Peak Oil Review
Vol. 5 No. 6
February 8, 2010

Tom Whipple, Editor

Steve Andrews, Publisher

1. Prices and Production
It was a volatile week with oil prices opening around $73 a barrel, climbing to touch $78 on Wednesday and then falling on Thursday and Friday to below $70 a barrel before closing at $71.19. As the week opened, reports of increasing Chinese economic growth, shrinking US stockpiles, a weaker dollar, and a marked decline of oil kept in floating storage sent prices higher.

On Thursday sentiment swung with concerns about sovereign debt in Europe, a stronger dollar, over-production by OPEC, falling demand in the US and increased US jobless claims. Oil recorded its steepest one-day percentage loss since last July falling by nearly $4 a barrel amidst a substantial fall in the equity markets. The week ended with crude at a seven-week low and the Euro at an eight-month low against the dollar. The overriding concern is that European efforts to deal with deficits in Greece, Portugal, and Spain will slow economic recovery.

 

2. Sovereign Debt and Economic Recovery
Fears are rising on both sides of the Atlantic about the massive debts governments are ringing up in efforts to forestall another great depression. The most immediate fears are in Europe where Greece, Spain, and Portugal are perceived as edging closer to defaulting on their debt. With 16 European states tied together in an economic and monetary union, no one is sure of the outcome should one or more members default on their debt. The markets seem to be saying that it can’t be good for near-term economic recovery as the stronger European states may be obliged to bail out the weaker members of the monetary union.

The massive and increasing US deficit is also causing concern. Worries about collapsing financial institutions leading to a great depression seem to be morphing into concerns about a more general US financial meltdown. Some believe that when the US government debt to GDP ratio hits 90 percent (it is now 84 percent), we will have reached a tipping point from which there is no recovery. The US federal debt limit, which was just raised to $14.3 trillion (vs. $7.8 trillion in 2005), is projected to grow steadily for the next decade.

There are no signs of any substantial economic recovery. Unemployment continues to grow and US Treasury receipts in 2010 are running 5 percent below those of 2009. State and local revenues continue to fall. In addition to the federal debt, many other indicators suggest imminent trouble including the trade deficit, falling foreign purchases of US debt, health care, undefended pensions, foreclosures and real estate values – the list goes on and on.

No one really knows what a financial meltdown may look like. It could involve hyper-inflation, the fall of the US dollar as a world reserve currency, a major drop of global GDP, and again the list goes on. Even the timing of such an event – months or years away – is up in the air.

It is logical to assume that oil demand will drop, and that even the growing Asian economies will be sucked in. In such an environment, nominal oil prices could go anywhere from way down to way up.

 

3. Violence in Iraq
A few weeks ago there was much optimism that Iraq’s new oil production agreements would add another 8 or 9 million b/d to the world’s production within the next five years. Many of the world’s major oil companies are committed to investing billions in Iraq’s long neglected, but easy to find and exploit, oil fields. Baghdad is supposed to become the new Saudi Arabia of the Middle East. Most of the foreign oil companies now involved in Iraq are state-owned so are less interested in making large profits than in gaining access to Iraqi oil.

The problem with these new agreements is the Kurd-Sunni-Shiite disputes which have been going on for centuries, not to mention opposition to the plan in parliament. In recent weeks, as the US has been turning over increasing security responsibility to the Iraqis, the frequency of suicide bombings has been increasing. Although some of this violence is related to the forthcoming elections, animosities run deep. There is no reason to think that the violence will not continue after the US withdrawal which is starting this year.

The Iraqi elections, which will take place on March 7th, could be a major turning point in the history of post-invasion Iraq. In the meantime US contractors are warning that we should not expect a big increase in Iraqi oil production in the immediate future.

 

Quote of the Week
• "Motor vehicle gasoline demand is down, is headed down and is going to continue to head down.”
-- Rex Tillerson, CEO of ExxonMobil

 

The Briefs (clips from recent Peak Oil News dailies are indicated by date and item #)
• OPEC has told the BBC that compliance with production targets fell to 50-56% last month compared with 80% a year ago. OPEC’s Secretary General also said that their producers need a price where they can invest in new capacity, new supply and also cater for the wealth of their people; anything below $70 will not permit them to invest. (2/3, #5)

• Saudi Aramco plans to invest around $120 billion over the next 5-6 years in developing projects in the oil and petrochemicals sectors. Half will be spent in the oil sector.(2/1, #5)

• José Sergio Gabrielli, the CEO of Petrobras, gave a presentation in December 2009 in which he shows world oil capacity, including biofuels, peaking in 2010 due to oil capacity additions from new projects being unable to offset world oil decline rates. His statements now align with those of other oil company executives including Sadad al-Husseini, former Saudi Aramco executive, who states that world oil production is on a peak plateau, and Total's CEO, Christophe de Margerie, who doesn't see global oil production ever exceeding 89 million barrels per day. (2/5, #17)

• BP CEO Tony Hayward said on Thursday that world oil demand will peak between 95 and 110 million barrels a day, sometime after 2020. (2/5, #5)

• According to Western oil companies' engineers, the Nigerian oil fields that produce 80% of production require $15 billion in new wells, pipelines, and maintenance. So the Nigerian National Petroleum Company, which owns 55% of those fields, needs to come up with its share – $8.5 billion – to keep the field producing optimally. But the Nigerian government only gave the company $4.5 billion to spend on those projects. (2/6, #9)

• Nigeria’s oil minister Rilwanu Lukman said the $5 billion proposed in the 2010 budget for the joint ventures' so-called "cash calls" was not enough to fund proposed projects, adding there was a need to explore alternative sources of financing. (2/4, #5)

• China’s CNOOC has agreed to buy a stake in the Ugandan oil assets of Tullow Oil for $2.5 billion, people with direct knowledge of the deal said Friday. (2/6, #11) Tullow, which operates in 15 African countries, plans to produce at least 5,000 barrels a day in Uganda in 2012, with output rising to 150,000 barrels a day within five years. (2/5, #10)

• One more measure of China’s growing global clout – so much Saudi oil is flowing China’s way that it may soon replace the US as the leading market for the world’s largest oil exporter. (2/4, #4) China may set a new record for crude oil imports this year as a recovering economy spurs fuel demand growth. (2/4, #11)

• Cnooc, China’s largest offshore producer, plans to start operating nine new projects off the coast this year to support production growth in 2010, the oil and gas producer said. Cnooc said it is targeting a reserve replacement ratio of more than 100 percent this year. (2/2, #12)

• The Falkland Islands said it would oppose any Argentine company exploring for oil and gas in its waters, amid a diplomatic row between the U.K. and the South American nation over drilling in the disputed territory. Argentina summoned U.K. embassy officials on Feb. 2 to protest the imminent start of drilling near the islands by London-based Falkland Oil & Gas Ltd. A partnership led by the Argentine unit of Spain’s Repsol YPF SA plans to start exploratory drilling in the Argentine- controlled waters of the Falkland basin in the second half of 2010. (2/6, #12)

• Argentina's oil and gas production fell last year 4.3 percent and 3.7 percent, respectively compared with the previous year, marking the third consecutive decline since 2006. (2/6, #13) [Editor’s note: Argentina hit peak oil in 1998 at about 900,000 b/d; production declined between 17% and 27% since then, adjusting EIA and BP data, respectively, with the latest report.]

• According to a recent energy security study by UK energy regulator Ofgem, without decisive action there could soon be times when sufficient natural gas to heat homes and run power plants is not just expensive but unavailable at any price. (2/5, #16) Ofgem said there was "reasonable doubt" about whether the UK's energy market would be able to deliver steady supplies in the coming decade. The Government is at odds with its own regulator - it denies there is any risk to security of supply in the coming decade. (2/3, #13)

• Large oil companies such as Exxon Mobil snapping up shale-gas acreage overseas will likely find it hard to develop that land due to constraints such as infrastructure availability, the CEO of Chesapeake Energy Corp said on Thursday. (2/5, #13)

• Iran’s nuclear plans—different takes: Iran might be close to a deal to have uranium enriched abroad, the country’s foreign minister said Friday. (2.6, #7, #8) On Saturday, U.S. Defense Secretary Robert Gates said he doesn’t regard Iran as close to an accord with international powers on the handling of uranium. (2/6, #6)

• China told other world powers on Thursday that discussing sanctions against Iran was counterproductive, striking a blow to a Western push to rein in Tehran's nuclear program. As China's UN Ambassador Zhang Yesui put it: "It is not time to impose sanctions since diplomatic efforts are still under way." (2/4, #2, #3)

• The Australian firm Resourcehouse has signed a $60 billion deal to supply coal to Chinese power stations. The firm will build a new mining complex to ship 30m tons of coal a year to China for 20 years—likely Australia’s largest export contract ever.(2/6, #14)

• As of November 2009, the U.S. was importing 0.9 million b/d from Venezuela, making it our #3 source. Its exports to the US. peaked at 1.8 million b/d in 1997, the same year as its production peaked. Venezuela’s net exports (production minus consumption) have fallen 38% from the 1997 peak of 3.1 million b/d to 1.9 million b/d in 2008. (2/6, #19)

• Indian state oil refiners including Indian Oil Corp. gained in Mumbai trading after a government- appointed panel recommended that prices of gasoline and diesel be freed from price controls, easing their losses from selling fuels below cost. (2/4, #14) The business community has strongly criticized the government’s decision to increase petroleum prices by 9%, saying the price hikes would wreak economic havoc. (2/3, #9)

• Pirates preying on commercial ships off the coast of Somalia are shifting attacks from the tightly patrolled Gulf of Aden to the Indian Ocean, the head of the EU’s anti-piracy force said. Somali pirates seized ships for ransoms estimated at $60 million to $80 million last year. (2/3, #10)

• A surge in domestic US natural-gas supplies is stalling ambitious plans for a raft of liquefied natural-gas import terminals along the country's coastlines. At present, the US has nine LNG receiving terminals, including one in Puerto Rico. (2/3, #11)

• Russia's National Oil Consortium and Venezuela's state-owned oil company PDVSA have signed an agreement to set up a $10 billion joint venture to develop the Junin-6 oil block. The Junin-6 oil block is located in Venezuela's Orinoco River region. Oil output at the block is expected to amount to 450,000 barrels of heavy oil a day. (2/2, #8)

• Climate warming in the Arctic will cost the global economy between $61 billion and $370 billion in 2010 alone, according to a study by the Pew Environment Group. (2-6, #3)

• Senator Richard Lugar: “Food security is closely tied to energy costs that will continue to be highly unpredictable. As we know, farming is an energy intensive business. Crops have to be transported efficiently to market, and petroleum based fertilizers and pesticides are used in many agriculture systems. Future energy price spikes are likely to hit with even greater ferocity than the spike we experienced in 2007 and 2008. Moreover, if peak oil theories are correct, at some point in the next few decades we may see sharp declines in supply that will raise fossil fuel costs to unprecedented levels.” (2/6, #5)

• President Obama's budget seeks to repeal valuable tax incentives and research funding for domestic oil and gas production, a change that would affect thousands of small and large producers and some universities in Texas. The proposed U.S. budget would cut funding for fossil energy programs by 20 percent in 2011. (2/2, #16)

• The Obama administration slashed the nation’s 2010 cellulosic ethanol mandate by 94 percent—from 100 million gallons to 6.5 million gallons. (2/4, #16)

• Ahmad Abdallah, analyst at GaveKal Research, calculates that transportation efficiencies could knock five million barrels a day, or 15%, off combined oil demand in the U.S. and Europe by 2020. (2/3, #4)

 

Commentary: The Market Potential of CNG as a Transportation Fuel
By Steven R. Kopits

(Note: Commentaries do not necessarily represent ASPO-USA’s positions; they are personal statements and observations by informed commentators.)

In the search for alternative fuels and technologies to oil-based engines, basic cost-benefit analysis is often over-looked, and yet the dissemination of a new technology works is most successful when the market actually wants it. In making an initial assessment of the potential of a new technology, venture capitalists often apply a set of relatively simple tests to determine whether the business potential is there at all. These tools may be applied in the case of any sort of new fuel and vehicle; perhaps no fuel has no greater potential than compressed natural gas (CNG), an alternative heavily promoted by the likes of T. Boone Pickens and Aubrey McClendon, CEO of shale gas powerhouse Chesapeake Energy. How does CNG stack up?

The first test applied is that of cost or benefit differential, also known as comparative advantage. In general, venture capitalists look for a new product to be at least 25% less expensive or better than the incumbent product. There is nothing special about the 25% threshold, but a number around this range is commonly used in the industry. In our case, the appeal of the consumer is made on the basis of cost. A consumer should buy a CNG vehicle because it’s cheaper than gasoline. Does this assertion hold up?

We looked at retail regular gasoline and CNG prices in three states: California, Texas and New York. In each of these states, CNG at the pump cost $0.80 - $1.10 less than unleaded gasoline on a gallon of gasoline equivalent (GGE) basis. In each case, CNG was 28-43% less expensive, comfortably passing the 25% threshold test.

But would anyone care? Do consumers actually want a lower-priced fuel? Lower price does not always equal market demand. Indeed, early stage technology companies often mistake a cost advantage for a value proposition. They are not the same. To induce switching to a new product, the difference not only has to be of sufficient size for people to take notice, it also has to be material to the customer in terms that matter, that is, compared to their incomes or budgets. Sometimes it doesn’t. Take, for example, retail financial products like checking accounts or credit cards. Although a competitor may introduce a product with lower fees or better benefits, most people will not switch—not because the offer isn’t better, but because switching is a hassle and the savings aren’t that important in the greater scheme of things.

In general, we use a 1% threshold for this test. That is, if new the product/service saves 1% of a person’s ongoing income or budget, then they will tend to switch to the new product/service. We can apply this test to CNG.

If we assume the average vehicle uses 500 gallons of fuel per year, then the savings from switching to CNG would range from $400 to $500 per year per vehicle for the states we examined. If we look at the value of such savings, we can see that, for our sample states about 40% of households should be interested.

Importantly, these are the lower 40% of households by income. The market opportunity for alternative fuels is therefore primarily at the bottom of the market, not at the top. Peak oil, therefore, is not a primarily an affliction of the rich, or more precisely, the above-average. It hits lower income households disproportionately hard. They will be the market segment looking for an alternative, because the savings that CNG offers are meaningful to them.

This should not come as a surprise. And yet, many of the alternative-fuels solutions proposed are really targeted at wealthy individuals. Consider the battery-powered Chevrolet Volt. Its list price has been reported in the $40,000 - $43,000 range. Thus, it competes head-to-head with, say, the BMW 328i. Is the consumer going to consider the Chevy Volt superior to a BMW? And if it is, will it surpass the US sales of the BMW 3-series, pegged at around 200,000 units per year? Probably not. Thus, the value proposition for a high-priced battery-powered vehicle will be quite different from that of a CNG vehicle. The market for CNG vehicles is predicated on price, and estimated on the basis above, represents an addressable market of up to 5 million new passenger vehicles per year in the United States. The Chevy Volt can hope to take a slice of a market of less than 1 million units, and within that, must struggle for product superiority, rather than competing on cost. Taken as a whole therefore, the market potential for a battery-powered vehicle, based on the economics of the Chevy Volt, is perhaps one-tenth that of a CNG vehicle. This explains why several studies, including those by sBoston Consulting Group and Nissan, conclude that sales of battery-powered vehicles will only range from 6-10% of the total market in 2020. Of course, should the economics of battery-powered vehicles change, its market potential will change in tandem. But for now, CNG vehicles have a potential to alter consumer behavior in a way electric cars do not.

Thus the second test, which tests for ‘market opportunity’, tells us that there is a significant market opportunity for CNG vehicles that is an order of magnitude greater than that of battery-powered cars.

For completeness, let’s address the last two tests: profit potential and barriers to entry. ‘Profit potential’ refers to the ability of a company with a new product to be able to make a profit. For example, newspapers nowadays can have many readers but are finding it hard to turn a profit. For this test, the numerical thresholds are those standards used in the respective industry and can be measured as gross or net profit margins, internal rates of return or net present value.

California               Gasoline             CNG

Retail Price             $ 3.01               $ 2.00

Fuel Taxes                 0.53                   0.53

Wholesale  Price       2.30                  0.80

Gross Margin             0.18                  0.67

Operating Costs        0.13                      ?

Net Margin                 0.05                      ?

In the table above, we look at the gross margin for CNG in California. Although CNG retails for about $1 less than gasoline, it costs even less on a wholesale basis, about $0.80 / GGE. As a result, it would appear to provide a gross margin four times that of gasoline. We have not looked at operating costs yet, but an initial analysis would suggest that CNG could be a quite profitable business for filling stations, provided they could sell the fuel in large quantity. More work needs to be done in this area, as well as in the area of vehicle manufacturer’s cost, and we are conducting a workshop to examine the matter in greater detail in conjunction with the Center for Energy, Marine Transportation and Public Policy (the Energy Center) at Columbia University in New York. Notwithstanding, our initial analysis suggests that CNG has the potential to be a profitable product—indeed, in the era of peak oil, the profitable product—for filling stations in the next 10-15 years.

Finally, the issue of barriers to entry: Whenever a company introduces a new product, it has to defend the uniqueness of the product to maintain its profitability. In the case of vehicle fuels, the barriers to entry are high. If the average consumer could choose between CNG and gasoline today, they would, in most cases, choose CNG because it is much less expensive. However, they can’t, because the fleet on the road today cannot use CNG without modification and, even if it could, there are few places to buy compressed natural gas. The barriers to entry are high indeed, and today they work against CNG, rather than in its favor. This is again an issue—in reality, a series of issues—which requires further examination and comprises some of our efforts with Columbia University’s Energy Center.

CNG and battery-powered vehicles are often presented as competing alternatives for the future of transportation, and in some sense, that’s true. However, based on today’s economics, they have far different potentials and address quite different market needs and niches. For those who believe in peak oil, at least in the sense of a limit on the volume of affordable oil, CNG represents potential as a critical alternative fuel which can permit the global economy to grow again.

On the other hand, CNG is unlikely to reduce carbon dioxide emissions. Peak oil theory dictates that all the oil that can be produced at reasonable prices, will be. By extension, oil demand is therefore assumed to be greater than supply over time, with oil a shortage commodity characterized by rising prices. Struggling with an inadequate supply of fuel, the market will be hungry for an additional source of energy, and natural gas may fit the bill. As a result, natural gas will tend to augment, rather than displace, oil-based fuels. Consequently, under most scenarios (but not all), natural gas as a transportation fuel will tend to increase CO2 emissions, even if natural gas is clearer burning than oil. Battery-powered vehicles, by contrast, have greater potential to be green.

CNG and electric vehicles, therefore, should be understood to target different market segments and solve different social problems. Both are potentially important alternatives for society in the coming years.

Mr. Kopits manages the New York office of Douglas-Westwood, energy business consultants. Douglas-Westwood assists energy companies with market research, strategy development and transactions support.