The Oil Depletion Spiral

As geopolitical events in Iraq and Libya are once again dominating the headlines and putting the spotlight on the stability of the world’s most important oil producing regions, many are wondering what adverse effects such sudden disruptions to the supply of oil would have to the global economy.

It is pretty obvious that such sudden and abrupt disruptions cannot possibly be good. After all, the chorus of US energy independence and the re-emerging Iraqi oil exporting powerhouse ushering in the return of cheap oil and happy motoring again from mainstream media has been deafeningly loud. Rain on the parade, anyone?

What isn’t obvious, but nonetheless presents no less a challenge to our debt laden society still barely crawling out of the last recession seven years after it started, is another dynamic which has been quietly emerging in the past few years and which will assert itself in an increasingly forceful manner.

This dynamic is not obvious for a couple of reasons. The noise created by the new-tight-oil-and-gas-revolution meme makes many from the otherwise Don’t-just-sit-here-Worry crowd put off their guard in a euphoric slumber. Another reason is that the development of this trend is gradual but slow. Human minds are not well developed to detect slow motion changes. Another case of a frog in a pot of water slowly brought to a boil.

Key dynamics driving oil price and our oil based economy

Near future oil price and its economic impacts are inherently difficult to predict, as their interdependent relationship is complex and there are a lot of non-linear factors influencing both the supply and demand sides of the equation. The following are the key assumptions and drivers which will play a very important role affecting the overall outcome.

On the supply side of the equation:

  • Peaking global production. While oil production has been increasing in a small handful of regions – tight oil in the US and oil sand in Canada being the notable few, the overall rate of production globally has been flat to down since 2005. Conventional oil production, which constitutes about 95% of the world’s overall production, has been slightly declining.
  • Rising price floor. As the easy-to-get oil (i.e. the conventional oil) is being used up, it is increasingly more difficult, and, therefore, costly to find and bring to production the next marginal barrel. The cost of a new marginal barrel, likely coming out of unconventional oil such as tight oil, is somewhere between $100 and $130 (more than $110 for the major oil companies).
  • Ugly ROI leads to capex cuts. The oil majors have witnessed runaway exploration and production (E&P) costs in the past few years while production actually dropped. At the current price of oil which is below the price required to achieve positive cash flow under their current capital expenditures and dividend program, the majors are cutting back on E&P expenditures and some are selling off marginal assets. This will almost ensure that their oil production will fall even further in coming years.
  • Abrupt supply disruptions. While renewed turmoil in Libya would dash any near term hope of having their oil production restored to levels before the country became a ‘democracy’ thanks to Western divine intervention, the impact of such is manageable as the country is a small exporter relatively speaking. The same cannot be said if disruptions become serious in Iraq and spread to other major oil producing countries in the region. The dismal failure of the US foreign policy for that region – ‘humanitarian bombing’ being the latest example – certainly does not help the situation.

And on the demand side:

  • Price ceiling. At the current price of around $100 per barrel, the world’s major economies are barely crawling out of their recession. Absent any new fundamental drivers which will bring on a genuine recovery to our debt saturated economies, the price of oil our society is able to absorb without choking is estimated to be around $130 tops.
  • Global economies rolling over. The incomprehensible amount of liquidity injected into the financial system and zero interest rate policy orchestrated by the central banks of the world in an effort to stabilize the banking system have managed to sweep a lot of the dirt under the carpet for now. But it has done very little to revive the non-financial economy, and there are signs of regional economies rolling over in different parts of the world. The demand destruction brought on by another recession would bring down oil prices in a hurry, however briefly.

The oil depletion spiral

The confluence of the supply and demand factors, namely, the inability of oil producers to cap their cost of production and the inability of oil consumers to bear the high cost of oil beyond a certain price point, would likely result in our economies trapped by the dynamics of an oil depletion spiral, as depicted in the diagram below.

Oil depletion spiral

Depletion spiral dynamics:

  • Phase 1 – Production cuts. At $100 per barrel, the oil majors are cutting back on E&P, as the marginal revenue does not justify the marginal cost.
  • Phase 2 – Price Rise. As production decreases, price rises as demand remains constant, absent any economic catastrophe.
  • Phase 3 – Recession. Once oil price hits the price ceiling, economies choke and go into recession.
  • Phase 4 – Price collapse. Depending on the severity of the recession, oil price temporarily collapses.
  • Phase 1 – Production cut. Oil producers further cut production as price falls, further reducing supply.
  • Phase 2 – Price Rise. Price rises again as a result of decreased supply and when demand picks up again as recession recedes.
  • Phase 3 – Recession. Hitting the ceiling again.
  • Rinse, repeat.

This depletion spiral is bounded in a rather narrow zone by a price ceiling and a price floor. As the price floor creeps higher faster than the price ceiling is raised by the increase in our ability to absorb higher oil prices, this narrow zone is being squeezed tighter and tighter by the day.

In order words, the muddle-through economy is never far away from the shadow of another oil-shock induced recession. Any price reprieve from the collapse in oil demand will be limited and brief, as the price floor would simply cut off more supply.

Is this the end of the world?

No, of course it isn’t. Societies have experienced worse adversities in the past and have shown to be very resilient. The end of the cheap oil era will not be the end of the world; only the end of the way of life as we know it.

Just as people would stop (or be told to stop) watering their lawns during a draught, hopping into one’s SUV and driving 10 km to get a jug of milk, or commuting 100 km to and from work every day just would not make sense when gas hits $3 per liter at the pumps.  Economic factors alone would force behavior change, pure and simple.

Oil is and will remain for the foreseeable future a critical and irreplaceable resource for our transportation, agriculture and industrial needs. Some uses of this resource are critical to the functioning of our society while other uses less so. The transition of oil from being a cheap and abundant commodity to a less abundant and expensive one will necessarily force society to rationalize on how a valuable commodity should be utilized.

 

Peak oil

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