Petrol Depletion and Economics: Part II

Here's part II of my earlier post:

Extraction from an individual field follows a common pattern. Production rises over time until a plateau is reached. Production remains at the plateau for some period of time. Eventually, production begins to decline and will continue to do so until the field is abandoned. The shape of the production curve is both a function of market and physical forces.

A strong market will favor rapid exploitation; a quicker ramp-up, a higher and more extended peak production accompanied by a faster decline. Although market forces determine what is worthwhile to extract, they don’t appreciably change the overall size of the deposit - the area underneath the production curve. Faster exploitation improves the return on capital, but it results in a steeper decline.

The underlying physical forces are straightforward. As oil is extracted from a deposit, the pressure of the reservoir decreases. The pressure drop makes it more difficult to extract at the same rate. There are ways to maintain pressure (e.g. injecting carbon dioxide or seawater), but they add expense. In some cases, the ‘water cut’ of the liquid pumped out of the ground increases over time. Again, the water can be separated out at a cost. To summarize - the incremental costs of extraction rise as the deposit depletes. This is part, but not all, of the reason why the rate of extraction decreases as a deposit depletes.

In order to draw conclusions about the overall resource, the behavior of individual fields needs to be aggregated. This is complicated by many factors. The depletion characteristics vary a great deal across deposits (geology) and countries (public/private ownership, OPEC membership, tax incentives, technology, etc…). A further complication is that standards of reporting also vary from country to country. Generally, the depletion community aggregates production by country. First, it minimizes the risks of counting ‘apples and oranges’ together. Second, it highlights an alarming fact:

Outside of OPEC and the FSU, nearly all countries have peaked and are in decline.

Earlier, it was noted that giant fields held a substantial amount of the overall oil ‘wealth’. They also make up a significant percentage of overall production as well. These fields are old and it will take a lot of smaller fields to replace their production once they begin to decline.

These factors point to increasing market power for the FSU and OPEC. They also imply that in the relatively near future, someone is going to have to invest a great deal of money to replace the supply lost as the giant fields decline.

The depletion community looks at the non-FSU non-OPEC depletion, makes a guess as to what the FSU and OPEC are going to do in order to generate an estimate of when the world supply of oil will peak. The conclusion is that oil production will peak within the next decade. As an aside, other methods have used a ‘shifted discovery’ method. This was based on the observation that the U.S. peaked in the early 70’s, about forty years after the peak of discovery. Since world production peaked around the early 1960’s, this puts the peak sometime in the next few years. Although supported by some observations, the shifted discovery method makes even more assumptions than the first method and should be discounted.

The discussion above effectively ignores the role of technology. Although improved technology can dampen the effects of depletion, it doesn’t negate the overall effect. It should be noted that the drop in world discovery and the peaking of many countries production occurred despite substantial improvements in technology.

There is a critical condition that underlies the observations and analysis outlined above. On their own, deposits or countries, the U.S. included, are price takers. Their production decisions were made in an environment where they couldn’t substantially affect the price. As depletion continues prices should increase (if for no other reason than to reflect the increased average costs of production). A country whose production is declining under current market conditions may be able to, temporarily, reverse this decline if prices were high enough. Of course, this would be followed by an even more rapid decline.

This isn’t a fatal flaw. The general conclusions remain valid, but predictions that show a smooth, slow variation in the oil supply are suspect. The market described above would be prone to wild gyrations. Most predictions get around this by assuming that OPEC will adopt a ‘swing’ role. Thus keeping supply, and by extension price, relatively stable.

My personal opinion is that the underlying instability will be too much for OPEC to manage. Queuing theory provides some insight. Queues are generally well behaved, until demand approaches the constraints of the queue. When that happens, the variation in queue depth can increase dramatically. Even ‘optimal’ algorithms are subject to this. If OPEC’s decision-making suddenly to become optimal, they still would not be able to remove the instability. Noisy, unpredictable variations (e.g. weather) would be magnified by the market, injecting instability.

Furthermore, there is no reason to believe that the boom-bust cycle would disappear. But it takes time to bring a new field online so a bust sets up the market for a boom a few years down the line.

The unstable situation described above is arguably worse than the one usually put forward by the depletion community. There are the considerable costs of the instability itself. More importantly, the instability will hide the market signal that would be desperately needed to correct the long-term imbalances.

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That’s it for supply. Let me know what you think. As I said before, I don’t want to turn you into an editor, but I’m amenable to any improvements you suggest. Depending upon interest, I can go through this discussion in more detail and/or continue the discussion by examining demand, investment and international trade. I have tagged on a discussion of natural gas in North America below. I think it ties in with this discussion well.

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The same geological processes give rise to oil and natural gas. There are a few key differences, most of which come down to that one is a liquid and the other is a gas.

Since it is a gas, natural gas is more difficult to transport overseas. It has to be liquefied or compressed for transport. The infrastructure to do this is fairly expensive. Because of this, overseas transport makes up a small percentage of the overall market. (There are about four LNG terminals in the U.S.) This means that the world market is effectively broken into independent markets, North America being one of them.

There are many similarities to oil. There is a general consensus on the overall endowment in NA. Some members of the depletion community believe that natural gas supply is NA at, or close to, its peak. Again, the distribution of field size varies dramatically. In some areas, a small fraction of fields make up almost half of production. Also, there have been relatively few discoveries of very large deposits in recent years.

Earlier, it was mentioned that physical forces caused the incremental cost of oil extraction to rise as the deposit depleted. This provides a signal to the producer that the field is in decline. Since it’s a gas and not a liquid, the incremental costs of extracting natural gas remain relatively constant until the field is exhausted. Compared to oil, it is like switching off a light.

The problem comes when one considers that a relatively small number of large fields contribute a large fraction of production. Most of these large fields are old. Unlike oil, there isn’t much advance notice before a field depletes. When these large fields deplete, many small fields to replace them. It isn’t difficult to see how this could result in substantial ‘jitter’ in the supply of natural gas. In turn, this jitter is another source of instability in the market. The NA natural gas market shares the same depletion issues as oil, with two exceptions. It is even more prone to instability and it is closer to entering the ‘exogenous components dominate supply’ phase.

I believe that the effects of depletion are starting to show up in the market now. The natural gas spot market has shown a lot of variation (with one very notable spike) over the last couple of years. Alan Greenspan has weighed in on the subject a few times in his testimony to Congress this year.

Although it didn’t get a lot of press, there were two principal reasons why natural gas prices calmed down over the summer. The weather was very mild, reducing demand for electrical generation. Even so, prices remained high and there was a significant amount of demand-destruction. Many industrial customers simply shut down. Some are even moving operations out of NA permanently.

Here in NA, natural gas is already demonstrating some of the effects of depletion; price increases and spikes and increased price variability. It also demonstrates that reducing demand is a way to mitigate the price swings. Unfortunately, nearly all new electricity generation capacity over the past five or so years uses natural gas (a topic for another day). Like oil demand, electricity demand is relatively inelastic. Even though prices seemed to have calmed down since the spring, it is only a matter of time. Mild weather could help hide this for a year or two. On the other hand, another cold winter, or hot summer, could put the market right back to where it was this spring. This time, there isn’t as much industrial demand to destroy to bring the market back into balance.

Finally, if my predictions over natural gas don’t pan out over the next couple of years don’t be shy about reminding me. If I want to crow when I’m right, I have to eat crow when I’m wrong.