Saudi Arabia and the oil bank

Saudi Arabia and the oil bank
By Chris Cook

As crude oil prices climbed back over US$80.00 per barrel during 2009 - after the dramatic spike to $147 and subsequent collapse to $35 - United States politicians and regulators were in no doubt as to who to blame.

They accused "speculators" such as exchange traded funds (ETFs) and hedge funds of manipulating oil prices through the use of futures and options contracts on the dominant exchanges - the New York Mercantile Exchange and the Intercontinental Exchange - and also off exchange, through bilateral over-the-counter (OTC) contracts.

But the truth lies elsewhere.

Introducing oil leasing
In 2005, Shell had a brainwave. It agreed with ETF Securities - a provider of exchange traded funds - that a new oil fund could invest directly in Shell's oil production. Whereas most ETFs that are exposed to the oil price use the oil futures markets, this initiative cut out the middlemen and all of the costs associated with maintaining a position in a futures market over time.

The outcome was that Shell borrowed dollars from the fund, while the fund borrowed, or leased, oil from Shell through forward sale agreements or otherwise. Everything was, and remains, above board and relatively transparent; but this innovative form of financial oil leasing appears to have been turned to other uses by other market participants.

Macro manipulation
Simply stated, producers have an interest in high prices. Cartels of producers have therefore often been created to openly manipulate prices by artificially supporting them. A classic example was the International Tin Council, which supported the tin price by buying tin - and stockpiling it - if and when the price fell to its "floor" price. Unfortunately, the high prices stimulated new production; eventually the ITC ran out of money; and the tin price collapsed in 1985.

In the late 1980s and early 1990s, Yasuo Hamanaka, a Japanese copper trader acting for Sumitomo Corporation, successfully manipulated the copper market not only for five years before someone blew the whistle, but even for another five years afterwards. The mechanism used was for investment banks to lend dollars to Sumitomo, which in return loaned copper through forward sales on the London Metal Exchange.

The only way to manipulate commodity prices is through the ability to secure supply. In the oil markets, funds, whether ETFs or hedge funds, are categorically unable to make or take delivery of the underlying commodity, and are therefore unable to manipulate the price. It is only "end user" producers and distributors, or the few traders with the capability to make and take delivery, who are in a position to manipulate oil prices, and in order to do so they require funding, or leverage.

I believe that it is macro manipulation by oil producers, funded by cheap money from investors, which has been the principal reason for recent movements in the oil price. The advantage producers have over oil traders is that producers are able to store their oil in the ground for free.

The Brent complex
More than 60% of global oil production is priced against the price of the United Kingdom's North Sea Brent, Forties, Oseberg, Ekofisk (BFOE) quality crude oil. Most of the rest is priced against the US West Texas Intermediate (WTI) price, but in the past 10 years, the WTI price has increasingly become the tail on the BFOE dog through "arbitrage" trading.

In order to support the global oil price, it would be necessary to secure supply through acquiring sufficient amounts of BFOE crude oil lifted each month. By the standards of the relatively few major market participants involved in the market, this is easily achievable if the funding is available.

As the credit crunch unfolded from late 2007, fund money began to pour into existing and new ETFs.

The zero bound
As short-term dollar interest rates fell to zero - "the zero bound" - investors switched their dollars into other assets, and particularly commodities, which also carry zero income, but which at least have intrinsic value, unlike the dollar or indeed any other "fiat" currency. We therefore saw simultaneous spikes in the oil markets, agricultural markets and metals markets - spikes that had nothing whatever to do with underlying supply and demand.

These rises in price continued until the destruction of demand created surpluses beyond global storage capacity, and prices thereupon collapsed as the bubble of leverage funded by investors deflated. The oil price collapsed to about $35 per barrel, and since short-term interest rates remained at 0%, the conditions were ripe for a repeat.

Banking on oil
What follows is necessarily speculative in the absence of hard evidence, but in my opinion, the 2008 "spike" was driven by one or more major commercial oil producers leasing and hence monetizing oil stored in the ground to one or more investment banks. In return, the banks collected and deployed fund money through opaque structured finance products or otherwise. Liberal helpings of hype in relation to oil shortages helped to inflate and support the market price.

In the course of a two-hour meeting in London in 2004, Kazempour Ardebili - who by then had been the Iranian representative at the Organization of the Petroleum Exporting Countries (OPEC) for some 18 years - explained that for almost all of that time he had been advocating an OPEC bank and an OPEC investment institution, but that this had never found favor with the Saudis.

Moreover, he looked back with nostalgia on the long periods of stability that pre-dated the development of the current market pricing structure. He pointed out that while high oil prices were in producers' interests, wild price swings destroyed Iran's ability to budget and invest.

The oil market in 2009 saw a rapid re-inflation from $35 to around $70 per barrel and the price has for several months been relatively stable within a range of $75 to $85. Commentators have suggested that perhaps $50 of that price is accounted for by supply and demand, while the balance is purely financially related.

It appears to me that Saudi Arabia - its participation is essential - could currently be playing the role of a central bank whose currency is crude oil, backed by the country's reserves of crude oil in the ground. Through extremely opaque market interventions by investment banking intermediaries, they could lend oil to the market - financial oil leasing - against dollar loans from investors in oil, and buy back their forward sales of crude oil in order to support the oil price within their chosen parameters.

The outcome - which has the effect of monetizing oil in the ground - is very similar to the way in which some governments maintain their currency more or less pegged to the US dollar and illustrates the reality that oil is not priced in dollars: dollars are priced in oil.

Whether or not it is in fact, as I suspect, macro manipulation by producers that accounts for movements in the prices of crude oil and oil products, and the flows and storage of crude oil and oil products, is a judgement I must leave to expert traders. But I am absolutely certain that the "speculator" investors blamed by US politicians and public for the movements in oil prices are not in fact responsible.

Unstable equilibrium
The oil market has been swinging dramatically between a lower boundary price, where an excess of supply means that, in a "buyer's market", sellers compete for sales, and the upper boundary of a "seller's market" price, where demand destruction kicks in.

According to an OPEC spokesman, the current market price is "perfect". If it is the case that the price is being financially supported at the "upper bound" within tighter pricing levels, then this is a fundamentally unstable position, where increasing supply of crude oil, or falling demand for products, would lead to a collapse - due to de-leveraging - similar to that in the tin market in 1985, and indeed, of the 2008 spike.

Although the interests of consumers and producers diverge in terms of price levels - with many in the US still convinced it is their oil that is under the Saudi desert - both have an interest in price stability. That is not the case for trading intermediaries - the middlemen - and particularly not for the investment banks that thrive on volatility and opacity, and for whom the only bad news is no news at all.

So, like a roll-on, roll-off ferry sailing in calm waters with water swilling about the car deck, I believe that the oil market will continue in a state of unstable equilibrium until it hits the next wave - which could be at any time - and the ferry overturns.

The current market architecture is fundamentally dysfunctional, and in my view a new settlement is both possible, and long overdue.

Nonsense, Peak Oil, and Oil Prices

Nonsense, Peak Oil, and Oil Prices....?

After the oil price collapse of 2008, the subsequent rise to $80 this year convinced many that people that oil traders were anticipating a tight oil market with the economic recovery. Meanwhile, others felt that speculators were reacting to financial factors like the weak dollar rather than market fundamentals. The former were very much encouraged by the many advocates of “peak oil” who perceived a long chain of negative news and predictions as heralding the end of the oil age.

Here’s the reality: we are nowhere close to the end of the oil age. A careful examination of the facts shows that most arguments about peak oil are based on anecdotal information, vague references and ignorance of how the oil industry goes about finding fields and extracting petroleum. In fact, today’s oil market is similar to what we saw back in the 1980s, which saw an oil price spike, followed by a price collapse that persisted for years.

Let’s consider the arguments of the peak oil promoters. The more alarmist of these people claim that oil production peaked sometime in the past few years, and that helps explain the triple-digit prices that occurred last year. But blaming peak oil for the price spike requires two rather extraordinary beliefs. One is that the May 2005 peak in crude-plus-condensate production is irreversible, even though such peaks have occurred in the past. The other is that last year’s 3-million-barrel-per-day reduction in OPEC production was due to a decline in OPEC capacity that just coincidentally happened as prices were collapsing and OPEC reduced quotas by 3.5 MMbbl/d.

The recent round of warnings began in the 1990s, when some geologists used so-called Hubbert curves to estimate resources and predict production around the world. This resembles the fallacy many economists fall prey to, namely believing the model over reality. Hubbert curves are not the norm in the real world, nor have they successfully predicted production except in rare cases. In 1980, Hubbert himself used the curve to estimate remaining US gas resources at 270 to 400 trillion cubic feet; US gas production since 1980 has totaled 500 Tcf, and gas reserves have increased.

Most (but not all) peak oil advocates have abandoned this theory, along with the corollary that a peak in production represents the point at which half of the resource has been produced. Since many countries have had multiple peaks, this is obviously false. Instead, these analysts rely on estimates of resources using creaming curves, made up of discovered fields by size, which tend to flatten out as an area is depleted.

Unfortunately, in doing so, two shortcomings have been ignored. First, field size estimates are not fixed, but tend to grow over time as better recovery methods are applied and new investment adds to oil-in-place. Peak oil advocates argue that new methods do not improve recovery, pointing to occasional field examples to support their claim, despite the overwhelming evidence to the contrary. Again, reality trumps models.

Additionally, creaming curves are only reliable if there are no serious constraints on drilling. Witness the interpretation (by Jean Laherrere) of the sharp drop-off in field size in the Middle East as evidence of resource scarcity in the region, when in fact it merely represents the shift in drilling after 1980 from the major countries (Iran, Iraq, etc.) to Oman, Syria and Yemen. Policy, not geology, is the explanation.

Finally, there are the recent efforts to predict production by categorizing fields and/or countries into rising, plateau or declining categories. Like other efforts, this ignores all variables (politics, economics, infrastructure, technology) in favor of a time-element, presumed to represent geology. Again, this flies in the face of the historical data, where many countries have seen production decline, only to recover upon tax reduction, the welcoming of new foreign investment, or by the simple expedient of investing more money.

And the emphasis on depletion rates, found to be increasing lately, raises a valid concern but is lacking. While new technologies allow fields to be produced more quickly, this is an input rather than an output. Drilling more wells will offset that decline rate, as witness countries like Iran, said to have an 8% depletion rate, yet whose production has not fallen—until its quota was reduced last year. Differential levels of investment explain why some countries’ production is stable or rising rather than falling, and the countries whose production is falling are often those that have a xenophobic or confiscatory investment environment.

Moving beyond the data which peak oil advocates emphasize, there is ample evidence that the petroleum resource remains abundant. In the 1990s, it was correctly noted by some peak oil advocates that there was a rough consensus (reached in the 1970s) that the recoverable petroleum resource (not the total, or in-ground, resource) was about 2 trillion barrels. Since then, however, most analysts have produced estimates of around 3.5 trillion barrels of recoverable petroleum. With a global recovery rate of about 35%, this implies approximately 10 trillion barrels of oil in place. (I personally consider that conservative, based on experience with resource estimates.) And this is conventional oil, with easily that much unconventional, mostly shale, oil around. The sky may not be the limit for production, but clearly there is no resource constraint.

Certainly, resource nationalism is a concern, since it forces the industry to exploit more expensive resources than otherwise, but it is also two-edged knife. Recall that the last major price collapse, in 1998, followed the decision by the Venezuelan government to reform its upstream sector, leading to an increase of 1 MMbbl/d in six years, mostly conventional oil. There are a number of countries that have the potential to increase production by significant amounts in the next few years, including non-OPEC countries like Brazil, Mexico, and Russia, as well as many small countries that are likely to reverse their recent declines and raise production, implying that the peak is nowhere in sight.

And while some analysts, such as CERA and Total, argue that they can’t see production rising for more than another decade or two, this is more an acceptance of the limits of their foreknowledge: we can’t see where new automobile capacity will come from in two decades, but that doesn’t mean production will peak.

The current market resembles that of the early 1980s, when, after a peak, prices moderated somewhat. Analysts warned that weak oil demand was due to slow economic growth, not conservation, and non-OPEC costs were much too high to allow any significant new supplies to come on line. As late as 1985, when OPEC production had dropped by nearly 50% in five years, almost no one anticipated the subsequent price collapse. This time around, many in the industry are more wary of predictions of tightening markets, but the likelihood of much lower prices in the next five years will almost certainly mean another major round of industry consolidation.

Michael Lynch, the former director for Asian energy and security at the Center for International Studies at the Massachusetts Institute of Technology, is an energy consultant.

Doubts about Nabucco linger on

Doubts about Nabucco linger on


On December 12 President Berdymukhamedov of Turkmenistan and President Hu Jintao of China inaugurated the first flows of gas through the Chinese pipeline from Turmenistan to China. This is an 1800 km pipeline to transport up to 40 bcm/y of gas from the Bagtyarlyk territory on the right bank of the Amudarya River to the Chinese Province of Xinjiang. It runs through Uzbekistan and Kazakhstan – where it can eventually gather additional gas – feeding onto China’s west-east pipeline system. The gas will come initially from five fields developed or upgraded by CNPC. The first indication of this Chinese intent was a deal with Kazakhstan in 2003, followed by negotiations below the horizon with both Uzbekistan and Turkmenistan. Basically 6 years from opening the talks to opening the pipe. It helps to have a single national company from well-head to the market.

Talks with Azerbaijan about flows of its gas towards Europe and eventually Turkmen gas have been ongoing for over 15 years. Many really thought Iranian gas would feed the pipe, and maybe it will, but not for some time. Nabucco came along early in that period (2004) after Austria decided it could well provide a hub for FSU imports and OMV began scouting the market for other interested partners. The interest was not long in developing, but it tended to be more among governments with geopolitical agendas than among companies with gas agendas. Ministers would meet and discuss, while the private sector prevaricated and simply wasn’t ready to buy Azeri gas. In the meantime, Austria has sold half of its Baumgarten hub to the Russians.

Some say the opening of the China-Turkmen pipeline spells the end of Nabucco, as if Turkmenistan holds the final piece of the Nabucco puzzle. Nothing could be further from the truth. If Nabucco has degenerated into endless talk it is because problems on the west side of the Caspian are unresolved. European gas interests are still not sure they want the gas, Turkey continues to play hard to transit, Azerbaijan plays its hand cautiously with a wary eye on its Russian neighbor and important difficult-to-resolve regional tensions are adding their own complications. If all this isn’t enough, some suggest that the August agreement on South Stream spells the end for Nabucco. Here again, this is far from the truth. South Stream is a rhetorical pipeline designed to frustrate Southern Corridor gas – in particular Nabucco. South Stream would cost too much, replicate transport capacity, not deliver Caspian gas anyway and has no other identifiable source of gas to fill it – it won’t happen.

Elsewhere, the US is producing 70-80 bcm of unconventional shale gas per year, thereby not needing roughly the same amount that it would have taken from world LNG markets. This, combined with a surge in global LNG liquefaction just now, means that LNG will be available at considerably lower prices than European contract gas or even Azeri net-back gas for some time. The take-or-pay clauses between Gazprom and European gas companies look particularly onerous just now. Add to that the temporary slump in demand due to the economic recession. As a consequence, new pipelines are not seen to be as crucial to Europe’s energy security as they once seemed. So while China ramps up its imports of Turkmen gas over the next months, a European link to Caspian gas through Turkey looks set to slip considerably further into the future. And while Turkey may continue to hope in can leverage other political and commercial objectives through its transit negotiations, its lever is probably getting shorter.

Whatever, there is room for confidence that Nabucco will continue to dominate the conferences and workshop of the Caspian chattering class - but will it ever be built?

Balochistan cancels $3.5bn copper mine contract

http://dailybalochistanexpress.com/archive_news/16122010/express/news/news10.htm

Balochistan cancels $3.5bn copper mine contract..... Local authorities in Pakistan have canceled an agreement with an Australian company for the exploration of copper and gold in the Reko Diq area in southwestern Balochistan province at a time when a feasibility study for the project was near completion. Australia's Tethyan Copper Company (TCC), a joint venture between Canada's Barrick Gold and Chile's Antofagasta Plc, had an exploration license for the copper mine at Reko Diq, which has an estimated four billion tonnes of low-grade copper and gold, in the district of Chagai. Last month, when the Balochistan government passed a motion to terminate the contract with TCC, it called the move a step towards getting control over provincial resources in accordance with the wishes of the people. Critics said the local government's action was politically motivated to appease Baloch nationalists in the desperately poor and insurgency-hit province, who have been demanding the cancelation of the agreement. The deal was signed under the government of former president Pervez Musharraf. The present central coalition government led by the Pakistan People's Party is trying to end the insurgency and recently presented a "Balochistan Package", which recommends a series of constitutional reforms, economic measures and administrative steps to assuage the feelings of the Baloch people. Balochistan chief minister Nawab Aslam Raisani said TCC had violated its contract, which had been signed only for exploring for minerals, according to the Dawn newspaper. The federal government had not yet sought any explanation from the Balochistan government over the cancellation of deal, the report cited Raisani as saying. The provincial cabinet decision relates to the termination of the exploration contract after it expired, while the fate of the company's proposal for a mining agreement is yet to be decided, according to the chief minister. Tethyan, which had a 75% interest in the project, allegedly introduced unnecessary delays and exceeded the limits of the contract, which was awarded only for drilling purposes. The provincial government, which has decided not to lease out the land to TCC for further work, is believed to be looking for other investors and technical expertise to manage the project indigenously. TCC sees the contract cancelation as a violation of internationally accepted exploration rules, under which the exploration company gets the first rights to mining in the project area, as no mining firm can invest billions of dollars only in exploration. The United States has urged the central and provincial governments to stand behind their agreements with international companies, as the cancelation of the Reko Diq copper contract, involving two major international mining firms threatens to cost the country a loss of US$3.5 billion in investment for one of its least developed regions. "Multinational corporations will not invest in a country where deals are canceled," a Business Recorder report last Thursday quoted the US ambassador to Pakistan, Anne Patterson, as saying. Some analysts believe the Reko Diq mine may now be developed with the help of China, which is engaged in extracting copper from the Saindak mine in the same district. They also warn that the government should learn from its experience at Saindak. Metallurgical Corp of China (MCC), which acquired Saindak on a 10-year lease in September 2002, is overmining in the area at the cost of the mine's estimated life of 19 years, say local experts. They also point out that copper extraction creates various toxic wastes, but there is still no reliable data available on the production and environmental impact at Saindak. Reko Diq, with an estimated life span of more than 50 years, is four times larger in copper ore tonnage than Saindak. The provincial government has handed over affairs of the Reko Diq project to the provincial department of mines and mineral development, which has acquired the services of Samar Mubarakmand, an eminent Pakistani nuclear scientist. TCC has been criticized for selling its interests to Antofagasta and Barrick without the permission of the Balochistan government, which holds the remaining 25% interest. Barrick's share price in New York has declined from a one-year high of just below $48 on December 1 to $41.43 last week, after recovering from about $38 on December 17. Antofagasta is trading at 1,024 pence in London, close to its one-year high and more than double its price of a year ago. Analysts also question why, if the provincial government had some grievance against TCC's operations, it did not react earlier when the company declared in July that it would invest $3 billion in the project in the current fiscal year, which ends in June. The cancelation is "a non-routine solution", said Sardar Shaukat Popalzai, president of the Balochistan Economic Forum, according to The Nation daily newspaper. The relevant departments and political leadership should not take unwarranted decisions after projects are considered and then initiated after all clearances are granted on their merits, he said. Popalzai has reportedly suggested that a provincial assembly committee, along with a sub-committee consisting of local stakeholders, including the investors, should be formed to remove all irritants. TCC itself has "not yet received any cancelation notice for the Reko Diq project from the government", Samia Ali Shah, the company's public relations manager, told Asia Times Online. "We will decide our strategy as soon as we receive notification from the Balochistan government." She said, "Tethyan is currently undertaking a feasibility study, which is in its final stages, for development of the Reko Diq mine." Feasibility studies include engineering analysis and studies of infrastructure alternatives involving the likes of rail, road, power, port and water supplies and overall technical and economical viability. "The environmental and social impact assessment [ESIA] of the project is also expected to finish at the end of the first quarter of this calendar year." The Balochistan government first signed a contract for the Reko Diq exploration area with BHP Minerals in July 1993 and established a joint venture with BHP Billiton in June 2000, with the government keeping a 25% interest against BHP's 75%. TCC, which holds an alliance with BHP Billiton, raised funds for the project by floating its shares on the Australian Stock Exchange and planned to start the project in 2003 with an investment of $130 million. Samia said her company was responsible for progress made since 2006, when Antofagasta and Barrick Gold took complete control of TCC, which is now a joint-venture company. She said, "We have so far made significant progress. We had only 50 people as employees of the project in 2006 when Barrick Gold and Antofagasta took over the project. The number of our permanent employees presently exceeds 200. "We spent $100 million, including expenditures on the feasibility study in 2008. An additional 146,000 meters were drilled last year and showed significantly large resource estimates at Reko Diq. The infrastructure developed at the exploration and feasibility stage of the project includes an airstrip and high-standard camp site facilities." Samia said a large part of the promised investment of $3 billion would start coming as soon as the project entered the construction phase, after completion of the feasibility report and signing of agreements with the government. Balochistan, the country's least-developed province but a prospective metaphorical and literal gold mine for companies eyeing its untapped mineral reserves and hydrocarbon resources, direly needs foreign investment to create jobs, develop communities and boost revenues. The district of Chagai is one of the most backward and least-developed areas in Balochistan. It lacks healthcare facilities and has a poor educational infrastructure. The human development indicators in the district are among the most challenging in the country. With no infrastructure, no proper road network and no industry, the people of the Chagai desert lack almost any employment opportunities. TCC has spent $1.5 million to date on initiatives such as training local people, local procurement, a school house, a health clinic, teacher training, and humanitarian aid for natural disasters like floods and earthquakes in Balochistan. The company also provides training to the local women in tailoring skills to establish local businesses to supply TCC uniforms. Samia said, "We plan extensive training and capacity building programs to prepare local people for work within the Reko Diq project. We see our role as a catalyst for economic and social development of the communities we operate in." The first batch of TCC employees, 80% from the province and about 76% of them from Chagai, has already been sent to the Descon Institute in Lahore for training.

The Future of Global Oil Supply:

http://www.fromthewilderness.com/free/ww3/100405_petrocollapse_speech.shtml

http://www.cera.com/aspx/cda/client/report/report.aspx?KID=5&CID=10720

Understanding the Building Blocks

by Peter Jackson, Senior Director, IHS Cambridge Energy Research Associates

Context: Predicting Supply in a Complex World

Fears about "running out" of oil are recurrent. At their strongest, they coincide with periods of high prices and tight supply-demand balance. The latest such period of "peak oil" concerns became very evident from 2004, when strong oil demand ran up against capacity constraints. In contrast, IHS CERA’s reference case for global liquid productive capacity shows growth through 2030 to around 115 million barrels per day (mbd) and finds no evidence of a peak in supply appearing before that time.

Hydrocarbon liquids—crude oil, condensate, extra heavy oil, and natural gas liquids—are a finite resource; but based on recent trends in exploration and appraisal activity, there should be more than an adequate inventory of physical resources available to increase supply to meet anticipated levels of demand in this time frame. Post-2030 supply may well struggle to meet demand, but an undulating plateau rather than a dramatic peak will likely unfold. Moreover, if the "peak demand" now evident in the OECD countries is a precursor of later developments in the emerging markets, world demand itself could eventually move on to a different course.

In the short term the industry is at another crossroads following the precipitous fall in demand in 2008–09 in response to the onset of the recession. The oil price has roughly halved from its peak of $147 per barrel in July 2008, OPEC has recently cut production, OPEC spare capacity has nearly tripled to 6.4 mbd, and the industry has slowed its pace of expansion. Early in 2009 IHS CERA estimated that as much as 7.5 mbd of new productive capacity could be at risk by 2014 if costs remained high and oil prices hovered just below the cost of the marginal barrel for two years. Since then the oil price has recovered strongly to around $70–$80 per barrel, and some confidence has returned. Even in these unpredictable times the industry has continued to invest and to build new productive capacity; indeed, Saudi Arabia recently brought onstream the giant Khurais field, which at plateau is expected to produce 1.2 mbd. With sustained investment, a healthy cushion of spare capacity, and slow to moderate post-recession economic growth, supply should not present major problems, at least in terms of availability, in the short term.

Of course looking further ahead, it is important to recognize that oil is a finite resource and that at some stage supply could fail to meet demand on a consistent basis. It is impossible to be precise about the timing of this event, but given the pace at which demand has increased in the past decade a pivot point may well be reached before the middle of this century. Much depends on key factors such as global economic growth, the capability of the upstream industry, costs, government policies on access and taxation, the evolution of renewable and alternative energy sources—particularly for transportation—and the effect of climate change issues on policies and regulations concerning the use of fossil fuels. However, there is time to prepare and to make rational decisions to avoid being forced into short-term approaches that may not resolve longer-term problems.

Many studies of future oil supply examine subsurface issues and focus in particular on the scale of the resource while giving limited consideration to technology, economics, and geopolitics. Though belowground factors are critical, it is aboveground factors that will dictate the ultimate shape of the supply curve.

This IHS CERA Report presents the main points in our current productive capacity outlook to 2030 and discusses the architecture of future conventional and unconventional oil supply. In order to provide a framework, the methodology and foundations of the outlook are reviewed and the results of supporting studies on decline rates and giant fields are included.

In so doing, this report addresses the debate over "peak oil." There is much emotion involved in that debate. In our view much would be gained by lowering the emotional level and instead shifting to a more objective dialogue, based on a comparative view of data, methodology, and analyses. Our hope is that this paper can contribute to such a discussion and exchange. Our further hope is that out of such a dialogue will come a deeper understanding of the world’s oil supply in the decades ahead—a question crucial to the world’s overall future.

There are many areas of overlap between IHS CERA’s view of future oil supply and other outlooks. Oil is a finite resource, and at some stage supply will begin to fall short of meeting demand on a consistent basis if there is no break in the connection between economic growth and oil demand. The basic differences in opinion appear to center on when this will happen and on what happens after the inflection point. The view that oil supply will plummet after the inflection point and oil will run out, like the gasoline in an automobile, is misleading for the layperson.

IHS CERA believes that this inflection point will herald the beginning of an undulating plateau of supply that will last for perhaps two decades before a long, slow decline sets in (see Figure 3). It represents a transition period when traditional market forces and government policy will be unable to adjust supply to meet growing demand and limits are reached. Of course the path of demand will exert a controlling influence on the future supply curve. Peak demand is an equally important concept that may well be viewed in hindsight, from the perspective of a half century from now, as the main driver of peak supply.

But one further important point: Though a peak of global oil production is not imminent, there are major hurdles aboveground to negotiate.

Methodology: Defining the Yardsticks

Let us begin with the methodology with which we approach these questions.

Productive capacity is defined as the maximum sustainable level at which liquids can be produced and delivered to market. Productive capacity estimates account for routine maintenance, but not for general operational inefficiency, temporary interruptions such as weather or labor strikes, nor for dramatic swings in political and economic factors. For example, a field may have a productive capacity of 140,000 barrels per day (bd) but in reality produce 130,000 bd on average over a year because of unforeseen maintenance issues, regulatory inspections, rig movements, and tie-ins.

At the core of IHS CERA’s methodology is recent production history, which is considered the most reliable data available on which to base a supply projection. We can measure the barrels arriving at the surface over time. Future production trends are extrapolated using a comprehensive framework of decline rates and knowledge of operational plans for individual projects and fields. Remaining reserve data are an important constraint on the future supply profiles but—given the uncertainties in reserves estimation—can be used only as a broad guideline of future supply.

Four key components of supply are included in the outlook (see Figure 1):

fields in production (FIP)

fields under development (FUD)

fields under appraisal (FUA)

yet-to-find (YTF) resources

IHS CERA has fully incorporated the data from the IHS International Field and Well Data database so that there are approximately 24,000 fields and discoveries underpinning the outlook. In addition, we have conducted detailed analysis of field production characteristics, especially decline rates, which have been incorporated at the field and project levels.

A detailed database of approximately 450 OPEC and non-OPEC FUD provides a clear insight into the immediate plans of the industry to execute new projects ranging individually up to 1.2 mbd at production plateau. YTF resources are estimated by extrapolating historical activity and success rate data and making assumptions about future levels of activity in key countries. We have recently compiled historical exploration data from the IHS International Field and Well Data database on well count, success rate, and discovery sizes for each country, which has improved the YTF analysis.

In this activity-based model we take account of project efficiency, costs, timing, hardware availability, and our detailed oil price outlook. We adopt a holistic portfolio perspective to evaluate global productive capacity. Although it is clear that some giant fields such as Mexico’s Canterell are now strongly in decline following a successful secondary production program, and many countries are past their "peak," the sum of the parts as we currently see them show that global productive capacity should be able to grow for at least the next two decades.

Why So Much Variation Among Published Outlooks?

The long and complex debate about the future of global oil supply is characterized by two overriding characteristics: the very large range of potential outcomes projected and sustained disagreement about "the answer."

Production volumes are closely related to reserves, rock physics, and investment. Publicly available data tend to be limited and of variable quality. A wide range of methodologies have been applied to the problem, from those encompassing systematic analysis and careful assumptions to less robust techniques such as Hubbert’s method, which can provide a good approximation in certain circumstances but fall down especially where government policy constrains production. Importantly, Hubbert’s approach, developed in the 1950s when technology was stagnating, also fails to account for fluctuations in demand, technology advances, and the discovery of new hydrocarbon plays. Additionally different studies are based on variable views on reserves/resources, field production performance, future exploration, technology, and commercial issues. Few have attempted to incorporate the impact of aboveground factors such as demand and geopolitics.

Some models are based on a very pessimistic view of the future, which is not borne out by scrutiny of recent trends in exploration and production. For example, frequent claims—that "half of global oil reserves have been produced," "global reserves are not being replaced on an annual basis," and "deepwater exploration is essentially exhausted"—are questionable. The recent discoveries of ten giant oil fields below a thick salt layer in the Santos Basin, Brazil, may have boosted global resources by at least 25 billion barrels. Further assertions that giant oil fields are past their prime simply are not borne out in a recent detailed study of 548 giant oil fields in the IHS CERA Private Report Giant Fields: Providing the Foundation for Oil Supply Now and in the Future? This study demonstrates these fields’ continuing strong contribution to global supply and that some 76 giant fields, representing 84 billion barrels, remain undeveloped. Fields in general and giant fields in particular still show considerable potential for reserves upgrades, as illustrated in many studies.

IHS CERA’s 2009 Supply Outlook: "Pausing for Breath"

In our most recent reference case outlook, global productive capacity is expected to average approximately 92 mbd in 2009 and to rise to 115 mbd by 2030. This is a lower rate of growth than we have projected in the past and reflects the reaction of the oil industry to recent changing market forces. This is just one version of many possible outcomes, and we use it in this report to illustrate the architecture of supply and the nature and scale of the problem. This reference case provides a view of the building blocks of future supply in terms of FIP, FUD, FUA, and YTF as well as "Others," the category of unconventional liquids that include extra heavy oil, biofuels, coal-to-liquids/gas-to-liquids, and natural gas liquids. With aggregate decline rates of around 4.5 percent per year, FIP provide a diminishing proportion of the total future capacity. But in terms of the conventional oil asset life cycle, exploration replenishes the appraisal project inventory, which feeds into sanctioned development projects and ultimately producing fields. Figure 1 is a snapshot of a very dynamic system.

This summary does not show evidence of a peak in oil productive capacity before 2030. However, it does emphasize the importance of future exploration and the role of unconventional liquids in generating growth in the future. IHS CERA believes that unconventional liquids already contribute around 14 percent of total global capacity, and we expect this share to grow to 23 percent by 2030. The contribution of exploration is emerging as one of the key uncertainties and is the subject of current IHS CERA research.

This model assumes that

The oil price stays above the cost of the marginal barrel for most of the period to 2030.

There are adequate existing and future resources to support these sustained volumes of higher capacity.

The industry can build the hardware and develop the technical capability to implement investment programs.

What Are the Challenges to Producing a Robust Outlook?

Predicting future productive capacity hinges on an in-depth understanding of a complex multicomponent system, which is driven by the interplay of both aboveground and belowground factors. It is not realistic to treat the global oil endowment as if it were simply in a tank being emptied. IHS CERA’s experience of evaluating productive capacity over two decades suggests that there are no unique answers, a point reinforced by the wide variety of published outlooks noted above.

As part of our ongoing research program IHS CERA has concentrated on a number of factors that will strongly influence future supply:

Data. The IHS CERA reference case outlook is based largely on the IHS International Field and Well Data, and North American databases, which are arguably the most comprehensive available upstream data sets available. A reliable and comprehensive database is critical to any credible projection—but the complexity of the analysis requires making some significant assumptions. IHS CERA has critically tested many of these assumptions by studying some of the key questions relating to historical exploration trends, resource replacement, and oil field performance.
But even a perfect data set would generate a range of possible outcomes in modeling because of the complexity of the problem. The debate about future supply and data has tended to focus on subsurface technical data, especially reserves data. But there is a wide range of sources related to aboveground drivers that is also crucial in assessing country-specific economic data and projections—which drive supply—as well as rig count, yard space, and service sector capability.

Reserves. To date, the analytical core of this debate appears to have hinged on knowledge of field and global reserves. Oil and gas reserves are defined as the volumes that will be commercially recovered in the future. Hydrocarbons are trapped in reservoirs underground and cannot be physically audited or inspected, so estimates are based on the evaluation of data that provide indirect evidence of the scale of the reserve base. The Society of Petroleum Engineers (SPE) has produced a detailed set of six categories of reserves and contingent resources and three categories of undiscovered prospective resources. These reserves estimates entail large degrees of uncertainty, and a great deal of experience and judgment are required in performing the calculations.

Given the complexity of the calculations there are no unique answers at the individual field or global levels, and we still do not know exactly how much has been discovered or what remains to be found, despite any claims to the contrary. Current estimates can only be considered as orders of magnitude. The questionable use of resource estimates is well illustrated by Hubbert’s (1982) approach, which suggests that a peak of production occurs when half of the global inventory of supply has been produced. This seems plausible initially, given that some 1.1 trillion barrels of oil has been produced to date and there are apparently some 1.2 trillion barrels remaining to be produced. But that is appearances. What this approach does not make clear is that this analysis is based on "proven plus probable conventional reserves" alone, which amounts to 2.3 trillion barrels. It ignores all the remaining categories of conventional and unconventional reserves and resources (including possible, contingent, and prospective reserves), defined by the SPE, which could ultimately contribute at least as much again. IHS CERA estimates that global resources could be approximately 4.8 trillion barrels, including just over 1.1 trillion barrels of cumulative production to date.

It is clear that we are dealing with a finite resource, but more consistency in reserves reporting and further systematic studies are needed, such as the United States Geological Survey (2000) study of global YTF resources, to improve the quality of the numbers. Remaining reserves data are an important constraint on the future supply analysis—but given the uncertainties this can be used only as a broad guideline. Existing resource estimates have a habit of being increased as fields are upgraded and new plays are established.

Decline rates and field performance. At the core of IHS CERA’s productive capacity model is an extrapolation of historical production data into the future. We have completed a study of over 1,000 fields to understand the characteristics of field production through the buildup, plateau, and decline phases. Central to this analysis is an attempt to estimate typical decline rates for a range of field sizes and types in different geological and geographic environments. Information from relatively mature, data-rich areas such as the North Sea and Norway suggested that decline rates were well above an alarming 10 percent on an individual field basis, so it was important to complete this study to develop a more accurate and representative picture around the world.

In the discussion there often seems to be a confusion betweendepletion and decline. All oil fields start to deplete the day production begins, but not all fields have production in decline. Oil field production only starts to decline after the plateau period of production has ended. From our 1,000 field study database only 40 percent of production comes from fields in decline, suggesting, perhaps surprisingly, that a significant proportion of all production comes from fields building up or on plateau. This striking point often seems to be lost in the discussion. This study showed that the average decline rate for fields that were actually in the decline phase was 7.5 percent, but this number falls to 6.1 percent when the numbers are production weighted. The numbers were subsequently corroborated by the IEA (2008). Importantly, the global aggregate decline rate of all fields currently in production (which includes fields building up and on plateau) works out to be around 4.5 percent. It is anticipated that aggregate decline rates might increase slowly with time and also that ultimate recovery will continue to increase medium term.

Giant fields are still the cornerstone of global production. Some 548 giant oil fields contribute 61 percent of the total; and although production from the giants has risen, that proportion has remained steady in recent years. Recent IHS CERA research on giant oil fields shows that collectively the giant fields are not in decline and that some 60 percent of their recoverable oil remains to be produced. The number of giant field discoveries has declined in recent years, but their contribution seems unlikely to plummet in the near term.

Costs and capability. The IHS CERA Upstream Capital Costs Index (UCCI) is a combination of a set of indexes used to monitor the current state of the global upstream cost environment. Set at 100 in 2000, it more than doubled by the end of 2008 (230). This means that oil companies were essentially spending twice as much to undertake the same amount of work as in 2000. By the end of September 2009 the UCCI declined to 202, putting costs back to early 2007 levels; and although oil prices recently fell back to 2004 levels, cost reductions are projected to drop only gradually over the next six months. Some service sectors, such as the deepwater rig market, will sustain a high pricing structure because of the sustained demand; others, such as jackup rig markets, have softened and may continue to do so.

One critical factor for future oil output is people. Current upstream sector demographics are such that a large proportion of experienced professionals will retire in the next ten years. The industry has acknowledged this for a number of years and has taken steps to hire and train a new generation of experts, but this may be too little too late. In the current downturn the industry is again in danger of further erosion of its skills base. The service sector in particular is under pressure from operating companies to reduce costs, and this means rationalizations of staff, which will seriously restrict the capability of the service sector in the future.

Other aboveground factors. One key driver of the future supply outlook, rarely considered, is the ability of OPEC countries to control production. In most non-OPEC countries exploitation has progressed without much constraint. This means that for many non-OPEC countries, especially those with modest reserves, production has already peaked. While non-OPEC production capacity still has the potential to grow, it always produces at the limits of its productive capability with limited flexibility. On the other hand, with its vast resource base, much of it undeveloped, OPEC has controlled investment and production, depending on market conditions. Many OPEC countries have specific policies that control the pace of exploitation for future generations. Also many national oil companies have a different approach to oil field exploitation that focuses on optimizing long-term recovery. Extrapolating the impact of current OPEC investment and policy on future supply does not support a short- to medium-term shortage of oil.

Any outlook can present only one potential version of the future. IHS CERA uses a reference case production capacity outlook to generate three scenarios for future production—Asian Phoenix, Break Point, and Global Fissures—that enable an understanding of the range of possible drivers of future supply and describe three feasible outcomes. Recent oil price volatility has further reinforced the point that the future is highly uncertain and a range of outcomes should be considered.

The Big Picture

It would be easy to interpret the following market and oil price events from 2003 through 2008 in isolation to support the belief that a peak in global supply has passed or is imminent:

oil price spike to $147 per barrel in July 2008

tight supply-demand balance of around 2.5 mbd through mid-2008

considerable decline in global production to around 83 mbd

However, these events are linked to an array of political and economic factors, including a global boom, "the rise of the emerging markets," financial market impact, and constraints on "catching-up" in developing new capacity. They do not herald the onset of a peak and at the simplest level illustrate that the market continues to act as the shock absorber of major volatility. Supply continues to respond to prices (conditioned by expectations of future demand), and simultaneously demand responds to prices.

Improved data availability and transparency could help to produce more accurate outlooks for future capacity—but even this will not provide unique, reliable answers. Subsurface data on reserve levels and decline rates are only a part of the story. Some of the major aboveground factors that will continue to affect what actually happens to output are listed below. Both their importance and the range of possible outcomes inherent in them are evident:

future course of the global economy

government policies and decisionmaking in resource-holding countries

balance and impact of the complex web of geopolitics

future course of oil prices

course of government policies that focus on controlling demand

development of renewable energy sources and climate change issues

Many projections, including those based on the methodology of Hubbert, fail to account for the impact of economics, technology, or geopolitics,while others concentrate on conventional oil alone and fail to account for the growing proportion of unconventional oil being developed and produced. One is struck by the conviction, in each period, that technology has gone "about as far as it can go."

IHS CERA tackled this issue by developing a possible range of outcomes through plausible scenarios for the future of global energy. Even this comprehensive study—completed in 2006—does not present a unique base case projection, but rather develops the three scenarios noted above—Asian Phoenix, Global Fissures, and Break Point—extending to 2030. Indeed elements of these scenarios have played out during the past three years.

The Break Point scenario, developed in 2006, envisaged that oil prices would reach $150 per barrel. It demonstrated the importance of the feedback loops. In this scenario high prices and fear of shortage have a strong price response and policy response. The results include a shift by consumers and automakers, and programs to enhance energy efficiency and accelerate growth of alternative fuels, and oil loses its monopoly on transportation.

Global Fissures envisions a deep recession. A widespread political backlash against free trade and globalization, combined with global trade and political disputes, lowers economic growth and weakens energy prices. One of the triggers is a hard landing of the US economy, owing to the overhang of debt in housing and other sectors. Global Fissures reflects the current global climate most closely.

Looking ahead, we can see that the upstream industry faces many challenges. There is little doubt that the existing and possible future resource base can support growth in capacity through 2030. There is no shortage of new projects or exploration potential to replenish the hopper. Exploration and field upgrades have tended to replace global production in recent years. Exploration is not yet in terminal decline, and while recently some 12 billion barrels of oil has been discovered annually, the five-year moving average is actually growing (see Figure 2).

The longer-term problem lies not belowground, but in obtaining the investment and resources that the industry will need to grow supply significantly from current levels. Both OPEC and non-OPEC countries have a strong current inventory of some 450 projects under development. The recent fall in oil prices has precipitated a slowdown in the rate at which projects are being sanctioned and developed—but this temporary situation will ease when the global economy starts to recover. The projected medium-term slowdown in the rate of supply growth is a simple function of economics rather than evidence of an imminent peak.

Yet there are a number of trends that cause concern. Non-OPEC growth has been worryingly anemic for five years, driven largely by slowing growth of productive capacity in Russia. Non-OPEC may well struggle to regain the annual growth levels greatly exceeding 500,000 bd that were common before 2004. OPEC countries will be a key element of future growth, but prolonged periods of low oil prices (below $60 per barrel) and abundant spare capacity of around 6.5 mbd might well start to inhibit long-term supply growth. But just over the horizon a period of strong economic growth could quickly reverse this trend.

However, structural changes currently occurring in the service sector in response to falling costs will pose a threat to future supply expansion. After nearly a decade of strong growth in response to increasing demand, some service sector companies are downsizing and restructuring, and this will affect the ability of the service sector to help bring on new supply at an appropriate pace when demand starts to recover.

While the current economic situation has driven a reduction in exploration and production investment, it has also coincidentally provided a supply cushion that will take some time to work its way back into the system. Companies continue to build new productive capacity, albeit at a slower rate than one year ago. Collectively this will provide a short-term cushion until the global economy starts to pick up again from 2010 onward. One can well envisage a scenario half a decade or so from now in which a period of strong demand growth again leads to a period of tight supply and higher prices as investment and capacity growth fail to keep up.

But this should not be confused with the inflection point (see Figure 3). Ultimately there will be an inflection point when sustained growth of productive capacity will cease. As already noted, one fundamental difference is the view of when it occurs—is it imminent or two decades or more away? The other difference is on the question of what happens after the inflection point. The idea that oil supply will collapse after the inflection point and that oil will run out of the "tank in the ground" confuses the public. In our view this inflection point will inaugurate a new era—the beginning of an undulating plateau of supply. That, in turn, will last for another two decades or so, before a long, slow decline sets in. Would that be in 2050 or 2060 or even 2070? Whenever, it would take us into still a third era—the start of a transition period when traditional market forces and government policy will be unable to adjust supply to meet growing demand and the real limits are reached.

But much will happen before then that will affect demand—from changes in the automobile engine and the electric battery to changes in demographics and values. That is why the concept of "peak demand" is so important. Ironically, it may come be viewed in retrospect as the main driver of peak supply. In that case what happens aboveground will have set the tempo for what happens belowground.

Free trade, USA's freekenomics

Free trade, USA's freekenomics

No economic policy could better serve Americans than genuine free trade, but open trade policies are failing Americans.

Free trade is a compelling idea. Let each nation do more of what it does best, and specialization will raise productivity and incomes. Americans are not sharing in those benefits because President Barack Obama, like president George W Bush, permits China and others to cheat on the rules, unchallenged, to the detriment of the US interests he was elected to champion.

The World Trade Organization has greatly reduced tariffs, prohibits virtually all export subsidies, and regulates other national policies that could subvert trade, such as health and product safety standards arbitrarily slanted to favor domestic suppliers.

For these rules to optimize trade, raise productivity and boost incomes, exchange rates must adjust to reasonably reflect production costs. To buy Chinese televisions, Americans must be able to purchase yuan with dollars; however, an artificially strong dollar that overprices US tractors and software in China will unravel the benefits of trade by denying Americans opportunities to export to pay for those televisions

Exchange rates are established in currency markets, created by businesses trading through major financial institutions. Unfortunately, China and several other Asian governments blatantly manipulate those markets without a credible US response and with ruinous consequences for American workers.

The United States annually exports US$1.6 trillion in goods and services, and these finance a like amount of imports. This raises US gross domestic product by about $170 billion because workers are about 10% more productive in export industries, such as software, than in import-competing industries, such as apparel.
Unfortunately, US imports exceed exports by another $400 billion, and workers released from making those products go into non-trade-competing industries, such as retailing, where productivity is at least 50% lower. This slashes gross domestic product by about $200 billion, overwhelming the gains from trade, and requires workers displaced by imports to accept lower wages.

The trade deficit creates an excess supply of dollars in international currency markets, as Americans offer more dollars to purchase foreign products than foreigners demand to purchase US products.

Simple supply and demand should drive down the value of the dollar against the yuan and other currencies, make US imports more expensive and exports cheaper, and reduce or eliminate the trade deficit. But the Chinese government subverts this process by habitually printing and selling yuan for dollars in currency markets, keeping its currency and exports artificially cheap.

Currency manipulation creates a 25% subsidy on China's exports, and other Asian countries are impelled to follow similar policies, lest their exports lose competitiveness to Chinese products.

Also, huge trade imbalances between Asia and the West, perpetuated by currency mercantilism, create an imbalance in demand - a shortage of demand for the goods and services produced in the United States and Europe, and artificially robust demand for products made in China and elsewhere in Asia.

Consequently, to keep the US economy going, Americans must both borrow from foreigners and spend too much, as they did through 2008, or their government must amass huge budget deficits by borrowing from abroad, as it is now does thanks to stimulus spending and the Troubled Asset Relief Program.

In the bargain, the United States sends manufacturing jobs to Asia in industries that would be competitive, but for rigged exchange rates. The trade deficit slices $400 billion to $600 billion off GDP, and Americans suffer unemployment above 10%.

China grows at nearly 10% a year and makes American diplomats look like fools for advocating free markets as a growth policy.

Campaigning for the presidency, Barack Obama promised to do something about Chinese currency manipulation. Instead, like a good supplicant, he now thanks Chinese officials for buying US Treasury securities.

China's development policies make its leaders look smart, but nothing makes them look like geniuses better than an American president who appeases their beggar-thy-neighbor policies.

It will be impossible for the United States to create the 9 million jobs needed to bring unemployment down to pre-recession levels without taking on China's currency manipulation and other unfair trade practices.

For that, Americans may need to wait for a better president - one with the courage to stand up to China.

Through dollar hegemony, the United States is the only country that can defy the Mundell-Fleming thesis. For more than a decade since the end of the Cold War, the US has kept the fiat dollar significantly above its real economic value, attracted capital account surpluses and exercised unilateral policy autonomy within a globalized financial system dictated by dollar hegemony. The reasons for this are complex but the single most important reason is that all major commodities, most notably oil, are denominated in dollars, mostly as an extension of superpower geopolitics. This fact is the anchor for dollar hegemony which makes possible US finance hegemony, which makes possible US exceptionism and unilateralism.

When China exports real wealth to the US for fiat dollars, it is receiving US sovereign credit in exchange of material wealth in the form of goods. Thus the US trade deficit denominated in dollars is in fact US lending to China through buying Chinese goods on credit. China now is a holder of US fiat money and as such is acting as a state agent of the US, with the full faith and credit of the US behind the US sovereign credit instrument (dollar), which is good for paying US taxes and is legal tender for all debt public and private in the US.

Fiat money, like a passport, entitles the holder to the protection of the state in enforcing sovereign credit. It is a certificate of state financial power inherent in sovereignty. Since China does not pay US taxes, the dollars that China receives can only be used to buy US sovereign debt (Treasuries) through extinguishing the US sovereign credit instruments (dollars). Through this transaction, China changes its position from that of an agent of US sovereign credit to that of a creditor to the US. This is why China must buy Treasuries with its surplus dollar - to change its position from that of a US agent to that of a US creditor.

2010, the darkest scenario is not far off

2010, the darkest scenario is not far off

If Murphy’s Law ever met 2010, it could literally mean the end of an era that began in the industrial revolution, what will one day be called the industrial age. An age that will be marked by three phenomena: consumption, extreme violence (against humans and the environment), and innovation. The beginning of the 19th Century saw the perfect synthesis of an untapped, virtually virgin planet earth, a scientific culture on the brink of major breakthroughs and a human culture economically organized to create and fulfill unlimited human demand.

As we look back at the post-war era from a post industrial age perspective it will seem like a drunken paradise. Paradise in the sense of being able to quench, at least by the rich, almost any whim or desire, a limitless orgy. Drunken because only an intoxicated society could have been so blind to the destruction it was causing. Even while on the brink of disaster, the wealthy kept on living as if nothing was ever going to happen to them. The Titanic had already hit the iceberg but they refused to believe it. History will not be kind to this generation.

Another, much larger part of the world, looked on in envy and despair, left out of the party, stripped of their natural resources and left broke by corrupt governments and overwhelming foreign debt. They have little to lose and will only cry because of their compatriots who made it to the Promised Land only to suffer along with the rich. The year 2009 will be remembered as the false peace, the year when the rich decided to dive headfirst back into the cookie jar instead of wising up. Who doesn’t sense now that something is very wrong? Remember that feeling of real confidence in the future, like the 1990’s? Does anyone believe that we are really okay? Is there any confidence left in financial, political, or media elites?

There are two terms that will become the catchwords of 2010, and unfortunately they are neither sexting nor iPhone. We will look back nostalgically for the time when we could have the luxury to care about Tiger Wood’s sex life. The two key terms we will have to deal with are Peak Oil and Fractional Banking/Quantitative Easing. People will scream and howl about how our politicians and leaders were so blind, how they did nothing about this, and they will only be denying their own guilt. These concepts have been around for over a quarter of a century, and since the onset of the Internet, widely circulated. We can only blame ourselves. We let this happen, and we must find a solution.

Peak Oil is a concept developed by a Shell geologist M.K. Hubbert in 1956. He correctly predicted that America would hit Peak Oil around 1970. Peak Oil simply means that we have used half of all available oil. If there were, imagine, a total of 1,000 barrels of oil in the ground, when we extract barrel 500, we have reached peak. Below is a graph which describes peak oil. It is impossible to predict exactly when we reach peak because calculations of how much oil is in the ground, and fluctuations in demand either bring it closer, or push it farther out. The time when we reach peak can be debated, but the concept itself is just simple math, not much to argue about...., hence the 9/11 "inside Job" wall to wall, for the complete militarization of energy resources and choke points, transportation, pipelines etc. and all the wars initiated/ongoing since 2000....


Why is Peak Oil a problem? Once we hit peak can't we just switch to solar, wind or even nuclear power? Not so easy. Petroleum is the basis of our entire society: agriculture, transportation, electricity, in short, just about everything we do, eat, wear, consume, listen to or watch is based on cheap and available oil. The United States uses almost as much oil for food production as for driving, not to mention highways, plastics and airplanes.

Once we hit peak, or come very close to it, something dramatic happens. World demand for oil is relatively static. In a major world recession demand might fall two or three percent, but in most cases, especially considering the growth of China and India, world demand for oil will grow about two or three percent a year. Oil is not like caviar, if the price gets too high we can’t stop consuming it. We have to drive to work, heat our houses, eat food that is grown with tractors, shipped by truck, stored in a refrigerated supermarkets that are powered by an electrical grid based in part on oil. Once we hit peak, demand will remain constant, but supply will fall. This means two things. The price will sky rocket and someone will have to go without. Every day that passes there will be less oil available, meaning that prices will continue to rise and more shortages will occur. The geo-political implications are obvious. It's possible that we have already hit peak oil at 85 million barrels a day, but only time will tell as demand grows again in an expanding world economy.

Not only will our economy unravel, so will our financial system. Human history from the beginning of the industrial revolution and the advent of cheap energy, coal and oil, has had one characteristic that has set it apart, constant growth. Have you ever wondered why the economy must grow? Things aren’t so bad now, so what if they stay the same for a few years? We must grow because our financial system is based on loaning money. Banks loan money to businesses and people at rates in the developed world on average from 5% - 15%. For those businesses, and in turn people, to pay the money back, they must make a return on the money that allows them to pay back the loan, and make a profit. If the economy doesn’t grow it means a lot of bad debt.

Cheap energy has allowed us to grow in a way that is unprecedented in human history. It has also allowed us to create a banking system that creates money out of thin air. The fractional banking system permits banks to keep only a fraction of the money they have on deposit and loan the rest, usually they can loan out about 80% or 90%. When it is loaned out, someone spends the money, which is then deposited, and again, loaned out at 80%. Eventually, the original deposit is multiplied by 5 in a system where the bank must keep 20% on deposit. See diagram below.

By lowering the interest rates from which banks borrow money from the Federal Reserve, in the case of the United States, the Fed can encourage banks to loan more money thereby creating liquidity and creating extra money out of nothing. Now, if interest rates go to zero, the reserve banks are not completely out of options. There is something called quantitative easing. This is a term invented by the Japanese as they looked for ways to inject liquidity into an economy that stagnated even with interest rates at 0%. What the reserve banks then do is buy back their own debt from the banks with invented money, ex nihilo. In the case of the United States, the Federal Reserve purchases US government bonds from banks, but not with borrowed money or money raised from taxes, but with ex nihilo, hence the bank will hopefully lend the money and overall money supply will increase.

This sounds like something that should eventually lead to Zimbabwe type inflation. Not necessarily. If the economy grows at a reasonable rate, population grows, etc. the economy needs more liquidity, and so while there is some inflation it can be kept low, combined with growth and things can move on smoothly as they have been for the last 60 years. Cheap energy gave us growth, which let us borrow money, run up big debts, and continue to grow. A few times in the last 50 years it seemed like the end was near. In the late 70’s the US lost much of its inertia and the baton seemed ready to pass to Japan and Europe as the leaders of the world economy. But Ronald Reagan led a remarkable spending spree, running up incredible debt and creating a renewed economic expansion while Japan became mired in an unending stagnation. But even then, after a minor hiccup in the late 80’s and early 90’s, two things extended the debt party.

The cold war ended giving the world a new sense of hope, the first Gulf War a warning sign of what new challenges lay ahead. Peak oil was still 20 years down the road, and Ronald Reagan taught us to live for today, not like that stuffed shirt Carter. And the 1990’s brought with it the information age, a true economic revolution; the United States actually had a balanced budget. While peak oil was beginning to raise its ugly head most people, overwhelmed with technological advances, were convinced that technology could solve everything. In reality, the worldwide economic boom was bringing peak oil ever closer but who could really believe it amidst the splendor of the 1990’s? Then came 9/11 and the dark, violent years that followed. Oil prices began their slow march upward and the markets began to sense the realities of peak oil.

Then the summer of 2008 oil reaches an all time high of $146 a barrel that should bring the world economies to a screeching halt, or at least slow them. We would later find out that we were already in a recession, but it didn’t feel like it. Eight months into a recession with oil prices at $146 a barrel? Then the world financial crisis two months later. Few connected the dots, but they should have.

The connection between peak oil and debt (fractional banking/quantitative easing) is a simple one. Oil means easy economic growth. For banks to loan money with interest, there must be economic growth, if not, the whole pile of debt, close to $60 trillion of it combined public and private in the USA alone, on a GDP of $15 trillion, cannot be serviced. Any kind of minor hiccup and the $3 trillion dollars or so just in interest payments on that debt (assume around 5% average interest) and there is a problem. Tack on the insanity of Wall Street and their derivatives on mortgages with that hiccup, and it is easy to see what happened. We are on a roller coaster and we are reaching the top, the click, click, click is getting louder, the tension is growing. When you feel your stomach turn it will be too late to get off, if it isn’t already.

The panic could hit even before we reach peak. Once this idea reaches critical mass, which it hasn’t yet, it won’t make much difference if we hit peak in 2009, 2010 or 2011. When Peak Oil becomes completely mainstream the speculation will collapse the financial system. I am certainly not the first to connect the dots and begin to shoot off flares. As more and more see the iceberg through the fog, the panic will spread, and it will not be pretty.

What will happen? Shortages, unemployment, social unrest. We will wish guns had never been so ubiquitous in our society. The absurdity of oil shortages, SUV’s, and no viable public transportation in cities like Houston or LA will give them a surreal and apocalyptic air. Politics will actually become a serious business. We will stop paying attention to political/entertainment and turn to the government for food, heat and basic transportation. People will wonder how they didn’t see this coming. How could we spend so many years consuming like there was no end while we worked at meaningless and unproductive jobs pushing paper and selling consumption.

The enormous egos of our public figures and our own not so small ones will take a bashing. We will experience as a country a real economic and cultural decline. The future will be worse than the present for a long time to come. The hangover will be immense and special interest groups that have controlled the media and Wall Street will be in for a rude awakening as old taboos fall by the wayside.

How will this playout? First the US and world economy must begin to recover. Employment will improve; GDP will become positive, people will actually begin to believe we are finally out of the hole. Once there is hope, banks begin to lend all that cash they are sitting on. Real estate will look cheap; there will seem to be big opportunities. That is the moment to cash out. We will see rising inflation, but our Ivy League leaders will tell us it is a small price for renewed hope and employment. Ben Bernanke, in all his Greenspanesque brilliance and his Robert Rubin appointed Wall Street cronies in Washington have injected so much liquidity into the economy that once it begins to circulate and be loaned out again the inflationary monster will rise out of control before anything can be done to stop it.

The spending and greed orgy has been described in detail in many places, lets just look at one part. The Fed has bought close to 85% of all new mortgages issued in the United States in 2009. This is equal to about $1 trillion, or about 6% of GDP. Imagine when that $1 trillion becomes $5 trillion, what will happen to inflation? And no rest for the weary, all this at a time when 14% of mortgages are either in foreclosure or delinquent, with the numbers sure to be worse in 2010. Great investment Ben!

How did the Fed raise so much money? Taxes? I think not. They made it up, out of thin air and it will multiply in a heated economic environment. How many times? How quickly? Nobody really knows. If this were the only problem, we would survive. But this is not it. As world oil demand begins to increase again after the major world recession, we will find that it can’t be met. Peak oil will hit just as we reach runaway inflation. Could this happen in 2011, or the even more poetic 2012? Maybe, but grant me one moment of artistic license. When Time magazine made Ben Bernanke man of the year in 2009, I knew in my bones it had to be 2010....

« Le peuple ne commence à réfléchir aux défauts
de ses maîtres que lorsqu’il souffre.... » Louis Latzarus (1878-1942),