Peak oil: are we there yet?

With oil prices spiraling ever higher, the question is whether supply has hit a brick wall; Has ‘peak oil‘ arrived? The short answer is yes. However, the longer answer is yes, but there are ways around this problem.

Speculation is only part of the oil price story today. Peak oil is a major reason that oil prices have spiraled out of control. Having reached a temporary plateau in oil supply, we should expect prices to spiral higher until demand destruction is enough to trigger a global recession and a crash in the price of oil — whereupon we’ll start the whole cycle again.

In the meantime, the high price of oil will spur a renewed interest in energy conservation and alternative fuels.

The theory
Peak oil is not just a theory, it’s a movement. Look online and do a search for ‘peak oil.’ You’ll find thousands of ‘peak oil’ evangelists adding their voice to the din of cacophony surrounding this subject. Peak oil takes on tremendous importance today due to the high cost of oil worldwide.

In essence, the concept of peak oil was started by a geologist named M. King Hubbert, an American geologist who spent most of his career working for Shell Oil. Ken Deffeyes, one of the foremost experts on the theory and a former Professor at Princeton University, describes the origins of the theory like this:

“In 1956, the geologist M. King Hubbert, predicted that U.S. oil production would peak in the early 1970s. Almost everyone, inside and outside the oil industry, rejected Hubbert’s analysis. The controversy raged until 1970, when the U.S. production of crude oil started to fall. Hubbert was right.”
-Page 1, Hubbert’s Peak, Kenneth S. Deffeyes

The original claims of peak oil in the 1950s and 1960s were met with the same derision with which peak oil supporters today are met. Later, Hubbert was proven right a few years after 1970, when it became apparent that oil production in the lower-48 states had peaked in 1970.

The essence of his theory rests on the bell-shaped curve of both discovery and production of oil. King found that oil discovery resembled a bell curve, otherwise known as the normal distribution, when one plotted the quantity discovered across time. Interestingly, he found the same was true for production with a predictable lag between discovery and production. Therefore, if he had enough data, he could pinpoint very accurately when oil discovery peaked and solve to find when oil production peaked as a result. This is now known as Hubbert’s peak.

Peak oil applied
After Hubbert was proven right his theory was expanded to assess peak oil production for other individual countries and for the world as a whole. Most theorists, including Deffeyes put peak oil somewhere within this decade.

“Around 1995, several analysts began applying Hubbert’s method to world oil production, and most of them estimate that the peak year for world oil will bebetween 2004 and 2008.”
-Page 1, Hubbert’s Peak, Kenneth S. Deffeyes

The point of the peak is not to suggest we will literally be out of gas, but rather to identify the point at which potential oil production output cannot be increased further. When production has reached a ceiling, rising demand will outstrip supply. This is important because when demand outstrips supply, prices go through the roof. See, demand for oil is very inelastic, meaning we need it so much that we are willing to pay much higher prices for it before we cut back on our usage.

It’s like trying to move from the first demand curve, D1, to the new demand curve, D2, as demand increases. That would move us from point P1Q1 to P2Q2 on the graphic to the right. But we can’t do that; since supply CANNOT be increased, we move to a new point, Q1P3 on the demand curve D2, taking the dotted line Q1 and extending it upwards.

Because demand for oil is very inelastic, P3 is much, much higher than P1. That’s where we are right now in 2008.

That’s a pretty grim picture for the future. But, we have to caveat this thing. First and foremost, in today’s world, central banks are printing money like it’s going out of style. This is inflationary. With more than a few asset prices falling after the housing bubble was revealed, there are few places for this excess liquidity to go. Would you rather invest in wheat, oil and gold or residential property? So, the money is going into commodities, driving prices there even higher than they otherwise might be.

Then there is the ‘type’ of oil available. Even if one thinks that peak oil will actually come later, one can agree we have met a peak ‘light, sweet’ oil plateau. Most oil refineries have been configured to process light, sweet crude. This is crude oil that is low in sulfur and metal contaminants. However, all of the available excess capacity that does exist is heavy, sour oil. This is true in the Middle East as much as anywhere else. Therefore, as demand has increased, a large price differential between these types of oil has opened up. The hope is that the Saudis can bring additional capacity of heavy sour crude online to alleviate the problem. Nevertheless, this will only be a partial solution as most refineries can’t handle this type of crude.

The likely outcome
In all likelihood, we have temporarily arrived at a point of world peak oil. This means that prices will spiral higher until demand comes to heel. Demand destruction is a negative for economic growth, meaning the world does face a global recession in the face of limited oil capacity. However, this peak may only be temporary. As prices go higher, the ability to use new fossil fuel sources in deep water or via shale oil, oil sands or clean coal becomes economic.

I reckon we will not be able to exploit these additional resources before demand destruction occurs. Therefore, a global recession is definitely in the cards. Once, demand is destroyed, we can start the cycle all over again until we hit a new plateau at an even higher oil price where demand will be destroyed again, setting off the cycle again.

The Armageddon scenario
The problem here, of course, is that the world is very dependent on oil. And, there is no guarantee that the excess capacity actually exists.

There has been a lot of speculation of late regarding oil field production capacities declining. In particular, there are great worries regarding Russian and Saudi production capacities. The available data on Saudi production is especially opaque. Matthew Simmons, an expert oil investment banker, has written a book questioning the data the Saudis have provided regarding the proven reserves available for production and the production capacity of the Saudis major fields including Super Giant Ghawar, the largest oil field in the world. I recommend anyone interested in this debate read his book, “Twilight in the Desert.”

This leads us to the Armageddon Scenario. Nuclear-armed nations like China, Russia, India and the United States are desperate to keep their standard of living up. As a result, with oil supplies dwindling, competition for oil supplies will increase. The risk of armed conflict to procure necessary supply increases as peak oil becomes apparent. The U.S. has invaded Iraq, has troops stationed in Saudi Arabia and is threatening Iran, all because of oil — and in Iran’s case, the possibility of another nuclear-armed nation entering the strategic quest for oil. This is a battle of extreme importance strategically for a number of countries. They may stop at nothing to achieve their ends should peak oil become a problem.

The obvious solution is for nations to recognize that we are at a critical juncture in world history and that the time is now to break dependency on fossil fuels. Conservation is certainly part of the solution. But, alternatives in geothermal, wind, solar, tidal, and nuclear do exist as well. I am optimistic that we will find a technological solution to our problems and that we can continue to grow. But, the time to act is now.

See: This week’s Special Report on Energy in The Economist.

Suggested reading
Hubbert’s Peak, Kenneth S. Deffeyes
The Party’s Over, Richard Heinberg
Out of Gas, David Goodstein
Twilight in the Desert, Matthew R. Simmons
The Prize, Daniel Yergin
Titan: The Life of John D. Rockefeller, Sr., Ron Chernow
Oil & Honor: The Texaco-Pennzoil Wars, Thomas Petzinger, Jr.
Beyond Oil: The View from Hubbert’s Peak , Kenneth S. Deffeyes

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