Gas Is Coming Down

As most of you have no doubt noticed, gasoline prices at the pump have come down: seriously, ‘way down.

I haven’t yet heard anyone pooh-pooh “peak oil,” they way they’ve scoffed at “global warming” when they get record snowstorms in Washington, DC, but I was a little curious about other people’s take on this, so I started browsing.

Here’s what seems like a pretty sensible discussion that I found very enlightening.

It’s interesting to me that some people still try to talk about “peak oil” like it’s a physical phenomenon, i.e. “we’re running out of oil.” We aren’t even close to running out of oil. What we’re running out of is cheap oil, and the “peak” has less to do with oil than economics.

In a nutshell, here’s what happens when you start using a non-renewable resource of any sort, whether it is oil, or germanium, or flints. This describes the upside of the production curve:

  • Production costs drop
  • Competitors enter the market
  • Prices fall due to dropping production costs and competition
  • Demand rises due to falling prices, causing higher prices, more business opportunity
  • Supply rises to catch up with demand, lowering prices again
  • The economy grows

Most of us have lived this and been taught about it in Economics 101. Supply and Demand. All that. What we haven’t lived, and haven’t been taught, is the downside of the curve:

  • Production costs rise
  • Competitors drop out, or consolidate into monopolies
  • Prices rise due to rising production costs and less competition
  • Demand drops due to rising prices, causing lower prices, less business opportunity
  • Supply drops to match demand, raising prices again
  • The economy shrinks

Two symmetrical spirals, one moving up, one moving down. In between is a peak — a bumpy plateau where both production and demand are as high as they have ever been, or will ever be again.

We are right at the peak of oil production. We might linger here for a few years, maybe a decade, then we’ll be on the downslope. But it’s really interesting to watch the dynamics right now.

The demand for oil is effectively saturated. Yes, everyone would like more oil. Everyone would also like a date with Taylor Swift, and a unicorn.

The normal price of oil is too high for people to be willing to actually buy more oil. If the price goes up to even a little over $4.00/gallon in the US, people stop driving as much. They simply aren’t willing to spend any more money on gasoline, and because we are pretty much just wasting most of it on frivolous driving anyway, people have a lot of flexibility in cutting costs by using less oil. They may not like the solutions — moving to be closer to the workplace, perhaps, or telecommuting more aggressively, or doing a stay-cation rather than a vacation — any more than they like being told, “Get Lost,” by Taylor Swift, but they can make those adjustments.

Demand in China is no different. They’d love to switch from coal to the much-cleaner oil for their power plants, but it’s just too expensive. So they don’t, and burn coal instead.

Europe has been going through its Euro crisis, and also tends to be a little smarter (politically) than the US, so they aren’t jumping on the petrol bandwagon, either.

At normal oil prices — meaning, oil prices based on production costs — the market is currently saturated. Everyone who wants and can afford oil at the normal price, is getting exactly as much as they want, and no one wants any more at that price.

So the effect of fracking — or the Keystone pipeline, or any other new competition to the established supply sources — is interesting.

Let’s say that the frackers have developed “magical” improvements in fracking technology — let’s just agree with that rosy industry propaganda at the moment — that lets them exploit previously inaccessible reserves for a much lower cost than before. If that magic technology lowered the cost of fracked oil to, say, $10/barrel with the kind of long-term capacity to keep it flowing for decades, it would certainly revitalize the entire oil industry. We’d be back on the upside of the curve, and the “peak” would have been pushed off into the distant future.

But that isn’t what happened. The “magical technology” has lowered the cost of fracking from some astronomical, unaffordable value to about $40/barrel in the very best cases. Only a handful of shale deposits are viable below $60/barrel. A substantial number aren’t even viable below $80/barrel, and some require a price of over $150/barrel to become profitable. Furthermore, fracking wells deplete very quickly, so you have to go out and drill and exploit new wells. Constantly. The $40/barrel shales quickly play out, and become $50/barrel and $60/barrel shales. There’s simply no long-term cheap-oil future in fracking.

However, they can dump $40/barrel oil on the market right now.

Oil is currently selling at about $45/barrel. So the lowest-cost fracking is making about $5/barrel over raw production costs, and that isn’t close to enough profit margin to run a business with ups and downs like oil. Fracking is currently going belly-up.

The irony here is that the more oil the (barely) profitable frackers produce, the less profit they make. If they produce enough, they’ll put themselves right out of business.

Farmers raising corn in Iowa are well-familiar with this cycle of self-destruction. The world can only use so much corn, and already has all the Iowa corn it wants. The more corn the farmers produce, the lower the prices go.

On top of this, economic troubles in China and Europe, as well as the evisceration of the middle class in the US, has lowered demand even further, and until the wealth gap shrinks, that isn’t going to change.

That’s why pump prices around here have plummeted to $1.25/gallon for gasoline. It’s because we’re awash in a glut of overproduction. There’s too much oil on the market.

If you look at the cycles described above, this is the point where you would expect the monopolies — the OPEC cartel in this case — to limit production, to push prices back up. And OPEC actually tried to do this. Saudi Arabia — the 600-pound gorilla in the room1 — held out on the vote, and so OPEC did not vote to limit production. OPEC hasn’t limited production at all, and so the world is awash in oil that no one wants, and prices are going through the floor.

Why on earth would Saudi Arabia do this? The same reason any monopoly lets prices drop: to drive competitors out of business.

It’s a WalMart moment in the oil business. Saudi Arabia is trying to push all the new competitors, and all the Mom and Pop shops, out of business by pushing the price of oil down so low that competitors will go bankrupt.

It’s really the only thing that makes sense for Saudi Arabia to do.

The frackers can only hope to make any money in this business if the big producers like Saudi Arabia back off and limit their own production, driving up prices enough so that fracking can be profitable.

But at that higher price, demand simply can’t grow — oil is too expensive to start using it for new things, like running electrical power plants. So if OPEC does limit production to keep prices up, these new competitors like frackers are going to come in and — well, compete with them. For a fixed demand. Which means OPEC, and Saudi Arabia in particular, will lose customers, and profits.

It’s exactly the same problem an Iowa corn farmer faces when his neighbor decides to stop raising soybeans, and start raising corn. More competition, fixed demand, lower profits for both competitors.

Let’s look at some actual numbers regarding the cost to produce a barrel of oil:

Mideast/N.Africa oilfields 6 – 28
Other conventional oilfields 6 – 39
CO2 enhanced oil recovery 30 – 80
Deep/ultra-deep-water oilfields 32 – 65
Enhanced oil recovery 32 – 82
Arctic oilfields 32 – 100
Heavy oil/bitumen 32 – 68
Oil shales 52 – 113
Gas to liquids 38 – 113
Coal to liquids 60 – 113

Saudi Arabia can play “how low can you go” with the US fracking industry any day of the week, and win without trying.

However, they are currently pissing off the other OPEC nations. If you read the article these numbers came from, Saudi Arabian oil costs about $6/barrel to produce, and Venezuelan oil (another OPEC nation) costs $20/barrel. So this game of Limbo is digging deeper holes in Venezuela’s pockets than in Saudi’s, and they aren’t terribly happy about it.

The first article above doesn’t want to talk about when oil prices will eventually go up, and I’d be hesitant to guess.

However, what none of these articles ever discuss is that this is happening because we are currently at the production peak for oil.

Trying to decide whether gasoline will be $1.25/gallon in 2020, or $12.50/gallon, is a difficult problem. But the overall shape of the curve is pretty much inevitable. In 2100, we will most assuredly not be paying even $12.50/gallon. Gasoline, if you can even obtain it outside of government requisition, might be $125/gallon, and ordinary folks will not put it in their car to take a trip to grandma’s house.

We’ll be doing things differently.


1 This is from an old joke — Q: Where does a 600-pound gorilla sit? A: Wherever he wants.

This entry was posted in General.

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