Irv Mills: My Peak Oil Journey

For some time now I been intending to do a post about “My Peak Oil Journey”, describing how my understanding of Peak Oil has evolved over the years. I think it will fit nicely at this point in my series of autobiographical notes.

Throughout the history of this blog I’ve focused on three of the challenges we face: Climate Change, Peak Oil, and Economic Contraction.

I first became aware of climate change in the late 80s and had no trouble accepting its reality. I expected that nuclear fusion or possibly renewable power sources, especially solar, would take over from fossil fuels and solve the problem with ease. But things have not worked out quite so well.

Sometime in 2000 or 2001 I first heard of Peak Oil. Again, my initial reaction was that improved technology would solve the problem. But I was drawn back to the topic repeatedly and by the time I retired from Hydro One, I was convinced that this is not a problem we are going to solve. I retired with a very nice pension, but also a keen awareness that this pension was contingent on the continuing growth of the economy. And even that early on, my reading about Peak Oil made it pretty clear that continued economic growth was far from a sure thing.

My current understanding of the economy took much longer to come together, and is intimately intertwined with my understanding of Peak Oil.

In the early 2000s many people, myself included, had quite a naive understanding of how Peak Oil might play out. I think many of us thought of oil fields as big underground tanks, originally full of oil. In this view we’d be able to keep pumping oil out of the ground until one day it suddenly ran dry. We also thought that the demand for oil was quite inelastic and running out would cause a very serious disaster, quite possibly the collapse of industrial civilization.

There was a lot of speculation about the amount of oil that was actually left, and good reason to suspect that official estimates of oil reserves were artificially inflated. Both the privately owned oil companies and the OPEC countries had (and still have) much to gain from claiming that their reserves are larger than they are in reality. Some of the agencies estimating future oil use numbers based them solely on predicted demand, without considering the realities of the supply side at all.

Gradually, this way of thinking came around to a more realistic picture of porous rock formations saturated with oil and gas and capped with layers of impermeable rock. Drill through the cap rock and the oil (and gas) would start running out. With this more accurate picture came many inconvenient details which gradually, as events played out over the years, became more obvious.

The rate at which oil comes out of the ground is determined by the geology of each particular well, and is at a maximum when the well is new and declines as the well ages until eventually it is no longer profitable to operate the well, the costs of operation being higher than the small remaining production is worth. This happens before all of the oil is removed from the well. There are techniques such as water injection which can be used to increase the rate at which oil comes out of a well, but this may increase the decline rate so that the total production of the well is less in the end.

Discovery of new oil resources must make up for the decline of existing wells and allow for increased use of oil as the economy grows. For the last few decades this has not happened, and it appears to me that the production of “conventional” oil peaked around 2005. This was reflected in the increase in the price of oil from around $12 per barrel in late 90s to just over $140 per barrel in the summer of 2008. The price of oil goes up as demand exceeds supply or even if events make it seem that supply might soon be constrained. It seems that in the months leading up to the summer of 2008, both of those factors were involved in making the price of oil spike upwards.

Looking back on the effect of oil price on the economy, post 2008, it became clear that almost every recession since the 1950s had been preceded by a spike in the price of oil. It turns out that the demand for oil is not nearly so inelastic as some had imagined. When the price goes up we see what is known as “demand destruction”—economic growth slows and people find themselves short of cash, cutting back on discretionary spending and doing whatever they can to use less energy. If the price goes high enough, even conservation begins to look like attractive.

At the same time, the idea that there is no alternative to oil turns out to be a little too simplistic. As the price goes up, oil wells that have been shut down as unprofitable become profitable again. Alternative forms of oil, what is known as “non-conventional oil” (deep offshore oil, Arctic oil, fracked oil, heavy oil and bitumen from tar sands) which had previously been too expensive to bother with, also become economically feasible.

The demand for oil dropped off from 86.3 million barrels per day in 2007 to less than 84.5 in 2009, and the price dropped to just over $40 per barrel. As the economy recovered, non-conventional oil made up for the decline in production of conventional oil and total demand increased to over 99 million barrels per day in 2018. Higher prices 2010 to 2014 (peaking at over $100 per barrel in early 2014) no doubt drove developments in non-conventional oil, while at the same time slowing the recovery of the economy.

In that period (2008 to 2014) the idea of Peak Oil was alive and well. Lots of people were interested, there were numerous websites and books being published, and a variety of groups, (of which the Transition Town movement is probably best known) sprang up in an attempt to bring people together to prepare for what was coming.

And while overall global oil production kept growing, many oil exporting countries reached their production peaks. In a phenomenon described by https://en.wikipedia.org/wiki/Export_Land_Model”The Export Land Model”, this happened even quicker than it might have otherwise. As most such countries were experiencing growth in their own economies and improvements in their standards of living, so their domestic consumption of oil was increasing, leaving even less to export than could be accounted for by natural decline, and putting their balance of payments in an ever worsening situation post peak.

In the Middle East climate change brought on increased temperatures and droughts, making agriculture less and less feasible. And this was at a time when money to import food and jobs for bankrupt farmers fleeing to the cities were both in short supply. There is no doubt in my mind that both climate change and peaking of oil exports were factors in the so called “Arab spring”. But changing governments does little to improve the situation when there are real, fundamental problems that even the best government would be hard pressed to cope with. In general, everywhere in the world, there is growing disillusionment with new governments, elected to deal with economic and social problems, who turn out to be just as inept as the old ones, and just as much in denial about what’s wrong.

It was sometime after 2008 when I put together the missing pieces in my understanding of economics.

The first thing was to realize that it’s not really about money.

Money is just a convenient set of tokens—a medium of exchange, a unit of account and a store of value. Of course, a whole “meta” level of business, the financial sector, is based on money. But it’s vital not to lose sight of the underlying realities.

The second thing was to understand role of growth in the economy.

Modern economies run on credit. Money is created by the banks as debt and those debts must be paid back with interest. The extra money for the interest comes from yet more loans. This works fine as long as the economy is growing and the banks have good confidence that debtors will continue to pay back their loans, with interest. If the economy stops growing, or even if its growth slows down very much, governments, businesses and individuals who have taken out loans find themselves unable to continue making their payments and are forced to default on their loans. Too many defaults and the banks themselves start failing. So it is vital that the economy continued to grow.

The third thing is the role of energy in the economy.

The reason that debtors can pay back loans is that they used the borrowed money to set up enterprises that create more value than the capital and labour that are put into them. This surplus value can be used to pay off loans, with interest, and leave something as well for the owners of the enterprise. Or in the case of large companies, pay dividends to the investors. Conventional economic theory is pretty vague about where this extra value comes from. But when I read up on “biophysical economics” it became clear to me that the extra value comes from the energy inputs to the process, because the energy costs substantially less than the value it enables us to create.

That Wikipedia article I linked to doesn’t mention the two sources where I learned about biophysical economics: Energy and the Wealth of Nations by Charles Hall and Kent Klitgaard, and Life After Growth by Tim Morgan. Morgan also has a website with up to date information.

Extra value (wealth) coming from surplus energy was true to a limited extent even in the past when energy came in the form of food and was converted in mechanical form by human or animal muscles. Things improved somewhat when we learned to harness the mechanical energy in moving air (wind) and falling water. But with the invention of engines that could convert the heat of burning fuel into mechanical energy, things really took off. These engines could drive automated factories which could produce goods with a fraction of the human labor previously required. This started with steam engines burning coal to pump water out of coal mines, replacing horse powered pumps. What followed was the industrial revolution.

The economy grew as it never had before, and as long as abundant cheap energy was available, it continued to grow.

Throughout the history of fossil fuel use, we’ve used the lowest hanging fruit first—the easiest to access and the highest quality fuels among those. With the result that as time passes, the remaining fuels are harder to access and/or of poorer quality. This leads us to concept of Energy Returned on Energy Invested (EROEI), and the related idea of surplus or net energy.

Taking a typical oil well from the early twentieth century, the energy equivalent of 1 barrel of oil would have been used to get 100 barrels of oil out of the well. This gives you an EROEI of 100, and surplus energy of 99 barrels of oil equivalent.

Looking at present day corn based ethanol, to produce 1.3 gallons, it takes the energy equivalent of 1 gallon of ethanol. This gives you an EROEI of 1.3 and surplus energy of .3 gallons of ethanol equivalent.

This can be helpful in choosing the sorts of energy we should be using—early twentieth century oil wells are something we can only dream of today and the corn ethanol business is hardly viable without large subsidies. But there is more to it than that, because surplus energy is what drives the economy and makes economic growth possible. If you look at all the energy sources a country uses and calculate a weighted average EROEI, it can tell you quite a lot about that country’s economy.

As that average EROEI declines toward about 15, economic growth grinds to a halt and it becomes difficult to raise capital to start new ventures and to maintain existing infrastructure. Below 15 a modern industrial civilization quits working. Because this is a weighted average, choosing to produce more energy from low EROEI sources makes things worse while temporarily seeming to make them better. It has been estimated that the current average EROEI of the world economy is around 11. Of course some lucky countries are doing much better than that.

But because of our “lowest hanging fruit first” approach, EROEI continues to decline. Real economic growth appears to have stopped in the 1990s, with governments using clever new ways of calculating gross domestic product, and unemployment and cost of living statistics to make things look better in the short run. And low interest rate policies to encourage lots of borrowing and keep the economy growing, again, in the short run.

By early 2014, oil prices had topped $100 per barrel and it looked to many of us like the economy might fall apart again as it had done in 2008.

But then oil prices started to fall, bottoming out below $40 per barrel. Why the slump happened is not well understood, but it had been predicted by a few (notably Nicole Foss of the Automatic Earth) as yet another step on the way to Peak Oil.

There was a glut in oil supply from 2014 to 2017. Several factors contributed to this.

The first, no doubt, was the increase in non-conventional oil production, particularly tight oil in continental US, accessed through the “hydro-fracturing” process, commonly referred to as “fracking”. Contrary to popular belief this was not enough supply all of America’s demand for crude oil. But it did add about 4 million barrels a day to US oil production.

All the hype about fracking as a new source of crude oil and natural gas caused some people to conclude that Peak Oil was dead, and that any shortage of oil was a very long way in the future. Even President Obama announced that there was enough tight oil to last 100 years. In fact, nothing could be further from the truth. In 2017, the United States produced an average of about 14.2 million barrels per day, and consumed about 19.8 million barrels per day, with the difference made up by imports, changes in petroleum inventories, and petroleum refinery processing gain.

No doubt fracking has significantly decreased the amount of oil the US has to import. But this is temporary—the decline rates of fracked wells are much higher than those of conventional wells and most of the sweet spots in the tight oil plays have already been used up. Realistically, America’s supply of tight oil will likely run out early in the 2020s.

But even if there was enough tight oil and gas to last 100 years, fracking is a classic case of trying to use a low EROEI energy source (somewhere between 3 and 5, in this case) to keep an economy going. You might expect that this oil would be more expensive than conventional oil, but as we learned in 2008, high energy prices cause recessions, which should lead to over-production and lower prices.

Parts of this happened—oil prices certainly went down. But oil consumption continued to grow, by about 1.7% per year. Strangely, it appears that this extra energy did not result in corresponding growth of the US economy. It is a bit of a puzzle where the energy went, until you realize that fracking is a very energy intensive process (the “energy invested” part of EROEI). Fracking itself is the “gas guzzler” that was causing the growth in US oil consumption. This is what I call “energy sprawl”, where the extensive infrastructure and energy use required to make low EROEI energy sources work begins to dominate the economy and the landscape.

OPEC was initially unwilling to cut back production to bring the price back up, but in late 2016 an agreement to cut production was signed by many OPEC producers and Russia as well. At the same time, many other non-OPEC producers were experiencing natural decline.

The price of oil bottomed out just under $40/barrel in early 2016, bounced around in the $40s and low $50s, and then in mid 2017 started to increase pretty much steadily, as the glut began to dwindle. Today the price is in the high $70s/barrel and has topped $80 in the past few weeks. The glut is over and the U.S. government has quietly asked Saudi Arabia and some other OPEC producers to increase oil production by about 1 million barrels a day to bring the price down to a more acceptable level.

OPEC economies were hurt badly by several years of low prices and one suspects they will be only too glad to increase production. The question is how long they will be able to do so before the natural decline rates of their oil fields catch up with them.

The major oil companies were hurt by low prices too, and cut back on their investment on discovery in order to save money. This has left us in a very bad situation as far as oil supply goes over the next few years. Trillions of dollars would have to be spent on discovery to catch up with demand. It seems to some of us that there is no sweet spot where oil prices are low enough to keep the economy growing and high enough to make the oil business profitable.

In any case, it seems unlikely that there are actually sufficient oil resources out there even if we could find the money to spend on discovery. Beyond natural supply decline and reduced spending on discovery, we are seeing geopolitics playing a role in Peak Oil as well. Major oil producers like Venezuela are facing sanctions and internal economic chaos. Their oil industry is suffering as a result and production is falling off. If President Trump gets his way, something similar will likely happen with Iran. An overall peak in production will likely occur sometime in the next few years.

How will the economy respond to this? Not well, to be sure, but the specific details will include some surprises that are very hard to anticipate.

That’s my “Peak Oil Journey”, to date at any rate. No doubt there is more to learn. We’re pretty good at explained what just happened, but not so good at predicting what’s coming next. It always seems to involve something we just haven’t considered yet.

While I was following the story of Peak Oil, my life carried on and I tried to prepare for the challenges that lay ahead. Eventually this lead to me starting this blog and calling myself a “Kollapsnik”. More on that next time.

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