The Theory behind Peak Oil

28 Sep

Oil production can’t be expanded endlessly due to given geological restraints. At some point it will peak and then decline. Are we close to the global peak?

Crude oil is a finite resource. Certain conditions must be met or there isn’t any oil to be found. There must be source rock (which transformed organic material into crude oil). The source rock must have been inside the oil window (which is the term used to describe the surface between 7,500 and 15,000 feet below the surface), there must be a reservoir rock (a rock which contains the oil) and a cap rock (a rock which prevents the crude oil from coming to the surface where it would eventually evaporate). If any one of these conditions isn’t met, there is no oil. Furthermore, there is no oil below the oil window. Hydrocarbon chains (this can be oil or natural gas) of crude oil are broken into smaller chains below 15,000 feet, so there is no oil below the depth of 15,000 feet. You may find natural gas below the oil window, but no crude oil. So drilling deeper isn’t an option.

Furthermore, if half of the available crude oil has been produced, production will peak. This is the essence of Peak Oil theory, which is a proven theory. Some respected geological authorities believe that world crude oil production has actually peaked or will peak soon, depending of the number of crude oil reserves you use for the calculation.

The main message is that the old boom-and-bust cycle for oil may no longer be true as supply is restrained by geology and will no longer respond to higher prices, which used to lead to greater supply of crude oil on the world market.

The importance of this theory for investing is obvious. It should therefore be explored deeper as there is an ongoing battle between the followers of Peak Oil theory and some optimists who can’t see any shortage of crude oil.

The guy who invented Peak Oil theory was called King Hubbert. He was a widely respected authority in the famous Shell Laboratories in Houston in the 1950s. Peak Oil theory was only one of his valuable contributions to the science of oil.

Hubbert used the available data and predicted that US oil production would peak at the beginning of the 1970s. His forecast was made in 1956. Hubbert received a lot of scorn, and he just seemed to be another prophet in a long list of false prophets to predict that the party for US oil would soon be over. But Hubbert was right.

US onshore production peaked in 1971. You may have noticed the word “onshore”. Hubbert didn’t include the Gulf of Mexico and the large (at this time undiscovered) Prudhoe Bay oilfield off Alaska.

To take a closer look at this theory, we need to understand how the production capacity of an oilfield develops over its lifetime. For someone coming from business administration, the production curve over the lifetime of an oilfield resembles the product cycle graph used in marketing to explain the lifetime of a product, so I’ll explain that first.

A new product is launched, you have to find buyers, place ads, your sales will start to grow (hopefully); sometime later, your product has a certain market share, turnover is high, and finally your product is old, fewer people are willing to buy it, and turnover starts to decline. This is the time to bring a new product on the market in order to replace the old product.

Oilfields are similar – replace turnover with daily crude oil production and you’ve got it. A new field is ramped up, it starts with a few barrels soon to be expanded. Sometime later, the field produces its maximum number of daily barrels. This doesn’t last forever; declining pressure, water intrusion or dissolving gas leads to a decline of output. You can use some measures to postpone this decline or to soften it, like water injection to keep reservoir pressure and output high, but, like marketing, where you can spend more on advertising or make some modifications to your product, decline is inevitable.

To retain your production capacity after one of your fields started to decline, you have to find a new field or new fields to replace it. This happened in Russia where the Sakhalin field made up some of the decline in the more mature Russian oilfields. And this is what the Saudis are trying to do at the moment. We will have a closer look at that later on.

But as the geologists explained to us, if you draw a circle around any part of the world you will start to discover oilfields, but after some time, you won’t find any more oil inside this circled territory. At this point, this territory is heading towards peak production as the decline of mature fields can’t be offset by bringing new fields into production.

Has global crude oil production already peaked?

At this point, I would like to think of Peak Oil theory as a proven theory. A number of geologists – among them a former colleague of Mr. Hubbert and professor of Princeton, Kenneth Deffeyes – claim that global crude oil production has already peaked as we have produced half of the whole crude oil reserves available on earth. The circled territory is now the whole world.

The effect of this is of course tremendous. It means that the old boom-and-bust cycle isn’t working any more when it comes to crude oil. Higher prices caused by increasing demand won’t automatically lead to a larger supply of crude oil as geological restraints don’t allow more crude oil to be produced.

If this is true, and I have no reason to distrust Mr. Deffeyes, a huge spike in crude oil prices is well ahead of us, a bad message for all oil consumers (and the consumers of products derived from crude oil), but a unique investment opportunity for those daring to put their money on the table and bet on this theory.

Peak Oil theory has one underlying hypothesis, that half of the world’s crude oil reserves have been used. So before we bet on this theory, we should thoroughly check the status of proven crude oil reserves. As you will soon see, there is no such thing in the world of crude oil reserves as “proven”.

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