Receding Horizons

April 27, 2007 at 10:31 am
Contributed by:

Folks,

This longish article was broken into two parts for Energy and Capital (here and here), but I have reprinted it whole here for convenience.

In it, I discuss the paradox that many highly-anticipated oil and gas projects around the world are being delayed or cancelled due to the high cost of oil…when the high cost of oil was supposed to make them economical.

I think this is an important dynamic to be aware of as we cross into post-oil peak terrority. Our expectations for future production may not be fulfilled.

–C

Receding Horizons

By Chris Nelder

April 17, 2007

The bear went over the mountain

The bear went over the mountain

The bear went over the mountain

And what do you think he saw?

He saw another mountain…

Last
week, energy blogger Robert Rapier published a thorough analysis of what went
wrong with thermal depolymerization (TDP), a much-hyped technology that
promised to turn anything (starting with turkey guts) into usable oil and other
clean, usable byproducts, while being net energy positive and economical.

I
blogged it myself back in 2004 when it was supposed to be the Next Big Thing,
able to harvest landfills and deliver liquid fuels in a post-peak oil world, in
one fell swoop.

Rapier’s
account of the TDP story is an interesting study in how the “next big thing” in
energy often turns out to be overpromised and underdelivered.

“This
is the same mistake that proponents of tar sands, GTL, oil shale, cellulosic
ethanol, and many others have run into,” Rapier observed. “They believe that
oil prices will rise, and yet their costs will magically remain where they
were. In fact, what happens is that as oil prices rise, all the costs
associated with these various projects rise.”

He called
TDP a victim of a phenomenon known as the “Law of Receding Horizons.”

A Horrible Irony

So far, April is living up to T.S. Eliot’s aspersion that she is the cruelest
month.

Energy projects in oil, natural gas, and tar sands have been getting cancelled or
delayed left and right for the last two weeks or so.

Why?

Because of a horrible irony we have observed before: the rising cost of oil causes the
project’s costs to balloon until it is no longer economical. (Plus a healthy
dose of geopolitical unrest, and basic environmental overshoot.)

The horizon recedes. Like an oil slick mirage—always just out of reach, just
another mile or a billion dollars away.

Thanks to the record oil revenues
being raked in by oil producing countries of the Middle East, they’re building
and expanding infrastructure like gangbusters, which has led to a global
shortage of contractors, raw materials, equipment and qualified labor…and led in
turn to higher prices for all the world’s big construction projects, including
its own.

Talk about the snake eating its own tail.

We’re not just talking refineries,
either. Didja hear about the planned 68-story combination hotel,
apartment and office tower complex in Dubai, where each floor rotates 360
degrees independently, to create a constantly changing architectural form?

Well, whatever it takes to entertain the likes of Michael
Jackson, I guess.

But I digress…

The Unconventional Oil Mirage

The
point is, any time we hear that oil has to be over $30…or $40…or $x/barrel in
order for some marginal energy project to make sense economically, we should be
instantly skeptical.

Because
when oil does get to that cost per barrel, the project’s costs often
turn out to be based on the cost of oil back when they made the estimate…but now,
the project is still too expensive to make sense.

I
don’t know how they get away with such predictions, actually. We’ve all seen
this movie before, haven’t we?

And
yet, the cost overruns are always called “unexpected.”

One
clear example of this is the production of the oil shale of the American West.
Once you factor in the future cost of all the energy that it will take
to harvest those low-quality hydrocarbons, it never pencils out. Indeed
it seems to be a calculation that few even attempt.

The standard joke is: "Shale oil–fuel of the future, and always will be."

Back in 1946, you’d have seen a
billboard along the route of today’s I-70 suggesting that you "Get In On
the Ground Floor" of real estate there, to capitalize on the impending shale
oil rush. And it’s still not too late, because to this day there is still not a
single production scale oil shale facility.

Another
good example of receding horizons was given in the recent report by the Energy Watch
Group on the impending peak of global coal production. The report’s authors
concluded: “the present and past experience does not support the common
argument that reserves are increasing over time as new areas are explored and
prices rise.”

I’ll
say it yet again: when it comes to non-renewable resources, neo-classical
economics just doesn’t work. The Invisible Hand stays in its Invisible Lap, and
God doesn’t put more oil in the ground just because we’re willing to pay more
for it.

Unfortunately,
the cancelling of these projects is coming at a time when we’re just barely
able to balance global supply and demand, no matter what OPEC may say to the
contrary.

Claude
Mandil, executive director of the IEA, said last week "Demand growth has
exceeded the capacities put on the market, which currently are barely balanced….Even
if we are happy with increasing investments in Middle East countries of OPEC,
we think the rate of investment and capacity growth is not enough to meet
future oil demand."

Not
enough to meet future oil demand.

Let’s
take a look at the next cavalry regiment who has decided to stay home.

Bear
in mind that all of this has happened since April 1.

The Rogues Gallery

Nigeria: In Nigeria, the number five supplier of crude to the U.S.
and one of the few sources that can actually (theoretically) increase
production, militant groups have declared “full blown war” on the federal
government unless they withdraw all military personnel from the Niger Delta,
where the militants have continued to stay busy sabotaging the oil
infrastructure and taking oil workers hostage.

Multinational
oil companies are pulling out, workers are refusing to expose themselves to
dangerous sites, and many projects are being put on hold. But the oil companies
are largely staying mum.

California: The state Lands
Commission voted not to approve an environmental impact statement that would
have been necessary to proceed with a proposed liquefied natural gas (LNG)
facility 14 miles off the Ventura-Los Angeles County coast. They also denied a permit for the
pipelines to cross state lands, so the project is effectively dead. This bodes
poorly for the three other similar LNG projects that are still in the approval
process, and another Long Beach project which is currently being fought in
court.

Louisiana:
Shell has put the kibosh on a new LNG import terminal 36 miles off
the coast of southwest Louisiana, due to protests
over the environmental impact of the facility, which would have used millions
of gallons of Gulf water to warm the gas from liquid back into a gas.

Canada: In the Northwest Territories, the Deh Cho tribe,
the last aboriginal holdout against a natural gas
pipeline across the Mackenzie Valley, is making their approval of
the project conditional upon the federal government agreeing to set aside 60%
of the tribe’s lands as protected wilderness. The 1,220-kilometer
pipeline is needed to access large gas reserves in the Arctic, but its cost has
more than doubled to $16.2 billion.

Natural gas drilling in Canada has also been dampened
by the Canadian government’s dubious decision to kill the golden goose of
investment money flowing into its energy projects, by phasing out the sweet tax
benefits that the Canadian investment trusts who funded the projects used to
enjoy.

Accordingly, exploration and production companies are
scaling back on drilling. The number of drilling rigs that are operating in Canada
now are less than half the number that were operating there at the end of 2005.

"A lot of marginal drilling activity taking place
last year is probably gone for good," said Bill Herbert, co-head of
research for Matthew Simmons’ company, Simmons & Company International. He
called the run of rig withdrawals a "blood bath," and projected that the
second quarter of this year will see the rig count fall by 40 percent from last
year’s level.

For those of you keeping score, this is not good news. North America is well past the peak of its natural gas production and is on the decline. Just
to stay even with current consumption, we need to increase imports. But, as we are
seeing in southern California, new facilities to import natural gas aren’t exactly
being welcomed with open arms.

Since natural gas is the primary feedstock for West
Coast electricity plants, this surely will translate into higher grid prices
here.

And since natural gas is a key feedstock for the
production of oil from the Canadian tar sands, it could dampen those projects
too. That’s scary, because that 1 million barrels a day of oil made from the tar
sands is equivalent to more than 10% of the U.S.’s oil imports.

Canada is, after all, our number one supplier of crude.
We’re counting on them to make up for the loss from our number three supplier, Mexico, due to the catastrophic decline of its main oil field, Cantarell.

So we’d like to see Canada increasing its production as
fast as possible—indeed, we lobbied them hard last quarter to do so, asking
them to suspend their environmental reviews in order to fast-track oil sands
projects.

But they demurred.

Now, the Canadian Association of Oilwell Drilling
Contractors anticipates that the number of oil wells drilled will drop from 22,575
last year to 19,023 this year.

With oil prices going up.

What does that tell you?

It tells me that the investment money is pulling back,
and that could very well be because the best prospects for drilling have already
been tested, and that they’re getting more and more dry holes and less payout
from the wet ones, even as the cost of drilling rises dramatically.

Oh, Canada!

Mexico: In a startlingly frank interview of Matthew Simmons on the
Financial Sense newshour with Jim Puplava, Simmons actually recommended that Mexico cut back on its oil production, in order to save a little for the rainy day
ahead when oil is scarce, and so are oil revenues.

“If I were Mexico today, as painful as this would
be temporarily, I would lower Cantarell’s production rate to about 800,000
barrels a day, and keep the other sister fields next to it from going into a
nitrogen injection program—or do the nitrogen injection, but then, don’t let
those wells flow as fast as they can. Cap it. And let it last at a lower rate
for 10 years while they try to figure out what in the world do we do once we
basically are no longer a major producer of oil, because otherwise, they have
no Plan B–just like we have no Plan B.”

Reinforcing his expectation of a near-term peak, he said “I don’t think we
have until 2010. It’s a pretty grim picture. …We need to have oil prices go way
up from where they are today.”

Russia: A government official
said that construction of the second leg of its pipeline to Asia could
be pushed back from its originally scheduled March 2008 completion by as much
as four years, because oil production from its underdeveloped East Siberian fields
has failed to meet expectations.

Saudi Arabia: The state-owned oil company Aramco
said that its ample supplies of heavy sour crude will continue to go
under-used, because the rising cost of construction materials such as steel and
concrete have caused delays in plans to build more of the complex refineries
needed to process it. The cost of building a refinery is up over 70% in the
last three years.

Many of these refineries may not materialize,"
Aramco’s Mishari said at the Middle East Petroleum and Gas conference in Dubai.
"The downstream bottleneck could remain."

Construction costs have also
doubled, to US$22 billion, for a planned large-scale refinery and
petrochemicals complex in eastern Saudi Arabia. The first cost estimate for the
project was $10 billion, which went up to $15 billion last July when Aramco
announced its partnership with Dow Chemical on the project. Now it’s $22
billion. Apparently, they are moving forward with the project anyway.

Anybody trust the new estimate?

More importantly, anybody want a
marker on what the real cost will be, if and when it gets completed?

Iran: According to an April 5 announcement by the French oil
company Total SA, their planned $10 billion LNG project in Iran is now in jeopardy because of—again—rising costs.

CEO Christophe de Margerie told reporters Thursday that the
costs "are so high that they are close to damaging the project."
"We have to renegotiate all our agreements" with suppliers, de
Margerie said, adding costs "have more than doubled" in recent years
and that this is a "strong concern."

He said the company also needs to re-evaluate the
geopolitical environment before deciding to go ahead with the project. (Duh!
And who thinks that assessment will come up rosy?)

The project was to harvest the
massive South Pars gas field, which holds about 1 billion barrels of oil
equivalent of proven reserves. It was scheduled to begin production by 2011.

For the record, de Margerie also
has the distinction of being the only head of a major oil company to give a
fairly realistic date for peak oil: 2020. He has also questioned whether it is
possible to increase global oil output from today’s 85 million barrels per day
to 100 million barrels per day, as many officials have projected. He should be
commended for his candor.

Kuwait: A proposed
615,000 barrel-a-day refinery in Kuwait was initially projected to cost around
$6 billion, but the contractors came in with prices in excess of $15 billion.
Part of the reason is that the cost of shallow water drilling rigs has exploded
from $50,000 a day just a few years ago, to $200,000 a day now.

Algeria: Our #7 source of imports, and Africa’s largest gas
exporter, may scrap a planned 36,000 bpd gas-to-liquids (GTL) plant due to—you
guessed it—the soaring energy costs of construction. “We had three bidders and
one dropped out,” said the country’s oil minister, “It is too expensive
apparently, so we may drop it.”

He said other GTL projects have been pushed back as far as 2011. The
projects “are being delayed because of haggling over costs and lack of
subcontractors.”

An LNG plant under construction in Algeria will also be delayed, according
to the builder, Spain’s Repsol.

Qatar: Realizing
that project costs are delaying oil and gas projects around the globe, Qatar’s Oil Minister Abdullah bin Hamad Al Attiyah met recently with the chairmen of oil
and gas companies. "Cost is a big concern," he said, and is "one
of the issues we should be concerned about before it snowballs."

While this happened in February
and not April, it bears repeating. In Qatar, home of the world’s
third-largest reserves of natural gas (after Russia and Iran), the energy
minister said that the future of some multi-billion dollar GTL projects planned
by Conoco Philips and Marathon Oil was in doubt, and their fate wouldn’t be
decided until a cost study is completed in 2009.

And, as we reported earlier, a much-anticipated,
$15 billion LNG project in Qatar was scrapped by Exxon due to costs running out
of control, and rising domestic gas needs.

Everywhere oil is owned by the state: And bringing up
the end of our rogues gallery is: everywhere foreign oil companies operate. It seems
that the days of windfall profits for oil companies are numbered, as oil
producing nations realize that they have the leverage to demand a bigger share
of the wealth.

The renationalizing of energy assets by Russia, Venezuela, and Algeria are just part of this picture. Nationally owned oil companies, or
NOCs, currently control some 75% of the world’s remaining reserves, and their
share will soon increase to 90%.

That puts them in the driver’s seat for dictating the terms
of future deals. And unless the international oil majors—overwhelmingly
companies from countries in the West that are past their own production
peaks—want to go out of the oil business entirely, they have to play ball.
Because that’s where the oil is.

In addition, the state owned oil companies have learned a
thing or two from their long partnerships with the Western majors, and are now
capable of taking on complex projects on their own. They don’t need the majors
as badly anymore, and tend to use them for their E&P expertise and then
toss them out just when the going gets sweet.

Sounds like a blues number, doesn’t it?

These days, says ConocoPhillips Chief Executive James Mulva:
"Big Oil is not so big."

And Exxon Chief Executive Rex Tillerson expects the new
trends to continue: "Until you get a change in the price environment, I
don’t see the pressure coming off much," he said last month.

A few examples: Anadarko Petroleum Corp., the largest
foreign producer in Algeria, estimates that the new taxes levied on it will
reduce the company’s income from Algeria by 12% to 23%.

Marathon Oil will now face taxes on any windfall profits in Equatorial Guinea.

Venezuela has raised taxes and royalties, and has taken a
controlling interest in all its heavy oil projects, which are among the most
profitable in the world for Western oil companies. Income taxes on heavy oil
projects are up 50% over the past couple of years, and royalty rates doubled to
33%…when they started at 1%.

A Questionable Future

This high-level survey of future of the world’s oil and gas
production clearly leads to some important questions.

Can we trust our expectations for future oil and gas
production? How eager do we think Big Oil is really going to be, between now
and say, five or ten years from now, when we’re clearly past the global oil
peak and they’re basically powerless to do anything about it?

What do these developments—or should I say, lack of
developments—imply for the timing of the global peak? For the price of oil?

And what about the other much-anticipated liquid fuel
alternatives? What corn price puts the hurts on ethanol production? On food
prices in general?

And can the vast resources of oil shale, tar sands, and coal
in North America really save the day?