Everything that you need to know about the future of Saudi Arabian
oil production can be found in a staff report to the subcommittee
on international economic policy of the committee on foreign
relations of the United States Senate (1979). Regardless of what
you may or may not have heard on that increasingly relevant
subject, between 1979 and now hardly anything has changed,
although the question must still be asked why this and similar
documents were – and still are – overlooked by many energy
professionals.
The purpose of this article is to add few observations on the
structure and dynamics of the global oil market to my earlier work
on the subject, which means that I have to repeat some previous
materials. Geology and supply-demand mechanics are still of
crucial importance, but more attention has been paid to what might
be called ‘petroleum (= oil + gas) microeconomics’, as well as
certain game-theoretical insinuations. Some very useful background
to the present exposition is provided in an article by Murray
Duffin (2004) on EnergyPulse.
As will soon be noticed, the main actor in this drama only
appears en-passant before the fourth section. One reason is that
the business press is now filled with easy-to-read information
about Saudi Arabia, and they have almost always gotten it at least
partially correct. What they have missed, however, is that
according to the logic of mainstream development economics, the
countries of the Middle East are not going to exhaust their
supplies of irreplaceable energy resources in order to pull the
chestnuts of American and European motorists out of the fire, even
if they assure every government and television station in the
world that they prepared to do so – and even if, as Humphrey
Bogart remarked in the film ‘Sahara’, they adore chestnuts. There
is also a widespread tendency to overlook or misinterpret certain
extremely important macroeconomic themes having to do with oil,
and which need repeating as often as possible.
INTRODUCTION
According to the journalist Max Rodenbeck, the United States
became a net importer of crude oil for the first time in 1976, and
in 2000 imports accounted for more than half of the US consumption
of this commodity. At the present time imports are about 11
million barrels per day (= 11 Mb/d). These observations by Mr
Rodenbeck – who ‘covers’ the Middle East for the Economist – have
enough validity to be useful to many of the readers of that
publication, even if most of his other comments principally serve
as a reminder that the present state of knowledge about the most
important raw material in the world is far from what it should and
could be. For instance, he is in error about the way that real
world oil markets work, and he does not have an adequate
acquaintance with the basic scarcity of oil – a scarcity that
turns on the inelastic demand for that commodity over the
foreseeable future. Moreover, his reference to the “vast and
conveniently located reserves of oil shale” in Canada is the kind
of mistake that I always advised my students to never make if they
wanted to survive the first five minutes of an employment
interview. (The relevant non-conventional resource in Canada is
oil from tar sands, and while vast it is far from convenient.)
Both my energy economics textbook (2000) and my book on oil
(1980) failed to give adequate recognition to the crucial role
that Saudi Arabia has played on the world oil scene and, more
important, is expected to occupy in the future. But now is the
time to correct this oversight, because in my opinion the plans of
the Saudi Arabian government are very different from those
attributed them by many journalists, as well as fly-by-night
experts from academia. Very different in fact from their own
optimistic and accommodating pronouncements. Moreover, these
intentions have not changed over the past 30 years or so. Let me
add that an attempt to make a comprehensive estimate of the
present goals of the leadership of the most important oil producer
on the face of the earth, as well as some knowledge of the
intentions of other governments and firms toward that producer,
may turn out to be the key to introducing some energy economics
wisdom into the lives of certain influential observers who still
expect that the oil future will resemble the oil past.
As alluded to in the sequel, the general feeling today is in
the direction of pessimism where both oil production and
investment in new capacity are concerned. This makes a great deal
of sense. There are still, however, a few observers of the
flat-earth variety who do not share this attitude. In their world,
physical investment is capable of finding oil that the geologists
say is not there – or, to put this another way, they think that
‘market solutions’ and technological innovation can overwhelm the
laws of physics. Steve Forbes, owner/editor of what might be the
best business magazine in the world, apparently sees the interplay
of supply and demand eventually reducing the price of oil to under
$40/b, while Martin van Weyler – financial commentator of The
Spectator (UK) – believes that technology will provide a hundred
more years of oil. Actually it will provide thousands, however
once global production has peaked it hardly makes any difference
what the actual figure turns out to be.
For what it is worth, the Petroleum Economist (October 2004)
stated flatly that investment no longer keeps pace with high oil
prices, which is a sure sign that in the executive suites of major
oil companies, the general belief is that there are no longer
investment opportunities capable of matching those of the past.
Regardless of the upbeat bulletins and rumors emerging from those
venerable premises, this should always be kept in mind, because
even investment in OPEC countries (by local and/or foreign
‘players’) has slumped badly, and if this trend continues the
production forecasts of the International Energy Agency (IEA) and
US Department of Energy cannot possibly be fulfilled. One
prominent consulting organization, PFC Energy, has stated that by
2020 at the latest, OPEC will not be able to make up the
difference between non-OPEC supply and global demand. This is not
a very welcome prophecy, and I am at a loss to explain why it is
not more widely discussed.
A FEW GENERAL OBSERVATIONS
Before attempting to put the supply of Saudi energy resources
into perspective, a few general remarks about oil are essential.
The theory is now frequently advanced that high oil prices no
longer threaten the stability of the global macroeconomy, but as
far as I am concerned this is a serious misunderstanding. It is a
misunderstanding that is largely based on hero-worship of the
Chairman of the US Federal Reserve System (i.e. central bank),
Alan Greenspan. What observers do not realize however is that Dr
Greenspan’s undeniable success is mainly due to the huge debts
that, luckily for him, could be accumulated by households in the
US, as well as by the US government, and in addition over the past
few years there has been a level of capital investment by large
corporations that was sufficiently moderate to restrain interest
rates. An arrangement of this sort is untenable in the long run,
as readers of the financial press are constantly informed in
unambiguous language.
Private consumption in the US is still at a record high. It has
been raised to a much greater than normal extent by increases in
the price of real estate (i.e. a wealth effect), as well as the
continued availability of inexpensive credit. At the same time
there is underconsumption in most of the rest of the world,
particularly in Europe and China. According to the chief economist
of (the investment bank) Morgan Stanley, Mr Stephen Roach, the
deficit in the US balance of payments is now close to 7.5% of the
gross national product, while at the same time the US accounts for
70% of the total global balance of payments deficits. (He could
have added that a large fraction of the US current account deficit
can be attributed to imports of energy, and in particular oil.)
Roach regards this as unnatural, which it is, and he predicts a
“crisis”. Moreover, he pictures that crisis reaching every part of
the world because of the cross-border linkages created by
globalization. As it happens though, regardless of the curse of
globalization, these linkages have always existed for reasons
shown in every book dealing in any way with international
economics, to include my elementary international finance textbook
(2001).
The exact circumstances that would initiate this crisis are
unclear, but I am ill convinced that it will be via a sharp
(upward) interest rate adjustment, either directly because of a
decrease in the saving of foreigners, or indirectly because of
another sustained increase in the oil price boosting the
macroeconomic price level. The wealth effect referred to above
would then move in the opposite direction, and the impact effect
of the resulting decrease in spending could have serious
consequences for both physical and financial markets everywhere.
Note the expression “impact effect”, because (ceteris paribus)
eventually a decrease in spending in the US will have to take
place in order to obtain what they called an ‘equilibrium’ in your
macroeconomics courses.
This might also be a good place to mention the ‘yield’ curve’
(which is a plot of the interest rates (or yields) for a
particular type of bond, against different maturities for that
asset). As explained in Chapter six of my finance book, a
flattening (or inversion) of this curve – which is taking place as
this is written – could lead to a very bad macroeconomic scene.
The reason for this inversion turns on rising short-term interest
rates, along with an increased demand for long-term paper.
Unfortunately, Alan Greenspan entertains a few illusions where
the yield curve is concerned, saying that an inversion no longer
implies a recession, as was often the case earlier. This assertion
may not be incorrect, however it is not consistent with the
financial history of the last fifty years or so. By way of
contrast though, the chairman has never ceased trying to make it
clear that very high oil and gas prices are capable of badly
damaging the US economy. He undoubtedly remembers the recessions
that followed previous oil price escalations, and more important
he understands that while the laws of economics – unlike those of
physics – can be rescinded temporarily, they cannot be abolished.
For example, the macroeconomic and financial markets expansions of
the 1990s almost certainly would have been impossible if the
nominal (i.e. money) price of oil in that period had been anywhere
close to where they are at the present time. (The real – i.e.
inflation adjusted – price of oil is still lower than it was 20
years ago, using the l973 oil price as a base, but I get the
impression that attention is usually called to the real price by
persons who want to claim that oil costing $65/b or more is not
particularly expensive.)
The International Energy Agency (IEA) has postulated an
increase in the world oil demand from the present 84.5 Mb/d to 121
Mb/d in 2030. Normally, I would express some curiosity as to the
scientific background for that estimate, however I propose to use
it to make another preliminary remark about the supply
capabilities of Saudi Arabia. At the time when this 121 Mb/d is
supposed to be produced, OPEC is pictured as being responsible for
about one-half (as compared to approximately 35% just now). This
suggests an expected OPEC production of approximately 60 Mb/d. At
the present time Saudi Arabia supplies almost a third of OPEC oil,
and given their reserve situation relative to the other OPEC (and
non-OPEC) countries, this fraction will hardly decrease. (Saudi
Arabia apparently has proven reserves of about 260 billion
barrels, while second place Iraq has 120 billion barrels.)
Accordingly, it seems that IEA experts believe that Saudi Arabia
will supply at least 20 Mb/d in 2030.
One of the main purposes of my recent work is to convince
readers that Saudi Arabia is not going to willingly supply 20 Mb/d
in 2030, or at any other time in the near or distant future,
regardless of what you may hear on the grapevine. A high-ranking
Saudi official has stated that 15 Mb/d should be possible, and
once this amount is attained he appeared certain that it could be
maintained indefinitely. This kind of assurance undoubtedly sounds
lovely to the world’s motorists, but the economics that I teach
informs me that 15 Mb/d is a goal that will not be easy to reach,
while the game theory that I have taught tells me that this kind
of talk should be taken with a grain of salt. Furthermore, and
more important, even if that production level was realizable, it
would not be maintained for more than a comparatively short period
– unless the Saudi government had come to the conclusion that less
money was preferable to more.
What I do accept however is that the government of that country
will do everything possible to approximately double its share of
the global petrochemical output from its present 7 percent share
over the next five years. The reason I accept this is because from
an economic point of view, a greatly increased petrochemical (and
refining) output in the near future is a more reasonable economic
goal than attaining a crude oil production of more than 12 Mb/d at
any time. According to the Saudi government, foreigners are
welcome to invest/participate in the production of petrochemicals
and refined products in that country, but I suspect that the
reason for this generosity is the desire to use the influence of
large energy companies to facilitate the access to foreign markets
of Saudi Arabia’s petrochemical and refined output.
There is also some question as to what OPEC as a whole will be
able to achieve. A report from the consulting firm PFC Energy (as
mentioned in the Petroleum Economist, October 2004) states that
OPEC is producing about 8 billion barrels a year more than it has
been finding. This situation has been pictured as changing if e.g.
Libya and Iraq intensify their exploration activities, however
even under the best of conditions I find it impossible to believe
that this will be of other than marginal significance for the IEA
targets mentioned above.
Of late we have been hearing a great deal about oil from tar
sands (in the Athabasca region of Canada), and the heavy oil of
the Orinco region in Venezuela. As it happens, if a large
expansion takes place in the output of these unconventional
resources, then those observers who feel that the resources of the
Middle East are overrated might be correct, because in those
circumstances it is conceivable that the 9-10 Mb/d output of Saudi
Arabia could be matched or overmatched.
As suggested by Crandall (2005) and Reynolds (2005), the total
output of unconventional oil from these two regions will not reach
anywhere near 9-10 Mb/d in the near or medium future, and by the
time it does the global production of conventional oil might have
turned down. Accordingly, we would still be faced with an oil
price that is capable of devastating the international
macroeconomy, as well as creating social/political chaos in the
large importing countries. The CEO of one of the major oil
companies has sworn what almost amounts to a sacred oath that his
enterprise is prepared to assume the responsibility for developing
the kind of technology needed to make unconventional oil
economically attractive, but this sounds like the kind of pledge
that is delivered late at night after the cognac has gone around
the table a couple of times.
SOME ABSOLUTELY ESSENTIAL OIL MICROECONOMICS
This section will begin with an extremely important but simple
numerical example dealing with the reserve-production (R/q) ratio
of oil – or for that matter gas. (Reserves (R) are measured in
e.g. barrels (b), while production (q) is measured in barrels per
unit of time.) The assumption here will be that when this ratio
reaches a ‘critical value’ (R/q)* – which will be taken as 10,
since that was the number mentioned most often in the seminal
article of Flower (1977) – then in order to optimize the value of
the output from a particular deposit, the annual output from the
deposit should ideally be kept from falling below 10% of the
remaining recoverable reserves. Accordingly, from that point on
(and as shown in a numerical example immediately below) this ratio
will determine production: production must adjust in such a way as
to hold the R/q ratio at (or around) the critical value. If this
were not done, then it would be tantamount to ‘overworking’ the
deposit, and as a result of accelerated (physical) depreciation,
reducing the amount of oil that can ultimately be obtained. The US
government document referred to in the first paragraph of this
article also takes notice of this concept.
Now for the example. Assume that we have a field with 225 units
(= R) of accessible oil reserves, and we desire to lift 15
units/year (=q). It is obvious that we can have an output of 15
units/year every year for 5 years. During this time, the R/q ratio
falls from 14 (at the end of the first year) to 10 (= (R/q)*) at
the end of the fifth year, and reserves fall to 150 units. After
that, however, if we continue to remove q = 15 units/year, we are
violating our constraint: the R/q ratio will fall under the
critical value (= (R/q)* = 10). For instance, if we removed 15
more units during the sixth year, or q6 = 15, then reserves fall
to 135, and (R/q)6 declines to 135/19 = 9. To keep this ratio at
10, production in the 6th year cannot be larger than 13.64.
![](Banks2.gif)
Continuing in the same vein, in the 7th year production cannot be
larger than 12.4 units/year.
Readers should be able to get these results by simple trial and
error, however this discussion may be generalized to show that
This expression can then be solved to give
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(Be careful to note that in the present example, this ratio is
measured at the end of the year.) In terms of the bizarre
mathematical expositions that fill the scholarly economics
literature on exhaustible resources, this expression does not
appear to have much to offer, but in point of fact it is very
useful! To begin, if the discussion is carefully examined, the
reader will see that it involves construction of a production
plateau and decline phase of an oil deposit. (An example showing a
production profile with a growth phase and peak is easily
constructed by assuming that initially, after beginning with e.g.
an output of 15 units/year, q increases by a certain percentage
every year. For instance, try 5% = (0.05) as the rate of increase,
but to make the exercise more interesting begin with R = 450 units
The only trouble with this exercise is that while there is a peak,
there is no production plateau.)
Now for something that is extremely important! In the numerical
example given above, production turned down after the fifth year.
At that time we have (150/225) x 100% = 66.7% of the original
reserves still in the ground. If we had calculated the ‘length of
life’ of this oil field at the beginning of the exercise, we would
have obtained 225/15 = 15 years, which would have presented a
completely false impression of the availability of oil! Your
favorite journalist or energy economist might tell you that the
global R/q ratio of oil at the present time is approximately 41
years, but what we should understand in the light of the above
discussion is that this number is almost completely
inconsequential. It is made that way by the importance of the
critical R/q ratio (= 10 in the above example), as well as
Hubbert’s Peak: the tendency for the production of oil from a
given reservoir to decline at approximately the time when the
half-way point is reached. For instance, the global length of life
of oil reserves is not the 41 years that is usually cited, but
thousands of years – in fact it approaches infinity – but some
experts associated with the Association for the Study of Peak Oil
(ASPO) think that the global peak could come in ten years.
In 1962 Dr. M. King Hubbert reissued an updated version of a
highly controversial report in which he had claimed that oil
production in the ‘lower 48’ of the US would peak between 1966 and
1970 at a point where approximately half of the total amount of US
reserves had been produced. (Total here means the sum of the
amount of oil extracted plus proven reserves.) The peak came very
late in l970, and although the US still possessed a tremendous
amount of reserves, output has been trending down ever since.
Hubbert’s warning of potential oil shortages was in general
ignored because of an ingrained – and to a considerable extent
understandable – belief in the efficacy of the price system:
higher oil prices should theoretically speed up the introduction
of a superior oil recovery technology, and at the same time
increase exploration and the amount and intensity of drilling. All
of this is true, but as previously noted, technological progress
cannot find oil that does not exist. (It can, admittedly, locate
and play an important role in the production of ‘heavy’ oil, and
oil from tar sands and shale, however these non-conventional
resources are in a higher cost class.)
Some observers insist that enough oil can eventually be
squeezed out of existing deposits to compensate for the inability
to discover major new deposits. My immediate reaction here is that
since between 75 and 80 percent of today’s oil output come from
fields that were discovered more than a quarter of a century ago,
and since almost all of these fields are in full decline, this is
another case in which upbeat expectations should be carefully
examined and justified before our political leaders and their
experts use them to make pivotal decisions.
The argument used above almost certainly has its origin in the
well-known theorizing of Professor Morris Adelman, and what it
begins with is a (correct) hypothesis that the amount of oil that
can be removed from a typical deposit almost always exceeds the
original estimates. Exploration only discloses pools of unknown
magnitude (and likely profitability). It is when these pools are
turned into producing properties that we can judge their various
attributes, to include getting a good estimate of the reserves
that are present. The US is often used as an example here, but
unfortunately it is the wrong example. Regardless of the
technological prodigies that are ostensibly being performed on or
planned for deposits in that country, aggregate production will
continue to decline.
This is not a particularly attractive prospect for a country
like the US, where a shortage of oil is often pictured as a direct
threat to national security and economic well-being, however there
is not very much that can be done about it. The US oil sector is
on the falling portion of its depletion curve, and a durable
reversal of this situation is almost unthinkable – and by that I
mean almost unthinkable if every square inch of onshore and
offshore US territory, to included the Arctic National Wildlife
Refuge (ANWR), were immediately thrown open to exploration and
production, regardless of the environmental costs.
On one of the occasions that I lectured on the world oil
market, I was brusquely reminded that the R/q ratio in the UK
North Sea was closer to 5 than to 10. This does not, however,
vitiate the above discussion. What it probably meant is that even
in medium-deep water, production costs can be so high that, unless
expected prices are high, maximizing (discounted) profits might
entail consuming (i.e. destroying) some of the deposit (R) in
order to speed up the recovery of the capital that was invested in
the deposit so that it can be invested elsewhere. I can note here
– and as indicated in the US government document referred to
earlier – that if the critical R/q ratio is ignored where output
is concerned, then when the decline in ‘q’ takes place it is
steeper.
For those persons who have spent too much time with the
conventional academic economics literature on exhaustible
resources, it needs to be emphasized that the key variable in oil
production is pressure in the deposit. As a result it may be so
that when, on the average, about half of a typical deposit is
exhausted, the pressure has been reduced to a level where raising
or maintaining production by additional investment is too
expensive. If this is true, then Hubbert’s peak is as much an
economic as a geological phenomenon. Several researchers have
tried to extend Hubbert’s work so that it takes on a distinct
economics makeup, but the opinion here is that they have not been
successful, because they have not given adequate consideration to
e.g. pressure.
The average ‘recovery factor’ for oil at the present time is
about 35%, where this factor is defined as the ratio of the amount
of oil (or gas) expected to be recovered, to the total amount of
oil (or gas) ‘in place’. (Note: recoverable oil, and not oil in
place, are oil reserves.) In some parts of the world the recovery
factor is well under 35% – e.g. for some heavy oil, it may only be
5%, which is something well worth remembering; while it has been
know to reach 80% for light oil (and gas). The important thing
here is that given the movement of the recovery factor over the
past two or three decades, there is no longer any reason to
believe that it will take the dramatic lunge upward that is
necessary to radically change the global reserve figure!
The production of conventional oil involves reservoir fluids
flowing under pressure out of the reservoir rock into a production
well (or borehole). Initial production tends to be constant for a
period ranging from several days to several years. Then, as the
pressure drops and the oil has to move further through the
reservoir rocks to reach a given borehole, the output will tend to
decline – ceteris paribus. One of the things that will reduce the
pressure is a too rapid depletion. This can result in the deposit
being damaged, which in turn makes the oil more difficult to
extract (for the same effort), as well as decreasing the recovery
factor. Now we see why the R/q ratio is so important: by operating
below the critical R/q ratio (taken as 10 in the above
discussion), we reduce the ultimate flow of oil. Something else
that should be recognized is that petroleum engineering is a
serious profession, and most economists are like myself in that
they lack the background to understand the more elusive details of
oil production. Thus, for economists, levels and changes in the
R/q ratio might be capable of serving as a proxy for a great deal
of important geological information.
As is well known, the production profile for a typical oil
field – where a field is a group of reservoirs in the same general
area – exhibits rising production, a plateau, and then falling
production. Obtaining this profile calls for drilling a number of
production wells. Initially the flow from new wells exceeds the
depletion of those already drilled, and so we start out with a
rising production pattern. Then, new drilling takes place at a
pace that is designed to keep output more or less constant; and
finally drilling slows because as the amount of oil remaining in
the field declines, the cost of extra wells is high compared to
the additional amount of oil obtained.
As an example we can consider the Khurays field in Saudi
Arabia, where expansion may already be under way. It is estimated
that altogether 400 wells will be required over a period of 3
years in order to obtain a total of 1.2 Mb. What happens after
those 3 years is uncertain, however I presume that the field will
be in full decline. It will also need 2 million barrels/day of
water injection, facilities to process the water, and pipelines.
The same sort of thing is true for other fields, and so a natural
question might be ‘why bother?’ As suggested in the next section,
the money involved in these investments might be better spent on
increasing petrochemical and/or refining capacity.
Accordingly, any analytical model that aspires to a meaningful
exposition of oil production must explain how reservoir pressure
influences the interaction between current output, investment, and
the (likely) dependence of recoverable oil on the time path of
production. Furthermore, the latter item should cause careful
observers to immediately think of the R/q ratio, because as
already noted, by driving this ratio too low, the total amount of
recoverable oil is reduced due to physical ’depreciation’ of the
deposit.
If a reservoir is tapped by a well, and the pressure in the
well-hole is considerably less than that in the reservoir, there
can be a ’natural’ flow of oil to the surface, and into a
pipeline. This category of production is termed natural drive, and
it tends to prevail for a relatively long time in the richest oil
fields. Eventually, this pressure will fall, and some category of
artificial lift must be introduced, and/or other wells drilled.
Thus, what some observers think of as a pure ’one shot’ investment
problem leads unavoidably to a complicated intertemporal
consideration of investment.
Finally, many reservoirs are rate sensitive, and a too rapid
production of oil may reduce reservoir pressure, and cause a
permanent loss of the resource. What is a ”too rapid” production
of oil? The simplest way to describe it is a production level
which pushes the R/q ratio below what was earlier defined as the
critical R/q ratio; but in addition it should be appreciated that
if e.g. 10 Mb of oil are to be extracted over a 5 year period, an
extraction program that lifts 2 Mb/y for 5 years could have a
different effect on the ultimately recoverable amount of this
resource than a program that removes 5 Mb the first year, and 1.25
Mb in each of the remaining four years.
A topic that will not be considered in this paper is ‘natural
depletion’, which is roughly the amount that would be lost from
reserves even if no production took place. An article in Business
Week (October 10, 2005) reported that for Saudi Arabia this
amounts to between 400,000 and 500,000 barrels per year. I
strongly suspect that this estimate is too small.
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