Perceptions of future, often

Kjell Roland
ECON Centre for Economic Analysis
Oslo

About this series

WITH THIS ARTICLE, THE OIL & GAS JOURNAL BEGINS A SIX-PART

series on the international oil industry and factors that can influence its future as seen from a Norwegian perspective.

Oil is a serious matter in Norway. In a little more than 25 years, it has turned this once relatively poor kingdom into one of Europe's most prosperous countries. It is the only Scandinavian country that has declined to join the European Union. Oil is critical for the Norwegian economy and its social entitlement program. It is no wonder then that the country is intensely interested in the future of the oil and gas industry.

As a result, the Norwegian Petroleum Society (NPS) commissioned the ECON Centre for Economic Analysis, Oslo, to analyze the role of oil and natural gas in the 21st century. Kjell Roland, president of ECON, delivered the frank report, from which this series is taken, at a conference in Oslo on Nov. 27, 1997. It was held as part of the celebration of the NPS's 25th anniversary on that date.

The report, titled "Oil and Gas-A Sunset Industry? The role of petroleum in the 21st century," was sponsored by 22 companies active in Norway.

Contents

This series is, as is the original report, essentially divided into three sections:

Parts 1 and 2 focus on "fallacies," insights, and perceptions that have changed over the past 25 years.

Parts 3 and 4 summarize some of the most important changes or trends (megatrends) that have shaped energy industries and which are expected to influence developments in the decades to come.

Parts 5 and 6 cover issues that ought to be part of the agenda when exploring what the future may bring in general to the international and Norwegian petroleum industry.

The bibliography for the entire report appears at the end of Part 1.

Part 2 will appear next week and be followed by weekly or biweekly installments of the remaining parts.

Credits

Kjell Roland is the principal author of this report. Valuable contributions were made by Torleif Haugland, Paul Parks, Bj rn P. Saga, Jan Arild Snoen, Knut Vralstad, and May Brith Hakonsen.

The sponsoring companies were Aker Maritime ASA, Amerada Hess Norge A/S, Amoco Norway Oil Co. Ltd., Asea Brown Bovari AS, Christiania Bank og Kreditkasse ASA, Deminex Norge AS, Den norske stats oljeselskap a.s (Statoil), and Det Norske Veritas. Also, Enterprise Oil Norge Ltd., Esso Norge AS, Kongsberg Offshore AS, Kv'rner Oil & Gas AS, Neste Petroleum AS, Norsk Agip A/S, Norsk Hydro ASA, Norske Conoco AS, A/S Norske Shell, Saga Petroleum ASA, Phillips Petroleum Co. Norway, Schlumberger Norge A/S, Smedvig ASA, and Ultveit-Moe AS.

L.R. Aalund, Managing Editor-Technology

Oil industry policies and long term commercial commitments are built on past experiences and on our present perception of the future.

This report explores our understanding of the petroleum industry after more than 25 years of petroleum activity in the North Sea and reviews the current perceptions commonly shared by industry and analysts regarding future developments.

During the past quarter century, the North Sea has become a major new petroleum province and Norway the worlds 8th (soon to be 7th) largest oil producer. The country is the world's second largest oil exporter and soon will become the most important supplier to the European continental gas market.

Past achievements (or investments) in the North Sea are the accumulated results of concerns and expectations of policy makers and oil industry executives over the past 3 decades. Yet during this period, both the world and our views of it and the energy business have changed radically and often.

One of the messages that history teaches us in this business is to be humble about our ability to understand and predict what the future may bring. A few examples illustrate the point:

Energy too important to be left to the market

In the 1970s, oil, gas and other natural resources were regarded to be too important to be left to market uncertainties. In large parts of the world, direct government ownership of energy was the preferred option. At that time, it seemed that government ownership in the oil and gas industry was on a forever upward trend and private ownership, represented by the international oil majors, was on the defensive. Indeed, the stewardship of energy resources properly belonged in the public domain.

Nationalization in the Organization of Petroleum Exporting Countries (OPEC), together with the establishment of national oil companies in many consuming countries, was the result of this belief. Norway's own Den norske stats oljeselskap a.s. (Statoil) was born very much in this mood.

However, today the opposite view prevails. The last decade has seen the re-emergence of market forces and private capital as the primary factors in the energy industry. These factors are now viewed as the primary determinants of the future. The view is increasingly that, given a proper regulatory framework, markets and private companies are in fact in a better position to service our need for energy than are governments.

Statoil, supported by the government, as well as the Storting (the Norwegian Parliament), illustrates this new trend. Statoil is increasingly being exposed to competition at home, and the company is actively pursuing a strategy of expansion, primarily outside the North Sea.

The corporate aims are to become an international, perhaps in the long term even a multinational, oil company. Furthermore, even the ownership structure is not sacred anymore. Over the next decade, the company will most likely move away from the present 100% government ownership towards a private/government mix.

Overly optimistic oil price expectations

Much has been said and written about oil prices. In the 1970s, the physical fact that oil and gas are exhaustible and that prices would trend forever upward was viewed as the base reality facing the energy industry; indeed the world.

The question then was only when and how fast, not if, such price rises would happen.

In the North Sea, huge commitments in the late 1970s and first half of the 1980s were based on oil prices being double or triple of what they turned out to be. Even at those high price expectations, a number of field developments were only marginally profitable.

Since the mid-1970s, the oil price expectations of pundits in the first half of the 1980s bumped up and down, from a high of more that $100/bbl at the turn of the 21st century to a low of around $8-12/bbl after the 1986 price crash. Despite the volatility, however, the overall trend of price forecasts is much lower than that of the 1970s.

Conservative production projections

It was not only a struggle to understand the dynamics of the market forces, but also the interplay between geology and technology. This proved equally difficult to anticipate.

For example, recoverable reserves in a geological structure have tended to increase substantially beyond initial estimates, as has been the case in the North Sea and elsewhere in the world. Enhanced oil recovery, horizontal drilling, 3D seismic, and subsea production systems have made it possible to drain the reservoirs better than before and to find more oil and gas in the same area-and at significantly lower costs.

Thus, projections of oil production consistently turned out to be lower than what were realized. Production was once expected to peak early in a field's or geological province's life, and then decline quickly. Instead, production continues longer and is more stable. This is the experience in Norway and elsewhere.

Important surprises

The preceding examples show how limited our ability to foresee and to predict even the most salient future developments have been. With the benefit of hindsight, we can now recognize our limitations in terms of understanding important factors that dramatically changed the future, but were not on the agenda 2 decades ago. A couple of examples may again be useful.

In the early 1970s, nobody foresaw how information technology (IT) would transform modern society. Production of computers and software have developed into industries surpassing the petroleum industry in size in most industrialized countries. It is now a part of our daily professional and private lives. Yet when the first gas from the continental shelf reached the west coast of Norway, we were using pencils and calculators. Pocket-size cellular phones and personal computers had not been invented.

As a result of modern IT, the petroleum industry itself, as most other major industries, has significantly changed its way of operating, not to mention its organization. Modern IT has allowed the industry to change from a huge, centrally controlled and vertically integrated machine, typical for the multinational oil companies, to decentralized systems of cooperating but autonomous entities. It changed from a system of long lines, like spider webs, carrying commands from a far away headquarters possessing ultimate power, into a series of commercial interactions between partners cooperating in their own self interest.

In the words of business consultants, reengineering has changed companies from large, integrated, and self-contained giants, to slim, decentralized service and knowledge-based entities. Important management strategies in this regard foster outsourcing of noncore businesses like accounting, transportation, and legal services.

Another example of what was not (but should have been) on the agenda 25 years ago, was the environment. The fundamental changes in the energy sector that have taken place (and even more, which may take place in the future) because of environmental concerns, were not at all understood in the mid-1970s (more on this later in Parts 4 and 6 of the series).

A healthy industry

Despite the fact that price expectations consistently turned out to be wrong, projections of crude production far too pessimistic, and serious underestimation of our ability to improve on technology and at the same time lower costs, the Norwegian oil and gas industry today is in very good shape.

Costs are coming down, production is increasing, most companies collect handsome profits, and rents are pouring into government coffers. In fact, even with the very significant government take, only modest complaints are voiced against the present system of taxes and levies.

With the benefit of hindsight, it is fair to say that a lot of good things happened by accident or as unexpected byproducts of decisions. Some of the good that we sought to achieve turned out to be without merit. But great triumphs were achieved by visionary decision makers guided by insights and strategic goals.

Forecasting questioned

Past experience gives ample reason to be humble when we look forward from NPS's 25th anniversary, and reflect on what is to be expected over the next 25 years of petroleum in Norway. Seriously questioned is the reliability of number crunching and projections of prices, production costs, and revenues more than a few years into the future.

The feeling that framework conditions and political priorities are highly unpredictable and may easily change is also shared by many in this industry. Yet our actions today will always be guided by our expectations of the future. Thus, despite our past flawed view of the future, we need to try, in a cautious way, to analyze what it may bring.

As will soon be obvious, this report addresses and discusses a large number of complicated and often linked issues. No attempts are made to cover all of these issues in depth or otherwise do full justice to the issues involved. Rather, the aim is to remind us all of how unpredictable and changing the energy world has been and is likely to remain, and to discuss and also possibly influence how we today perceive the future of energy.

Fallacies of the past

Looking back on the past 25 years of oil and gas history, it is useful to revisit areas where our perceptions proved wrong. In such cases, we may either have changed our mind and based our present decisions on other assumptions about the world. Or we may simply have come to the conclusion that our knowledge of the world is less perfect than we thought it to be, and accepted the uncertainty involved.

Moving back a couple of decades, energy policy debates centered around the following beliefs:

• Physical resources of petroleum are finite and the impending shortage is of primary importance to policy makers and markets.
• The industrialized world was doomed to be overly reliant on OPEC and unstable supplies of crude, and that serious actions were needed to address this.
• Multinational (and other) companies, their parent governments, and their motives and actions, were to be mistrusted.

State-owned companies were the remedy.

Exhaustion: a "non" problem

Spurred by the first oil price hike in 1973, the notion that the world would soon run out of oil made it into newspaper headlines and soon became conventional wisdom. In the public debate, this perception was precisely articulated by Paul Ehrlich in his question: "What will we do when the pumps run dry?"

In the academic world, economists rediscovered a seminal article from 1931 (Hotelling, 1931). In this article, Hotelling started out from the assumption of a fixed stock of a mineral asset and discussed how prices and depletion would take place in a competitive market.

The logic and aesthetics of his theory were attractive from an academic perspective and well-suited for sophisticated mathematical analysis within the neo-classical paradigm. Given Hotelling's fixed and known stock assumptions, the "hockey stick" forecast of oil prices became a logical conclusion and a commonly shared perception of the future.

This became the accepted paradigm despite the fact that commodity prices historically have tended to be on the decline, as shown in Fig. 1 [52,208 bytes].

The belief was that there was not sufficient oil in the ground to meet demand unless costs of extraction escalated. The question was not if, but when, the real price of oil would have to start climbing to balance demand and the limited resources of gradually more costly and hence expensive oil to be produced.

Hardly any other perception of the future has been so persistent and survived in the industry despite the lack of support in historical data (except for the very peculiar hiccups in the oil prices in the 1970s) and its poor performance in terms of predicting future prices (Fig. 2 [52,485 bytes]).

However, our modern fear of a doomsday has long historical roots. Malthus (1798) argued that an increasing population would force agriculture into more and more infertile land, and in the end push the standard of living down to a subsistence level where population stopped expanding. This argument has later been called the Malthusian error. Later, in 1865, W. Stanley Jevons (1865) wrote a comprehensive study to explain why England's economic growth would grind to a halt due to exhaustion of the country's coal resources.

Unconventional

Among modern energy analysts, two important exceptions to the "hockey price" curve perception need to be pointed out. Both Morris Adelman and Peter Odell revolted against conventional wisdom. In Adelman's words, "the world's reserves are unknown, probably unknowable, but above all unimportant." All that really matters is costs-like in all other industries. The notion of a fixed stock is misleading and should be dismissed. (See Adelman, 1995 or Odell, 1986.)

The same kind of argument is extended by Simon (1996) to the discussion of natural resources in general, not only petroleum. He argues that there is only one resource that is ultimate, and that we need to be seriously concerned about in the long term. The ultimate resource is "human imagination coupled with the human spirit."

Many argue that energy is special in the sense that it is hard to do without, and that the resource base in this case is, in fact, likely to be limited relative to human needs. Among the natural resources, energy is indeed special in the sense that it is required to exploit all other natural resources, and in the sense that when used, it is gone and may not be recycled.

We cannot do without energy. What is said about energy in general also goes for fossil fuels given today's dependence on oil, gas, and coal. Thus, how and when energy resources are depleted is something that we need to understand and reflect on.

However, empirical studies do not indicate that the world is running out of fossil fuels. There is plentiful coal, increasing proven reserves of gas, and more oil today than in the mid-1970s when "scarcity" as measured in terms of number of years that the present reserves (i.e., inventories) may sustain present production was assumed to be on a declining path (Fig. 3 [53,003 bytes]).

More specifically, one intuitive illustration of the "scarcity" of oil is the size of accumulated production to date relative to identified reserves plus undiscovered resources. On a global level, accumulated production in modern time is close to 700 billion bbl which compares to 1,600 billion bbl of estimated remaining discovered and undiscovered resources (Fig. 4 [53,467 bytes]).

This means that if this estimate is largely right, we have produced around 44% of our conventional resources.

In addition to this, there are unconventional resources, such as extra-heavy oils and tar sands. Estimates of these resources suggest that heavy oils in the Orinoco region in Venezuela and tar sands in Western Canada approximately equal world identified reserves of conventional crude in the Middle East. Thus, it is possible to conclude that the world in time may deplete conventional and other sources of oil.

When this will happen, we do not know. However, within the time frame considered in this study-25 years ahead and even far beyond-there is no reason to believe that limitations in the resource base will require prices to raise to balance supply and demand even at a much higher level of consumption than today.

Cost matters

Our limited resource and human imagination and spirit will be challenged over the next decades to see to that our energy needs are met at acceptable costs. The concern that should occupy policy makers as well as industry executives is not the volumes of resources that do exist in the crust of the earth, but the amount of human effort needed to bring these resources to the consumers.

The North Sea experience in terms of the costs of extraction over the past few years is a telling one, and gives hope for the future for our own industry. Norsok, a joint initiative by industry, government, and contractors, was established to improve the competitive standing of the Norwegian offshore sector in the international oil and gas industry.

The aim was to review all phases of offshore development to reduce costs. Through this joint effort, very significant reductions in costs in all parts of offshore development were achieved over a short period of time.

The Government critically reviewed its licensing procedures to reduce the period from the time the Plan for Development and Operation (PDO) was submitted until initiation of development. Contractors and oil and gas companies significantly reduced costs through effective cooperation, standardization, less bureaucracy, and uniform information management. As Fig. 5 [54,745 bytes] and Fig. 6 [55,455 bytes] show, costs came down more than most people expected to be possible in most offshore activities.

Similar industry/government initiatives were achieved in the U.K. Thus, the evidence does not support the idea that petroleum is in short supply and costs are edging upwards because we are pushed into marginal and increasingly expensive resource deposits. On the contrary, the petroleum industry so far has been able to develop more-sophisticated technology that allows costs to be reduced while increasing production in more remote areas.

The Malthusian error in gas

In addition to the errors that were made in the Malthusian direction on future oil prices, the notion of fixed and rather limited stocks of oil and gas in the ground also strongly affected gas policies in the latter part of the 1970s.

To preserve resources for the future beyond what the market would presumably bring about, the idea emerged that natural gas was a premium fuel too precious for bulk use. In fact, natural gas should be reserved for "premium" use in households and the commercial sector.

In Europe, the European Union in fact took this literally and introduced a directive to curb growth of new power stations fuelled by gas. As we all know, today gas used in Combined Cycle Gas Turbines (CCGT) in large parts of the Organization for Economic Cooperation and Development (OECD) as well as in many developing countries, is the preferred alternative in power generation both for financial and environmental reasons. In some countries, gas-fired power generating capacity is actively promoted by environmentalists.

Geopolitics, not depletion

The geopolitical distribution of conventional oil reserves is, however, rather skewed (Fig. 7 [54,892 bytes] and Table 1[53,099 bytes]). The dominance of the Middle East is significant and does not change when comparing only identified reserves or when including possible undiscovered resources. Geopolitical concerns, therefore, influence our views as to how much oil "should" be consumed, and raise the issue of supplies.

However, even if the notion of depletable resources does not influence gas policies today, the notion of a basic upwards tilt of real prices is still in the mind of some analysts and policy makers.

This report does not share this view, nor the belief that prices need to increase over the next couple of decades due to limited physical availability of resources and related costs.

However, the fact remains that a disproportionate share of the world's proven oil reserves are located in a limited number of countries situated in an unstable part of the world dominated by a political and cultural environment not always friendly to the West, nor particularly friendly to their upcoming dominant customer; the rapidly growing countries in Asia. Therefore, the issue of future prices is likely to remain heavily dependent on the geopolitics of oil.

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