Natural Gas and Oil Outlook - How Serious is the Situation? Part 1
9.21.05   Dennis Moran, Center for Environmental Energy Engineering

In the first draft of this paper several months ago, the title was "Is There a Problem." The events of the last month have answered that question with a resounding YES. We now are experiencing a taste of what the future holds. The problems have been building for quite some time and Katrina has triggered the first in a series of crises. Nevertheless, there still are many people in this county who think the natural gas (NG) and oil problems are only temporary. They argue that high prices will trigger demand reductions and technological innovations that will bring prices back down to “normal” levels within a few years. However, the optimistic analyses I have seen typically exclude or ignore key considerations. When you consider all of the relevant supply-side and demand-side factors, it is not possible to conclude that these problems are temporary.

The latest Energy Outlook published by the US DOE predicts that oil and gas consumption will increase steadily until at least 2025. This forecast assumes that US producers and foreign suppliers will provide a steadily increasing flow of oil and gas. The data on the following pages shows that it is extremely doubtful that they can or would do so. We are far more likely to see flat or declining supply. If demand keeps growing and we do not come up with alternative energy sources, we will see shortages and turmoil that exceeds Katrina’s aftermath.

The US economy and infrastructure is built on cheap energy and is highly dependent on a continued, reliable supply of inexpensive energy. However, that era is rapidly disappearing and we must adapt to significantly higher energy prices. The following assessment should help those who still are in denial finally acknowledge that we have a problem and accept the fact that we must change our behavior. We need to focus on creating a sustainable energy future. Doing so will require massive changes in infrastructure and lifestyle. There is no quick fix available. Further delaying action will only make the transition more expensive and painful.

 

Situation Summary

We have begun a forced transition from a period of adequate energy supply and low prices to an era of persistent shortages. The basic reason is that growing demand for both natural gas and oil is colliding with shrinking supplies. Domestic production of both of these resources peaked back in the 1970s and growing demand has been satisfied by a steady increase in imports. This trend cannot be maintained indefinitely. Contrary to many forecasts, consumption of oil and gas will shrink in coming years due to supply and economic constraints. The most optimistic outlook is that we will see a slow reduction stretched out over decades. However, we also could see a rapid decline over a short period of time – the “falling off a cliff” scenario.

Most demand for both resources is highly inflexible and we are producing them at essentially 100% of effective capacity. There is no margin in the system and as we are seeing now, small shortfalls lead to price spikes and economic disruption. Technological innovations will help mitigate future shortages, but those improvements will only postpone the problems temporarily. Since it will take decades to ramp up production of alternate energy sources and dramatically reduce consumption, it will be virtually impossible to avoid periodic severe problems.

My forecast is that the transition will be characterized by a series of “boom / bust” cycles. Periods of tight supply will lead to shortages and high prices which trigger economic downturns. Lower demand during the downturns will lead to periods of adequate supplies and (relatively) low prices. The timing and magnitude of these fluctuations will depend on factors that are beyond our control or ability to predict – i.e., weather, the strength of the US and world economy, political turmoil, the success of efficiency improvement and alternate fuels programs, the success of NG exploration efforts, and the rate of growth of liquefied natural gas (LNG) imports. Given the current supply situation, political climate, and decision maker behavior patterns, there is little doubt that the US will experience several periods of severe economic and social disruption before the country adapts to a world of expensive energy.

On the NG side, we should see the first significant shortages when the period of exceptionally mild weather that began in early 2003 ends – the hot weather of this summer may signal the end of this period. North American NG production has been declining for the last few years in spite of a massive increase in drilling. Hence, periods of “adequate supply” should become increasingly shorter over the next few decades unless we experience a major protracted economic downturn. Aggressive action to locate new sources, improve energy efficiency and produce alternate fuel supplies could stretch out the “adequate supply” periods and the transition period. However, at some point in the relatively near future we will enter a period of permanent NG shortages.

Our NG problems are dominated by North American supply and demand issues, but oil markets are affected by events throughout the world. Predictions of when the peak in worldwide oil production will occur vary, but many (if not most) analysts predict that the peak will occur within the next decade. While supply will begin declining shortly, oil demand is poised to grow tremendously, largely due to rapid economic growth in China, India, and other developing countries. Liquid fuels are essential for transportation and many other uses and there are no suitable near-term substitutes for oil in most of these applications. Given the worldwide lack of surplus production capacity, we are certain to experience periodic crises triggered by political turmoil, weather or geological catastrophes, or simply suppliers’ inability to increase production during periods of high demand. During these periods prices could spike to levels well above previous highs (around $110/bbl in 2004$).

Oil shortages and the resulting price spikes also will lead to intense political conflicts. The developed world will fight for the energy needed to maintain current lifestyles while the developing world will fight for the energy needed to grow their economies and improve their lifestyles. When shortages appear, the level of frustration and desperation can escalate rapidly. If the situation becomes intolerable, violent confrontations and possibly military action become increasingly likely.

Natural Gas Situation

Economic Considerations

Natural gas production capacity in the US exceeded demand by a comfortable margin from the early 1980’s until around 2000 when rising demand ran into shrinking production as shown in Figure 1. Figure 2 shows that prices stayed relatively low prior to 2000, but they have been extremely volatile and trending upward since then (Note: Fig. 2 shows national average prices; spot market prices have been significantly higher in recent years). Basic economics tells us that when demand exceeds supply, prices will rise until sufficient demand is destroyed or new supplies are available to bring the market back into equilibrium. If the high prices do not destroy enough demand to bring the market into balance, supply interruptions occur and/or the government will step in to allocate supply.

Recent experience has clearly demonstrated that the price elasticity of remaining natural gas demand (a large share of industrial demand already is gone) is very low, which means that large price increases are needed to significantly reduce demand. When demand equals or exceeds supply, a small demand or supply change can dramatically affect price (one analyst estimated that a 2.5% reduction in NG demand during the last spike would have reduced prices by around 25%). Consumption trends clearly indicate that the major NG and oil prices increases of the last few years have not been large enough to generate a significant demand reduction. This reinforces the conclusion that prices will need to rise far higher to reduce demand if significant supply shortages occur.

High prices in the last few years have led to a major increase in drilling which has generated some new supplies. However, the production industry’s efforts to halt the decline in total production that started in 2002 have been unsuccessful. Even higher prices should stimulate additional drilling, but several factors constrain the industry’s ability to increase production. These factors include drilling capacity limits (virtually all available drilling are in use already), the downward trend in NG volume per well, a shortage of attractive exploration targets (which largely is due to federal and state restrictions on exploration), and industry risk-aversion born from extreme financial turmoil in the 1980s and 1990s.

An added problem is that extreme price volatility will continue to have a negative impact on efficiency improvement & substitution activities. Energy is a relatively small portion of their total costs for most users and decision makers are reluctant to invest limited resources in energy systems. This is particularly true when they do not have reliable price projections. Consequently investment will be limited until decision makers are confident that 1) the “low” prices during the down cycles still will be high enough to justify the investment, 2) the risk of not acting is significantly higher than the risk of acting, or 3) government action creates floor prices (e.g., an energy tax that creates a floor for market prices).

Supply Considerations

The NG industry is struggling to maintain output at current levels, but analysis of recent trends and available data indicates that they are not likely to succeed.

  • Production from conventional onshore wells peaked in the 1970s and has been steadily declining since. (Figures 3, 4 and 5).

    - Increased production from offshore and non-traditional sources (e.g., coal bed methane, deep water drilling) and increased imports have offset the decline in conventional onshore production.

    - Total production peaked in 2002 and then declined 2-4% in 2003 plus 1-4% in 2004 (estimates vary).

     

  • The annual depletion rate for proven reserves rose from around 16% in 1990 to 25% in 2000 and it appears to be steadily rising (Figure 6). At a 25% rate, around 5.5 – 6 trillion cubic feet (TCF) of new supply must be acquired each year to keep total supply flat.

    - The Energy Information Administration (EIA) reports that proven reserves of dry natural gas increased by 3.3% in 2001, 1.9% in 2002, and 1.1% in 2003. Note that the rate of growth decreased steadily in spite of a major increase in drilling since early 2002. (Note: the depletion rates equals the percentage of proven reserves inventory on January 1 that is produced during that year). The EIA numbers indicate that the amount of gas found in 2003 equaled production + 1.1%.)

    - Estimates for 2004 are not yet available, but given the large number of oil reserve volume restatements by major oil companies in 2004, it would not be surprising if NG reserve estimates also are adjusted downward.

     

  • Exploration is prohibited in some promising areas due to environmental concerns. Given the current political climate, it is doubtful that these areas will be opened before we experience a major supply/price crisis. In any event, if large quantities of gas are found in these areas, delivering this NG to the market will be inhibited by infrastructure constraints for several years.

    - The main closed areas are in the Rocky Mountains and off the Pacific coast, Atlantic coast, and Florida Gulf coast.

    - The Rocky Mountain region contains the bulk of restricted resources, but most of that NG is contained in tight sands and coal beds. Developing these fields will involve drilling a large number of small-volume wells which also requires large expansion of the collection pipeline network.

    - New transmission lines would be needed to move large volumes of offshore gas. Transportation lines leading from the Rocky Mountain to the rest of the country also need to be expanded.

    - Field processing equipment must be provided for all new sources.

     

  • Imports from Canada rose from around 1 TCF in the late 1980s to 4 TCF (17-18% of consumption) in 2001 and have stayed near that level since then.

    - The Canadian reserves situation is similar to the US situation and it is doubtful that exports to the US could expand significantly.

    - The Canadian government instituted NG production restrictions in 2004 to ensure that sufficient gas is available to extract heavy oil from their tar sand reserves, which further inhibits their export potential.

     

  • LNG is supposed to become a major new source, but it is doubtful that capacity can be expanded fast enough to match EIA’s projections.

    - Annual LNG imports increased from around 0.2 TCF in 2002 to approximately 0.5 TCF in 2003 and 0.6 – 0.7 TCF (3% of total US consumption) in 2004. (Figure 7)

    - More than 20 new import terminals have been proposed for the US, but all analysts agree that many/most will not be built due to local resistance and financial challenges.

    - EIA projects that imported LNG will account for around 2.5 TCF in 2010 and 6.4 TCF in 2025 (Figures 8 & 9). It is unlikely that these levels can be achieved due to infrastructure constraints (primarily liquefaction facilities and tankers) and the fact that we will face intense competition for available supplies from other countries.

Demand Considerations

The DOE Energy Information Administration forecasts that US consumption of natural gas will be 31 – 35 TCF in 2025, an increase of 35 – 50% from current levels (Figure 9, 10 & 11). However, these projections do not seem reasonable given challenges of increasing supply which are noted above.

One projection we can safely make is that demand will fluctuate depending on several key factors:

  • The dominant factors affecting demand are weather and the strength of the economy.

    - Exceptionally mild summer and winter weather since early 2003 (the last cold winter) through the spring of 2005 was a key factor in avoiding supply shortages and corresponding price spikes. Increased consumption due to a hot summer was a major contributor to the price increases in the month prior to Katrina.

    - Economic weakness in the early part of the decade helped keep demand low.

     

  • The main secondary factors affecting demand are fuel switching (to oil or electricity) and efficiency improvements.

    - Switching to oil has been limited by technical capability and the fact that oil currently is more expensive than gas.

    - Switching to electricity or significantly improving efficiency frequently requires equipment changes that are expensive and time consuming.

     

  • Traditionally, large price-sensitive industrial loads (e.g., ammonia) shut down or switch to alternate fuels when NG prices rise. Much of this load already has shut down due to high prices in recent years, which reduces our ability to quickly reduce demand during future price spikes.

    - One leading energy industry analyst estimates that in early 2005, about 1 TCF of additional demand (or 4-5% of current consumption) could be eliminated by another $2 or $4/MMBtu price increase. However, most load beyond that is highly inelastic.

    - NG generally is a small share of the total operating cost of the industrial users who have not curtailed use already. These customers’ demand will depend largely on level of output.

     

  • Interest in improving energy efficiency spiked after the 2000/2001 NG price increase, but most of this interest lagged when prices dropped.

    - Consumer attitudes vary over a wide range, but industry sources indicate that the majority of decision makers have not yet changed their design/construction practices and equipment selection practices in response to recent energy cost increases.

    - It will take decades to achieve large increases in the efficiency of buildings and energy utilization equipment (e.g., HVAC, cars, process equipment) that exist today.

Oil Situation

While the natural gas evaluation focused on the domestic situation, oil must be evaluated on a worldwide basis. The international oil outlook is just as discouraging as the US NG situation – production is peaking when demand is poised to rise rapidly. The factors affecting supply and demand are similar to those affecting US NG markets. However, there are significant differences.

 

Supply Considerations

While US NG production peaked over 20 years ago, worldwide oil production has been increasing steadily for decades as shown in Figure 12. When production will peak is unknown, but most forecasts indicate the peak is likely occur within the next 10 to 20 years if it hasn’t occurred already – it is not possible to identify the peak until after it happens.

Another major concern is that the current lack of surplus production capacity, which is illustrated in Figure 13, increases susceptibility to disruption and price volatility.

  • Most countries other than OPEC and former Soviet Union (FSU) states are experiencing level or declining production.

     

  • OPEC or FSU’s ability to increase production is uncertain due to a lack of reliable reserve data and the unknown future impact of past poor field management practices.

     

  • Few (or no) large high-potential exploration opportunities appear to exist in politically stable areas. There are some significant promising opportunities in politically unstable areas, but exploring them will be difficult and dangerous.

     

  • In any event, the rate at which new giant oil fields are being found has dropped to zero (Figure 14) in spite of aggressive exploration. Only one giant field has been found since 1995 – the Kashagan field in Kazakhstan – and there are concerns over how much can be recovered from that field due to serious environmental challenges. Finding an equivalent amount of oil in small fields requires far more exploration.

 

  • Global demand was around 55 MM bbl/day in 1973, 65 in 1979, and 70 in 1995; estimate for 2005 is around 85 MM bbl/day

     

  • Assuming 2% growth in demand and FSU and non-FSU supply flat, projections for 2010 are:

     

  • Current OPEC call is around 30 MM bbl/day and a 50% increase does not appear feasible under any reasonable scenario.

     

  • There is relatively high potential for supply disruption due to widespread political problems (e.g., Iraq, Russia/Yukos, Saudi Arabia, Nigeria, Venezuela) and terrorist action.

    Another challenge we are facing is the shift in the type of crude oil being found, which will create refining problems.

    • Production of light sweet (low-sulfur) crude clearly has peaked and is declining while production of heavy sour crude is rising.

       

    • A large share of worldwide refining capacity is designed for light sweet crude. These refineries will need to add considerable amounts of new equipment to process heavier crudes and converting them will require major investments.

    Demand Considerations

    Demand by developing countries (particularly China and India) will increase significantly as their economies are to grow (Figures 15 & 16). Their demand growth will increase competition for available supplies.

    • Note that figures 16 & 17 presents demand in terms of bbl/person. US consumption actually is lower than China’s consumption when measured on a bbl/$ of GDP basis.

    Other important demand-side considerations include:

    • The potential for high prices and possibly shortages is significantly higher in areas that have stringent gasoline formulation requirements for emissions control. There are a limited number of refineries that can produce these formulations and disruptions in the supply of crude oil on which these refineries are designed to operate could lead to serious localized problems.

       

    • The lack of good alternatives to oil for transportation, chemical feedstock, and certain other applications ensures that competition for available supplies will be intense, particularly during times of high demand/supply shortage.

       

    • A significant share of the recent US price increases is due to the weakness of the US dollar in recent years (Figure 17). Further declines would have a disproportionate impact on the US and countries that have tied their currency value to the US dollar.

    Part 2 of this assessment will address:

    • What can be done to mitigate these problems

       

    • What are the main barriers we need to overcome

       

    • Why should you believe this assessment rather than the more optimistic forecasts

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