A revolutionary report on the future of oil

In the debate over oil supplies, July 2007 may be seen as a turning point. The International Energy Agency, a body set up to advise OECD nations on energy supply and security, broke with its previous optimistic projections of world oil supply and threw the future of oil into doubt. The IEA’s recently released “Medium-Term Oil Market Report” (PDF 1.87MB) reads like a summary of peak oil concerns made acceptable for the ears of government by occasional disclaimers to the contrary. However, its central declaration is clear:

Despite four years of high oil prices, this report sees increasing market tightness beyond 2010, with OPEC spare capacity declining to minimal levels by 2012 … It is possible that the supply crunch could be deferred [by decreased demand growth] - but not by much.

As the chart above indicates, even if growth in demand is lower that expected, growth in oil supply nevertheless fails to meet growth in projected demand by 2011. If world demand growth is higher, then the oil shortages come sooner.

The chart above also shows a number of other interesting points. While considerable new supply should come on stream in 2008 (and lead to a temporary drop in fuel prices) there is less optimism for later years. Also, the growth of biofuels, while significant, is relatively limited. (When examining the chart, remember the world is currently using about 85 million barrels of oil per day [mb/d].)

It has been the habit of previous Medium Term Reports to assume that the OPEC nations will raise production to meet any shortfall in growth from non-OPEC suppliers. However, now this report declares:

Recent history would suggest that a conservative approach to OPEC capacity is justified.

Despite the declaration of caution, the IEA then makes assumptions of Saudi Arabian capacity that are not justified by its production performance over the past few years, including recent times when oil prices have been high and would reward maximal production.

As illustrated by an insightful comment on the website, www.theoildrum.com, the IEA assumes current Saudi capacity that is probably over 1mb/d greater than reality. Saudi Arabia’s declared ability to increase production is very important in the IEA’s growth projections for the next five years but in the contrarian peak-oil community there is considerable debate over the truth behind Saudi Arabia’s claims.

The IEA report is also quite upbeat about new refinery capacity coming online, especially in the Middle East and China, and the effects this will have on fuel availability - at least for everything other than shipping (see below). As the world’s easily extracted oil comes to an end, the "heavier" (more viscous), more "sour" (higher sulfur) grades remain. This oil requires greater processing by refineries before it can be used but world refinery capacity has recently be struggling to cope with demand due to decades of underinvestment. However, that is now changing:

The refining industry … has responded to market incentives. Investment in sophisticated refinery capacity is continuing apace … a significant improvement in refinery flexibility is foreseen.

Interestingly however, this increased refinery capacity shows that every silver-lined cloud has a black interior. At the moment, shipping uses heavy grade fuel oil that is cheaper than the lighter grades of oil more suited to gasoline and diesel fuel production. However, if the capacity exists to refine heavier oil grades into gasoline then:

The large discounts needed to clear surplus fuel oil production will become a thing of the past.

... we expect fuel oil markets to tighten significantly in the next five years. …the new, largely complex refineries will have low fuel oil yields, and upgrading capacity additions at existing refineries will further cut fuel oil production.

If this leads shipping to burn lighter fuel grades then the:

… potential for distillate markets to ease over the next five years would be dwarfed by the impact of [shipping] switching from fuel oil to distillate.

So increased capacity to refine heavier grades of oil into diesel and gasoline may ease supply for road transport for a while but may create its own problem by reducing the oil available to shipping and forcing them to compete for lighter grade fuels. In fact, it is hard to see how this will not occur if ship transport is to continue - which it must to support our globalised economy.

The IEA report is also especially notable for the damper it has put on expectations for growth in natural gas production. The Economist magazine and others have been optimistic that natural gas might substitute for a large fraction of oil production. But:

Not only does oil look extremely tight in five years time, but this coincides with the prospects of even tighter natural gas markets at the turn of the decade. … it is abundantly clear that if the path of demand does not change on its own, it may well be driven to change by higher prices.

In other words, prices of oil and gas will rise until sufficient demand is destroyed to keep them in balance with supply.

The IEA and peak oil

The IEA report is refreshingly explicit on the dwindling production from older fields and the peak oil idea:

Net oilfield decline rates average 4.6 per cent annually for non-OPEC and 3.2 per cent per year for OPEC crude. … All told, the forecast suggests the industry needs to generate 3.0mb/d of new supply each year just to offset decline.

But, unlike those who support the “peak oil” theory, the IEA is unwilling to give primacy to oilfield decline as the major factor determining the volume of oil produced over the next five years:

… Hydrocarbon resources are finite, nonetheless issues of access to reserves, prevailing investment regime and availability of upstream infrastructure and capital seem greater barriers to medium-term growth than limits to the resource base itself.

So the IEA sees geopolitical problems (for example, resource nationalism), escalating project costs and, especially, “slippage” (delays) in project completions as being more important in restricting oil production than decreasing oil production from maturing fields.

When talking about oil production in non-OPEC nations, the report admits that conventional crude oil production from these nations is declining and is only maintained at current levels by new, non-conventional sources of oil. However, the IEA then attempts (rather unconvincingly) to avoid declaring that non-OPEC oil production has peaked by saying that the definition of what is “conventional” crude oil changes with time:

Certainly our forecast suggests that the non-OPEC, conventional crude component of global production appears, for now, to have reached an effective plateau, rather than a peak. ... While there might be a temptation to extrapolate this trend, citing a peak in conventional oil output, a degree of caution is in order. Firstly, the concept of “conventional” oil changes with time, technology and economics.

OPEC is expected to provide an additional 4mb/d of crude oil by 2012, an increase of over 11 per cent from this year (and almost half of this increase is expected to come from Saudi Arabia which has recently shown falls in production - see also the preceding comment on Saudi Arabia).

Other points of interest in the report

Growing demand from China and other developing nations will be the central cause of “market tightness”:

The main driver of demand growth in Asia will be China ... Given the country’s booming economy, oil product demand is projected to increase by 5.6 per cent per year on average … roughly a quarter of the world’s annual demand increase.

But India’s role in the oil market is overestimated:

It is worth emphasising that, despite the similar size of their populations, India and China are not in the same league with regards to oil demand. The frequently quoted concept of “Chindia” is misleading: India’s demand will barely represent a third of China’s by 2012.

The report speaks surprisingly frequently of delays in both oilfield development and refinery construction due to a number of factors. For example, when forecasting production from new projects in non-OPEC nations, the report states:

Slippage varies between two and 36 months, but is typically around six months … shortages of labour, raw materials, fabrication and drilling capacity and transport infrastructure may continue to undermine output growth for some time.

The report is also notable for its pessimism (i.e. realism) about the potential of biofuels. The report’s authors sound very similar to peak oil advocates when warning of the potential for biofuel production to raise food prices and the effects this will have on poorer nations:

Such a lifting of agricultural prices could have far-reaching global economic effects - even excluding the moral issues related to food supply …

… The International Monetary Fund (IMF) warned in a recent report that global food prices had risen by 10 per cent in 2006, in part due to higher US demand for corn (for ethanol production). Demonstrations against higher corn prices were reported in Mexico, where it is a staple of the national diet.

… There are similar worries about the environmental impact of biofuels. Hailed by some as an easy way to limit carbon emissions, others have pointed at the scope for environmental damage. … forests are being razed for feedstock plantations, offsetting potential gains through carbon capture. … In many countries there is concern that increased corn production will put a significant strain on available water.

Concluding remarks

The IEA Medium Term Market Report is 82 pages long and contains much more of interest than I have summarised here.

The most pessimistic supporters of peak oil believe that decline of total world oil production is imminent. Indeed, I previously described how major figures in the industry such as energy investment banker Matt Simmons, oil entrepreneur T. Boone Pickens and retired National Iranian Oil Company Vice-President Ali Samsam Bakhtiari believe we are now at peak.

Nevertheless, the IEA Medium Term Report is refreshingly open and balanced in its approach to this most vital of topics. It is a further nail in the coffin for the irresponsibly optimistic future oil production scenarios painted by industry cheerleader Cambridge Energy Research Associates and the biggest of Big Oil - ExxonMobil. The publication of the IEA report means that the writing is now on the wall for all governments and industry to see.

Much higher oil prices can be expected within five years at best. Before this, a short, but deceptive, fall in oil prices may occur in 2008-9. It remains to be seen whether the political courage exists to openly discuss this issue and begin the painful process of weaning ourselves off oil. I am not optimistic.