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Sunday, February 19, 2006


Oil markets are set for a rough opening on Monday. Attacks this weekend in Nigeria have seriously curtailed that country’s production and more violence appears in the offing. Two problems closer to home, however, are also threatening U.S. energy security. Recent developments in both Venezuela and Mexico cast doubt on those two countries’ ability to remain steady crude oil suppliers to the U.S. The good news, however, is that Washington may be on the verge of understanding the real problem posed by a world addicted to oil.


Just as the oil market seemed to be shrugging off its fears about Iran, Nigerian unrest has cut the legs out from under world supply. On Friday Nigeria’s Movement for the Emancipation of the Niger Delta (MEND) said that it would begin a ‘total war’ against oil production in the region. The price of oil closed up over $1 on the news. Violence in Nigeria over the previous two weeks had already cut 10% of Nigeria’s production. But then the rebels did something surprising: they made good on their threats. On Saturday rebels attacked Nigeria’s Forcados tanker terminal, one of the country’s largest crude loading platforms, as well as a nearby pipeline. Nine oil workers, including three Americans, were also taken hostage in a separate attack on an oil transport barge.

The damage to its facilities and fear of further violence has led Royal Dutch Shell to suspend exports of 380,000 barrel per day and shut down the 115,000 barrel per day EA oilfield, cutting 21 percent of Nigeria's 2.4 million barrels of daily supply to world markets. A spokesman for MEND said on Saturday that the attacks were a response to military air raids earlier this week and would be followed by another wave of violence “on a grander scale.” Earlier today a man identifying himself as a commander of the movement told reporters by telephone that his group was poised to escalate the violence by firing rockets at crude oil tankers offshore.

While Saudi Arabia announced earlier this month that it would cover any Nigerian losses from its 1.5 million barrels per day in spare capacity, the overture will have little dampening effect on oil prices come trading on Monday. Nigeria’s crude is of the highly valuable light, sweet variety best suited for production of refined products such as gasoline. Saudi spare capacity is in heavy, sour crude, which requires specially tooled refineries to effectively produce high-demand petroleum products. Nigeria supplies over 1 million barrels of crude per day to the U.S. and is its fifth largest foreign supplier.


As if that weren’t bad enough, the situation with regard to the United States’ fourth largest foreign supplier, Venezuela, continues to deteriorate as well. Shortly before the Nigerian attacks, Venezuelan President Hugo Chavez claimed (yet again) that he would cut off oil supplies to the U.S. if it “crosses the line.” This time, however, he claimed already to have scouted buyers to take Venezuelan crude in America’s stead, although he demurred when asked for the details. Venezuela exports 1.5 million barrels per day of oil to the U.S., and with 77 billion barrels of conventional reserves and over 200 billion barrels of oil sands reserves, Venezuela has the potential to be a steady, long-term to supplier to the U.S. as world reserves diminish.

Fortunately for the U.S., nearly three-quarters of Venezuela’s crude ends up in the U.S. for good reason. Exports to locations other than the U.S. are problematic for Venezuela because it has no Pacific pipeline route to facilitate exports to Asia. Some crude travels through the Panama Canal, although those shipments are limited because the canal is not large enough to handle conventional crude transport ships. Sending crude eastward to Europe or around the Horn of Africa to Asia is a possibility, but shipping oil such long distances adds significantly to transport costs. Regardless, Chavez’s saber rattling still contributes to the risk premium embedded in world oil prices. Markets like consistency, which is a character trait somewhat less abundant in Venezuela than oil.


Despite the noisy and potentially serious disruptions in Nigeria and Venezuela, a third recent revelation, this time coming from Mexico, poses a much more serious and endemic problem for U.S. energy security. A secret report by Mexico’s state-owned oil company, Petroleos Mexicanos (Pemex),leaked to the Wall Street Journal, said the country may be facing a steep decline in output that would further tighten its export capacity and further fuel rising prices. Mexico is the U.S. second largest crude oil supplier behind Canada.

The problem in Mexico is easy to identify because 63 percent of Mexico’s oil production comes from a single field, Cantarell, which is the world’s second largest. Within a few years of its discovery in 1976, it was producing over a million barrels a day from only 40 wells. When Cantarell’s production began to decline in the 1990’s, Mexico successfully reversed the trend by injecting 1.2 billion cubic feet per day of high-pressure nitrogen into the field, bringing production up to its ultimate peak of 2.1 million barrels per day.

However, one of the few truisms in oil production is the adage that ‘the faster they rise, the harder they fall.’ According to the Mexican report, declines at Cantarell may indeed be soon and severe. In its worst-case-scenario description, output from the field could fall from its current level near 2 million barrels per day to 875,000 barrels per day by the end of next year and 520,000 barrels per day by the end of 2008. Pemex itself publicly acknowledges a clearly optimistic decline rate of 14 percent per year, which would knock over 500,000 barrels per day off its production total by 2008. Another major contributor to Mexican output, the nearby Abkatun-Pol-Chuch field, is also in decline. It produced 321,000 barrels per day of crude oil in 2004, but has been in steady decline since its peak in 1996.

In Mexico, as in all major oil producing regions, the largest oil fields are drilled first and fast. Once the inevitable production declines in set in, the losses must be made up through the development of a larger number of smaller fields. Lacking the economies of scale characteristic of larger fields, these small projects inevitably entail higher exploration, production, and development costs. Pemex, however, is heavily in debt, making exploration and production investments slow and expensive. Even if Mexico has sufficient resources in the ground to produce --which itself is not a foregone conclusion-- it seems exceedingly unlikely that new fields can come online fast enough to make up for the aging fields’ declines.


While the U.S. has had to deal with declining domestic production of oil for decades, the reality that the world’s oil is quickly depleting while demand is soaring has begun to affect the policy thinking of those once inured to worries about the depletion of fossil fuels. The President himself declared that the U.S. is addicted to oil. That’s a pretty forthright appraisal for a Texas oilman to make; after all, the first step on the road to recovery is admitting you have a problem.

But that’s only half the story. In fact, the world writ large is addicted to oil. Even though the U.S., with just 5 percent of the world’s population, consumes 25 percent of daily crude production, the largest increases in the demand for oil in the coming decades will come from developing nations, such as India and China. A reduction in U.S. demand for oil would simply open the door for increased and lower cost consumption by these economies. The rate of world oil depletion would be slowed little, if at all.

This seems to be the thinking, at least, behind the President’s announcement of the Global Nuclear Energy Program. The program would develop partnerships with other established nuclear countries such as Britain, France, Russia, and Japan to export the waste from conventional nuclear reactors to developing countries and encourage them to use specially designed reactors that burn plutonium and other by-products from conventional nuclear fuel production. The US and other supplier countries would then dispose of the final waste, maximizing the amount of energy drawn from plutonium and preventing nations from acquiring weapons-grade nuclear material.

While the plan is in its infancy –a mere $250 million was allocated to it in the 2007 budget- it seems likely to garner the support of the international community. In fact, it is essentially an internationalized variation of the Russian offer to supply Iran with nuclear fuel for civilian nuclear power generation. While critics of the plan fear that the transport of nuclear fuel and waste will increase the likelihood of nuclear materials falling into the hands of terrorists, it is a risk that the energy hungry world may have to take.

There are other reasons too to think the U.S. is starting to understand the reality of oil depletion. The 2007 budget requests only $648.9 million for the Office of Fossil Energy. That’s a 23 percent reduction from the 2006 appropriation. $61 million of the savings is accounted for in the termination of support for energy companies to explore for oil and gas, ostensibly because, according to the Department of Energy, “such R&D activities are more appropriate for the private sector to perform.” From an Administration that is generally pro-oil and willing to assist large oil companies with various tax incentives, this explanation is hard to believe.

A more likely explanation for the program cut is that there simply isn’t enough cost-effective oil out there to find, even at current high prices. In fact, large U.S. oil companies themselves have been steadily decreasing their expenditures on new oil exploration because it is a bad investment. Instead, these companies have tried to replace produced reserves on their asset sheets by simply purchasing other oil companies with booked reserves. Any excess cash –of which there is a lot in the oil industry of late—is often used simply to buy back their own stock.

To what extent the President’s newly announced Advanced Energy Initiative, including the Global Nuclear Energy Plan, is reflective of a new thinking on scarcity of oil is unclear. A pessimistic reading would suggest that the new attention reflects only that the Administration recognizes energy efficiency as a political winner, but not a real problem. On the other hand, U.S. oil companies clearly understand in which direction the long term trends in oil supply and demand are headed. And if they know, it may indeed be the case that the Administration gets it as well. Alas, only time will tell.


In a world full of dangerous uncertainties, securing energy supplies at consistent price is always a challenge. Nigeria and Venezuela made that clear this week. The longer term supply issue, however, is much quieter and much more serious. After more than sixty years of oil production, the world’s major oil producing regions are mature and beginning to decline. Cantarell is only one of many giant and super giant fields whose days are now numbered. While nuclear energy can replace a portion of oil and natural gas used for heating and electricity, it cannot, at least any time soon, replace the gasoline that powers our cars and airplanes and that is a vital ingredient to agriculture, plastics, and petrochemicals. For those needs to be met, new technologies and ways to conserve oil will be needed.


At 7:23 AM, Blogger David Amulet said...

Wow, an ominous post. I fell like running for the hills to be safe!

-- david


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