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Oil and Saudi Arabia - Part 1

10.24.05   Ferdinand E. Banks, Professor

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Everything that you need to know about the future of Saudi Arabian oil production can be found in a staff report to the subcommittee on international economic policy of the committee on foreign relations of the United States Senate (1979). Regardless of what you may or may not have heard on that increasingly relevant subject, between 1979 and now hardly anything has changed, although the question must still be asked why this and similar documents were – and still are – overlooked by many energy professionals.

The purpose of this article is to add few observations on the structure and dynamics of the global oil market to my earlier work on the subject, which means that I have to repeat some previous materials. Geology and supply-demand mechanics are still of crucial importance, but more attention has been paid to what might be called ‘petroleum (= oil + gas) microeconomics’, as well as certain game-theoretical insinuations. Some very useful background to the present exposition is provided in an article by Murray Duffin (2004) on EnergyPulse.

As will soon be noticed, the main actor in this drama only appears en-passant before the fourth section. One reason is that the business press is now filled with easy-to-read information about Saudi Arabia, and they have almost always gotten it at least partially correct. What they have missed, however, is that according to the logic of mainstream development economics, the countries of the Middle East are not going to exhaust their supplies of irreplaceable energy resources in order to pull the chestnuts of American and European motorists out of the fire, even if they assure every government and television station in the world that they prepared to do so – and even if, as Humphrey Bogart remarked in the film ‘Sahara’, they adore chestnuts. There is also a widespread tendency to overlook or misinterpret certain extremely important macroeconomic themes having to do with oil, and which need repeating as often as possible.

INTRODUCTION

According to the journalist Max Rodenbeck, the United States became a net importer of crude oil for the first time in 1976, and in 2000 imports accounted for more than half of the US consumption of this commodity. At the present time imports are about 11 million barrels per day (= 11 Mb/d). These observations by Mr Rodenbeck – who ‘covers’ the Middle East for the Economist – have enough validity to be useful to many of the readers of that publication, even if most of his other comments principally serve as a reminder that the present state of knowledge about the most important raw material in the world is far from what it should and could be. For instance, he is in error about the way that real world oil markets work, and he does not have an adequate acquaintance with the basic scarcity of oil – a scarcity that turns on the inelastic demand for that commodity over the foreseeable future. Moreover, his reference to the “vast and conveniently located reserves of oil shale” in Canada is the kind of mistake that I always advised my students to never make if they wanted to survive the first five minutes of an employment interview. (The relevant non-conventional resource in Canada is oil from tar sands, and while vast it is far from convenient.)

Both my energy economics textbook (2000) and my book on oil (1980) failed to give adequate recognition to the crucial role that Saudi Arabia has played on the world oil scene and, more important, is expected to occupy in the future. But now is the time to correct this oversight, because in my opinion the plans of the Saudi Arabian government are very different from those attributed them by many journalists, as well as fly-by-night experts from academia. Very different in fact from their own optimistic and accommodating pronouncements. Moreover, these intentions have not changed over the past 30 years or so. Let me add that an attempt to make a comprehensive estimate of the present goals of the leadership of the most important oil producer on the face of the earth, as well as some knowledge of the intentions of other governments and firms toward that producer, may turn out to be the key to introducing some energy economics wisdom into the lives of certain influential observers who still expect that the oil future will resemble the oil past.

As alluded to in the sequel, the general feeling today is in the direction of pessimism where both oil production and investment in new capacity are concerned. This makes a great deal of sense. There are still, however, a few observers of the flat-earth variety who do not share this attitude. In their world, physical investment is capable of finding oil that the geologists say is not there – or, to put this another way, they think that ‘market solutions’ and technological innovation can overwhelm the laws of physics. Steve Forbes, owner/editor of what might be the best business magazine in the world, apparently sees the interplay of supply and demand eventually reducing the price of oil to under $40/b, while Martin van Weyler – financial commentator of The Spectator (UK) – believes that technology will provide a hundred more years of oil. Actually it will provide thousands, however once global production has peaked it hardly makes any difference what the actual figure turns out to be.

For what it is worth, the Petroleum Economist (October 2004) stated flatly that investment no longer keeps pace with high oil prices, which is a sure sign that in the executive suites of major oil companies, the general belief is that there are no longer investment opportunities capable of matching those of the past. Regardless of the upbeat bulletins and rumors emerging from those venerable premises, this should always be kept in mind, because even investment in OPEC countries (by local and/or foreign ‘players’) has slumped badly, and if this trend continues the production forecasts of the International Energy Agency (IEA) and US Department of Energy cannot possibly be fulfilled. One prominent consulting organization, PFC Energy, has stated that by 2020 at the latest, OPEC will not be able to make up the difference between non-OPEC supply and global demand. This is not a very welcome prophecy, and I am at a loss to explain why it is not more widely discussed.

A FEW GENERAL OBSERVATIONS

Before attempting to put the supply of Saudi energy resources into perspective, a few general remarks about oil are essential. The theory is now frequently advanced that high oil prices no longer threaten the stability of the global macroeconomy, but as far as I am concerned this is a serious misunderstanding. It is a misunderstanding that is largely based on hero-worship of the Chairman of the US Federal Reserve System (i.e. central bank), Alan Greenspan. What observers do not realize however is that Dr Greenspan’s undeniable success is mainly due to the huge debts that, luckily for him, could be accumulated by households in the US, as well as by the US government, and in addition over the past few years there has been a level of capital investment by large corporations that was sufficiently moderate to restrain interest rates. An arrangement of this sort is untenable in the long run, as readers of the financial press are constantly informed in unambiguous language.

Private consumption in the US is still at a record high. It has been raised to a much greater than normal extent by increases in the price of real estate (i.e. a wealth effect), as well as the continued availability of inexpensive credit. At the same time there is underconsumption in most of the rest of the world, particularly in Europe and China. According to the chief economist of (the investment bank) Morgan Stanley, Mr Stephen Roach, the deficit in the US balance of payments is now close to 7.5% of the gross national product, while at the same time the US accounts for 70% of the total global balance of payments deficits. (He could have added that a large fraction of the US current account deficit can be attributed to imports of energy, and in particular oil.) Roach regards this as unnatural, which it is, and he predicts a “crisis”. Moreover, he pictures that crisis reaching every part of the world because of the cross-border linkages created by globalization. As it happens though, regardless of the curse of globalization, these linkages have always existed for reasons shown in every book dealing in any way with international economics, to include my elementary international finance textbook (2001).

The exact circumstances that would initiate this crisis are unclear, but I am ill convinced that it will be via a sharp (upward) interest rate adjustment, either directly because of a decrease in the saving of foreigners, or indirectly because of another sustained increase in the oil price boosting the macroeconomic price level. The wealth effect referred to above would then move in the opposite direction, and the impact effect of the resulting decrease in spending could have serious consequences for both physical and financial markets everywhere. Note the expression “impact effect”, because (ceteris paribus) eventually a decrease in spending in the US will have to take place in order to obtain what they called an ‘equilibrium’ in your macroeconomics courses.

This might also be a good place to mention the ‘yield’ curve’ (which is a plot of the interest rates (or yields) for a particular type of bond, against different maturities for that asset). As explained in Chapter six of my finance book, a flattening (or inversion) of this curve – which is taking place as this is written – could lead to a very bad macroeconomic scene. The reason for this inversion turns on rising short-term interest rates, along with an increased demand for long-term paper.

Unfortunately, Alan Greenspan entertains a few illusions where the yield curve is concerned, saying that an inversion no longer implies a recession, as was often the case earlier. This assertion may not be incorrect, however it is not consistent with the financial history of the last fifty years or so. By way of contrast though, the chairman has never ceased trying to make it clear that very high oil and gas prices are capable of badly damaging the US economy. He undoubtedly remembers the recessions that followed previous oil price escalations, and more important he understands that while the laws of economics – unlike those of physics – can be rescinded temporarily, they cannot be abolished. For example, the macroeconomic and financial markets expansions of the 1990s almost certainly would have been impossible if the nominal (i.e. money) price of oil in that period had been anywhere close to where they are at the present time. (The real – i.e. inflation adjusted – price of oil is still lower than it was 20 years ago, using the l973 oil price as a base, but I get the impression that attention is usually called to the real price by persons who want to claim that oil costing $65/b or more is not particularly expensive.)

The International Energy Agency (IEA) has postulated an increase in the world oil demand from the present 84.5 Mb/d to 121 Mb/d in 2030. Normally, I would express some curiosity as to the scientific background for that estimate, however I propose to use it to make another preliminary remark about the supply capabilities of Saudi Arabia. At the time when this 121 Mb/d is supposed to be produced, OPEC is pictured as being responsible for about one-half (as compared to approximately 35% just now). This suggests an expected OPEC production of approximately 60 Mb/d. At the present time Saudi Arabia supplies almost a third of OPEC oil, and given their reserve situation relative to the other OPEC (and non-OPEC) countries, this fraction will hardly decrease. (Saudi Arabia apparently has proven reserves of about 260 billion barrels, while second place Iraq has 120 billion barrels.) Accordingly, it seems that IEA experts believe that Saudi Arabia will supply at least 20 Mb/d in 2030.

One of the main purposes of my recent work is to convince readers that Saudi Arabia is not going to willingly supply 20 Mb/d in 2030, or at any other time in the near or distant future, regardless of what you may hear on the grapevine. A high-ranking Saudi official has stated that 15 Mb/d should be possible, and once this amount is attained he appeared certain that it could be maintained indefinitely. This kind of assurance undoubtedly sounds lovely to the world’s motorists, but the economics that I teach informs me that 15 Mb/d is a goal that will not be easy to reach, while the game theory that I have taught tells me that this kind of talk should be taken with a grain of salt. Furthermore, and more important, even if that production level was realizable, it would not be maintained for more than a comparatively short period – unless the Saudi government had come to the conclusion that less money was preferable to more.

What I do accept however is that the government of that country will do everything possible to approximately double its share of the global petrochemical output from its present 7 percent share over the next five years. The reason I accept this is because from an economic point of view, a greatly increased petrochemical (and refining) output in the near future is a more reasonable economic goal than attaining a crude oil production of more than 12 Mb/d at any time. According to the Saudi government, foreigners are welcome to invest/participate in the production of petrochemicals and refined products in that country, but I suspect that the reason for this generosity is the desire to use the influence of large energy companies to facilitate the access to foreign markets of Saudi Arabia’s petrochemical and refined output.

There is also some question as to what OPEC as a whole will be able to achieve. A report from the consulting firm PFC Energy (as mentioned in the Petroleum Economist, October 2004) states that OPEC is producing about 8 billion barrels a year more than it has been finding. This situation has been pictured as changing if e.g. Libya and Iraq intensify their exploration activities, however even under the best of conditions I find it impossible to believe that this will be of other than marginal significance for the IEA targets mentioned above.

Of late we have been hearing a great deal about oil from tar sands (in the Athabasca region of Canada), and the heavy oil of the Orinco region in Venezuela. As it happens, if a large expansion takes place in the output of these unconventional resources, then those observers who feel that the resources of the Middle East are overrated might be correct, because in those circumstances it is conceivable that the 9-10 Mb/d output of Saudi Arabia could be matched or overmatched.

As suggested by Crandall (2005) and Reynolds (2005), the total output of unconventional oil from these two regions will not reach anywhere near 9-10 Mb/d in the near or medium future, and by the time it does the global production of conventional oil might have turned down. Accordingly, we would still be faced with an oil price that is capable of devastating the international macroeconomy, as well as creating social/political chaos in the large importing countries. The CEO of one of the major oil companies has sworn what almost amounts to a sacred oath that his enterprise is prepared to assume the responsibility for developing the kind of technology needed to make unconventional oil economically attractive, but this sounds like the kind of pledge that is delivered late at night after the cognac has gone around the table a couple of times.

SOME ABSOLUTELY ESSENTIAL OIL MICROECONOMICS

This section will begin with an extremely important but simple numerical example dealing with the reserve-production (R/q) ratio of oil – or for that matter gas. (Reserves (R) are measured in e.g. barrels (b), while production (q) is measured in barrels per unit of time.) The assumption here will be that when this ratio reaches a ‘critical value’ (R/q)* – which will be taken as 10, since that was the number mentioned most often in the seminal article of Flower (1977) – then in order to optimize the value of the output from a particular deposit, the annual output from the deposit should ideally be kept from falling below 10% of the remaining recoverable reserves. Accordingly, from that point on (and as shown in a numerical example immediately below) this ratio will determine production: production must adjust in such a way as to hold the R/q ratio at (or around) the critical value. If this were not done, then it would be tantamount to ‘overworking’ the deposit, and as a result of accelerated (physical) depreciation, reducing the amount of oil that can ultimately be obtained. The US government document referred to in the first paragraph of this article also takes notice of this concept.

Now for the example. Assume that we have a field with 225 units (= R) of accessible oil reserves, and we desire to lift 15 units/year (=q). It is obvious that we can have an output of 15 units/year every year for 5 years. During this time, the R/q ratio falls from 14 (at the end of the first year) to 10 (= (R/q)*) at the end of the fifth year, and reserves fall to 150 units. After that, however, if we continue to remove q = 15 units/year, we are violating our constraint: the R/q ratio will fall under the critical value (= (R/q)* = 10). For instance, if we removed 15 more units during the sixth year, or q6 = 15, then reserves fall to 135, and (R/q)6 declines to 135/19 = 9. To keep this ratio at 10, production in the 6th year cannot be larger than 13.64.
Continuing in the same vein, in the 7th year production cannot be larger than 12.4 units/year.

Readers should be able to get these results by simple trial and error, however this discussion may be generalized to show that
This expression can then be solved to give

(Be careful to note that in the present example, this ratio is measured at the end of the year.) In terms of the bizarre mathematical expositions that fill the scholarly economics literature on exhaustible resources, this expression does not appear to have much to offer, but in point of fact it is very useful! To begin, if the discussion is carefully examined, the reader will see that it involves construction of a production plateau and decline phase of an oil deposit. (An example showing a production profile with a growth phase and peak is easily constructed by assuming that initially, after beginning with e.g. an output of 15 units/year, q increases by a certain percentage every year. For instance, try 5% = (0.05) as the rate of increase, but to make the exercise more interesting begin with R = 450 units The only trouble with this exercise is that while there is a peak, there is no production plateau.)

Now for something that is extremely important! In the numerical example given above, production turned down after the fifth year. At that time we have (150/225) x 100% = 66.7% of the original reserves still in the ground. If we had calculated the ‘length of life’ of this oil field at the beginning of the exercise, we would have obtained 225/15 = 15 years, which would have presented a completely false impression of the availability of oil! Your favorite journalist or energy economist might tell you that the global R/q ratio of oil at the present time is approximately 41 years, but what we should understand in the light of the above discussion is that this number is almost completely inconsequential. It is made that way by the importance of the critical R/q ratio (= 10 in the above example), as well as Hubbert’s Peak: the tendency for the production of oil from a given reservoir to decline at approximately the time when the half-way point is reached. For instance, the global length of life of oil reserves is not the 41 years that is usually cited, but thousands of years – in fact it approaches infinity – but some experts associated with the Association for the Study of Peak Oil (ASPO) think that the global peak could come in ten years.

In 1962 Dr. M. King Hubbert reissued an updated version of a highly controversial report in which he had claimed that oil production in the ‘lower 48’ of the US would peak between 1966 and 1970 at a point where approximately half of the total amount of US reserves had been produced. (Total here means the sum of the amount of oil extracted plus proven reserves.) The peak came very late in l970, and although the US still possessed a tremendous amount of reserves, output has been trending down ever since. Hubbert’s warning of potential oil shortages was in general ignored because of an ingrained – and to a considerable extent understandable – belief in the efficacy of the price system: higher oil prices should theoretically speed up the introduction of a superior oil recovery technology, and at the same time increase exploration and the amount and intensity of drilling. All of this is true, but as previously noted, technological progress cannot find oil that does not exist. (It can, admittedly, locate and play an important role in the production of ‘heavy’ oil, and oil from tar sands and shale, however these non-conventional resources are in a higher cost class.)

Some observers insist that enough oil can eventually be squeezed out of existing deposits to compensate for the inability to discover major new deposits. My immediate reaction here is that since between 75 and 80 percent of today’s oil output come from fields that were discovered more than a quarter of a century ago, and since almost all of these fields are in full decline, this is another case in which upbeat expectations should be carefully examined and justified before our political leaders and their experts use them to make pivotal decisions.

The argument used above almost certainly has its origin in the well-known theorizing of Professor Morris Adelman, and what it begins with is a (correct) hypothesis that the amount of oil that can be removed from a typical deposit almost always exceeds the original estimates. Exploration only discloses pools of unknown magnitude (and likely profitability). It is when these pools are turned into producing properties that we can judge their various attributes, to include getting a good estimate of the reserves that are present. The US is often used as an example here, but unfortunately it is the wrong example. Regardless of the technological prodigies that are ostensibly being performed on or planned for deposits in that country, aggregate production will continue to decline.

This is not a particularly attractive prospect for a country like the US, where a shortage of oil is often pictured as a direct threat to national security and economic well-being, however there is not very much that can be done about it. The US oil sector is on the falling portion of its depletion curve, and a durable reversal of this situation is almost unthinkable – and by that I mean almost unthinkable if every square inch of onshore and offshore US territory, to included the Arctic National Wildlife Refuge (ANWR), were immediately thrown open to exploration and production, regardless of the environmental costs.

On one of the occasions that I lectured on the world oil market, I was brusquely reminded that the R/q ratio in the UK North Sea was closer to 5 than to 10. This does not, however, vitiate the above discussion. What it probably meant is that even in medium-deep water, production costs can be so high that, unless expected prices are high, maximizing (discounted) profits might entail consuming (i.e. destroying) some of the deposit (R) in order to speed up the recovery of the capital that was invested in the deposit so that it can be invested elsewhere. I can note here – and as indicated in the US government document referred to earlier – that if the critical R/q ratio is ignored where output is concerned, then when the decline in ‘q’ takes place it is steeper.

For those persons who have spent too much time with the conventional academic economics literature on exhaustible resources, it needs to be emphasized that the key variable in oil production is pressure in the deposit. As a result it may be so that when, on the average, about half of a typical deposit is exhausted, the pressure has been reduced to a level where raising or maintaining production by additional investment is too expensive. If this is true, then Hubbert’s peak is as much an economic as a geological phenomenon. Several researchers have tried to extend Hubbert’s work so that it takes on a distinct economics makeup, but the opinion here is that they have not been successful, because they have not given adequate consideration to e.g. pressure.

The average ‘recovery factor’ for oil at the present time is about 35%, where this factor is defined as the ratio of the amount of oil (or gas) expected to be recovered, to the total amount of oil (or gas) ‘in place’. (Note: recoverable oil, and not oil in place, are oil reserves.) In some parts of the world the recovery factor is well under 35% – e.g. for some heavy oil, it may only be 5%, which is something well worth remembering; while it has been know to reach 80% for light oil (and gas). The important thing here is that given the movement of the recovery factor over the past two or three decades, there is no longer any reason to believe that it will take the dramatic lunge upward that is necessary to radically change the global reserve figure!

The production of conventional oil involves reservoir fluids flowing under pressure out of the reservoir rock into a production well (or borehole). Initial production tends to be constant for a period ranging from several days to several years. Then, as the pressure drops and the oil has to move further through the reservoir rocks to reach a given borehole, the output will tend to decline – ceteris paribus. One of the things that will reduce the pressure is a too rapid depletion. This can result in the deposit being damaged, which in turn makes the oil more difficult to extract (for the same effort), as well as decreasing the recovery factor. Now we see why the R/q ratio is so important: by operating below the critical R/q ratio (taken as 10 in the above discussion), we reduce the ultimate flow of oil. Something else that should be recognized is that petroleum engineering is a serious profession, and most economists are like myself in that they lack the background to understand the more elusive details of oil production. Thus, for economists, levels and changes in the R/q ratio might be capable of serving as a proxy for a great deal of important geological information.

As is well known, the production profile for a typical oil field – where a field is a group of reservoirs in the same general area – exhibits rising production, a plateau, and then falling production. Obtaining this profile calls for drilling a number of production wells. Initially the flow from new wells exceeds the depletion of those already drilled, and so we start out with a rising production pattern. Then, new drilling takes place at a pace that is designed to keep output more or less constant; and finally drilling slows because as the amount of oil remaining in the field declines, the cost of extra wells is high compared to the additional amount of oil obtained.

As an example we can consider the Khurays field in Saudi Arabia, where expansion may already be under way. It is estimated that altogether 400 wells will be required over a period of 3 years in order to obtain a total of 1.2 Mb. What happens after those 3 years is uncertain, however I presume that the field will be in full decline. It will also need 2 million barrels/day of water injection, facilities to process the water, and pipelines. The same sort of thing is true for other fields, and so a natural question might be ‘why bother?’ As suggested in the next section, the money involved in these investments might be better spent on increasing petrochemical and/or refining capacity.

Accordingly, any analytical model that aspires to a meaningful exposition of oil production must explain how reservoir pressure influences the interaction between current output, investment, and the (likely) dependence of recoverable oil on the time path of production. Furthermore, the latter item should cause careful observers to immediately think of the R/q ratio, because as already noted, by driving this ratio too low, the total amount of recoverable oil is reduced due to physical ’depreciation’ of the deposit.

If a reservoir is tapped by a well, and the pressure in the well-hole is considerably less than that in the reservoir, there can be a ’natural’ flow of oil to the surface, and into a pipeline. This category of production is termed natural drive, and it tends to prevail for a relatively long time in the richest oil fields. Eventually, this pressure will fall, and some category of artificial lift must be introduced, and/or other wells drilled. Thus, what some observers think of as a pure ’one shot’ investment problem leads unavoidably to a complicated intertemporal consideration of investment.

Finally, many reservoirs are rate sensitive, and a too rapid production of oil may reduce reservoir pressure, and cause a permanent loss of the resource. What is a ”too rapid” production of oil? The simplest way to describe it is a production level which pushes the R/q ratio below what was earlier defined as the critical R/q ratio; but in addition it should be appreciated that if e.g. 10 Mb of oil are to be extracted over a 5 year period, an extraction program that lifts 2 Mb/y for 5 years could have a different effect on the ultimately recoverable amount of this resource than a program that removes 5 Mb the first year, and 1.25 Mb in each of the remaining four years.

A topic that will not be considered in this paper is ‘natural depletion’, which is roughly the amount that would be lost from reserves even if no production took place. An article in Business Week (October 10, 2005) reported that for Saudi Arabia this amounts to between 400,000 and 500,000 barrels per year. I strongly suspect that this estimate is too small.

Part 2 will be published tomorrow, October 25th.

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