High Costs Could Prompt Premature End to Oil Production

Consider what’s now happening at the major mining companies as a harbinger of what we can expect to see with oil production companies. According to a recent article appearing in The Wall Street Journal (link below), a number of mining companies are curtailing certain of their operations, in some cases shutting them down completely. The explanation, which at first blush seems strange, especially given the run up in commodity prices over the last few years, has to do with operating and investment costs. The cost of energy to run mining trucks and other equipment has skyrocketed. In addition, certain materials needed to make mining buildings and related infrastructure, materials like steel, have also become considerably more expensive.

Mining nickel, lead, copper and other metals from the ground actually has many similarities to pumping oil out of the ground. While the processes are technologically different, in both cases we are talking about discovering and extracting a commodity that is in limited supply. In both cases, the supply of these commodities is in the process of being exhausted, and as a result, these commodities are increasingly more difficult to find, and increasingly more expensive to extract from the earth. For example, no new giant oil fields are being discovered these days. Producers must now go into very inhospitable environments, such as the bottom of the sea, in order to find significant new deposits of oil.

In the future, firms that are mining minerals, and firms that are producing oil, will both be hit with the double whammy of higher energy prices combined with higher commodity prices. Higher energy prices mean that the cost per ton of ore produced, or the cost per barrel of oil produced, will be higher than it was in the past. Higher commodity prices will discourage investment in new and more efficient infrastructure, just as it will discourage efforts to develop additional deposits.

As was the case for carrier pigeons, bison and many other animals, the extraction of these “resources” continues until it is no longer economical. Personally, I think it’s deplorable that organizations make these decisions primarily based on economics, but that’s the way the system is set up right now. So the production of minerals and petroleum from the ground will continue until it is no longer economical for the producers to engage in this activity. This point comes when the variable operating costs, and the fixed investment costs, both mentioned above, no longer look attractive relative to the revenues that can be obtained from further production activities.

Exactly when this point will come for oil or other commodities is hard to estimate. Many factors will affect this timing, including remaining supplies, prevailing demand levels, available technology, government subsidies and taxes, as well as the cost of capital. The important take-away point is that there will come a time when the producers stop producing, NOT because supplies have run out, and NOT because demand has dried up. At that point, it won’t matter who you are, or how important your organization’s mission is, nobody is going to produce the commodity your organization may be dependent upon.

So the traditional bell-shaped depletion curve that is generally drawn by those who speak about peak oil is therefore a bit misleading. The smooth symmetrical bell shaped curve was relevant for the U.S. because the gap between the countries’ production and consumption could be made up by imports from other countries. But when worldwide oil production peaks, if it has not done so already (and ample evidence indicates that it has) then there will be no other country that can supply the missing oil. So the curve doesn’t neatly move down asymptotically approaching the horizontal axis of the diagram – at some point it just stops. That is the point when it is no longer economical to extract petroleum from the earth.

Confirming this reality, firms that produce oil are now dealing with heavy oil, oil produced from tar sands, oil high in sulfur, and otherwise undesirable grades of crude oil. It is much more expensive to extract and refine these types of oil than was the case with the light sweet crude that has been traditionally produced. So this day or reckoning, when oil will no longer be produced, is not all that far away.

From a managerial perspective, what does all this mean? First, it underscores the importance of reengineering your organization so that it is no longer dependent on a rapidly-depleting limited-supply commodity such as oil. It would be far better to transition to renewables, such as ethanol and butanol, that can be distilled from biomass and other forms of renewable waste. Better yet would be sources of energy that do not depend on any potentially unreliable external input whatsoever. For example, electric cars can be powered by solar, wind, geothermal, wave, tidal and other forms of energy that are predictable and do not deplete over time.

Secondly, this reality points to the need to get more specific about the economics of producing oil, so that we might get a better sense of the date when production will cease. Just having a conversation about this date, and attempting to calculate when it could be, will also be important, because it underscores the increasing fragility of any operation that remains dependent on petroleum.

Thirdly, this reality points to the need for much greater diversity in our energy supply. Because petroleum now makes up about 60% of the world’s energy supply, if oil producers were to stop producing, there would be widespread and unprecedented adverse impacts. But if petroleum made up a much smaller part of the world’s energy supply, and if specific organizations used multiple sources of energy, the impact would be substantially reduced. Even if this day when oil is no longer produced is far away, it is in everyone’s best interest to more toward greater energy supply diversification.

Fourthly, knowledge of this day when petroleum will no longer be produced underscores how important it is for organizations to recognize that they are dependent on suppliers on the other side of the world, suppliers that they have no relationship with whatsoever, suppliers about whom they really know very little. This recognition should push management to consider making its own transportation fuels, and otherwise setting up in-house (or at least local) energy-generating systems. For example, it is now possible for organizations to manufacture their own bio-methane (also called renewable natural gas), to refine this gas, to store this gas for long periods and to use this gas in their own transportation vehicles. The technology to do this is now sufficiently advanced that organizations can go out and buy a turnkey manufacturing system to capture and refine this gas.

Charles Cresson Wood, MBA, MSE, is an alternative fuels management consultant with Post-Petroleum Transportation in Sausalito, California. His most recent book is Kicking The Gasoline & Petro-Diesel Habit: A Business Manager’s Blueprint For Action. You can learn more about the book, read his alternative fuels blog, and reach him at www.kickingthegasoline.com.

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