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 Kopits provides evidence that in fact the Demand view is no longer applicable today, so this whole story is wrong. Continue reading
There is a lot of confusion about which limit we are reaching with respect to oil supply. There seems to be a huge amount of “reserves,” and oil production seems to be increasing right now, so people can’t imagine that there might be a near term problem. There are at least three different views regarding the nature of the limit:
- Climate Change. There is no limit on oil production within the foreseeable future. Oil prices can be expected to keep rising. With higher prices, alternative fuels and higher cost extraction techniques will become available. The main concern is climate change. The only reason that oil production would drop is because we have found a way to use less oil because of climate change concerns, and choose not to extract oil that seems to be available.
- Limit Based on Geology (“Peak Oil”). In each oil field, production tends to rise for a time and then fall. Therefore, in total, world oil production will most likely begin to fall at some point, because of technological limits on extraction. In fact, this limit seems quite close at hand. High oil prices may play a role as well.
- Oil Prices Don’t Rise High Enough. We need high oil prices to keep oil extraction up, but as we reach diminishing returns with respect to oil extraction, oil prices don’t rise high enough to keep extraction at the required level. If oil prices do rise very high, there are feedback loops that lead to more recession and job layoffs and less “demand for oil” (really, oil affordability) among potential purchasers of oil. One major cut-off on oil supply is inadequate funds for reinvestment, because of low oil prices.
Why “Oil Prices Don’t Rise High Enough” Is the Real Limit
In my view, our real concern should be the third item above, “Oil Prices Don’t Rise High Enough.” The problem is caused by a mismatch between wages (which are not growing very quickly) and the cost of oil extraction (which is growing quickly). If oil prices rose as fast as extraction costs, they would leave workers with a smaller and smaller percentage of their wages to spend on food, clothing, and other necessities–something that doesn’t work for very long. Let me explain what happens.
Because of diminishing returns, the cost of oil extraction keeps rising. It is hard for oil prices to increase enough to provide an adequate profit for producers, because if they did, workers would get poorer and poorer. In fact, oil prices already seem to be too low. In years past, oil companies found that the price they sold oil for was sufficient (a) to cover the complete costs of extraction, (b) to pay dividends to stockholders, (c) to pay required governmental taxes, and (d) to provide enough funds for investment in new wells, in order to keep production level, or even increase it. Now, because of the rapidly rising cost of new extraction, oil companies are finding that they are coming up short in this process.
Oil companies have begun returning money to stockholders in increased dividends, rather than investing in projects which are likely to be unprofitable at current oil prices. See Oil companies rein in spending to save cash for dividends. If our need for investment dollars is escalating because of diminishing returns in oil extraction, but oil companies are reining in spending for investments because they don’t think they can make an adequate return at current oil prices, this does not bode well for future oil extraction. Continue reading