Folks,

This longish article was broken into two parts for Energy and Capital (here and here), but I have reprinted it whole here for convenience.

In it, I discuss the paradox that many highly-anticipated oil and gas projects around the world are being delayed or cancelled due to the high cost of oil…when the high cost of oil was supposed to make them economical.

I think this is an important dynamic to be aware of as we cross into post-oil peak terrority. Our expectations for future production may not be fulfilled.

–C

Receding Horizons

By Chris Nelder

April 17, 2007

The bear went over the mountain

The bear went over the mountain

The bear went over the mountain

And what do you think he saw?

He saw another mountain…

Last week, energy blogger Robert Rapier published a thorough analysis of what went wrong with thermal depolymerization (TDP), a much-hyped technology that promised to turn anything (starting with turkey guts) into usable oil and other clean, usable byproducts, while being net energy positive and economical.

I blogged it myself back in 2004 when it was supposed to be the Next Big Thing, able to harvest landfills and deliver liquid fuels in a post-peak oil world, in one fell swoop.

Rapier’s account of the TDP story is an interesting study in how the “next big thing” in energy often turns out to be overpromised and underdelivered.

“This is the same mistake that proponents of tar sands, GTL, oil shale, cellulosic ethanol, and many others have run into,” Rapier observed. “They believe that oil prices will rise, and yet their costs will magically remain where they were. In fact, what happens is that as oil prices rise, all the costs associated with these various projects rise.”

He called TDP a victim of a phenomenon known as the “Law of Receding Horizons.”

Related articles on receding horizons: The Cavalry Stays Home The Dirt on Coal 2007: Renewable Energy Gets Real

I am grateful to whomever gets the credit for that little coinage, because I’ve been barking up that tree without a good name for the concept for a while now, and it’s an apt description for what I’ve been seeing in the energy press lately: receding horizons.

A Horrible Irony

So far, April is living up to T.S. Eliot’s aspersion that she is the cruelest month.

Energy projects in oil, natural gas, and tar sands have been getting cancelled or delayed left and right for the last two weeks or so.

Why?

Because of a horrible irony we have observed before: the rising cost of oil causes the project’s costs to balloon until it is no longer economical. (Plus a healthy dose of geopolitical unrest, and basic environmental overshoot.)

The horizon recedes. Like an oil slick mirage—always just out of reach, just another mile or a billion dollars away.

Thanks to the record oil revenues being raked in by oil producing countries of the Middle East, they’re building and expanding infrastructure like gangbusters, which has led to a global shortage of contractors, raw materials, equipment and qualified labor…and led in turn to higher prices for all the world’s big construction projects, including its own.

Talk about the snake eating its own tail.

We’re not just talking refineries, either. Didja hear about the planned 68-story combination hotel, apartment and office tower complex in Dubai, where each floor rotates 360 degrees independently, to create a constantly changing architectural form?

Well, whatever it takes to entertain the likes of Michael Jackson, I guess.

But I digress…

The Unconventional Oil Mirage

The point is, any time we hear that oil has to be over $30…or $40…or $x/barrel in order for some marginal energy project to make sense economically, we should be instantly skeptical.

Because when oil does get to that cost per barrel, the project’s costs often turn out to be based on the cost of oil back when they made the estimate…but now, the project is still too expensive to make sense.

I don’t know how they get away with such predictions, actually. We’ve all seen this movie before, haven’t we?

And yet, the cost overruns are always called “unexpected.”

One clear example of this is the production of the oil shale of the American West. Once you factor in the future cost of all the energy that it will take to harvest those low-quality hydrocarbons, it never pencils out. Indeed it seems to be a calculation that few even attempt.

The standard joke is: “Shale oil–fuel of the future, and always will be.”

Back in 1946, you’d have seen a billboard along the route of today’s I-70 suggesting that you “Get In On the Ground Floor” of real estate there, to capitalize on the impending shale oil rush. And it’s still not too late, because to this day there is still not a single production scale oil shale facility.

Another good example of receding horizons was given in the recent report by the Energy Watch Group on the impending peak of global coal production. The report’s authors concluded: “the present and past experience does not support the common argument that reserves are increasing over time as new areas are explored and prices rise.”

I’ll say it yet again: when it comes to non-renewable resources, neo-classical economics just doesn’t work. The Invisible Hand stays in its Invisible Lap, and God doesn’t put more oil in the ground just because we’re willing to pay more for it.

Unfortunately, the cancelling of these projects is coming at a time when we’re just barely able to balance global supply and demand, no matter what OPEC may say to the contrary.

Claude Mandil, executive director of the IEA, said last week “Demand growth has exceeded the capacities put on the market, which currently are barely balanced….Even if we are happy with increasing investments in Middle East countries of OPEC, we think the rate of investment and capacity growth is not enough to meet future oil demand.”

Not enough to meet future oil demand.

Let’s take a look at the next cavalry regiment who has decided to stay home.

Bear in mind that all of this has happened since April 1.

The Rogues Gallery

Nigeria: In Nigeria, the number five supplier of crude to the U.S. and one of the few sources that can actually (theoretically) increase production, militant groups have declared “full blown war” on the federal government unless they withdraw all military personnel from the Niger Delta, where the militants have continued to stay busy sabotaging the oil infrastructure and taking oil workers hostage.

Multinational oil companies are pulling out, workers are refusing to expose themselves to dangerous sites, and many projects are being put on hold. But the oil companies are largely staying mum.

California: The state Lands Commission voted not to approve an environmental impact statement that would have been necessary to proceed with a proposed liquefied natural gas (LNG) facility 14 miles off the Ventura-Los Angeles County coast. They also denied a permit for the pipelines to cross state lands, so the project is effectively dead. This bodes poorly for the three other similar LNG projects that are still in the approval process, and another Long Beach project which is currently being fought in court.

Louisiana: Shell has put the kibosh on a new LNG import terminal 36 miles off the coast of southwest Louisiana, due to protests over the environmental impact of the facility, which would have used millions of gallons of Gulf water to warm the gas from liquid back into a gas.

Canada: In the Northwest Territories, the Deh Cho tribe, the last aboriginal holdout against a natural gas pipeline across the Mackenzie Valley, is making their approval of the project conditional upon the federal government agreeing to set aside 60% of the tribe’s lands as protected wilderness. The 1,220-kilometer pipeline is needed to access large gas reserves in the Arctic, but its cost has more than doubled to $16.2 billion.

Natural gas drilling in Canada has also been dampened by the Canadian government’s dubious decision to kill the golden goose of investment money flowing into its energy projects, by phasing out the sweet tax benefits that the Canadian investment trusts who funded the projects used to enjoy.

Accordingly, exploration and production companies are scaling back on drilling. The number of drilling rigs that are operating in Canada now are less than half the number that were operating there at the end of 2005.

“A lot of marginal drilling activity taking place last year is probably gone for good,” said Bill Herbert, co-head of research for Matthew Simmons’ company, Simmons & Company International.  He called the run of rig withdrawals a “blood bath,” and projected that the second quarter of this year will see the rig count fall by 40 percent from last year’s level.

For those of you keeping score, this is not good news. North America is well past the peak of its natural gas production and is on the decline. Just to stay even with current consumption, we need to increase imports. But, as we are seeing in southern California, new facilities to import natural gas aren’t exactly being welcomed with open arms.

Since natural gas is the primary feedstock for West Coast electricity plants, this surely will translate into higher grid prices here.

And since natural gas is a key feedstock for the production of oil from the Canadian tar sands, it could dampen those projects too. That’s scary, because that 1 million barrels a day of oil made from the tar sands is equivalent to more than 10% of the U.S.’s oil imports.

Canada is, after all, our number one supplier of crude. We’re counting on them to make up for the loss from our number three supplier, Mexico, due to the catastrophic decline of its main oil field, Cantarell.

So we’d like to see Canada increasing its production as fast as possible—indeed, we lobbied them hard last quarter to do so, asking them to suspend their environmental reviews in order to fast-track oil sands projects.

But they demurred.

Now, the Canadian Association of Oilwell Drilling Contractors anticipates that the number of oil wells drilled will drop from 22,575 last year to 19,023 this year.

With oil prices going up.

What does that tell you?

It tells me that the investment money is pulling back, and that could very well be because the best prospects for drilling have already been tested, and that they’re getting more and more dry holes and less payout from the wet ones, even as the cost of drilling rises dramatically.

Oh, Canada!

Mexico: In a startlingly frank interview of Matthew Simmons on the Financial Sense newshour with Jim Puplava, Simmons actually recommended that Mexico cut back on its oil production, in order to save a little for the rainy day ahead when oil is scarce, and so are oil revenues.

“If I were Mexico today, as painful as this would be temporarily, I would lower Cantarell’s production rate to about 800,000 barrels a day, and keep the other sister fields next to it from going into a nitrogen injection program—or do the nitrogen injection, but then, don’t let those wells flow as fast as they can. Cap it. And let it last at a lower rate for 10 years while they try to figure out what in the world do we do once we basically are no longer a major producer of oil, because otherwise, they have no Plan B–just like we have no Plan B.”

Reinforcing his expectation of a near-term peak, he said “I don’t think we have until 2010. It’s a pretty grim picture. …We need to have oil prices go way up from where they are today.”

Russia: A government official said that construction of the second leg of its pipeline to Asia could be pushed back from its originally scheduled March 2008 completion by as much as four years, because oil production from its underdeveloped East Siberian fields has failed to meet expectations.

Saudi Arabia: The state-owned oil company Aramco said that its ample supplies of heavy sour crude will continue to go under-used, because the rising cost of construction materials such as steel and concrete have caused delays in plans to build more of the complex refineries needed to process it. The cost of building a refinery is up over 70% in the last three years.

Many of these refineries may not materialize,” Aramco’s Mishari said at the Middle East Petroleum and Gas conference in Dubai. “The downstream bottleneck could remain.”

Construction costs have also doubled, to US$22 billion, for a planned large-scale refinery and petrochemicals complex in eastern Saudi Arabia. The first cost estimate for the project was $10 billion, which went up to $15 billion last July when Aramco announced its partnership with Dow Chemical on the project. Now it’s $22 billion. Apparently, they are moving forward with the project anyway.

Anybody trust the new estimate?

More importantly, anybody want a marker on what the real cost will be, if and when it gets completed?

Iran: According to an April 5 announcement by the French oil company Total SA, their planned $10 billion LNG project in Iran is now in jeopardy because of—again—rising costs.

CEO Christophe de Margerie told reporters Thursday that the costs “are so high that they are close to damaging the project.” “We have to renegotiate all our agreements” with suppliers, de Margerie said, adding costs “have more than doubled” in recent years and that this is a “strong concern.”

He said the company also needs to re-evaluate the geopolitical environment before deciding to go ahead with the project. (Duh! And who thinks that assessment will come up rosy?)

The project was to harvest the massive South Pars gas field, which holds about 1 billion barrels of oil equivalent of proven reserves. It was scheduled to begin production by 2011.

For the record, de Margerie also has the distinction of being the only head of a major oil company to give a fairly realistic date for peak oil: 2020.  He has also questioned whether it is possible to increase global oil output from today’s 85 million barrels per day to 100 million barrels per day, as many officials have projected. He should be commended for his candor.

Kuwait: A proposed 615,000 barrel-a-day refinery in Kuwait was initially projected to cost around $6 billion, but the contractors came in with prices in excess of $15 billion. Part of the reason is that the cost of shallow water drilling rigs has exploded from $50,000 a day just a few years ago, to $200,000 a day now.

Algeria: Our #7 source of imports, and Africa’s largest gas exporter, may scrap a planned 36,000 bpd gas-to-liquids (GTL) plant due to—you guessed it—the soaring energy costs of construction. “We had three bidders and one dropped out,” said the country’s oil minister, “It is too expensive apparently, so we may drop it.”

He said other GTL projects have been pushed back as far as 2011. The projects “are being delayed because of haggling over costs and lack of subcontractors.”

An LNG plant under construction in Algeria will also be delayed, according to the builder, Spain’s Repsol.

Qatar: Realizing that project costs are delaying oil and gas projects around the globe, Qatar’s Oil Minister Abdullah bin Hamad Al Attiyah met recently with the chairmen of oil and gas companies. “Cost is a big concern,” he said, and is “one of the issues we should be concerned about before it snowballs.”

While this happened in February and not April, it bears repeating. In Qatar, home of the world’s third-largest reserves of natural gas (after Russia and Iran), the energy minister said that the future of some multi-billion dollar GTL projects planned by Conoco Philips and Marathon Oil was in doubt, and their fate wouldn’t be decided until a cost study is completed in 2009.

And, as we reported earlier, a much-anticipated, $15 billion LNG project in Qatar was scrapped by Exxon due to costs running out of control, and rising domestic gas needs.

Everywhere oil is owned by the state: And bringing up the end of our rogues gallery is: everywhere foreign oil companies operate. It seems that the days of windfall profits for oil companies are numbered, as oil producing nations realize that they have the leverage to demand a bigger share of the wealth.

The renationalizing of energy assets by Russia, Venezuela, and Algeria are just part of this picture. Nationally owned oil companies, or NOCs, currently control some 75% of the world’s remaining reserves, and their share will soon increase to 90%.

That puts them in the driver’s seat for dictating the terms of future deals. And unless the international oil majors—overwhelmingly companies from countries in the West that are past their own production peaks—want to go out of the oil business entirely, they have to play ball. Because that’s where the oil is.

In addition, the state owned oil companies have learned a thing or two from their long partnerships with the Western majors, and are now capable of taking on complex projects on their own. They don’t need the majors as badly anymore, and tend to use them for their E&P expertise and then toss them out just when the going gets sweet.

Sounds like a blues number, doesn’t it?

These days, says ConocoPhillips Chief Executive James Mulva: “Big Oil is not so big.”

And Exxon Chief Executive Rex Tillerson expects the new trends to continue: “Until you get a change in the price environment, I don’t see the pressure coming off much,” he said last month.

A few examples: Anadarko Petroleum Corp., the largest foreign producer in Algeria, estimates that the new taxes levied on it will reduce the company’s income from Algeria by 12% to 23%.

Marathon Oil will now face taxes on any windfall profits in Equatorial Guinea.

Venezuela has raised taxes and royalties, and has taken a controlling interest in all its heavy oil projects, which are among the most profitable in the world for Western oil companies. Income taxes on heavy oil projects are up 50% over the past couple of years, and royalty rates doubled to 33%…when they started at 1%.

A Questionable Future

This high-level survey of future of the world’s oil and gas production clearly leads to some important questions.

Can we trust our expectations for future oil and gas production? How eager do we think Big Oil is really going to be, between now and say, five or ten years from now, when we’re clearly past the global oil peak and they’re basically powerless to do anything about it?

What do these developments—or should I say, lack of developments—imply for the timing of the global peak? For the price of oil?

And what about the other much-anticipated liquid fuel alternatives? What corn price puts the hurts on ethanol production? On food prices in general?

And can the vast resources of oil shale, tar sands, and coal in North America really save the day?

Stay tuned to this space to find out.

Until next time,

–Chris