.  Eventually the infrastructure will cover the whole country.  At that point the internal combustion engine will become history.  

One company is now developing such a system.  Two countries have agreed to roll it out, Israel and Denmark.  Both are ideal because they are compact, wealthy, and have ample reliable renewable energy sources - sun in Israel and wind in Denmark.  The system will expand to discrete cities within developed countries and eventually throughout all developed countries.  

It is not clear how poor countries will handle the transition, since it is very capital intensive.  India and China, for example, are much more likely to expand their automotive systems with very fuel efficient small cars rather than this electric system.  Perhaps that can work for another 25 years or so, but eventually all countries will be forced to migrate to an electric system.  Perhaps by that time the cost of the battery technology will have been reduced sufficiently.  

Increases in electrical efficiency will also be astounding. For example lightbulbs will migrate from today’s incandescents to light-emitting-diodes (LED’s), now used for specialty applications, with an energy savings of possibly up to 95%. The purchasing costs of the bulbs will be higher at first but those prices will come down and, combined with the payback based on longer lives and lower operating costs, will cause LED’s to become the standard choice within ten years.

Electricity will be generated locally in many parts of the world through solar photovoltaic (”PV”) transformation. PV will be especially useful in very poor and very remote parts of the world that currently struggle to access electricity. Locally generated electricity will free some of our centralized electric generating capacity to help power newly electrified trains and other mass transit vehicles. And those electric generating plants will be powered increasingly by wind and by a technology called “concentrating solar,” which uses mirrors to focus the sun’s rays on a liquid-to-steam assembly, so that the electricity itself is actually produced by an old fashioned steam generator. Back to the future. Such plants exist now, more are being built now, and they are getting more economical every year.

I am also a believer in the efficacy and safety of nuclear power plants. Nuclear will gain market share, particularly beyond the borders of the U.S. Many OPEC members are now pushing for local nuclear energy despite having enormous stockpiles of oil and gas. Perhaps they can see more clearly than other countries how rapidly our fossil fuel legacy is being depleted.

It is not clear at this time exactly how air and sea transportation will be powered after the age of petroleum has passed. Airplanes may use a bio-fuel produced from plant or animal inputs with a conversion process powered by electricity. For shipping, there may be some combination of these sorts of fuels with wind (maybe it will be called a “sailboat”) and/or possibly small nuclear powerplants. The U.S. Navy loves its nuclear powered submarines and aircraft carriers, which have wonderful records of safety and effectiveness. The Navy will probably forge new mini-nuclear technologies that will find their way into commercial shipping.

It is also not clear what will happen to agriculture when oil and natural gas become much more expensive and scarce. Today commercial agriculture is extremely dependent on oil for powering farm equipment and natural gas for fertilizer.

The wind and solar powered future that will eventuate in 25 - 75 years will be much “greener” than was the fossil fuel era because it will include very little burning of fossil fuels. If, by that fine day, the earth has not already heated up beyond repair, I suspect humans will eventually experience once again the climate of pre-industrial society. In the meantime, I suspect that the limited availability of oil, natural gas and even coal, which will cause such industrial angst, will be seen as a happy condition for mitigating the trends of global warming.

It’s the Rapid Transition, Stupid

If I sound like Pangloss, it is only because I have not yet discussed the hard part, the transition from the fairly stable fossil fuel based energy world we have today to the better and also stable renewable fuels future. The transition is the rub.

Actually, to be more precise, it is the Rapid Transition that is the problem. We are already in the early stages of transition. We are generating new synthetic fuels, new technologies for solar and wind power, new ways to conserve. But this is slow work now because the perceived need is small. After all, we are still buying more gasoline each year, and gasoline is still cheap in the US compared with Europe or even compared with a cup of coffee. A cup of gasoline costs only about 20 cents compared with several dollars for certain cups of coffee. So we are not motivated to change rapidly. But at some point, after we see that Peak Oil is here, the price of energy will go into a “hockey stick” phase of escalation, and that escalation will engender the period of Rapid Transition, which will probably not be fun.

A few years ago a group of military planning experts modeled the transition from the coming of Peak Oil to the stable future. They wrote up the results in a document called The Hirsh Report. The Hirsch Report concluded that the transition will take about 20 years if it begins before oil production actually peaks. The closer to the peak we are before we get serious about transitioning, the longer the transition will take and the more difficult it will be. That’s because the transition itself will require a lot of energy to produce the replacement equipent, infrastructure, and technologies we will require. So the more energy we need to make the transition, the more expensive it will be and the more it will strain the availability of energy for consumer use.

Only substantial conservation actions begun now can mitigate the pain of the Rapid Transition. We cannot drill our way out or produce sufficient alternatives to solve the problem. Rather, we must consume less, just as we are starting to do with more fuel efficient cars in the U.S. But we must speed the transition to fuel efficient cars and go beyond that toward much more electric powered mass transit.

Unfortunately, at this time, even with $3 gasoline, the necessary price signals to make conservation happen rapidly are absent. The implied policy now is to wait for the market to tell us when we have a very serious problem. But when such a price signal does occur, when oil, say, suddenly jumps to $250 a barrel it will be far too late for us to make the adjustments without huge economic pain and many more years of effort than would be needed if we started the transition sooner. Therefore, what we need now are actions like a substantial and permanent tax on gasoline and more tax incentives for people to buy high fuel efficiency cars instead of large gas guzzlers.

Peak Oil

There is starting to be nearly as much written about Peak Oil as about Shakespeare or the Bible. Not quite, but almost. If you are just starting to read about it, a search of Wikipedia might be worthwhile. My study of the subject has focused on what I think an investor needs to know, and this is summarized below. If you are new to this concept, I recommend you plow through it. If you are an expert, you might still consider my critique of some current thinking about the proximity of the peak.

Oil (and all fossil fuels) occur in finite amounts on planet earth. Therefore, assuming demand continues to expand rather than diminish, some point in time will occur when the rate at which they can be extracted will peak and thereafter can only decline. That is the point to which “Peak Oil” refers.

In contrast, “renewable energy” refers to solar, wind, hydro, and geothermal sources for generating electricity, all of which are dependent on the recurring energy we get from the sun or from heat stored underground. Their supply, in theory, is virtually infinite and their production can be expanded almost infinitely so long as the planet remains roughly as it is today climatically. In addition, there are what I call “hybrid renewables”, which refers to products like ethanol, and hydrogen. These depend in some ways on a renewable input such as corn or cellulose, but also require a substantial input of processing that, at least at present, consumes a good deal of fossil fuels.

At the present time we extract about 85 million barrels per day (mb/d) of oil, including oil from oil sands and from natural gas liquids (a rapidly growing category that refers to liquids that are recovered as a byproduct of extracting natural gas). What the study of Peak Oil attempts to do is to project how far (if at all) that amount of production can grow. Analysts then compare such projected future production with their estimate of future needs to see when we might run into real problems.

But Peak Oil is a geological concept - referring only to the physical limitations of oil production. In the real world, both demand and supply are subject to substantial impacts from technological and/or political developments. Most Peak Oil commentators omit such considerations, but that could be dangerous from an investment perspective. If peace were suddenly to break out in Iraq, it could increase oil production by possibly over 3 million b/d over a number of years. The same could be said about Nigeria. Venezuela also has a substantial capacity to increase oil production, but there the problem is obviously political incompetence rather than chaos.

Technology can impact both supply and demand for oil. The speed at which a given oil deposit can be extracted and what sorts of mineral deposits can be used as a source of oil are effected by technology. For example, the oil sands in Canada and Venezuela are now considered a major source of oil in the world, but only ten years ago, before the technology for turning the oil sands into oil were perfected, and before the price of oil was high enough to make the higher cost oil sands production profitable, the oil sands were not considered to be a reliable source of oil.

New ways to pressurize oil fields from underneath have been developed using gas and water injection to bring the oil up to the surface faster (and empty the reservoir more completely). This increases the speed at which oil is recovered and the amount that can be ultimately recovered. New drilling technologies, particularly using a set of horizontal pipes in addition to vertical ones have also enhanced the amount and speed of recovery. These new techniques for oil extraction are known as Enhanced Oil Recovery (”EOR”) and are often cited as a reason why peak oil will not soon occur.

Technological developments are also key to the demand for oil. What if we all drove cars that got 100 miles to the gallon? What if a new cellulosic ethanol technique costing pennies and not using food inputs were developed and were much cleaner and cheaper than gasoline? In either case, demand for oil could drop significantly. In fact, compared with the 1950’s we have already benefited enormously from technology in terms of energy efficiency. That trend will certainly continue. The question is whether the benefits flowing from future technological developments will be incremental, as in the past, or game-changing. If the latter, it could be a very long time before we find out when Peak Oil will be reached.

The part of the Peak Oil debate that has not been mentioned so far is probably the most interesting because it is not well understood by the public and it is the most predictable part. It is the concept of decline. M. King Hubbert, a geologist for Shell Oil, developed the theory of Peak Oil in the ‘50’s based on mathematical projections of decline, which is the fact that the production rate of any given oil field tends to increase for a while, then reach it’s maximum output (the “Peak”) and then decline. He predicted that the U.S. would peak in 1970 and guess what? He was right on the money.

Predictions of the growth and decline rates for an individual oil field were fairly straightforward if you are a mathematician and you operated in Hubbert’s era. But the oil world has changed since Hubbert was around because of new understandings and new technologies. EOR’s, as mentioned above will enable a field to produce more oil at a higher rate and for a longer time than was the case in Hubbert’s day. But the flip side of using EOR to increase production is that decline rates operate on steroids when they come AFTER the positive impacts of EOR have run their course. If you jack up production from a field by pressurizing it and using horizontal drilling techniques, then when it finally does start to decline, the rate of decline will be far faster than otherwise would have been the case. If in Hubbert’s time, a normal oil field might start to decline at 4%-6% per year, a field in modern times, after the application of EOR, might decline at 15%.

In fact, that is exactly what is happening to the Cantarell field in Mexico, one of the five largest fields in the world. Cantarell supplies 60% of Mexico’s oil. In the ‘90’s it’s production was jacked up through gas pressurization from a little over 1 mb/d to about 2.4 mb/d in 2004. But in 2005 it began to decline. Production was down by 15% in 2006 and is estimated to be down 20% in 2007. Mexico could be facing a financial disaster within just a few years.

Some people believe that the Ghawar field in Saudi Arabia (”KSA”) has peaked now. This field has produced 5 mb/d of oil for many decades. It is the largest field in the world and accounts for about half of KSA production capacity, although in recent months KSA production has declined “voluntarily” to about 8.7mb/d. Some analysts believe that KSA’s reduced production is not totally voluntary, but rather is a function of the declining production of Ghawar. We may find out fairly soon because analysts predict that oil demand during the winter of 2007 - 2008 will reach 88 mb/d, which is 3 mb/d more than the world has ever produced previously.

Most of the world’s oil fields are in decline. As mentioned, the U.S. began to decline in 1970. It now imports about 14 mb/d of the 21 mb/d that it uses. China, which exported oil until a few years ago now imports about 4 mb/d and is estimated to need 20 mb/d of imports by 2020. In addition, 62 other countries in the world are in decline, meaning they produce less oil now than in their peak year of production. More importantly, all of the five largest oil fields in the world are in decline with the possible exception of Ghawar in KSA, which is not ascertainable with current data.

What about new discoveries of oil? We read about large fields being discovered in the Gulf of Mexico, Brazil, and China recently. Yes, there are new discoveries announced all the time. In addition there are still large parts of the world that are not well explored. Experts believe that much oil lies under the Arctic ice mass. But the salient fact in regard to discoveries is that oil discoveries peaked in the early 1960’s and have declined steadily. It is therefore highly unlikely that new discoveries could be large enough to offset the decline rate for existing fields during coming years.

A second important point about new discoveries is that the vast majority are coming offshore. Underwater oil fields tend to decline sooner and faster than land based fields. That is because the drilling equipment required to work far offshore is so much more expensive and the conditions are so inhospitable and therefore expensive that drilling companies cannot afford to keep the equipment and men in place to do the painstaking EOR work need to keep fields from declining earlier. Since so much of the new oil we are bringing up now is deepwater offshore oil, the rapid decline rates for deep offshore oil tends to reduce the amount of new oil available to offset declines from other existing fields.

The point of this discussion of decline rates is that they indicate a high likelihood that the global production of oil will soon peak. Experts believe that the production of “light, sweet crude” oil, the most valuable oil and the oil that’s price is quoted in the news, has already peaked. But there are other, less valuable grades of oil that are still in a growth mode. Both Saudi Arabia and Canada are increasing production of heavy, sour crude.

When do I believe that oil production, in the sense of all products that can be refined into liquid fuels for transportation, will peak? Well there now seems to be 1 or 2 mb/d of spare oil capacity. The annual growth of demand going forward is projected at 1.5 mb/d. So you might think we will peak in about a year. But new oil production could still outpace decline rates. There are many new oil fields coming on stream between now and 2009 based on a great deal of drilling and exploration work that has been done since oil prices began rising in 2004. Also some major fields in the Caspian Sea are growing their production. Also, the production of ethanol and bio-fuels is rising around the world and an increasing amount of liquid fuel is being produced from Natural Gas Liquids, a by-product of the production of natural gas. Also improved technologies are succeeding in producing more oil for longer periods from many more old fields than has been expected. And finally, the higher price of oil is causing more oil to be developed in smaller fields that are ancillary to existing fields. On the other hand, decline rates are growing. It is estimated that the world is now losing about 3.3 mb/d each year from the decline of existing fields. So to keep producing more, we need to grow production by more than that.

Based on the work of Chris Skrebowski, who tracks all major oil projects in the world, it seems that production will be able to grow, net of declines, through 2009 or 2010, after which the backlog of new oil fields coming on stream becomes much smaller. On the other hand, oil hoarding is becoming more of a factor, plus new projects tend to slip and of late they seem to be slipping more. Therefore, I expect Peak Oil to be sometime in the 2008 - 2010 time frame, absent significant oil production growth in Iraq, Nigeria, and, to a less degree, Venezuela. If by some miracle, peace breaks out in Iraq and/or Nigeria in the next few years, the global peak oil production could be deferred perhaps two or three more years. After that, I would expect the increasing amount of decline to overpower even new oil in Iraq and Nigeria.

Whether in 2007 through 2009 the world can grow it’s oil production enough to both overcome the decline of 3.3 mb/d and supply1.5 mb/d of new demand is a different question. In other words, we may face a significant scarcity well before we reach Peak Oil. I suspect we are already in such a period now. All said and done, it seems that one cannot look forward too many years - possibly fewer than two years and probably fewer than five years - without seeing a need for much more oil than the world could possibly produce even if there were no political or military issues that artificially restrict production.

That forecast assumes the continuing growth of the global economy. Some think that such growth is likely to be at least as fast in the future as it has in recent years and maybe even faster. For example, if the Chinese were to use as much oil per capita as the Mexicans do today, their demand for oil would be 5 mb/d greater than it is today. That fact, I think, provides an important perspective. To me, taking all forces into account, it is very hard to believe that the price of oil over the next five years is likely to do anything but rise significantly, absent a global depression.

Oil and Politics

One quickly learns that just as politics is key to energy production, so is energy key to politics. We wonder whether oil is one of the driving motives underlying American foreign policy (or French or Russian policy for that matter). And we also see a potential impact of oil pricing on military policy and military capabilities. For example, the U.S. Air Force uses 1% of all the oil used by the U.S. The military has been studying (meaning worrying about) energy for the past several years and it is now managing an emergency program for alternative fuel development for military usage.

How will America or other countries project force throughout the world when the price of oil rises dramatically ? With scarcity of petroleum fuels, it certainly will not be as easy to project military power to distant lands. Will energy costs eat a hole in military budgets so large that the only possible solution is geographical pull-back? How will that effect Europe? China? The United States? Will it put Russia, as an energy exporter, at an increasing advantage? Does it increase the fears of Middle Eastern countries like Saudi Arabia of being attacked and invaded for their oil?

This website is not about politics per se. On the other hand, the realities of war and peace on earth have had much to do with the price of oil and even natural gas. So it is important for an energy investor to avoid political naivete. Some parts of my outlook on near term energy prices have key political inputs, of necessity, particularly as it relates to hoarding oil, or “resource nationalism”, as hoarding is now known in diplomatic discussions.

Finally, I must note that as oil becomes more scarce, the poor will be the main victims - both poor people in general and poor countries in particular. Some African countries today are doing without fuel because at $90 oil is no longer affordable. No doubt some poor people in America - and all over the world - are even now facing hardships for the same reason. These are people whose very poverty prevents them from taking the defensive measures (buying a more fuel efficient car, for example) that the more affluent will increasingly use to offset higher energy prices. During the Rapid Transition, the most affected victims will be poor people and poor countries. That presents the world with another set of political problems. Viewing politics through the perspective of energy is far from an academic exercise, especially for the poor.

Energy Investment Implications

Today (December, 2007), we are in a period of manageable energy stability and gradually increasing energy prices. This environment should continue to allow for global economic growth with only slightly greater inflation due to higher energy and food prices. So, all other things equal, stocks should continue to offer worthwhile returns until we reach an inflection point in energy prices which will signal the start of the Rapid Transition period.

Prior to that time, we may see huge bull runs for “energy stocks”, followed perhaps by dramatic retrenchments. Such cycles certainly occurred during all the prior Tsunamis that I witnessed in mobile homes, cable television and cellular telephony. It is likely to be even more pronounced for energy, since energy is a much larger Tsunami. In this environment, portfolio managers should be conservative in their use of leverage and remember that an energy portfolio is inherently more volatile in the short term than the market as a whole because energy prices are set by commodity traders, and therefore can fluctuate substantially and quickly.

The good news is that within an energy portfolio one can choose among companies in a wide variety of industries. In addition to those mentioned earlier (energy and alternative energy producers and suppliers to such companies plus companies benefiting from energy conservation), one can look at agriculture, which is now connected to energy both as a heavy energy user and as a supplier of ethanol, and companies in fields like shipping that are part of the infrastructure of globalization. The trend toward globalization is integral to the energy tsunami because it is the growth of China, India and similar countries, caused by globalization, that is behind the growth in the demand for energy. This growing demand is hastening the arrival of Peak Oil and is causing the initial mild scarcities in energy that we are now seeing.

Making predictions is hard, especially about the future, as Yogi once said. Nonetheless, I have an idea that as oil prices sea-saw upwards to new heights and as the public gradually begins to understand and believe the Peak Oil story, investors will devote increasing percentages of their equity portfolios to energy stocks. Energy stocks will continue to outperform the market, just as they have during the past three years. Over time, they will become like the “Nifty Fifty” stocks of the 1970’s. If that happens, it will be only a matter of time before energy stocks will have a severe correction, along with all stocks. That will probably occur during the early stages of the Rapid Transition period. Economic dislocations may be extreme and it may be a very difficult time for financial markets. The stock market may not be the best place to be invested. Cash may be better, or for the more sophisticated, possibly direct investments in commodities or futures.

There may be as much as five to ten years of financial turmoil during the early years of the Rapid Transition. But eventually, the economic sun will shine again as the world adds new energy sources, adjusts its behavior to restricted availability of oil, and discovers new technologies for energy efficiency. It will then be safe to go back in the water, but energy may not continue as a Tsunami. It may then be time to concentrate one’s equity investments somewhere else.