Doubling down on oil

Considering that competition for liquid fuels is becoming increasingly fierce (China and India will propel a 20% global rise in demand to 103 million b/d by 2025), the United States will continue to need all resources at its disposal. Since half of current US oil demand is imported, without a larger domestic stockpile, we face the prospect of extended supply shortages, higher prices, worsening trade deficits, and persistent national security vulnerabilities. Nevertheless, the anti-drilling slogan has been a steady drumbeat:

• As a fossil fuel, oil is "running out" and will continue to harm the environment;
• Oil drilling is unsafe;
• Incremental domestic crude oil will not reduce our imports;
• Renewable energy will be displacing oil;
• OPEC can just cut back to keep prices high.

For many Americans, this reality of oil (and fossil fuel) dominance has been a bitter pill to swallow, or perhaps even too difficult to comprehend. Clearly, a weaker math and science curriculum, along with the high number of lawyers as opposed to engineers in the US Congress, plays no small role in this problem. A national forward-looking energy strategy still dangerously escapes us.

While high costs and technical limitations will continue to slow the adoption of renewable energies, a series of unique characteristics – higher energy content, ease of transport and storage, versatility in end-use – will keep petroleum the lifeblood of the modern world. The present analysis seeks to dispel some of the criticisms surrounding more domestic oil drilling and illustrate why the "oil age" will hardly be going "gentle into that good night."

1. Oil is not "running out" and the technologies used are evolving

According to the EIA, despite the extraction of some 175 billion barrels, the US now has about 20 billion barrels of proven petroleum reserves, or as many as we had at the end of the Second World War. This is because reserve counts are only snapshots in time that depict how much of the original oil in place (at least 600 billion barrels) is technologically and economically feasible to produce under prevailing market conditions. These conditions are always in flux, however, and technological advances and higher prices continually elevate our resource into reserves. In fact, many producers such as ExxonMobil have long been steady on 100%+ yearly reserve and production replacement.

Because future changes in price and technology are unknowable, the amount of oil that we have left is also therefore unknowable. With 85% of US coastal waters off-limits to energy exploration, Houston's Rice University concludes that we could still have 2 trillion barrels of recoverable oil – almost double the proven reserves of OPEC. Indeed, over the next 20 years, despite the continued extraction of roughly 2 billion barrels a year, the EIA's NEMS forecasts that we will actually extend our proven petroleum reserves 25% to 25 billion barrels. Oil may be a finite resource, but especially as our massive unconventional resource becomes more economical, the total amount remaining is likely measured in centuries not decades.

In short, the common assertion that fossil fuels in general and oil specifically are not compatible with our goal to implement a more sustainable energy system is becoming increasingly false. This is because renewable energy technologies will not be competing against conventional fuels as they are now, but as they will become. For example, the US National Energy Technology Laboratory reports that "next-generation" technologies will make the oil yielded from carbon dioxide-enhanced oil recovery 100% + "carbon free," up from 70% today.

According to the US Department of Energy (DOE), we still hold a stranded resource base of at least 400 billion barrels. Producers can now drain several oil fields from a single platform, and with each upgrade in performance and efficiency, fewer wells are needed to recover more resources. The DOE reports that "If Alaska's Prudhoe Bay oil field was opened with today's technology, its footprint would be almost a third of its current size." In any event, a low-carbon energy portfolio will take decades to develop, so as the bridge, more fossil fuel production will stay absolute.

2. Oil drilling is safe

Although the procedures and policies that led to the BP Deepwater Horizon spill in April 2010 are being remedied, some have taken advantage of the accident to call for an end to offshore drilling or oil development altogether. The US oil industry is as complex as any, and although accidents are inevitable, safety statistics verify the tremendous strides that have been made.

Since the 1989 Exxon Valdez spill especially, producers have installed programs (e.g., ExxonMobil's Operations Integrity Management System) to manage risks to safety, security, health, and the environment. Since 2000, lost time injuries and illnesses have decreased by 66% (0.48 incidents per 200,000 work hours to 0.16).

Since the early-1970s, while total consumption has risen by 25%, average annual spill volumes in the US have plummeted from roughly 17 million gallons to 1.2 million gallons. Thus, in an entire year, our oil industry spills as much oil as the country uses in two minutes. Considering the inherent challenges involved in the upstream, midstream, and downstream processes utilized to get petroleum out of the ground and into our planes and vehicles, the US oil industry's safety record is firmly established.

Unfortunately, most of the criticism over safety has focused on the offshore industry, where progress has been particularly impressive since the early-1990s, after the Exxon Valdez spill led to broader liability laws and prompted majors to replace single-hull tankers with double-hull ships. The US Minerals Management Service (MMS), now called the Bureau of Ocean Energy Management, Regulation, and Enforcement (BOEMRE), has stated the case bluntly: "The nation's record for safe and clean offshore natural gas and oil operations is excellent."

The former MMS documents that 19,150 wells were drilled offshore during the 2000s, but only 0.001% of the total offshore yield has been spilled in the past 30 years. Looking forward, companies realize that aging infrastructure will see more throughput and transport, and a good reputation is invaluable. Beyond lost expensive product, the US Environmental Protection Agency (EPA) reports that it costs $218 to clean up a single gallon of crude oil. The Deepwater Horizon spill sparked a major shakeup at BP, and the company's market capitalization was sliced in half just six weeks. Since the accident, Platts has buried BP in its Top 250 Global Energy Company Rankings from 2nd to 118th.

3. Incremental domestic crude oil does reduce our imports

E&P spending is underpinned by crude oil prices, which are likely to remain firm for years due to higher production costs, rising global demand, the general weakness of the US dollar, and even greater instability in the Middle East. In the past three years, the US has seen consecutive gains in annual crude oil production for the first time since the mid-1980s. The widening spread between oil and gas prices, augmented by a gradually rebounding economy, has led to the deployment of the hydraulic fracturing and horizontal drilling technologies being used in our large shale gas plays to their liquid-bearing formations. There has been a shale oil boom based in Texas (Eagle Ford play) and North Dakota (Bakken play) that has dropped US liquids imports from 60% of demand in 2008 to below 50% today.

Pre-recession growth trends are beginning to reemerge, and the 30-1 oil to gas price spread in recent months has no end in sight. Raymond James & Associates say that over the next 5 to 10 years US oil supply could expand by 400,000 b/d each year, as the recovery of drilling budgets and operations continues. Predictability and lower taxes signify that US oil companies want to reverse a growing trend of booking more reserves abroad than a home. Wider exploration could lift the former MMS estimates that our Outer Continental Shelf alone holds 87 billion barrels of undiscovered oil.

US exports of liquid fuels have some suggesting that policies to grow domestic crude oil production are unnecessary. The reality, of course, is that exports are an integral and inevitable part of the complex refining business because closer customers decrease shipping costs (e.g., US Gulf Coast to Mexico) and oversupply is common. Importantly, some 99% of domestic exports are refined products, compared to just 1% for crude oil, the basis of our import problem. One reason companies export is because recent EPA laws required domestic highway diesel fuel to meet ultra-low sulfur standards, but refiners did not have to invest the billions of dollars needed in technical improvements. Thus, refiners have been producing large amounts of high-sulfur diesel that get exported because there is no domestic market.

Even after careful analysis, the output at a refinery is often above demand. If this excess cannot be exported, there would be a variety of adverse consequences on markets and supply lines. For example, if we stop shipping distillates to Europe, refiners there would have to squeeze out more themselves, likely by trimming their gasoline yields. This would mean less gasoline available for export to the US East Coast, pushing our prices higher. In addition, other domestic laws have made byproducts like petroleum coke and residual oil more difficult to use, so they get exported.

4. Renewable energy will not displace oil in the foreseeable future

The faculty of wind and solar energy (used for electricity) to displace oil (used for transportation) is routinely overstated. That is because they have two different functions in the US energy economy. Power generation accounts for just 3% of our daily liquids intake, so "clean power" mandates will not materially alleviate our fundamental need for more petroleum.

Alternative liquid fuels are still highly limited and would take many decades and massive investment to scale up to significance. Ethanol, for instance, requires an expensive new infrastructure build-out, has a smaller energy density, devours huge swaths of land, and pumps up food prices. The US Congress's ambitious mandate to produce 36 billion gallons of biofuel by 2022, up from 14 billion gallons in 2011, will have far reaching consequences and is still far off from the 140 billion gallons of gasoline and 60 billion gallons of diesel fuel that we consume each year. These limitations explain why non-oil fuels now meet only around 5% of US liquids demand. Further, natural gas in the transportation sector has been slowed by high costs and would need a whole new infrastructure network.

This lack of material substitutes for oil explains its "price inelasticity of demand," where higher prices have only a minor effect on consumption. In 2025, for instance, the EIA's NEMS forecasts that a near quadrupling in the price of a barrel of oil ($51 to $186) would lower demand by just 9% (See Figure 2). Currently, electric vehicles are the only real connection between wind and solar energy and oil, and with General Motors announcing a production halt on the Chevy Volt in March, President Obama's goal for a million plug-ins by 2015 is rapidly fading. The US has 255 million oil-only vehicles anyway, and low turnover rates will keep the gasoline-powered internal combustion engine predominating in our fleet for the first half of this century at least. As a constantly growing nation (an additional $6.5 trillion in gross domestic product and 45 million people by 2025), there is no historical evidence to conclude that higher Corporate Average Fuel Economy standards for new light-duty vehicles will cut US oil demand in the absolute sense being claimed. In reality, efficiency gains have tended to increase fuel use because they: 1) make energy relatively cheaper ("Jevons Paradox") and 2) spur economic growth for the economy and the individual ("rebound effect").

5. OPEC's ability and desire to cutback for new US oil production is questionable

The domestic anti-drilling push also uses mercurial OPEC as a reason not to drill. Incremental US oil production, the mantra goes, will not lower crude or gasoline prices because OPEC can simply cutback output to compensate. While it is true that the US only produces 7% of global petroleum, "more production from anywhere would tend to lower prices," notes Adam Sieminski, chief energy economist at Deutsche Bank. Moreover, AlMadi and Zhang (2011) conclude that our West Texas Intermediate "significantly leads" the other three main crude oil benchmarks (Brent, Dubai, Oman).

Oil prices are not only set by today's production, but also by the expectations that buyers and sellers have about future production. So if more US resources are opened for development, we could shift long-term expectations on supply. And if we can produce closer to our potential, OPEC might lower its price to maintain market share. To be sure though, the decision-making of another producer will remain too precarious, but we can confirm that less US oil production pushes prices in the wrong direction. Newt Gingrich's claim of $2 gasoline is ultimate, but with a barrel of our oil out-pricing a gallon of our gasoline 27-1 since 2005, $70 to $80 crude oil could keep gasoline prices below $3. OPEC has already stamped this range as rational, as stability in price makes continued growth possible.

Perhaps more importantly, the collectiveness of OPEC is not what many assume. OPEC was first recognized as a "clumsy cartel" by noted economist Morris Adelman decades ago, and production quotas among the 12 Member Countries are commonly ignored.

The division between OPEC's price hawks (e.g., Iran and Venezuela) and doves (e.g., Saudi Arabia and the UAE) has been well documented. And a growing rift between Saudi Arabia and Iran, OPEC's two largest producers, over oil policy has been exacerbated by the Iran-West nuclear standoff. Indeed, Saudi Arabia has a strategic relationship with the US (oil for security) that is fundamental to the kingdom's position as the world's leading producer. In addition, member countries realize that all-important China and India covet energy security, and any attempt to artificially raise oil prices (or block supply lines) would make OPEC appear even riskier to do business with. To that end, OPEC is typically not served by price maximizing behaviors because they refocus the spotlight on alternatives and erode global economic growth. Thus, high oil prices are ultimately a threat to the very hallmark of OPEC's existence: the ongoing demand for more oil. Member countries are fast growing and now more than ever realize that the rising expectations of the people must be met. Oil exports account for the bulk of revenue earnings.

Conclusion

The reality of oil dominance should guide any national energy strategy put forth. We have literally hundreds of billions of barrels left to produce, and the constant advance of technology will have us utilizing our oil endowment differently tomorrow than we do today. Recent production gains on private land have more than compensated for the drastic slowdown in drilling permit approval on federal lands and indicate how quickly more E&P can reduce imports, making our supply less vulnerable to geopolitical interruption.

More domestic oil development is integral to US energy security because demand will remain high even if prices spike. The safety record of the oil industry justifies a dismantling of barriers to the leasing of federal lands by offering royalty reductions, tax breaks, and other economic incentives. More US oil production will minimize the transfer of our wealth abroad, create more local jobs, and help insulate us from a less predictable marketplace where rising giants China and India need to procure more oil. Since enhancing self-sufficiency is not the same as unrealistically seeking "energy independence," we should also recognize that OPEC sees high oil prices as unsustainable over the mid- and long-term. OGFJ

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