1 Energy Policy 34 (2006) Oil scarcity: What have the past three decades revealed? G.C. Watkins University of Aberdeen and Cerecon Limited, Canada Abstract Oil shortages have been predicted over the past 30 years. In fact, oil is more plentiful now in an economic sense than in The reason for such misconceptions lies mainly in reliance on analytical techniques that do not comprehend oil as an economic commodity. r 2005 Published by Elsevier Ltd. Keywords: Oil prices; Reserves; Hubbert curve 1. Introduction In 1973, proven oil reserves remaining in the world were 635 billion barrels, production was 59 million barrels per day (mmb/d), of which 31 mmb/d or 53% was supplied by OPEC countries; the ratio of oil reserves to annual production (R/P ratio) was 31 years. Thirty years later (2003), remaining reserves had increased by some 80%, production had risen by about 30%, OPEC output was at much the same level as in 1973, its share of the world total had dropped to around 40%, and the world R/P ratio was some 40 years. Reserve additions over the 30-year interval more than replaced total production, a total which in turn exceeded the 1973 reserve base. Yet, the dominant opinion in the mid-1970s and beyond was one of looming oil shortages that would lead to very heavy reliance on OPEC. US President Jimmy Carter proclaimed in 1977 that We could use up all the proven reserves in the entire world by the end of the next decadey. 1 Admittedly, this was an egregious example, but there have been many other studies intent on spreading Severe Anaemic Reserves Syndrome (SARS) a species of belief that has proved remarkably resistant to evidence. 2 1 As quoted in Francisco Parra (2004, p. 254). 2 See various studies cited in Parra (2004, pp ); in 1979, Resources for the Future (RFF) said While the petroleum and natural gas era is not over, the contribution of these fossil fuels to world energy requirements will probably pass its peak within the lifetime of most persons now living (Resources for the Future (1979, p. 426). For a recent apocalyptic opinion (2002), see Deffeyes ysomewhere between two and My paper starts by remarking on oil as an economic commodity, before examining two types of evidence on oil scarcity. The first is an elaboration of the background data on the world oil supply cited above. The second is information on reserve prices what willing purchasers and sellers paid for reserves in the ground over the past 20 years or so. I then look at the analytical foundation underlying much of the SARS view of the oil world. Next, I suggest a more suitable analytical framework, and mention the results of one attempt to estimate oil supply functions. Concluding remarks follow. 2. Oil: an economic commodity Oil entered the economic system because it was cheaper than alternatives or served new forms of energy demand. Oil will leave the economic system when it becomes more expensive than alternative sources or when the end uses it satisfies disappear. The oil industry is not a freak. Like other mineral extractive activities, supply is added by new investment, offsetting depletion. But the results of that investment (reserve additions) are uncertain, varying from abundant to meagre unlike, say, adding capacity by building a manufacturing plant. One never knows what will be found, if anything. When exploration is successful and a field is discovered, its recoverable reserves will not be disclosed (footnote continued) six years from now, worldwide production will peak. After that chronic shortages will be a way of life quoted in Ryan (2003, p. 9) /$ - see front matter r 2005 Published by Elsevier Ltd. doi: /j.enpol
2 G.C. Watkins / Energy Policy 34 (2006) Table 1 Salient oil reserves and production data World reserves (billion barrels) Total OPEC 401 (63%) 475 (66%) 775 (76%) 882 (77%) ME OPEC 317 (51%) 392 (59%) 650 (64%) 718 (63%) Other OPEC 84 (13%) 83 (12%) 123 (12%) 164 (14%) Non-OPEC 234 (37%) 248 (34%) 249 (24%) 266 (23%) World output (mmb/d) Total OPEC 31 (53%) 18 (32%) 27 (41%) 30 (39%) ME OPEC 21 (36%) 11 (20%) 18 (27%) 21 (27%) Other OPEC 10 (17%) 7 (12%) 9 (14%) 9 (12%) Non-OPEC 28 (47%) 39 (68%) 39 (59%) 47 (61%) World R/P ratio (years) Total OPEC ME OPEC Other OPEC Non-OPEC World price (nominal $US/b) $3.29 $28.77 $16.97 $28.83 ($US2003/b) $13.68 $53.30 $21.74 $28.83 Sources: BP Statistical Review, Note: 1973, 1983 prices are Arabian Light posted at Ras Tanura; 1993, 2003 prices are Brent dated. until abandonment, when reserves will have equalled production. Another peculiarity of the oil industry is that its inventory level represented by its reserves instead of lasting for a few weeks or months must be large enough to last for several years. Other things equal, investment per unit of reserves would be expected to increase as exploration proceeds from more attractive to poorer prospects, although any strict sequential upward ratcheting over time seldom holds (low cost deposits are not necessarily found first). Correspondingly, prices would progressively increase over time until demand would be choked off. Yet, unit costs albeit more difficult to track down of late with inferior information generally have been in denial of any such secular trend. Other things have not been equal: the data reviewed below suggest that overall new knowledge has offset expected declining yields as exploration in areas under cultivation became more intense, and new horizons have continued to emerge. This picture is consistent with a stand-off for what Adelman has called the endless tug-of-war between diminishing returns and increasing knowledge (Adelman (1990, p. 3)). 3. Evidence from salient supply data Table 1 shows key data on oil supply for 10-year intervals, starting in It might have been equally entitled Confounding Cassandra. Proven reserves of crude oil remaining in the world rose by some 500 billion barrels, 2003 over 1973, notwithstanding total production of about 730 billion barrels over this period: some shortage. 3 Reserve additions have more than offset depletion. Reserves in the Middle East remain predominant. Reserves in non-opec countries, even though the rate at which they were being produced greatly exceeded that in the Middle East, nevertheless increased by some 30 billion barrels by 2003, compared to The noticeable jump in world reserves between 1983 and 1993 was less a result of new investment adding supply, and more a reassessment of reserves by OPEC countries, especially those in the Middle East, not the least encouraged by competition among them for OPEC quotas. In 1973, OPEC production accounted for 53% of the world total, but expectations that its share would expand further have been squashed: in 2003, OPEC production was slightly smaller absolutely than in 1973 and its market share has been dramatically cut to around 40%. Production by Middle East OPEC members was the same in 2003 as in In 2003, the majority of the oil market was 3 Reserves are proved reserves, ythose quantities that geological and engineering information indicates with reasonable certainty can be recovered in the future from reservoirs under existing economic and operating conditions (BP Statistical Review, 2004, p. 4). Oil here includes crude oil, oil sands and natural gas liquids (NGLs). However, Canadian oil sands reserves are confined to those serving projects under active development; these reserves thus exclude the great bulk of the 175 billion barrels of remaining bitumen reserves which Alberta regards as established. The quality of much of the reserve data outside of North America (excluding Mexico) and the North Sea is not good and has tended to deteriorate further after the mid-1980s. Note, there may be some inconsistency between reserve definitions in 1973 and those for other years.
3 510 ARTICLE IN PRESS G.C. Watkins / Energy Policy 34 (2006) supplied by non-opec countries, at about 60% of world production, in contrast to 47% in Proven reserves are equivalent to warehouse inventory. A prudent profit sensitive producer operating in a competitive market would operate with an R/P ratio of years. 4 The non-opec countries aggregate R/P ratio now approaches this level, declining from 23 years in In short, non-opec is producing at a mature R/P ratio, one where production is not subject to restraint from either policy measures or insufficient installed capacity. By way of contrast, OPEC s R/P ratio of currently about 80 years illustrates the degree of excess commercial reserves held by these countries; and while the accuracy of OPEC s reserve estimates is questionable, it would take a very major error to alter this picture of a substantial reserve surplus. If OPEC s installed capacity matched a lower R/P ratio, oil would flood the market, prices would plummet and the more expensive non-opec production would be stranded. Hence OPEC s policy of production restraint to keep prices in a target range well above marginal costs of Middle East sources does not displease governments of those non- OPEC countries, e.g., the United States, with sizeable, high-cost domestic production. Prices in 2003 were close to nine times higher than those in 1973 in money-of-day terms, in real terms they were about double; in 1983, the corresponding numbers in relation to 1973 were over seven times and over three times. Note that 1973 prices in turn approached double those prevailing in the Middle East in Extending the perspective to 1970 would make the price increases more pronounced. 5 In large measure, the strong performance of non-opec production over the past 30 years was a classic response to opportunities created by the umbrella of higher prices sustained by OPEC, although the umbrella leaked when OPEC quota discipline was especially lax or when the burden of output adjustment devolved mainly on one OPEC country (Saudi Arabia). To recapitulate, the physical quantity of proven reserves is a measure of scarcity, though not a particularly good one, since proven reserves are in the nature of working inventory and do not represent eventual supply. Yet, the world inventory of reserves has markedly increased over three decades even though production has risen strongly. This runs counter to the opinion anticipating emerging shortages. 4 An analogy with reserve deliverability requirements for natural gas is useful here. In the 1980s, typical long-term contracts in North America called for a rate of 1 mmcf/d/7.3 bcf of reserves, implying an R/P ratio of 20 years. With the elimination of spare capacity in the 1990s, current contracts of which few are long term call more for corporate warranties than specific deliverability standards, and the implicit R/P ratio is about 10 years, matching the aggregate North American natural gas industry ratio. 5 The posted price of Arabian light ex Ras Tanura in 1970 was $1.80/b (BP Statistical Review, 2004, p. 4). 4. Evidence from reserve prices Price and costs trends are economic indicators of scarcity. Ostensibly, prices of flowing oil (wellhead prices) cover user cost the impact on future net profits of current production and extraction cost, but they can be misleading. For example, price levels in the first quarter of 2004 have been heavily influenced by OPEC s restraints on output to keep the oil price in a desired range hardly a yardstick for measuring scarcity. 6 Indeed, the need for this kind of action indicates excess rather than tight supply. A better scarcity measure is provided by trends in the inground value of reserves; these cast a longer shadow than wellhead prices. Moreover, if there was a competitive market in reserves, the reserve price less development investment incurred represents the market value of an undeveloped reserve. In turn, this equals user cost, the value of the undeveloped asset in the ground relinquished by its sale (Adelman (1991)). Over the past decade or so, Morris Adelman and I have had a go at putting together a price series for reserves in the ground using North American data. Initially, we relied on a fairly small sample of proven reserve sale and purchase data (see Adelman and Watkins (1995)). Later, we have had access to a more extensive database of US reserve transactions (e.g., Adelman and Watkins (1997)). We pursued this research for three main purposes: to provide information about national income and wealth, which includes oil and gas reserves; because in-ground values (compared with replacement costs) are crucial in assessing industry trends; and reserve values have important implications for the basic theory of mineral resources, including testing propositions such as the Hotelling Valuation Principle. Our most recent exhibit is Adelman and Watkins (2003), where inter alia, we estimated a US oil and natural gas reserve price series from 1982 to We have now extended the series to include 2003 (Adelman and Watkins (2005)). Actual transaction data reflect appraisals by teams of engineers, geologists, bankers, economists and investors. The forecasts of prices, production and costs embedded in their calculations may be refuted, but values at which reserves actually change hands merit serious attention. Money is being put on the line. At first glance, evidence based on US transactions might seem parochial. However, deregulation of US oil prices in 1981 effectively plugged the US market into the world market; non-us corporations search for and develop oil in the US, and US corporations have long gone abroad. Hence, information on the competitive US market implicitly provides a window on reserve prices in all regions open to new investment in oil resources. This includes most non-opec countries, and a few OPEC countries. 6 On the problems of using the current price as scarcity measure, also see discussion in Krautkraemer (1998, p. 2089).
4 G.C. Watkins / Energy Policy 34 (2006) Table 2 Estimates of in-ground crude oil price, United States, (nominal and real terms) In-ground oil price ($US/bbl) In-ground oil price ($US/bbl) Year Nominal $ $2003 a Year Nominal $ $2003 a Source: Adelman and Watkins (2003, Table B-2a) and Adelman and Watkins (2005). a Expressed in US$2003 using US Producer Price Index. My concern here is with information these data provide on industry trends does the reserve price time series, a leading indicator of supply conditions, suggest that reserves in an economic sense are becoming scarcer, or more abundant, or show no particular inclination? Table 2 shows the results of our latest analysis, including 2003; the reserve prices are also plotted in Fig. 1. The figure reveals no visible secular trend in reserve prices, , sometimes falling, sometimes rising, as they have recently but to levels in 2003 only marginally higher than at the previous peak in 1985 in money-of-the-day terms; in real terms, the estimated 2003 reserve price is around 20% below the 1985 peak. 7 The reserve prices broadly reflect changing perceptions about the world oil market, not the US domestic market. Overall, the price series offers little evidence of a nascent supply shortage. 8 However, since 2000, reserve prices have moved to distinctly higher levels, as field prices used in company evaluations have increased, registering OPEC s new found ability to keep wellhead prices comfortably above $20/barrel. We also computed the 1-year return to holding an asset in the ground by comparing each year s value of a unit of reserve with the previous year s, from which we subtracted the 1-year risk-free discount, approximated by the 1 year US Treasury bill rate. The achieved return premia so calculated only exceeded an estimate of the minimum risk premium for petroleum finding and development activities in nine of 21 years, If the original reserves in 7 The inflation index used is the Producer Price Index. Prices in real terms would be higher if the US GDP or US CPI were employed. 8 Regressing reserve prices on time was not pursued it seemed superfluous. For discussion of price expectations embedded in the reserve price series in relation to the world oil market, see Adelman and Watkins (2003, p. 33). 9 The minimum risk premium adopted was the US Federal Reserve Board 10-year treasury rate. Reserve Price ($US/bl) Year the ground were fixed and depleted by consumption, the unit value of what remains in the ground would increase over time and owners would expect returns sufficient to offset year over year annual risks. In 21 trials, fluctuations can be expected: you win some, you lose some. But losing 12 times out of 21 is not consistent with perceptions of growing scarcity (see Adelman and Watkins (2003, pp ) and Adelman and Watkins (2005)). 5. Analytical foundations I discuss here two main approaches to analysing oil reserves and production. One is a life cycle technique, predicated on work by Hubbert. The second simply applies the economist s notion of supply curves to a depletable resource such as oil Hubbert approach Nominal Prices Real Prices (With US PPI) Fig. 1. Estimates of US oil reserve prices, Much of the analytical framework underpinning the view that oil is running out is based on Hubbert curves purporting to plot the life of oil resources. Their shape is a symmetrical uni-modal Bell profile that grows, peaks and then goes in to inexorable decline see Fig. 2. Hubbert s seminal article published in 1962 (Hubbert (1962)) has founded a cult still much in vogue. 10 Yet several investigations find the inferred curve as far from symmetrical, with the downward portion typically skewed outward to the right. 11 What is wrong with Hubbert s construct in the context of the life of oil as an economic commodity? In econometric terms, Hubbert s model is a classic example of omitting key variables, specifically price and technology. More broadly, in the real world, these variables drive the investment process. Various attempts have been made to graft economic variables on to the Hubbert schema e.g., see Cleveland and Kaufman (1991). A pertinent question is: why attempt to create these hybrids? To ask Hubbert curves to handle 10 Indeed a society, the Association of the Study of Peak Oil (ASPO), has been founded; apparently Hubbert style modelers are predominant. 11 For example, see comments by Ryan (2003); also see Lynch (2002).
5 512 ARTICLE IN PRESS G.C. Watkins / Energy Policy 34 (2006) Production Rate Ultimate Cumulative Production Time Fig. 2. Hubbert curve. an economic commodity such as oil is akin to asking a eunuch to sire a family. An unfortunate feature of the Hubbert approach is that it trumpets the notion of ultimate reserves. As illustrated in Fig. 2, the stock is fixed; supply simply runs out: the last barrel is produced. Exhaustion prevails. The dictionary defines ultimate as a final or fundamental fact. In that light, the elasticity displayed by estimates of ultimate reserve estimates is remarkable. 12 I think it is a fair generalization that in virtually all instances ultimate reserve numbers for regions investigated have increased rather than decreased over time. This is not surprising. It registers increasing knowledge. The notion of ultimate reserves channels attention to the wrong track. I ve quoted Adelman s comment about resource exhaustion more times than I care to count, but one more time won t come amiss: The total mineral in the earth is an irrelevant nonbinding constraint. If expected finding-development costs exceed the expected net revenues, investment dries up and the industry disappears. Whatever is left in the ground is unknown, probably unknowable, but surely unimportant: a geological fact of no economic interest (Adelman (1990, p. 2)). The many estimates of world oil ultimate reserves, optimistic or pessimistic, must all be dismissed because they purport to measure what their sponsors cannot possibly know: future science and technology. Although it would be safe to assume technology will improve, one cannot know with any precision how it will evolve. But one can of course estimate volumes recoverable from currently designated areas, under current conditions of knowledge. Ultimate reserves, then, are unknowable. In the context of economic analysis of oil supply, the less time spent on efforts to estimate them the better. Hotelling s analysis of finite non-renewable resource depletion generates rules governing flow equilibrium in mineral output markets and stock equilibrium in asset markets (Hotelling (1931)). It contemplated final exhaustion at a set time, with output falling to zero. The pricing 12 For example, in an earlier paper (Watkins (1992, p. 18)), I listed estimates of Alberta ultimate natural gas reserves, , showing they had continually increased. implications of this model have been applied to the industry as a whole. In my view, this distorts Hotelling s insightful work, work directed more at the firm level where the focus is on a deposit of known, fixed quantity. Be that as it may, an oft neglected aspect of Hotelling s seminal paper was the role of his demand function, which set a maximum price, reached as output approached zero. Whether exhaustion would be achieved in finite or infinite time depended on the nature of the demand curve. In general, the higher the price anticipated when the rate of production becomes small, the more protracted the period of operation (Hotelling, 1931, p. 142). Technological change was seen by Hotelling as possibly leading to introduction of substitutes. The Hotelling model, then, was not just a supply side phenomenon. Indeed, he anticipated that as production fell and price rose, demand dynamics would increasingly intrude Economic supply function approach A preferable approach to the Hubbert framework would be to focus more diligently on the economist s notion of a supply function, one readily applicable to oil reserves stacked in order of ascending cost. A supply function moves outwards in response to new discoveries and costsaving technological improvements and inwards as resource depletion proceeds see Fig. 3. Whether an aggregate crude oil supply function is shifting, and if so in what direction, is at the crux of any assessment of the oil industry outlook. Direct measurement is difficult, and the results often unreliable. Part of the reason is the poor quality and lack of data. Certainly one attempt I made (with Shane Streifel) at estimating supply functions for conventional oil was constrained by data problems (Watkins and Streifel (1998)). The data available dictated simple models of reserve additions as a function of the inferred in situ price of discovered but undeveloped reserves, and of time. The price of undeveloped reserves, estimated as the price of developed reserves less development cost, represented the window of opportunity for exploration (and indicated user cost see earlier). The time variable was a surrogate for the net impact of changes in prospectivity, resource depletion, cost efficiency and technology. 13 Functions were estimated for 41 countries, using data for the period from the mid 1950s until In broad terms, we found that outside of North America, on balance non-opec countries had a rightward shifting (expanding) supply function. North American conventional oil was probably moving in the contrary direction 13 The simple reduced form supply function was RA ¼ a þ bðv2iþþct, where RA was reserve additions in a given period, t was time, V was the value of a barrel of developed reserve in the ground, I was development investment per barrel of proved reserve, and a, b and c were estimated coefficients.
6 G.C. Watkins / Energy Policy 34 (2006) Price of Reserves/unit of time P S D S contracting: less would be found at a given price. 14 Note a leftward shift in a supply function does not mean reserves will not continue to be added. Rather, it indicates that returns from further exploration have started to diminish returns not offset sufficiently by technological or efficiency improvements, or by opportunities to exploit new plays. Supply conditions in OPEC countries could not be depicted by the interaction of conventional supply functions with price; OPEC output restraint entails a rather different model specification. Smith and Paddock (1984) estimated economic oil supply functions divided into two stages: a discovery model and a production model. The discovery process described the physical returns to exploration. The production model specified the economic costs of bringing new fields on stream and likely production rates. In both stages, the negative influence of resource depletion was modelled explicitly. The models were applied to data for 37 individual regions around the world, from a 1978 perspective. The discovery model disclosed a large potential for new fields in most areas. There have been other efforts. The pity is that they have been so few and far between. 6. Concluding remarks Three decades beyond 1973, oil reserves increased by 80% even though production has continually increased. There has been less, not more, reliance on OPEC. Indicators of resource scarcity do not provide evidence that oil has been becoming scarcer. 15 Instead, new plays, more intense development of existing plays, allied with cost saving and innovative technology, have offset resource depletion. In short, Nature as Scrooge has to date met its match in Knowledge s Lady Bountiful. S D Resource Depletion S A S Reserve Additions/unit of time Fig. 3. Oil reserve supply curves. New Prospects, Technological Improvement 14 For a list of the 41 countries, see Watkins and Streifel (1998, p. 35); for a list of the contractionary and expansionary groups, see Watkins and Streifel (1998, p. 45). 15 Krautkraemer (1998) reached a parallel conclusion in a more general mineral industry context, not just for oil. S A Can this stand-off between knowledge and depletion over the past 30 years be assumed to continue? Will supply always be plentiful? That is more than anyone could pretend to know. Some day the balance may shift. The great majority of giant conventional fields many would say all may well have been found. Perhaps, the impact on oil demand of economic development, especially in Asia (India and China), is a harbinger. This degree of uncertainty encourages agnosticism about whether technology and new knowledge will continue to keep the forces of depletion at bay. 16 At the same time, a generous backstop of non-conventional oil supplies (oil sands, heavy oils, oil shales) looms once returns become sufficiently attractive. A persistent change in the return to holding oil in the ground, with a definite upward trend emerging in reserve prices, would provide an early warning system. Indeed, the recent upward trend validates OPEC s success in meeting its price targets, and beyond those levels, as demand presses on aggregate world installed capacity. However, recent wellhead price levels of over $50/bbl register contrived not actual scarcity a shortage price without a shortage of in-ground resources. Techniques to analyse oil supply should pay less heed to Hubbert and more to the economic framework. Oil as a resource is a gift of nature. In-ground recoverable reserves are an economic commodity. They need to be treated as such. Acknowledgements I acknowledge helpful comments from Morris Adelman, Jeffrey Krautkraemer, Roland Priddle and James Smith the usual disclaimer applies. References Adelman, M.A., Mineral depletion with special reference to petroleum. Review of Economics and Statistics 72 (1), Adelman, M.A., User cost in oil production (with Harindar De Silva and Michael F. Koehn). Resources and Energy 13. Adelman, M.A., Watkins, G.C., Reserve asset values and the Hotelling Valuation Principle: further evidence. Southern Economic Journal 61 (3). Adelman, M.A., Watkins, G.C., The value of United States oil and gas reserves: estimation and application. In: Moroney, M.J. (Ed.), Advances in the Economics of Energy and Resources, Energy Supply and Demand, vol. 10. JAI Press Inc. Adelman, M.A., Watkins, G.C., Oil and natural gas reserve prices : implications for depletion and investment cost. Working Paper , MIT Center for Energy and Environmental Policy, October. Adelman, M.A., Watkins, G.C., Addendum to CEEPR WP with results for MIT Center for Energy and Environmental Policy Research, forthcoming. Cleveland, C.J., Kaufman, R.K., Forecasting ultimate oil recovery and its rate of production: incorporating economic forces into the models of M. King Hubbert. Energy Journal 12 (2), Tilton (2003) takes a similar position.
7 514 ARTICLE IN PRESS G.C. Watkins / Energy Policy 34 (2006) Hotelling, H., The economics of exhaustible resources. Journal of Political Economy 39, Hubbert, M.K., Energy resources. A Report to the Committee on Natural Resources, National Academy of Sciences, Government Printing Office, Publication No. 1000D. Krautkraemer, J.A., Nonrenewable resource scarcity. Journal of Economic Literature 36 (4), Lynch, M.C., Forecasting oil supply: theory and practice. Quarterly Review of Economics and Finance 42(2); In: Smith, J.L. (Ed.), Oil and the Economy: Recent Developments in Historical Perspective (Special Issue). Parra, F., Oil Politics a Modern History of Petroleum. I.B.Tauris. Resources for the Future, Sam, S., et al., Energy in America s Future: The Choice Before Us. Washington, DC, USA. Ryan, J., Hubbert s peak: déjà vu all over again. IAEE Newsletter, 2nd Quarter. Smith, J.L., Paddock, J.L., Regional modelling of oil discovery and production. Energy Economics. Tilton, J., On Borrowed Time? Assessing the Threat of Mineral Depletion. Resources for the Future, Washington. Watkins, G.C., The Hotelling Principle: Autobahn or Cul de Sac? Energy Journal 13 (1). Watkins, G.C., Streifel, S., World crude oil supply: evidence from estimating supply functions by country. Journal of Energy Finance and Development 3 (1).