The Shrinking Pie

Now that oil has settled into a more comfortable range--never mind that it is still double the price at which it traded in 2003--the controversy over Peak Oil seems to have receded, somewhat. Yet although we've gone months without a major headline on Peak Oil in the Wall Street Journal or New York Times, the idea of a Peak--a point beyond which global oil production will start to shrink, instead of continuing to grow--has been percolating into the public consciousness in much the same way that the Limits to Growth meme did in the 1970s. That's certainly good for those in the alternative energy business, because it underpins the energy security concerns that are helping to stimulate technology investment. Today's Wall Street Journal included two articles that ought to cheer up alternative energy investors, because they remind us that a strict geological peak in production isn't necessary to create serious constraints on the future oil exports necessary to meet growing demand in the US and Asia.

On the Journal's front page, we read about the squeeze that Iran's growing internal oil consumption is putting on that country's exports. Iran currently consumes a third of its own production, leaving 2.5 million barrels per day (MBD) available for sale to others. A companion article suggests that the combination of growing demand and stagnating production could end Iranian oil exports within 10-15 years. Nor is Iran the only exporting country with similar concerns. Indonesia has already become a net importer, and Mexico and the UK, at least, seem headed in the same direction over the next decade. The US Department of Energy's base-case forecast indicates total oil production rising from the current 84 MBD to nearly 120 MBD by 2030, with OPEC production increasing from the current 34 MBD to 45 MBD. But even if these optimistic projections can be achieved, world oil markets would tighten, as the pool of exporters shrinks, while the demand for imports goes up.

This is complicated by another key factor, illustrated in the Journal's report on the difficulties in developing a petroleum law in Iraq. Not only can the parties not agree on what constitutes an equitable allocation of oil revenues among Shia, Sunni and Kurdish areas, but they also apparently disagree on the future philosophy of development. And while these issues have received prominent attention, because of our understandable focus on the Iraq War, similar problems are simmering in Nigeria, and Indonesia has only recently resolved a low-level civil war in Aceh, with oil at its heart. These sorts of disputes amplify the political risk of oil projects in countries that are already problematic, and they remind us that the interests of the ultimate resource owners may be quite different from ours, as consumers.

While these two articles illustrate larger, generic problems in the industry, the occurrence of these problems in Iran and Iraq is significant in itself. Together, these two countries hold 250 billion barrels of estimated proved reserves, representing the second and third largest national reserves of conventional oil after Saudi Arabia, with roughly 20% of the world total. If Iran and Iraq aren't going to contribute materially to the required expansion of global oil exports, it will put that much more pressure on the Saudis and their desire to stretch out their production for many decades. It also puts more power in the handful of countries, including Russia, with realistic possibilities of growing their oil exports.

To what degree do current oil markets reflect this impending collision between export supply and the demand for oil imports? In theory, efficient markets "bake in" this sort of information. I'd love some reassurance on that from someone who currently trades the long-dated end of the oil market. From my own extensive but outdated experience in this area, I'm skeptical. I just don't believe that the market is moving based on abstract discussions like this; I see it driven primarily by near-term supply and demand fundamentals and the perceptions of how those are likely to shift over the next few years. And that's why I don't believe we can wait for the market to tell us it's time for alternative energy. Whether the future discontinuity is the arrival of a Peak, or simply the consequence of the trends we can see today, I doubt the market will forecast the crunch, any more than it foretold today's conditions four years ago.