Dangerous Times Ahead as Energy Sources Get Costlier to Extract
Remember the term "peak oil"? With all the oil now available from oil shale, tar sands, and other new sources, many analysts assume that the old talk of peak oil has been proven dead wrong. They buttress this conclusion with statistics showing decreased per capita oil usage, a signal, they say, of our entry into a golden era of rising supply and falling demand that will cut energy prices and fuel economic growth.
The optimists believe that our energy problems have been largely solved. I wouldn't bet on that. The real issue with oil isn't how much we have or even whether we can continue to increase production. That's what peak oil had come to represent and why, in retrospect, it was a misleading term.
Rather, what really matters is the cost of resources, in terms of resources required, including energy resources, to keep producing oil. On that front, the U.S. is losing ground at an alarming pace.
Simply put, it takes energy to get energy. In today's world, it takes rising amounts of energy to get all the new energy sources out of the ground and ready to use.
The critical concept is "energy return on investment," or EROI. This means the amount of energy obtained from each unit of energy invested. When oil first began to flow, its EROI was around 100, according to State University of New York professor Charles Hall. Drillers would use one barrel to extract 100 barrels from the ground. As more wells were drilled and producers added infrastructure, the EROI ratio dropped. New wells over time grew less productive, further decreasing EROI. In the early 1950s the EROI associated with refined oil products like gasoline was about 20. Today, it takes about one barrel of conventional U.S. oil to produce the equivalent of nine barrels, or 378 gallons of gasoline.
Meanwhile, the EROI for nonconventional oil, that is, oil produced from shale and tar sands, stands even lower, at about four. For every barrel of oil used to drill, producers obtain only four barrels of nonconventional oil, or 168 gallons of gasoline.
The lower the EROI, the less energy can be made available for the economy. If EROI were one, the economy would be channeling all energy produced into making energy. In other words, it would be curtains for our civilization. SUNY professor Hall estimates that for an industrial society to function and grow, EROI should measure at least five to nine. Oil from tar sands and shale does not make that cut.
It's telling that, based on 12-month averages, oil prices today are only some 5% below their all-time peaks, although, according to the Energy Information Agency, per capita consumption of oil has decreased 17% from its 2007 high. Why don't we see a larger price decline? Economics 101 would suggest that greater supply coupled with lower demand should produce tumbling prices. That isn't happening, since we funnel much of the extra oil made available by lower demand and rising production into oil production itself.
What explains the significantly lower EROI of non-conventional energy sources? To understand, we must realize that all resources are inextricably interconnected, and also require energy to produce. We can't overlook the reality that drilling apparatus and infrastructure needed to extract oil from shale also demand large quantities of steel, derived from iron ore, whose production and refinery in turn require energy.
Huge energy costs are also inherent in the transport of water, chemicals and other materials essential to fracking. Tar sands likewise require mining equipment whose manufacture and transport consume still more energy. Mining tar sands, moreover, also uses natural gas.
These added costs appear on the balance sheets of banks, where oil and gas lending is the fastest-growing category. Indeed, according to Schlumberger SLB +1.2%, the industry's capital expenditures for oil and gas have grown by about 12% annually over the last decade. Oil and gas production grew less than 2% a year in the same period. Clearly the more money and resources needed to maintain adequate production of oil and gas, the less money and resources available for other endeavors.
One vicious cycle playing out in America starts with the consumer, who has had to cut back on energy use. Less energy translates into less mobility, less shopping, and in general fewer consumer expenditures. Fewer consumer expenditures mean less demand and more pressure on corporations, which are also squeezed by higher resource costs. Wages in turn get squeezed, but resource prices remain high, and the vicious circle is completed. It is no surprise that this century has seen a 10% decline in real median income, which when measured in time and depth is probably the most protracted on record.
Things may be even worse than that, however. EROI refers to how much energy is needed to produce more energy. The concept leaves out a lot of linkages among resources. Resource-intensive production of oil and gas increases the scarcity and costs of other resources such as water and therefore of food, which depends on water as well. Other resources such as copper and iron ore that use lots of water and energy are also squeezed, and you have another vicious, potentially catastrophic, cycle. It would take me too far afield to focus on all these interrelationships, but an examination of the more general concept of resource return on investment, or RROI, would probably find the U.S. in a lot worse shape than as measured only by EROI, or the amount of energy required to get more energy.
Let's consider how to use EROI to determine the most potentially rewarding energy investments. Clearly energy sources with EROIs above five are attractive. According to an April Scientific American article, both wind and solar energy make the grade. Neither uses water to generate energy, further conserving precious resources. Unfortunately, it is hard to find clear beneficiaries of wind or solar, as companies in this space are highly competitive with one another. However, I do continue to recommend silver, a critical ingredient in photovoltaics, the most pervasive and fastest-growing form of solar energy. I view the recent slump in silver prices as an exceptional buying opportunity.
As for oil and gas producers, I see the critical metrics as free cash flow and growing production. There was a time when negative free cash flow was not so bad for oil companies. It often signified investment in growth. Today, however, given the ever-increasing amounts of oil and other resources needed to produce oil, negative free cash flow frequently suggests that a company is running in place.
Oil and gas stocks with negative free cash or slumping production, especially those involved in non-conventional hydrocarbons, will probably require ever greater spending to sustain that growth, which to me is a recipe for long-term disaster. In fracking especially, another factor contributing to the lower EROI ratio is the high depletion rate of the wells. In an earlier era, producer growth related closely to the number of wells drilled. Today, oil production from a new well often declines sharply after the first year.
http://www.forbes.com/sites/greatspeculations/2013/06/05/dangerous-times-as-energy-sources-get-costlier-to-extract/
Remember the term "peak oil"? With all the oil now available from oil shale, tar sands, and other new sources, many analysts assume that the old talk of peak oil has been proven dead wrong. They buttress this conclusion with statistics showing decreased per capita oil usage, a signal, they say, of our entry into a golden era of rising supply and falling demand that will cut energy prices and fuel economic growth.
The optimists believe that our energy problems have been largely solved. I wouldn't bet on that. The real issue with oil isn't how much we have or even whether we can continue to increase production. That's what peak oil had come to represent and why, in retrospect, it was a misleading term.
Rather, what really matters is the cost of resources, in terms of resources required, including energy resources, to keep producing oil. On that front, the U.S. is losing ground at an alarming pace.
Simply put, it takes energy to get energy. In today's world, it takes rising amounts of energy to get all the new energy sources out of the ground and ready to use.
The critical concept is "energy return on investment," or EROI. This means the amount of energy obtained from each unit of energy invested. When oil first began to flow, its EROI was around 100, according to State University of New York professor Charles Hall. Drillers would use one barrel to extract 100 barrels from the ground. As more wells were drilled and producers added infrastructure, the EROI ratio dropped. New wells over time grew less productive, further decreasing EROI. In the early 1950s the EROI associated with refined oil products like gasoline was about 20. Today, it takes about one barrel of conventional U.S. oil to produce the equivalent of nine barrels, or 378 gallons of gasoline.
Meanwhile, the EROI for nonconventional oil, that is, oil produced from shale and tar sands, stands even lower, at about four. For every barrel of oil used to drill, producers obtain only four barrels of nonconventional oil, or 168 gallons of gasoline.
The lower the EROI, the less energy can be made available for the economy. If EROI were one, the economy would be channeling all energy produced into making energy. In other words, it would be curtains for our civilization. SUNY professor Hall estimates that for an industrial society to function and grow, EROI should measure at least five to nine. Oil from tar sands and shale does not make that cut.
It's telling that, based on 12-month averages, oil prices today are only some 5% below their all-time peaks, although, according to the Energy Information Agency, per capita consumption of oil has decreased 17% from its 2007 high. Why don't we see a larger price decline? Economics 101 would suggest that greater supply coupled with lower demand should produce tumbling prices. That isn't happening, since we funnel much of the extra oil made available by lower demand and rising production into oil production itself.
What explains the significantly lower EROI of non-conventional energy sources? To understand, we must realize that all resources are inextricably interconnected, and also require energy to produce. We can't overlook the reality that drilling apparatus and infrastructure needed to extract oil from shale also demand large quantities of steel, derived from iron ore, whose production and refinery in turn require energy.
Huge energy costs are also inherent in the transport of water, chemicals and other materials essential to fracking. Tar sands likewise require mining equipment whose manufacture and transport consume still more energy. Mining tar sands, moreover, also uses natural gas.
These added costs appear on the balance sheets of banks, where oil and gas lending is the fastest-growing category. Indeed, according to Schlumberger SLB +1.2%, the industry's capital expenditures for oil and gas have grown by about 12% annually over the last decade. Oil and gas production grew less than 2% a year in the same period. Clearly the more money and resources needed to maintain adequate production of oil and gas, the less money and resources available for other endeavors.
One vicious cycle playing out in America starts with the consumer, who has had to cut back on energy use. Less energy translates into less mobility, less shopping, and in general fewer consumer expenditures. Fewer consumer expenditures mean less demand and more pressure on corporations, which are also squeezed by higher resource costs. Wages in turn get squeezed, but resource prices remain high, and the vicious circle is completed. It is no surprise that this century has seen a 10% decline in real median income, which when measured in time and depth is probably the most protracted on record.
Things may be even worse than that, however. EROI refers to how much energy is needed to produce more energy. The concept leaves out a lot of linkages among resources. Resource-intensive production of oil and gas increases the scarcity and costs of other resources such as water and therefore of food, which depends on water as well. Other resources such as copper and iron ore that use lots of water and energy are also squeezed, and you have another vicious, potentially catastrophic, cycle. It would take me too far afield to focus on all these interrelationships, but an examination of the more general concept of resource return on investment, or RROI, would probably find the U.S. in a lot worse shape than as measured only by EROI, or the amount of energy required to get more energy.
Let's consider how to use EROI to determine the most potentially rewarding energy investments. Clearly energy sources with EROIs above five are attractive. According to an April Scientific American article, both wind and solar energy make the grade. Neither uses water to generate energy, further conserving precious resources. Unfortunately, it is hard to find clear beneficiaries of wind or solar, as companies in this space are highly competitive with one another. However, I do continue to recommend silver, a critical ingredient in photovoltaics, the most pervasive and fastest-growing form of solar energy. I view the recent slump in silver prices as an exceptional buying opportunity.
As for oil and gas producers, I see the critical metrics as free cash flow and growing production. There was a time when negative free cash flow was not so bad for oil companies. It often signified investment in growth. Today, however, given the ever-increasing amounts of oil and other resources needed to produce oil, negative free cash flow frequently suggests that a company is running in place.
Oil and gas stocks with negative free cash or slumping production, especially those involved in non-conventional hydrocarbons, will probably require ever greater spending to sustain that growth, which to me is a recipe for long-term disaster. In fracking especially, another factor contributing to the lower EROI ratio is the high depletion rate of the wells. In an earlier era, producer growth related closely to the number of wells drilled. Today, oil production from a new well often declines sharply after the first year.
http://www.forbes.com/sites/greatspeculations/2013/06/05/dangerous-times-as-energy-sources-get-costlier-to-extract/
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