Peak Oil Price: The Latest Industry Worry

There have been many calls on peak oil - the tipping point at which global production reaches a peak - and, due to dwindling reserves, production declines, even if demand continues to rise. In reality, the industry and the technology have proved more resourceful than predictions have allowed and production has continued to rise.

Indeed, the recent opening up of tight oil reserves in the US heralds the possibility that the US may become self-sufficient in a number of years if rates of production growth continue.

Yet in spite of this creativity on the part of the extraction industry in finding new reserves (and even more challenging ways to extract them from tight formations or deep underground), we have rapidly become accustomed to the prices that would have been considered crippling just a few years ago.

The price of oil has more than quadrupled over the last 10 years from about $25/barrel in 2002 to $110/barrel last year. "Hurrah!" say the environmentalists - only through high prices will consumers make better decisions about fuel economy, power use and alternative fuels - and no doubt they are right.

But the reality is we have rapidly become used to high prices, and while the current oil price is certainly not helping the global recovery, there is little evidence to suggest the price is likely to drop enough, in spite of shale oil, to help it.

The main assumption for the high price of oil is demand (and in particular, Asian demand) that wasn't there 10 years ago. But a less-discussed influence on the price has been the rapidly rising cost of extraction.

As an FT article amusingly puts it, there was a time you could poke a straw in the sand and oil would spurt out: think Iraq, Saudi Arabia, even Texas. But today, oil is increasingly coming from much more challenging sources. As the author of the article observes, oil companies have invested billions to turn Canada's bitumen into synthetic oil, and freeze natural gas into an exportable liquid.

Related article: Why the High Oil Prices if Supplies Really are Abundant?

They have ventured out into the remote, iceberg-strewn waters of the Arctic, discovered huge new oil reserves under a 2-kilometer-thick layer of salt off the coast of Brazil and "fracked" their way through vast shale and "tight" oil formations from Texas to North Dakota.

"Projects are getting bigger in scale and more remote. The oil is harder to find and more expensive to get out," Christian Brown, chief executive of Kentz, the engineering and services group, is quoted by the FT as saying. As a result, the cost of oil extraction has mushroomed.

Schlumberger, the oil services group, is quoted as saying annual capital spending for the industry has more than tripled in the past 10 years, reaching $550 billion in 2011.

Yet even so, the European majors failed to find enough new oil and gas to replace what they had produced, chalking up a reserve replacement ratio of only 92 percent. Not only are new reserves not meeting extraction, but costs are being driven up by budget overruns and delays. A recent study by Independent Project Analysis is cited, saying the average big exploration and production project is 22 percent late and 25 percent over budget.

One such is Kashagan, a vast oilfield in the Kazakh sector of the Caspian Sea that has turned into the world's most expensive oil development project. Due to technical and environmental challenges, the cost of the first phase alone has ballooned to $46 billion, at least three times more than initially planned and enough to bail out Cyprus three times over!

Related article: A Quick Quiz on US Oil Production

Over the past 10 years, the top seven oil and gas majors are said to have increased their development capital expenditure by 255 percent, yet compound average growth rate has been practically zero as expensive new production has simply replaced cheap dwindling reserves.

The worst cost overruns are currently in Australia, in part due to a strong Aussie dollar, but as much due to the strain of trying to develop seven LNG projects simultaneously - costs have rocketed. The cost of Chevron's Gorgon project had ballooned by 41 percent to US $52 billion as labor, materials and energy costs have all risen fast.

Labor is said to be costing $200/hr when accommodation costs are taken into account, due to the difficulty in attracting and retaining workers in such remote locations, compared to $68/hr on the US Gulf Coast.

Such cost pressures will keep oil and gas prices high even if demand growth flattens out, which seems unlikely on the basis of rising Asian demand. As cheaper resources are exhausted, new finds will demand ever-higher prices to justify exploitation.

We may not be at risk of 2008-level prices of $140/barrel in the short term, but it is only a matter of time before such levels are approached again.

By. Stuart Burns