Peak Oil & Gas, Energy Cornucopia, and Reality, Part I

Last week, my colleague Byron King wrote a two-part article entitled “Association for the Debunking of Peak Oil & Gas.” The article is a response to last week’s press release issued by Cambridge Energy Research Associates (CERA), which asserts that Peak Oil theory “falls down because of serious flaws in logic and application.” I highly recommend Byron’s article if you’ve not yet had a chance to read it.

In this debate, it may be tempting to join one camp as if it were a political party. All of us can fall victim to groupthink and rigid adherence to our preconceived notions. But the tone of this debate should not be “us versus them” in a battle of debating skills to determine the exact peak production dates of conventional oil and natural gas. Rather, we should consider how the dynamics of oil and natural gas markets would be revolutionized as the fuels upon which modern society depends become more and more scarce.

Where do I stand in the Peak Oil debate? From everything I’ve researched on both sides, I’m more inclined to agree with the “early peak” argument. Until we find another North Sea or Prudhoe Bay — something beyond this summer’s relatively untested, media-hyped deepwater Gulf of Mexico discovery — I remain skeptical. Looking at the major oil field projects under way around the world, it’s difficult to imagine lots of little wells ramping up production enough to offset the big production declines occurring right now at major wells.

Some extremely well-informed investors, including billionaires Richard Rainwater and T. Boone Pickens, are of the same mind-set. Leading hedge and mutual fund managers are long-term energy bulls, buying more energy stocks on each dip.

Geopolitical Tension Runs in the Same Direction as Energy Prices

CERA’s consistent forecast of “ample” future hydrocarbon supply always comes with the asterisk that “geopolitics is the unpredictable wild card.” The firm remains adamant about the presence of abundant, scalable underground reserves, claiming that access to the world’s largest oil field database gives it special insight into future production trends. But reserves data are very shaky and often subject to large revisions, and as such should be given far less weight than geopolitical factors in any analysis of future production. For an example of how much of a “guesstimate” most reserve data are, see the step change in reserve additions that many OPEC members announced after they indexed production to reserve size:

CERA’s analytical foundation rests on one similar to Keynesian economics. They both are too optimistic about human nature. They both assume that all actors, whether a state-owned oil company or an individual consumer, always act in a completely rational manner and live in a world of perfect information.

I think it’s important to distinguish between reality on the ground and the best-laid plans in a perfect world. It would be nice if the majority of the world’s proved oil and gas reserves did not rest under the sovereign territory of regimes that are unfriendly to the West. But they do.

When oil and natural gas increase in price, it’s amazing how perceptions about these vital commodities change from relative abundance to relative scarcity. Entrepreneurs will certainly increase production where they can. But OPEC members are in control of the vast majority of production and are not entirely driven by the free market. In my view, OPEC will expand production very slowly in areas where it can. It has every incentive to minimize reinvestment in oil production capacity and maximize the price it can extract out of the West.

In addition to Byron King’s response in Whiskey & Gunpowder last week, I recommend reading the response of a few ASPO contributors to CERA’s report, found at this link.

CERA Chairman Testifying About Reality and a Perfect World

The North American natural gas market provides a nice example on which to base hydrocarbon production forecasts. This is a market with practically zero geopolitical risk, so there are few aboveground impediments to the free market. CERA’s track record forecasting this market was not bad in 2004 after prices had spiked dramatically, but was way off the mark in 2001. That year, the firm had issued a forecast of a dramatic ramp in supply and very low prices by the year 2005, just four years later.

What changed from 2001 to 2004? CERA Chairman Daniel Yergin explained in an October 2004 testimony before Congress (emphasis added):

“‘The reason we are in a crisis is not that demand has surged, it is that supplies are stagnant. In the Lower 49 United States, we have not been able to increase gas production for a decade…

“‘There is strong evidence that simply adding more drilling rigs will not solve the problem, as it has in previous decades …North American natural gas productive capacity is not expected to grow meaningfully, and U.S. gas productive capacity, like oil, is now in permanent decline …’

“At the same time, North America is set for a large increase in gas demand to fire electric power plants. In recent years, almost 200,000 megawatts of gas-fired power plants have been installed, equal to one-fourth of the country’s total installed capacity in 2000. With these plants in place, demand for natural gas will grow steadily as economic growth inevitably pushes their usage higher. ‘With supplies unable to grow in the near term, power demand is squeezing price-sensitive industrial demand out of the market, with negative consequences for competition and employment in gas-intensive industries in the U.S. and Canada…

“‘Unfortunately, CERA expects that natural gas demand growth in the power sector will come at the expense of more constrained industrial sector consumption — what is described as “demand destruction.” Indeed, industrial consumers are already examining offshore locations for new plants…

“‘By contrast, many parts of the world are awash with gas ,’ he noted, ‘and outside North America, global natural gas reserves are growing. Projects are now under way to bring these new global resources to North America in the form of liquefied natural gas (LNG). And there are huge quantities of stranded gas in Alaska, and gas as well in the Canadian Arctic.'”

Since Yergin’s presentation, the free market has had two years to work. Operating margins (hence the incentive) for U.S. gas producers have been at super-normal levels over this two-year period. Yet this is the supply response to the high 2004 price environment:

CERA Whiffed on a 4-Year Forecast

Lastly, here is a final indication of CERA’s track record estimating natural gas supply a couple of years out (let alone 20 years out). Last year’s influential “Hirsch Report” (available free of charge), reports:

“In 2001, CERA stated, ‘the rebound in North American gas supply has begun and is expected to be maintained at least through 2005. In total, we expect a combination of U.S. lower-48 activity, growth in Canadian supply, and growth in LNG imports to add 8.95 bcf per day of production by 2005.'”

Not only did this 8.95 bcf per day in additional gas production fail to materialize by 2005 — production actually fell from slightly over 50 bcf per day to slightly under 50 bcf per day over this four-year period. Are we supposed to hold CERA’s 20-year forecast in high regard when it had difficulty looking out a couple of years?

Even with a surge in drilling activity between 2001-2004, Yergin acknowledged that it had only offset production declines. As he said in his testimony, “There is strong evidence that simply adding more drilling rigs will not solve the problem, as it has in previous decades.” Yet CERA doesn’t appear to factor the current global rig shortage into its forecast of abundant oil supplies just a few years down the road.

The global LNG market remains very competitive, so even if there is an enormous ramp in liquefaction capacity in the Middle East, it is more likely to be headed for Asian or European markets — markets that consistently pay large premiums for spot LNG. Just because “many parts of the world are awash with gas” doesn’t mean a global LNG trade will develop overnight, or over 10 years, for that matter. Again, when evaluating energy markets, you want to invest based upon reality on the ground, not the best-case scenario in a perfect world.

Good investing,
Dan Amoss, CFA
November 21, 2006