Peakonomics: no country for old men

This article was first published in New Scientist, 16 August 2012.

In 2007 James Schlesinger claimed the intellectual arguments around peak oil had all been won. With global oil production flat-lining and prices surging towards their all-time high of $147 per barrel, the former US Energy Secretary declared “we are all peakists now”.

Five years on and global oil production has risen by 2.7 million barrels per day, prices recently slumped from almost $130 to around $90, and the sceptics are jeering “I told you so”. A recent and much-touted report by Leonardo Maugeri, an Italian oil executive, forecasts that far from running out of oil, this decade will see the strongest growth in production capacity since the 1980s and a “significant, stable dip of oil prices”.

So is that it then, panic over? Unfortunately any reasonable reading of developments in the oil market suggests otherwise.

The recent hysteria rests heavily on the rise and rise of shale oil production in the US, which was unforeseen and is certainly significant. After four decades of decline, US oil production turned in 2005 and generated the bulk of the global supply growth since then. But to brand this development a “paradigm-shifter”, as Mr Maugeri does, would be wrong.

Maugeri forecasts the shale oil boom will lead to an astonishing 4mb/d of additional US shale production capacity by 2020. By contrast the US Energy Department – not known for its pessimism – predicts US shale oil production will peak at just 1.3 mb/d in 2027. One reason Maugeri’s forecast is so high is that he assumes that production from existing shale oil wells will decline at just 15% per year, as the impact of fracking wears off, whereas figures from industry consultant Art Berman show decline rates on planet earth are around 40%.

Analysis by Bob Bracket of Bernstein Research shows similarly steep declines, and also that the average shale oil well takes just six years to become a ‘stripper well’ – producing just 10-15 barrels a day. As a result of such declines – far higher than for conventional wells – the industry must drill furiously just to stand still, and it is this treadmill that will limit future production growth. Mr Bracket’s research note concludes, “we still maintain the world will not find itself awash in oil (shale or otherwise) and thus we remain bullish on the long term oil price”.

It is distressing that Mr Maugeri’s report– now shown to be full of glaring mathematical mistakes and wholly discredited – got so much attention, while an excellent working paper by a team at the IMF received much less. It is also ironic that parts of the commentariat are turning against peak oil just as some economists – traditionally hostile to the notion – are coming round to it. Peakonomics, if you will.

The IMF Working Paper sets out to test the idea that the ten-year rise in the oil price can be explained by geological constraints. The team investigated an approach known as Hubbert linearization – after the father of the peak oil school of thought – which expresses mathematically the idea that oil becomes harder to produce, the less there remains to be produced. This is clearly right: why else would we be scraping out the tarsands if there were any easy oil left?

When the IMF team combined Hubbert linearization with a more conventional econometric model that allows oil production to respond to GDP and the oil price, the results were striking. By back-testing the model against the historical data, they found its oil production forecasts were more accurate than those of both peak oilers, traditionally too pessimistic, and authorities such as the US Energy Information Administration, which have generally been far too optimistic.

Their price forecasts were also far more accurate than traditional economic models that take no account of oil depletion, forecasting a strong upward trend that closely fits what has actually happened since 2003. “When you look at the oil price [over the past decade], the trend is almost entirely explained by the geological view”, said Michael Kumhof, one of the authors, in an interview.

The paper also slays the economics shibboleth that rising oil prices will liberate vast new supplies and vanquish peak oil. The team found that production growth has halved since 2005, and forecast that even the lower rate of growth will only be sustained if the oil price soars to $180 by 2020. “Our prediction of small further increases in world oil production comes at the expense of a near doubling, permanently, of real oil prices over the coming decade”, write the authors. In this context, shale oil is not a ‘game-changer’, but a sign of desperation. “We have to do these really expensive and really environmentally messy things just in order to stand still or grow a little bit”, says Kumhof, “it doesn’t mean the picture is all rosy”.

It is perfectly true that global oil production has not yet peaked, but it’s almost beside the point. The people who fixate on this need to wake up and smell the fumes we are reduced to running on. The IMF paper shows clearly we are supply constrained – as if it needed explaining. The oil price itself ought to be a clue: persistently above $100 per barrel, ten times higher than the lows of 1998-99. Spikes to $147 in 2008 and almost $130 this year continue to waterboard the economies of the West, with recessions now smearing into a generalised depression. These spikes and recessions are the inevitable consequence of the rising competition for limited supplies from fast-growing developing economies. Consumption among major oil producers such as Saudi Arabia is also soaring, cannibalising exports and reducing supply to the rest of the world. While global production rose in the five years to 2010, global net exports fell by 3mb/d, according to US geologist Jeff Brown. How much worse would you like it?

In the film No Country for Old Men, two lawmen come across the wreckage of a drug deal gone bad, with corpses strewn about the desert. The deputy remarks, “it’s a mess, ain’t it?”, to which the sheriff replies, “well if it ain’t, it’ll do til a mess gets here”. Likewise, if peak oil has not yet arrived, what I call the last oil shock certainly has. It’ll do til the peak gets here.