Our Petroleum Future: Better Than You Thought

This post is a follow up to my ticklish post on "The Ethanol Bust."

Readers may recall that the market for corn-based alternatives fuels is collapsing (the Wall Street Journal's article is here). This might seem kind of strange, when world oil prices are currently hovering around $90 a barrel. One might think that demand for oil would decline amid peak prices, and alternatives to fossil fuels would be enjoy increased attention. This doesn't appear to be happening.

Now, I'm no economist, but I've been an energy optimist amid all the recent doom and gloom over environmental depletion and global warming.

With that introduction, check out the November/December 2007 issue of Foreign Policy and it's hip contrarian piece by Vijay V. Vaitheeswaran, "Think Again: Oil" (by subscription):

Is the world running out of oil?

Hardly. The world has more proven reserves of oil today than it did three decades ago, according to official estimates. Despite years of oil guzzling and countless doomsday predictions, the world is simply not running out of oil. It is running into it. Oil is of course a nonrenewable resource and so, by definition, it will run dry some day. But that day is not upon us, despite the fact that a growing chorus of “depletionists” argue that we’ve already reached the global peak of oil production. Their view, however, imagines the global resource base in oil as fixed, and technology as static. In fact, neither assumption is true. Innovative firms are investing in ever better technologies for oil exploration and production, pushing back the oil peak further and further.

The key is understanding the role of scarcity, price signals, and future technological innovation in bringing the world’s vast remaining hydrocarbon reserves to market. Thanks to advances in technology, the average global oil recovery rate from reservoirs has grown from about 20 percent for much of the 20th century to around 35 percent today. That is an admirable improvement. But it also means that two thirds of the oil known to exist in any given reservoir is still left untapped.

The best rebuttal to the depletionists’ case lies in the world’s immense stores of “unconventional” hydrocarbons. These deposits of shale, tar sands, and heavy oil can be converted to fuel that could power today’s ordinary automobiles. Canada, for example, has deposits of tar sands with greater energy content than all the oil in Saudi Arabia. China, the United States, Venezuela, and others also have large deposits of these energy sources. The problem is that the conversion comes at a much greater environmental and economic cost than conventional crude oil. But the very same high oil prices that doomsters claim are a sign of imminent depletion also provide a powerful incentive for the development of these mucky deposits—and for the technology that will allow us to extract them in a cleaner fashion.

How about these high gas prices? Here to stay?

Don’t bet on it. High oil prices are the result of short-term mismatches between supply and demand, a relationship seen in all commodity markets. All it takes is another global economic hiccup like the Asian financial crisis for oil markets to shift out of balance, leading prices to soften or worse, just as they did in 1997.

The key variable to watch is the spare oil production capacity maintained by the Organization of Petroleum Exporting Countries (OPEC) cartel. For much of the past three decades, OPEC has been capable of pumping far more oil than it actually delivered to market, which helped it manage prices. In particular, Saudi Arabia used its cushion to act as a swing producer, flooding the market with its buffer supply when normal global output was disrupted, such as during the Iran-Iraq War and the first Gulf War. The price increases that have occurred with regularity during the past several years are chiefly the result of the Saudis’ allowing their buffer capacity to fall during the 1990s and the global failure to anticipate the growth in Chinese oil imports. To address the increased demand, the Saudis are spending tens of billions of dollars rebuilding their spare capacity, and an unprecedented wave of new oil—the result of investments made a decade ago—is now coming online in Russia, the Caspian, and West Africa.

If supply in Saudi Arabia and elsewhere surges, or if demand, particularly in China, falters, then the new price floor that many investors assume is permanent will look increasingly shaky. OPEC will, of course, seek to stabilize prices if other oil producers (or oil alternatives, for that matter) take off. But history suggests that the cartel cannot maintain perfect production discipline. Inevitably, some greedy members defy the leadership and cheat on their quotas, again undermining the future of sky-high prices.

How about the "Big Oil"? Are we being gouged by the petroleum giants?

Actually, no. Whenever the cost of a gallon at American gasoline pumps shoots up, politicians and energy activists claim oil companies like ExxonMobil and BP are fixing prices. Big Oil may appear all-powerful to the consumer, but in reality the major private-sector energy companies with the famous brand names are powerless compared with the OPEC goliaths.

The issue again is supply and demand. Unlike during the 1970s oil shocks, when most oil was sold through bilateral contracts, much of the world’s petroleum today is sold through sophisticated and highly liquid futures markets, such as the New York Mercantile Exchange. It is therefore difficult for firms to manipulate prices. And when there are suspicions of back-room dealings, market watchdogs step in.

It is true that the oil market is far from unfettered, distorted as it is by a host of subsidies and handouts. It is also true that a conspiratorial cabal does meet regularly behind closed doors to rig prices and supply. However, that cabal is not Big Oil. It is OPEC. Saudi Aramco, a charter member, holds 20 times the oil reserves of ExxonMobil, the biggest of the private-sector majors. In other words, the Western firms are price takers, not price setters.

In fact, despite the current spate of record profits, Big Oil is in big trouble. Oil-rich countries, such as Venezuela and Russia, are nationalizing their resources, just as Saudi Arabia and Iran once did. That means most of the world’s reserves, and all of the cheap or easily accessed oil sources, are no longer available to the major private companies. The Western oil firms are running out of their primary product, even though the world at large is not. And that is a development that could ultimately hurt consumers, because Big Oil is the only counterweight to OPEC we have.

Now, this query's the best: What about hybrid automobiles? Will hybrids save the planet?

Not quite. Imagine a world in which 100 percent of cars are gasoline-hybrids like the Toyota Prius, and you still have a world that is 100 percent addicted to oil. A partial move toward alternative fuels won’t ever be enough; the future actually calls for a radical shift in both new fuels and engine technologies. Condemning SUVs as environmental menaces misses the central problem: It’s not the size of the car that matters—it’s the fuel it burns. This year, two thirds of U.S. oil consumption—and half of global oil consumption—will be sucked up by cars and trucks. Reinventing the car is the only serious way to wean the world off oil. The advanced electronics found in the Prius are but the first, helpful step in the clean-car revolution now getting under way.

From Silicon Valley to Shanghai, inventors, entrepreneurs, and environmentalists are zooming ahead of Big Oil and Detroit. Today, it’s far easier for new start-ups to challenge the major automakers because key technologies are no longer jealously guarded in-house but outsourced around the world. While the auto dinosaurs dawdle, giants from other industries are investing millions to stake a place in the game. In fact, the car of the future may well be brought to you by Sony, Apple, or Intel. Perhaps it will even come from two teenage whiz kids working tirelessly in their garage on the Next Big Thing. What’s certain is that its day is near.

Vaitheeswaran's pragmatic in his conclusion. We can't live on black gold forever. There's a role for investment in new technologies, and political leaders can spur innovation with policies designed to level the playing field for new market entrants.

(I drive a Honda Civic, by the way, a vehicle that ranges around 30 MPG on the highway. Some analysts of hybrid technologies have argued that the fuel economy advantage of driving a Toyota Prius is neutralized on the freeway, when the electric motor component's not kicking-in to propel the vehicle. Driving a hybrid's a environmental fashion statement, an indicator that hybrid owners probably aren't economists themselves.)