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The Largest Risk to the US Economy Today is an Oil Shock – Awareness of this Risk is Minimal

Steve Kopits, Managing Director of Douglas-Westood consulting firm, made a presentation called “Oil, the Economy, and Policy” to the US House of Representatives Energy Subcommittee recently that I thought was interesting. I this post, I explain the presentation a bit and give my views related to it.

I was impressed that Steve was able to make a presentation to this group. (Steve later clarified that his presentation was really the subcommittee staffers–but they are very important too. They are often the hands-ons people in drafting legislation.) He sent me the presentation by e-mail; I am not aware that the presentation is available online. Steve recently wrote a post called An Oil Shock in 2012? (published by ASPO-USA) that covers part this material, if readers would like more of his explanation.

I find the historical information slides in the first part of  the presentation interesting in and of themselves. I am not sure I would come up with the same forecasts of future production as shown in this presentation, though–it seems to me that they are on the optimistic side. There is a question of what forecast a person should show to a committee such as this congressional committee: even a fairly high estimate is likely to shock the committee, and too low an estimate is likely not to be believed. Many of us, in a similar circumstance, would offer our most optimistic view of the future. It may be that Douglas-Westwood is shading its estimates a little on the optimistic side, too–I don’t know.

Oil, the Economy and Policy
Slide 1

An Oil Perspective
Slide 5

The footnote on Slide 5 says, “Demand growth = GDP growth – 1.2% annual efficiency gain.” It is interesting to see what formula is being used. This equation would seem to suggest that if a decline in oil supplies of greater than 1.2% per year takes place, GDP growth can be expected to be negative.

I (Gail, not Steven) would expect that the recent surge in coal consumption has been one of the factors that has helped keep economic growth higher, in the absence of oil growth. Rising natural gas production may also have helped.

Upstream Exploration
Slide 7

There has been huge growth in capital expenditure in recent years. The amounts shown are in nominal dollars (that is not inflation adjusted), but even if one mentally adjusts for the impact of rising costs, there has been a real increase in capital expenditures for exploration and production. These rising costs no doubt reflect the fact that we now have to pursue oil in increasingly expensive to produce locations, such as in deep-sea locations, and where extensive fracking is required (for example, Bakken shale).

Capital expenditure
Slide 11

I skipped some slides about where all of the new expenditure went: more sophisticated equipment, more total drilling rigs, more employees in total, and more PhDs on staffs. The result of all of this additional expenditure has been no increase in oil production–it just kept production approximately level.

Note that the graph shows that total expenditures for the ten-year period 1995-2004 period were equal to those for the six-year period 2005-2010. Thus, the average yearly expenditure was much higher in the later period, but the drilling results were terrible–a small decline in production compared to an increase in the 1995-2004 period.

Oil Prices and Recession
Slide 12

Douglas-Westwood comes to the same conclusion about oil prices being recessionary as results I have quoted elsewhere from Steven Balogh, Dave Murphy, and Charles Hall–at $85 barrel. The ratios to GDP appear different (4% for Douglas-Westwood; 5.5% for Hall, Balogh, and Murphy), because one analysis uses retail oil prices and the other uses wholesale oil prices, but the fact that the two approaches come out with the essentially the same dollar threshold for recessionary impact shows that they are equivalent.

Oil and the Recession
Slide 13

“First peak oil recession?” This sounds pretty much like what I (Gail) have been saying.

Liquids Supply
Slide 17

I hadn’t focused on the extent to which the recent rise in production is in fact Natural Gas Liquids (NGLs) production. I know that the US has had a recent rise in NGLs because of the recent shift to “liquids-rich” gas plays. I hadn’t focused on the big increase in NGL production in OPEC, though.

NGLs have lower energy per barrel than crude oil and generally sell for a lower price than crude oil. NGLs include propane, butane, and other “liquids” that are close to gases. One thing I have been trying to learn more about is the extent to which these actually act as substitutes for crude oil. I know that some portion of these liquids can be added to “winter” gasoline, but not to summer gasoline, because they tend to evaporate too much in warmer weather. This is one reason why winter gasoline prices tend to be lower than summer gasoline prices. Clearly, NGLs can be “reformed” into longer chains. I don’t know how expensive or how widely available this procedure is, though.

Spare Capacity to 2012
Slide 20

How much spare capacity Saudi Arabia really has is a big question. Steven Kopits says if Saudi Arabia’s maximum level of production is really on 10 million barrels a day (that is, the bottom line on his graph), an oil shock is theoretically expected in the third quarter of 2012, based on Douglas-Westwood’s demand estimates.

Did Oil Majors Pass Peak Production
Slide 23

I don’t remember seeing a slide like Slide 23 before. One question I would ask is where all of the future increases in oil production that Douglas Westwood is forecasting are going to come from, if all of the majors are past peak. Does this mean that all of the increases are going to be from much smaller operators, producing NGLs, Barnett Shale, and the like? If so, these smaller operators are going to have come up with enough capital to finance all of their increases in operations. Theoretically, if oil prices are high enough, this could work out, but as this presentation indicates, recession tends to set in at $86 a barrel. So it is by no means clear that prices will be high enough to make production economically attractive.

Petroleum Liquids Supply Forecasts
Slide 24

This is a comparison of “all liquids” production estimates for the year 2030. (All liquids includes ethanol, natural gas liquids, and other liquids besides crude oil.) In a way, this slide is irrelevant, if the real message of this presentation is that there will be an oil supply crunch occurring as soon as 2012, and this in itself could have very unpleasant impacts.
The mitigation attempts that are shown in the later slides are based on the assumption that growth will continue as shown in this forecast. In my (that is, Gail’s) view, financial and political changes are likely to take place between now and 2030, so production in 2030 may be quite different from what is suggested by the range of forecasts.

Global Oil Consumption
Slide 25

This slide uses an estimate of 100 million barrels a day of oil production in 2030. This is in the range forecast by the EIA, based on Slide 24. The conclusion that Douglas-Westwood reaches is that in this scenario, US consumption in 2030 would be 14 million barrels per day, down 1/3 from consumption of 21 million barrels per day in 2007.

The slide says, “Bad, but not the end of the world.” I (Gail) would point that such a decline in oil consumption is likely to result in continuing recession and a huge amount of loan defaults. The graph suggests a similar fate for Europe and the rest of OECD. (Note that we are already at a recessionary price level for oil.) Maybe continuing recession and major loan defaults wouldn’t be the end of the world, but it seems to me that it could very easily lead to even more adverse outcomes (major international defaults, governments overthrown, etc.). If these changes tend to interfere with international trade, then it seems to me that there could be disruptions to oil extraction and liquids production, since international trade is involved in replacement parts for oil equipment, and in high technology equipment. As a result, no country may do as well in terms of oil consumption in 2030 as the graph suggests.

US Petroleum Liquids Prospects
Slide 28

Here, the presentation shows where increases in “liquids” production are likely to come from. Conventional onshore production, shown at the bottom, is likely to continue to its decline. Natural gas liquids, shown in grey next above, become a thicker layer. Renewable liquids, which I would interpret to be biofuels, becomes a much thicker layer. Other liquids (dark gray), which I would assume would include coal-to-liquid, would become much larger than today. Alaskan production of the type we have today will drop off fairly significantly. Shale oil (such as that from the Bakken, shown in rose-gray) is seen as increasing greatly. Offshore Gulf of Mexico oil is seen as dipping, then increasing until perhaps 2018, before it declines again. The big increase between 2020 and 2030 relates to oil from Alaska’s Outer Continental Shelf.

The question I would have, is whether these ramp-ups in production can really be done at affordable price levels. If the economy goes into recession above $86 barrel, will it really be feasible to produce high-priced oil from the Bakken, or from Alaska’s Outer Continental Shelf? We haven’t yet found a way to produce cellulosic ethanol or diesel from algae at an affordable price level, either. Unless there are huge technology breakthroughs, some of these forecasts seems to imply the production of extremely expensive oil, and thus the likelihood that oil prices will need to be much higher than today.

Gulf of Mexico Outlook
Slide 30

What this slide shows is EIA’s estimate of future oil production from the Gulf of Mexico (excluding a little strip along the shore, which is state controlled, rather than federally controlled). The point being made is that the forecast drop in oil production from the Gulf of Mexico of about 600,000 barrels per day is very significant, amounting to 11% of crude oil production. The expected job loss according to Douglas-Westwood’s calculations is 65,000 full-time equivalent employees.

The point should probably made too, that the loss from the Gulf of Mexico is actually crude oil, while quite a bit of forecast new production is products which have lower energy per barrel than crude oil. Thus, a drop in Gulf of Mexico production can be expected to have a bigger impact than an equivalent drop in something like ethanol or natural gas liquids.

CNG as a Transportation Fuel
Slide 36

Here, I would very much agree with Steven Kopits–if natural gas vehicles are to be used, they need to be priced the same as gasoline vehicles. I am less convinced than he is that we actually will have enough extra natural gas to make a significant switch work, though. See my recent post Don’t Count on Natural Gas to Solve US Energy Problems.

Electric Vehicles
Slide 37

I (Gail) hadn’t seen this quote from Steven Chu, but it pretty well summarizes the problem with electric cars. I have been making the point that high-priced oil is recessionary. The problem is that high-priced substitutes for oil, including high-priced electric cars to replace internal combustion cars, are also recessionary. So they leave us worse off than we were before, from a financial point of view, unless there total costs to the consumer per mile are lower.

To date, electric vehicles have not had to pay taxes to cover road improvements. It seems to me that this cannot continue, if electric vehicles are to become any significant share of roadway users. Cost comparisons should include these taxes as well.

Slide 40

This is the first two summary slides. Steve suggests here that the next oil shock is in 2013, even though the earlier slide seemed to suggest 2012 as a possibility, and Steve’s recent post for ASPO-USA is called An Oil Shock in 2012? Perhaps this summary statement is a matter of shading the results a bit for an audience who will be shocked even by an estimate of an oil shock in 2013.

Conclusions 2
Slide 41

This is the final slide. It seems to me (Gail) that if we can’t get the price down to a reasonable level (and I am afraid we can’t), we do need to dismiss Alaska’s Outer Continental Shelf as a possibility. This will be something oil companies will be learning more about, as they look into the particulars of extraction in that part of the world.
Steve’s final point is

The single largest risk to the US economy today is an oil shock— awareness and management of this risk appear minimal.

I would very much agree with this, which I believe is his major point to the committee.

By. Gail Tverberg

Gail Tverberg is a writer and speaker about energy issues. She is especially known for her work with financial issues associated with peak oil. Prior to getting involved with energy issues, Ms. Tverberg worked as an actuarial consultant. This work involved performing insurance-related analyses and forecasts. Her personal blog is ourfiniteworld.com. She is also an editor of The Oil Drum.

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