Monday, August 11, 2008

Oil Supplies to Rise

We consistently hear from oil bulls that we've reached peak oil as production can no longer keep up with demand. We discussed the demand situation here, but what about the supply? Have we reached a point where we just don't have enough oil to supply demand? In the short term we're close, but in the long term, with prices at these levels, productive capacity will grow. There are many articles that discuss how supply and demand work, but here let's take a look at past data for the oil industry to see this in action.

Below is a chart showing both the price of oil along with the number of exploratory wells drilled for the last 30 years:

Notice how high oil prices in the early 80s resulted in a strong incentive to drill for oil. As a consequence, supply increases, resulting in lower prices. Clearly, with the price of oil being so low from the mid 1980s to the early 2000s, there was little incentive to explore for oil, as profits were too low. This has resulted in the situation we are in today, with little excess supply. Since 2005, however, incentives appear to again exist for further exploration, and we an increase in drilling occurring.

At first glance, however, it appears that the number of wells drilled is still far below where it was during the 1980s. Could this be that we've run out of places to look? Not so. Digging a bit further reveals that as technology has improved, well exploration success rates have increased, as follows:

Throwing substitutes for oil into the mix (e.g. alternative energy), suggests a future for oil similar to the one we've seen in the past: high oil prices result in exploration that increases supply, and increases use of alternatives, as we've seen here. As such, the long term price of oil will decrease as supplies increase and demand declines.

5 comments:

Charles Morand said...

Saj:

Your analysis omits 2 critical points:

1) Yes, drilling and exploration technologies have improved, and their costs have also increased appreciably. In oil markets, it is the marginal barrel that sets the price, and the marginal barrel's price is currently being set in the context of oil that is increasingly costly to get to (e.g. off-shore, tar sands). You can't only look at the % of successful wells and leave your analysis at that. You have to look at the marginal cost of extracting oil from those wells, and that is most often determined by their location. On-shore, easily accessible large conventional fields aren't being found anymore - that supply base is exhausted. Yes, higher prices lead to more exploration...of marginal resources!

2) Yes, high oil prices eventually lead to demand destruction. However, I disagree with your assessment that emerging market demand will have a benign impact on the supply/demand situation globally. The IEA, a great source of energy stats, recently put out a forecast on this (http://blogs.wsj.com/environmentalcapital/2008/07/01/peak-oil-iea-inches-toward-the-pessimists-camp/). According to the IEA, emerging markets will account for 90% of incremental oil demand in the next 5 years, and your assertion that they will be able to reduce their absolute demand through efficiency gains is quite optimistic. If anything, most of these countries are already at the efficiency frontier in terms of car size and consumption per capita, so I'm unsure where you expect them to squeeze out more efficiencies with economic growth well excess of 5% annually in many of them.

Saj Karsan said...

Hi Charles,

1) The nature of the oil extraction industry requires high fixed-cost investments. At these prices, those initial investments are economically viable. However, as the supplies increase (as producers take advantage of these prices), the prices will come down. Left with sunk cost fixed investments, it is economically viable going forward for producers to continue to extract, even though the marginal cost of each barrel when considering the entire investment is high. The history of the oil industry is littered with this phenomenon.

2) Businesses and individuals in emerging markets have less capacity to absorb cost increases than do developed markets, as they don't have as much disposable income. Thus far, they have benefited greatly from government subsidies which have artificially propped up demand. These subsidies are not sustainable going forward. Furthermore, as technologies continue to emerge (thanks in large part to the high oil prices), both in more efficient oil usage, as well as alternative energies, these technologies will be employed in emerging markets as well, as energy prices are high for everyone, not just developed markets.

Charles Morand said...

Just so everyone knows, Saj and I continued this discussion offline and we now have a bet going on the price of oil in 5 years.

If others are interested in joining, Charles says pricier than today in 5 years, and Saj says cheaper.

Andrew said...

I realize this post is rather old, but I came to it via your post today.

Two thoughts. First, take a look at the production data http://www.bp.com/liveassets/bp_internet/globalbp/globalbp_uk_english/reports_and_publications/statistical_energy_review_2008/STAGING/local_assets/2010_downloads/oil_section_2010.pdf for the world over the last 5 years. Even in at peak oil prices the world as a whole was unable to bring on significant additional capacity. It is possible that if the oil price would have stayed higher longer more higher cost (oil sands) capacity could have come on line but it appears that from conventional sources were are supply constrained.

Second, in the 1980's, during the last oil price shock, roughly 30% of the oil used in the US was heavy fuel oil for electric power generation. Today that number is about 3% and those plants only run as a plant of last resort (i.e. the last plant called on hot summer days) Any increase in energy efficiency, in terms of power, should not lead to a significant drop in the oil price.

Saj Karsan said...

Hi Andrew,

No worries about the late comment. The good thing about this topic is that it never gets old!

I'll answer your two points:

1) You are right that there were no meaningful increases in oil production despite high prices, but this is because of the nature of extraction. You cannot increase production meaningfully overnight. It takes years of investment and exploration. You can see in the chart for the early 80's that the supply response (for exploration) did occur, but took years to bear fruit. You see that happening again today (on the right side of the chart).

Also, oil production is strongly affected by OPEC quotas, so production is kept low artificially. For this reason, I suggest looking at "proved reserves" as well. From the file you provided, reserves are up from 2009 over 2008, and the global reserve to production ratio (page 10) is higher than it's been in 25 years.

2) I agree that the purposes for which we use oil have changed since the last shock, but there's no reason to assume efficiencies can only come from power plants. Today, our use of gasoline for transportation makes up a much bigger portion of how we use oil, and so efficiencies there should make a bigger impact on our oil consumption.

This is happening. Demand for fuel efficiency is high, and car companies are responding with more fuel efficient cars. You don't have to rely on anecdotal evidence, however. While one cannot change their fuel consumption overnight, the number of miles per gallon continues to increase as consumers make fuel efficiency a priority in purchasing new vehicles. The data shows that this happened in the early 1980s, and it is happening again now.

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