World Watch

Planning For the Peak

You will never wake to the headline, "World Runs Out of Oil."

Rather, global oil production will rise, reach one or more peaks, and decline. Well before production declines to very low levels, the peak will mark a point of no return that will be a watershed in the economic history of the 21st century. For the first time, industrial economies will be forced to a lower-quality energy source. And this decline will affect every aspect of modern life.

The notion of a world speeding towards a peak in oil production was made famous by the geologist M. King Hubbert. In the late 1950s and early 1960s, Hubbert used a simple bell-shaped curve to forecast the annual rate of production in the lower 48 U.S. states. At a time when oil production was increasing rapidly, Hubbert forecast that it would peak in about a decade (1965-1970) and decline thereafter. Despite provoking nearly unanimous derision, his forecast was remarkably accurate. Oil production peaked in 1970 and declined fairly steadily thereafter. A similar bell-shaped pattern appears in several other oil producing nations, such as Norway, the United Kingdom, and Egypt.

Subsequent research indicates that Hubbert's forecast was part genius and part luck. U.S. oil production is determined by the costs of production, the price of oil, and the quantity of oil "shut in" by the Texas Railroad Commission, which aimed to stabilize prices by opening and closing oil wells in Texas to ensure a balance between supply and demand from the 1930s through the early 1970s. Had prices evolved over some alternative path or had the Commission controlled production using some other criterion, Hubbert's prediction probably would have been less accurate.

The element of luck has been overlooked by those who use Hubbert's method to forecast the peak in global oil production. Their forecasts have consistently erred, suggesting an imminent peak, only to be revised when production continued to rise after the predicted date. Hubbert's methodology cannot predict the peak in global oil production because it mistakes the price-induced slowing of oil consumption during the 1970s and 1980s for the effects of resource depletion.

The genius in Hubbert's approach stems from a simple aspect of his bell-shaped curve: relatively large uncertainties about recoverable oil supply have relatively little effect on the timing of the peak. For example, updating Hubbert's analysis through 2003 and including Alaskan production indicates that about 230 billion barrels will be produced from fields in the United States, which is nearly 30 percent more than Hubbert's original estimate of 171 billion barrels. Despite this increase, the timing of the peak "backcast" hardly changes. Put simply, compared to pessimistic assessments, optimistic estimates for the amount of oil that remains only postpone the peak slightly. Given this fact, I can confidently state that the peak in global oil production will occur in my lifetime (I am 48).

The peak in global oil production marks a fundamental change in supply. Prior to the peak, production can increase significantly with little or no increase in price. This is possible because most of the world's supply is found in a few very large fields. For example, there are more than 14,000 oil fields in the United States. Of these, the largest 100 contain nearly 40 percent of total supply. Increasing production from these large fields is relatively inexpensive. But once these large fields are depleted, they are replaced with fields that are one-tenth or one-hundredth their size. These high-cost fields reduce the profitability of production even at higher prices.

The importance of production costs is illustrated by the history of U.S. production. Oil production in the lower 48 states increased more than ten-fold between 1900 and 1970, but the real price of oil barely increased. After 1970, real oil prices doubled and then tripled. This price increase caused drilling to double. Nonetheless, production declined nearly 20 percent. As a result, the oil and gas sector increased its fraction of national investment without increasing its contribution to GDP -- in effect, hundreds of billions of dollars were flushed down a dry hole.

The economic effects of the peak go beyond spending more at the pump. Because oil readily comes from the ground and is easily refined, it generates a large "energy surplus," which is the difference between the energy obtained and the energy used to obtain it. The large energy surplus powers the non-energy sectors of the economy, such that goods can be imported and exported at little extra cost, people can live far from work, and a small fraction of the workforce can feed those that produce the goods and services we associate with modernity. All of this may change following the global peak in oil production. After the peak, each barrel of oil will require more energy to extract, leaving less to power the non-energy sectors of the economy.

No alternative fuel now being researched generates a greater surplus or can be used more efficiently than oil. This reduction in the energy surplus differentiates the peak in global oil production from previous energy transitions. As society changed from wood to coal and from coal to oil, each new energy resource was "better" than its predecessor. It could be used more efficiently and it generated a greater surplus.

This creates an additional difficulty for the inevitable transition away from oil. Alternative fuels can generate an energy surplus large enough to power the U.S. and world economies, but to do so the infrastructure for the alternative fuel needs to be larger than the current oil infrastructure. If 1 Btu (British thermal unit) of oil could be used to extract 50 Btu of new oil from the ground (which was the ratio at the U.S. peak), most alternatives currently produce 2-10 Btu per Btu invested. The infrastructure for such alternatives would need to be five to twenty-five times larger than the current oil infrastructure.

The expanded infrastructure requires a timely transition. If the infrastructure for the alternative energy source is put in place before the peak arrives, the energy used to do so will have a relatively small impact on non-energy sectors. Conversely, if society waits until the peak, constructing the large infrastructure for the alternative fuel will siphon large amounts of energy from the non-energy sectors of the economy at the very time that the total supply and energy surplus from oil is shrinking. In short, society has to pay the costs for the transition. We can pay them now, while we have oil in the bank, or we can pay them later, when our oil bank account is emptying.

Economists often assure us that the competitive market will induce the needed investments in a timely fashion. I am less sanguine. The markets' ability to anticipate the timing of the peak and the rate of decline is limited by a lack of transparency in the world oil market. Estimates from the Organization of the Petroleum Exporting Countries (OPEC) of its proven reserves are a mix of geology and politics. This uncertainty is critical because much of the oil produced between now and the peak (and beyond) will come from OPEC. As such, the market cannot know how much oil remains and therefore cannot cause prices to rise in anticipation of the peak.

The market therefore needs help to ensure that the entrepreneurial spirit will manage the transition from oil. But not the kind embodied in the Energy Policy Act of 2005. No serious person can believe that it will help. The current bill demonstrates that Republicans and Democrats have the same view of energy policy: they just give tax money to different groups. Sound policy should instead establish an economic environment that increases the economic returns and reduces the risk to long-term research and development on alternative energies. Policy should impose a large Btu or carbon tax on energy that is phased in over a long period, perhaps 20 years. This would signal entrepreneurs that there will be a market for alternative energies.

Furthermore, increases in the energy tax should be offset by reducing other taxes, such as payroll or corporate taxes. Economic studies show that such an approach can generate a win-win solution--reduce energy use (and the environmental damages not paid by users), stimulate research and development on alternative energies, and speed economic growth. Notice that the tax does not pick technologies--that will be left to the market, which is smarter than any politician (or economist!)

Government policy aimed at the next energy transition must strive for economic efficiency, but efficiency cannot be the sole criterion. The potential for large impacts may force policy makers to rely heavily on the precautionary principle (see p. 30), which compares the costs of being correct against those of being incorrect. We know that oil production will peak within our lifetime, we are pretty sure that market prices will not anticipate this peak, and we know that not having alternatives in place at the time of the peak will have tremendous economic and social consequences.

So if society does too much now to stimulate alternative energies, as opposed to later, there will be some loss of economic efficiency. But if society does too little now, as opposed to later, the effects could be disastrous. Under these conditions, doing too little now in the name of economic efficiency will appear in hindsight as rearranging deck chairs on the Titanic.

Copyright 2006 World Watch. All rights reserved.

Over the Peak

As oil prices soared from $24 per barrel in early 2003 to a peak of $70 per barrel in September 2005, the question being asked by experts and policy makers alike was whether we've "entered a new era," as Chevron Corporation CEO David O'Reilly has said, or just encountered a temporary glitch that will be corrected by market forces, as ExxonMobil President Rex Tillerson argued in a speech to the World Petroleum Congress last September. The most intriguing thing about this raging debate over whether oil production will soon peak -- and put an end to the go-go days of the petroleum age -- is that it's occurring at all. The fact that a century into the age of oil, and with the global economy dependent on $3 trillion worth of this black liquid each year, we don't know how much is left, is extraordinary.

It turns out that most of the forecasters who are responsible for the long-term energy projections on which private and public decision makers rely -- from Wal-Mart to the International Energy Agency -- have been on automatic pilot, assuming that whatever the future level of demand, the oil companies will be able to extract sufficient oil to meet it. You don't have to be a card-carrying member of the "peak oil" school that has gathered behind former Shell geologist Colin Campbell to see that this is a dangerous assumption.

One fact is undeniable: over the past decade, oil production has been falling in 33 of the world's 48 largest oil producing countries, including 6 of the 11 members of OPEC. In the continental United States, the world's oil pioneer, production peaked 35 years ago at 8 million barrels per day, falling to less than 3 million barrels per day now. Among the other major oil-producing countries where production is declining are the United Kingdom and Indonesia. Those who take a more sanguine view of the global oil prospect point to the 1.1 trillion barrels of "proven" reserves that are currently on the books of the world's oil companies -- equivalent to all the oil extracted over the past century, or more than 40 years of consumption at the current rate. Although those same figures appear in most official oil reports, it turns out that roughly three-quarters of the world's oil is controlled by state-owned companies, whose reserve figures are never audited and are based as much on politics as on geology. Many countries have added paper barrels to their reserves at times they weren't even looking for oil.

Since oil can't be extracted unless it is found, one of the most persuasive arguments that oil production is nearing its peak is that oil extraction has exceeded discoveries by a factor of three during the past two decades. This is clearly a trend that cannot continue. PFC Energy, an oil industry consulting firm, has recently analyzed these figures and concluded that non-OPEC oil production will peak within five years, and that OPEC production could peak within another five years. Chevron Corporation is among those that have argued that nearly half the world's exploitable oil has already been extracted.

The largest wild card facing the future of oil is the Middle East, where highly secretive state-owned companies have kept silent on the condition of their vast oil fields for the last 30 years. Contrary to the popular myth that their oil resources are so vast as to flow freely from the Earth wherever a hole is punched, papers published by Saudi engineers indicate that massive water injection and other forms of secondary recovery are now needed to keep the oil flowing. A handful of 30 to 50-year-old oil fields supplies most of the nearly 10 million barrels of oil that Saudi Arabia produces each day, and hardly any new fields have been discovered in the last two decades. Late last year, U.S. intelligence analysts questioned whether Saudi Arabia can even meet its near-term pledge to raise production modestly, let alone achieve the massive increases that many oil-consuming countries appear to be counting on.

Those who live by the crystal ball often end up eating ground glass, so I won't join those in the peak oil school who have predicted which month world oil production will peak. But there's one conclusion on which I'm ready to stake my reputation: the current path -- continually expanding our use of oil on the assumption that the Earth will yield whatever quantity we need -- is irresponsible and reckless.

The first step in getting off that path is to agree that far greater transparency is needed on the part of oil-exporting companies and governments. Just as commercial aircraft cannot land at international airports unless they meet accepted safety standards, and companies must meet accounting standards to be listed on stock exchanges, those who sell oil internationally should have their reserves regularly monitored by outside experts -- as is already required of the large private companies such as ExxonMobil and Shell.

On the question of what can be done to reduce dependence on oil, I part company with some of the peak oil advocates -- particularly those with an apocalyptic bent who are predicting an end to civilization as we know it. While it is undeniable that oil is central to the modern economy and that a peak in oil production would be a shock, human societies have created new energy systems before. And if we have to, we will do so again.

The same technological revolution that created the Internet and so many other 21st-century wonders can be used to efficiently harness the world's vast supplies of wind, biomass, and other forms of solar energy -- which are 6,000 times greater on an annual basis than the fossil resources we now rely on. Technologies such as solar cells, fuel cells, biorefineries, and wind turbines are in about the same place today that the internal combustion engine and electromagnetic generator occupied in 1905. These key enabling technologies have already been developed and commercialized, but they are just now entering the world's largest energy markets.

Thanks to a potent combination of advancing technology and new government policies, those markets are now shifting. Since 2000, world biofuels production has grown at an 18-percent annual rate, wind power at 28 percent per year, and solar power at 32 percent per year. During the same period, the use of oil has grown at less than 2 percent annually. Roughly $30 billion was invested in advanced biofuels, giant wind farms, solar manufacturing plants, and other technologies in 2004, attracting companies such as General Electric and Shell to the fastest growing segment of the global energy business.

As with everything from automobiles to cell phones, mass production is driving down the cost of renewable energy, which is beginning to attract the same kind of buzz that surrounded John D. Rockefeller's feverish expansion of the oil industry in the 1880s -- or Bill Gates's early moves in the software business in the 1980s. Indeed, in the last year, new energy technologies have been almost as popular with Silicon Valley venture capitalists as the latest Internet software. These "new renewables" now provide just 2 percent of the world's energy, but as the computer industry discovered decades ago, double-digit growth rates can rapidly turn a tiny sector into a giant. Brazil already gets over 40 percent of its light transportation fuel from ethanol derived from sugar cane, and studies in the United States indicate that this largest of all oil consumers could grow well over half its liquid fuels using advanced new technologies that are expected to be commercialized in the next decade.

None of this is to say that the transition away from oil will be easy. Energy prices are likely to rollercoaster in the years ahead, disrupting the world economy, and making it difficult to smoothly plan the development of alternatives. But crises often create opportunities, and the potential rewards from an energy transition are substantial indeed: creating whole new industries, particularly in developing countries; reviving agricultural markets and strengthening rural economies; and pinching off the money pipeline that is destabilizing the Middle East.

But there is another danger surrounding a potential peak in world oil production: the impact on global warming. Some have argued that a forced march away from oil will push the world economy into dependence on fuels that add even more carbon dioxide pollution to the atmosphere: oil shale, tar sands, and coal, all of which are extremely abundant -- and dirty.

That danger is real. High oil prices make it more economical to turn these carbon-based fuels into liquids, and if they receive heavy subsidies while the cleaner alternatives are starved, we may be facing an ecological crisis as well as an economic one. On the other hand, if rising oil prices give a serious boost to investment in energy efficiency, public transportation, biofuels, and other renewable energy sources, they could jumpstart the energy transition that is needed to solve the climate emergency now facing the world.

One point is inarguable: a century after the oil age began in earnest, humanity faces an historic test. Human ingenuity is one resource that won't peak -- but whether it can be mobilized quickly enough to surmount these challenges is not yet clear.

Copyright 2006 World Watch. All rights reserved.

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