Why Peak Oil has no effect on oil prices

An increasingly common explanation for soaring oil prices is the phenomenon of Peak Oil - the idea that we are rapidly reaching the point of no return in terms of oil production. But how can this be true, with vast potential reserves in Canada's oil sands and in oil shale in the US? As Justice Litle points out in the Daily Reckoning, the problem isn't so much the amount of oil in the ground - it's getting it out. And that's the real reason why oil prices will remain high for a long time to come...

By MoneyWeek

published 29 June 2006

in Features

Does it really matter that the United States has 2 trillion barrels worth of recoverable oil shale resting in the shadow of the Rockies? Not anytime soon it doesn't.

Before you spit out your coffee, let me explain. (If I'm too late, I

apologise.)

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In terms of the long run - we're talking decades here - Peak Oil is serious business. The same is true of that oil shale bonanza out in Colorado and Utah. Eventually, we might find the will and the way to tap it. But in the intermediate term - meaning the next five years or so - neither Peak Oil nor recoverable US oil shale will have any real bearing on the energy landscape.

While it may be playing an indirect role, the Peak Oil phenomenon has not kicked in as a direct price driver for energy yet, and may not do so for a while. It is true that Saudi fields are looking sketchy to some outsiders, and new replacement reserves are getting harder and harder for the globetrotting oil majors to find.

But there are more factors there than meet the eye. The toughness of finding new replacement reserves, for example, is arguably more of a geopolitical issue - it has a lot to do with state-run energy behemoths muscling out the private players where the pickings are good.

Back to US oil shale. I've had a number of my Outstanding Investment subscribers write in after receiving a special report titled 'The US Government's Secret Colorado Oil Discovery.' It spoke of 'the next American oil boom' and said the United States could become 'the new Middle East.' This led at least a few readers to ask reasonable questions like, 'What does this mean for the energy bull market?'

So how does this affect the Peak Oil scenario?

Consider this recent quote from Bob Loucks, a former manager with Shell who oversaw its shale oil recovery operations: 'Despite all the attempts to develop a shale oil industry in the United States over the past 100 years, the fact remains that no proven method exists for efficiently moving the oil from the rock. There are a number of candidate processes possible, but none has demonstrated a practical capability to produce oil.'

Bob Loucks is no diehard pessimist or skeptic. In addition to his field experience, he is also the author of the book Shale Oil: Tapping the Treasure. Loucks is long-term bullish on the prospects for America's oil shale. But he recognizes that, here and now, we are still not there yet technologically.

There are a number of problems yet to be solved before US oil shale can be recovered on any type of meaningful scale, let alone a mass scale. And getting the extraction technology right is only one monkey wrench in the works with US oil shale. There are others.

For example, there are questions of air quality regarding domestic oil shale operations. How badly would these operations pollute the air? Would the levels be acceptable? Shell isn't sure.

There are questions of water availability. During the extraction process, how much water would be required?

Shell isn't sure. An early 'guess' is two to three barrels of water per barrel of shale. This could be a conservative estimate. Either way, will the massive amounts of water necessary for heavy-duty shale extraction even be available in the first place, given that the Colorado River Basin is already running low?

There are seven Western states - fast-growing states - fighting over the Colorado River's water as it is. Are they supposed to happily set aside their interests and share water rights with a humongously thirsty newcomer? Oh, and there are farmers with skin in the game too.

There are questions of a power source. Just as it takes money to make money, it takes energy to recover energy. Regarding a study that took place last year, the Grand Junction Daily Sentinel reports:

'The 2005 RAND study estimated that a commercial-scale oil shale plant for Shell would require the construction of the largest power plant in Colorado history, costing about $3bn, and would consume 5 million tons of coal each year and produce greenhouse gases in the process.'

Environmentalists are still up in arms over itty-bitty ANWR (the possibility of drilling in the Arctic National Wildlife Refuge). Do we expect the green crusaders to smile and go right along with construction of the largest coal-fired power plant in history in one of America's most beautiful Western states, when a patch of Alaskan ice and a couple of scraggly caribou already had them lathered into a frenzy?

We may actually tap America's oil shale one day. But it won't be today.

Nor tomorrow. Nor the day after. That day will be many, many years into the future, if ever. There are just far too many logistics problems yet to be solved: technological issues, water issues, power issues, labour issues, political issues.

The West is famous for NIMBY and BANANA politics ('Not in My Back Yard' and 'Build Absolutely Nothing Anywhere Near Anybody'). Trying to develop oil shale deposits in Colorado and Utah here and now would blow up into the biggest NIMBY/BANANA double-whammy environmental debacle of all time.

For those of you who still worry what the overhang of recoverable US oil shale might do to the energy markets, a simple question: Remember Canada? The country is sitting on its own private Saudi Arabia too, in the form of the Athabasca oil sands. We've all known about that for a while.

And those oil sands are being developed at flat-out top speed; because the Athabasca region is so sparsely populated, Canadian oil sands have virtually none of the NIMBY/BANANA headaches a US oil shale project would face.

Consider why oil is still in the $60s and $70s with all that northern bitumen just ready for extraction. How can it be that the price of crude is so expensive when there is so much recoverable oil in the ground? Because the whole trick is getting it OUT of the ground.

I've used this analogy before, but it's the best one I can think of offhand. Imagine a magic gas station with tanks that never run dry.

Infinite amounts of gasoline for all! Now imagine that this one magic gas station has to serve thousands of cars at once with its six pumps. It doesn't matter that there is plenty of gasoline for everyone. The problem is getting it out of the ground (or, in this case, the tanks).

With only six pumps and thousands of cars waiting to fill up, you are going to get gas lines hundreds of cars long. And that gas is going to be very expensive, even though there is plenty of it (a virtually infinite supply of it!) because high prices are a clearing mechanism for determining who really wants it bad when real-time availability is limited. The problem is a bottleneck in extraction and distribution.

This is analogous to our present-day scenario, and the main reason I don't think Peak Oil matters much for the time being. The high cost of energy is being set at the margins and driven by an intersection of demand and geopolitics.

Secular demand for energy is growing at such an aggressive long-term clip that available supply sources are running flat out to supply it. Oil fields have a maximum rate of output per day; if you push an oil field too hard, you risk permanent damage and a loss of some of the reserves. It's a good thing substitution technologies are already starting to kick in, because if they weren't, prices might be even higher.

It is an infrastructure problem...a bottleneck problem. The fact that there are billions of barrels worth of recoverable oil in the form of tar sands and shale doesn't really matter at this point. Heck, 'peak infrastructure' is a better explanation than 'Peak Oil' for the long-term commodity bull. At some point, the world's inadequate extraction and distribution infrastructure for energy and metals will finally catch up with demand - and when that happens, the commodity boom will be well and truly over. But that day is 5-10 years away or more.

I would love it if that Colorado oil shale report were true. It wouldn't be so hot for oil stocks - when you think about it, everything BUT oil stocks would boom if America became 'the new Middle East' - but it would be a wonderful benefit for the United States and the global economy. Too bad the logistical conclusions are impossibly, ridiculously optimistic.

The main point here is that the long-term energy bull market we are in is more of a demand-driven infrastructure arbitrage, playing out over a period of many years, than a Peak Oil phenomenon. By the time Peak Oil really kicks in, things on the ground will look quite different. And we will hopefully be much farther down the alternative energy road than we are now, enabling us to better deal with the strain.