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ANWR, Peak oil theory, and oil economics - were are we going?

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May 16, 2008 – Comments (22)

I just listened to the 100th brain-stem politician screaming about opening up ANWR for oil  development.  As an economist, and an energy user,  this is really starting to annoy me. These same fear mongers also claim that the US economy will crash due to the high cost of hydrocarbons. Actually I believe the opposite is true. The US oil fueled economy is old and tired IMHO. A new vibrant US economy is coming if we start real investing in all the oil alternative technologies.

 While the US should continue to drill in all our current developed areas (US land, GOM up to 2 miles of coastline, etc.), their is no economic reason to drill in ANWR:

  "An Energy Information Administration analysis in 2004 concluded that "By 2025 ANWR is projected to reach .9M barrels a day". This report further states that it would take about 12 years for the US to receive any hydrocarbon from ANWR. So if ANWR were approved today, the US would get its first barrels of oil in 2020. Of course between now and 2020, there would be a huge increase in infrastructure, and construction activity to develop ANWR. This activity needs energy, specifically diesel fuel for all this construction. So the US would have a further rise in oil demand while this project is being built-out, increasing fuel cost for all Americans.

So with this above time-frame in mind, it appears the politicians feel we will still be highly dependent on oil in 2020-2040? We could just build cars that don't use oil, would not this be more logical? My view is just let economics work. Gas at the pump of 5-10 dollars a gallon would make the manufacturing of the combustion engine vehicle a big ole dodo bird - kinda like these politicians.

Even better, the US does not need any technological breakthrough to make the current vehicle engine extinct. Coal liquification into diesel fuel has been done on a large scale since WW2. Can the CTL technology be clean? Well yes it could, but not at 3 bucks a gallon. The diesel engine is 35% more efficient than a combustion engine, so if we use coal vs oil, this one component change would make the US independent from middle eastern oil.

We also have natural gas powered cars, fuel cell, and electric cars. These technologies are here today, and will continue to improve every year if we allow natural economics to continue.

 

Peak oil theory

This is a very misunderstood concept. Peak oil has very little to do with actual oil reserves. Lets assume the world has 100 years of oil reserves, hell for argument sake lets just bump that figure up to 2000 years supply of oil reserves. So with 2000 years of oil left, how can the peak oil theory stand up? Actually very well. One needs to understand economics, and infrastructure.

Peak oil has nothing to do with reserves, but instead the rate of extraction, distribution, and refinement. Wiki gives a concise view:"Peak oil is the point in time when the maximum rate of global petroleum production is reached, after which the rate of production enters its terminal decline."

Currently world oil extraction and distribution is about 85 million barrels a day. Is this the peak? Hard to say, but we can say based on economics, the world is either at the peak or within 10-15 % of a possible peak.

Of course we need assumptions, An economist can't get through the day without a few assumptions! Here are my world oil economic assumptions.

1)  World-wide demand for energy, and transportation energy will continue to increase between 1-3% per annum.

2) Supply and distribution of oil will be between 85-88 milion barrels a day.

3) World-wide pollution taxes, or Cap and trade programs to increase dramatically over the next 10 years, the effect of which is a 10-20% tax on polluting sources of energy(oil, & coal).

So if the world is currently capped at about 85M barrels a day of extraction and distribution, but demand for oil rises 3% per annum - what happens?. Since the demand curve for oil is very inelastic, this means the price of oil can rise very sharply in the short term. This is what we have seen during the past 3-4 years.

For me, as a long term investor, I am very interested in the next question: What about the pricing dynamics for oil in the long term. This is also the most important question for any decision on ANWR, since consumers will not see any significant oil from ANWR until 2025.

 

Long term oil economics:

This is more complex than it appears. As stated above the short term economics indicates much higher oil related energy prices given the above assumptions. Governments and investors all over the world are very interested in this topic. We all see that it is transportation - vehicles, that drive the demand and price for oil. For the first time, it is clear that alternative vehicles will be competitive - long term.

In order for current oil extraction, and distribution to even stay at 85M a day, or to increase this amount, oil infrastructure investment must increase. For future extraction, the world needs new oil platforms and deep sea oil rigs. For transportation, the world needs VLCC's, 500,000 dead weight tons of steel. Once transported we need large refineries to create the distillates. After refining, we need miles of steel pipelines, trucks, etc. In the medium term, I like investing in steel stocks.

The cost of the above infrastructure is huge. Building a VLCC takes years, at a cost of over 120 million. This cost has risen over 50% in just a few years. As fuel cost rise, the cost to make everything also rise - Steel plates, large diesel engines, precision tolls,etc...This economic dynamic is the same for the very expensive new rigs, refining capacity, and transportation pipelines and vehicles.

Here comes the crux. CEO's of firms in the oil industry must always do a financial cost benefit analysis of these new large infrastructure purchases. With the current high cost of gas and diesel($4-5 dollars a gallon), and pollution taxes in the future increasing this price to over $5 a gallon for the foreseeable future, alternative natural gas engines(1-3 dollars a gallon), and electric vehicle engines(under $1 a gallon), and coal-diesel engines(4 dollars a gallon) are all economically preferred.

With the much higher differential in the cost of powering the current oil based vehicle engines, the world will quickly adopt natural gas, battery, fuel cell powered vehicles over the next 10 years. So why invest 120 million dollars in a large crude carrier, when it could be obsolete in 10 years? The same thinking applies to large oil rigs, new refineries, etc. And again, why waste money money drilling in ANWR - by the time the US gets the oil, we probably will not even need it.

As in investing and life, timing is everything. When will firms stop ordering all this expensive oil infrastructure equipment? If they were prudent, I would expect a drop-off in oil infrastructure demand over the next 3-5 years.

 

What will happen with oil prices?

As stated above, oil prices will continue to stay high in the short run, but at some point in the next few years, I predict a sharp downturn in oil prices, as alternative power sources are used in vehicles. This is how economics should work. I am surprised this shift has taken 100 years. As an investor, this changes how I value many energy firms.

Firms that are 100% levered to the extraction and distribution of oil, will have falling cash flows after 2013-2015 IMHO. Individuals and businesses change their vehicles quite often - every 3-5 years, so one can see how the technological changes in transportation area can impact the demand for oil fairly quickly. As for electric generation, this timing is different. We don't change our power plants out every 5 years. So the demand for coal, and natural gas will remain strong at least 10 years out.

As I have written before, firms that are in the natural gas business will outperform the oil related firms in the future. Also firms in battery, fuel cell technology should outperform. These changes will invigorate the US economy if the government stays out of the way. Current ethanol mandates, and ANWR drilling plans, all have one purpose - to slow down the natural economic change from oil to all its alternatives.

Some of my favorite long term stocks for this peak oil economics are:

- Precision Drilling (PDS)

- Apache Corporation (APA)

- Chesapeake Energy (CHK)

- Pengrowth Energy Trust (PGH)

- Provident Energy Trust (PVX)

- Pride International (PDE)

- Bronco Drilling (BRNC)

- Helmerich & Payne (HP)

- Swift Energy (SFY)

- Pioneer Drilling (PDC)

- EnCana Corporation (ECA)

- Nabors Industries (NBR)

- Devon Energy (DVN)

- Capstone Turbine (CPST)

- FuelCell Energy (FCEL)

22 Comments – Post Your Own

#1) On May 16, 2008 at 1:25 PM, FleaBagger (29.24) wrote:

If you really are surprised it has taken > 100 years for oil to start to be replaced by alternative energy, you are no economist, or really naive about how little people (not "little people" but rather "how little" people) care about pollution. Petroleum is still wonderfully inexpensive to extract, refine, transport, and use, in relation to its energy yield. This stands in stark contrast to losers like ethanol, solar, and hydrogen cells, which are tremendously difficult and/or expensive to produce. Otherwise, we would be using them without government direction.

I wrote a blog in which I agree with you, though, that the oil price will plummet if and when peak oil causes it to rise too far in relation to alternatives. Scale will allow solar to be more competitve soon (though not very soon if you back out their generous subsidies), and oil may rise to price itself out of contention for mass consumer use.

By the way, any reason not to let private companies drill in ANWR at their own risk?

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#2) On May 16, 2008 at 1:45 PM, bellard (99.31) wrote:

Flea;

When you start a comment by bashing someone, you will not get a great response. If you want to bash, leave CAPS and go over to the Yahoo boards and do us all a favor. These are my views as an economist, If you have a different view - post it, no need for the negativity!

Drilling in ANWR makes ZERO economic sense, but I am for free markets. So if a private firm can first buy that public land at market prices from me and the rest of the US owners of that land, then yes, that private firm should be able to drill. I can't make money by starting a business in the nation forest, I would love to have a nice office in one of the Colorado national forest, but guess what - the US government will not let me.

I want fair free markets! I do not think the current oil price is high. Hydrocarbons have been very cheap to extract, but no longer.....

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#3) On May 16, 2008 at 1:50 PM, FourthAxis (< 20) wrote:

YES!  I love that people are having the peak oil discussion!

 I'm not going to get into the ANWR discussion, but I am going to jump into the energy demand fray.

1.  The Chinese and Indians outnumber U.S. 7:1
2.  The Chinese and Indians eat 1/3 the chicken and beef (per capita) than U.S.
3.  The Chinese and Indian Chicken and Beef consumption rates are increasing with standard of living.
4.  It takes 10X more grain to feed animals to feed us than it does to just feed us grain.

Now...if the dietary habits keep shifting from rice to Chicken and Beef...we first multiply the grain consumption by 3 to make up for the per capita, then we multiply by 10 for animal's increased share.  Now by my fuzzy math we'll need 30 times more grain if the dietary habits keep changing.  That doesn't include population growth or cars on the road, etc.

1.  That is a hell of a lot of crops.
2.  That is a hell of a lot of energy needed to produce crops.

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#4) On May 16, 2008 at 2:03 PM, bellard (99.31) wrote:

"That is a hell of a lot of crops.
 That is a hell of a lot of energy needed to produce crops. "

Fourth;

I totally agree. I have seen the 1-3% world energy demand increase published, but I think this demand could increase at an even higher rate! This will just push oil up higher, until the personal and ag vehicles switch to cheaper energy sources - NG, coal, solar, wind, etc....then oil prices will crash IMHO.....

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#5) On May 16, 2008 at 2:23 PM, madcowmonkey (< 20) wrote:

Fourth- that is a hellofa good statement. Just the demand that China and India will be putting on the radar screen alone is enough to see that energy and ag will be an investors delight. Most people are just looking at what the cars will be needing with India and China opening up the doors for buyers in the market. It is no miscalculation when people realize the potential for these two sectors.

As for the alternatives. I am in on the same side as bellard. The gov is slowing the process down. Energy and Ag is still going to be huge, but the US does need to open the doors for the alternatives. I write about this as well and I feel that the politics are making a mockery of the real issues, so that they can line their pockets. What they don't understand is how much they have to gain by stepping in and making true viable changes.

bellard- cpst is a definite mover that I like as well. PVX is like a love machine with the div. I also like your statement about the Natural Gas. I think it is getting more and more lime light on caps, that I have seen as of late. I added a couple that I liked back in March/April. XTO and CNQ 

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#6) On May 16, 2008 at 3:08 PM, bellard (99.31) wrote:

Madcow;

I really like XTO - I forgot to add that to my list. I will look into CNQ.....I am still mad I closed out my green thumb on my CPST!!!!

 

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#7) On May 16, 2008 at 3:20 PM, madcowmonkey (< 20) wrote:

You and me both. I put a 5 year hold on it in caps, but I really don't worry about it too much when I close picks. It would have been nice to be holding it in rl from $1.80, but I had put a limit on the minimum price for a stock when I invest in a company. I am not sure if it has saved me or lost me money. In this case it was a big loss at this point. 

CNQ- think of what they have to burn the oil sands projects with. I have been spitting out the good and the bad of this topic, trying to get a decent discussion going, but rarely any takers. I have been planning on doing a morality blog on this topic, but I would like to do some more research on the projects and argue both sides when I do.  

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#8) On May 16, 2008 at 3:53 PM, bellard (99.31) wrote:

Madcow;

Are you talking about the environmental concerns with Canadian oil sands? I do own some oil sand stocks, so any links or info keep me in the loop!

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#9) On May 16, 2008 at 4:44 PM, mindmuse (83.12) wrote:

Excellent post - wish I could give you extra recs.

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#10) On May 16, 2008 at 4:59 PM, mindmuse (83.12) wrote:

Excellent post - wish I could give you extra recs.

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#11) On May 16, 2008 at 6:40 PM, ATWDLimited (< 20) wrote:

Actually, it would ease the Geopolitical pressure on the price, because speculators are betting on a shortage of oil in the future, but If they here there will be some new massive source being used in the future, than it would lower the price, especially because the country producing it is more stable. Second, the question of NAWR is not so simple, the environmentalists Democrats and Liberals have already messed it up to the point where it will not make as much of an impact, but it would help a hell of a lot more than cutting the pathetic SPR, or Strategic Petroleum Reserve shipments.If we had just drilled 20, 15, even 10 years ago, we would be fine, but no, we have to protect the 3 mile strip where nothing lives.

So don't even try to pretend like it won't do any thing we need oil today, we need it tomorrow, and we will need it 20 and 40 years from now. Self sufficiency never hurt anyone, so why not try to be slightly, same for coal, use the stuff we got, don't put caps on things, for a bunch of weak CO2 backed global warming stuff, let the market work, cut government size, regukation, taxes and subsidies its called capitalism.

Note if you need along explanation on why Global temperature shifts are caused by the SUn just google it or ask em, I will gladly explain. 

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#12) On May 16, 2008 at 7:11 PM, bellard (99.31) wrote:

ATWD;

I want the free markets just to work. I am not a global fear monger - I would like to see pollution taxes - but just on REAL pollution like: nox, sox and mercury.

We don't need ANWR, we need the government just to let economics work, then alternative energy investment will begin. 

 

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#13) On May 16, 2008 at 10:43 PM, Hezakiah (92.12) wrote:

Maybe you can better explain why you feel that  "oil prices will continue to stay high in the short run" and then "crash" sometime in the next few years. 

This prediction clearly banks on the fact that an economic alternative source of energy can become widely adopted.  I will give you that, though I am skeptical it will happen in the next few years.  Once this happens, as ATWD mentioned, the price of oil would certainly lose its "uncertainty" and "speculative" components.  But it seems like there would be a bit of a price floor at whatever the alternative energy was selling for.  Since the method of global energy consumption is not going to change overnight (even when an economical way is found), people are only going to switch over so long as oil is clearly more expensive.  Also, capital investment in oil projects would also quickly dry up, thus limiting supply.  Does this not instead lead to the argument for a slow decay in the price of oil until demand finally dies off?

I would agree with your prediction of a "crash" if it included a massive prior runup in the price of oil.  I for one think that the major global equity markets that count (mostly U.S., Europe, and Japan) are going to struggle over the next several years.  Investors seeking returns are going to flee to commodities, which will be perceived to be in a superbull market due to the economic development in China, India, etc.;  a subsequent bubble will form in my opinion.

So I guess I see the price of oil surging over the coming years, then falling to prebubble values (somewhere near $100 in today's dollars), and then finally slowly decaying from there as demand slackens.  Of course accounting for inflation and dollar devaluation only complicates the analysis.

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#14) On May 16, 2008 at 11:31 PM, bellard (99.31) wrote:

Hez;

I predicted a sharp downturn in oil price, not a crash. I do not know the timing - a few years is 5 years maybe?? I posted the demand dynamics will be complex - as when alternatives become a definite, oil infra spending will slow down, reducing oil supply, slowing the downturn in oil prices...

I think the only real difference in our views is I see a sharp downturn back to normalized levels, were as you see a slower move back down.

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#15) On May 17, 2008 at 12:33 AM, Hezakiah (92.12) wrote:

Cool...  other than that small aspect I thought it was a very good post.

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#16) On May 17, 2008 at 9:32 PM, Tastylunch (29.21) wrote:

I thought it was an excellent post too Bellard. I'm more of Hezakiah's mindset though, in 5 years from now I fuly anticipate 75%+ of america to still be driving gasoline powered automobiles bare minimum. I just don't think any replacement tech is anywhere near ready for mass production/adoption.

we might be looking at 10-15 years or more for the scenario you are talking about re: oil prices.. 

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#17) On May 18, 2008 at 12:03 AM, bellard (99.31) wrote:

Tasty;

Your timeframe may be closer to reality. The reason I think we can change quickly is because we already have the technology. If we just drove Diesel cars, we would drastically reduce our oil consumption....

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#18) On May 19, 2008 at 2:41 PM, madcowmonkey (< 20) wrote:

Here is an outdated article about the oil sands projects. It is written by MIT, but you will get the jist of why I would think twice about these companies:)

Technology Review: Photo Essay: Dirty Oil 

I don't think too many people want to hear that this is the route we have taken instead of producing the alternative fuel. Like Hemp seed oil.  

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#19) On May 20, 2008 at 12:16 PM, bellard (99.31) wrote:

Hi Mad;

Thanks for the article. I agree with you about the oil sands, I can't see how it can be done cleanly......

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#20) On May 20, 2008 at 6:29 PM, ATWDLimited (< 20) wrote:

All my argument is is that it removes uncertainty in the market and does more than the SPR shipments, or trying to sue OPEC, or beg for oil. If we had built more refineries/opened ANWR  just 15/10 years ago, we would be doing fine. Any way, we really should just use our deep water reserves, they are cheaper to get, but the environmentalist idiots are blocking it and by the time we need it, like now, people like you, not in a bad way, will say oh well, it won't help, problem is it would have but it was stopped from happening. Its like saying no medicine for a sick man, than latter when he is far worse saying it is a waste because now it won't do as much. 

Thats why we really need nuclear, most efficient process besides mater anti matter annihilation. the mass to energy conversion is unrivaled. If we got 50% of electricity from nuclear, 30% coal and 20% alternative we would be fine. For fuel Coal to Liquid, gas to liquid and algae are the best solutions. 

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#21) On May 21, 2008 at 9:07 AM, floridabuilder2 (99.24) wrote:

great post bellard...  i think what some people like to argue is the timing of things and not actually that it won't happen 1 year, 2 year, 5 years, 10 years is irrelevant... it all comes down to supply / demand and cost / benefit....  this is the argument i have for housing... people get too caught up with timeframes and not the bigger picture of these two levers

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#22) On May 21, 2008 at 10:31 AM, bellard (99.31) wrote:

ATWD;

Thanks for your views. We probable agree more than not. I am an environmentalist, and a "greed is good" capitalist pig. The two are not opposing.

ANWR has never made any economic sense IMHO. I agree with nuclear - and water drilling of all the US coast right up to 2 miles of shore line....

What we need the most - and nobody wants to hear - is much higher prices for the end user - just listen the Boone Pickens....

 

FB;

Thanks. I agree that my timing of events may be too quick. The world has a lot of $$ invested in oil infrastructure, and moves away from oil will be hit with resistance.

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