There is a raging bull market in "peak oil" websites and books. Four recent books on the subject, and the obligatory darkening days ahead, grace the "Life After the Oil Crash" front page along with do-it-yourself solar equipment, dried foods and how to build an atomic shelter in your home. We are led to believe this is all essential stuff for '08 and beyond.
I've read a lot about the coming oil shortages for the past 50 years. Shortages and exhaustions are phenomena that engineers or accountants can measure, and they have: discovery rates, flow rates, inventories, and a heavy overlay of dubious but always bearish assumptions lead to exhaustion. My grandfather used to laugh about predictions of running out of oil that he heard in the 1920's, an observation which always elicits wan but knowing smiles of disdain when related to engineers and modern analysts.
The assumptions for peak oil are that oil in the earth is of a finite amount from "creation" forward; that all very large oil fields have already found; and that producers are producing as fast as can be done. On the face of it these arguments are similar to the flat earth argument and are somewhat similar to Biblical creationism. It is given.
The undeniable fact that the rate of oil output has slowed over the past twenty to thirty years seems ample evidence for the assumptions of peak oil enthusiasts which are then confidently projected forward. Case closed. There are, however, a number of important factors left out of this theory: primarily economics, politics, and history which are rather more difficult to measure than are flow rates. In fact they require thinking and some fore-knowledge.
However, despite all the "peak oil" talk, none of the multi-national oil giants has yet taken T. Boone Pickens' route from nearly thirty years ago and spun off their mature "wasting assets" into royalty trusts. If oil were truly winding down forever, at least one of the mega-cap and multi-national oil companies should already have elected to spin off (but still service) their oil fiefdoms in trust for their shareholders, and redeploy their capital elsewhere. Exchange traded pass-through, tax-free grantor trust units are now well-established as an investment medium in a number of countries.
For some background it's well to review Pickens' outline of a speech he gave in October 1982 in Lubbock, Texas. This is fairly long for a blog, but it's well worth reviewing what happened after the last bull market in oil ended in 1980:
"I have been asked to provide an outlook for the oil and gas industry. I will address this topic by first assessing where we are today in the industry and projecting what i believe will spell the difference between success and failure for oil and gas companies in the future.
"Now, let's take a brief look at the current state of the industry. The year 1982 will be remembered as the end of a boom era in the industry that began in 1973, culminating in 1980-1981 with new highs recorded in the industry in revenues and profits. The major factor for the prosperous eight year period was the escalating price of crude oil...prices orchestrated by OPEC. During this period, a period in which there was a twelve-fold increase in the price of crude oil, "boom time mentality" became commonplace; cash was plentiful, drilling was skyrocketing, and everyone was rushing to get into the business...and I mean everyone from tennis pros to doctors."
"Even though our management began to see the symptoms of a decline as early as October of 1981, it was very difficult to turn things around quickly. The point i want to make here is that as long as record revenues and income were being recorded in the industry due primarily to OPEC price increases, most managements were not overly concerned with rising finding costs, rising interest rates, and temporary over supplies of gas and crude oil."
"But with the drop and eventual stabilization of prices, these symptoms surfaced as major problems for many companies in the business. We have seen the drilling rig count continue to decline from its high water mark of 4,530 in december 1981 to the current level of 2,380. (Eventually the rig count sank to under 800.)"
"Managements have responded to these conditions by slashing capital budgets,tightening up on personnel and postponing projects dealing with alternative energy sources. Management themes have become "greater efficiency and productivity." Drillable prospects are being scrutinized more cautiously now, and managements are reversing the trend toward diversification. The confidence of many, within the industry and on Wall Street, is fading. It's difficult to sell a deal in today's market."
"However, i do not believe the uncomfortable conditions that exist within the industry, brought on in large part by the drop and stabilization of prices, are necessarily unhealthy. Consumers have benefited and inflation in our country has been blunted. This tough period that we are in has forced our industry to take a good, hard look at itself. As a result, I believe we will see revolutionary changes occur within the industry during the next several years,resulting in an overall strengthening of the oil and gas business. Challenging times are upon us—some will make it and some will not. We are already seeing some companies fall by the wayside."
"This raises the question "who will be the most successful in the new business environment?" One answer to this question is..."the managements that can determine and maintain the optimum size of their companies." The overriding goal of management should be to protect and expand the assets of the company and the value of their shareholders' interests."
"Perhaps the most important remark that I will make today is...(pause)...oil and gas companies, both large and small, are managers of depletable assets...their reserves of oil and gas. It is incumbent upon companies to increase reserves annually to ensure the maintenance and growth of their shareholders' investment. Therefore, the enhancement of reserves becomes an important measurement when evaluating whether or not a company is at its optimum size."
"Many companies in our industry, misled by rising oil prices and record earnings, have been liquidating for years; they simply have not been increasing their reserves annually. After paying corporate and windfall profit taxes, the dividend check that they have been sending their shareholders has been merely a return of capital."
"The biggest job facing exploration and production companies is to protect their reserve base and to expand it at a reasonable cost...either through exploration or acquisition. Recently, the finding cost and purchase price curves have been too far apart...they must come closer together to spur new drilling activity. Currently, merger and/or acquisition are very attractive ways of increasing reserves. Some of you may recall that we recently made an acquisition attempt! if a white knight had not come to our target's rescue,we would have purchased oil in the ground for about $3 per barrel."
"Other than utilizing exploration and acquisition measures to ensure optimum size, managements should also consider the benefits of restructuring based upon the royalty trust concept, pioneered by Mesa in 1979, with the formation of Mesa Royalty Trust. We have also announced our second trust, the proposed Mesa Offshore Trust, which will be created by the end of the year."
"The Mesa Royalty Trust and Mesa Offshore Trust were not created to solve a reserve problem—for we have consistently increased reserves for 18 years. Rather, we created the trusts as a means of ensuring realistic value for the company's assets. Our shareholders have a direct income stream from the properties placed in trust, avoiding two levels of taxation at the corporate level."
"Incidentally, the IRS has ruled that the Mesa Royalty Trust is a grantor trust and most recently has concluded that royalty
income attributable to the trust will not be taxable to Mesa."
"By reducing size, new discoveries have a greater impact on a company and increase the value of the shareholders' investment. Some managements equate success with bigness—they should be concerned with keeping their company's size at a level that provides its shareholders the best opportunity to make a profit. The managements that will be the most successful in achieving this goal will be ones that know their assets well and can make the necessary adjustments quickly."
"Let's quickly review some of the adjustments our management has made to maintain optimum size: when it appeared that Canadian E&P operations would be severely impacted by government regulation—we sold out in 1979. When our management foresaw the impending taxation and regulation of North Sea operations by the United Kingdom—we sold out in 1979. When our management addressed the question "why sell at below asset value if you are increasing reserves?"—we formed the Mesa Royalty Trust in 1979 and our stockholders received a direct ownership in producing properties. As finding and development costs of Gulf Coast properties escalated and became less economically viable—we announced a second trust—Mesa Offshore Trust—to place the assets of these high potential properties directly in the hands of our shareholders. Each of these strategic decisions was made with one overriding objective—to maintain the optimum size of our company, thereby benefiting our shareholders in the most positive way possible."
"This brings me to a question I would like to pose: "are we embarking upon an age of awareness in the oil and gas business?" I believe the answer to this question is..."yes." The investing public is becoming more aware that oil and gas companies are managers of depletable assets and that reserves must be increased annually to protect and enhance their investment."
"I believe we will see shareholders speak out more...particularly when the assets of the company are being liquidated. It's incredible to me the attitudes some CEO's have toward their shareholders...they forget that we are paid to get the best return for the stockholder. They often equate company with management rather than equating company with shareholders. To help "force" managements to begin thinking as investors—I believe shareholders will begin to insist that management be given meaningful stock options. They will then be somewhat assured that management will make decisions which are in the best interest of shareholders—not decisions which will merely perpetuate managements' jobs."
This short T. Boone Pickens speech is a graduate school seminar on the oil business. Rarely do we hear the insider candor and vision of good business leaders, but here we see the whole landscape of the greed of governments and the sometimes incompetence of business leaders, and the history of a transitional period of time when prices went from up to down. But for current purposes the critical issue was the wasting asset in the hands of its owners. Every well and every mine is a wasting asset, unlike the forestry or agricultural industry. Not to say that vast acreages of forest and field haven't been wasted. They have, but in theory, and under good practice, they are renewable. Even under good management wells and mines are wasting assets, but they are sometimes also wasted beyond their natural lifespans by imprudent management. The most imprudent management is applied by governments which are rarely headed by the best or most competent managers, to be kind. They are headed by mad men and mobs more often than not whose goals are instantaneous and totally inconsiderate of the future.
According to Pickens and most others, OPEC had "caused" the price rises of the 1970's due to political pay back for earlier real and imaginary losses. My own view is that much of the rise was a simple matter of supply and demand in the long wave cycle since it happened just at the "right time" in that cycle. But note how many governments reacted to events by taxation, price increases, and nationalizations of oil companies, developments we we are seeing now from Indonesia and Venezuela, Canada, and Alaska and Russia. When prices are low, government wants nothing to do with maintenance and development. When prices grow high they want the whole hog. So oil output depends to a great extent upon price and upon government intervention. When prices are low many oil companies themselves have little incentive to spend a lot of money for maintenance, discovery and development. As Pickens described, it was a great time to merge with or buy out weaker players. When the prices are high the governments come in and take more and more, and the companies are satisfied to see great profits roll in to share with government. In earlier times governments were smaller and weaker and not so numerous as they are now. Mexico and Saudi Arabia nationalized their oil early on and Iran just a bit later. Now oil is nationalized or controlled nearly everywhere. Russian de-nationalized and then re-nationalized in under a decade. The UK did the opposite.
In the end, governments all over the world weaken oil development and maintenance, and also prevent companies from making gains on new developments. The higher prices resulting from this then make spending mega-billions for new development less realistic. Governments want to spend their profits on various other national goals, and oil companies will not have the continued profits or future prospects to warrant their making bold new moves. Pickens described all this in the early 1980's, but the situation has grown even worse. And this is largely due to accelerating government intervention everywhere rather than from probable "exhaustion" of natural supply. Communism failed, but state socialism has "triumphed" to create high prices and supply shortages beginning when demand naturally picked up after the 1997-98 Asian crisis.
This is why I see "Freak Oil" as a better phrase to describe shortages and high prices than "Peak Oil". Just as tobacco became a great source of government taxation, so too has energy. Over one-half the price of gasoline at the US pump consists of taxes at all levels. Governments are taxing and nationalizing energy, and the economies which depend upon it into oblivion. The simple mechanistic exhaustion formulas of of the Peak Oil internet industry can recommend no solution, only a grim future for all of us. But politics and economics are always amenable to reversal and to progress if the real facts are widely understood.
Recent Comments