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Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy Excerpt from Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy

by Matthew R. Simmons

The Long-Term Price of Oil

For the better part of the last century, almost every oil price forecast has been off the mark by a factor of some magnitude. Given the poor track record of these attempts to divine how real-world forces will drive the price of such a basic commodity as oil, can we expect that it will now be possible to determine what an optimal long-term price for oil should be? What process would be required to ensure the objectivity of this calculation and to achieve agreement about it from both producers and consumers of all sorts? Would this price differ from the prices that are established through existing market mechanisms?

It is impossible to now assemble precise data on all the cost components that will ultimately drive the long-term price of oil. What is clear, though, is that the historical prices that have been paid for oil, after smoothing out periodic volatile cycles, have been heavily influenced by a nominal notion of the marginal "least cost" barrel. As a result, the long-term financial returns in the petroleum business have been less than stellar, other than on occasions when vast amounts of oil have been discovered or when oil prices have spiked far above historical norms.

Anyone closely observing the huge jump in global oil demand that occurred over the last decade ought to recognize that there is nothing on the horizon to make us believe that growth in oil consumption is nearing an end. Instead, it is becoming increasingly clear that many of the over five billion people on earth who have historically used little or no oil are now quickly adopting the tastes, behaviors, and lifestyles of more affluent nations that will drive their oil use up by an order of magnitude. Satisfying this new demand, to the extent possible, will accelerate the trajectory toward peak oil.

Once oil supply peaks and begins to decrease, the scarcity factor alone will force oil prices to far higher levels than today's perceived "high prices." This is simple Economics 101. In a world where pending oil gluts vanish and no longer threaten to collapse oil prices, and where demand steadily pulls ever higher than physical supply, is there any sensible way to determine a fair price for oil? Is Adam Smith's "invisible hand" alive and well? Will some per-barrel price calculation magically then make a free market for oil work again? Can there be any viable alternative to ruthless free-market pricing for the allocation of increasingly scarce oil supplies? Is there a genuine ceiling for the future price of oil that halts any further demand growth?

As has been the case with so many other questions posed, these questions are valid and easy to raise. The answers are, however, by necessity rather vague. The only simple answer is that the future price of oil, in a scenario where supply is limited and demand wants to grow, will be much higher than it has been through 2004 and early 2005. How high prices will go is unclear. It is even less clear how high prices should go.

The uncertainty about "fairness" of oil prices relates to the poor correlation between Generally Accepted Accounting Principles (GAAP) and the real cost to create added oil supply. GAAP methodology as it relates to oil and gas is flawed. The numbers it creates are heavily tied to the practice of capitalizing all costs of developing oil and gas supplies and then expensing these costs by an estimated volume of proven barrels over the life of an oilfield. Over the past decade or two, these numbers created an impression that the cost of finding and developing oil and gas was around five to six dollars per barrel. These numbers, while widely used as guidelines for the cost to create new oil supplies, are close to meaningless as a basis for determining what oil should cost in market transactions. The process by which they are derived is equivalent to determining the cost of a high-rise office building with a construction price tag of several hundred million dollars at, say $300 per-square-foot, then estimating the building's useful life at 50 years and proceeding with that assumption to generate a cost per square foot per day. What this calculation renders for this $300-per-square-foot, multi-hundred-million-dollar building becomes a cost of less than two cents per day. The calculation is correct. The analytical value of the number, however, is meaningless. Equally meaningless is the notion that the finding and development cost for oil is somewhere around five dollars per barrel.

If the costs of all the new oil projects underway around the world to bring on major supply additions are properly analyzed, and all projects using existing infrastructure are ignored, it now costs $20,000 to $40,000 per daily barrel to create most new supplies. This is the equivalent to $300 per square foot to build a new high-rise building. But, the high-rise building stays at its completed height. The oilfields, on the other hand, soon begin to decline.

The best definition of fair as applied to the price of oil is "just" or "equitable." In the traditional world of oil and energy economics, a truly "fair" long-term price for oil is a price that generates enough money to deliver solid financial returns to all the parties that own and develop the resource. These will include the country that owns the oil, the providers of the money necessary to explore for and find the oil, drill and equip wells, construct GOSPS, pipelines, refineries, tankers, and so on, and the companies that provide all the critical services and equipment. The calculation assumes an environment of growing oil supplies, in which profit is invested to replace declining existing reserves and develop new sources of supply. It reflects the sunny world of pre-peak conventional oil.

In the conventional pre-peak environment, if a brand new oil system suddenly had to be created, every aspect of this long chain of activities had to be built from scratch, and every stakeholder demanded a minimum 10 percent after-tax return, I suspect this would require a price of oil today that far exceeds $100 per barrel. Might it be as high as $200 a barrel? Until we have better knowledge of the real replacement costs for assets like drilling rigs, pipelines, and refineries over the next 10 to 20 years, any estimate is a random guess. But $200-per-barrel oil could be too low.

In the post-peak environment, the goal of growing oil supplies ceases to be relevant, and the effort to sustain oil supplies by replacing some percentage of existing reserves may come to be seen in a different light: the twilight perspective. High oil prices (assuming market allocation of supplies rather than some other mechanism) will generate surging revenues for oil producers, much of which may well be viewed as windfall profits. In this environment, how should we gauge the profit that producers are allowed to make? Will it be appropriate in the twilight world to introduce such language into the discussion? In the early 1980s, when skyrocketing oil prices led to so-called windfall profits for U.S. oil companies, politicians decided that it was appropriate to capture a percentage of that profit for the public through higher taxes. Will such strategies gain serious consideration from the twilight perspective? Should constraints be placed on how much of the excess profit producers can spend on the endgame process of finding, developing, and extracting increasingly more expensive sources of oil? Will the political process entertain arguments that some of the revenue stream be directed toward meritorious efforts to develop non-petroleum energy sources for the long-term future?

The time has come for energy analysts of the world to begin calculating the real future costs of sustaining oil supplies at some reasonable level, as ultimately this is how real-market economics work. The sooner oil users begin to understand what the real long-term cost of oil has to be, the easier it will be for everyone to cope with fast-rising prices for the world's highest-volume and most important commodity. Furthermore, it is only by knowing those future costs that we can get a handle on the amount of profit that high prices will create during the twilight years and engage in intelligent discussion of issues such as the distribution of those profits among the owners of the oil and the consuming public, particularly with regard to further investment in new petroleum supplies and development funding of new energy sources.

Once prepared, a realistic economic model that honestly assesses the fair long-term price for oil will also highlight what a Faustian bargain the developed world has lived by over the last two decades as we used up the last of our cheap petroleum, too often in a casual and at times wasteful manner.

Challenges in a World of Oil Scarcity

As oil becomes a scarce resource, its use will have to be rationed in one way or another. There are ways to allocate oil use and direct it to its most valuable applications. But achieving such a rational plan will require a carefully orchestrated, global, country-by-country effort. Left unattended, this process could quickly evolve into genuine chaos. The global economy can function after oil supplies peak, but not in the same manner in which we live today.

Once oil supply peaks, the world will be forced to create ways to substantially conserve our oil and other energy sources. This shift should force a rapid rethinking of the notion that transporting people and products anywhere in the world is an almost incidental cost of doing business. "Transportation" turns out to be the biggest single user of oil, and we need to begin finding ways to minimize everyone's transportation needs and make the use of transportation fuel as efficient as possible. Today, the most wasteful use of transportation fuel is probably traffic congestion. A world beyond Peak Oil will be forced to solve this problem, too. Whether its solution is living closer to one's work or using more mass transportation, both become viable ways to address traffic congestion and use oil more efficiently as prices rise. Simply building additional miles of wider and wider roads no longer works. Even a new fleet of more fuel-efficient vehicles will take too long to implement and may still use too much oil. If we do not alter our transportation systems as a matter of policy and public planning, the inexorable operation of pricing mechanisms will do it for us. At some price for gasoline, traffic congestion will diminish.

There is no question that a world of increasingly scarce oil will foster a growing competition among energy-consuming countries. As the reality of declining oil supply becomes better understood, this country-by-country competition could evolve either into a manageable process (like the economic competition that has existed for decades among the various OECD countries) or an aggressive free-for-all that triggers new wars. If the problem is misunderstood or left unaddressed, war could easily prevail over peaceful competition. Securing adequate oil supplies was, after all, an important element in all the major wars of the twentieth century and in the United States' two most recent interventions in the Middle East. If the magnitude of the problem is fully understood and the risks of a laissez-faire approach are appreciated, all nations should be able to recognize the necessity of working out comprehensive ways to allocate an increasingly scarce supply of oil among the world's many deserving countries.

The competition for oil supplies is not waiting for the day when oil production peaks and begins to decline. Scarcity is not simply a function only of production and supply; it also results from increasing demand. And that is the situation we are facing today. More people in more places want a share of the world's petroleum resources. Rising demand over the past several years has altered the previous market balance and quickly turned oil from a relatively abundant to a far scarcer commodity. The most aggressive new entrants into the international petroleum markets are China and India, the world's two most populous nations with two of the fastest growing economies. They will, within the lifetime of a majority of Americans and Europeans alive today, become the two largest national economies in the world by most measures, although they will not be the wealthiest.

The developing oil needs of China and India are huge, and their leaders seem now to be truly understanding the issue, perhaps far better than the leadership in many already prosperous countries. They are now using every means traditionally employed by Western nations and their oil companies, short of military force, to secure sources of supply. These means include diplomatic relations and foreign aid, direct investment, bilateral agreements, technology assistance and transfer, and the exploitation of frictions in the traditional relationships between Western nations and non-Western oil producers. China has forged agreements with three of the largest Petroleum exporters -- Saudi Arabia, Iran, and Venezuela -- and with several others. Not surprisingly, several of these exporting countries are currently in disputes with the United States. These countries may not be above using their increased market leverage in ways that will damage U.S. interests.

The growth in China's and India's need for oil has now become very visible. Less visible is the meager oil use by many other countries that now also aspire to be like "us." In a world where oil is limited, it is vital that a truly global International Energy Agency (IEA) begin to embrace the needs of all the world's energy users and not simply view its role as that of the energy watchdog for the prosperous energy consumers.

I happen to think the world can make the transition into what we might call the post-Saudi oil era in some very rational ways that will limit economic disruption. As a perpetual optimist, I believe the world still works beyond Peak Oil. While oil prices in this new world will obviously rise, this rise can be a blessing, not a curse. Far higher oil prices make all other forms of energy more competitive and spur on energy research programs that might discover some real long-term fixes.

Higher oil prices will also trigger a massive influx of money to all oil-exporting nations, even as their reserves and daily outputs shrink. With proper guidance, and based on the grim reality that this great flow of fluids for these oil countries is essentially a "last call" instead of just another boom that will be followed by another bust, oil-producing countries can make the most of the revenues that higher oil prices create.

It is imperative for countries like Saudi Arabia and the Middle East producers in general to wisely invest their pending windfall profits toward creating modern societies that work beyond oil. If such plans are enacted, their unforeseen benefits could turn into a surprising global miracle. The time for using high oil prices for guns, palaces, and Swiss bank accounts is over. This money now needs to be used to create the basis for more abundant life in these countries after Peak Oil.

Do the math to understand how powerful this spending boom could be. OPEC, as a group of countries, now has about 600 million people. By 2025 or 2030, the OPEC population could easily exceed one billion people. If future oil prices were to remain as low for the next 20 years as they have been over the last 10 years, it would almost ensure an ever-increasing gap between vast wealth for the ruling elites in these important countries and increasing poverty for the masses. Such a model is unsustainable. Social chaos, increasingly violent terrorism, and political or military revolutions would ultimately become "normal events" throughout all OPEC countries.

If the process is managed in a rational manner, an era of high oil prices can create the necessary revenue to begin building a genuine middle class in most OPEC nations. This process would, in turn, unleash a buying spree for OECD goods and services. The growth in demand for such goods that this new middle-class OPEC society would want might make even the economic miracle unleashed when the Marshall Plan rebuilt Europe appear modest in comparison. It would certainly overwhelm the economic miracle of the 1980s and 1990s when the Asian tigers finally rose to prominence.

A world that learns to live with a dwindling oil supply will also be forced to control the emissions that energy use creates in an entirely different way than anyone envisioned when worries of global warming first began to surface. A continuation of urban sprawl would become an intolerable trend as the transportation that supports it becomes too costly. Fortunately, the world has already created the necessary tools to allow many highly productive people to stay and work at or closer to home. How odd it would be if the Internet became best known as a great tool to help pave the way for a world that uses less oil.

The biggest danger the world faces, if my thesis about Saudi Arabia's oil is correct, is that no one will begin preparing Plan B. As far as I know, there is not a single contingency plan in place or currently being written by any of the think tanks of the world that sets out a model illustrating how the world can continue to function smoothly once it is clear that Saudi Arabian oil has peaked. In a nutshell, it is this total lack of any "alternative scenario thinking" that makes this unavoidable event so alarming.

Copyright 2005 Matthew R. Simmons