A Distant Peak?

The Daily Reckoning PRESENTS: The Peak Oil theory is still widely debated…and our intrepid correspondent, Byron King, sends us this report back from the Offshore Technology Conference, where Exxon Mobile gave their take on the subject. Read on…

A DISTANT PEAK?

First, here is a fast summary of Peak Oil. “Peak Oil” is a shorthand way of describing a “peak” in mankind’s ability to extract conventional oil from the crust of the Earth due to certain absolute limits on the petroleum resource base. In other words, you cannot extract oil that does not exist or that has not been discovered.

The Oil Age commenced in 1859, ushered in by the establishment of the Drake well in Titusville, Pa. For the past 15 decades, people have been getting better and better at lifting conventional oil out of the ground. We have progressed to the point where, in the past two years, daily global oil production has hovered around 81-82 million barrels per day (b/d), plus the 3-4 million b/d of natural gas liquids and synthetic crude from Canadian tar sands. Hence you often read of current world oil output of about 85 million b/d. If you follow the production curve back over the years, you will see that oil output has risen steadily almost every year over the past century, with some interruptions by the Great Depression, World War II and, more recently, the Iranian Revolution in the late 1970s. But now, in the past year or so, it appears that world daily output has reached some sort of peak or plateau.

Exxon Mobil’s position is to disagree that the current state of affairs represents any sort of present or imminent “peaking” in world oil output. In fact, Exxon’s stated position is this:

“A peak in petroleum liquids production, resulting solely from resource limitations, is unlikely in the next 25 years. Predictions of an imminent peak based on [the methodology developed by Shell Oil Co. geologist M. King Hubbert] in 1956 do not adequately account for resource growth from application of new technology, knowledge and capability, which combine to increase recovery, open new producing areas and lower economic thresholds.

“Supplies from OPEC and non-OPEC countries, gas-related liquids and unconventional resources are growing. Furthermore, nations with the largest remaining resources produce under long-term restraints not envisioned in Hubbert’s method. The ultimate peak in petroleum production may result from factors other than resource limitations.”

Exxon Mobil (NYSE:XOM) forecasts an increase in demand for petroleum liquids from about 85 million b/d in 2006 to 115 million b/d in 2030, or average growth in demand of about 1.2 million b/d per year. Worldwide, over the next 25 years, the ability of the petroleum industry to meet this demand will depend, in great measure, on what Exxon calls “adequate access to petroleum resources.” This latter term includes ensuring that the oil industry has access to drill in areas not previously explored or exploited, such as geographically or politically isolated areas, as well as areas of deep water or extreme climate, that require the development of new technology.

Exxon Mobil challenges the Hubbert methodology on two fronts. Hubbert’s methodology rests on two interconnected assumptions. First, the methodology assumes that the size of the ultimate resource base can be known with some degree of accuracy. And second, the methodology assumes that the peak in production occurs when approximately 50% of that resource base has been extracted. According to Exxon Mobil, “An analysis of resource assessments and production history suggests that neither assumption is necessarily valid.”

First, “there appears to be a systematic bias that underestimates the size of the resource base by ignoring the future increase in recoverable volume.” That is, new petroleum discoveries, plus what is called “reserve growth” continue to add to the original resource base, thus pushing the extraction and decline curves out to future years.

Second, if the ultimate size of the resource base is systematically underestimated, it is not possible to state when 50%, or anything near that percentage, of the oil resource has been extracted.

The Exxon Mobil thesis is that Hubbert’s methodology worked when he applied it to the U.S. as an oil province, because the U.S. was extensively explored during the time period that covered Hubbert’s career. “Hubbert’s 1956 prediction turned out to be right; lower-48 U.S. production peaked in 1970,” just as he said it would, according to Exxon Mobil. But Exxon Mobil criticizes attempts to extend the application of what it characterizes as Hubbert’s “simple approach” to the entire world. And due to a misunderstanding of the Hubbert approach and its misapplication to a poorly defined world resource base, “a popular view has emerged that the world faces an imminent decline in global liquids production resulting from depletion of resources.”

Thus, according to Exxon Mobil, “the Peak Oil theory has raised questions about the future of the oil and gas industry, how resources are estimated, the current supply situation, the role of technology and other factors in determining future supply.”

Most previous estimates of a peak in oil extraction have been wrong, noted Mr. Vierbuchen. For the most part, these previous estimates “missed the concept of reserve growth,” which refers to the process by which the initial identified reserves of an oil province “grow” over time as new drilling and new knowledge make it apparent and quantifiable that there is more oil down there than was first thought.

There are numerous examples of new technology, as well as novel ways of thinking, that have and will in the future contribute to reserve growth. First, the more wells that are drilled in any region, the better the geological control over that region. More wells equals more knowledge of the exact types and depths of rocks, as well as subsurface structures and rock and reservoir conditions. This greatly facilitates expanding the resource base.

Second, new advances in seismic processing have given geologists better imagery of the subsurface. It is now possible to identify features that were formerly simply unknown and unknowable with previous technology. Even with older seismic methods, these features were indecipherable on the best of days. This new look from seismic processing facilitates improved reservoir modeling and better well placement.

In addition, new drilling techniques have enabled geologists and engineers to “extend” their reach, in terms of vertical depth and horizontal distance from the surface wellbore, and into certain identifiable “sweet spots” that were formerly the province of pure chance.

Once a well is completed, there are new methods to stimulate production, over and above classical pressure-maintenance techniques such as water flooding. These include new methods to fracture the reservoir rock and increase the surface area of rock face, from which oil can migrate toward the borehole. The new methods include advanced chemical mixtures that can dissolve the rock matrix, as well as enhance the oil recovery with chemicals such as “surfactants” that essentially wash the oil out of the rock pores.

In essence, the new technology that is expanding the petroleum resource base is a function of many truly novel scientific and engineering developments, coupled with economic incentive to apply resources to the unique problems of every oil province, and every oil field in that province. “There was never an age of ‘easy oil,'” Vierbuchen said, a statement with which almost every head in the room was nodding in agreement.

One of the greatest constraints on future oil production, according to Exxon Mobil, is the political fact that much of the world is essentially “off-limits” to exploration and production. These limitations vary from region to region and from country to country, but cumulatively, have a potentially large negative effect on future oil output.

In the U.S., large areas onshore, and essentially all of the offshore areas outside of the western Gulf of Mexico and parts of Alaska, are off-limits to new drilling. In the U.K., the government has just raised tax rates to an onerous level that will inhibit future exploration in the North Sea. Issues of resource nationalism in nations from Russia to Venezuela are making future investment by any but the national oil companies (NOCs) – or politically favored outsiders – problematic. War in Iraq is preventing almost any petroleum development at this time. Insurrection in Nigeria makes for tough going in that part of the world. And the list goes on.

At the end of the argument, however, Exxon Mobil is not stating that there will never be a peak in rates of oil extraction. Instead, the company is arguing that any valid predictive methodology should properly place that event 25 or more years in the future. Specifically: “It does not follow that there is unlimited potential for production growth, rather that the eventual peak in global production is likely to be much further in the future than is commonly suggested.”

Exxon Mobil also notes that “it is possible that the peak, when it occurs, may result from a cause other than resource limitation (e.g., government policies, lack of access to existing resources, competition from alternative energy sources, improvements in energy efficiency).”

So Exxon Mobil is not claiming that there is no Peak Oil problem. It is just a question of timing and time frames, and according to the world’s largest publicly traded oil company, the time for Peak Oil is not now or in the immediate future. To the extent that there is an oil supply problem anywhere on the near horizon, the Exxon Mobil view is that it derives from limited access to prospective regions and under-investment in exploration, development and other related extractive infrastructure. To the extent that prices are rising, it is because global demand for liquid hydrocarbon has been strong and growing, particularly in the developing world, and certainly in China and India.

Whether Mr. Vierbuchen and Exxon Mobil are correct or wildly incorrect about the timing of a peak in world oil production is something that many of us will probably live to see.

Until we meet again…

Byron W. King
for The Daily Reckoning
May 2, 2007

P.S. But whether Peak Oil is already upon us, or imminent within a few years down the road, there must and will continue to be massive, ongoing investment in every segment of the oil business. So for the next generation or two, the oil industry will be one of the most vibrant parts of the world economy.

And if you are not investing in the companies that will supply the goods and services to the oil industry, you are missing the boat.

Editor’s Note: Byron King currently serves as an attorney in Pittsburgh, Pennsylvania. He received his Juris Doctor from the University of Pittsburgh School of Law in 1981 and is a cum laude graduate of Harvard University. Byron is also co-editor of Outstanding Investments, and frequent contributor to Whiskey and Gunpowder. Whiskey and Gunpowder is a free e-letter that covers resources, oil, geopolitics, military history, geology and personal freedom.

We open the papers this morning and find the same two-headed dragon we have been watching for so many, many months.

One head proudly announces that not only is everything doing well – it is doing better than ever in history. The Dow hit a new record yesterday. The funds are flush with cash. Takeovers…Mergers and Acquisitions…new IPOs…are all headline news. Rupert Murdoch is bidding for Dow Jones; Microsoft (NASDAQ:MSFT) is working on a major purchase. Money…money…money! Deals…deals…deals…!

“It is glorious to get rich”, as Deng Tsaio Ping put it. And many people, all over the world, think they are bound for glory.

Meanwhile, the other head hangs down in despair. “Actual underlying conditions of the world economy continue to deteriorate,” it mumbles.

Larry Fink, CEO of Black Rock (SEA:BLR), a trillion-dollar fund management company, spoke out last week and said that all these mergers and acquisitions were going to cause ‘tomorrow’s problems.’ Why? Because they are all funded with debt. And lending standards for big, commercial deals have gone the same way as the lending standards for people buying trailers.

“Standards have deteriorated to a level that we never even dreamed we would see,” said Fink.

Almost on the very same day, the Bank of England said almost the same thing. Loose credit standards have, “increased the vulnerability of the [global financial] system.”

The Boston Globe helpfully provides more detail:

“Private equity firms are raising gigantic new funds, which in turn are buying companies on an unprecedented scale. The targets are bigger than ever, and the deals are gushing at fire-hose volume. But that isn’t just a function of all the billions raised from limited partner investors. Borrowed money is the real fuel driving an overheated market.

“I think of this as a debt bubble, not a private equity bubble,” says Kevin Landry, chief executive of the Boston private equity firm, TA Associates.

“Debt markets that finance private equity transactions have changed in three important ways. They are charging lower interest rates, reducing the premium normally charged for greater risk. They are lending more money for the purchase of an operating company, exceeding normal caps based on the cash generated by the acquired business. Finally, debt markets are reducing or virtually eliminating covenants and other rules that now make it almost impossible for private equity investors to default on loans used to buy companies.

“Got that? Low rates, more leverage, practically no conditions. How do you think that story is going to end?

“‘The reality is the markets are willing to provide extraordinary amounts of debt, almost indiscriminately,’ says Scott Sperling, co-president of Thomas H. Lee Partners, the big Boston private equity firm. ‘It’s hard to put these companies into default. I can’t think of the last time we had a real covenant in one of our deals.'”

In the financial deal business, it is still like the middle of the property boom, when householders practically couldn’t default, because lenders wouldn’t let them. As soon as they got into trouble, the lenders would give them more money.

Landry explained that in a deal his company made recently, he didn’t even have to make the scheduled payments. If he ran into trouble he could pay a ‘toggle payment,’ or ‘payment in kind,’ essentially borrowing more to make the regularly scheduled loan payment.

“‘How do you default?’ asks Landry. ‘You used to say, “Can I pay down enough of this debt so if a recession hits I can get through it?” Now it doesn’t matter even if a recession hits next week.’

“Investors stretching for yield are making all kinds of markets do strange things. Look at the subprime mortgage market to see how that practice can end badly. Private equity’s debt bubble could become another story with a very ugly ending.”

The bubble in subprime lending ended when the value of its collateral – housing – stopped rising in price. (But the property bust is nowhere near over – and subprime is the ticking time bomb under Wall Street.

The bubble in private equity financing will pop too when its collateral – ultimately, the stock market – ceases to go up.

Then, over-stretched lenders will go broke. A few high-profile hustlers, prosecuted for financial hanky-panky, will go to jail. And, like soldiers tripping over the bodies of their dead comrades, the survivors will have to find some other route to glory.

More news:

————–

Addison Wiggin, reporting from Charm City…

“Back in 1933, after having run on a platform of ‘sound money’ backed by gold, FDR made it illegal for U.S. citizens to own the yellow metal. It took 44 years for ‘citizens’ to regain their right to own it. Now the feds are at it again – just as many readers have feared.

“Monday, the Department of Justice issued a bench warrant for the largest online transaction service backed by gold. According to a press release, ‘A federal grand jury in Washington, D.C., has indicted two companies operating a digital currency business and their owners on charges of money laundering, conspiracy, and operating an unlicensed money transmitting business.’

“‘The indictment is reaching…’ says Kevin Kerr. ‘In my opinion, the underlying motive here is to create another hurdle for investors trying to move out of the ailing U.S. dollar and into other means of transacting business.'”

For more on this story – and to find out why one reader thinks this case could force the U.S. government to pay its debts in gold, see the latest issue of The 5 Min. Forecast

————-

And more views:

*** How time flies! It is already May – the 5th month of the 7th year of the 21st century. Who’d have thought?

We remember back in the 1950s…we wondered what it would be like in the year 2,000. Flying cars…regular commutes to the moon…we imagined all sorts of things that turned out to be farther in the future than we had thought.

What really changed in the last half century? Cars, airplanes, skyscrapers, golf, hamburgers, TV, air-conditioning, antibiotics, nuclear bombs – all the big things that shaped our lives had already been invented. What has been invented since then? Hmmm…the Internet?

We can’t think of anything else.

Of course, the Internet is changing the world. It is part of the reason real estate prices are going up faster in desirable resort locations than elsewhere – so many more people can live in these places and still continue working.

It is also changing the way we get information and ideas; never before have so many people had such ready access to so many bad ideas.

In today’s headline news is a report from New York, where Rupert Murdoch has just offered to buy Dow Jones. He’s offered a 65% premium over yesterday’s share price. Major shareholders are said to be considering it.

Elsewhere is news that the New York TIMES has sold it’s flagship building in Manhattan to a diamond merchant.

And everywhere traditional news media, in which the lies are printed on the pulp of trees, is giving way to the new news media, in which the drivel comes to you electronically.

Through no fault of our own, we have occasionally been the victim of news stories, in which the ‘news’ differed dramatically from what we knew to be true – often to such a degree that the reader would come away with the exact opposite of the truth. But what would you expect? The fourth estate is no less self-interested than the other three – and it is dominated by a class of people who are particularly dull-witted and lazy. Generally, they have ‘the storyline’ already in mind – because it has been written hundreds of times already – before they have ever taken a single note or looked at a single fact.

“But it’s really gotten a lot worse in the last few years,” explained a journalist friend. “The newspapers used to spend a lot of money on investigative journalism…to come up with facts that would keep readers interested. But now, they don’t want to spend any money on research or investigating. They don’t even want the facts, because they might interfere with the storyline. They spend all their money hiring pundits…”

*** Meanwhile, in London, global warming seems to be having a delightful effect. The trees are green. The wisteria is blooming a month early. The sun is out all day long. It is not spring at all; it more like midsummer.

The ocean is so warm, that icebergs are melting faster than ever. Dry areas seem to be getting drier.

Is global warming real? We don’t know…all we know is that it seems unusually warm and pleasant here in Europe.

“Winters have been milder than they used to be,” said a couple from Nova Scotia, with whom we lunched on Monday. We were in Paris. The flowers were out. The smell of blooming things was in the air. The sidewalks were crowded with tables. People were out…walking…sitting…sunning themselves in the parks.

*** And last night, we almost had a chance to sample urban poverty for ourselves, when we had a brief brush with the life of the homeless. Economists and investors should always remember to eat at regular intervals; otherwise, their blood sugar level is likely to drop to such dangerous levels that they will do something stupid. So it was, that upon entering our hotel, we got into an argument with the desk clerk and at midnight proudly marched out of the hotel in ‘high dudgeon,’ as they say…only to find ourselves with nowhere to stay.

We wandered the streets of South London for a while, wondering about the life of the homeless. How did they support themselves? Where did they eat? What did they do all day? They were beginning to bed down. A group of young bums spread out filthy sleeping bags under a bridge. An old man lay down on a piece of cardboard in a doorway, covering himself with newspaper. A mental defective sat in a dark corner, asleep, but still holding a cup and a sign: Please Help.

We considered the choices. We could lie down with the young whelps under the bridge. Or we could grab a piece of cardboard from a dumpster and join the old dog in the doorway. Or, we could just sit in a corner until daybreak…perhaps muttering to ourselves in order to look like we belonged there.

Instead, we checked into the Hilton…

———————