The Elephant in the Room: How OPEC Sets Prices and Limits Carbon Emissions
Alfred Cavallo is an energy consultant based in Princeton, New Jersey, and formerly was a physicist with the US Department of Homeland Security. He worked on nuclear fusion experiments at the Princeton Plasma Physics Laboratory, the Max Planck Institute for Plasma Physics in Munich, and the French Atomic Energy Commission in Paris. He later moved to the Center for Energy and Environmental Studies at Princeton University, working on indoor air quality and wind-utility system integration issues, including the analysis of compressed-air energy storage systems for intermittent wind power. In an attempt to understand how renewable energy can compete with fossil fuels, he became interested in resource limitations on petroleum and natural gas — and how those constraints affect US national security.
Despite a North American oil boom, non-OPEC crude oil production is approximately constant because new production roughly balances existing oil field decline. This situation allows OPEC, which has spare production capacity, to control the total global oil supply and therefore oil pricing. OPEC has raised crude oil prices by a factor of about four since 2002, reducing world demand. Thus, world crude oil production has been flat since 2005, and a major source of carbon emissions has been capped. This production plateau has been maintained in spite of significantly increased demand from China, India, and other developing countries. But governments in both developed and developing countries could reduce emissions more efficiently and fairly, and facilitate a much smoother transition to renewable energy technologies, by putting in place, for example, a zero-net-revenue carbon emissions surcharge regime, with all collected funds returned directly to consumers.
It is an ironclad rule for oil companies that petroleum is forever, and while old wells and fields may be exhausted and abandoned, a new giant discovery is always just over the horizon. The one exception to this occurred in 2004, when the Exxon Mobil Corporation with refreshing candor discussed oil quantitatively as a finite, limited resource1. In its report2 “The Outlook for Energy: A 2030 View” it stated that crude oil production outside the Middle East (from non-OPEC producers) would peak by 2010, remain constant for several years and then begin to decline. At the same time it noted that demand for liquid fuels would continue to grow and that it expected OPEC3 (Middle Eastern) producers to increase production as necessary to supply the market. Although unstated, it was evident that from this point on OPEC would fully control incremental supply and that prices could increase quite substantially. This would have profound consequences for the economies of the U.S. and the rest of the industrial world, as well as for those transitioning societies that hoped to follow Western patterns to increase their standard of living. Yet in spite of the alarming implications, the forecast was ignored by almost everyone, including governments, consulting groups and environmental organizations. ExxonMobil, however, based on this forecast decided that it would build no new oil refineries4 since increasing supplies of non-OPEC petroleum would not be available.
While the basis for this projection was never explained, it probably made use of data from the U.S. Geological Survey’s (USGS) World Petroleum Assessment 20005, which evaluated world oil resources using the best available science, engaging experts not only in government, but also in intelligence agencies, petroleum companies and petroleum consulting groups. It was by far the most credible study of its kind ever done. In addition, ExxonMobil may have modeled oil production using M. King Hubbert’s logistic growth curve-fitting approach (Hubbert, 1956; Cavallo, 2005). This is particularly well suited for a non-OPEC production forecast since for best results a reasonable estimate of total reserves is needed as input; other requirements for the applicability of this econometric model, including affordable prices for consumers and sufficient profits for producers are also met over a long time span. In contrast, most OPEC producers jealously guard information on their oil industries so that OPEC reserve estimates are somewhat uncertain. In summary, all the necessary data and tools needed to make a credible projection of non-OPEC crude oil output were available to Exxon Mobil analysts, as well as to other consulting (Cavallo, 2002) and research groups including those at OPEC6, once the USGS Assessment was released in April 2000.
It is now over seven years since the ExxonMobil projection was made, and well beyond the 2010 non-OPEC peak year given in the report. It is appropriate to ask many questions starting with the obvious one: Was ExxonMobil correct? As is well known, one of the great hazards of making short or long term forecasts, especially about the oil business, is that the future happens in ways that may make fools of the most astute and capable observers, to their enormous embarrassment, due to advancing technology7 or factors trivial or otherwise that were neglected or could not be imagined.
As it developed, ExxonMobil was correct about the peak in non-OPEC crude oil output. Based on data provided by the U.S. Energy Information Administration8, annual average non-OPEC conventional crude oil production increased by 16 percent over ten years, from 36.3 million barrels per day in 1994 to 42.1 million barrels per day in 2004, and then over the past seven years has remained very close to this level. Thus, non-OPEC production has indeed reached a peak/plateau, if somewhat sooner than predicted. Given all the uncertainty involved in making such an estimate, this result should be regarded as a major triumph.
The World Oil Industry: Non-OPEC Producers
To appreciate the profound significance of the non-OPEC crude oil peak, it is necessary to understand, in a general sense, how the world oil industry functions. Crude oil is the backbone of the petroleum industry; other liquids such as ethanol, biodiesel and natural gas liquids (petroleum liquids obtained as a byproduct of natural gas production), included in world oil statistics, have much lower energy content and/or much smaller resource base and will not be able to replace crude oil. Unconventional crude oil, that is oil derived from tar sands, heavy oil deposits or shale oil (produced using the newly developed rock fracturing technology), is much more difficult to extract and also has a small resource base and will only add marginally to world oil output. These other resources will probably prolong the plateau in liquid fuel production, but will not be a replacement for conventional crude oil.
Non-OPEC producers currently supply about 57% of the world crude oil demand. There are several different categories of non-OPEC producers: publicly or privately owned and operated companies (e.g. ExxonMobil, BP, Shell), national oil companies such as Pemex (Mexico’s state oil company) or quasi-national companies such as Petrobras (Brazil) or CNOOC (China National Offshore Oil Company). All of these very diverse organizations share the same objective: to find and produce as much oil as possible as quickly as possible, and to make as much money as they can doing so. There are no production quotas for any of these organizations, and indeed there is intense, cutthroat competition to find new oil deposits and begin extraction with deliberate speed. Profits are derived almost entirely from exploration and production, while refining and distribution of petroleum products are much less lucrative, so that there is an intense focus on successfully locating new oil deposits.
Clearly, given the market rules under which non-OPEC producers operate, a peak in non-OPEC production means that it is physically impossible for these organizations to increase oil production either from new conventional discoveries or using improved technologies to extract previously inaccessible conventional oil.
Non-OPEC Decline Rates: the Hidden Killer
Discovery of new fields is necessary not only to meet rising demand, but also to compensate for declining production in mature discoveries. New offshore fields found, for example, in the Gulf of Mexico or offshore Brazil, are often announced in press releases that are propagated around the world. Hydraulic fracturing of oil-rich impermeable shale has enabled significant extraction from such formations in North Dakota and Texas, and has been widely portrayed as a bonanza for the U.S and heralding a revolution in world oil production.
There is unfortunately an elephant, or perhaps a herd of elephants, in the room. What is never spoken about is that production from all these new resources is now just compensating for an approximately 7.1 percent per year decline of non-OPEC fields, according to a study published by the International Energy Agency in 2008. This corresponds to a production drop of about 3 million barrels per day per year for non-OPEC fields. Moreover, decline rates can be expected to increase as the large, easy to discover fields are exhausted and smaller, harder to find deposits are exploited.
Oil from unconventional deposits9 will not alter the situation substantially. Production from Canadian tar sands in 2011 averaged about 1.35 million barrels per day and has been increasing slowly; oil production from tight shale deposits in the U.S. (mainly Texas and North Dakota) is currently around 1.2 million barrels per day and is projected to increase to 4.2 million barrels per day by 2020. Yet even though U.S. oil production has increased by about 1.8 million barrels per day and tar sands production by about 0.35 million barrels per day between 2006 and 2011, non-OPEC oil production has remained essentially flat over this period. Thus, it appears that crude oil from these unconventional sources will only help to lengthen the plateau in liquid fuel production and not significantly increase the overall rate of production.
Increased extraction from these new resources should be compared to the minimum production decline of conventional crude oil over this same period (2012-2020) of at least 24 million barrels per day. Thus, while some oil companies stand to profit handsomely from these new reserves, market fundamentals remain unchanged.
In contrast, OPEC, which supplies 43 percent of crude demand, is formally committed, as described in its founding statue, to maintaining a stable market; this is something that non-OPEC producers cannot and do not worry about. OPEC keeps demand and supply in balance, and prices within a band that it deems reasonable. In order to accomplish this it will not only increase, but also will decrease production as needed. Each member country has a production quota which is based roughly on the member states’ proven reserves, as well as on many other factors such as need for revenue. However, these quotas are mostly for public consumption, and members may or may not abide by them since the only result that matters is a tranquil market.
OPEC always maintains what is termed “spare capacity,” which is the ability to add additional supply to markets on short notice in case of unforeseen developments. One recent demonstration of OPEC’s capability in this regard occurred following the loss of Libya’s output of 1.79 million barrels per day as a consequence of the Libyan civil war which began in January, 2011. By August, increased production from Saudi Arabia, Kuwait, Iraq, Qatar and the UAE had replaced the Libyan output with negligible disruption to the world economy. (Of course this implies that this much production was being withheld from the market to maintain high prices before the Libyan collapse.) In another example, OPEC decreased production by about 3 million barrels per day between July 2008 and January 2009 following the near collapse of the world financial system and the onset of the Great Recession; non-OPEC production was virtually flat during this period. Had OPEC not cut production, prices would have dropped to the low single digits, driving many non-OPEC producers to bankruptcy in the process.
Although never mentioned in discussions of oil prices today, the existence of spare capacity and control of marginal, or swing production gives OPEC control of the market price, or more properly speaking, the market price band. This is set far above the cost of extraction, which for OPEC oil is a few dollars per barrel.
It is important to note that day to day or week to week prices on commodity exchanges are influenced by all market participants. This includes businesses such as airlines or oil refineries that need to protect themselves from changes in prices as well as speculators who place bets on future price directions. For example, if a refinery has an accident, an oil tanker is attacked, or a there is a report of an excess of oil stocks in the U.S., speculators moving in or out of the market can immediately increase or decrease the market price. Longer term prices are set by the supply and demand balance controlled by OPEC10: too much supply on the market means prices will drop slowly but steadily, and too little supply means prices will rise. In either case there can be significant fluctuations within or outside the price band since there is no official cooperation between consumers (oil importers) and producers to balance the market. Indeed, price fluctuations can be viewed as an integral part of the price setting mechanism in that they help to mask the real reason for price increases.
The Oil Weapon: Unmentioned But Potent
To complicate matters still further, OPEC sets prices11 for geopolitical as well as economic considerations and never announces or explains its decisions. Nonetheless, one can make reasonable guesses about the motivation behind some short term price movements. For example, OPEC might not want gasoline prices to be an issue in U.S. presidential elections so would adjust production to insure stable prices for such events. Also, while certain OPEC members might not favor a nuclear armed Iran, even less desirable would be a U.S. or especially an Israeli attack on that country; unexplained higher oil prices — the oil weapon — are the perfect way to send a message. It could well be that the spikes in oil prices in 2007-2008 and 2011-2012 were directly related to the threat of an attack on Iranian nuclear facilities.
Finally, oil prices dropped significantly following the financial panic in 2008, not because OPEC was unable to decrease production sufficiently to support higher prices but perhaps because OPEC did not want to be seen as contributing to the strain on Western economies. This is all mere conjecture, but given the circumstances is the best that can be done. The important point to understand is that OPEC controls the market price band and is willing to use this to achieve its own economic and geopolitical goals.
To the average U.S. gasoline consumer, price signals are totally confusing over the short or intermediate term, while memory fails completely for long term trends, that is changes taking place over more than three to six month periods. However, it is precisely these longer term trends that are most relevant for understanding the second part of ExxonMobil’s forecast, that of increased crude oil production by OPEC.
OPEC’s Choice: Increase Supply or Increase Price
Once non-OPEC production reached a maximum, OPEC, contrary to what was stated in ExxonMobil’s report, actually had a choice. It could increase production, maintaining the prevailing price band; this was the expected and desired outcome. On the other hand it could limit its own production, keeping the market well supplied, but increase prices to bring demand and supply in balance. This latter course of action had and has many advantages. It requires minimal investment in new fields, conserves what is now obviously a finite resource, and allows income to rise much faster than from a production increase.
In addition, raising prices rather than production serves to put a cap on a major source of greenhouse gas emissions, and by encouraging the owners of other fossil fuel reserves to raise prices and thus reduce demand, reduces emissions still further. This is totally irrelevant as far as the petroleum industry is concerned, but of seminal importance for understanding how to persuade the world‘s consumers to reduce fossil fuel consumption.
OPEC chose to increase prices rather than production. World crude oil production reached a peak of 73.7 million barrels per day in 2005 and has remained near this value through 201112. In contrast to the peak in non-OPEC production, which is caused by real physical limitations in the ability to extract more oil, OPEC members, especially Saudi Arabia, Iraq, Iran and the UAE, are believed to have very large proven and undiscovered reserves and could increase their output significantly if they decided to make the necessary investments. OPEC production limits are consciously chosen rather than dictated by available resources, and have been of enormous benefit both to OPEC and non-OPEC producers as well as to the overall health of the planet.
Since petroleum is a fundamental requirement for a modern industrial society, raising prices is a delicate matter. Consumers would like prices to be as low as possible and based on the finding and extraction cost, which for the Middle East is well under $5 per barrel13. Resource owners would like prices to be set as high as possible, and based on what value is extracted from oil by the user. For example, it is well known that people everywhere will pay very high prices for personal mobility; gasoline prices in Europe are predominantly determined by imposed taxes, even today with crude oil prices about $105 per barrel ($2.50 per gallon of crude oil; with tax, gasoline prices of $8 per gallon in Europe). This demonstrates that much of the value14 is captured by European governments rather than the producers and indicates a crude oil worth of at least $250 per barrel ($6 per gallon).
In addition, abrupt price increases should be avoided since consumers and industry will need time to adapt, either with new technology or changes in lifestyle. Demand must always be restrained by gradual price increases, not by reducing supplies; indeed, the threat of a supply interruption must never be mentioned or in any way suggested.
It seems that OPEC began increasing prices in 2003, and has continued to do so since then (with a pause due to the onset of the Great Recession). In 2002, the year before the U.S. invasion of Iraq, the annual average OPEC crude oil basket price15 was $24.36 and OPEC spoke openly of increasing or decreasing its production to maintain oil prices within a band16 of $22-$28 per barrel. However, after the U.S. invasion of Iraq in March, 2003, mention of this approach became less and less frequent and finally disappeared completely.
The attack on Iraq halted oil production from that country, which at the time amounted to about 2 million barrels per day, most of which was exported. OPEC made up for the shortfall by increasing production (Cavallo, 2004); indeed, anything less would probably have been used as justification for retaliation and retribution. However, the invasion provided the perfect opportunity to begin raising prices, given the uncertainty and violence in the region that is the major source of the world’s petroleum; the average annual OPEC basket price increased by about 15 percent in 2003, to $28.10 per barrel; by December 2003, prices had risen to about $30 per barrel.
The U.S. was thoroughly preoccupied and distracted first by its successful invasion, and then by the intractable problems of a failed occupation. It appears that OPEC, far from being cowed into submission by the shock and awe display of overwhelming military force, took the opportunity to increase prices gradually. Using craft and guile, it orchestrated a masterful campaign of misinformation and pretended innocence. Between 2002 and 2012, the OPEC annual average basket price increased from $24.36 to about $105 per barrel, or about a factor of 4.3 (3.3 adjusted for inflation) an astonishing accomplishment. This far exceeds the rate of inflation over this period (approximately a factor of 1.3) and has had a relatively tolerable impact17 on the world economy; the gradual change has allowed consumers to adapt while the Great Recession has cut demand in the developed world.
Initially, industry analysts and commentators explained increased oil prices by saying that the markets were reacting to the unrest in the Middle East by adding a “war premium” or a “terrorist premium” or a “fear premium” onto prices18. There were even attempts to quantify this by conjuring up a sum to be added to what analysts thought the real price should be. There was absolutely no basis for such an assignment and any “premium” charge was in effect pulled out of thin air; one might as well have proposed a “leprechaun premium” to explain the escalating prices. At one point an OPEC spokesperson simply stated that he did not understand why oil prices were so high since the markets were obviously well supplied.
Most recently the favored causative agent cited by OPEC and others has been “speculators,” a brilliant choice given the terrible damage banks, hedge funds and other such financial buccaneers and their enablers have inflicted on the world economy. This is the perfect scapegoat, and serves to distract consumers, politicians and environmentalists from the OPEC managers controlling the market, as well as from the root cause of the problem which is the real limits on petroleum resources.
Anyone familiar with how oil markets function in practice should be able to see through such fantasy, yet this charade has been a complete success in that OPEC has remained nearly invisible and is virtually never cited in the news media as having anything to do with setting oil prices. Western and other non-OPEC oil companies will not challenge this narrative since they have profited enormously from it. Environmental groups and consumer organizations lack the expertise or the will to penetrate the misleading rhetoric from authoritative sources, and in any case are totally focused on the problem of climate change. To a casual observer it would seem that prices are indeed determined by what appears to be free markets since large volumes of oil are traded daily on commodity exchanges. These markets do serve useful functions, but setting the price band for oil is not one of them. There should be no doubt that OPEC can and does control oil prices based on what it regards as its own economic and strategic best interests.
The Climate Connection
OPEC’s decision to increase oil prices and thereby limit demand, rather than to increase production, has another important consequence: It puts a cap on a major source of greenhouse gas emissions and, by encouraging the owners of other fossil fuel reserves to raise prices and thus reduce demand, reduces emissions still further. The question is whether demand will continue to increase so the price hikes can be maintained, and whether there is any possibility of satisfying the increased demand from available oil resources.
Given the large and growing decline rates for non-OPEC oil fields, one should expect oil prices to have significant fluctuations and a strong upward bias. Yet there is another factor that puts still more pressure on prices, and that is increased demand in places like China and India. These two nations have a population of about 2.5 billion people and are moving rapidly to adopt more comfortable lifestyles. To understand what this means it is useful to compute how much oil would be needed to elevate their standard of living to a level enjoyed by Europeans (Table 1).
Annual Petroleum Supply Needed to Raise China/India Living Standards
To European Levels
|Average European Petroleum Consumption||~10 barrels/person/year|
|Final China/India Petroleum Consumption||25 billion barrels/year|
|Current India/China Petroleum Consumption||5 billion barrels/year|
|Increased World Oil Production Needed||20 billion barrels/year|
|Current World Oil Production||32.5 billion barrels/year|
Current world crude oil production has been nearly constant at about 74 million barrels/day (26.9 billion barrels per year), since 2005; it is clear that a world oil production increase of 20 billion barrels/year is out of the question. The world is indeed on the threshold of a fundamental transformation in energy consumption, but the primary driver has remained deliberately obscured.
Both China and India are diligently following Western development templates and seem completely unaware of the unfeasibility of the “business as usual” model. It appears that we are on a collision course not only with limits on petroleum resources but also with limits to conventional growth patterns fueled by increased oil supplies. China and India cannot consume petroleum at the same level as Europe much less the U.S. (average U.S. consumption is about 22 barrels per person per year.): the resource base just does not exist. (On top of this, Africa and Latin America are following this same path and hope to improve their standard of living in precisely the same way.)
This most certainly means that nobody will be able to consume petroleum or other fossil fuels, even at current, modest European rates, for much longer, and we will all be forced to adapt to significantly higher fuel prices. Fortunately, it does appear that while renewable energy supplies and new technologies19 are more expensive than fossil fuels, they are certainly affordable and will allow people to live comfortably; the world is not going to freeze in the dark without fossil fuels.
Running out of oil
OPEC is thus sensibly using increased prices to limit demand, a classic case of “demand destruction.” For all practical purposes, the world will never run out of oil: Price will be used to ration a scarce commodity, and there will be oil for sale at, for example, $500, or $600, or $800 per barrel. Moreover, natural gas prices are linked to oil prices everywhere outside the United States, so a similar process is taking place with this fuel.
It has become evident over the past decade that most consumers are incapable of voluntarily reducing their fossil fuel consumption, even when told that the stability of the Earth’s climate is threatened. It is therefore important to explore all possible means of motivating people to move away from fossil fuels.
It is generally agreed that a zero-net-revenue carbon surcharge is the fairest, simplest, and most effective way to reduce fossil fuel consumption. While there is strong resistance to such a surcharge, it should be noted that the $2-per-gallon price increase OPEC imposed between 2002 and 2012 is approximately equal to a carbon tax of $200 per metric ton20. This indicates another way to persuade people to move away from fossil fuels: immediate economic necessity due to high fossil fuel prices demanded by the owners of the resource.
While an effective carbon tax imposed by the resource owners is infinitely better for the climate than no tax at all, it is far from ideal. The resource owners in this scenario collect all of the revenues; a far better approach would be to recycle at least a portion of the effective tax to consumers, to subsidize new technologies. It remains to be seen whether politicians are willing to acknowledge resource limitations and use this as a justification to impose, for example, a zero-net-revenue surcharge21 on fossil fuels.
In any case, it may well be that in the very near future price increases dictated and collected by resource owners alone22 will be sufficient to move society toward a more sustainable economy and to avoid the worst consequences of our insatiable demand for fossil fuels.
A new approach to oil pricing and taxes
It appears that oil companies as well as automobile manufacturers, hedge fund operators and investment houses are aware of the immediate reality of finite oil resources. This scarce commodity will be rationed through prices set by OPEC, the owner of the largest and lowest-cost reserves. Higher prices will encourage the development of alternatives, such as new technologies and lifestyle changes. OPEC leaders seem well aware of the challenges they face and so far have carried out their strategy of price rationing with consummate skill. This set of circumstances also presents an opening for others who wish to limit fossil fuel consumption to mitigate climate change; hopefully, they can use the facts related to oil supplies and pricing to persuade citizens and, particularly, leaders of developed countries that they must deal with petroleum differently if they are to maintain an acceptable standard of living on a crowded planet.
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1 Warnings that the U.S. was about to run out of oil have a long and checkered history. To this author’s knowledge the oldest such statement came in 1874, just fifteen years after “Colonel” Drake’s first oil well, from a Pennsylvania geologist who projected that we would run out of oil by 1878 (Anderson, 1984). New oil discoveries in Indiana immediately voided this forecast, but similar warnings regularly occurred from this point on. Forecasts of scarcity would be followed by new discoveries and overabundance, a characteristic boom and bust cycle for which the oil industry became infamous. After the 1973 oil embargo stories of decline and oil famine became almost a cottage industry; end of oil proponents might be termed oil doomsters, eager catastrophists or anti-industrial romantics, describing or implying the end of civilization and mass destitution following the exhaustion of oil reserves. Until very recently such attitudes might be excusable since the mechanisms of petroleum formation, migration and accumulation were not understood and credible estimates of oil resources and reserves were lacking. It was only with the acceptance of the theory of plate tectonics and advances in geophysics, geochemistry and geology that a scientific approach to the problem became possible. As will be shown, we now have reasonable estimates of world petroleum resources that can be used to project the evolution of the oil industry with acceptable uncertainty; assuming that petroleum resources are infinite is not a justifiable input in any model of the evolution of a modern industrial society or of how carbon emissions are likely evolve.
2 http://www.exxonmobil.com/corporate/files/news_pub_eo_2010.pdf. This report is updated each year; the 2004 version is no longer available. On p42 of the 2010 version there is a plot entitled Liquids Supply versus Time (1980-2030); non-OPEC crude oil production appears to decline slightly after about 2004 but remains flat out to 2030. That world crude oil production has not increased since 2005 and that prices have increased substantially as well is not mentioned.
3 OPEC producers strictly restrict access to and control of their oil resources. International oil companies such as BP, ExxonMobil or Shell may be hired as contractors but are never allowed to take ownership of the reserves. This is the reason for ExxonMobil’s interest in the peak in non-OPEC production: for all practical purposes OPEC reserves are not accessible to non-OPEC companies.
5 http://pubs.usgs.gov/dds/dds-060/; U.S. GEOLOGICAL SURVEY WORLD PETROLEUM ASSESSMENT 2000 – DESCRIPTION AND RESULTS. The report provides estimates of the amounts of conventional oil, natural gas and natural gas liquids outside the U.S. that can be added to proven reserves between 1995 and 2025. The report does not analyze the implications of these findings and specifically states that these data can be used for additional environmental, geologic, geopolitical and environmental studies.
7 Hydraulic fracturing is an excellent example of a technology that was much more successful than most observers believed possible. It has certainly had a huge impact on the U.S. natural gas industry, but is unlikely to have a similar effect on the world petroleum industry.
8 See http://www.eia.gov/cfapps/ipdbproject/iedindex3.cfm?tid=50&pid=57&aid=1&cid=&syid=2008&eyid=2012&freq=Q&unit=TBPD. The EIA website is excellent and can be used to examine details of world crude and world liquids production.
9 http://digital.ogj.com/ogjournal/20140106?sub_id=LqhvjCW6dypr#pg50; Gaswirth S and Mara K, Bakken Three Forks Largest U.S. Continuous Oil Accumulatiion, 48-53; The USGS estimates U.S. total recoverable reserves of shale oil as 13 billion barrels. This should be compared to current U.S. consumption of about 7 billion barrels per year.
10 Current OPEC oil production figures are somewhat uncertain. See for example: http://www.opec.org/opec_web/static_files_project/media/downloads/publications/MOMR_December_2012.pdf, p53. Two sets of OPEC production data are shown, one from secondary sources, which are used by all those following the oil industry, the other from direct communication with OPEC producers; there is a differential of about 1.3 million barrels per day between the two sets of figures. Most of the difference is due to Iran, which claims about 1 million barrels per day more production than is recognized in secondary sources. This might indicate significant oil smuggling by Iran to circumvent the U.S. led campaign to restrict Iran’s oil sales and thus cripple its nuclear program. Ignoring this subterfuge allows the U.S. to satisfy domestic supporters of Israel while avoiding drastically increased prices resulting from an effective blockade which would damage the world economy. It is clear that what is of primary concern is the maintenance of an orderly petroleum market.
11 The OPEC basket price, available at www.opec.org, will be used as the benchmark (or standard reference price) in this discussion. The normally quoted WTI (West Texas Intermediate, Cushing, OK) price is no longer representative of world oil markets due to the rapid increase in unconventional oil production in North Dakota and the lack of pipeline capacity at the distribution point in Cushing, OK, depressing the WTI price artificially.
12 For the first three quarters of 2012 world crude oil production was about 75.5 million barrels per day (computed using the lower Iranian production figures). Non-OPEC production is virtually unchanged at 42.4 million barrels per day in spite of significantly increased shale oil production in the U.S. so that almost all of the increase in world crude oil extraction is attributable to OPEC.
13 Finding and extraction costs are much higher for new non-OPEC conventional and especially unconventional oil. While such costs are generally regarded as proprietary, information on oil and gas company acquisitions and asset sales is available in the Oil and Gas Financial Journal (www.ogfj.com). This indicates that proven U.S. conventional on-shore oil reserves are currently valued at about $20/barrel. North Dakota oil shale is profitable at a West Texas Intermediate (WTI) price of less than $60/barrel while Canadian tar sands requires a WTI price of $60-$100/barrel, depending on the extraction method used (information from OGFJ, July 2012, p 34). These figures should be regarded as for guidance only since there can be wide variations in profitability due to resource quality (“sweet spots”), advances in technology (especially for oil shale), operator skill and luck, and taxation and royalty regimes. Given the current WTI price of above $90/barrel it is clear that the oil business is immensely profitable for competent producers.
While OPEC profits are rarely discussed in the open literature, Iraq’s need for outside assistance in reviving its oil industry after decades of war and U.S. imposed sanctions has provided some indication of development and extraction costs in the Gulf. Foreign oil companies were invited to bid on contracts to restore and expand Iraqi production in existing fields or to establish production from new fields; these companies would not receive production sharing agreements, as is often the case, but would be rapidly reimbursed for their investments and receive a minimal fee for each barrel produced. Iraq will then sell the oil at the market price, currently about $105/b.
In 2009 a group led by CNPC (Chinese National Petroleum Company) signed an agreement for the development of the supergiant Halfaya field (4.1 billion barrel reserves) (http://www.ogj.com/articles/2010/01/group-signs-halfaya.html; http://www.ogj.com/articles/2009/12/shell--cnpc-groups.html; http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ai2RXfGm2.EU;). Development costs of about $7 billion will be reimbursed and a fee of $1.40/b paid for oil produced above a threshold of 70,000 b/d. ExxonMobil led a group that promised to expand production from the West Qurna 1 field (8.7 billion barrel reserves) with reimbursement of expenses (unspecified) and a fee of about $1.60/b. And BP won a bid to increase production from the Rumalia field (17.6 billion barrels reserves) from 1.05 million to 2.875 million barrels per day for reimbursement of expenses ($25 billion) and a fee of about $2.00/b.
Although the agreed-upon fees seem quite low, BP and ExxonMobil claim to be confident that they will achieve returns of nearly 20 percent (S. Harbison, B. Montalbano and L. Pugliaresi, Oil and Gas Journal, vol. 109.12, May 2, 2011, pp 24-36).
These contracts are notable for several reasons. The most obvious is the low fees allowed the oil companies, insuring that Iraq will retain almost all of the advantages of increased oil output. Another is that the overwhelming majority of these bids was won by non-U.S. companies, portending a minimal U.S. involvement in the revived Iraqi oil industry and in the Iraqi economy. The contracts also mandate a 25 percent local working interest in the projects, insuring that Iraqi personnel will be trained to eventually manage these efforts. While the capital expenditures are large, over $100 billion, relative to the increase in production they are perhaps one-fifth of what would be expended elsewhere on a per barrel per day basis, demonstrating the extraordinary low cost of exploiting Iraqi deposits. The specified increase in production, about 10 million barrels per day, is significant relative to OPEC crude oil production, currently about 30 million barrels per day. While this production level may never be achieved for many reasons such as political instability, security issues, technical challenges moving the oil to market or the desire to conserve resources, it is clear that in the near future Iraq will be a much more significant oil producer and a more important member of OPEC. Currently, Iraqi production has increased modestly from 2.45 million barrels per day (average, 2009) to about 3 million barrels per day (2/2013).
14 Who gets what from imported oil, November 2012; http://www.opec.org/opec_web/en/publications/340.htm.
16 A search of the Oil and Gas Journal (www.ogj.com) website for “oil price band” yields over 50,000 results, e.g.: http://www.ogj.com/articles/2003/12/market-watchbroil-prices-mixed-at-end-of-november.html. The target price band ($22-$28/barrel) is specifically mentioned, as is the “terrorist premium.” Bear Sterns oil market analysts quoted in the article seem mystified by high oil prices ($28.45/barrel), citing a terrorist premium of $2/barrel and other fears adding $4-$6/barrel as the cause. Note that the price band represents a very substantial variation of ±12 percent around a central value of $25/barrel. This gives some indication of OPEC’s willingness to tolerate large swings in price before adjusting production. As prices increase, the magnitude of the price variation increases proportionally.
17 The impact of this oil price increase is not well measured by the inflation rate. For example, higher income people can easily adapt to increased gasoline prices by buying a more efficient car or simply paying the greater price. On the other hand people trying to earn a living working for minimum wages are much more severely impacted, and a significantly larger fraction of their already small disposable income must now be spent for fuel. They generally drive older, less efficient cars and may be forced to commute longer distances from affordable housing to their workplaces.
18 A Google search of “fear premium oil prices” returned over 2 million results. A fairly representative article can be found at: http://www.chinadaily.com.cn/english/doc/2004-06/02/content_335812.htm. According to the article a fear premium of $10-$15 per barrel (or between $5-$12 per barrel, depending on the source), was in June of 2004 adding $0.36 per gallon to the cost of gasoline, then about $2 per gallon with crude oil at $42 per barrel. The story notes “Many oil industry analysts estimate that without the cloud of uncertainty posed by terrorists and the continued violence in Iraq, oil prices probably would be in the US$30 range. They say there's still plenty of oil available.” None of the stories indicate that prices might be deliberately set or manipulated by OPEC.
19 These new technologies include compressed air energy storage to integrate intermittent energy sources onto utility grids, heat pumps for heating and cooling as well as battery powered cars and plug-in hybrid cars.
20 Between 2002 and 2012, OPEC increased prices by about $80 per barrel, or nearly $2 per gallon (there are 42 gallons in a barrel). Each gallon of gasoline burned releases about 0.009 metric tons of carbon dioxide (see http://www.epa.gov/cleanenergy/energy-resources/refs.html), so a $2-per-gallon price increase is almost equal to a carbon tax of $200 per metric ton ($200 x 0.009 = $1.80).
21 One example of such an effort is the Boxer-Sanders bill proposed in the Senate. The bill is not an ideal approach to a surcharge but is a step in the right direction. See http://www.sanders.senate.gov/imo/media/doc/021413-2pager.pdf.
22 Allowing the resource owners to set the market price to limit consumption means these owners collect all of the profits. This makes it economically feasible for them to extract oil from increasingly fragile and challenging locations, such as the Arctic Ocean. The amount of oil available in such areas is small relative to proven and undiscovered conventional oil resources, so the world resource limits remain. However, the risk of environmental degradation increases significantly for extraction of these marginal reserves.
These contributions have not been peer-refereed. They represent solely the view(s) of the author(s) and not necessarily the view of APS.