OPEC, peak oil, and the end of cheap gas

By Alfred Cavallo | July 28, 2008

Since the beginning of the modern oil age in 1859, pessimists have warned that the oil wells would soon dry up or that oil production would peak and not be able to keep up with ever-increasing demand. Again and again, the pessimists have been proven wrong, often embarrassingly so, as science and technology have allowed more oil to be extracted from existing fields and from deposits in more challenging locations such as the Arctic and the deepest waters of the continental shelf. Indeed, oil production rates have increased, on average, by about 1.1 million barrels per day per year over the past 10 years.

But in many oil-producing nations, oil-field production really has peaked due to depletion of resources. This includes large producers such as the United States, Britain, Norway, Mexico, and Russia, and small producers such as Indonesia, Argentina, and Australia. Moreover, new oil field discoveries are generally getting smaller and more inaccessible.

Yet amid all the discussion about peak oil, one voice has been conspicuously absent, that of the Organization for Petroleum Exporting Countries (OPEC). OPEC’s position on the petroleum-resource question should be the decisive factor in this ongoing and seemingly inconclusive debate. The organization now supplies about 42 percent of the world’s petroleum and, unlike all other producers, OPEC members have quotas that are adjusted to insure that supply and demand are in equilibrium: If non-OPEC production were to either reach a plateau or begin to decline, OPEC producers would need to increase production substantially to meet ever-increasing world demand.

Oddly then, OPEC has been virtually silent on this issue. Their quiet refusal to comment cannot be due to lack of interest or expertise: OPEC now has its own research group that produces an annual World Oil Outlook and a Monthly Market Report that rival the work of any other energy forecasting group. Similarly, OPEC is certainly aware of the U.S. Geological Survey’s World Petroleum Assessment Project, which for the first time brought industry and government experts together to evaluate world oil and gas resources. And OPEC is surely cognizant of ExxonMobil’s projection of a non-OPEC production peak by 2010 and the extensive discussion of petroleum resources in trade journals and the popular press.

Thus, OPEC’s reasons for not publicly engaging in the peak oil debate must reside outside the rational business of drilling wells, building pipelines and refineries, and making market forecasts. Dissimulation or silence on the part of OPEC on these issues is a matter of prudence and subtle calculation.

Although they possess an immense treasure, all of OPEC’s members lack a significant military-industrial base, putting them at risk of being taken over by their larger, more powerful neighbors or ruthless global powers, who work behind the scenes through local cooperative factions or undisguised military intervention. Open admission of an imminent non-OPEC production peak would make their oil reserves that much more valuable and make these countries even more tempting prizes. (This pertains especially to the countries around the Persian Gulf–Iraq, Iran, Kuwait, the United Arab Emirates, and Saudi Arabia, where the largest, most accessible, and cheapest-to-recover proven reserves are located.) Each of these nations is well aware of the dangers of covert and overt foreign attack or interference.

Indeed, OPEC has a history of manipulating the oil market in response to political events. For instance, in 1973, OPEC raised oil prices by about a factor of four and embargoed oil exports to the United States in retaliation for U.S. support of Israel in the 1973 Arab-Israeli War. From 1985 to 1986, when Iran seemed about to win the war that followed Iraq’s invasion in September 1980, OPEC increased oil production to drive down the price of oil in order to pressure Tehran to end the war. Following 9/11, OPEC decreased production by up to 5 million barrels per day to stabilize falling prices. In 2003, OPEC increased production by several million barrels per day to compensate for lost Iraqi supplies following the U.S. invasion and occupation of Iraq.

This history–by no means thorough or complete–demonstrates that OPEC is fully capable of taking decisive action to increase or decrease the price of oil by adjusting its production levels to protect its interests.

At the November 2007 Third OPEC Summit, the Saudis claimed that their production capacity was 11.3 million barrels per day and that they were producing slightly less than 9 million barrels per day (See “The Third OPEC Summit: A Report from the Field.”) The official OPEC position is that prices are set on the open markets in London and New York. In a sense this is true: Daily prices are determined by short-term market forces such as bad weather or industrial accidents. But the long-term price band is determined exclusively by OPEC’s production relative to demand. Withholding nearly 2.3 million barrels per day from the market obviously supports the elevated price band that’s in effect today.

Since 2002, OPEC has increased its annual average basket price from about $24 per barrel to more than $125 per barrel–more than a factor of five. It has accomplished this increase with minor disruption in the world economy and without provoking significant retaliation from consumers. It’s a stunning achievement. The most recent world oil production statistics in Oil and Gas Journal are sobering: The world crude extraction rate has increased by 1.12 million barrels per day (for the first quarter of 2008 versus 2007) while the OPEC rate has increased by 2.1 million barrels per day, indicating a decrease in the non-OPEC production rate of about 1 million barrels per day. The largest OPEC increases came from Saudi Arabia, followed by Iraq, Angola, Kuwait, and Iran. Among non-OPEC producers, significant production increases in Kazakhstan and Azerbaijan didn’t compensate for much greater decreases in Mexico, Russia, and the North Sea. It appears as if non-OPEC production has reached a peak or plateau, and OPEC is in full control of the market.

Some observers hint that OPEC’s long-term objectives can be gleaned from its website. The paper “Who Gets What from Oil?” compares consumer gasoline prices in developed economies. As is well-known, Europeans have always paid high prices for gasoline because their fuel is heavily taxed. These high pump prices are an indication of the real worth of petroleum, but for many decades, most of this value has been captured by European governments. It would seem that prior to 2002, OPEC was virtually giving away its crude oil. Now, at least in the near term, it has every intention of obtaining more of the real value of its exports from consumer nations. Given that European consumers have demonstrated a willingness to pay a high price for personal mobility–and combined with increased demand for oil in developing economies–U.S. motorists should plan for gasoline prices much closer to European prices, or between $5 and $10 per gallon over the next two or three years. These price increases will be camouflaged by large fluctuations, but with a strong upward bias.

OPEC is also interested in maintaining stable markets and avoiding physical shortages that have a negative impact on economic activity and essential services in consumer nations because such disruptions could be used to justify military action against OPEC member states. Much higher oil prices reduce demand, and thus, the call on finite OPEC resources. (While petroleum consumption is relatively difficult to diminish, the higher prices of the early 1980s proved that there was a limit to what consumers would pay for oil.) Moreover, high oil prices give OPEC members much greater latitude in decreasing production, should the need arise, without crippling their own economies.

Considering all of these factors, it’s safe to conclude that the era of cheap oil is over, and that petroleum extraction rates won’t increase substantially above current values. The transportation sector, which overwhelmingly relies on liquid fuels, will need to move toward much higher efficiency vehicles and electrification. Heating oil will become unaffordable, and heating and cooling using heat pumps powered with renewable electricity will have to become the new convention. Modern industrial economies will adapt to this new regime–if managed correctly, a benefit to everyone in the long run.

Furthermore, high oil prices mean that natural gas prices will also increase dramatically. In many markets, natural gas prices (including liquefied natural gas) are contractually tied to those of crude oil, while in the United States the link is informal. Since it costs as much to discover and drill for gas as it does for oil, producers in the past have obtained approximately equal prices (per unit of energy) for both. Thus, U.S. consumers should expect the current price differential (about a factor of two in the United States) between these fuels to diminish or disappear in the immediate future. Coal prices have also begun to increase, although we shouldn’t expect near-parity with oil.

It’s also important to note that the rise in oil prices is equivalent to the imposition of a substantial carbon tax: In July 2003, the average U.S. gasoline pump price was $1.49 per gallon, while it’s $4.11 as of this July. The increase of about $2.60 per gallon is equivalent to a tax of $290 per ton of carbon dioxide emissions. There’s a distinct possibility that carbon emissions will be limited not by voluntary measures such as cap-and-trade, higher automobile fuel-economy standards, or legislatively imposed carbon taxes, but by market-driven price increases of finite petroleum resources.

“The Age of Expensive Oil” has finally arrived without large disruptions in the world economy, which is contrary to what many doomsayers predicted. They couldn’t imagine that a modern economy could adapt to peak oil and foresaw the end of the modern industrial state, the end of large cities, and a return to a simple agrarian lifestyle coupled with a massive decrease in world population. Instead, peak oil has arrived gradually, without fanfare, and without major financial upheaval. The fundamental cause isn’t primarily a limit on petroleum resources, but OPEC’s long-term strategic considerations.

This development is as unexpected as it is welcome. For while it’s appealing to believe that our addiction to oil will be cured by a sort of worldwide religious revival and the voluntary acceptance of limits on consumption, in practice, this is extremely unlikely. Far more certain is a market-based approach of gradually increasing prices to ration a scarce commodity and force consumers to take on efficiency, conservation, and new technologies as matters of extreme urgency.

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