Crude Operators
An Economics Lesson

Clive Bates (International Institute for Energy Conservation)

Part 1 - The end of oil
When will the oil run out? If you look at the predictions of 30 years ago, you might imagine that it would run out in 2010. But NOW, reserves stand at another 46 years, and that’s on a much larger base of production. By this we mean that if you divide all the oil that people think can be removed by the amount that gets removed each year, you end up with 46 years.

So how is this process actually happening? This diagram is a sort of conceptual view that we’re going to use to explain the concepts of oil reserves and resources. You can think of the outside box representing the RESOURCE of oil, which is how much oil there is actually in the ground. (And even that is a slightly vague concept because oil is a lot of different things, and you can go down to the very lowest grade oils - shale tars and so on). But there’s two dimensions to the resource - there’s how much of it is discovered (obviously there’s oil in the ground that hasn’t actually been discovered yet); and then there’s how much of it can be economically exploited - oil that you can get out of the ground at less than the price that you could get for it, ie profitably. There is also some oil that you know about, but which is too expensive to get out, so it basically is regarded as uneconomic. See Chart A.

When people talk about RESERVES - when they say that the reserves are 46 years - what they mean is how much oil has been discovered which can be withdrawn economically, at current production costs and current prices for oil. And that immediately gives you a clue as to how reserves can change, and basically keep up with production. Because what is economic, after all? Well, there’s two important factors affecting it.

First of all, there’s the technology that you use to get the oil out. And there’s been enormous advances in those sorts of technologies. For instance in the North Sea, it used to cost companies $16 for each barrel of oil that they get out - that would be in the early eighties. It’s now down to about $12 per barrel. And that’s for oil that is actually physically more difficult to get hold of. What’s happened in the North Sea is that there’s been amazing development of the technology, particularly the reduction of cost. So what’s happening there is oil is changing from being unexploitable to exploitable. Nothing is happening to the oil itself, but the reserves can change simply because the technology for getting it out of the ground is becoming more cost effective. And that’s a movement of the vertical dotted line to the right. Secondly, new reserves are always being discovered, and that’s pushing the horizontal boundary upward. Meanwhile, exploration technology is also advancing, and actually the time, risks and costs involved with exploration are coming down, enabling more exploration to take place.

So what’s happening is those two processes of more exploration and more cost-effective extraction technology are constantly pushing out the boundaries of the proven reserves.

I should just say one other thing about this, on what determines economic and uneconomic. There’s another factor at work there, and that’s taxation. What matters to the oil company is the revenue that they get for the oil, and that is what enables them to pay for the exploration, the drilling rigs, the seismic, and all the rest of it. So if you have a very punitive tax regime, or a steep tax regime, it means that getting the oil out of the ground has to be extremely cheap, for them to be able to sell it and still make a profit. So, what happens is that as you get into more marginal fields, there’s a temptation on the government of the day to slacken off the tax regime, and that’s exactly what we’ve seen - the tax regime for new fields in both the Atlantic and the North Sea is much less punitive than the early tax regime in the North Sea where the oil was relatively easy to get. That has meant that fields that perhaps weren’t economically viable once, are now viable because the Government is reducing ITS take from the field.

So governments have some say in where the vertical line is, according to the tax regime that they apply, and of course the more liberal they are - the more slack they are - with the tax regime, the less the taxpayer benefits, the more the company benefits, the more oil gets produced. So just something to bear in mind, that there is a policy lever there - it’s not purely technology.

The top left quadrant is referred to here as the ‘unproven reserves’, and the whole thing is referred to as ‘resources’.

Okay, so that’s basically a first sense of what this actually means, and it’s important to think of reserves not as a quantity of oil, but as an interaction between a quantity of oil and the technology for extracting it.

Now I just want to take that a little bit further, and explain how it can be that oil is just not going to go away. This is a slightly more elaborate version of the same thing. Now you can imagine this - imagine the big box (see chart B). Lets say the full thing is all the oil that there’s ever been, under the ground. The black box - it’s not to scale by the way, but the black box is the oil that’s been taken out. And the grey area is the oil that’s currently under development or under production. So that grey area is the active oil industry now.

What happens is that as that grey area gets closer to this dashed perimeter here, it sends a signal to the oil companies, possibly because the price is beginning to rise, saying, “develop new technology, and start looking for oil”. So, what’s happening here is this dashed frontier is getting pushed outwards by the dynamics of the current oil industry, and that’s why 30 years ago we had oil reserves of 42 years, and today we still have oil reserves of 46 years, and that process is likely to continue for quite a long time.

Now, as you push this dashed boundary upwards into more and more isolated areas, and to the right into more and more marginal fields where you need more and more advanced technology, you’d like to think that that’s going to push the costs up and therefore the prices up, and therefore there would start to be an effect on demand - if the price goes up, there should be less of it actually required. But unfortunately what seems to be happening is that the pace of technology development and the exploration technology is moving ahead of the price rises itself, and there’s actually a gentle downward trend in oil prices at the moment. But over time it’s likely that that sort of potential will be exhausted, and what will happen is the pressure from the current oil industry will find it harder and harder and harder to push out these boundaries of reserves into new, remoter areas, or into the top right area on the diagram - into the most marginal fields. And then we’ll see the cost of production starting to rise.

Which brings me on to my next point, which is, ‘how will the oil industry end?’ What’s likely to happen in the longer term, is that as these frontiers push into more and more marginal, more and more remote and difficult areas, and as the actual resources start to be exhausted, the price will start to go up, and this is how economists see the end of oil. As the price goes up, a few things happen. First of all, the signal to consumers is, “use less”. You know, “it’s more expensive, therefore use less.” There’s also a signal to those people who make the alternatives to oil, that says “look here, there’s a market coming”. The price that you’re comparing your wind power, or solar power, or whatever, with is actually going up, and therefore power that previously wasn’t cost effective, becomes cost effective. Okay, so prices go up. Even if the solar power itself doesn’t change in cost, more of it is viable, more of it’s cost effective. That is a stimulus to manufacturing, that in turn brings the price of the alternatives down.

What happens is this ratio of the oil price, which is essentially driven by the exhaustion of the resources, to the alternatives price, increases. What will happen is that oil will gradually, gradually be displaced by the alternatives, and will gradually start to fade away. I mean, there won’t be a day when somebody declares that the oil has run out - that just will not happen. What will happen is it will sort of gradually run down. It will be less and less attractive to withdraw it because the alternatives will be more and more competitive.

So this concept here of the ratio of the oil price to alternative price is really important, and it’s why it’s really important now to start to stimulate the alternatives industries, whether that’s renewables or energy savings-type investments, or other sort of efficiency-type investments, because the price of those technologies will ultimately be the undoing of oil, okay? And probably oil will never run out - there will always be a little bit used for petrochemicals or other sort of specialist niche products, but eventually the alternative energy sources will take over.

Okay, so that’s the end of my bit on the end of oil. Any questions?

Q - What’s the proportion of the use of oil for energy, and as a feedstock? Because presumably the feedstock won’t always be there.

CLIVE - I think roughly - somebody correct me - but I think roughly 80:20. It’s mostly energy. But the same applies to feedstocks. You know, there are alternatives to plastics. You know, if the raw material costs of plastic starts to rise, then that’s a signal to the people who make, I don’t know, hemp - whatever the latest alternative to plastic is - for them to start beefing up their production facilities. So the same kind of economic effects happen if the costs of these feedstocks start to rise.

Q - I was just going to say, I think you’re being very optimistic. Don’t you envisage that what might happen is oil starts to trickle off, and then there’s lots of civil wars between various countries, fighting for that last little bit.

CLIVE - Actually I think that’s business as usual with the oil industry. It’s not like it’s GOING to be a trend. And I think, actually, if oil becomes less important in the world economy, and other things become more important, then they’ll have wars over those things, instead. You’re right, this is probably an optimistic scenario, but I’m just trying to gee everybody up. Basically you can argue if you want to that the whole world’s fucked, but that’s not a good thing to say to a meeting like this!

Q - I saw what you were saying about this being a finite time. But the fact, when you said that the reserves increased, from 42 years to 46 years. Can you envisage a greater increase in the future, if you see what I mean - is that boundary going to be rolling?

CLIVE - That’s difficult to call, actually, because you have to make judgements about, first of all what will be discovered (although actually you can do that fairly easily), then you have to make judgements about what the future prices will be, and you have to make judgements about what the technologies will actually do. And I envisage if that whole process is left alone, that kind of 40-year horizon will continue for some time yet.

We’re not talking about anything particularly significant happening after 40 years because the reserves are at 40 years now. What I’m, in an optimistic sort of scenario, saying, is as this process advances, over an unspecified time period, the cost of pushing these dashed lines outwards, will get higher and higher, and that will create the signal - more of a signal - for the alternatives to come in behind it.

Q - Does that 40 years thing take into account, the growth in oil consumption - the consumption levels of oil are going to go through the roof, surely.

CLIVE - Right, that’s a good point, actually. When people quote oil reserves in terms of years, they’re actually talking about a reserves to production ratio. So you take the annual production, which is so many million barrels, and you divide that into the reserves, and you get how many years oil will last if it’s used at the current rate. If as you say, you expect oil consumption to increase as it has done over the past few decades, then that quantity of oil would run much quicker. But of course what would be happening at the same time as that grey area is pushing up against that dashed area, that dashed area is getting pushed outwards, and that’s where the basic engine of the oil industry is - in keeping, if you like, a bit of a distance between where we are today, and what’s identified as reserves. And historically, that seems to have been at around 40 years. That starts to get less if the ratio between what’s known to be there and extractable, and what’s currently being extracted, gets less than 40 years, and that’s a signal for them to start more exploration and develop better technologies.

Q - Somebody sent me this article where some analyst is saying that basically there’s going to be a problem with the technology not keeping up with the demand for oil, and there’ll be an oil shock quite soon.

CLIVE - Well, the jury’s out on that. I mean, the projections for future oil prices for say just 2010, which is fairly short-term, vary between $30 per barrel and $15 per barrel, and that’s like experts saying, “well, we haven’t got a clue, really”, when you’ve got that sort of range. But there are certainly people now predicting that this is going to get very hard to push this green envelope out, and the price effects we’re talking about are going to start cutting in. But then there are other people who say that this process, this technology process and this exploration process is far from exhausted.

Q - It’s like the west of Shetland oil field - that’s like a testing ground for deep-water technology - you know, one accident or a few years of trouble-free operation could make a real difference.

CLIVE - Yeah, if that technology’s proven there, then I suspect that will unlock a whole lot of other deposits which will move from being seen as uneconomic to being economic.

Q - But you might find also that it will be a bit erratic. You might find something like an accident occurring which may push people for a while, like the oil crisis, into other forms of energy, but oil might make a come-back, so you might find it going up and down a bit.

CLIVE - Yeah. And there’s - and this is grossly simplified again - the whole security aspect of oil and gas. You know there may start to be a lot more substitution of gas for oil, but then there’s the political concern that most of the oil reserves around Europe are either Russian or Algerian, so the oil might be cheap, but it’s from people that you don’t want to do business with.
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