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Steve Kopits recently gave a presentation explaining our current predicament: the cost of oil extraction has been rising rapidly (10.9% per year) but oil prices have been flat. Major oil companies are finding their profits squeezed, and have recently announced plans to sell off part of their assets in order to have funds to pay their dividends. Such an approach is likely to lead to an eventual drop in oil production. I have talked about similar points previously (here and here), but Kopits adds some additional perspectives which he has given me permission to share with my readers. I encourage readers to watch the original hour-long presentation at Columbia University, if they have the time.
Controversy: Does Oil Extraction Depend on “Supply Growth” or “Demand Growth”?
The first section of the presentation is devoted the connection of GDP Growth to Oil Supply Growth vs Oil Demand Growth. I omit a considerable part of this discussion in this write-up.
Economists and oil companies, when making their projections, nearly always make their projections depend on “Demand Growth”–the amount people and businesses want. This demand growth is seen to be rising indefinitely in the future. It has nothing to do with affordability or with whether the potential consumers actually have jobs to purchase the oil products.
Kopits presents the following list of assumptions of demand constrained forecasting. (IOC’s are “Independent Oil Companies” like Shell and Exxon Mobil, as contrasted with government owned companies that are prevalent among oil exporters.)
Thus, it is the demand constrained view of forecasting that gives rise to the view that OPEC (Organization of Petroleum Exporting Nations) has enormous leverage. The assumption is made that OPEC can add or subtract as much supply as much as it chooses. Kopits provides evidence that in fact the Demand view is no longer applicable today, so this whole story is wrong.
One piece of evidence that the Demand Model is wrong is the fact that world crude oil (including lease condensate) production has been nearly flat since 2004, in a period when China and other growing Eastern economies have been trying to motorize. In comparison, there was a rise of 2.7% per year, when the West, with a similar population, was trying to motorize.
Kopits points out that China’s big source of oil supply has been US main street: China bids oil supply away from United States, to satisfy its needs. This is the way that markets have made oil available to China, when world supply is not rising much. It is part of the reason that oil prices have risen.
Another piece of evidence that the Demand Model is wrong relates to the assumption that social tastes have simply changed, leading to a drop in US oil consumption. Kopits shows the following chart, indicating that the major reason that young people don’t have cars is because they don’t have full-time jobs.
Kopits makes a comparison of the role of oil in GDP growth to the role of water in plant growth in the desert. Without oil, there is less GDP growth, just as without water, a desert is starved for the element it needs for plant growth. Lack of oil can considered a binding constraint on GDP growth. (Labor availability might be a constraint, but it wouldn’t be a binding constraint, because there are plenty of unemployed people who might work if demand ramped up.) When more oil is available at a slightly lower price, it is quickly absorbed by markets.
“Supply Growth” is the limiting factor in recent years, because the amount of extraction is rising only slowly due to geological constraints and the number of users has risen to the point that there is a shortage.
Experience of Major Oil Producing Companies
Kopits presents data showing how badly the big, publicly traded oil companies are doing. He looks at two pieces of information:
- “Capex” – “Capital expenditures” – How much companies are spending on things like exploration, drilling, and making of new offshore oil platforms
- “Crude oil production” –
A person would normally expect that crude oil production would rise as Capex rises, but Kopits shows that in fact since 2006, Capex has continued to rise, but crude oil production has fallen.
The above information is worldwide, not just for the US. At some point a person might expect companies to start getting frustrated–they are spending more and more, but not getting very far in extracting oil.
Kopits then shows another version of Capex history plus a forecast. (This time the amounts are labeled “Upstream,” so the expenditures are clearly on the exploration and drilling side, rather than related to refineries or pipelines.)
The amounts this time are for the industry as a whole, including “NOCs” which are government owned (national) oil companies as well as IOCs (Independent Oil Companies), both large and small. Kopits remarks that the forecasts shown were made only six months ago. When talking about the above slide Koptis says,
People in the industry thought, “Capex has been going up and up. It will continue to do very well. We have been on this trajectory forever, and we are just going to get more and more money out of this.”
Now why is that? The reason is that in a Demand constrained model for those of you who took economics–price equals marginal cost. Right? So if my costs are going up, the price will also go up. Right? That is a Demand constrained model. So if it costs me more to get oil, it is no big deal, the market will recognize that at some point, in a Demand constrained model.
Not in a Supply constrained model! In a Supply constrained model, the price goes up to a price that is very similar to the monopoly price, after which you really can’t raise it, because that marginal consumer would rather do with less than pay more. They will not recognize [pay] your marginal cost. In that model, you get to a price, and after that price, there is significant resistance from the consumer to moving up off of that price. That is the “Supply Constrained Price.” If your costs continue to come up underneath you, the consumer won’t recognize it.
The rapidly growing Capex forecast is implicitly a Demand constrained forecast. It says, sure Capex can go up to a trillion dollars a year. We can spend a trillion dollars a year looking for oil and gas. The global economy will accept that.
I quote this because I am not sure I have explained the situation exactly that way. I perhaps have said that demand had to be connected to what consumers could afford. Wages don’t magically go up by themselves (even though economists think they can).
According to Koptis, the cost of oil extraction has in recent years been rising at 10.9% per year since 1999. (CAGR means “compound annual growth rate”).
Oil prices have been flat at the same time. On the above chart, “E&P Capex per barrel” is pretty much the same type of expenses as shown on the previous two charts. E&P means Exploration and Production.
Kopits explains that the industry needs prices of over $100 barrel.
The version of the chart I have up is too small to read the names of individual companies. If you would like a chart with bigger names, you can download the original presentation.
Historically, oil companies have used a discounted cash flow approach to figure out whether over the long term, pricing for a particular field will be profitable. Unfortunately, this “standard” approach has not been working well recently. Expenses have been escalating too rapidly, and there have been too many new drilling sites producing below expectation. What Kopits shows on the above slide is the prices that companies need on different basis–a “cash flow” basis–so that each year companies have enough money to pay today’s capital expenditures, plus today’s expenses, plus today’sdividends.
The reason for using the cash flow approach is because companies have found themselves coming up short: they find that after they have paid capital expenditures and other expenditures such as taxes, they don’t have enough money left to pay dividends, unless they borrow money or sell off assets. Oil companies need to pay dividends because pension plans and other buyers of oil company stocks expect to receive regular dividends in payment for their equity investment. The dividends are important to pension plans.
In the last bullet point on the slide, Kopits is telling us that on this basis, most US oil companies need a price of $130 barrel or more. I noticed that Brazil’s Petrobas needs a price of over $150 barrel. (OSX, Brazil’s number two oil company, recently went bankrupt.)
In the slide below, Kopits shows how Shell oil is responding to the poor cash flow situation of the major oil companies, based on recent announcements.
Basically, Shell is cutting back. It no longer is going to tell investors how much it plans to produce in the future. Instead, it will focus on generating cash flow, at least partly by selling off existing programs.
In fact, Kopits reports that all of the major oil companies are reporting divestment programs. Does selling assets really solve the oil companies’ problems? What the oil companies would really like to do is raise their prices, but they can’t do that, because they don’t set prices, the market does–and the prices aren’t high enough. And the oil companies really can’t cut costs. So instead, they sell assets to pay dividends, or perhaps just to get out of the business. But is this sustainable?
The above slide shows that conventional oil production peaked in 2005. The top line is total conventional oil production (calculated as world oil production, less natural gas liquids, and less US shale and other unconventional, and less Canadian oil sands). To get his estimate of “Crude Oil Normal Decline,” Kopits uses the mirror image of the rise in conventional oil production prior to 2005. He also shows a separate item for the rise in oil production from Iraq since 2005. The yellow portion called “crude production forward” is then the top line, less the other two items. It has taken $2.5 trillion to add this new yellow block. Now this strategy has run its course (based on the bad results companies are reporting from recent drilling), so what will oil companies do now?
Above, Kopits shows evidence that many companies in recent months have been cutting back budgets. These are big reductions–billions and billions of dollars.
On the above chart, Kopits tries to estimate the shape of the downslope in capital expenditures. This chart isn’t for all companies. It excludes the smaller companies, and it excludes the National oil companies, so it is about one-third of the market. The gray horizontal line at the top is the industry consensus back in October. The other lines represent more recent estimates of how Capex is declining. The steepest decline is the forecast based on Hess’s announcement. The next steepest (the dotted gray line) is the forecast based on Shell’s cutback. The cutback for the part of the market not shown in the chart is likely to be different.
Oil and Economic Growth
Kopits offers his view of how much efficiency can be gained in a given year, in the slide below:
In his view, the maximum sustainable increase in efficiency is 2.5% in non-recessions, but a more normal increase is 1% per year. At current oil supply growth levels, OECD GDP growth is capped at 1% to 2%. The effect of constrained oil supply is reducing OECD GDP growth by 1% to 2%.
We seem to be short of oil. Whenever there is extra oil on the market, it is quickly soaked up. Oil prices have not collapsed. No one is nervous about a price collapse.
China recently has been putting little price pressure on the market–its demand is recently less high. Kopits thinks China will eventually return to the market, and put price pressure on oil prices. Thus, oil price pressures are likely to return at some point.
An obvious point, which I thought I heard when I listened to the presentation the first time, but didn’t hear the second time is, “Who will buy all of these assets on the market, and at what price?” China would seem to be a likely buyer, if one is to be found. But when several companies want to sell assets at the same time, a person wonders what prices will be available.
The new strategy is, in effect, maintaining dividends by returning part of capital. It is clearly not a very sustainable strategy.
It will take a while for these cut-backs in Capex expenditures to find their way through to oil output, but it could very well start in a year or two. This is disturbing.
What we are seeing now is a cutback in what companies consider “economically extractable oil”–something that isn’t exactly reported by companies. I expect that what is being sold off is mostly not “proven reserves.”
In this talk, it looks like lack of sufficient investment is poised to bring the system down. That is basically the expected limit under Limits to Growth.
In theory, if an expansion of China’s oil demand does bring oil prices up again, it could in theory encourage an increase in drilling activity. But it is doubtful that economies could withstand the high prices–they are already having problems at current price levels, considering the continued need for Quantitative Easing to keep interest rates low.
A recent news item was titled, G20 Finance Ministers Agree to Lift Global Growth Target. According to that article,
Mr Hockey said reaching the goal would require increasing investment but that it could create “tens of millions of new jobs”.
The cutback in investment by oil companies is working precisely in the wrong direction. If these cutbacks act to cut future oil extraction, it will bring down growth further.
How long can economic growth continue in a finite world? This is the question the 1972 book The Limits to Growth by Donella Meadows and others sought to answer. The computer models that the team of researchers produced strongly suggested that the world economy would collapse sometime in the first half of the 21st century.
I have been researching what the real situation is with respect to resource limits since 2005. The conclusion I am reaching is that the team of 1972 researchers were indeed correct. In fact, the promised collapse is practically right around the corner, beginning in the next year or two. In fact, many aspects of the collapse appear already to be taking place, such as the 2008-2009 Great Recession and the collapse of the economies of smaller countries such as Greece and Spain. How could collapse be so close, with virtually no warning to the population?
To explain the situation, I will first explain why we are reaching Limits to Growth in the near term. I will then provide a list of nine reasons why the near-term crisis has been overlooked.
Why We are Reaching Limits to Growth in the Near Term
In simplest terms, our problem is that we as a people are no longer getting richer. Instead, we are getting poorer, as evidenced by the difficulty young people are now having getting good-paying jobs. As we get poorer, it becomes harder and harder to pay debt back with interest. It is the collision of the lack of economic growth in the real economy with the need for economic growth from the debt system that can be expected to lead to collapse.
The reason we are getting poorer is because hidden parts of our economy are now absorbing more and more resources, leaving fewer resources to produce the goods and services we are used to buying. These hidden parts of our economy are being affected by depletion. For example, it now takes more resources to extract oil. This is why oil prices have more than tripled since 2002. It also takes more resource for many other hidden processes, such as deeper wells or desalination to produce water, and more energy supplies to produce metals from low-grade ores.
The problem as we reach all of these limits is a shortage of physical investment capital, such as oil, copper, and rare earth minerals. While we can extract more of these, some, like oil, are used in many ways, to fix many depletion problems. We end up with too many demands on oil supply–there is not enough oil to both (1) offset the many depletion issues the world economy is hitting, plus (2) add new factories and extraction capability that is needed for the world economy to grow.
With too many demands on oil supply, “economic growth” is what tends to get shorted. Countries that obtain a large percentage of their energy supply from oil tend to be especially affected because high oil prices tend to make the products these countries produce unaffordable. Countries with a long-term decline in oil consumption, such as the US, European Union, and Japan, find themselves in recession or very slow growth.
Figure 1. Oil consumption based on BP’s 2013 Statistical Review of World Energy.
Unfortunately, the problem this appears eventually to lead to, is collapse. The problem is the connection with debt. Debt can be paid back with interest to a much greater extent in a growing economy than a contracting economy because we are effectively borrowing from the future–something that is a lot easier when tomorrow is assumed to be better than today, compared to when tomorrow is worse than today.
We could not operate our current economy without debt. Debt is what has allowed us to “pump up” economic growth. Consumers can buy cars, homes, and college educations that they have not saved up for. Businesses can set up factories and do mineral extraction, without having past profits to finance these operations. We can now operate with long supply chains, including many businesses that are dependent on debt financing. The ability to use debt allows vastly more investment than if potential investors could only the use of after-the-fact profits.
If we give up our debt-based economic system, we lose our ability to extract even the oil and other resources that appear to be easily available. We can have a simple, local economy, perhaps dependent on wood as it primary fuel source, without debt. But it seems unlikely that we can have a world economy that will provide food and shelter for 7.2 billion people.
The reason the situation is concerning is because the financial situation now seems to be near a crisis. Debt, other than government debt, has not been growing very rapidly since 2008. The government has tried to solve this problem by keeping interest rates very low using Quantitative Easing (QE). Now the government is cutting back in the amount of QE. If interest rates should rise very much, we will likely see recession again and many layoffs. If this should happen, debt defaults are likely to be a problem and credit availability will dry up as it did in late 2008. Without credit, prices of all commodities will drop, as they did in late 2008. Without the temporary magic of QE, new investment, even in oil, will drop way off. Government will need to shrink back in size and may even collapse.
In fact, we are already having a problem with oil prices that are too low to encourage oil production. (See my post, What’s Ahead? Lower Oil Prices, Despite Higher Extraction Costs.) Other commodities are also trading at flat to lower price levels. The concern is that these lower prices will lead to deflation. With deflation, debt is strongly discouraged because it raises the “inflation adjusted” cost of borrowing. If a deflationary debt cycle is started, there could be a huge drop in debt over a few years. This would be a different way to reach collapse.
Why couldn’t others see the problem that is now at our door step?
1. The story is a complicated, interdisciplinary story. Even trying to summarize it in a few paragraphs is not easy. Most people, if they have a background in oil issues, do not also have a background in financial issues, and vice versa.
2. Economists have missed key points. Economists have missed the key role of debt in extracting fossil fuels and in keeping the economy operating in general. They have also missed the fact that in a finite world, this debt cannot keep rising indefinitely, or it will grow to greatly exceed the physical resources that might be used to pay back the debt.
Economists have missed the fact that resource depletion acts in a way that is equivalent to a huge downward drag on productivity. Minerals need to be separated from more and more waste products, and energy sources need to be extracted in ever-more-difficult locations. High energy prices, whether for oil or for electricity, are a sign of economic inefficiency. If energy prices are high, they act as a drag on the economy.
Economists have missed the key role oil plays–a role that is not easily substituted away. Our transportation, farming and construction industries are all heavily dependent on oil. Many products are made with oil, from medicines to fabrics to asphalt.
Economists have assumed that wages can grow without energy inputs, but recent experience shows the economies with shrinking oil use are ones with shrinking job opportunities. Economists have built models claiming that prices will rise to handle shortages, either through substitution or demand destruction, but they have not stopped to consider how destructive this demand destruction can be for an economy that depends on oil use to manufacture and transport goods.
Economists have missed the point that globalization speeds up depletion of resources and increases CO2 emissions, because it adds a huge number of new consumers to the world market.
Economists have also missed the fact that wages are hugely important for keeping economies operating. If wages are cut, either because of competition with low-wage workers in warm countries (who don’t need as high a wages to maintain a standard of living, because they do not need sturdy homes or fuel to heat the homes) or because of automation, economic growth is likely to slow or fall. Corporate profits are not a substitute for wages.
3. Peak Oil advocates have missed key points. Peak oil advocates are a diverse group, so I cannot really claim all of them have the same views.
One common view is that just because oil, or coal, or natural gas seems to be available with current technology, it will in fact be extracted. This is closely related to the view that “Hubbert’s Peak” gives a reasonable model for future oil extraction. In this model, it is assumed that about 50% of extraction occurs after the peak in oil consumption takes place. Even Hubbert did not claim this–his charts always showed another fuel, such as nuclear, rising in great quantity before fossil fuels dropped in supply.
In the absence of a perfect substitute, the drop-off can be expected to be very steep. This happens because population rises as fossil fuel use grows. As fossil fuel use declines, citizens suddenly become much poorer. Government services must be cut way back, and government may even collapse. There is likely to be huge job loss, making it difficult to afford goods. There may be fighting over what limited supplies are available.What Hubbert’s curve shows is something like an upper limit for production, if the economy continues to function as it currently does, despite the disruption that loss of energy supplies would likely bring.
A closely related issue is the belief that high oil prices will allow some oil to be produced indefinitely. Salvation can therefore be guaranteed by using less oil. First of all, the belief that oil prices can rise high enough is being tested right now. The fact that oil prices aren’t high enough is causing oil companies to cut back on new projects, instead returning money to shareholders as dividends. If the economy starts shrinking because of lower oil extraction, a collapse in credit is likely to lead to even lower prices, and a major cutback in production.
4. Excessive faith in substitution. A common theme by everyone from economists to peak oilers to politicians is that substitution will save us.
There are several key points that advocates miss. One is that if a financial crash is immediately ahead, our ability to substitute disappears, practically overnight (or at least, within a few years).
Another is key point is that today’s real shortage is of investment capital, in the form of oil and other natural resources needed to manufacture the new natural gas powered cars and the fueling stations they need. A similar shortage of investment capital plagues plans to change to electric cars. Wage-earners of modest means cannot afford high-priced plug in vehicles, especially if the change-over is so fast that the value of their current vehicle drops to $0.
Another key point is that the alternatives we looking at are limited in supply as well. We use far more oil than natural gas; trying to substitute natural gas for oil will lead to a shortfall in natural gas supplies quickly. Ramping up electric cars, solar, and wind will lead to a shortage of the rare earth minerals and other minerals needed in their production. While more of these minerals can be accessed by using lower quality ore, doing so leads to precisely the investment capital shortfall that is our problem to begin with.
Another key point is that electricity does not substitute for oil, because of the huge need for investment capital (which is what is in short supply) to facilitate the change. There is also a timing issue.
Another key point is that intermittent electricity does not substitute for electricity whose supply can be easily regulated. What intermittent electricity substitutes for is thefossil fuel used to make electricity whose supply is more easily regulated. This substitution (in theory) extends the life of our fossil fuel supplies. This theory is only true if we believe that coal and natural gas extraction is only limited by the amount those materials in the ground, and the level of our technology. (This is the assumption underlying IEA and EIA estimates of future fossil use.)
If the limit on coal and natural gas extraction is really a limit on investment capital (including oil), and this investment capital limit may manifest itself as a debt limit, then the situation is different. In such a case, high investment in intermittent renewables can expected to drive economies that build them toward collapse more quickly, because of their high front-end investment capital requirements and low short-term returns.
5. Excessive faith in Energy Return on Energy Investment (EROI) or Life Cycle Analysis (LCA) analyses. Low EROI returns and poor LCA returns are part of our problem, but they are not the whole problem. They do not consider timing–something that is critical, if our problem is with inadequate investment capital availably, and the need for high returns quickly.
EROI analyses also make assumptions about substitutability–something that is generally not possible for oil, for reasons described above. While EROI and LCA studies can provide worthwhile insights, it is easy to assume that they have more predictive value than they really do. They are not designed to tell when Limits to Growth will hit, for example.
6. Governments funding leads to excessive research in the wrong directions and lack of research in the right direction. Governments are in denial that Limits to Growth, or even oil supply, might be a problem. Governments rely on economists who seem to be clueless regarding what is happening.
Researchers base their analyses on what prior researchers have done. They tend to “follow the research grant money,” working on whatever fad is likely to provide funding. None of this leads to research in areas where our real problems lie.
7. Individual citizens are easily misled by news stories claiming an abundance of oil. Citizens don’t realize that the reason oil is abundant is because oil prices are high, debt is widely available, and interest rates are low. Furthermore, part of the reason oil appears abundant is because low-wage citizens still cannot afford products made with oil, even at its current price level. Low employment and wages feed back in the form of low oil demand, which looks like excessive oil supply. What the economy really needs is low-priced oil, something that is not available.
Citizens also don’t realize that recent push to export crude oil doesn’t mean there is a surplus of crude oil. It means that refinery space for the type of oil in question is more available overseas.
The stories consumers read about growing oil supplies are made even more believable by forecasts showing that oil and other energy supply will rise for many years in the future. These forecasts are made possible by assuming the limit on the amount of oil extracted is the amount of oil in the ground. In fact, the limit is likely to be a financial (debt) limit that comes much sooner. See my post, Why EIA, IEA, and Randers’ 2052 Energy Forecasts are Wrong.
8. Unwillingness to believe the original Limits to Growth models. Recent studies, such as those by Hall and Day and by Turner, indicate that the world economy is, in fact, following a trajectory quite similar to that foretold by the base model of Limits to Growth. In my view, the main deficiencies of the 1972 Limits to Growth models are
(a) The researchers did not include the financial system to any extent. In particular, the models left out the role of debt. This omission tends to move the actual date of collapse sooner, and make it more severe.
(2) The original model did not look at individual resources, such as oil, separately. Thus, the models gave indications for average or total resource limits, even though oil limits, by themselves, could bring down the economy more quickly.
I have noticed comments in the literature indicating that the Limits to Growth study has been superseded by more recent analyses. For example, the article Entropy and Economics by Avery, when talking about the Limits to Growth study says, “ Today, the more accurate Hubbert Peak model is used instead to predict rate of use of a scarce resource as a function of time.” There is no reason to believe that the Hubbert Peak model is more accurate! The original study used actual resource flows to predict when we might expect a problem with investment capital. Hubbert Peak models overlook financial limits, such as lack of debt availability, so overstate likely future oil flows. Because of this, they are not appropriate for forecasts after the world peak is hit.
Another place I have seen similar wrong thinking is in the current World3 model, which has been used in recent Limits to Growth analyses, including possibly Jorgen Randers’2052. This model assumes a Hubbert Peak model for oil, gas, and coal. The World3 model also assumes maximum substitution among fuel types, something that seems impossible if we are facing a debt crisis in the near term.
9. Nearly everyone would like a happy story to tell. Every organization from Association for the Study of Peak Oil groups to sustainability groups to political groups would like to have a solution to go with the problem they are aware of. Business who might possibly have a chance of selling a “green” product would like to say, “Buy our product and your problems will be solved.” News media seem to tell only the stories that their advertisers would like to hear. This combination of folks who are trying to put the best possible “spin” on the story leads to little interest in researching and telling the true story.
Wrong thinking and wishful thinking seems to abound, when it comes to overlooking near term limits to growth. Part of this may be intentional, but part of this lies with the inherent difficulty of understanding such a complex problem.
There is a tendency to believe that newer analyses must be better. That is not necessarily the case. When it comes to determining when Limits to Growth will be reached, analyses need to be focused on the details that seemed to cause collapse in the 1972 study–slow economic growth caused by the many conflicting needs for investment capital. The question is: when do we reach the point that oil supply is growing too slowly to produce the level of economic growth needed to keep our current debt system from crashing?
It seems to me that we are already near such a point of collapse. Most people have not realized how vulnerable our economic system is to crashing in a time of low oil supply growth.
In order to understand what solutions to our energy predicament will or won’t work, it is necessary to understand the true nature of our energy predicament. Most solutions fail because analysts assume that the nature of our energy problem is quite different from what it really is. Analysts assume that our problem is a slowly developing long-term problem, when in fact, it is a problem that is at our door step right now.
The point that most analysts miss is that our energy problem behaves very much like a near-term financial problem. We will discuss why this happens. This near-term financial problem is bound to work itself out in a way that leads to huge job losses and governmental changes in the near term. Our mitigation strategies need to be considered in this context. Strategies aimed simply at relieving energy shortages with high priced fuels and high-tech equipment are bound to be short lived solutions, if they are solutions at all.
OUR ENERGY PREDICAMENT
1. Our number one energy problem is a rapidly rising need for investment capital, just to maintain a fixed level of resource extraction. This investment capital is physical “stuff” like oil, coal, and metals.
We pulled out the “easy to extract” oil, gas, and coal first. As we move on to the difficult to extract resources, we find that the need for investment capital escalates rapidly. According to Mark Lewis writing in the Financial Times, “upstream capital expenditures” for oil and gas amounted to nearly $700 billion in 2012, compared to $350 billion in 2005, both in 2012 dollars. This corresponds to an inflation-adjusted annual increase of 10% per year for the seven year period.
Figure 1. The way would expect the cost of the extraction of energy supplies to rise, as finite supplies deplete.
In theory, we would expect extraction costs to rise as we approach limits of the amount to be extracted. In fact, the steep rise in oil prices in recent years is of the type we would expect, if this is happening. We were able to get around the problem in the 1970s, by adding more oil extraction, substituting other energy products for oil, and increasing efficiency. This time, our options for fixing the situation are much fewer, since the low hanging fruit have already been picked, and we are reaching financial limits now.
Figure 2. Historical oil prices in 2012 dollars, based on BP Statistical Review of World Energy 2013 data. (2013 included as well, from EIA data.)
To make matters worse, the rapidly rising need for investment capital arises is other industries as well as fossil fuels. Metals extraction follows somewhat the same pattern. We extracted the highest grade ores, in the most accessible locations first. We can still extract more metals, but we need to move to lower grade ores. This means we need to remove more of the unwanted waste products, using more resources, including energy resources.
Figure 3. Waste product to produce 100 units of metal
There is a huge increase in the amount of waste products that must be extracted and disposed of, as we move to lower grade ores (Figure 3). The increase in waste products is only 3% when we move from ore with a concentration of .200, to ore with a concentration .195. When we move from a concentration of .010 to a concentration of .005, the amount of waste product more than doubles.
When we look at the inflation adjusted cost of base metals (Figure 4 below), we see that the index was generally falling for a long period between the 1960s and the 1990s, as productivity improvements were greater than falling ore quality.
Figure 4. World Bank inflation adjusted base metal index (excluding iron).
Since 2002, the index is higher, as we might expect if we are starting to reach limits with respect to some of the metals in the index.
There are many other situations where we are fighting a losing battle with nature, and as a result need to make larger resource investments. We have badly over-fished the ocean, so fishermen now need to use more resources too catch the remaining much smaller fish. Pollution (including CO2 pollution) is becoming more of a problem, so we invest resources in devices to capture mercury emissions and in wind turbines in the hope they will help our pollution problems. We also need to invest increasing amounts in roads, bridges, electricity transmission lines, and pipelines, to compensate for deferred maintenance and aging infrastructure.
Some people say that the issue is one of falling Energy Return on Energy Invested (EROI), and indeed, falling EROI is part of the problem. The steepness of the curve comes from the rapid increase in energy products used for extraction and many other purposes, as we approach limits. The investment capital limit was discovered by the original modelers ofLimits to Growth in 1972. I discuss this in my post Why EIA, IEA, and Randers’ 2052 Energy Forecasts are Wrong.
2. When the amount of oil extracted each year flattens out (as it has since 2004), a conflict arises: How can there be enough oil both (a) for the growing investment needed to maintain the status quo, plus (b) for new investment to promote growth?
In the previous section, we talked about the rising need for investment capital, just to maintain the status quo. At least some of this investment capital needs to be in the form of oil. Another use for oil would be to grow the economy–adding new factories, or planting more crops, or transporting more goods. While in theory there is a possibility of substituting away from oil, at any given point in time, the ability to substitute away is quite limited. Most transport options require oil, and most farming requires oil. Construction and road equipment require oil, as do diesel powered irrigation pumps.
Because of the lack of short term substitutability, the need for oil for reinvestment tends to crowd out the possibility of growth. This is at least part of the reason for slower world-wide economic growth in recent years.
3. In the crowding out of growth, the countries that are most handicapped are the ones with the highest average cost of their energy supplies.
For oil importers, oil is a very high cost product, raising the average cost of energy products. This average cost of energy is highest in countries that use the highest percentage of oil in their energy mix.
If we look at a number of oil importing countries, we see that economic growth tends to be much slower in countries that use very much oil in their energy mix. This tends to happen because high energy costs make products less affordable. For example, high oil costs make vacations to Greece unaffordable, and thus lead to cut backs in their tourist industry.
It is striking when looking at countries arrayed by the proportion of oil in their energy mix, the extent to which high oil use, and thus high cost energy use, is associated with slow economic growth (Figure 5, 6, and 7). There seems to almost be a dose response–the more oil use, the lower the economic growth. While the PIIGS (Portugal, Italy, Ireland, Greece, and Spain) are shown as a group, each of the countries in the group shows the same pattern on high oil consumption as a percentage of its total energy production in 2004.
Globalization no doubt acted to accelerate this shift toward countries that used little oil. These countries tended to use much more coal in their energy mix–a much cheaper fuel.
Figure 5. Percent energy consumption from oil in 2004, for selected countries and country groups, based on BP 2013 Statistical Review of World Energy. (EU – PIIGS means “EU-27 minus PIIGS’)
Figure 6. Average percent growth in real GDP between 2005 and 2011, based on USDA GDP data in 2005 US$.
Figure 7. Average percentage consumption growth between 2004 and 2011, based on BP’s 2013 Statistical Review of World Energy.
4. The financial systems of countries with slowing growth are especially affected, as are the governments. Debt becomes harder to repay with interest, as economic growth slows.
With slow growth, debt becomes harder to repay with interest. Governments are tempted to add programs to aid their citizens, because employment tends to be low. Governments find that tax revenue lags because of the lagging wages of most citizens, leading to government deficits. (This is precisely the problem that Turchin and Nefedov noted, prior to collapse, when they analyzed eight historical collapses in their book Secular Cycles.)
Governments have recently attempt to fix both their own financial problems and the problems of their citizens by lowering interest rates to very low levels and by using Quantitative Easing. The latter allows governments to keep even long term interest rates low. With Quantitative Easing, governments are able to keep borrowing without having a market of ready buyers. Use of Quantitative Easing also tends to blow bubbles in prices of stocks and real estate, helping citizens to feel richer.
5. Wages of citizens of countries oil importing countries tend to remain flat, as oil prices remain high.
At least part of the wage problem relates to the slow economic growth noted above. Furthermore, citizens of the country will cut back on discretionary goods, as the price of oil rises, because their cost of commuting and of food rises (because oil is used in growing food). The cutback in discretionary spending leads to layoffs in discretionary sectors. If exported goods are high priced as well, buyers from other countries will tend to cut back as well, further leading to layoffs and low wage growth.
6. Oil producers find that oil prices don’t rise high enough, cutting back on their funds for reinvestment.
As oil extraction costs increase, it becomes difficult for the demand for oil to remain high, because wages are not increasing. This is the issue I describe in my post What’s Ahead? Lower Oil Prices, Despite Higher Extraction Costs.
We are seeing this issue today. Bloomberg reports, Oil Profits Slump as Higher Spending Fails to Raise Output. Business Week reports Shell Surprise Shows Profit Squeeze Even at $100 Oil. Statoil, the Norwegian company, is considering walking away from Greenland, to try to keep a lid on production costs.
7. We find ourselves with a long-term growth imperative relating to fossil fuel use, arising from the effects of globalization and from growing world population.
Globalization added approximately 4 billion consumers to the world market place in the 1997 to 2001 time period. These people previously had lived traditional life styles. Once they became aware of all of the goods that people in the rich countries have, they wanted to join in, buying motor bikes, cars, televisions, phones, and other goods. They would also like to eat meat more often. Population in these countries continues to grow adding to demand for goods of all kinds. These goods can only be made using fossil fuels, or by technologies that are enabled by fossil fuels (such as today’s hydroelectric, nuclear, wind, and solar PV).
8. The combination of these forces leads to a situation in which economies, one by one, will turn downward in the very near future–in a few months to a year or two. Some are already on this path (Egypt, Syria, Greece, etc.)
We have two problems that tend to converge: financial problems that countries are now hiding, and ever rising need for resources in a wide range of areas that are reaching limits (oil, metals, over-fishing, deferred maintenance on pipelines).
On the financial side, we have countries trying to hang together despite a serious mismatch between revenue and expenses, using Quantitative Easing and ultra-low interest rates. If countries unwind the Quantitative Easing, interest rates are likely to rise. Because debt is widely used, the cost of everything from oil extraction to buying a new home to buying a new car is likely to rise. The cost of repaying the government’s own debt will rise as well, putting governments in worse financial condition than they are today.
A big concern is that these problems will carry over into debt markets. Rising interest rates will lead to widespread defaults. The availability of debt, including for oil drilling, will dry up.
Even if debt does not dry up, oil companies are already being squeezed for investment funds, and are considering cutting back on drilling. A freeze on credit would make certain this happens.
Meanwhile, we know that investment costs keep rising, in many different industries simultaneously, because we are reaching the limits of a finite world. There are more resources available; they are just more expensive. A mismatch occurs, because our wages aren’t going up.
The physical amount of oil needed for all of this investment keeps rising, but oil production continues on its relatively flat plateau, or may even begins to drop. This leads to less oil available to invest in the rest of the economy. Given the squeeze, even more countries are likely to encounter slowing growth or contraction.
9. My expectation is that the situation will end with a fairly rapid drop in the production of all kinds of energy products and the governments of quite a few countries failing. The governments that remain will dramatically cut services.
With falling oil production, promised government programs will be far in excess of what governments can afford, because governments are basically funded out of the surpluses of a fossil fuel economy–the difference between the cost of extraction and the value of these fossil fuels to society. As the cost of extraction rises, the surpluses tend to dry up.
Figure 8. Cost of extraction of barrel oil, compared to value to society. Economic growth is enabled by the difference.
As these surpluses shrink, governments will need to shrink back dramatically. Government failure will be easier than contracting back to a much smaller size.
International finance and trade will be particularly challenging in this context. Trying to start over will be difficult, because many of the new countries will be much smaller than their predecessors, and will have no “track record.” Those that do have track records will have track records of debt defaults and failed promises, things that will not give lenders confidence in their ability to repay new loans.
While it is clear that oil production will drop, with all of the disruption and a lack of operating financial markets, I expect natural gas and coal production will drop as well. Spare parts for almost anything will be difficult to get, because of the need for the system of international trade to support making these parts. High tech goods such as computers and phones will be especially difficult to purchase. All of these changes will result in a loss of most of the fossil fuel economy and the high tech renewables that these fossil fuels support.
A Forecast of Future Energy Supplies and their Impact
A rough estimate of the amounts by which energy supply will drop is given in Figure 9, below.
Figure 9. Estimate of future energy production by author. Historical data based on BP adjusted to IEA groupings.
The issue we will be encountering could be much better described as “Limits to Growth” than “Peak Oil.” Massive job layoffs will occur, as fuel use declines. Governments will find that their finances are even more pressured than today, with calls for new programs at the time revenue is dropping dramatically. Debt defaults will be a huge problem. International trade will drop, especially to countries with the worst financial problems.
One big issue will be the need to reorganize governments in a new, much less expensive way. In some cases, countries will break up into smaller units, as the Former Soviet Union did in 1991. In some cases, the situation will go back to local tribes with tribal leaders. The next challenge will be to try to get the governments to act in a somewhat co-ordinated way. There may need to be more than one set of governmental changes, as the global energy supplies decline.
We will also need to begin manufacturing goods locally, at a time when debt financing no longer works very well, and governments are no longer maintaining roads. We will have to figure out new approaches, without the benefit of high tech goods like computers. With all of the disruption, the electric grid will not last very long either. The question will become: what can we do with local materials, to get some sort of economy going again?
NON-SOLUTIONS and PARTIAL SOLUTIONS TO OUR PROBLEM
There are a lot of proposed solutions to our problem. Most will not work well because the nature of the problem is different from what most people have expected.
1. Substitution. We don’t have time. Furthermore, whatever substitutions we make need to be with cheap local materials, if we expect them to be long-lasting. They also must not over-use resources such as wood, which is in limited supply.
Electricity is likely to decline in availability almost as quickly as oil because of inability to keep up the electrical grid and other disruptions (such as failing governments, lack of oil to lubricate machinery, lack of replacement parts, bankruptcy of companies involved with the production of electricity) so is not really a long-term solution to oil limits.
2. Efficiency. Again, we don’t have time to do much. Higher mileage cars tend to be more expensive, replacing one problem with another. A big problem in the future will be lack of road maintenance. Theoretical gains in efficiency may not hold in the real world. Also, as governments reduce services and often fail, lenders will be unwilling to lend funds for new projects which would in theory improve efficiency.
In some cases, simple devices may provide efficiency. For example, solar thermal can often be a good choice for heating hot water. These devices should be long-lasting.
3. Wind turbines. Current industrial type wind turbines will be hard to maintain, so are unlikely to be long-lasting. The need for investment capital for wind turbines will compete with other needs for investment capital. CO2 emissions from fossil fuels will drop dramatically, with or without wind turbines.
On the other hand, simple wind mills made with local materials may work for the long term. They are likely to be most useful for mechanical energy, such as pumping water or powering looms for cloth.
4. Solar Panels. Promised incentive plans to help homeowners pay for solar panels can be expected to mostly fall through. Inverters and batteries will need replacement, but probably will not be available. Handy homeowners who can rewire the solar panels for use apart from the grid may find them useful for devices that can run on direct current. As part of the electric grid, solar panels will not add to its lifetime. It probably will not be possible to make solar panels for very many years, as the fossil fuel economy reaches limits.
5. Shale Oil. Shale oil is an example of a product with very high investment costs, and returns which are doubtful at best. Big companies who have tried to extract shale oil have decided the rewards really aren’t there. Smaller companies have somehow been able to put together financial statements claiming profits, based on hoped for future production and very low interest rates.
Costs for extracting shale oil outside the US for shale oil are likely to be even higher than in the US. This happens because the US has laws that enable production (landowner gets a share of profits) and other beneficial situations such as pipelines in place, plentiful water supplies, and low population in areas where fracking is done. If countries decide to ramp up shale oil production, they are likely to run into similarly hugely negative cash flow situations. It is hard to see that these operations will save the world from its financial (and energy) problems.
6. Taxes. Taxes need to be very carefully structured, to have any carbon deterrent benefit. If part of taxes consumers would normally pay to the government are levied on fuel for vehicles, the practice can encourage more the use of more efficient vehicles.
On the other hand, if carbon taxes are levied on businesses, the taxes tend to encourage businesses to move their production to other, lower-cost countries. The shift in production leads to the use of more coal for electricity, rather than less. In theory, carbon taxes could be paired with a very high tax on imported goods made with coal, but this has not been done. Without such a pairing, carbon taxes seem likely to raise world CO2 emissions.
7. Steady State Economy. Herman Daly was the editor of a book in 1973 calledToward a Steady State Economy, proposing that the world work toward a Steady State economy, instead of growth. Back in 1973, when resources were still fairly plentiful, such an approach would have acted to hold off Limits to Growth for quite a few years, especially if zero population growth were included in the approach.
Today, it is far too late for such an approach to work. We are already in a situation with very depleted resources. We can’t keep up current production levels if we want to–to do so would require greatly ramping up energy production because of the rising need for energy investment to maintain current production, discussed in Item (1) of Our Energy Predicament. Collapse will probably be impossible to avoid. We can’t even hope for an outcome as good as a Steady State Economy.
7. Basing Choice of Additional Energy Generation on EROI Calculations. In my view, basing new energy investment on EROI calculations is an iffy prospect at best. EROI calculations measure a theoretical piece of the whole system–”energy at the well-head.” Thus, they miss important parts of the system, which affect both EROI and cost. They also overlook timing, so can indicate that an investment is good, even if it digs a huge financial hole for organizations making the investment. EROI calculations also don’t consider repairability issues which may shorten real-world lifetimes.
Regardless of EROI indications, it is important to consider the likely financial outcome as well. If products are to be competitive in the world marketplace, electricity needs to be inexpensive, regardless of what the EROI calculations seem to say. Our real problem is lack of investment capital–something that is gobbled up at prodigious rates by energy generation devices whose costs occur primarily at the beginning of their lives. We need to be careful to use our investment capital wisely, not for fads that are expensive and won’t hold up for the long run.
8. Demand Reduction. This really needs to be the major way we move away from fossil fuels. Even if we don’t have other options, fossil fuels will move away from us. Encouraging couples to have smaller families would seem to be a good choice.
Intermittent renewables–wind and solar photovoltaic panels–have been hailed as an answer to all our energy problems. Certainly, politicians need something to provide hope, especially in countries that are obviously losing their supply of oil, such as the United Kingdom. Unfortunately, the more I look into the situation, the less intermittent renewables have to offer. (Please note that I am not talking about solar hot water heaters. I am talking about intermittent renewables added to the electric grid.)
1. It is doubtful that intermittent renewables actually reduce carbon dioxide emissions.
It is devilishly difficult to figure out whether on not any particular energy source has a favorable impact on carbon dioxide emissions. The obvious first way of looking at emissions is to look at the fuel burned on a day-to-day basis. Intermittent renewables don’t seem to burn fossil fuel on day-to-day basis, while those using fossil fuels do, so wind and…
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