There is a clear glut in oil supply at present. This has led many, including former Saudi oil minister Ali al-Naimi, to declare the death of peak oil. Previously, concerns had been raised about the ability of future supply to meet demand at a price acceptable to current standards of living. Now, it is more common to see discussion of “peak oil demand” – the idea that electrification and automation of transport, coupled with more stringent regulations in response to climate change, will eventually see the collapse of oil demand.
Properly understood, peak supply, as we will call it for clarity, was never about oil ‘running out’, nor about a catastrophic and instantaneous collapse of fossil fuel-based civilisation despite the many bestsellers written about such a scenario. More modestly, it was the idea that the most easily accessed (and therefore cheapest) oil resources have been exploited, and as a result average prices will be higher from now on. Despite the derision with which the theory is greeted by some very eminent scholars, particularly in a price crash caused by a glut, there remains some truth to this concern. Fundamentally, humanity would not be developing oil sands, shale, or ultra-deep water prospects if demand could be met from sources that are easier to access and cheaper to produce.
Nevertheless, the impressive quantities of oil added to global production from unconventional sources – mostly underestimated by peak supply adherents – are often used to suggest markets work adequately to mitigate its effects. Faced with higher prices, operators go out, find more oil and develop better techniques for producing it, leading to the lower prices and monster inventories we see today. A similar argument is made for peak demand. Faced with climate change, human ingenuity develops alternatives.
And yet, three years ago today, Brent was at $105.77/bbl. From October 2009 to November 2014, Brent was continually above $70/bbl. What is more, even as companies face more financial woes as the glut forces prices to the $40s, real prices are higher than in most of history outside of embargoes or financial crises. The dismissal of unconventionals by those convinced by peak supply was mainly on the grounds of what could be profitably produced. On this point, they were broadly correct with regards to shale. Many LTO producers failed to generate free cash flow when prices were higher, and are now facing issues, even after cost savings, as prices fall again.
Both sides missed the role debt was to play in the LTO sector in the post-financial crisis low interest rate climate. Elsewhere we have written about some of the perverse incentives involved. The effect on supply is that the low hurdle rate and short time to payback, combined with perverse incentives to grow beyond what the price can support, mean shale gets produced at the expense of longer term, more secure sources of supply like deepwater. Demand dictates some LTO should be produced, but the reason we have a glut right now is because it was overproduced to meet financial demands, not physical demands.
If oil demand is to peak, it will logically be because oil is expensive relative to its alternatives. The current case for peak demand argues that regulation of carbon emissions and the falling costs of both renewable technologies and electrified vehicles will lower the cost of oil’s competitors – a “greening by choice”. Because supply and demand are inextricably linked, peak supply would follow peak demand – lower oil prices due to less demand would shut-in production and lead to fewer projects. Equally, the reverse is true – if the supply of “reasonably priced” oil has peaked, higher prices mean we should expect alternatives to look more attractive by comparison.
The first is akin to the development of oil production itself: the discovery and harnessing of a better resource. The second means having to substitute a worse resource. Which scenario reality most closely resembles will make a big difference.