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Underfunded

March 31st, 2005

There’s an interesting story in today’s Fin (subscription only) about a study of a remote NT Aboriginal community which found that government spending per person there was substantially less than the average for NT residents in general. I don’t know how general this is, but I’ve seen similar results before. The idea that “we have spent massive sums of money on Aboriginal problems and have nothing to show for it” is based on dubious empirical assumptions. A common source of this thinking, at least when ATSIC was around was to look at the total amount allocated to Aboriginal health, education and so on, without netting out the amount that would otherwise have been spent through the mainstream health and education budgets.

Also in today’s Fin, I have a piece on oil prices. Most of it will be familiar to readers, but I’ve put it over the fold anyway.

Oil is the classic example of an exhaustible resource (there’s a charming, but apparently false, belief that it comes from decayed dinosaurs) Whenever the price of oil rises sharply then, people start asking whether this is a mere market fluctuation or an indication of the impending exhaustion of the resource.

Of course, oil will never simply ‘run out’. As the supply of any commodity declines, prices increase and, for relatively low-value uses, the costs exceed the benefits. Where they are available, low-cost substitutes become more attractive.

Before the 1973 increase in prices, oil was commonly used as fuel in electricity generation and home heating. Following the increase in prices, most oil-fired power stations were converted to gas or coal. Where natural gas was readily available, the same was true of home heating. The relevant question then, is not whether oil will run out, but whether it will become so scarce as to be uneconomic in its main uses, the most important of which is as fuel for motor vehicles.

The price of oil is typically quoted in $US/barrel, for some specific grade of oil such as West Texas light sweet crude. This need not be an accurate indicator of the cost of oil in general, because of variations in the purchasing power of the US dollar and because the relative prices of different types of oil fluctuate. The current upsurge in prices is due in part to the devaluation of the US dollar against other major currencies.

Critics of predictions of resource exhaustion have plenty of history on their side. In the 19th century, the eminent economist W.S. Jevons predicted the imminent exhaustion of reserves of coal. He was wrong, as were a series of subsequent prophets of resource exhaustion, most notably the Club of Rome in the 1970s.

Time after time, scarcity has been met by new discoveries and by improvements in resource technologies that have made it economic to extract resources from sources that were once considered valueless. In the case of oil, the estimate of ‘proven’ reserves in 1973 was 577 billion barrels. The Club of Rome pointed out that given projections of growing use, reserves would be exhausted by the 1990s.

The economic slowdown from the 1970s onwards meant that the actual rate of growth was slower. Nevertheless, between 1973 and 1996, total usage was around 500 billion barrels. Yet at the end of the period, estimated reserves had actually grown to over 1000 billion barrels. This is a pattern that has been repeated for many other commodities, and should give pause to any advocate of the exhaustion hypothesis.

Yet believers in the exhaustion of oil reserves have some history on their side too. Their key exhibit is the Hubbert curve which is supposed to show that oil output from a field should peak about 25 years after discovery. The big success for the Hubbert curve was Hubbert’s 1956 prediction of the peak in US oil output around 1970.

Hubbert’s model implies that world oil output should have passed its peak a year to two ago. The current period of high prices and short supply gives some support to advocates of the Hubbert peak.

The really striking events have been those relating to reserves. For the first time, downward revisions to estimated reserves have become commonplace.

The Shell company has been the most notably affected so far, being forced to announce a series of downward revisions in estimated reserves. But there have also been suggestions of similar problems in many other oil-producing countries, either because reserves have been overstated for political reasons, or because fields have been mismanaged.

Of course, some fields are still expanding. For example, new leases are being issued for deep water prospects in the Gulf of Mexico. But the very fact that such marginal prospects are being explored is an indicator that oil companies expect high prices to persist.

Then there is the possibility that oil can be economically extracted from sources such as shales and tar sands, which contain vast quantities of oil, but have proved too costly to process. Some promising results have been reported recently from Canadian tar sands. On the other hand, the recent abandonment of plans to develop the Stuart oil shale deposit near Gladstone is an indication of the difficulties with these sources. To adapt an old saying, it seems that shale oil is the fuel of the future, and always will be.

On balance, current high prices are likely to persist and to rise over time.

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  1. JN
    March 31st, 2005 at 14:35 | #1

    You seem to be holding back on what could happen if oil prices become unaffordable in terms of current economic norms. Some are predicting a catastrophe. The problem with both greenhouse friendly alternative fuels such as ethanol and dirty fuels such as oil-from-shale is the low net yield. A huge shift of activity would be required to generate volumes that could even partly replace present levels of fuel use. Some well entrenched activities could prove uneconomic (such as the 90 minute commute to work) and others would contract as fuel costs shrunk discretionary spending. Very few commentators seem prepared to speculate where this is all heading.

  2. March 31st, 2005 at 14:53 | #2

    Actually, Jevons was right, if you consider the particular coal he was thinking of – high quality British coal, Britain’s sustainable competitive advantage. Add to that the well known problems, and the fact that mine management is not best handled by the greedy algorithms involved in free markets (a natural market failing), and you have a recipe for the very problems that began to work through the British economy in the early 20th century.

  3. snuh
    March 31st, 2005 at 15:57 | #3

    i’ve heard it said that oil companies are no longer reporting increases in their reserves because, like all other industries, they’re excessively focused on short-term profitability, and have become more reticent in making big investments in things that have only long term prospects of a return, such as exploration.

    is there anything to this? it seems hilariously short-sighted, but still, this has hardly stopped any stock-market-minded CEO in the past.

  4. March 31st, 2005 at 17:55 | #4

    John, have you considered coal liquefaction in your analysis? It’s old technology (it was used by the Nazis and the South Africans, both because they were cut off from other oil supplies), it works, and according to the article it’s cost-competitive at about $35 per barrel. It’s also horrible from a greenhouse perspective if the CO2 emitted from the process isn’t geosequestered, but it does work…

  5. Andrew Reynolds
    March 31st, 2005 at 18:13 | #5

    snuh,
    After the last debate on this blog on this topic I did some reading. The reason why published reserves have not gone up is more to do with US stock market regulations than with any lack of discovery of oil. The way that the US regulations define ‘proven’ reserves was defined in the 1950’s and 1960′s and largely relies on things like actually drilling wells and getting oil out of the field. This is an expensive process. With many years of oil still in the ground, the companies do not need to do this as yet.
    They can show that there is lots of oil beyond the current ‘proven’ reserves using things like seismic surveys and 3D imaging that does not meet the US criteria of ‘proven’ reserves. Why spend millions of shareholder’s money on proving what you already know when you do not need to prove it yet? The whole Shell restatement thing did not actually reduce the amount of oil that Shell can ultimately recover – it was a question of whether they reserves met a narrow definition of ‘proved’.
    PrQ,
    Ultimately, you have to be right about the future destination of the oil price, as with all depletable resources. However, I doubt that this will occur in my lifetime.

  6. April 1st, 2005 at 00:28 | #6

    I’m not an economist but I work in Aboriginal communities a lot. Another area that seems to have contributed to the “massive overfunding” argument is that ATSIC provided housing, water, severage and power services to remote communities, so part of this “overfunding” was just infrastructure maintenance which would have been provided by local councils if the communities hadn’t been Aboriginal. The road from Broome to One Arm Point wasn’t graded for the best part of a year because Broome Shire Council and the communities couldn’t agree whose job it was, for example.

  7. April 1st, 2005 at 00:47 | #7

    RM, what counts for the alternatives such as synthesis isn’t so much whether they will eventually be cost effective but whether production can be ramped up rapidly enough. I think Jack Strocchi’s view here is that there will eventually be a literal crisis, i.e. sudden cut in oil supplies. To me it seems more likely that we will be able to move via transitional use of proven inefficient technologies to more cost effective alternatives.

    But all we can do here is formulate the questions in ready reckoner form, not answer them in advance.

  8. Ian Gould
    April 1st, 2005 at 16:13 | #8

    PM,

    I don’t think the question is whether there’ll be “crisis” it’s whether the crisis will be moderate (i.e. half of private cars banned from roads on alternative days or on week-ends; petrol rationing in some countries) or severe (people in places like the Northern US freezing to death for lack of heating oil).

    I tend to favor the moderate view.

  9. John Quiggin
    April 1st, 2005 at 16:31 | #9

    Andrew is broadly correct about the way reserves are defined, but I think gets the interpetation partly wrong. The lack of incentive to prove reserves on discovery partially explains why proven reserves rose steadily even where no new oil was being discovered. As currently proved resources were depleted, companies simply proved up reserves they had discovered long before.

    The fact that they can’t do this any more without running a risk of overstatement as with Shell suggests that the true resource is reaching its limits

  10. April 3rd, 2005 at 15:57 | #10

    IG, you have been hit by shifting language. There is no such thing as a moderate crisis, though there may well be things that are long drawn out and serious but slow building, even unmanageable in the worst case. But those are not called crises. There was a world crisis in 1914 but not so much so in 1939, but this is not being dismissive about 1939, just being careful with the intellectual toolkit.

    Of course, you don’t usually have to be that careful, it’s just that hereabouts I thought it mattered.

  11. Andrew Reynolds
    April 3rd, 2005 at 16:34 | #11

    PrQ,
    What happened at Shell was a corporate governance issue. Shell had an incentive scheme in place that was based partly on the amount of proven reserves, so these numbers got inflated, with the provable becoming proven – the amount of actual recoverable oil has not changed.
    The reason for the small results from exploration over the last 15 or so years says little about the amount of oil in the ground and more about the low price of oil during much of that period. Most of the reserves now being pumped were discovered during the last period of high oil prices – the early 70’s – also an artificial boom. The subsequent drop in price caused a drop in profits and therefore a drop in capital expenditure – there was no reason to go out and explore. The current high price period has re-awakened interest in oil exploration as well as the alternatives, so there will be plenty of oil for a while yet.

  12. Mark White
    April 5th, 2005 at 00:09 | #12

    What about taking up the biomass energy cause, John? burning grass pellets as a biofuel is economical, energy-efficient, environmentally friendly and sustainable, says a Cornell University forage crop expert.

    http://www.css.cornell.edu/faculty/cherney.html

    Found at: -
    http://science.slashdot.org/article.pl?sid=05/04/03/0258236&from=rss

    A biofuel economy in Australia will demonstrably result in long-term environmental and human generational gain as well as short to medium term economic benefits.

  13. kyangadac
    April 5th, 2005 at 02:02 | #13

    Is Andrew Reynolds suggesting that the amount of oil in the ground is solely dependent upon the price of oil? If not, then perhaps he could explain how he knows that there is so much oil out there waiting to be discovered?

  14. April 5th, 2005 at 17:02 | #14

    Is a good question, kyangadac. Apparently large oil fields are very easy to find. If they are there. It has been argued that it is highly unlikely that there are ANY giant oil fields undiscovered. This implies we have discovered the majority of the oil that’s out there.

    We are in the dark about Ghawar in Saudi. Only a few know the true state of that field. And they aren’t telling. There is no reason to be certain about it either way.

    Obviously, the easiest, most economical solution is to find new giant or super giant oilfields where large volumes of oil can be extracted and brought to world markets at low cost. That is just what is not the case today. According to a recent report from the Colorado School of Mines, ‘The World’s Giant Oilfields,’ the world’s ’120 largest oilfields produce close to 33 million barrels a day, almost 50% of the world’s crude oil supply. The fourteen largest account for over 20%. The average age of these 14 largest fields is 43.5 years.’ 1

    The above study concludes that ‘most of the world’s true giants were found decades ago.’ Over the past 20 years despite investment of hundreds of billions dollars by major oil companies, results have been alarmingly disappointing.

    The world’s major oil companies – Exxon-Mobil, Shell, ChevronTexaco, BP, ElfTotal and others – have invested hundreds of billions of dollars in finding enough oil to replace the existing oil supply sources. Between 1996 and 1999, some 145 companies spent $410 billion to find enough oil only to keep their daily production stable at 30 million barrels a day. From 1999 to 2002, the five largest companies spent another $150 billion and their production grew only from 16 million barrels a day to 16.6 million barrels, a tiny increase.

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