The Oil Drum

This is the second (the first can be found here) in a series of guest posts by Robert Smithson, a portfolio manager at a London based investment fund.

Introduction

The world’s oil supplies are not unlimited. Unless the abiogenic theory of oil is correct, then reserves will one-day dwindle, and production will decline. New barrels cannot be “magic-ed” by some trick of economics. Extraction of any fossil fuel extraction is limited. Peak oil is inevitable. Of course, there is debate about when production hits its highs; it may have already happened, perhaps it will come in the next few years, and just possibly, it will be in 2020 or later. But make no mistake about it, we are not endowed with infinite amounts of the stuff.

Sceptics rightly point out that this bell has been rung before. In the mid 1980s, world oil reserves were forecast to last about 20 years; and yet here we are in 2007, with near record production levels. Historically, we have always found new sources of oil – in Alaska, in the North Sea, in the Gulf of Mexico, and off the coast of Africa – to satisfy our addiction. There are prospects in the future too: there may well be (very substantial) new discoveries in the Middle East, ultra-deepwater drilling holds promise, as does the development of new areas such as the South Atlantic, and increased enhanced oil recovery will certainly play a role. This misses the point: finding new oil reserves may push out peak production, but it does not invalidate the concept. Our planet does not contain an unlimited amount of oil.

Many – particularly on this site - argue that economics has little that is intelligent to say about peak oil. Yet the very definition of economics is the study of scarcity, and in particular, the study of the efficient allocation of scarce resources. What more relevant subject could there be for studying the effects of peak oil?

[editor's note, by Super G] From the contributor formerly known as thelastsasquatch.

Fossil fuels comprise the largest commodity markets on the planet. In a world facing an upcoming date when it will have used 50% of its oil (and natural gas), interest in energy futures will continue to increase. And, as energy becomes more precious vis-à-vis dollars, the activity in the futures markets, particularly for crude oil and natural gas, will have increasing impacts on society. Indeed, the amount of finite oil that can be financially controlled by a near infinite amount of money is enormous. The following is a basic primer on energy futures and will be one of several foundational posts linked to a longer upcoming story, "Peak Oil, Investments, and Diversification". I will outline the basics of an oil futures contract, and discuss the risks and rewards of investing in energy futures. The post will conclude with a discussion of the growing paradox between money and energy.

On December 28th, the Energy Bulletin included a link to a paper called Technology and Petroleum Exhaustion: Evidence from Two Mega-Oilfields (pdf) by two economists, John Malcolm Gowdy and Roxana Julia, from the Rensselaer Polytechnic Institute in New York. Here's the abstract.

In this paper we use results from the Hotelling model of non-renewable resources to examine the hypothesis that technology may increase petroleum reserves. We present empirical evidence from two well-documented mega-oilfields: the Forties in the North Sea and the Yates in West Texas. Patterns of depletion in these two fields suggest that when a resource is finite, technological improvements do increase supply temporarily. But in these two fields, the effect of new technology was to increase the rate of depletion without altering the fields' ultimate recovery - in line with Hotelling's predictions. Our results imply that temporary low prices may be misleading indicators of future resource scarcity and call into question the future ability of current mega-oilfields to meet a sharp increase in oil demand.

The paper is fairly standard fare for the peak oil community but what turns out to be of interest is the application of the work of Harold Hotelling regarding the Extraction of Exhaustible Resources and their discussion of the economic view of resource scarcity as regards oil. Examining the use of EOR technology in the historic production of Yates (West Texas) and the Forties (UK North Sea), Gowdy and Julia conclude that temporary incremental production gains are offset by later steeper decline rates in the tail end of production without increasing the overall URR. Their main conclusions are essentially that 1) oil is not being treated as a finite resource as the oil field analyses predict and 2) temporary production gains mask real scarcity and result in misleading low oil prices. Let's look at the work of Hotelling in the context of peak oil and see where that goes. This post runs a bit long so I hope you'll bear with me here.