The End of Cheap Oil

Giles Tuffin on the future of the world’s oil supply.

Where will it end? From being below US$80 a barrel just last August, the price of oil has rocketed to well over US$110 per barrel for the first time since the onset of the GFC, a rise of over 30% in less than nine months. Whilst many of us simply moan at the increased cost of filling up the tank and others blame the civil war in Libya, few give thought to the possible ramifications of another oil shock and the potentially brutal impact on our lives. Besides the obvious uses of transport and other energy production, oil is crucial in producing everyday objects such as plastics, pharmaceuticals and detergents, and provides the basis for most fertilisers and pesticides which are essential for large scale agriculture. Almost every object around you right now either could not exist or would be inaccessible to you without cheap oil. In short, it is absolutely vital to our way of life, and without it, our globalised society would have to radically reform.

Whether the Middle East uprisings end peacefully or not is unlikely to make any difference to the price of oil over the next few years. A quick look at Brent Crude prices (the most common gauge for a barrel of oil) shows the price already soaring in 2008, only dropping as the world markets went into meltdown. Even now, whilst America and much of Europe are still in an economic slump, prices are again on a steep upward climb. Whilst some have blamed these high prices on speculation, this is essentially irrelevant – whether or not it’s true doesn’t change the amount you’re paying at the pump, and if derivative markets haven’t been significantly overhauled despite the GFC, they’re highly unlikely to be now. But are there other reasons why prices are climbing so rapidly?

The most obvious factor is the emergence of economic giants China and India, whose newfound wealth is creating huge new markets for almost everything. Many of these new products require oil for transportation, but it is specifically the market for cars which is stretching oil supplies. China alone is putting over a million new cars on the road every month, the vast majority of which are not replacing old models but are instead for first time buyers, and in India the Tata-Nano is available for less than $3000. Little wonder that demand has radically increased over the last decade.

Things are also tight on the supply side. Although oil continues to be found in significant quantities, it is nowhere near enough to keep up with global demand – and we are currently using three barrels of oil for every one we discover. Even the US military is worried, as they believe that current levels of infrastructure investment are simply not enough to keep up with supply requirements. In the 2010 Joint Operating Environment report (their annual study of possible global threats and events), they note ‘[a] severe energy crunch is inevitable without a massive expansion of production and refining capacity’, meaning that ‘by 2012, surplus oil production capacity could entirely disappear, and as early as 2015, the shortfall in output could reach nearly 10 Million Barrels per Day (MBD)’. In comparison, the entire world currently uses around 80 MBD, and the crisis in Libya has taken less than 2 MBD off the market.

Another obvious potential problem is further political strife in the Middle East. The five countries with the largest proven oil reserves are all situated on the Persian Gulf, and over a fifth of the world’s daily oil supply passes through the chokepoint of the Straits of Hormuz, making this 55 kilometre wide slice of water between Oman and Iran strategically vital. Tehran is aware of this, and in 1996 they occupied three previously uninhabited islands in the central straits, dramatically increasing their grip on the world’s most important oil shipping passage. Although America bases their entire 5th Fleet within the Gulf to ensure a reliable supply of oil, any whiff of trouble would certainly affect prices. And if Iran ever obtains nuclear weapons, you can be sure that markets will respond accordingly.

On top of this, the majority of the oil bearing areas on the Arab side of the Gulf are in minority Shia territory. Although history shows Persians and Arabs are not renowned for their friendly relations, recently Iran has been supporting disaffected Shia in Sunni dominated countries such as Saudi Arabia. The Shia have erupted numerous times during the House of Saud’s reign to protest against poor wages and conditions and to attempt to gain a bigger share of profits for what they consider as their oil. With current uprisings already shaking up the region and Iran providing support, it’s entirely possible that interesting times are ahead. Saudi Arabia is the lynchpin of global oil production, its supplies and production capacity dwarfing all others, and should trouble ensue then oil prices are guaranteed to skyrocket.

All of these possibilities are cause for concern, but the most significant potential problem is far greater – that the end of the Oil Age comes sooner than expected. Most oil companies predict an end to a cheap supply of oil around 2030.  However, this is premised on Saudi Arabia and the other OPEC states, the backbone of world oil supplies, being truthful about their reserves. Being a cartel, OPEC nations are limited in the amount of oil they are allowed to produce according to how large their reserves are, thereby keeping prices artificially high. Any attempt by a country to sell more than their quota sees the uber-producing Saudis deliberately increase production to such an extent that oil prices and profits plunge until the recalcitrant junior partner caves in, losing them vast sums as the Saudi’s lower their quota as punishment. But this system gives a direct incentive to overstate a nation’s reserves in order to be given a larger quota, meaning the world’s supplies may be greatly overestimated. This is particularly concerning in light of a document that was leaked to WikiLeaks showing communications between the US government and a senior Saudi oil executive, who claims that OPEC reserves are vastly overestimated. On top of this, it is worth noting that over half the world’s oil supply comes from only 100 fields, of which 98 were tapped before 1970, and the vast majority of which are in the Middle East’s OPEC nations. All this means the end of cheap oil may lie considerably closer than predicted.

And that’s where it gets scary. It’s one thing to experience a short sharp price shock which will certainly hurt the world economy but to which it will eventually adapt, it’s wholly another for prices to permanently skyrocket because the twenty years we thought we had to adjust the entire global economy turns out to be five or ten. Twenty years gives us time to develop new technologies such as fuel cells and electric cars – five means a global depression that would make the GFC look minute in comparison. It would also be catastrophic for the environment, as the only alternative cheap and quickly accessible energy source would be coal. With living standards dropping and businesses failing worldwide, few governments could resist the call for this short term fix, thereby dramatically increasing greenhouse gas emissions.

The best case scenario here is a prolonged period of stagnation, as lack of affordable transport means that worldwide trade grinds to a halt, millions become unemployed and non-food producing countries starve without the ability to import food. The worst case scenario is large parts of the globe descending into resource wars in an attempt to stave off collapse, though many countries such as Australia simply have no strategic petroleum reserves to use to fight such wars. By contrast, the US is thought to have enough to run its military at full capacity for over six months, and China has recently been rapidly expanding its own reserve.

Paradoxically, none of these scenarios mean that we’re actually going to entirely run out of oil any time soon. But what is unquestionably coming to an end is cheap oil. The oil we’re still discovering is far less accessible and more technically challenging than previous discoveries, as the explosion in the Gulf of Mexico proved last year. Unsurprisingly, deep sea or Arctic oil is more expensive to produce then land based wells, and these costs will be felt by the consumer. Even costlier is converting shale and tar sands into oil, both of which require considerable amounts of energy and water. Whilst wells in the Middle East are lifting oil for less than US $5 per barrel, turning tar sands into crude costs up to US $95 per barrel to produce. Coupled with rapidly increasing demand and stalling supply, this is going to make filling up your tank a very costly experience.

In short, barring a phenomenal technological breakthrough or some major policy shifts, the only way for the long run price of oil is up. With the entire world economy so dependent on this one increasingly expensive commodity, you’d think that most national governments would be keen to start moving away from oil and onto energy sources that, while expensive now, will ultimately prove cheaper in the long run – particularly if oil prices do suddenly and permanently spike. Unfortunately, most governments seem too afraid of a voter backlash to even consider introducing some sort of oil usage reduction policy, which is unsurprising when you consider how central it is to most people’s lives. This is particularly so in car focussed countries such as Australia, where a road trip down south or driving to the shops is virtually regarded as a birthright (or as former Labor numbers-man Graeme Richardson put it recently when commenting on the proposed carbon tax, ‘by the way, include petrol and you’re dead’). Nonetheless, the Conservative government in the UK recently suggested that the time had come to start the process of converting to a green economy, claiming that so long as oil was priced anywhere above US $108 a barrel, making the change will mean ‘the UK consumer will win hands down’. We can only hope that other governments around the globe will also have the courage to face the gargantuan task of weening us off our oil addiction.


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