[Ok-sus] The beginning of the end of the recent oil euphoria?

Bob Waldrop bwaldrop1952 at att.net
Wed Feb 26 03:26:14 UTC 2014

Comes now Gail Tverburg, the peak oil actuary, with some troubling news 
on cutbacks in oil exploration spending and what this may mean for the 

Bob Waldrop, Okie City
http://www.ipermie.net -- How to permaculture your urban lifestyle and 
adapt to the looming realities of peak oil, economic irrationality, 
climate instability, and political criminality.


(Note: depending on your email, the charts may not come through, so you 
may want to read this at her blog site.)

Steve Kopits recently gave a presentation 
<http://energypolicy.columbia.edu/events-calendar/global-oil-market-forecasting-main-approaches-key-drivers> explaining 
our current predicament: the cost of oil extraction has been rising 
rapidly (10.9% per year) but oil prices have been flat. Major oil 
companies are finding their profits squeezed, and have recently 
announced plans to sell off part of their assets in order to have funds 
to pay their dividends. Such an approach is likely to lead to an 
eventual drop in oil production. I have talked about similar points 
previously (here 
but Kopits adds some additional perspectives which he has given me 
permission to share with my readers. I encourage readers to watch 
theoriginal hour-long presentation 
<http://energypolicy.columbia.edu/events-calendar/global-oil-market-forecasting-main-approaches-key-drivers> at 
Columbia University, if they have the time.

*Controversy: Does Oil Extraction Depend on "Supply Growth" or "Demand 

The first section of the presentation is devoted the connection of GDP 
Growth to Oil Supply Growth vs Oil Demand Growth. I omit a considerable 
part of this discussion in this write-up.

Economists and oil companies, when making their projections, nearly 
always make their projections depend on "Demand Growth"--the amount 
people and businesses*want*. This demand growth is seen to be rising 
indefinitely in the future. It has nothing to do with affordability or 
with whether the potential consumers actually have jobs to purchase the 
oil products.

Kopits presents the following list of assumptions of demand constrained 
forecasting. (IOC's are "Independent Oil Companies" like Shell and Exxon 
Mobil, as contrasted with government owned companies that are prevalent 
among oil exporters.)

Kopits 10 Assumptions of Demand Constrained Forecasting 
it is the demand constrained view of forecasting that gives rise to the 
view that OPEC (Organization of Petroleum Exporting Nations) has 
enormous leverage. The assumption is made that OPEC can add or subtract 
as much supply as much as it chooses. Kopits provides evidence that in 
fact the Demand view is no longer applicable today, so this whole story 
is wrong.

One piece of evidence that the Demand Model is wrong is the fact that 
world crude oil (including lease condensate) production has been nearly 
flat since 2004, in a period when China and other growing Eastern 
economies have been trying to motorize. In comparison, there was a rise 
of 2.7% per year, when the West, with a similar population, was trying 
to motorize.

Kopits 20 Motorization and Oil in Historical Context 

Kopits points out that China's big source of oil supply has been US main 
street: China bids oil supply away from United States, to satisfy its 
needs. This is the way that markets have made oil available to China, 
when world supply is not rising much. It is part of the reason that oil 
prices have risen.

Another piece of evidence that the Demand Model is wrong relates to the 
assumption thatsocial tastes have simply changed, leading to a drop in 
US oil consumption. Kopits shows the following chart, indicating that 
the major reason that young people don't have cars is because they don't 
have full-time jobs.

Kopits 35 Driving and Employment 

Kopits makes a comparison of the role of oil in GDP growth to the role 
of water in plant growth in the desert. Without oil, there is less GDP 
growth, just as without water, a desert is starved for the element it 
needs for plant growth. Lack of oil can considered a binding constraint 
on GDP growth. (Labor availability might be a constraint, but it 
wouldn't be a binding constraint, because there are plenty of unemployed 
people who might work if demand ramped up.) When more oil is available 
at a slightly lower price, it is quickly absorbed by markets.

"Supply Growth" is the limiting factor in recent years, because the 
amount of extraction is rising only slowly due to geological constraints 
and the number of users has risen to the point that there is a shortage.

*Experience of Major Oil Producing Companies*

Kopits presents data showing how badly the big, publicly traded oil 
companies are doing. He looks at two pieces of information:

  * "Capex" -- "Capital expenditures" -- How much companies are spending
    on things like exploration, drilling, and making of new offshore oil
  * "Crude oil production" -

A person would normally expect that crude oil production would rise as 
Capex rises, but Kopits shows that in fact since 2006, Capex has 
continued to rise, but crude oil production has fallen.

Kopits 40 Oil majors capex and production 

The above information is worldwide, not just for the US.  At some point 
a person might expect companies to start getting frustrated--they are 
spending more and more, but not getting very far in extracting oil.

Kopits then shows another version of Capex history plus a forecast. 
(This time the amounts are labeled "Upstream," so the expenditures are 
clearly on the exploration and drilling side, rather than related to 
refineries or pipelines.)

Kopits 41 Upstream Spend continues Strong 

The amounts this time are for the industry as a whole, including "NOCs" 
which are government owned (national) oil companies as well as IOCs 
(Independent Oil Companies), both large and small. Kopits remarks that 
the forecasts shown were made only six months ago. When talking about 
the above slide Koptis says,

    People in the industry thought, "Capex has been going up and up. It
    will continue to do very well. We have been on this trajectory
    forever, and we are just going to get more and more money out of this."

    Now why is that? The reason is that in a Demand constrained model
    for those of you who took economics--price equals marginal cost.
    Right? So if my costs are going up, the price will also go up.
    Right? That is a Demand constrained model. So if it costs me more to
    get oil, it is no big deal, the market will recognize that at some
    point, in a Demand constrained model.

    Not in a Supply constrained model! In a Supply constrained model,
    the price goes up to a price that is very similar to the monopoly
    price, after which you really can't raise it, because that marginal
    consumer would rather do with less than pay more. They will not
    recognize [pay] your marginal cost. In that model, you get to a
    price, and after that price, there is significant resistance from
    the consumer to moving up off of that price. That is the "Supply
    Constrained Price." If your costs continue to come up underneath
    you, the consumer won't recognize it.

    The rapidly growing Capex forecast is implicitly a Demand
    constrained forecast. It says, sure Capex can go up to a trillion
    dollars a year. We can spend a trillion dollars a year looking for
    oil and gas. The global economy will accept that.

I quote this because I am not sure I have explained the situation 
exactly that way. I perhaps have said that demand had to be connected to 
what consumers could afford. Wages don't magically go up by themselves 
(even though economists think they can).

According to Koptis, the cost of oil extraction has in recent years been 
rising at 10.9% per year since 1999. (CAGR means "compound annual growth 

Kopits 43 Costs are Rising Fast 

Oil prices have been flat at the same time. On the above chart, "E&P 
Capex per barrel" is pretty much the same type of expenses as shown on 
the previous two charts. E&P means Exploration and Production.

Kopits explains that the industry needs prices of over $100 barrel.

Kopits 45 Industry needs oil prices over 100 

The version of the chart I have up is too small to read the names of 
individual companies.  If you would like a chart with bigger names, you 
can download theoriginal presentation 

Historically, oil companies have used a discounted cash flow approach to 
figure out whether over the long term, pricing for a particular field 
will be profitable. Unfortunately, this "standard" approach has not been 
working well recently. Expenses have been escalating too rapidly, and 
there have been too many new drilling sites producing below expectation. 
What Kopits shows on the above slide is the prices that companies need 
on different basis--a "cash flow" basis--so that each year companies 
have enough money to pay/today's/capital expenditures, 
plus/today's/expenses, plus/today's/dividends.

The reason for using the cash flow approach is because companies have 
found themselves coming up short: they find that after they have paid 
capital expenditures and other expenditures such as taxes, they don't 
have enough money left to pay dividends, unless they borrow money or 
sell off assets. Oil companies need to pay dividends because pension 
plans and other buyers of oil company stocks expect to receive regular 
dividends in payment for their equity investment. The dividends are 
important to pension plans.

In the last bullet point on the slide, Kopits is telling us that on this 
basis, most US oil companies need a price of $130 barrel or more. I 
noticed that Brazil's Petrobas needs  a price of over $150 barrel. (OSX, 
Brazil's number two oil company,recently went bankrupt 

In the slide below, Kopits shows how Shell oil is responding to the poor 
cash flow situation of the major oil companies, based on recent 

Kopits 46 The Majors Respond 

Basically, Shell is cutting back. It no longer is going to tell 
investors how much it plans to produce in the future. Instead, it will 
focus on generating cash flow, at least partly by selling off existing 

In fact, Kopits reports that all of the major oil companies are 
reporting divestment programs. Does selling assets really solve the oil 
companies' problems? What the oil companies would really like to do is 
raise their prices, but they can't do that, because they don't set 
prices, the market does--and the prices aren't high enough. And the oil 
companies really can't cut costs. So instead, they sell assets to pay 
dividends, or perhaps just to get out of the business. But is this 

Kopits 48 conventional oil production 

The above slide shows that conventional oil production peaked in 2005. 
The top line is total conventional oil  production (calculated as world 
oil production, less natural gas liquids, and less US shale and other 
unconventional, and less Canadian oil sands). To get his estimate of 
"Crude Oil Normal Decline," Kopits uses the mirror image of the rise in 
conventional oil production prior to 2005. He also shows a separate item 
for the rise in oil production from Iraq since 2005. The yellow portion 
called "crude production forward" is then the top line, less the other 
two items. It has taken $2.5 trillion to add this new yellow block. Now 
this strategy has run its course (based on the bad results companies are 
reporting from recent drilling), so what will oil companies do now?

Kopits 49 -Oil Majors Cut Capital Expenditures 

Above, Kopits shows evidence that many companies in recent months have 
been cutting back budgets. These are big reductions--billions and 
billions of dollars.

Kopits 50 Majors Capex 

On the above chart, Kopits tries to estimate the shape of the downslope 
in capital expenditures. This chart isn't for all companies. It excludes 
the smaller companies, and it excludes the National oil companies, so it 
is about one-third of the market. The gray horizontal line at the top is 
the industry consensus back in October. The other lines represent more 
recent estimates of how Capex is declining. The steepest decline is the 
forecast based on Hess's announcement. The next steepest (the dotted 
gray line) is the forecast based on Shell's cutback.  The cutback for 
the part of the market not shown in the chart is likely to be different.

*Oil and Economic Growth*

Kopits offers his view of how much efficiency can be gained in a given 
year, in the slide below:

Koptis 54 Oil Efficiency and GDP Growth 
his view, the maximum sustainable increase in efficiency is 2.5% in 
non-recessions, but a more normal increase is 1% per year. At current 
oil supply growth levels, OECD GDP growth is capped at 1% to 2%. The 
effect of constrained oil supply is reducing OECD GDP growth by 1% to 2%.


Kopits 59 Conclusions 
demand constrained models dominate thinking, in fact, a supply 
constrained model is more appropriate in recent years.

We seem to be short of oil. Whenever there is extra oil on the market, 
it is quickly soaked up. Oil prices have not collapsed. No one is 
nervous about a price collapse.

China recently has been putting little price pressure on the market--its 
demand is recently less high. Kopits thinks China will eventually return 
to the market, and put price pressure on oil prices. Thus, oil price 
pressures are likely to return at some point.

*Gail's Observations*

An obvious point, which I thought I heard when I listened to the 
presentation the first time, but didn't hear the second time is, "Who 
will buy all of these assets on the market, and at what price?" China 
would seem to be a likely buyer, if one is to be found. But when several 
companies want to sell assets at the same time, a person wonders what 
prices will be available.

The new strategy is, in effect, maintaining dividends by returning part 
of capital. It is clearly not a very sustainable strategy.

It will take a while for these cut-backs in Capex expenditures to find 
their way through to oil output, but it could very well start in a year 
or two. This is disturbing.

What we are seeing now is a cutback in what companies consider 
"economically extractable oil"--something that isn't exactly reported by 
companies. I expect that what is being sold off is mostly not "proven 

In this talk, it looks like lack of sufficient investment is poised to 
bring the system down.  That is basically the expected limit under 
Limits to Growth.

In theory, if an expansion of China's oil demand does bring oil prices 
up again, it could in theory encourage an increase in drilling activity. 
But it is doubtful that economies could withstand the high prices--they 
are already having problems at current price levels, considering the 
continued need for Quantitative Easing to keep interest rates low.

A recent news item was titled,G20 Finance Ministers Agree to Lift Global 
Growth Target 
According to that article,

    Mr Hockey said reaching the goal would require increasing investment
    but that it could create "tens of millions of new jobs".

The cutback in investment by oil companies is working precisely in the 
wrong direction. If these cutbacks act to cut future oil extraction, it 
will bring down growth further.

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