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Copyright © 2009. Nova Science Publishers, Incorporated. All rights reserved. The Completion of the Oil Era : The Economic Impact, Nova Science Publishers, Incorporated, 2009. ProQuest Ebook Central,

Copyright © 2009. Nova Science Publishers, Incorporated. All rights reserved. The Completion of the Oil Era : The Economic Impact, Nova Science Publishers, Incorporated, 2009. ProQuest Ebook Central,

ENERGY POLICIES, POLITICS AND PRICES SERIES

THE COMPLETION OF THE OIL ERA: THE ECONOMIC IMPACT

Copyright © 2009. Nova Science Publishers, Incorporated. All rights reserved.

No part of this digital document may be reproduced, stored in a retrieval system or transmitted in any form or by any means. The publisher has taken reasonable care in the preparation of this digital document, but makes no expressed or implied warranty of any kind and assumes no responsibility for any errors or omissions. No liability is assumed for incidental or consequential damages in connection with or arising out of information contained herein. This digital document is sold with the clear understanding that the publisher is not engaged in rendering legal, medical or any other professional services.

The Completion of the Oil Era : The Economic Impact, Nova Science Publishers, Incorporated, 2009. ProQuest Ebook Central,

ENERGY POLICIES, POLITICS AND PRICES SERIES Nuclear Power's Role in Generating Electricity Perry G. Furham 2009. ISBN: 978-1-60741-226-7 OPEC, Oil Prices and LNG Edward R. Pitt and Christopher N. Leung (Editors) 2009. ISBN: 978-1-60692-897-4 OPEC, Oil Prices and LNG Edward R. Pitt and Christopher N. Leung (Editors) 2009. ISBN: 978-1-60876-614-7 (Online Book) Dynamic Noncooperative Game Models for Deregulated Electricity Markets Jose B. Cruz, Jr. and Xiaohuan Tan 2009. ISBN: 978-1-60741-078-2

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Energy Prices: Supply, Demand or Speculation? John T. Perry (Editor) 2009. ISBN: 978-1-60741-374-5 Worldwide Biomass Potential: Technology Characterizations R. L. Bain 2010. ISBN: 978-1-60741-267-0 Power Plant Characteristics and Costs Stan Kaplan 2010. ISBN: 978-1-60741-264-9 The Completion of the Oil Era: The Economic Impact Carlos A. Rossi 2010. ISBN: 978-1-60741-340-0

The Completion of the Oil Era : The Economic Impact, Nova Science Publishers, Incorporated, 2009. ProQuest Ebook Central,

ENERGY POLICIES, POLITICS AND PRICES SERIES

THE COMPLETION OF THE OIL ERA: THE ECONOMIC IMPACT

Copyright © 2009. Nova Science Publishers, Incorporated. All rights reserved.

CARLOS A. ROSSI

Nova Science Publishers, Inc. New York

The Completion of the Oil Era : The Economic Impact, Nova Science Publishers, Incorporated, 2009. ProQuest Ebook Central,

Copyright © 2010 by Nova Science Publishers, Inc. All rights reserved. No part of this book may be reproduced, stored in a retrieval system or transmitted in any form or by any means: electronic, electrostatic, magnetic, tape, mechanical photocopying, recording or otherwise without the written permission of the Publisher. For permission to use material from this book please contact us: Telephone 631-231-7269; Fax 631-231-8175 Web Site: http://www.novapublishers.com NOTICE TO THE READER The Publisher has taken reasonable care in the preparation of this book, but makes no expressed or implied warranty of any kind and assumes no responsibility for any errors or omissions. No liability is assumed for incidental or consequential damages in connection with or arising out of information contained in this book. The Publisher shall not be liable for any special, consequential, or exemplary damages resulting, in whole or in part, from the readers‘ use of, or reliance upon, this material. Independent verification should be sought for any data, advice or recommendations contained in this book. In addition, no responsibility is assumed by the publisher for any injury and/or damage to persons or property arising from any methods, products, instructions, ideas or otherwise contained in this publication.

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This publication is designed to provide accurate and authoritative information with regard to the subject matter covered herein. It is sold with the clear understanding that the Publisher is not engaged in rendering legal or any other professional services. If legal or any other expert assistance is required, the services of a competent person should be sought. FROM A DECLARATION OF PARTICIPANTS JOINTLY ADOPTED BY A COMMITTEE OF THE AMERICAN BAR ASSOCIATION AND A COMMITTEE OF PUBLISHERS.

LIBRARY OF CONGRESS CATALOGING-IN-PUBLICATION DATA Rossi, Carlos A., 1960[Epílogo del petróleo. English] The completion of the oil era : the economic impact / Carlos A. Rossi. p. cm. Partly a translation of the 2007 work El epílogo del petróleo with additional chapters and new updated information. Includes bibliographical references and index. ISBN 978-1-61122-348-4 (Ebook)

Published by Nova Science Publishers, Inc.  New York

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CONTENTS Preface

vii

Dedication

ix

Acknowledgments

xi

Introduction

xiii

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Prologue

xxiii

Chapter 1

The Determining Factor of Our Century

1

Chapter 2

The End of the Petroleum Civilization?

11

Chapter 3

Alternative Energy

61

Chapter 4

The Bridge: The Nonconventional Reserves

89

Chapter 5

The Economists‘ Challenge

137

Chapter 6

An Oil Plan

155

Chapter 7

Strategy and Conclusions

169

Appendix

The Case for Economic Cooperation

191

Index

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PREFACE The main objective of this book is to lay out the Framework were Economists can help the energy scientists of the world win the war against the Peak Oil paradigm. Peak Oil is real and is the principal force behind the wreckage in the entire world‘s economic and financial system. The addictive dependence on oil as its primary energy source for the world‘s industrial civilization, from its factories to the farms and all the industries in between— especially transportation—is complete. The same is true for its economic growth and for the standard of living of all nations. Scientists agree that life as we know it would disappear if ever our capacity to produce increasing amounts of oil fails to meet increasing demand. Once we pass the critical Peak Oil point what follows is an irreversible depletion of the most efficient energy source mankind has ever known. This can only be mitigated in limited form by enhanced oil recovery methods, and ultimately through oil‘s gradual substitution by an optimal combination of fossil free alternative energy sources that are feasible, mass-affordable, renewable, environmentally sound and nationally safe. All non fossil energy alternatives cannot be ready to impact the energy balance in a long time because they all face massive technical, financial, security and energy hurdles as well as environmental challenges that need much time to be corrected. In the meantime, to mitigate Peak Oil the world needs the non conventional oil deposits of the Western Hemisphere, especially Venezuela, Canada and the United States, to bridge it though the non fossil energy world. To be able to built this transition bridge and cross it two elements in the economics supply-demand equilibrium must occur. On the supply side aggressive investment must be made to develop all non conventional and alternative sources; on the demand side world economic growth must be orderly restrained to cap oil demand growth and prolong its productive existence. That is, the energy scientists of the world and the economists and politicians must be in the same page and must coordinate at the highest international level a world economic order that restrains economic growth until the alternatives are in place to substitute gradually the world‘s addiction to a depleting source of energy. This book deeply analyses the world‘s dependence on hydrocarbons, the imminence of Peak Oil, the state of all energy alternatives, non conventional reserves, the Venezuelan paradox as well as the minor importance that economics has given energy. By combining known and expected oil supply reserves with projected demand scenarios, the book arrives through simulation exercises to the minimum bearable range of world economic growth that minimize the transition struggles towards a fossil free world. The Book‘s mayor contribution

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Carlos A. Rossi

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is that it recognizes that scientists cannot win the Peak Oil war without enlisting the help of economists and politicians, and thus provides the framework by which economists can help scientists accomplish this all important goal. For economists, it is necessary to revise the long held economic definition of money and incorporate energy front and center in the production functions and the monetary equation of exchange. The ultimate objective being to buy the energy scientists the time that they need to gradually substitute hydrocarbons by providing the world‘s productive agents the confidence needed to carry on investments and fulfill the economic aspirations of its growing population. A new re-invigorated version of the Bretton Woods Agreement in energy terms and game theory negotiation strategy is analyzed and strongly suggested. Make no mistake; the disappearance of its most efficient energy source with no substitutes at hand is unprecedented in the history of mankind, making it its greatest social crisis ever. Failure is not an option, this is a war against time that we must win or face unimaginable consequences.

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DEDICATION

Copyright © 2009. Nova Science Publishers, Incorporated. All rights reserved.

To my wife, Violeta, and my children, Jorge Felix (Georgie) and Carlo Luis

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ACKNOWLEDGMENTS When I started to warn my friends and colleagues about the forthcoming energy crisis that the world was about to face, due to the vast literature and technical information to which I was exposed to in my new position as the principal economics adviser of the Asociación Venezolana de los Hidrocarburos (AVHI, Spanish acronym for Venezuelan Association for Hydrocarbons, the official institutional representative of the privately-owned and international oil companies that operate in Venezuela), one of these friends, Juan Carlos Pifano, was the first to say, back in September 2005, ―Hey, man, you should really write a book.‖ Thus, it is ―Pifi‖ who really deserves to be formally acknowledged first. Geophysicist Dr. Eulogio del Pino, vice president of PDVSA, a member of its directory board, president of the Corporación Venezolana del Petroleo (Venezuelan Oil Corporation), a friend and former co-worker at PDVSA, deserves my most sincere recognition for having read my work and for writing its Foreword, which is a consideration that truly deserves my never-ending gratitude. Former Ambassador Luis X. Grisanti, a colleague of mine, life-long friend and executive president of this institutional agency, is included in this list for backing me up all this time and for reading the first manuscript and making valuable suggestions. I thank the editors and proofreaders of Nova Science Publishers, Inc., especially Mrs. Lorna Loperfido for her patience and encouragement, and Ms. Maya Columbus, who both worked on the editing, proofreading, images, printing, distribution, etc., because without their dedication, risk and patience this book would not have been published. Petroleum engineers Diego Gonzalez and the ex-OPEP governor, Felix Rossi Guerrero (my father), and chemical engineer Jose Prats also deserve my gratitude. Appreciation is also in order to The Association for the Study of Peak Oil (ASPO) and British Petroleum (BP) for giving me permission to use their database and graphs. But, without any doubt, the greatest gratitude and blessings go to my bright star and glitters, my wife Violeta and my two boys, Jorge Felix (Georgie) and Carlo Luis, who, especially my first-born, had to face the sacrifices of my physical and mental absences for way too long. It is them, and the forthcoming generations, to whom I dedicate these pages filled with reflections and suggestions in order that this miraculous spring that we call petroleum does not run out before the scientists of the planet have the time to develop the changeover link towards renewable and ecologic energy sources. Needless to mention, any faults and shortcomings the book may have are the complete and total responsibility of this author.

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INTRODUCTION The hottest places in hell shall be reserved for those who in times of crisis keep their neutrality.

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—Dante Alighieri

The facts are plain to see. Western civilization has grown addicted to oil ever since George Bissell, Jonathan Eveleth and associates bought a farm in Titusville, Pennsylvania in the 1850s and founded the Pennsylvania Rock Oil Company for the sole purpose of studying what they could profitably do with a stream of black gooey liquid seeping from the ground. When Yale chemistry professor Benjamin Silliman Jr. gave his thumbs up that it could be used for illumination, Colonel (he wasn‘t really) Edwin Drake was hired to drill for the stuff, which he successfully did with relentless tenacity. An industry was born that would subsequently transform the blue planet beyond any recognition in literally all of its phases; to the extent that it is safe to say that there is absolutely no one who lived in that epoch or before who would recognize anything in the world we now live in barely a century and a half after those fateful events in Titusville. The world would never be the same. Today, just about everything we own or perceive; what we eat, drink, wear, read, and drive; where we live; our healing; and whom we meet and interact with all have the footprints of the black gold we call petroleum or oil. The transformation of our society from rudimentary pastoral plains to modernized urban and suburban industrial civilizations in mega cities that don‘t produce food, the end of the horrendous agrarian socio economic system of slavery, the multiplication of the human species fivefold since the 1850s that must be provided for with energized commodities, and environmental degradation, are only the most visible aspects of the quantum leap that the planet experienced, slowly at first, but with rocket speed thereafter. But addiction has its perils, particularly if the stuff is non-renewable and only exists in limited fixed quantities found in concentrated hard-to-reach places that are challenging geologically, technologically, financially, ecologically, culturally and politically. If you include in this mix the fact that the underlining economic and monetary system on which civilization rests depends upon expansion as much as that growth depends upon oil for its energy, plus the fact that economists and politicians in general not only blatantly ignore what the natural scientists know but live in separate worlds with a much shorter time frame, then we have, quite possibly, the recipe for a disaster of unimaginable proportions.

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xiv

PERILOUS IGNORANCE It is hard to free fools from the chains they revere… There are men who think no deeper than a fact.

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—François-Marie Voltaire

A professor once told me that whoever coined the phrase ―what you don‘t know can‘t hurt you‖ should be shot. Since my religion and upbringing forbid me to shoot anyone, I cannot agree with his statement, but I would come close. As we will see in Chapters 5, 7 and the Conclusions, one of the most glaring mistakes in the economics profession is its almost complete neglect of the importance of energy and its impact on industrial civilization and living standards. Land, labor, capital, entrepreneurial ability, international trade, democracy, political risk, expectations, climate, endowment, geography, technology, education, medicine, demography, and indirectly, cultural history have all been vitally important elements which economists have progressively accepted and incorporated into their production functions to the extent these can be quantitatively measured or, if not, quantitative proxies are tangibly inserted. Economic modeling is an extremely hard but necessary undertaking not only to predict future economic behavior; but also, as in the case of the World Bank or the United Nations, to help it. But other biophysical elements that are and have been accurately measured for a long time have been generally missed by economists. They have, generally speaking, missed energy. They have missed it to the discomforting point that economists have been absent almost completely from the peak oil debate even though the impact on economic indicators are potentially devastating, as we are witnessing now with the financial meltdown in the U.S. and Europe. Indeed, one of the main purposes of this book is to provide the economists with the necessary tools and knowledge to step out from the sidelines, to become involved in this debate, and to enable them to be a part of the solution to this problem. When Albert Einstein wrote his famous essays over a century ago that postulated the theory of relativity in which he unveiled what is unquestionably the most famous physical equation ever, energy was at the center of all of it. What Einstein wanted was to prove that the inertia of a body does not only depend on its mass but on the energy that it contained within: that is, there is a mathematical equivalence between mass and energy that is given by the square of the (constant) speed of light multiplied times the mass itself—or, E=MC2. Understanding that the inertia of objects is subject not only to their mass or leverage (like gravitational force) applied to them but also that they move because of the energy contained within or provided was one of the most remarkable scientific breakthroughs in the twentieth century. The employment of primary energy to make things move faster and farther, to grow larger and to become more accurate, controllable, reliable, and cheaper did not escape the attention of the inventors and pioneers of the Industrial Revolution in their quest for profits, competitive edge and productivity. The refinement of coal in England was what energized the Industrial Revolution and made possible money lending for economic expansion. Its pioneers understood the implications of this well before Einstein. But, sadly, theoretical economists

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Introduction

xv

somehow missed primary energy‘s implications regarding economic growth, productivity and, most important of all, on the world‘s dependence upon it.1

OIL IS ALL AROUND US Other factors remaining constant, culture evolves as the amount of energy harnessed per capita per year is increased, or as the efficiency of the instrumental means of putting the energy to work is increased.…We may now sketch the history of cultural development from this standpoint. —Leslie White (White‘s Law)

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Oil is not running out. In fact, most experts agree that we have only consumed a bit less than half of what lies under the earth‘s mantle with present available technology. The problem is that, to get to the other more difficult half, we necessarily need to go through a production ceiling, or peak, beyond which the world‘s production cannot be increased to keep pace with increasing demand and the economic necessities of growth. After the peak plateau, oil commences an irreversible decline whose slope can only be determined by the speed of its consumption and depletion. In the meantime, prices will continue to increase as demand collapses to unmanageable proportions to all but the wealthiest members of the wealthiest countries (except, of course, those that can export the product) and, since oil is neither caviar nor champagne, this will invariably cause unacceptable social ramifications as industry, transportation, and agriculture all hit the brakes and slowly begin to collapse. Consider the following two graphs drawn by the U.S. Energy Information Administration for the World Petroleum Conference held in Madrid in June of 2008.

Source: EIA, Form EIA/28 (Financial Reporting System). Recent Increases in Exploration and Development Expenditures by FRS Companies Have Not Provided a Corresponding Increase in Reserve Additions.

1

Adam Smith could hardly be blamed for this. He wrote his landmark The Wealth of Nations—the economist‘s bible—some 83 years before Colonel Drake‘s drilling in Titusville, PA. But he did live under King Coal‘s era.

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Source: U.S. Energy Information Administration. Maximum Output? Global crude-oil production has slipped as demand increases.

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The first tells the sad but true story that the Full Reporting System companies (the big private oil companies) have actually invested very heavily in exploration and development but have so far shown scant results for it. The second graph is the direct result of the first one; in spite of record oil prices, world oil production has not only sluggishly increased but has actually stalled and initiated a reverse. What the graphs do not tell, as we will see, is that Big Oil has free access to only 6–8% of the world‘s proven reserves. Take into consideration the following quote printed in London‘s Financial Times from Michael Meacher, Great Britain‘s former environment minister. The world is using around 84 million barrels of oil a day, but due to the increase in demand coming from the accelerated economic growth in China, India and other countries, the U.S Energy Information Administration Agency has recently carried out a projection for demand of 121 million barrels per day by 2025. However, an increase of almost 50 % in oil demand cannot be satisfied in 20 years. As Total‘s Exploration Chief recently pointed out: ―Numbers such as 120 million per day are never going to be achieved, never‖. First, the oil is not there. In the last decade, the world has used up 24 billion barrels per year, but has found, on average, less than 10 billion barrels of new reserves of oil annually. Second, even if they were accessible, the implications on cost would make them prohibitive. The 2005 World Energy Outlook estimated investments of around US$20 trillion necessary to offer that oil to the consumers: that number is 50% higher than the Gross Domestic Product of the United States. Third, the infrastructure to charge all of this does not exist without prices rising to unmanageable levels. The additional capacities for production and refining are virtually gone.…Never before has a resource as essential as oil faced such a fast decline without a substitute at hand. The self-destructive strategy to stockpile declining oil and gas sources has to urgently move towards the construction of a new world energy order based on renewable energy and on the hydrogen economy, simultaneously with energy preservation. If we do not achieve this, we face the risk of a second Great 2 Depression, high military tension, and the prospect of big wars.

Because statements such as this cannot be taken lightly by any means, we do not have any other choice other than to become well-acquainted with oil and its uses; the reserves at the world scale; the means of producing them; its market and likely substitutes in the hydrocarbon family, nuclear, and the ecologically-friendly renewable sorts; the 2

See Meacher, Michael: ―Urgent Action needed to avert looming oil wars‖, Financial Times, London, UK, September 4, 2006.

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Introduction

xvii

nonconventional reserves; as well as the world‘s capacity for supplying, managing, producing and distributing them fairly in order to satisfy its unquenchable thirst. We also need to understand what‘s happening on the demand side and how we can economically manage a slowdown of oil consumption to stretch its usefulness along the years until the adequate mixture of substitutes is ready. This will take the rewriting of some concepts economists have held as tautological truths for a very long time. This book will argue that, luckily, total catastrophe need not be the only scenario, although it will fall in the likely worst possible range unless four conditions play out in a well-planned and synchronized fashion to build the time and space for the transition paths towards a fossil-free renewable and ecology friendly society. The first two conditions concern the supply side of the balance equation, the third condition falls onto the demand side, while the fourth is the equilibrium determinant that bonds them all together. The first is that the nonconventional petroleum reserves need to be aggressively developed with cutting-edge technology in drilling, mining, upgrading and refining. Nearly all of the gloomy peak oil scenarios only count the conventional easily-proven oil reserves. The second, also from the supply side, regards the now incipient and marginal renewable energy sources that need also to be very aggressively researched and developed in mass and scale while keeping a sharp eye on the nagging but legitimate environmental issues. The third, from the demand side, concerns the economists, all of whom have, so far, been largely left on the sidelines as neutral partners in this hellish struggle but who need to be brought aggressively into the game to help draft consciously planned macro-blueprints of internationally ranging policies that are necessary to control and reduce the economic growth of nations in order to slow energy demand and preclude a worldwide depression while, simultaneously, buying the time necessary for the natural scientists to pave out the transition paths toward a fossil-free and renewable fuel society. Economists not only need to be educated on energy matters to be brought to the same page as scientists, but the very framework on which they base their policy decisions needs to be reinstated, and this will be done in the Conclusions of this book. The fourth and final factor, the one that glues together the other three, concerns the politicians, as the elected officials of their countries, who need to round up the political will to make all of this happen and prevent the worst possible scenario described above. But politicians depend upon the will of their constituents, and for them to garner their support they need to come forward and inform the people of the complex nature of this problem. Any politician who does not provide his or her constituents with relevant but painful information for fear of short-term backlash is guilty of underestimating their intelligence and resolve capacity but also of dangerously misleading them, their offspring, and their foreign neighbors to potentially catastrophic consequences. Before the advent of the eminent depletion of this marvelous fluid, and not being ready to defend ourselves with substitutes that can be scaled and started up en masse for the eight billion people who will be wandering the planet when the last oil barrel is extracted, those of us who truly believe ourselves to be responsible economists have no other choice than to reconsider long-held and standard economic models and methodology, and to coordinate the international economic policies with the sole objective of buying precious time by minimizing world economic growth until the sciences can develop all the transition paths that we can count on.

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That is, the only and greatest contribution that the professionals of the ―dismal science‖ can make as part of the solution to this all-encompassing, overwhelming and potentially catastrophic problem is to draw up a comprehensive and practicable blueprint, or economic plan, that ensures minimal economic growth but saves up enough hydrocarbons until the scientists are able to progressively substitute them with ecologically-friendly, costcompetitive, scalable and massive renewable energy sources. This book proposes the principal guidelines for such a comprehensive economic plan.

FACTS ARE FACTS The writing of the General Theory in the early 1930s was a struggle to escape from habitual modes of thought and expression…a struggle made more difficult because I myself held with conviction for many years the theories which I now attack. —John Maynard Keynes

In order to quantify the economic sacrifices that the world will have to face, we have to develop first the probable future production profiles of the three countries that are known to still dispose of large semi-conventional and nonconventional oil reserves to later merge them with some simulations of global oil supply/demand. Based on the results of this exercise, we can then recommend the strategies that are needed to slow down the world oil demand while the large investments that are going to lay down the transition paths toward renewable and environmental energies speed up. The principal facts that we are going to reveal throughout this book and which are going to be used as the vital underpinnings for the development of the blueprint strategy of economic growth are the following:

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Oil has been the most fundamental natural resource of mankind since the beginning of the twentieth century until our days; it is the resource responsible for the quantum leap of our technology, civilization, agriculture and industry, as well as for our prosperity and living standards. It is the precondition for the massive production of all other mineral commodities and agriculture. Oil will continue to be the main energy source of the planet in the foreseeable future, particularly in the transportation sector, especially in the developing countries, and above all in the extra populous nations. Today, oil moves over $4 trillion per year in the world, larger than the gross domestic product of France and Spain together. Globalization, as a natural evolution for capitalism, has led to a structural change in the world energy equilibrium. It has also led to the awakening of the energy demand from extra populous countries. Oil is exhaustible, non-renewable and can only be replaced in the long term. Its largest conventional reserves belong to the OPEC countries. According to projections made by experts, by 2030 there will be more than eight billion souls in the world, and the gross domestic product will be double what it is now, which will increase energy demand by 50% over the current demand. Between 60% and 80% of the increase in oil demand projected by 2030 will come from developing countries.

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xix

According to the same projections, by 2030, fossil resources will represent 80% of all the energy consumed at that time. Oil and gas will make up 60% of all the energy supplied in 2030. Conventional oil reserves are not enough to satisfy even the most conservative projections of world oil demand in the mid term. Notwithstanding the fact that modern civilization was constructed over the pillars of cheap oil, it is safe to say that the era of inexpensive oil is over. Economic philosophy and political science are conceptually far apart from the natural physical sciences in knowledge, as well as in time consideration. Time in the oil industry is measured in decades, not in quarter years. Oil and gas are businesses that have to be planned and are carried out in the long term. The largest nonconventional oil reserves known today are found in Venezuela, Canada and the United States, in that order. The recent discoveries made in the Gulf of Mèxico and Brazil are too recent to be quantified. Both are ultradeep fields that lie below huge accumulations of salt (pre salt) and which development, although promising, pushes the limits of technology in accesing, drilling and moving. Some analyst think that these discoveries, although very good for the region/countries involved, may have negligible impact given the length of time it will take its development and the rate of depletion of exising fields. Others think that it may be the opening of a new oil frontier with unlimited potential. Both agree that it will take a long time to know and more to time to develop them. The development of nonconventional oil reserves takes far more time and consumes far more resources, including financial, than conventional reserves, mainly due to the type of crude and to the complex production and refining techniques. Nonconventional oil reserves could temporarily relieve the energy problem if they are developed now. They have the potential of buying the world somewhere between years and decades of oil time if they are developed now. To comply with the previous item, there are several ingredients that are necessary in huge proportions in the hydrocarbons chain value: reserves, investments, financial leverage, juridical security, peace, safety, high prices, infrastructure, qualified human capital, cooperation between stakeholders, best of relationships between producing and consuming countries, technological ingenuity, tenacity, luck and human patience. The alternatives to hydrocarbons, exhaustible as well as renewable, will be ready in a mixture to substitute oil en masse only in the long term. Several of these are in the laboratories or in the incipient stages and comprise a variety of technical, financial, scale and environmental challenges that will not be solvable for many years. None of these alternatives will be capable, by themselves, of replacing oil. But all of them, together, do have that potential to replace oil with the benefit of improvements in environmental pollution. Until the transition paths toward new renewable energy sources can be built massively, it will be the oil supply, measured by availability and economic cost, that will determine oil demand and, through it, oil supply also will determine economic growth in all countries of the world. That is, for the first time ever, it is the economist/politician who will be taking his or her cue from the scientists, not the

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•

other way around as it has always been; i.e., the market will be at the order of the scientists until the transition paths are completed. To accommodate this role reversal and paradigm shift, economists must make adjustments in their long-held economic thinking and methodology to affect their framework in policy prescription. Economists must realize that qualitative changes and paradigm shifts in the world must also affect their perspectives and reasoning. Economists must be willing to consider a rewriting of their monetary equation of exchange, its most important mathematical equation, as proposed in this book. The world will have to make sacrifices to slow down the speed of its economic growth in order to buy scientists the time needed to develop alternate energy sources. The longer we wait to make those sacrifices, the greater those sacrifices will be. Last, if we fail in establishing the transition paths toward renewable energy sources in a massive manner, there will be devastating and serious consequences that will affect the great majority of societies in the world in ways that are simply unimaginable.

Consider this simple calculation that coincides with the quote of the former British minister: According to the projections of the most specialized agencies—OPEC, the International Energy Agency and the U.S. Energy Information Administration, as well as the most renowned oil companies like Chevron, Total and Exxon Mobile—by the year 2030, the planet will demand between 105 (slow economic growth) and 120 million barrels (strong growth) of oil daily, or a conservative 1.4% annual increase in its demand. Upon writing these lines, the world consumption is approximately 86 million barrels daily, which means that we need to add to this planet around 30–33 million barrels daily in the next quarter of a century, which is around what all of OPEC produces today. Knowing that Saudi Arabia is the largest world oil producer, with about 10 million barrels a day with a plan to increase it to 12 MBD, this means that we are talking about finding something like three new Saudi Arabias to satisfy us and our children then. But this is not the end of the calculation. If we add the factor that the reserve base is depleting at a rate between 5% and 7% annually, then we are speaking of, at least, eight Saudi Arabias by the year 2030!

THE COMPLETION OF THE OIL ERA I do not think that economics is going to change, I think that it should change . . . We need empirical work that really changes the way in which we see the problems. —Ronald Coase, Nobel Prize Laureate in Economics

This book is divided into seven chapters, plus the Conclusions, and they all aim toward the following objectives: to investigate how much conventional and nonconventional oil is left in the world in quantitative terms, then to examine all the different alternate energy sources and find out their different development stages, inform economists so they too can help out, and then to bring together the different economic growth scenarios to find out, by considering world demand, how much oil is left in the world in qualitative terms—that is to say, how much time we economists/politicians can buy the scientists for their development of the transition paths toward renewable energy sources with a minimum of economic and social

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Introduction

xxi

repercussions. In the last chapter, multilateral negotiating insights are provided through game theory. In the conclusions, a long-standing economic equation is rewritten in energy terms, a blueprint scenario is unveiled and a strategy is proposed to accomplish this all-important objective. As we will see, to reach these objectives, we need to develop a specific plan in the production profiles of the three countries that still dispose of nonconventional reserves— Venezuela, Canada, and the United States. In spite of the possibility that there are other countries that might dispose of reserves that have not been discovered yet, as it is the case in the ultra-deep waters of the Gulf of Mexico and Brazil, Africa, the Caspian waters, China and Russia, for example, these cannot be included in our study due to reasons that we will explain further on. Having at hand the results of these simulations, the economic strategy will be suggested in the Conclusions, a strategy that will have to be followed by the world during the next decades with the purpose of buying the time needed by scientists to lay down the transition paths toward renewable energy sources. This economic strategy, as will be seen, is on a world scale and resembles another economic strategy, envisaged for an entirely different purpose, and applied with great success. The failure of this strategy or other similar strategies is not an option that we can contemplate calmly. As an appetizer to the first chapter, which briefly describes the importance of hydrocarbons in the life of the modern man—known to some as ―The Hydrocarbon Man‖—it is wise, to put it in the right context, to open up a window to the past and observe how life was before oil came about; that is to say, how the grandparents of our grandparents lived. This passage is narrated here eruditely by the Argentine sociologist and author, Dr. Carlos Sabino, who also wrote the Prologue of my first book. A not small purpose of this book is to make sure that this window to the past remains in the annals of history and completely shut for the future of humanity. The abundant archeological testimonies available clearly demonstrate the absolute lack of material goods of our ancestors, who always lived in prudent administration that just barely provided a means for living, hounded by hunger and illness, by plunderers and natural disasters. The historical and literary information available reminds us that the majority of the people lived in a rural environment, working, in the majority of cases, at agricultural tasks, in almost all of the countries in the world. In the cities, with few paved streets and electrical lighting just starting to be introduced, were large numbers of vehicles pulled by animals. Horses with majestic height or exhausted by work pulled elegant cars or brokendown load transportation, almost always in a noisy and unhygienic manner. Work for most people was repetitive and dehumanizing. In the field, whenever possible, animal force was used to pull simple agricultural instruments and everywhere tasks demanded, in general, a strong physical force, prematurely wearing down workers. The same was happening with household chores: women washed their clothes by hand, they used a large amount of time preparing and cooking meals—in coal kitchens—and sewed, with some exceptions, by the classical system of a thimble and a needle. Food, and we can state this without fear of exaggeration, was a true obsession. Even though the majority of the people worked in agriculture, food was not abundant and was relatively expensive: a good proportion of the income of the salaried people had to be spent on food and in times of crisis there was little left to dedicate to other consumptions. Without radio or television, with no movie theaters, or cafeterias or restaurants that could be affordable for the poor, life for most people was monotonous, precarious, and always subject to multiple illnesses and accidents. Almost all technological and practical innovations have been produced in the last century and a half; almost all revolutionary transformations in our style and life conditions are centered in the last one hundred and fifty years or two hundred years. Before antiquity until, approximately, half of the eighteenth century, there were scarce variations in living conditions—and that is a fact—that managed to produce cumulative effects with the passage of time. (Now) our world has radically changed in a number of ways, it is true, but economic changes have been in the background of many other civil, political, military and international relationship transformations. We live, as

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Carlos A. Rossi was once said by the great philosopher more than seventy years ago (the Spaniard José Ortega y Gasset), in the era of the masses, in a time where a normal man or woman enjoys the possibilities that were traditionally reserved for the nobility and the powerful, where our life, as a repertoire of possibilities, is magnificent, 

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exuberant, and better in quality than the ones ever historically known.



Sabino, Carlos. Desarrollo y calidad de vida. Cedice. Panapo. Caracas, 2001, pp. 17–23. Also look into the chronicles of the late economist from the United States, Julian L. Simon, The State of Humanity, Blackwell, Oxford, U.K, 1995. Finally, a reference to the master work from José Ortega y Gasset, La rebellion de las masas, Alianza ED., Madrid, Spain, 1992, p. 92.

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PROLOGUE I am highly honored by the request from Dr. Carlos A. Rossi to write the Prologue for this book that, besides the significance that it holds for its author, has allowed me to search more deeply into a group of splendidly-structured ideas that I have had the opportunity to discuss on some occasions, but that now, with the opportunity to review them in such a logical and sequential manner, makes me comprehend in a much more understandable approach the tendency that the use of petroleum has in this generation of humanity. The use of petroleum as the most important energy source for this generation, and the unavoidable truth that new alternative sources of energy are not likely to appear that can vie in economic, efficiency, scale and safety terms in the operations and environmental impact that is being progressively controlled, is analyzed in detail by the author, leading us to the conclusion that we have a pressing need to succeed at winning precious time in order to lay the bridges for alternative energy sources that can guarantee the welfare of the people for the coming centuries. It is exactly here where this book makes its greatest contribution for energy experts worldwide, and it comprises the very realistic and pragmatic approach of the current supply and demand balance scenarios, and the immediate perspective that these scenarios represent, which reveal Venezuela as a country of first-order strategic importance and relevance for the world energy equilibrium in this century. At this point, I would precisely like to highlight the importance that the Oil Sowing Plan represents to Venezuela and to the world, whereby two vital projects have been started for the future of world energy: the Magna Reserva Project and the Delta Caribe Project. The former, due to the importance of quantifying and certifying the current reserves volume in the 27 most important blocks of the Orinoco Oil Belt, will allow us to limit the areas required to develop the extra-heavy oil enhancement projects, carried out to fit the specific existing refineries or refineries to be built. These projects shall require large volumes of gas that can allow a larger oil recovery from the reservoirs, as well as the necessary amount for adequately hydro-treating the enhancement processes that improve the oil quality to the required specifications. The Delta Caribe Project will generate the required gas volumes for the efficient development of heavy oils of the Orinoco Oil Belt, and both projects must necessarily be developed simultaneously in order for the gas volumes to be present at the convenient time and amount for the Oil Belt Projects. Venezuela‘s sovereign decision and the importance that President Hugo Chavez has granted to these projects stands out when the relentless pages of this book are read, in which it

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xxiv

Carlos A. Rossi

is manifested that Venezuela represents the largest oil reserve that any country can have and can place it in the market in a framework of time, space and at costs that are highly competitive. We cannot stop thinking that, before 1998, there was a denationalizing oil strategy that minimized and even undervalued the real worth of this natural resource, which meant continuing to feed economies that wasted non-renewable resources, undoubtedly leading us to a confrontation of catastrophic dimensions. Carlos shows, in a clear and simple form, a series of graphs and charts that allow us to evaluate future scenarios with a reasonable degree of reliability and logic, from which he allows himself to prepare a number of recommendations to be followed to take advantage of the valuable time required before the conversion to alternative energy sources, so vitally needed by the population worldwide. It is here where I would like to emphasize the importance that oil, in the worldwide dilemma we face at the moment, be used as a final variable to compensate for world poverty and contribute to a better and fairer distribution of wealth. It is here, once again, where the oil policy initiated by the Venezuelan Government could not agree more with the studies now being carried out in which government companies from emergent economies—which are going to have more needs from the oil belt—take part in the reserve certification and quantification studies with the purpose that the development plans to be designed are as realistic and as close to the geologic characteristics of each area as they can be. When an author writes a book, it is treated like another child into whom ideas have been drained, hopes outlined and actions recommended. When Carlos gave me the honor of being one of the first people to know about it, to value it, and to learn from it, this humble servant was captivated by this excellent piece of investigation that will surely be of great use for oil policies that are being implemented at a national and international level. From the moment that I met Carlos a number of years ago, I could sense his deep mental sharpness that made him look farther away from the traditional simple answers to the questions that we asked ourselves. I consider this book a masterpiece of reflection and analysis that will be a sound reference in the years to come. Eulogio Del Pino, President of the Corporacion Venezolana de Petróleo CVP. Vice President of Exploration and Production of Petroleos de Venezuela

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Chapter 1

THE DETERMINING FACTOR OF OUR CENTURY The world‘s economy has been driven by an abundant supply of cheap oil-based energy for the best part of this century. The coming oil crisis will accordingly be an economic and political discontinuity of historic proportions, as the world adjusts to a new energy environment.

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—Collin Campbell

There are three factual truths about the XX century. The first one is that there was never in the history of mankind a century as productive and as booming in all of the industrial and technological aspects, even though it has not always been in the most desirable manner. In the XX century, a quantum exponential leap was taken in man‘s performance, excelling by far all other centuries even if we combined them together. If we could awake any person that never had the privilege of living in this century, let‘s say Copernicus, Da Vinci, Darwin, Franklin, Lincoln, Mozart, Bolívar, Newton or Socrates, and bring them to observe the world at the birth of the XXI century, they would not recognize anything in the planet that they had left, and they could all avow that they had crossed into the haze of the other world. The second truth is that this growth in the scientific, industrial and technological arenas has managed to spread until reaching and helping to elevate the living standards of the greater part of the world‘s population. A lot of this had a close relationship with the market economic system, since it managed the production best practices and, at the same time, it also managed to include acceptable distribution practices. Opposite to other economic systems, before and after, the market system is known for having provided most of the non winner plenty, enough to also increase expectations and prosperity. Today, without fear of exaggeration, the expansion of the middle classes of most countries has the benefit of health, work, productivity, entertainment, culture, longevity, style, transportation, information, communication, cooperation, education and infant mortality indicators that European royalty from olden times could never have dreamed of. The third and final truth is that the first truth, as well as the second, happened to a great extent due to the existence of petroleum. 1 1

The word petroleum literally means, ―stone‘s oil.‖ It is formed out of organic fossil materials (animal, vegetable, microbes) that are deeply buried under the ground in sedimentary layers formed millions of years ago; some geologists put it as far back as the Paleozoic era over 250 million years ago—long before the dinosaurs roamed the planet. During this long period and beyond perceivable time, this organic material transforms itself, due to heat and pressure, into the liquid oil viscous material. Since it is lighter than water, it moves

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Carlos A. Rossi

2

Although it is undeniable that none of the above came either reasonably or evenly distributed, as wars, invasions, hunger and the breakout of new diseases plus population explosion and environmental degradation all occurred and continue to abuse the emergency agenda of this young millennium, the fact remains that the transformation that oil accomplished for the inhabitants of this planet is complete. This is because to draw a list of the products that use oil as their basic input, is the almost same as drawing a list of the inventions of the XX century. It is almost impossible to think of a world without oil and without the freedom and the field of action, knowledge and science that has provided us the availability, use and management of this basic spring.2

The Power of Oil ‘If one could devine the nature of the economic forces in the world, one could fortell the future’’ Robert L. Heilbroner One must consider these facts to gauge the impact fossil energy has on our economics and daily lives: 

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

2

Transportation: About 55% of oil goes to power the world‘s autos, trucks, airplanes, trains and ships, together numbering some 600 million. For many types of transportation—including cars, trucks and airplanes—there are few realistic alternatives to oil. Today the world depends on oil in the form of gasoline, diesel and kerosene for more than 95% of its transportation energy needs. Food: It‘s estimated that people in the industrial world consume about 10 calories of fossil fuel for every calorie they eat. Oil powers the tractors on the farm and the trucks that ship crops and livestock to market. It runs factories that turn farm products into package goods. Fertilizers and herbicides are oil and gas based. Without these fossil fuel ‗inputs‘, farm yields could drop 50% or more, experts say.

upward of ground water, filling the porous rocks until filling an impermeable layer where the pores are too small to soak through the oil drops. Geologists call these oil traps, or reservoirs, where oil remains trapped until it is found through seismic waves and it is drilled. Other times, traps are not found and oil manages to migrate towards the surface forming lagoons, where even the Chinese philosopher Confucius, 600 B.C., made references to it. Some other times, it gets dissolved in the sands, as in the Alberta providence in Canada and other places, where it has to be mined and separated at a considerable financial, energetic and ecologic cost. Still other times it migrates farther from its original formation, as could be the case of the Orinoco Oil Belt of Venezuela, dragging in its pathway mineral waste and sulphur which reduces its quality, and makes it heavy and extra-heavy. That makes it more costly to extract and refine but technology has made possible its commercial production. In other cases, the underground temperature and pressure are so hot and high that oil becomes gaseous, with characteristics and uses similar to oil, but with complex handling and transporting treatments. In my Petroleum Economics class, I defied my students to imagine their world without oil. The youngest reminded me of the Hollywood movie, Gladiator,and the Venezuelan movie, Miranda. The oldest students reminded me of the 1970s TV series, ―Little House on the Prairie.‘‘

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The Determining Factor of Our Century 



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

3

Energy Sources:3 Roughly 35% of the world‘s energy comes from oil, and more than 80% comes from fossil fuel (oil, natural gas, and coal). The remaining 19% come from biomass, hydroelectric, nuclear and other renewable. Electricity and Heat: Roughly 70% of electrical power in the U.S. comes from fossil fuels—49% if which is coal, 20% natural gas and 1.6% oil. Nuclear energy provides 19.4% and hydroelectric and renewables the rest. Chemicals and Plastics: Modern life wouldn‘t be the same without the wealth of petroleum byproducts like: feedstock for plastics, drugs, detergents, synthetic rubber and fibers; asphalt for roads, airfields, shingles and floor coverings, solvents for paints, lacquers, and inks; lubricating oils and grease for engines and other machinery; petroleum wax and paraffin for candy making, packaging, candles, matches, and polishes4.

It is common knowledge that oil is used in land, aerial, and sea transportation, for the temperature of our homes and in the generation of our industrial, manufacturing and agricultural activities. It is also widely known that it is the most important element in the chemical and electrical industries. Oil is present in a highly diverse and volumetric myriad of end products that we see and use on a daily basis, and to certify this issue, we should just place ourselves in the middle of our homes and look around us. The energy, the machines and the tools that we use to process our food, microwaves, refrigerators, and stoves use and are made to a large extent from oil; also, the great majority of our entertainment devices, such as CDs, DVDs, cell phones, computers and video games, iPods, TV parts, are all made of plastic, whose base is oil, and are energized with oil and gas that, like oil, is also a hydrocarbon and therefore an oil derivative. Plastics are also present in several products that we see and use every day, as are all the products manufactured in the gigantic toy industries, and the ones related to medicine—and in all cases due to the same reasons: cost, durability, flexibility, versatility, water resistance and many chemicals, ease to manufacture and transport and for its ability for being adequately sterilized. Oil is also present as the main base of many products that we find in our markets and drugstores, as are bottled water, lipstick, aspirin, antiseptics, detergents, paint resins, deodorants, tooth paste and tooth brushes, vitamin capsules, nail polish, perfumes, key boards, pens, chips, records, glasses and contact lenses, earphones, crayons, boats, shampoo, handbags, cortisone, umbrellas, Scotch tape, rubber bands, guitars, shaving cream, tennis racquets, golf balls, candles, movies, insecticides, plates and glasses, helmets, disposable diapers, glue, car parts, electric tape, credit cards, heart valves, synthetic fiber, pillows, curtains, suitcases, pajamas, ink, synthetic tires, garbage bags, combs, telephones, etc. The synthetic textiles that go from polyester down to the sole of tennis shoes also have oil as their basic input. As it was duly stated by the American environmentalist Bill Mc Kibben: On top of everything else, the never-ending growth of the economy is built based on inexpensive fossil fuel … Coal, oil and natural gas were and still are, miraculous … they are compact, easy to transport, replete with BTUs and inexpensive … Precisely the same fuels that helped us grow are now threatening our 5 civilization. 3

Figures represent Total Primary Energy Supply for the year 2006 from IEA‘s Key World Energy Statistics, 2008 From the Asociation for the Study of Peak Oil (ASPO), ASPO-USA, 2009 5 McKibben, Bill. ―A Deeper Shade of Green,‖ National Geographic. Vol. 210, No 2, August 2006. 4

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Richard Barnett (1929–2004), in his book, The Lean Years: Politics of Scarcity,6 wrote that to produce one ton of copper requires 17.8 barrels of oil and one ton of aluminum requires 20 times more. Since all the electric industry depends on these two metals, the importance of hydrocarbons in our lives is not possible to exaggerate. Today, 80% of the energy of the world comes from the so-called fossil fuels, and oil is by far the most important one. In farms, products based on oil and gas are also responsible for the dramatic increase in agricultural productivity and the main reason that so many people can live in the urban mega cities of the world. The very robust fertilizers and pesticides, as well as the fuel that ignites the tractors and transportation trucks and makes irrigation possible in remote areas, are based on hydrocarbons. In fact, oil exists along the entire food chain; from the basic treatment of the soil through the manufacturing of the utensils we cut our food with down to the disposal and hygienic treatment of our human waste. From the fertilizers that nurture the land and transform the harvest in size, variety, abundance and speed, up to the pesticides that control the spread of insects and microorganisms, going through the whole range of machines and agricultural equipment that are manufactured using oil and are energized with oil, up to the elements that we use for its storage, packing, transport, cooling, heating and consumption in the urban markets. The DNA of oil and gas is in each one of the chain links of this value chain. For example, in the United States, a country well known for its agricultural production, between 1900 and 1998, the average corn grains per acre increased from 29 to 134, and this was all due to oil and gas.7

ROBERT MALTHUS (1766–1834)

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The constant tendency manifested in all living species to reproduce faster than the time needed to grow the food they need . . . is a natural law. —Robert Malthus, 1798

In 1798, Robert Malthus, the famous Anglican minister, English economist and father of demography, whom all of the economists of later generations have been taught to scorn, predicted that the population growth eventually would collapse the world production of food, since while the latter grew in arithmetically, population grew geometrically. Malthus‘s pessimism did not count on the shrewdness of the technology and the productivity of the centuries to come, and above all, the Green Revolution in the midst of the XX century, which allowed speeding up the production of food and therefore population increase. But this miracle was only possible due to the low prices and abundance of oil. Today we are facing the harsh reality that the principal physical limit to the increase in humankind is the access to inexpensive and abundant energy. Without it, the organization and performance of an industrial society is just not possible. The inexpensive energy of the XX century came from hydrocarbons, mainly oil and gas, accumulated forms of energy transformed millions of years ago into fossil materials. These amounts of reserves of fossil fuel have a physical limit (which is something that we economists do not calculate) and given the astonishing increase of the 6

7

See Barnet (1980), p. 118. See EROEI.com. The energy chain, 2006. Also see Cleveland, Cutler, ―Biophysical Economics: Historical Perspective and Current Research Trends‘‘; Ecological Modeling 38, Sept. 1987.

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population in the world and the pressure of their material necessities upon fixed commodities, this resource is depleting and, at the same time, we are damaging the environment. Cheap and abundant oil is the force that keeps present society as we know it. If oil becomes scarce and its price increases geometrically we can say good-bye to what we know as civilization and, at least we economists, would have to make a formal apology to that chatterer Malthus. In Figure 1, we can see the use of world liquids (petroleum) by end sectors and its reference case projections as made by the Energy Information Administration‘s International Energy Outlook 20088.

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Soueces: 2005: Energy Information Administration (EIA), International Energy Annual 2005 (JuneOctober 2007), web site www.eia.doe.gov/iea. Projections: EIA, World Energy Projections Plus (2008). Figure 1. World Liquids Consumption by End-Use Sector, 2005-2030.

Oil also has a direct influence in the improvements in the arts, education and sciences because it has helped people to have more free time, time that they used for making meals, clothing and houses. With its impact in energy, it has also given us time to be intellectually productive at late night hours. To give a simple example, take into consideration what the ancestors of our grandparents had to do 150 years ago in order to prepare a hot bath. First they had to chop wood with an ax, then make a fire, take out water from the spring, warm it up, pour it into the bathtub and take a bath; something they did very infrequently during the winter months; royalty included. Today that activity does not take more than 10 minutes. But it is in the transportation industry where oil and its derivative products have achieved a higher impact, especially in the automobile industry, as well as in the maritime and air industry, all of them managed to reduce time between distances and connecting civilizations and cultures on our blue planet. The transportation industry uses up to 52% of the liquid fuel and it is expected to increase to 58% in 2030 (EIA), and it is in that industry where the best scientists are making efforts to reduce its use by increasing its efficiency and substitution. 8

The reference case scenario reflects a scenario where current laws and policies remain unchanged throughout the whole projection period.

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GREEN OR BLACK REVOLUTION? You cause the grass to grow for the cattle: And all green things for the servants of mankind. You bring food out of the earth: and wine that makes glad the heart of man, oil to give him a shining countenance; and bread to strengthen his heart. —The Bible (Psalm 104)

Source: U.S. Census Bureau.

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Figure 2. World Population Billions.

It is not easy to conceive the idea that in the 1850s the world had a population of barely 1.3 billion people, which is equivalent only to the entire population of China today. It is also hard to swallow that it took roughly 17 centuries from the time of Jesus Christ for the world‘s population to double. We know now that the lack of energy had constrained the growth of population. From the 1850s to the industrial era that this hydrocarbon fostered, the world population has increased by a factor of five and 2008 ends with more than 6.7 billion inhabitants. According to the U.S. Census Bureau projections, by the year 2030, there will be 8.2 billion people, with an approximate increase of 67 million people every year. That‘s equivalent to a new Iran every year. Consider the following facts about agriculture‘s reliance on crude oil9: •

•

•

9

Commercial food production is oil powered. Most pesticides are petroleum- (oil) based, and all commercial fertilizers are ammonia-based. Ammonia is produced from natural gas. Virtually all of the processes in the modern food system are now dependent upon this finite resource, which is nearing its depletion phase. Oil-based agriculture is primarily responsible for the world's population exploding from 1.3 billion at the middle of the 19th century to 6.6 billion today. As oil production went up, so did food production. As food production went up, so did the population. As the population went up, the demand for food went up, which increased the demand for oil. Oil allowed for farming implements such as tractors, food storage systems such as refrigerators, and food transport systems such as trucks.

Church, Norman., ―Why Our Food Is So Dependent on Oil,‖ Energy Bulletin, April 1, 2005

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The Determining Factor of Our Century •

•

• •

•

•

•

7

The modern, commercial agricultural miracle that feeds all of us, and much of the rest of the world, is completely dependent on the flow, processing and distribution of oil, and technonogy is critical to maintaining that flow. Oil refined for gasoline and diesel is critical to run the tractors, combines and other farm vehicles and equipment that plant, spray the herbicides and pesticides, and harvest/transport food and seed. Food processors rely on the just-in-time (gasoline-based) delivery of fresh or refrigerated food. Food processors rely on the production and delivery of food additives, including vitamins and minerals, emulsifiers, preservatives, colouring agents, etc. Many are oil-based. Delivery is oil-based. Food processors also rely on the production and delivery of boxes, metal cans, printed paper labels, plastic trays, cellophane for microwave/convenience foods, glass jars, plastic and metal lids with sealing compounds. Many of these are essentially oil-based. Delivery of finished food products to distribution centres in refrigerated trucks. Oilbased, daily, just-in-time shipment of food to grocery stores, restaurants, hospitals, schools, etc., all oil-based; customer drives to grocery store to shop for supplies, often several times a week. Oil is also largely responsible for the advances in medicine that have been made in the last 150 years. Oil allowed for the mass production of pharmaceutical drugs, and the development of health care infrastructure such as hospitals, ambulances, roads, etc.

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The following quote from The Wilderness Publication by Dr. Dale Allen Pfeiffer is revealing. Between 1950 and 1984, as the Green Revolution transformed agriculture around the globe, world grain production increased by 250%.4 That is a tremendous increase in the amount of food energy available for human consumption. This additional energy did not come from an increase in incipient sunlight, nor did it result from introducing agriculture to new vistas of land. The energy for the Green Revolution was provided by fossil 10

fuels in the form of fertilizers (natural gas), pesticides (oil), and hydrocarbon fueled irrigation.

Geologist Colin Campbell, founder of the Association for the Study of Peak Oil (ASPO) lucidly wrote, ―If it (modern agriculture) can be defined as the transformation of oil into food…Money can be defined as the license to use energy.‖11 We must delve more deeply into the belly of the Hydrocarbon Man.

THE HYDROCARBON MAN Life derives the whole of its physical energy or power not from anything self-contained in living matter and still less from an external deity, but solely from the inanimate world. It is dependent for all the necessities of its physical continuance upon the principles of the steam engine. The principles and ethics of all human conventions must not run counter to those of thermodynamics. —Frederick Soddy, Nobel Laureate in Chemistry 10 11

Pfeiffer, D.A. ―Eating Fossil Fuels,‖ The Wilderness Publication, 2004 See Dr. Campbell inaugural presentation to ASPO 5th International Conference in San Rossore, Italy, 18th-19th, 2006

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Not unlike other animal species—from insects to rodents and fish, where the multiplication of species is closely related with the availability of the most basic support, especially food—the Hydrocarbon Man multiplies himself at a higher speed to the extent that his welfare, or the expectation of this welfare, improves. The availability of oil made the productivity of the land increase at a quantum leap, making it possible for a large number of people to migrate to the cities and for an absolute launch of the manufacturing industry, whose childlike beginnings had been already energized, even though in a limited manner, by coal. Given the immense usefulness that the human brain found and the prosperity that it brought, the world population took off in geometrical assortments in almost all the regions of the planet, until other economic, cultural and historical factors brought the demographic growth to stabilize in the principal OECD countries, but not so in some of the lowest income countries12. According to the United Nations Population Fund, 2010 will mark the first year in human history where the world‘s urban population will exceed its rural population. By 2030 the projections are that the urbanites of the planet will be about 60% of the total population of about 5 billion city dwellers13. China itself is adding 10 million city folks every year. The following quote, from a specialized Web site in the history of energy, summarizes it as follows:

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The industrial revolution, energized from the use of coal and its products, changed the ways in which mankind worked and lived. However, the use of oil, natural gas, and their products by the modern man, changed the human being in such a comprehensive manner that generated a sub-group of human beings called 14 ―Hydrocarbon Man‖: the human being that depends on oil for its survival.

The era of the Hydrocarbon Man is the civilization of the capitalist industrial man, where freedom of speech, creativity and productivity could take off collectively with the availability of inexpensive and massive quantities of oil, achieving success for the business ambition of large markets, open and competitive, with honest and democratic governments that would emphasize juridical security, fair play and the education of their citizens. But other countries and regions that did not opt for an ideal mixture of these variables, failed. This is the history since mid XIX century until the end of the XX century, this last century being the most productive and flourishing that humankind has ever known.

REWIND TO ANTIQUITY? By 2050, the world‘s population will rise to 10 billion, and energy demand will rise to between 30 terawatts and 60 terawatts (450 million to 900 million barrels of oil a day), according to United Nations data. Unfortunately, oil production will likely peak by 2020 and start declining. Without a change, developing countries will ultimately be left in the dark, and developed countries will struggle to keep the lights on. Conflict is inevitable…My guess is that this won‘t become a big issue unless there is a thalidomide event. We will have to see in the rear-view mirror that we are past the peak in worldwide oil production. —Richard Smallery, Nobel Laureate in Chemistry, 1996 12

Here is where the reverent Malthus erred. He believed the exact opposite would occur, that it would be the wealthy that would have the most offspring. But in this case the order of the factors doesn‘t matter. Or do they? 13 See the United Nations World Population Fund Report, 2007 14 See EROEL.com: The Energy Chain, 05-31-2006.

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Beginning the XXI century, the state of affairs threatens to turn the history clock thanks to pressure from a quadruple of factors. First because oil is finite, it can not be renewed and becomes depleted; second, because of the overpopulation pressure, especially in the developing countries, the oil depletion rate has increased to such a point that it can be stated that the rise in its price has and will have severe consequences for all human prosperity. Third, as we will see in chapter 3, alternate energy sources are not yet ready to be massively used, a large number of them are still in the laboratories with environmental, technical, financial and physical scale challenges; they all depend on the high oil prices and, at best, its massive use will be established in the long term. Finally, the human being, overwhelmed by these three factors, and with no reference as how to react to them, on some occasions has decided to pursue a radical nationalism, that when taken to the extreme, could endanger the whole situation, creating damages that could be irreparable. As expected, there is a close relationship between energy use per capita and the human/social development of a country, as the next graph from the United Nations shows.15

Source: United Nations Programme, Human Development Report 2001 (New York: Oxford University Press, 2001). Figure 3. Relationship between Energy Consumption and Economic Development.

15

See United Nations (2004)

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Carlos A. Rossi

The most notable example of that is none other than the United States. This country, with a GDP over US$ 13 trillion, which leads the world by far, manages 200 million automobiles and consumes 20.5 million of barrels of oil daily (more than 7.5 billion annually) or 25% of the world total. At a world level, according to the American Petroleum Institute,16 oil has been the fuel that has been developed to its largest extent. In 1950 oil accounted for 25% of the energy use on the planet, and today the number is 60% or nearly 30.7 billion barrels annually that are being consumed, largely, in over 700 million automobiles that exist in the world. Oil has added hours and energy to the day, it has multiplied the population and the years that we are living, the distances that we travel, the people that we meet, the freedom that we enjoy, as well as our health, safety and living standard, urban planning, the quality and quantity of our food, our education and culture, work, entertainment and has greatly increased the variety of available products that we can consume. Truly, there is no other product in the world—other than air, water and land—that has proven to be more useful for the human race and so accountable for its welfare, as oil and its derivatives. I finish this chapter with a quote from the president of Cambridge Energy Research (CERA), Daniel Yergin, who, in his Pulitzer-Prize-winning book, The Prize, anointed twentieth-century man the ―Hydrocarbon Man.‖ Oil is still the power that motivates the industrial society and the lifeblood of a civilization that it helped create. It is still the basis for the largest negotiations in the world, that cover the most extreme issues of risk and reward, as well as the relations and conflicts between entrepreneurs and their corporate companies, and between 17 private business and the nation-state.

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BIBLIOGRAPHY American Petroleum Institute (2005), Washington D.C. (Web page) Barnett, Richard (1980). The lean years: The politics of security: Simon & Schuster, Washington, D.C. Campbell, Colin (1997). The coming oil crisis. Multiscience Publishing Company Ltd., U.K.

Campbell, Colin (2006) Peak Oil in Perspective, Presentation given in the VASPO International Conference, San Rossore, Italy, July 2006.

Chevron, Web page: www.chevron.com United States Department of Energy (2005). Washington D.C. (Web page) The energy chain. EROEI.com. May 31, 2006. Exxon Mobil (2004). A report on energy trends, Greenhouse gas emissions & alternative energy (Houston, Texas). Gonzalez, Diego (2004). Notas sobre las reservas de petroleo & gas de Venezuela. Paradigmas XXI, C.A. Venezuela. United States Census Bureau: www.census.gov. Yergin, Daniel (1992). The prize: the epic quest for oil, money & power. Free Press, New York.

16 17

See the Amercian Petroleum Institute Web page. Yergin, Daniel (1992).

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Chapter 2

THE END OF THE PETROLEUM CIVILIZATION? Tell me what kind of agreement the United Nations reaches with regards to oil resources after the war and I will tell you what kind of peace there will be. —Harold Ikes, U.S. Secretary of the Interior, 1944

THE SHORT PERIOD OF INDUSTRIAL CIVILIZATION1 1920–2030

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20 July 1969

WAR

I 3.000,000 BC

1

2030

1920 est

Pre-Industrial

Ind.

3.000 AD

Post-Industrial

This is a modified graph from a very similar one I got from a presentation given by geologist Dr. Colin Campbell, founder and honorary chairman of the Association for the Study of Peak Oil- ASPO- based in Ireland, which has led the world in the study of the Peak Oil problem. I personally do not believe in this Armageddon scenario, but I do share the grave concern this good institution has on the devastating social consequences if anything like it ever came close to occurring. The important point is that the scenario is there, and we must do everything in our power to avoid it. This is what this book is all about.

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Considering the undeniable importance of oil in people‘s ways of living, and taking into consideration its non-renewable nature and its concentration in specific geographical regions, it is not a surprise that it has been, throughout the last hundred years, the core of innumerable disturbances, tensions and even wars between nations, and also has been the heart of debates and studies among intellectuals. At this moment, we are in the middle of another of these historical episodes, with the exception that this time there is an additional element that had not been present in any other ―petroleum crisis.‖ For the first time, the planet‘s capacity to supply oil has been scientifically questioned. Take into consideration the following 25 facts:2 i. ii. iii. iv. v. vi. vii.

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viii. ix.

x. xi. xii.

xiii.

2

A barril of oil is equivalent to 42 US Gallons, or 5,800,000 British Thermal Units (BTU), the standard energy measuring unit. This makes oil the world‘s most efficient primary energy source by far. It took 125 years for mankind to consume the first trillion barrels of oil from the planet. It will take 30 years to consume the following trillion. In 1987 the world was able to replace 160% of the production of that year with newly discovered reserves. By 2004 this number had come down to 80%. Since1988 the world has consumed more oil than the amount discovered. In 2005 the world consumed, on average, nearly 84 Million barrels per day (MBD) or two barrels for every barrel discovered. In the year 2025, the world will consume 40% more oil than in 2005. By the year 2030, the number of automobiles in the world will have increased by 50%. According to the Department of Energy in the United States, by the year 2025, the demand for gasoline and diesel will grow in this country by 43% and 48%, respectively. The United States has over 300 million people, a GDP over $13.8 trillion dollars, imports nearly 70% of the oil it consumes, and 66% of its GDP depends upon the consumption expenditures of its people. The United States has about 5% of the global population and consumes 25% of the oil produced. According to the same source, the United States will need 28 million barrels per day of petroleum to balance its demand in 2025 (almost the whole production of OPEC in 2005). According to Exxon Mobil, net imports of the United States and Europe can increase to 3 MMBD in the next 20 years; in Asia this increase might even be 15 MMBD. In the last three years, the following countries have reduced their petroleum production in spite of enjoying very attractive prices (listed here from larger to smaller): Norway, United Kingdom, Mexico, Syria, India, Colombia, Tunis, Egypt, Oman, Gabon and Ecuador. Without including Venezuela‘s Orinoco Oil Belt, OPEC controls 78% of the world oil reserves.

Sources: I–VI Chevron. VII–IX; U.S. Energy Department. X: OPEC. XI–XII: Exxon Mobil. XIII: Energy International Agency. XIV–XVI: Simmons 2005. XVII-XIX: Exxon-Mobil XXII–XXIII: Aleklett, K, 2005– 06. XXIV: Zittel W, Schindler J. & Systemtechn B. (2004). XXV Energy Information Administration, November 13, 2008.

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xv.

xvi.

xvii. xviii. xix. xx. xxi.

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xxii. xxiii.

xxiv. xxv.

13

According to the World Bank, the worldwide correlation between national income, human development and energy consumption is very positively strong. According to the International Monetary Fund, the 125 poorest countries of the world are now in a ‗‘tipping point‘‘ of economic distress because of the high prices of energy and, related, food staples. According to the International Energy Agency (IEA) in Paris, France, between 2005 and 2030 the world will have to invest over $21 trillion dollars in oil, gas, refining and electricity generation just to comply with the expected demand. This number is much higher than the gross domestic product of the United States. In accordance with the International Agency of Energy (IEA), the countries of the Middle East and North Africa will need investments in the energy sector of 1.5 trillion dollars, or 56 billion dollars yearly, between 2005 and 2030 to comply with the demand projected that year. Saudi Arabia is the only country in the world with extra capacity production of conventional oil (all others are producing at full capacity). Saudi Arabia has never allowed third parties to audit their oil reserves. More than 80% of the world production of oil comes from fields discovered before 1970. The largest fields were discovered over half a century ago. More than 80% of the oil fields are undergoing a decline in production capacity. According to the U.S. Geological Survey, the world oil discovery peak occurred in 1962. Ever since the onset of the 1970s new oil fields discovered have been generally smaller. During the decade of the 1960s, the world consumed about 6 billion barrels of oil per year, while it was finding between 30 and 60 billion yearly. Nowadays, the world consumes nearly 30.7 billion per year but finds less than 4 billion per year. In accordance with the World Research Institute, the amount of oil discovered every year in new fields is lower than 10 billion barrels and it is declining. Exxon Mobil places the rate of depletion of world production about 5% per year; other more recent estimatimates by the International Energy Agency place it 2 percentage points higher. Depletion rate increases in oil fields are unequivocal signs of past peak production. According to Exxon Mobil, by the year 2030 if the world duplicates its gross domestic product of 2005 its energy demand will increase by 50% from what it is now. Oil and gas will supply 60% of all energy consumed in 2030. Of the 42.000 oil wells have been found worldwide, 400 of them (1%) contain 75% of the oil of the world.Over one quarter of the world‘s production comes from 20 supergiant oil fields.

In the following graph, the history of past oil discoveries along with the declining level of new and projected discoveries together with the unrelenting increase in production/ consumption can be observed. For new discoveries, it is good to point out two things. First, that it refers to new fields and not to an increase in the recovery factor of old fields. Second, it refers only to conventional crude oil fields, that is, it does not include the nonconventional fields. Still the point is clear that production and consumption have outstripped new discoveries in the world since the late 1980s, and by ever increasing margins. What this means is that the world has been living out of lottery winnings for the past thirty years. The

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14

last largest discovery of new fields outside of Venezuela was in 1969 in the North Sea, with an estimate of 60 billion barrels and whose production peak reached 6 MMBD in 1999, and produces about 5.2 MMBD today.

Source: Aleklett, K. Petroleum: An Uncertain Future. University of Uppsala, Sweden. World Watch Forum, 2006.

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Graph 1.

Professor of Physics at the University of Uppsala, Sweden, and President of the Association for the Study of Peak Oil (ASPO), Dr. Kjell Aleklett, describes it this way: The basic scenario of the (International Energy Agency) for 2004 foresees that in 2030 the world oil demand will be 121 million barrels per year, that will require an increase in production of 37 million barrels per day during the next 25 years, from which, 25 mb/d should come from fields that have to be discovered. This means that we will have to find four deposits of oil the size of the North Sea. Is that possible? Every oil field comes to a point of maximum production that advanced technologies can either retard or expand, but not eliminate. The oil industry and the IEA accept the fact that the whole production of the existing oil fields is declining. According to Exxon Mobil, the percentage of decrease of production is between 4% and 6% per year. Current world production is 84 million barrels per day and for the next year all current fields will extract 80 million barrels per day. Taking into account the expected increase of the world GDP, in one year, the demand of oil will increase to 85.5 mb/d: for this reason alone it will have to increase the new capacity of extraction to 1.5 mb/d plus another 4mb/d, that is, 5.5 mb/d. In two years we will need to extract 11 mbd in new fields and in 2010 at least 25 mb/d. Could the oil industry supply them? If we extend the depletion rate in the existing fields to the year 2030 and accept the basic scenario of the IEA (the world demand will increase to 121 mbd), then ―we will need a production of 10 new Saudi Arabias‖. Some could say that this is the scenario of the Final Judgment day, but it is not me who makes such forecasts, but Sadad Al Husseini, vice-director of Saudi 3 ARAMCO, until a short while ago, the biggest oil company of the world.

To quote another of the experts of major recognition in this field, the ex-CEO from the largest private oil company of the planet, Lee Raymond, from Exxon Mobil:

3

K. Aleklett, K. Petroleum: An Uncertain Future. University of Uppsala, Sweden. World Watch Forum 2006.Petróleo

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Oil and gas will remain being essential for economic growth not only in the industrialized world, but also for developing nations searching for ways to improve their standards of living. When we consider that, while the demand rises and our existing bases of production are reduced, we find ourselves face to face with the magnitude of the task in front of us: About half of the volume of oil and gas that is needed to comply with the demand of the next decade is not being produced today....As we have been publicly warning for some time, the industry will need to add the equivalent of about 80 million barrels of oil per day during the next decade, to 4 comply with the projected demand, which is equivalent to two thirds of the levels of current production.

Does this all mean that we have arrived at the final crossroad in which oil soon will become as exclusive as caviar? Are the years of industrial civilization almost finished? Must we return to the rudimentary Middle Ages of donkeys, horses, wagons and beast-powered plows? The correct answer to these questions is: Nobody knows for sure. But there is certain consensus that this is precisely the future that awaits us if we do not start to do something now! The important thing is that this doomsday scenario, directly equivalent to an economic Armageddon, was unimaginable just a few years ago and has popped up on the radar and, if nothing is done, it will most certainly hit us with unthinkable consequences affecting all aspects of our lives—not excluding a possible social holocaust. The reason for that is due to the factors that affect the supply and demand of oil. On the side of the demand, since the beginning of this millennium, unexpected increases have arisen in the economic growth and consumption of crude oil coming from extra-populous countries (especially China and India), in addition to the strong increases coming from rich countries. This strong demand has not only increased the pressure for crude oil imports to mega-sized nations, but it has also increased their appetite for energy-intensive commodities, like food, steel and cement—and its transportation—from developing and industrial nations alike. On the side of the supply, the country with the largest conventional world oil reserves, Saudi Arabia, which has never allowed its reserves to be audited, has given signs that some experts have explained that their reserves (the immense majority of which comes from only 7 or 8 giant fields) can be in a process of declination and depletion. It could be that the world has sufficient oil left to fulfill its needs for another 50 years, or, as it readily seems, less than that. Peak oil does not mean we are running out of oil, it means that we have reached, or are about to, a zenith beyond which oil production cannot be increased, and since increasing oil availability and production is vital for assuring rational business expectations for productive investment, one does not have to stretch the imagination far to fathom what oil peak can do to economic growth and financial stability. One thing seems to be true, considering the consensus among experts: The era of easy and inexpensive oil has come to an end! The remaining large reservoirs yet to be discovered and developed, are located in especially deep and remote locations, are difficult to be reached geologically and politically, require large investments, advanced and costly technology, upstream (exploratory phase, production and recovery) and also downstream (refining, upgrading, transportation and environmental infrastructure); it also demands immense risks and uncertain rewards. Pressure also moves to the side of the demand towards the final consumer, especially in the automotive industry and electric generation industry to increase its efficiency in fuel consumption. 4

See Raymond, Lee (2003).

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BIG OIL Petroleum is the most unusual product in world trade—its sale is only limited by what can be produced. There is no other article in the world of which it can be said that its consumption is assured from the moment that it is produced…. It so happens that in the oil business one has to seize opportunities quickly; otherwise they escape. —Henri Deterding

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Founder of Royal Dutch Shell

Big Oil is what started the petroleum revolution that transformed the world we love. They are the ones to which we owe so much for being what we are and for living how we do. Oil, which had been dormant underground for literally millions of years didn‘t just pick our time to seep out of the ground and into our factories, cars, farms and all of the industries in between and beyond; it was Big Oil, or more professionally known as the International Oil Companies (IOCs) that made it happen. Did they do it out of the fondness of their hearts?? Of course not. They made $billions and continue to make $billions because the prize of completely changing our civilization for the better, of giving us the energy to quintuple population and creating the progress, technology, richness and the comfort that we enjoy that would have made all the roman Caesars and medieval kings green with envy cannot be cheap. This is why our bond with Big Oil is a love-hate relationship on the reverse, it is not that we love to hate them, it‘s that we hate to have to love them. Civilization-wise, our dependence on Big Oil and on the State and service oil companies that they helped create is total5. Indeed, the world owes the following man more than can be said. We owe George Bissell, Benjamin Silliman Jr. and Edwin (colonel) Drake for kick starting the industry, John D. Rockefeller for industrializing it, Daimler Benz, Henry Ford and the Wright Brothers for creating its biggest demand, and then Henri Deterding, John Galey, The Samuel Brothers, The Nobel Brothers, Baron Alphonse, William Knox D‘ Arcy, Ralph Arnold, George Reynolds, Caouste Gulbenkian, Walter Teagle, John Cadman, Columbus (Dad) Joyner, Everett Lee DeGolyer, ‘Doc‘ Lloyd, Jack Philby, Charles Eckes, Enrico Mattei, Juan Pablo Perez Alfonzo, Abdullah Tariki, Manuel Perez Guerrero, Armand Hammer, T. Boone Pickens, Zaki Yamani, John Paul Getty, Ida Tarbel and many others who traveled, settled and gambled fortunes upon fortunes in some of the most uncivilized, inhospitable and harshmosquito-jungle-disease ridden-bone freezing-sweating hot-desolate-lands in the planet (where ―the devil forgot his hat‖ as the saying goes) which to top it all, were sometimes ruled by ruthless plutocrat dictators that demanded ―sweet deals‖ to be convinced of their ventures.

5

When I say millions of years I mean hundreds of millions of years. I will never forget that the very first meetings my boss ordered me to attend right after I was assigned the task of evaluating financially the exploratory opportunities of Venezuela‘s oil company PDVSA, was a meeting on the Palaeozoic era in planet earth, meaning, the period BEFORE the dinosaurs where the trees were truly ghastly gigantic due to the enormous richness of the earth‘s nourishing capabilities. One of the eras within the Palaeozoic period, called the Carboniferous era (about 300-360 million years ago) is considered by geologists to be very prosperous in oil formation, as were the later periods in the Triassic, Jurassic and Cretaceous during which big animals roamed about a planet extremely rich in nutrients in its crust. Their crucial importance to today‘s economic activities has already been discussed at length.

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Many became ―filthy-rich,‖ most did not, but they all collaborated, competed and succeeded in changing the world beyond imagination and recognition.6 Part of the reason that there are so many of them is that oil is a very complicated product, much like medicine, where there is not just one doctor that knows everything but many specialized types of doctors depending on your particular ailment. In oil, the trip to extract it from the ground and into the end user in the transportation, industrial or petrochemical area, you need around your table the geophysicist, the petrophysicist, geologist, then the whole gem of engineers specializing in petroleum, reservoir, geography, computers, explosives, infrastructure, pipelines, chemical, gas, refining and upgrading (a new one), shipping, storage, security, firefighters, scuba divers, economists and finance, offshore platform builders, lawyers, public relation experts, business administration, marketing, distribution, and even sociologists and environmentalists (another new ones) etc… All of these have to be the top in their professions, most cannot be outsourced reasonably and all need to be familiar with the leading edge technology in their respective fields. At the management level in the oil business there are those who are meant to see the trees and those who are meant to see the forest and both perspectives can never be seen by the same person at the same time; although role switching, from trees to forest is possible. Both must have a minimal knowledge of what the other does and never be guilty of underestimating each other‘s jobs and difficulties. Understanding each other and optimizing team work, as two rails of a train that need each other to work and to intersect in parallel is key. The consolidation of companies such as Exxon, Mobil, Gulf, Shell, Chevron, Texaco and BP (the original sette sorelle-seven sisters) plus many others like Total, ENI, Repsol, Conoco, Lukoil, Teikoku, and Amoco which came and grew after World War II had proven beyond doubt oil‘s vital role in a country‘s economic expansion and military strength. It is no coincidence that the victors of that war had in their ranks the three greatest petroleum producers in the world: The United States, Venezuela and Russia in that order which together controlled over 80% of the entire production of the planet. A big part of the reason why people have this love-hate-love relationship with Big Oil is the fact that we are understandably suspicious of companies that profit enormously from other people‘s misfortunes. While the common street folk are struggling to make ends meet and their cars are running on empty, oil companies are recording record profits. It behooves them, some think, to collude to keep prices up and swell the pockets of their stockholders and the bonuses of their managers and staff. But with today‘s savvy and information technology that backs up audacious press reporters, plus all the good laws that prohibit this kind of behavior, it‘s hard to imagine them taking this kind of risk. What Ida Tarbel did to all powerful Standard Oil has not been forgotten, and neither has what the Middle Eastern and Latin American countries did to them in the 1930s, 1970s and 2000s. Regardless of the outcome at the oil company balance sheet, it does not change the fact that oil is vital for our well-being; it is finite, non renewable and at the moment irreplaceable. Big Oil is not the problem this time; it is a large part of the solution. Big Oil now controls about 8% of the world‘s proven reserves and has limited access to about 12% more.

6

Once again, see Yergin, Daniel The Prize, Free Press, New York, 1992

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THE HUBBERT CURVE Both the present and the past are possibly there in the future and the future is contained in the past. —T.S. Elliot

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We will start with the famous Marion King Hubbert (1903–1989) peak, that bright geophysicist from Shell Corporation, who in 1956 could predict, with scientific accuracy, that oil production from the 48 continental states of the United States would reach its peak in 1971 and would inexorably start to decline thereafter. According to him, the geological structures of that country had been sufficiently studied and recognized, and therefore we could predict its zenith, given the conventional demand scenario, and further reserve declination. Hubbert also thought that oil production peaks in the countries or areas with great reservoirs about 35–40 years after it has reached its discovery peaks of oil reservoirs, which happened in the United States in the 1930s. Let us define specifically what is referred to as ―oil peak‖. At this point it has to be said that no scientist of any of the sides of this debate questions the rigorous methodology used by Geologist Marion K. Hubbert, because as it always occurs when a natural resource is irreplaceable, exhaustible and non renewable, there will always be a point of maximum discovery, followed by maximum production and subsequently, an inexorable natural drop unless a substitute (or many) are discovered or invented and enhanced with technological and commercial capability. To stop oil depletion we have to increasingly make oil irrelevant, and so far, as we have seen and will see in more detail in later chapters, we are coming up very short on this objective. In other words, there is consensus that Hubbert was right; the debate is centered upon the time frame of his prediction around the world and its impact on the economy and society of nations.

Graph 2. Hubbert Curves.

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This curve pictures a Hubbert-like projection for both the discovery phase as well as the production phase, the latter which follows the former by about a decade according to most estimates, like the one presented here and reproduced by a study from the U.S. Geological Survey. In both cases, Peak oil occurs at the crest of the curve, at the tip where the negative inflexion point occurs and it starts descending, forming a bell-shape curve in the case of the discovery peak, or a more accelerated slope (or less accelerated) depending on the assumptions, which we will cover. The timing and size of the peak itself depends on many geological as well as technical, financial, economic, environmental, social and political factors. These factors can postpone the depletion rate or they can accelerate it, but they cannot eliminate it unless they abandon the basin. According to Colin Campbell, a widely recognized geologist and founder of the Association for the Study of Peak Oil (ASPO), oil peak is defined as: ―The term oil peak refers to the maximum rate of oil production in any considered area, admitting that is a limited natural resource subject to declination.‖7 This definition, as we will see throughout this book, has very deep geological, geopolitical, economic, financial and also social and therefore political consequences, because it means that when this peak is reached, on a world-wide scale, and assuming that there are no other viable substitutes, the only way out is to descend on the other side of the curve with no possibility of increasing oil production, which means that the economy that depends on the consumption of oil, has no possibility of growing. As economists, we all know that capitalism needs to grow to be sustained. But, it is important to know that total exhaustion of the world‘s oil basins is largely theoretical, because long before that happens, and assuming again that replacement by other sources does not take place at a large scale, the price of oil would increase and economic worldwide struggles of unimaginable proportions would ensue. The reason for this, as we have seen is that oil is an essential product, the precondition of most of the rest of all commodities, which means that it is not caviar or champagne that can easily be substituted by the poor masses with tuna and beer. Let us consider how many people would have to migrate to the countryside to produce food with the same techniques as our ancestors used to do in the old days. It is not only me who says so. In February 2005 a report made for the United States Department of Energy (called Peaking of world oil production; impacts, mitigation and risk management), better known as the ―Hirsh Report‖, states: The peaking of world oil production, presents the U.S. and the world with an unprecedented risk management problem. As peaking is approached, liquid fuel prices and price volatility will increase dramatically, and, without timely mitigation the economic, social and political costs will be unprecedented…The image is one of a world moving from a long period in which reserve additions were much greater that consumption, to an era in which annual additions are falling increasingly short of annual consumption. This is but one of a number of trends that suggest the world is fast approaching the inevitable peaking of conventional world oil production…In summary, the problem of the peaking of world conventional 8 oil production is unlike any yet faced by modern, industrial society .

7

8

See Campbell, Colin: ASPO Web site: www.peakoil.net (2006) Hirsch, Robert and others: Peaking of World Oil Production: Impact, Mitigation and Risk Management. U.S. Department of Energy, February, 2005.

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As soon as this report was made available to the public, the U.S. Congress launched its own investigation through its Government Accountability Office or GAO. Two years later to the month, they produced their own report with equally devastating conclusions: The prospects of a peak in oil production presents problems of global proportions whose consequences will depend critically on our preparedness. The consequences would be most dire if a peak occurred soon, without warning, and were followed by a sharp decline in oil production because alternative energy sources, particularly for transportation, are not yet available in large quantities. Such a peak would require sharp reductions in oil consumption, and the competition for increasingly scarce energy would drive up prices, possibly to unprecedented levels, causing severe economic damage. While these consequences would be felt globally, the United States, as the largest consumer of oil and one of the nations most heavily dependent on oil 9 for transportation, may be especially vulnerable among the industrialized nations of the world.

In July of 2007, following the GAO report, the U.S. National Petroleum Council (whose origins can be traced to Franklin D. Roosevelt), published its own 646 page report on the problem. Its conclusions are similar, as related by Ed Crooks of the Financial Times:

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While oil demand seems to keep growing, the outlook for oil supply is murky. International oil companies such as Exxon, Royal Dutch Shell and BP, which have the most advanced technology and capabilities for extracting oil and gas, are finding it increasingly difficult to operate. They control just 6% of the world‘s reserves and most of the countries where oil is plentiful are either closed to them or present daunting problems. The territories that are their traditional bases—Britain, Norway, onshore U.S.—are in relatively steep decline. In the areas where there are significant reserves to which the oil majors have access, such as the deep waters of the Gulf of Mexico, there are technical difficulties that call the investment case for their projects into question….Their problems are compounded by shortages of steel, equipment and skilled personnel, which have sent development costs soaring. As a result, the IEA expects non-OPEC oil output to grow by an average of just 1 percent a year during 2007–2012….Turning over the U.S. car fleet takes about 15 years. The NPC estimates that the average time between a new production technique in the oil industry being devised and coming into 10 general use is about 16 years. A big oil project can take 15–20 years from exploration to first production.

When Hubbert published his predictions, the great majority of his colleagues described him as exaggerated and ignored his conclusions, especially when in the next decade historical discoveries of giant fields in the Middle East were made, and oil went through a period of very low prices, given the excess of supply. However, when in 1970 the production of the United States reached its peak in 10.5 MMBD, exactly when Hubbert said it would come, Hubbert‘s fame was recognized. Since then, it has declined constantly down to 5.1 MMBD, while consumption went over 21 MMBD in the same period.11 Since then, questions started to arise that currently shape the industrial civilization. Where else are Hubbert´s peaks, which are about to occur, located? (From 1971 until today, almost all non-OPEC countries, except the USSR and Brazil, have gone through decreases in their oil production levels, due to reserves depletion as well as some OPEC nations such as Ecuador, Algeria and Indonesia—now formerly OPEC.) How much time do they have until their reserves start to decline and become exhausted? Can humanity cross towards other source(s) of energy with minimum pain or alteration?

9

See Uncertainty about Future Oil Supply Makes It Important to Develop a Strategy for Addressing a Peak and Decline in Oil Production. United States, Government Accountability Office, February, 2007. 10 See Crooks, Ed., ―Report on World Oil and Gas Supplies from the U.S. National Petroleum Council,‖ Financial Times, London, July, 19, 2007 11 Alaska‘s production is not included since Hubbert never took it into consideration in his first analysis.

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The answer to these questions is rather complicated and is subject to several debates and comparisons by some of the brighter minds of our generation. An accurate answer to these questions is beyond the knowledge of any person, economist or scientist. However, as an economist, one can not resist the temptation of drawing up a plan with the information that is known, either from the supply side (Geologists and Engineers) as well as in the economic demand (governments, entrepreneurs and society). This plan will commence from the almost structured principle that it will be the oil supply that will act as the determinant variable that orders and decides on world economic growth and its energy demand. That is, Economists and Polticians will be taking their cue from Energy Scientists, and not the other way around as it has always been. This represents a fundamental paradigm shift that the world will have to get used to until non fossil primary energy becomes abundant, affordable and environmentally acceptable. As we will see when we deal with The plan, we now handle more information than Hubbert did, especially regarding the nonconventional or semiconventional reserves that exist and that can be monetized. There are two sides to this debate; the pessimistic, who foresee a crisis of unthinkable proportions in all facets of our civilization, and the optimistic, who see the same data as their rivals, but that agree that there will be enough time to reach a smooth transition towards a world without fossil fuel, if and only if there is political will to achieve it. In the remaining part of the chapter, I will deal with the pessimistic side and in the next I will present the arguments from the other side of the table.

THE PESSIMISTIC VIEW

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Time exists when opportunity exists, and opportunity exits when there is little time left. —Hippocrates

The pessimistic side states their conclusions in the existing imbalance between the physical supply of oil, projected in the foreseeable short to middle term (between 30 and 50 years), and the projected oil demand during this period.12 Demand is divided between the rich and the poor countries and is driven by economic growth and price elasticity. Supply is divided between the oil reserves of the OPEC and non OPEC countries. Then, also in the supply context, alternatives are analyzed, and they are to be divided between those that belong inside the hydrocarbon context (conventional and nonconventional oil, as well as gas and coal) and the other non-fossil energy alternatives that are mostly renewable (except nuclear). The always relevant factor of technical efficiency, especially but by no means exclusively in transportation, also falls in supply analysis.

12

The difference between the short, middle and long term relates to the concept of time among the different sciences and disciplines. For example, for economists, short term can be measured between the first semester up to 1 year; the long term up to 5 years and the middle term somewhere in between. For geologists, periods of time are measured in millions of years, for engineers, periods of time are measured in the useful life estimated of the assets (usually not over half a century, as in this case), and for politicians, until the next elections. These vast gaps in the concept of time among all stakeholders plays, as it will be seen, a crucial role in the development of this analysis.

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Carlos A. Rossi

The following two graphs, the first from the Hirsh Report cited before and the second, which also uses as a source the actual and projected data from the U.S. Energy Information Administration, are revealing:

NUCLEAR HYDROPOWER

Source: Energy Information Administration.

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Graph 3.

In Graph 3, whose data is derived from the EIA, the demand for oil is compared to the demand for other fuels, including the non-fossil variety. As can be readily seen and scrutinized here in fuller detail in the next chapter, the fossil fuels, particularly oil, are still king of the primary energy hill and will be for the foreseeable future. This trend, I am afraid, cannot be reversed in the short or medium term; nor can it be postponed without enormous sacrifices by all concerned. According to this source, it is foreseen that oil consumption will account for 35% energy demand while natural gas will account for 25%, coal for 22%, with nuclear and others for the remaining 18% of all energy consumed during the same period. On the supply side of the equation, the first piece of information is that the remaining oil reserves that exist are concentrated in a few countries, which we associate with the Organization of Petroleum Exporting Countries (OPEC). These are all developing countries and the majority of them with relatively scarce population, and therefore, they possess and critically depend on a large surplus of oil to export. As I mentioned earlier, almost 80% of the oil reserves that are left are deposited in OPEC: The second piece of information, is that exactly the opposite takes place with the developed countries and the non OPEC countries, which hold less reserves and have a larger population, and that are by far the nations which consume the most and logically, the countries that Hubbert peak touched first as the following graph illustrates. Note that the history part of the graph comes from the data of British Petroleum, while the projected future is my own calculations assuming an average of 5% depletion rate per year up to 2030.

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PEAK OIL PRODUCTION IN 20 NON-OPEP NATIONS ASSUMING A DEPLETION RATE OF 5% PER YEAR HISTORY

30000

FUTURE

25000

20000

15000

10000

5000

25

29 20

21

20

17

20

13

20

09

20

05

20

97

01

20

20

93

19

89

19

81

77

85

19

19

19

69

73

19

19

19

19

65

0

USA 70

MEXICO 04

NORWAY 01

UNITED KINGDOM 99

OMAN 01

EGYPT 93

ARGENTINA 98

COLOMBIA 99

INDIA 04

AUSTRALIA 00

MALAYSIA 04

SYRIA 95

YEMEN 02

VIETNAM 04

GABON 96

ROMANIA 77

TRINIDAD & TOBAGO 78

PERU 80

UZBEKISTAN 99

ITALY 05

Number in parenthesis represents the peak year BP, Own Calculations

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Graph 4.

In Graph 4 we see the effects of oil depletion in several countries as an irreversible phenomenon that threatens very really to offset their standards of living. The fact that these nations have so far fended off by increasing their productivity to enable them to produce enough surplus to import their energy requirements will no longer suffice as peak oil will impose physical limits upon the shrinking quantity of the available oil supply. Today it is estimated that if the oil fields of extremely deep marine waters are excluded, 54 out of the 65 most important countries in oil production already past the Hubbert peak, and are in the declining phase, especially in the most important non OPEC countries such as the United States, England, Russia, Mexico and Argentina; all suffering from natural depletion in their oil fields.13 Observe also that Graph 4 may even shade in the optimist side because it assumes a 5% oil field depletion rate through out, and we know that this is likely to increase the farther we go beyond the peak point; case in point, as mentioned, the International Energy Agency estimated in 2009 that the world depletion rate had increased to 6.7%. In Graph 5, we see the net difference between oil discovered and oil consumed, which began to be negative (more oil consumed than discovered) ever since 1988: and this negative number increased with the passage of time. This gives credence to the above remark that the world has been living off a lottery winning ticket it redeemed about three decades ago. It so happens that if this gap continues to be negative, if mankind continues to consume more oil than it discovers, by definition, we would be eating on our reserves, and unless there is a miraculous replacement in a short period of time that humanity as a whole could use, this could mean that the Hubbert peak for the world will be reached close to 2015. According to British Petroleum, ―It is no secret that today for every barrel of oil we discover we are consuming nine barrels of oil.‖14 13 14

See Aleklett (2005) See www.bp.com

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Carlos A. Rossi

Source: The peak and decline of world oil and gas production, K. Aleklett and C.J Campbell.

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Graph 5. World Gap between Oil Discoveries and Consumption.

According to an expert‘s estimate, the rate for new discoveries of fresh reserves is less than a third of the rate of oil consumption15. In some manner, by 2010, the extraction of oil from the countries that will still have oil and from the deep marine waters will have to compensate for the decrease in 59 countries and the increase in demand in the rest of the world. If we take into account that the new fields can take up to a decade to develop and that the alternate sources of energy are incipient, we have an idea of the crisis that we are about to face if we assume an attitude of business as usual. The oil expert Professor Alekett ends up saying: ―We should have started at least 10 years ago. That is why we can not wait any longer, or the strokes or the bumps in the road could be devastating.‖16 That is why an urgent economic plan is needed. On Saudi Arabia, as well as its neighbors, given the secrecy of its authorities, definite statements can not be made; however, the renowned banker and oil analyst Mathew Simmons reviewed more than 220 works published in the Society of Petroleum Engineers, many of them written by Saudi scientists, and reached the conclusion that there are strong evidences to indicate that the Saudi kingdom could also be reaching the Hubbert peak, if it has not already done so.17

15 16 17

Ibid. Aleklett, Kjell: Petroleo: un futuro de incertidumbre. World Watch, Washington D.C. 2006 See Simmons, Mathew conference and his book. In an interview given to CNN in April 23, 2006, Simmons remarked, when asked about his worse case scenario that: ‗‘My worse case scenario is so bad that you don‘t want to go there…We would basically end up having a series of energy wars over who gets oil. And they are wars between you and your neighbor, and they are wars between one town and another, and ultimately one country and another.‖

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OIL RESERVES Alternatives, such as biological fuels (biofuels), ethanol, or biomass can have a marginal support role, but they will never come close to the scale that is expected from them. When we run out of oil, the economic and social dislocation will be unimaginable.

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—Michael Meacher Ministry of Environment of the United Kingdom, 1997–2003

Now, there is an important factor that has a large influence on this analysis, and it is non other than the classification of reserves itself. Since these reserves are located many kilometers beneath the surface and are not ―visible to the naked eye‖, geologists and geophysicists can only make statistical estimates of their existence depending on the technology available, which are sophisticated (and costly) seismic of up to 4 dimensions(4D). But the result of these actions is very uncertain because it depends on the depth and the geologic complexity of each reservoir, especially if it is located under ultra deep waters. Because of this, geologists assign probability ranges to the reserves found, and reserves to be found, and divide them up in three categories: proven, probable and possible, with different probabilistic degrees, depending on their categories. In this manner, proven reserves are assigned 90% or more of containing some amount of oil, probable reserves 50% or less, and possible reserves 10%. It is important to point out that governments only allow for companies to report on proven reserves, while the other two categories, probable and possible, can only be reported in the internal books and can never by disclosed publicly in order to avoid speculation.18 The probabilistic calculation of reserves includes geophysical and petrophysical elements (such as the porosity of the sandy layers, viscosity and permeability) whose explanation is not relevant at the moment. About the total amount of oil present in the reservoir, called ―oil in situ‖, or oil in place (OIP), what is calculated is the amount of oil that can be recovered, and this is called the ―recovery factor‖. The multiplication of the recovery factor times the OIP is what gives you the proven reserves. Without going into further detail, what is important to remember is that it is never a fixed range, it depends on three dynamic factors: the quotation price, the extracting and recovery technology, and the physical uncertainty of the reservoir. To the extent that the price of oil is higher, the most profitable its sale the larger the physical quantity of the reservoir that can be described as proven reserves. In the same way, while the extraction technology is more advanced, the physical recovery of the oil will be more feasible. None of the foregoing specifics lessen the fact that each reservoir can have an uncertainty factor and a physical limit, that is to say, a point is reached where it does not matter what the price or what technology is being used, proven reserves reach their Hubbert peak, start to decline and the reservoir becomes depleted.19 Without underestimating the foregoing, everything is not as clear as it seems to be, because a great deal depends on the methodology that is being used in the calculation of the reservoirs, which can vary from country to country, and of the amount of oil that can be recovered, given the projected price system and the technology available. There are no

18

Seismic consists of explosives loads throughout many kilometers of land and in multiple sessions, that emit radial waves through the surface towards stratigraphic depths that then have to be interpreted by geophysical experts. 4-D is the adding up of two 3-Ds together.

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independent audits in a large number of the reservoirs (in the Persian Gulf the magnitude of the oil reserves is considered a subject of ―national sovereignty‖), and multinational corporations as well as the national oil companies both have incentives to ―cook the books‖. For example, during the decades when ‗big oil‘ dominated the fields of the Middle East, they would ordinarily underestimate their reserves in order to validate production restrictions. Afterwards, when those fields where nationalized, nations suddenly announced increases in their reserves, which were fair corrections to adapt to reality. Afterwards the nations themselves started to inflate their reserves in order to justify more investments and higher OPEC quotas.20 This lack of standardization and data calculation on reserves and production exercise a strong influence on the famous ―lost barrels‖ from the nineties, on the reduction of prices in 1986 and 1997–98 and in the sudden price increase as of 2001.21 This debated standardization in the classification of oil reserves has led to a disparity of criterion amongst the most renowned professionals on the subject. An example is the company of Daniel Yergin, called Cambridge Energy Research Associates (CERA), a reputable consulting energy company known for its optimism. At the beginning of 2006, this company was purchased by IHS Energy from Houston, a merge that gave more strength to CERA‘s opinions for the single fact that now they could dispose of actual field data information from at least 90 countries. Year

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1990 2000 2006 2010 2015

Physical capacity for world oil production (MMBD) 70.0 78.4 88.7 102.1 110.0

Proportion of oil nonconventional liquids over the total (%)* 9.8 16.2 23.9 30.1 37.7

Includes condensates, NGL, LTG, extra-heavy oil (2.500 feet) Source: CERA, August 2006, November 14, 2006.

In August 2006, CERA made public its report that concluded, amongst others, that new fields that had been discovered a long time ago would now go into production and that this would elevate the physical capacity of world production from 88.7 MMBD in 2006 to 110 MMBD in 2015, which would be satisfactory to cover any scenario of reasonable demand up to that date. It is important to point out that in this report: 1) over 60% of this new capacity will come from OPEC, which strengthens its participation, and 2) that the non conventional

19

The same happens to the contrary. For example, due to the sharp fall in prices in the nineties, caused by the Asian crisis, all companies and countries saw their proven reserves reduced since they were not ―profitable‖. 20 See Khadduri (2005). 21 In the United States, after the Enron scandal, this changed when the Sarbanes-Oxley act came into effect in 2004, applying standard asset value methods to all energy publicly traded companies. It required, in Article 404, that all full reporting companies to the Securities and Exchange Commission to certify their ‗‘booked reserves‘‘ by conductng well tests; which converts them into proven reserves. An initial result was that several companies, notably Shell, were caught in reporting over optimistic oil reserves numbers and were thus forced to diminish them (this caused the exit of some of Shell‘s senior staff, including the E&P Director). But this law does not apply to National Oil Companies that do not trade in Wall Street.

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liquids, including the extra-heavy oils, would be assigned as a whole nearly 40% of this increase for 2015.22 The following table summarizes these predictions: Accordingly, the world oil production under this scenario would reach a peak, hold that peak or plateau for a while, and ultimately descend afterwards on a very slow slope or ―undo ling plateau.‖ Scientists from CERA do not deny the declining feature that oil has as a nonrenewable resource, they just say that it will occur at a much higher level (in terms of production) and that its declination rate will not be symmetrical with the upward part of the curve; that is to say, it will not fall in the same manner that it moved upward; but it will do so in a much slower and plateau manner. Global production will definitely follow a…plateau, for one or more decades before it becomes slowly smaller. The global production profile will not be the simple logic bell shape curve, postulated by Geologist M. King Hubbert, but it will be asymmetrical—with the slope of the fall more gradual and not reflecting the fast rate of its increase—and it will be strongly biased after its geometric peak. It will be a plateau that…can well 23 last for decades.

As soon as this report came out, plenty of criticism was poured on from many places. The most significant came from the ASPO 24 group, and two of its more strident voices, Randy Udall and Mathew Simmons. Their criticism to CERA´s forecasts can be summarized as follows: • •

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• • •

Overestimation of the capacity of countries and companies to comply with 100% of their production plans. Overestimation of the reserves of the OPEC countries and Russia that, according to CERA, is even higher than these countries claim. Overestimation of the technical capacity for extracting barrels in very complex locations, geopolitically as well as geologically. Underestimation of the depletion rate of the already existing wells. The forecast records from agencies such as CERA and the EIA (from the U.S. Department of Energy) have not been good, and in fact, they have been responsible for bad investment decisions (on electrical plants based on gas and large automobile models, for example), that have ended up as being very costly and dangerous for the energy security of United States.

Quoting Udall and Simmons: Depletion is limitless, it is a merciless enemy that never falls asleep, that grows and becomes stronger every day. Even if the forecasts from CERA of 21 million barrels of new additional barrels would appear, the 25 (net) world supply would slightly increase or would not even increase, given the depletion of existing fields.

22

See Jackson P. Esser R. W.: Expansion set to continue, global liquids productive capacity to 2015, CERA, August 2006. It is worth pointing out that CERA only emphasized the physical capacity of production, not including in its analysis risks of another nature, like political and nationalistic, for example. In fact, according to CERA, these risks are more dangerous in the interruption of supply than the physical risks of production capacity themselves. 23 See Cambridge Energy Association-Houston, 14-11-2006. 24 Association for the Study of Peak Oil, see: www.peakoil.net 25 See: Udall, R and Simmons, M. ―Cera‘s rosy oil forecasts: Pablum to the People,‖ Energy Bulletin, ASPO, U.S., August 21, 2006.

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I would add three more elements to this catalogue of criticism: 1 2 3

The year 2015 is just around the corner. As a member of the economist‘s society, I can assure anyone that the world will not face problems when oil becomes depleted, but when production stops to grow, which means, in the start of the peak or plateau itself. Consequently, CERA´s conclusions, far from mitigating the terror of its adversaries, confirm it.

EIA NOV 2008

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Graph 6. Depletion Rates in the World‘s Largest 800 Oil Fields.

The rates found by the EIA in its reference scenario to 2030 were high enough: 6.7% for past-peak fields, increasing to 8.6% by 2030. Averaged across all fields, the rate is 5.1%, but that includes 3.4% for the very largest fields, 6.5% for the next-largest and 10.4% for the next size down. Without underestimating the foregoing criticism, it is important to distinguish that CERA does consider in their analysis the importance of nonconventional liquids in its equation. As we will see in chapter 6 and in the conclusions, CERA has all the right to do so. Another important fact, and which has not been bypassed by the critic of the pessimistic side, is that the majority of the recent increases in the oil reserves that have been reported, from the multinational and state companies, have been mostly related to ―existing reviews‖ (fields that have been already discovered that add up proven reserves but take away from the probable and possible reserves) and no to the discovery of new fields. As we have seen, this is a perfectly legitimate practice, but still is worrying, given the evident deficiency of ―fresh‖ reserves. The data from British Petroleum is the time honored international source for most macro stats in the oil industry, and they are usually published in their annual Statistical Review of World Energy that appears in June of every year. That and their keenly maintained web site that also contains updated speeches and easily available presentations, including investor information, is a precious analytical source tool for all interested.

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Graph 7.

In Graph 6, we see that total global oil reserves have indeed been growing in the 1980s, reached a plateau in the 1990s and began to grow again in the early part of this decade only to stall in its latter part. Two things jump out. First, the growth of the last part was not due to fresh discoveries, but rather through the addition of existing oil reserves that were not previously counted as such. It is important to know that the definition of oil per se is generally accepted to be the shore of the Society of Petroleum Engineers (SPE) and also of the International Energy Agency, and until very recently most of the heavy and extra heavy oil did not qualify as ―oil‖ because its drilling and processing (refining) methods were ―un conventional‖. These types of gooey crude were typically classified as ―bitumen‖ and hence counted out of the oil equation (Venezuela, which possesses about 90% of the non conventional oil in the world, not counting the Canadian sands, was actually pleased with this classification because that allowed for their exclusion from their OPEC quotas). As the oil prices began their upward sky rocketing trip in this century and peak oil became the issue in the young millennium, both the SPE and especially the IEA widened their definition of oil to include just about every hydro liquid that energizes anything to move, except coal liquids and natural gas liquids, so far. Technology also played a role in this, because thanks to its un-relentless progress, heavy and extra heavy oil can now be upgraded and refined to increase its API grade to the levels of mid and even light crude However, the technological upshot does not come without its price, and this is in the form of very costly upgrades and environmental degradation, both of which play a key role in limiting the production potential of heavy and extra heavy oil (more on this in Chapter 4). So the increases in total global reserves observed in Graph 6 are mostly due to this redefinition of oil. The fact that it has flattened out in the recent years alongside production in spite of unprecedented oil prices is what keeps every policy maker awake.

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TECHNOLOGY If or when China and/or India attained even European current rates of oil demand per capita, let alone the OECD average rate (including the U.S., South Korea and Japan), of about 14 barrels/capita/ year (2006–2007), their increased demand would make it necessary to find and develop several ―new Saudi Arabias or Russias‖ to satisfy a radical increase in world oil demand.

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—Andrew McKillop

When the oil price increases, its profitability factor increases and also the incentive for human creativity to develop extraction technology. From ―upstream‖ to ―downstream‖, the hydrocarbons sector has gone through technological advances unmatched by any other scientific ambiance, except, maybe, by the computers and telecommunications. From exploratory seismic and the computer programs that help interpret the former, secondary recovery and development tertiary techniques (gas, vapor, nitrogen, etc.) drilling and recovery techniques (including, among others, horizontal, multilateral wells, ultra-deep water platforms and mining) deep conversion and ecologic refining, transportation, marketing, bitumen improvement technology, etc.26 all these have grown considerably, increasing the average recovery rate of the fields from 22% (1979–1981) to 35%, at the end of the century ( in the North Sea, the recovery factor has increased to over 66%). The proven reserves ratio on the production rates has gone, during that same period, from 20 to 40 years.27 Those exponential leaps in technology provide tools to the optimistic side: there are some on that side that are always betting on the fact that there will always be technological breakthroughs that help to increase the recovery factor and be able to consume the remaining 65% left. That is to say, according to them, many decades would have to pass by for us to become seriously worried about our fossil reserves, and then, it will not be relevant because we will have other energy sources. Technology can prolong the life of oil fields and postpone its depletion by inserting leading edge technology into what is known as ―enhanced oil recovery (EOR)‖. What it can‘t do is to eliminate the depletion all together. As the following illustration from the Hirsh report shows. As this graph shows, EOR is used mostly after the peak of the field is reached by normal drilling methods, and they can enhance the productive life of the field or its ultimate yield by a margin that can be considerable or not, depending on the size of the field itself. The purpose of EOR is to increase the recovery factor from basins and it has been used with success in certain cases, especially in secondary and third generation recovery methods, although the research is still an ongoing process. For costs considerations however, these methods are mostly applied after the well has peaked, which means that they do not have an effect on the peak oil of production; they basically act to increase the slope of the declining curve after the oil well has peaked.

26

Intevep, PDVSA‘s technological branch, has invented some of these techniques with success, above all, in the heavy oil improvement area with two patents that are being used in the Orinoco Oil Belt: aquacon conversion, that takes the carbon away from the crude oil, and HDH-PLUS, that adds up hydrogen. All that with the purpose of increasing the quality of the crude (API), and prepare it to be refined. 27 See Manzery (2004)

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HIRSH REPORT.

Graph 8. Enhanced Oil Recovery (EOR).

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Even then, their cumulative effect is not as great as one might expect primarily because as the recovery rate is increased through production mechanisms the depletion of the total reserves can be accelerated. Although many methods exist to enhance oil recovery, possibly the most successful is CO2 flooding that includes light hydrocarbons such as gas to act as solvents to move residual oil, and this can increase the oil recoverable in the range of 7– 15%28. The fact that most EOR methods are employed after the reservoir has peaked does help us, the economists, but only to the extent that it affords us a bit more time in the back end of the supply side to complement with the demand strategies that we must coordinate and put in place. However as we have discussed, and will discuss again, our problem begins at the peak itself, when production rates cannot be incremented. The Hirsh Report to the U.S. Department of Energy had this statement in its Executive Summary regarding EOR: Improved Oil Recovery (IOR) can marginally increase production from existing reservoirs; one of the largest IOR opportunities is Enhanced Oil Recovery (EOR), which can help moderate oil production declines from reservoirs that are past their peak production…Heavy oil/sand represents a large resource of lower grade oils, now primarily produced in Canada and Venezuela; those resources are capable of significant production 29 increases.

In fact, technology has managed to shift the declining side of Hubbert´s curve in time, since it has achieved an increase in the recovery factor of the great majority of the mature reservoirs, and also, as it is the case in the Venezuelan Orinoco Oil Belt, it has increased the quality of the oil by increasing its API degrees and, therefore, its commercial value. 30 On the other hand, technology can also become a double-edged sword, because upon increasing the recovery factor with advanced drilling methods (as in horizontal wells) it also means that reservoirs may become depleted sooner, as it has happened in the English fields in the North Sea and other places, which has contributed to the reduction of their reserves. 28 29 30

See the Hirsh Report 2005 pp. 39–40. Hirsh R., Bezdek R., & Wendling R., Peaking of World Oil Production: Impacts, Mitigation, & Risk Management. SAIC, February, 2005. API= American Petroleum Institute, that designed the methodology to measure the gravity of the oils according to this table:

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Extra-heavy

Less than 16 degrees

Heavy

Less than 21.9 degrees

Medium

22.0 to 29.9 degrees

Light

30 degrees or more

THE SAUDIS The first half of the oil age has just ended. It lasted 150 years, and it witnessed the fast expansion of industry, transportation, business, agriculture and financial capital, helping the population expand by a six-fold factor. The second half is emerging now, and it will be marked by the decline of oil and everything that depends on it, including financial capital. —Colin Campbell

Going back to the Saudis, Sadad Al-Husseini, the former chief of Exploration and Production at Saudi Aramco, made some significant statements on the status of the reserves of his country, which he must be acquainted with extremely well given his position. 31 Among the most significant parts of his presentation, the following stand out: •

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• • • • • • • •

• •

31

The total production capacity of the Middle East is of 21–23 million of barrels a day (MBD) In the best of cases, its capacity could reach 25 MBD in 2025. Saudi Arabia could reach 12 MBD, but cannot exceed this number. 90% of its oil production is concentrated in just 5 super-giant fields. These fields have been under production for 40-60 years. All fields are close to reaching their declination point. The proven reserves in books of Saudi Arabia are 260 billion, half of which are doubtful. The oil remaining in Saudi Arabia is the most difficult to extract. The basis for their current production is declining at an average rate of around 2% annually. That is to say, 800.000 barrels per day are required additionally for the year 2009 only to minimize declination. In the last 35 years, Saudi Arabia has invested plenty of money in the exploratory search of giant reservoirs and only found one. The world‘s Hubbert peak will be reached in 2015 at a height of 90–95 MBD, and will be able to maintain itself at this level a little after 2020, providing there will be technological improvements in energy efficiency and prices continuously increase.

See Simmons (2005). See also Peter Mass´s interview, 2005, in The New York Times and an editorial published in that same newspaper by Jeff Perth, 2005.

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In his words:

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The question isn‘t can we pump 15m or 20m barrels daily. The question is, how long can it be sustained? We could only manage 22m bpd for a very short time, maybe ten years. And that would mean an awful lot of 32 depletion which isn‘t in the best interest of the global economy.

At the beginning of the year 2005, Aramco, the state Saudi company, outlined an aggressive plan of US$ 50 billion to increase production, refining capacity, to double the number of rigs and replace their declining fields. The principal objective is to increase the total oil production by 3 MMBD by 2009, to reach a production capacity of 12.5 MMBD. If this is achieved, this would be the largest expansion in the history of a state company.33 This can represent an important increase and it is in the same order of ideas as the statements issued by Mr. Sadad Al-Husseini that would mitigate a shortage of supply in the short term. However, it is also interesting to point out that the expected increase in its production capacity falls short of the majority of projected demand models, which exceed the additional three million barrels in the years after 2009. In fact, according to the majority of the demand scenarios, Saudi Arabia would have to double its production (which today is around 9.5 MBD) to satisfy world consumption by 2025, and in conformity with these provisions, the Saudis will not be able to do so. In Al-Husseini‘s words, ―Expectations go beyond what can be accomplished.‖34 Besides, there are founded suspicions that the giant reservoir Ghawar—the largest oil structure of conventional oil that mankind has ever known discovered in 1948, and that throughout its 193 Km length has provided the planet with over 55 billion barrels and that today represents around 60% of the total of Saudi Arabia‘s production—reached its production peak in 1980 at 5.800 MMBD and has started to show signals of depletion by the amount of water that has slipped through the wells.35 If we also reiterate the fact that Saudi Arabia is the only country left in the world with extra conventional oil production capacity (excluding Iraq), but that in 2005 it only produced nearly 9.5 MBD, despite the fact that many of its OPEC members produced less than their quota and the Saudis were not able to match the difference, we reach the unavoidable conclusion that we can not expect that this country, or the Middle East in general, can continue being, indefinitely, the reliable and safe suppliers of oil in the world. Mathew Simmons, the American oil expert that examined over 200 works on Saudi Arabian fields published by the Society of Petroleum Engineers, reached the conclusion that its production peak had arrived.36 An example is none other than when this country was asked to increase its production to compensate for the loss in

32 33 34 35

Interview in The Sunday Telegraph, London, England, October 31, 2004 See Mouawad Jad: ―Saudis shun role as last resort for oil‖. The New York Times, December 5, 2005.

Ibid. Ibid. Even though the maximum level of water cut in the reservoirs varies from field to field, normally it can be said that a water cut of 40% implies total depletion. This range, however, can be increased in the event of it being a super-giant field, as in the case of Ghawar, which has been already injected with water to increase the pressure, and therefore, its secondary recovery. In 2003, the water cut in Ghawar was of 33%.

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11500 11000 10500 10000 9500 9000 8500 8000 7500 7000 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Source: BP Statistical Review of World Energy, 2008. Graph 9. Saudi Arabia Crude Oil Production (MBD).

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Venezuela and Iraq at the beginning of 2003 (the oil strike and the North American invasion, respectively) the Saudis could not compensate for both countries‘ lack of production. Another example was an article published in the New York Times that gave nervous bumps to everyone who read it. It said: Doubts on Saudi Arabia with respect to by how much and for how long can it expand its (production) capacity, have risen in a secret intelligence report, by individual analysts and even by a higher oil advisor from the (North American) Government…A higher intelligence official, that insisted on his anonymity, since he was not allowed to speak publicly on the subject, said that the plans of the Saudis of increasing production by almost 14% in the next 4 years will not be satisfactory to balance global demand. Even the Energy Information Administration (EIA) has lowered, recently, its expectations on how much more oil can the Saudis pump in 20 years.…The capacity of Saudi Arabia now is 11 MBD. The Saudis pump around 9.5 MBD, leaving a protection 37 of approximately 1.5 MBD, mostly the heavier gradients and of lower usefulness in the Western Hemisphere.

To end this section on oil supply, the following quotations, from the U.S. Geological Survey (USGS) in 2004, which belongs to the government of the United States of America, is revealing and disturbing: The world oil reserves are becoming depleted three times faster than the new discoveries. Oil is being produced over already discovered reservoirs, but the reserves are not being completely replaced. The remaining reserves of the companies must keep on decreasing. The disparity between the growing production and the decreasing discoveries can only have one outcome: a practical limit will be reached in the supply and the latter will not be available to fulfill the requirements into the future for the world demand of conventional oil… Even though there is not an agreement on the date in which the world oil production will reach its peak, the projections presented by Geologist Les Magno, from the USGS, by the Oil and Gas Journal, and by others, it is expected that this peak will occur between 2003 and 2020. What is noticeable…is that none of them expect the peak to happen after 2020, which suggests that the world could be facing an oil shortage sooner than 38 expected.

36

See Leggert, J.: ―Peak Oil: The Twilight Zone.‖ The Independent, London, 04-25-2005. Quoted in Duarte, Joel (2005). 38 See Vidal, John. The Guardian, 04-21-2005. 37

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OPEC OPEC is a business organization, not a political organization. All members just want one thing, they want more money. We have always benefited from a depoliticized organization. I have never driven apart from that principle. We are petroleum ministers, we are not foreign relations ministers. —Ali Al-Naimi, Saudi Arabia Petroleum Minister

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Inevitably, that brings us to OPEC, the organization of petroleum exporting countries, that today controls 40% of the world oil production and about three-fourths of its reserves. It was founded in 1960 by the initiative of the brilliant Venezuelan oil petroleum Minister Juan Pablo Perez Alfonzo. Its 13 members today are Algeria, Angola, Saudi Arabia, United Arab Emirates, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Oman, Qatar and Venezuela. Its history is well known and I will not go over it here, it is enough to say that it has been the most successful cartel of humanity, and in spite of its long periods of internal differences, today wields a vast power on the production levels of crude oil and on the bottom range of the oil prices. The source of this power is none other than its reserves and its capacity to bring them to market at a very low cost given the world addiction to oil, as the essential ingredient of western industrial civilization. The following two graphs depict the market power OPEC wields as well as the doubts of how much power that really is.

Graph 10.

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Graph 10 demonstrates that the OPEC 1339 wields a large disproportionate control over the oil reserves of the world, and that is not counting the non conventional reserves most of which are sitting in Venezuela‘s Orinoco Belt (see Chapter 6). But Graph 11 puts a question mark on the veracity of the level of the reserves by OPEC, and that is depicted within the area of the red circle. After many controversies on how to divide the production quotas, in a 1982 meeting, right in the middle of the second devastating oil shock, OPEC made the decision of establishing its quotas based on the reserves that each of them reports. Since these are not registered by any independent auditor, some if not most of the countries decided to ―increase‖ them overnight in their external books, up to the point of truly questionable exaggerations. Many people think that OPEC has been overstating its reserves for about two decades and, since many countries, especially in the Middle East, impede independent auditing, no one outside OPEC can know with a gradient of certainty its true levels. This uncertainty is at the core of much of the daunted pessimism of many petroleum analysts. Given the seriousness that reserve overstating is, the following extensive quote, from Stephen and Donna Leeb‘s provocative book is in order:

Graph 11. One thing that Campbell and Laherrere (of the ASPO institute) noted about the Middle East was that even though a good deal of production was occurring, the extent of reserves reported remained amazingly constant from year to year—and then jumped dramatically. For example, between 1980 and 1989, Saudi Arabia, the country with the largest reserves, reported only nominal changes. Then, in 1990, the country reported that its reserves had grown by nearly 90 billion barrels—the equivalent of three North Seas. Wow! 39

Currently Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libia, Nigeria, Oman, Qatar, Saudi Arabia, United Arab Emirates and Venezuela.

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A similar mystery enfolds the oil picture in Iraq and Iran. After a period in which its reported reserves had remained more or less constant, Iraq in 1988 announced that they had more than doubled, to 100 billion barrels! Equally miraculous, since then, Iraq‘s reserves, as officially reported, have remained at precisely 100 billion barrels despite continued production and a total absence of exploration. And Iran has followed an identical pattern, nearly doubling its estimate of reserves in 1988 after years of stagnation. In and of themselves these figures would defy belief; throw in the context of the Iran-Iraq War in the 1980s and they become even less likely—is it really possible to imagine that each of these countries carried out preternaturally successful exploration efforts while engaged in a bitter war? All these actions by the Saudis, Iraq, Iran—reporting reserves constant for years despite production and then announcing huge increases in reserves—strongly suggest that OPEC‘s reserves are overstated. And as Campbell points out, that is exactly what you‘d expect given the nature of the OPEC cartel. That‘s because quotas for the members are determined by production capacity, and production capacity is directly related to reserves…It seems indisputable, then, that OPEC has less oil left than it claims. The question is how much less

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40

The leitmotiv of OPEC‘s strategy is to assure sufficiently high prices to sustain a lasting flow of income that maintains their corresponding living standards, extends the useful life of their reservoirs, keeps competition (including alternatives) checked, and diversifies their economies (the latter has proven to be an elusive objective). This is done by trying to stretch the production profile in time, in a very cautious manner, since the speeding up of the production of a field reduces the amount of oil that can be recovered in the long term, as we will see in chapter 6. This strategy, however, has been the cause for the following dilemma. The goal of maintaining production increases to maximize income and extend the life of the reservoirs can raise prices and cause a global economic recession, and this has occurred in a number of occasions throughout the organizations life. OPEC has learned from these experiences, and learned to implant a strategy of flexible price floors and ceilings that allowed them to adapt to the market‘s needs and optimize their own goals in that strategy. But that can only be achieved if there is maneuvering room in the production levels of its members, and this is precisely what has changed. Today, only Saudi Arabia (short term) and Venezuela (long term), can increase their oil production considerably, a fact that gives the OPEC control on the price floor of oil, but not on the price ceiling. But there are certain exaggerated items that can kick off alarms. The first one of them is Saudi Arabia, which we already analyzed. Another from Iran and Iraq. Still another is Kuwait, which centers all of its production in just one field discovered back in the fifties with 8.3% of the world reserves, which has been questioned even by their own experts. For example, according to Petroleum Intelligence Weekly41, internal studies of a Kuwait oil geologist have determined that their oil reserves barely reach half of what they have stated. Other countries, non OPEC countries like Mexico and Russia, are under suspicion as well. Even British Petroleum has recently cast doubts upon the certainty of some of its reported statistics. For the first time in 2005 BP made it clear that the majority of their statistics are not theirs and that they just show secondary sources. Literally it says: ―The reserves numbers do not necessarily match with the definitions, guidelines and the practices that we use to determine proven reserves at an enterprise level.‖42 In the year 2000, while the world was celebrating the birth of the millennium, and after years of internal fights within the organization, of breaching quotas and breaking promises, the Government of Venezuela decided to invite the OPEC countries to a presidential Summit 40

Leeb, Stephen., Leeb Donna., The Oil Factor; New York, Warner Business Books, 2004., pp37. See their report published on the 23 of January of 2006 42 See BP Statistical Review of World Energy, June 2005, p. 4 41

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in Caracas, the first presidential meeting of that level in 25 years. President Chavez traveled personally to each country handing out invitation cards after its Minister of Energy and Petroleum had done the same, to reassure all other members that Venezuela would respect the OPEC quotas. A difficult sale because it had been precisely Venezuela who had egregiously violated for years, and to its detriment, the quotas of the organization that was its brain child. Indeed, Hugo Chavez had to promise each one of them, in an individual and collective manner, that his government would respect the OPEC agreements even if he had to fight it tooth and nail to defend it, and that he expected that the other countries would do the same. And so it was done, and OPEC was reborn with an energy that had not been seen in a quarter of a century. It became non other that the worlds central bank of oil, the product that moves and lubricates the civilization that we know. Notwithstanding, given the fragility that exists in the oil market equilibrium, there are some analysts that have put out the idea that OPEC´s center of power has already been surmounted and that it may be drifting towards irrelevance (OPEC, not the individual countries), since that power depends on its ―closed‖ capacity, that is to say, in the amount of barrels that they, if they wanted, could offer the world in the short term. This number droped to a critically low 1.5 MBD in 2006, representing less than 2% of total demand and all of it in Saudi Arabia. Because of the global recession in 2008-09, OPEC spare capaciy climbed to 8% of total demand in 2009, or about 4 million barrels, but it is projected by OPEC to drop again to 2% in 2013, which is unacceptably low, because spare capacity has been shown to correlate negatively well to large prices in peace time. As President Chavez himself said at the 141 Special Meeting of OPEC also held in Caracas, between May 30 and June 2, 2006, OPEC has lost its capacity to control the price ceiling of crude oil, but it still has the capacity to control the floor prices of crude oil, because, if for any reason—say a major economic recession in the G-7 countries— prices fall in a risky manner, OPEC simply calls a meeting and reduces production which, undoubtedly, will restore prices and strengthen OPEC´s power. As AVHI´s Economic Adviser, I got a formal invitation to this meeting from the Ministry of Energy and Mines (MENPET). Some months earlier, in an article that I published in a specialized magazine, I had given my point of view in favor of the position of establishing a floor on the oil price of US$ 50.00 per barrel, and to leave a free ceiling, since OPEC could not control it. Another way of visualizing OPEC´s increasing power is through the following chart: Dependence on Crude Oil Imports, 2004: Oil Imports Percentage Over Oil Total Consumption Japan Europe United States China

98 77 63 32

BP, Statistical Review of World Energy, 2005.

According to the founder and CEO of the renowned firm PFC Energy, assuming a growth in world energy demand of 1.8% the call on OPEC, was of 29 MMBD in 2005; it will be of 31 MMBD in 2010, between 35–38 MMBD in 2015 and between 40–52 MMBD in 2020. These projections, which match with many other qualified projections, also alert that if crude

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oil demand is of 2.4%, then these figures would be much higher43. In my opinion, they would be perilously higher, given the vulnerability of the supply available; if they are much lower, the price to pay is global recession, it‘s just that simple.

DEMAND A rich person is not one that has the most; it is the one that needs the least.

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—Mother Theresa of Calcutta

The fact that the physical limits of the world oil supply are being questioned and challenged is due to, in a large extent, the rise of oil demand that has rocketed in recent years, especially in the developing countries with mega-populations; there is no controversy here. The next quote, that comes from the current Head of the Central Bank of the United States of America, the Federal reserve, Dr. Ben Bernanke, is eloquent: ―The rise of China, India and the ex members of the communist block, implies that the vast majority of the countries of the world is intertwined, at least potentially, to the global economy …the scale and rhythm of this episode has no precedents . . . there are no historical records of this event.‖44 In fact, in 2004, in conformity with the International Energy Agency (IEA), oil demand grew at the fastest rhythm recorded since 1976 until reaching almost 81 million barrels per day, China leading the charge with approximately one third of the increase in demand. In 2005, it increased at a slightly lower rate as it did in subsequent years up to 2008. According to this same institution, in 2030 the developing countries could push oil demand by 47% to more than 120 MMBD, meaning that the oil countries and multinationals should have to invest around $100 billion dollars per year in order to develop the supply sources and adapt itself to this consumption rate.45 How much oil is left in the world is very much related with how much is being used, and this, at the same time, is closely related with the economic growth of the countries, especially the ones holding the largest population. During the seventies, for example, there was kind of a ―rule of thumb‖ among economists that said that a growth in the world economy of 3% would imply an increase in the energy demand of 2%, and an increase in the oil demand by 1%. Today, due to a variety of reasons, including environmental conditions and the awakening of densely populated nations, this relationship has changed towards a higher oil demand due to the economic growth. Lee Raymond, ex CEO of Exxon Mobil, stated it very eloquently and unambiguously as early in 2003: It is abundantly clear that the economic growth will be the primary driving force for energy demand. The world economy has increased at an average rate of around 3% annually since 1970. We expect that this growth 43

See West, Robin, The Age of energy Insecurity: Latin American Oil Lifetime at Risk. PFC Energy, Washington, DC January 2006 44 Speech given on August 25, 2006 in Wyoming. See Edmund Andrews editorial in The New York Times, August 26, 2006. In this speech, Doctor Bernanke made a comparison with the discovery of America by Christopher Columbus that changed the world after all, except that this event took a number of centuries to impact the world, whereas China‘s surge has barely taken 30 years. Ibid, see also the Web page of AIE: www.iea.org. 45 IBID www.IEA.org

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will continue at this rate for the next two decades, with reduced rates of population increase that are compensated with the growth of productivity. We expect the increase in energy demand to be at a lower rate reflecting significant advances that have yet to be materialized, in efficiency and in energy technology. We project that world energy demand will reach near 290 million barrels of equivalent oil per day, that represents an increase of 40% over the current levels…We anticipate that conventional fuels will be the leading source of 46 energy at least until the middle of this century.

According to OPEC, oil demand has been growing throughout the years and will continue to do so at a faster rate, especially in the developing countries and particularly in Asia, even though a considerable growth is anticipated in Latin America and in the oil exporting countries. Also, slight increases in the rich nations are being anticipated, which according to OPEC, between the European Union and the United States control 45% of the total consumption. However, as I will argue later on, given the price increases in fuel that are anticipated, it is very possible that the demand from the developing countries will be less than those projections indicate because the high prices will simply become unaffordable to many if not most of these people. If predicting the world oil supply is complicated, predicting world oil demand and consumption for the next two or three decades can also be complicated, even though it is more controllable from the economist‘s perspective and is right here where predictions from all experts fall in ranges that differ significantly. This uncertainty got very thorny in 2004, the year in which the growth in oil consumption exceeded, in each of the regions of the planet, the average for the last decade and it even doubled the annual world average in the last 10 years. The most noticeable region of all was East Asia, which has concentrated over 50% of the demand growth in the last decade. In that same year, the most populated country of the solar system, China, with an economy that expanded at an average rate over 9%, also managed to concentrate a third of the total increase in the world oil demand, displacing Japan to make itself the second consumer of oil of the world (behind the U.S.). To give it some perspective, the world growth of oil consumption in 2004 was almost equal to the production in Venezuela of that year; that is to say, in the year 2004, the world used nearly the production of the country with the largest oil reserve of the Western Hemisphere. This graph, which comes straight from the well cited Hirsh report to the U.S. Department of Energy projects the increasing oil demand from the different ―consumer types.‖ Developed regions such as the former Soviet Union, Japan and Western Europe are projected to stabilize or at least slow down their growth to negligible proportions, but they are still consuming considerably. The United States, which as said before consumes about a full quarter of the planet‘s yearly production, is expected to actually increase its demand because of the dynamics of its gigantic economy and sheer size of its country (later in this chapter we analyze the U.S. more thoroughly). By far the greatest growth in oil consumption comes from developing nations as they attempt to burst into the industrial revolution from very low (and mostly inefficient) energy production levels. China leads the way but so do others around and south of the Equator. The fact that globalization has shifted many of the highly intensive energy industries to these countries, such as steel, cement and auto manufacturing, only hastens this process.

46

See Lee Raymond, op.cit 2003

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Hirsh Report 2005

Graph 12. World Petroleum Consumption, 1960–2025.

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It is expected that the total sum of the oil demand from all sources be in the 120MBD range by the year 2025 (about 12 times the current production of Saudi Arabia), although since the Hirsh report the EIA (and others) have lowered their projections due to the energy related worldwide financial meltdown and economic recession which naturally bears a negative effect on total oil demand. It is my personal belief that levels such as 120MBD cannot physically be reached even with the unprecedented investments in the non conventional reserves at great environmental risk of degradation. If these levels of production are ever reached, the challenge of maintaining them will be even more daunting.

ELASTICITY If you don‘t worry about oil interruptions, you are living in a fool‘s paradise…our addiction to oil is a matter of national security. —James Woolsey, former CIA Director

A measure of demand that economists use with frequency is with regard to the concept of elasticity, which measures the sensitivity of a percentage change in the quantity demanded of a commodity in response to a price change of the same commodity. It is not a static phenomenon, and it can vary in the short-term period vs. the long-term period. Generally, a product is said to be ―price-elastic‖, if small changes in its price lead to large changes in the quantity demanded and, if the reverse is true, that large changes in the price lead to small changes in the quantity demanded, the product is said to be price inelastic. Similarly the measure is also applied to income, meaning that a product is said to be income elastic if small changes in income lead to large changes in quantity demanded and income inelastic if the reverse is true. Ultimately, all products have elastic portions in their demand schedule because at some point the consumer either substitutes the product with something else, or simply stops consuming it altogether (save basic necessities like air and water which are not scarce and are renewable). Inelasticity happens when the product is

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fundamentally useful and there are no ready substitutes, like oil and gas, whereas elasticity occurs when the opposite is true, like with a particular brand of soda. Economists (and consumers) prefer the elasticity scenario. Oil has been measured to be relatively inelastic with regard to price, at least in the short to medium term, but with a higher elasticity index with regard to income. Meaning that people are less likely to greatly reduce their demand for oil in the face of large price hikes, but they are more likely to do that if their income falls. Both of these news items are not good. Because they tell us that on the one hand our economy depends on oil for its functioning and people will rather use less of something else than sacrifice its oil consumption in response to a price surge, and on the other hand it also tells us that to reduce our consumption of oil we must incur going into a recession; because this is the only scenario where income falls. Later on in this same chapter we will establish firmly the close link between large price increases and economic recessions for the case of the United States. The following excerpt from the IMF, which cites reports of its own as well as from the U.S. Department of Energy, is insightful to gauge demand:

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Short term price elasticities of oil demand are generally believed to be low. The U.S. Department of Energy…considers them to be in the range of 0.01 to 0.04 (absolute values)—whereas income elasticities are much higher. Similarly…elasticities of 0.03 to 0.07 (absolute values) and values ranging from 0.03 to 0.08 were reported in the September 2005 World Economic Outlook (IMF). As a result, income effects have dominated price effects in oil demand. In a simple demand model with exogenous supply that ignores nonlinearities from low inventories and inter-temporal considerations, such price elasticities imply that a reduction in oil production of 0.5 million barrels a day—roughly the amount of the reduction in non-OPEC supply during the second half of 2007—should lead to prices that are 10–60 percent higher (based on 2007 production data). If longer-term price elasticities are higher than short-term ones, prices will overshoot their long-term increase in response to a 47 supply reduction.

Now, if we compare this sudden increase in the oil demand with the projected spare production capacity, around 2% of total demand , we start to detect the vast magnitude of the tsunami-like energy problem approaching us. Moreover, the oil refining capacity has been decreasing in an alarming manner in recent years, and not more than in the United States, where a new refinery has not been built in the last 30 years48. When some of these companies are asked why this is so, some state that the strict environmental restrictions prevent them from building refinery capacity. However, that statement almost borders on the ridiculous because it is known that Big Oil has a lot more money and lobbying muscle that the whole environmentalist movement put together49. The pessimistic, who know that a refinery could cost between US$500 million to US$2 billion and take up to four years to build and about seven to recover investment, think

47 48

49

See IMF World Economic Outlook, October 2008, Chap. 3. Notwithstanding, as of recent years, some efforts have been observed in the U.S. to expand some of its refineries. But since the U.S. Energy Secretary himself admits, this has been a slow effort. See the Spencer Abraham Speech (2004) in which he makes a convincing case for the development of the Arctic reserves.

However, this may vary depending on who is sitting in the oval office of the White House. Bill Clinton, for example, gave his veto in 1995 to a draft bill to develop the Arctic reserves precisely due to environmental causes. It is considered that, if he would have done the opposite, the U.S. could have one million barrels a day more of production. See Abraham‘s speech previously mentioned. To be fair to President Clinton, however, the oil prices and perspectives were different during his tenure.

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differently, and ask themselves: Could it be that multinationals think that there is not going to be enough oil to be refined in the future? The optimistic, who have the same information as their counterparts, have a different opinion and ask themselves—Could it be that oil is going to be replaced by another renewable source and refineries are going to become as obsolete as horse stables? Is the bottle half empty or is it half full? The point is that, given the balance, the equilibrium between current oil supply and demand, the range of operations in the market has been reduced to its minimum, which leaves the importing countries vulnerable and wholly dependent on their inventories if any political, terrorist or environmental quirk (hurricanes) were to disrupt their distribution. We will deal with those issues further on from another perspective. For now, we will concentrate on paying a short visit to two truly important countries during this story. These countries may be, if not already are, flying in an asteroid-like collision course towards each other from opposite directions; except that in this case their economies are highly dependent on each other: the United States and China.

THE UNITED STATES One can always count on the United States to do the right thing, but only after they have exhausted all the other alternatives.

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—Winston Churchill

During the course of centuries, there has most always been a dominant country, and history has displaced the dominion of each according to prevailing circumstances, normally with cruel and bloody wars that have occured either to maintain this power or enlarge it as well as to change it. It is not the purpose of this book to summarize the rise and the fall of empires and civilizations, but the point is that a large part of humanity‘s progress has been due to the internal and external control of those empires and to the sharing of knowledge and the opening of new transportation and commercial routes. Many innovations in technology have been the result of conflicts between civilizations. The United States is one of those cases, an immensely rich country in resources, population, creativity, freedom, legal rights, culture and especially what they call ―fair play‖ or ―level playing field,‖ where the little guy is guaranteed a shot at winning (reason that explains why so many poor people want to live there). The United States is also poor where it needs to be, as in its relative lack of aristocrats and famous names with inheritances. Along with democracy and fair play, perhaps its greatest strength is its competitive economic system that has produced unprecedented productivity, research and development investment, technological breakthroughs and unmatched Nobel Laureates in every field, including the arts. Its history has been really glorious throughout its short life, which is less than three centuries and, as in other countries, it has also had its share of dark moments, as was its unduly long period of racism, sexism, intervention and the harsh treatment of its indigenous population prior to the XX century. However, it was this country that had to take the economic, political, and military leadership in the world when the empires of the old continent in Europe and Asia demonstrated that they were not able to continue with their

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regional and global domain without bellicose confrontations of unacceptable bloody proportions. It is important to point out that the United States never pursued this leadership and even dodged it on at least one occasion, as when its Congress rejected Woodrow Wilson‘s proposal to incorporate the U.S. into the League of Nations after the First World War. But, with the mandate of Franklin D. Roosevelt, the worlds most important figure or the XX century, the United States accepted this leadership at the end of WWII and, upon making that decision, the United States, as well as the world as a whole, embarked towards the most progressive, free and productive half century in the history of mankind, far bigger than it could ever have dreamed; as evidenced by the exponential population increase, technological achievements and rising living standards for the greater part of the people (even though, not completely equal or fair). As we have seen throughout these two chapters, to a great degree the economic progress that the United States has led was due to the inexpensive employment and availability of oil, and it is precisely in this sector where the United States is now facing one of its greatest challenges (it has overcome the other ones). Take into consideration the following 22 facts:50      

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         

 50

Between 1972 and 2004, its oil reserves decreased by 41.5% to 21.4 billion barrels. It owns only 2.5% of the world oil reserves. It produces 9% of the world oil. It imports 27% of the world total oil commercial flow. The U.S. imports 63% of its needs for oil consumption. Around 16% of the total of its oil production comes from marginal wells or stripper wells that produce less than 10 barrels a day. According to specialists, the U.S. reserves at Prudhoe Bay, in Alaska, are declining at an 11% rate annually. In 2004, almost 400,000 of its stripper wells produced 2.1 barrels of oil a day. The U.S. relies 41% on oil and 23% on gas for its energy consumption. The U.S. depends 95% on oil for its transportation needs. The U.S. depends on oil for 99% of the fuel its residents use in their automobiles and trucks. 47% of its imports and 27% of its total consumption depend on OPEC imports. Its production and consumption centers are far apart; food travels in trucks an average distance of 3,000 miles between these centers. The gas consumption of the U.S. represents 39% of the world total. All economic recessions that it has endured in the last 30 years have been preceded by sharp oil price increases. By the year 2030, assuming an average growth in the economy of 3% per year, the United States would need to use 28 MBD of oil, which is OPEC´s total current production. It has not built a new refinery or a nuclear plant since the 1970‘s.

The sources of this data are different. See the U.S. Department of Energy; Energy Information Administration; BP Statistical Review; Oil and Gas Journal; Petroleum Industry Research Foundation and the American Petroleum Institute and Gerbino & Co. (all from 2005).

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 97% of its automobiles and trucks run on conventional internal combustion engines based on pistons; in Europe this percentage is nearly 50%.  Of the roughly 17 million cars that were sold in the U.S. in 2005, about 1.1% of them were hybrids.  The U.S. consumed in 2005 about 400 million gallons of oil per day.  Its two principal car making companies are noticeably inefficient in the use of fuel, with an average of 30–33 miles per gallon (MPG), compared to Europe and Japan that have an average of 40–45 MPG. American SUV‘s average near 21 MPG. Both companies are in difficult economic situations, which have been further complicated by the collapse of Wall Street. The U.S. government is financially helping them to bridge the technological gap towards fossil-fuel-free engines.  According to its Energy Department, there still are around 400 billion of proven semi-conventional reserves of oil in the U.S. that can be technically recovered with the current technology (see Chapter 6).

Source: U.S. Information Administration. Graph 13. United States Oil Production (MBD).

We could add to this scenario that in the most recent years the U.S. payments for oil consumption have increased by 54% equivalent to US$ 210 billion, to reach a figure of US$ 600 billion by 2005. According to an independent study, to grow and transport one frozen calorie of lettuce from California to the east coast of the country it needs 36 energy calories.51 In the words of the U.S. Department of Energy: ―Oil is the blood that provides life to the American economy52‖; and Samuel Bodman, Energy Secretary of the United States, who said in July 2006 that in the foreseeable future we will see how oil demand will exceed supply.53 As we have mentioned before, the United States reached its production Hubbert peak more than three decades ago. But, if one takes into account the proven reserves from the Arctic (ANWR), the undiscovered reserves in the Bakken formation of the upper midwest or beneath the Rocky mountains, and with some other uncertain and costly perspectives in the 51

McKibben, Bill- ―A Deeper Shade of Green.‖ National Geographic, vol. 210, No 2, August 2006. See the Web page: www.energy.gov/energysources/oil.htm. 53 Quoted in Meacher, Michael. ―Urgent Action Is Needed to Avert the Looming Oil Wars.‖ Financial Times. 11-42006, London, UK. 52

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deep waters of the Gulf of Mexico or the Atlantic coast, its production profile could flatten out considerably, but not before much time has passed because the development of these undiscovered reserves could take decades54. On the positive side, the United States has been able to improve its energy effectiveness considerably, through the combination of greater productive efficiency in its manufacturing sector, and also because it has been able to transfer abroad a large portion of its highly intensive energy consuming industries (by means of imports, such as steel, and also by relocating the physical facilities of their motor plants to places such as Mexico and China). Nonetheless, since the oil crisis of the 1970s to today, the U.S. has achieved success in reducing its monetary dependence on oil consumption by half of its GDP, an achievement that should be recognized.

A FOOL’S PARADISE? When a door of happiness closes, another one opens up, but so often we stare for so long at the closed door that we do not see the door that just opened.

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—Hellen Keller, American writer and intellectual, blind and deaf mute at birth

For many foreigners, the perspective on the consumer idiosyncrasy of the United States is, to say the least, negative, to the point that Pope John Paul II publicly criticized it whenever he used to visit the U.S. The point is that too many people describe the typical North American consumer as an insatiable glutton, where each privilege is a right, each luxury a need, whose only goal in life is to outpace their neighbors in material wealth, extravagance and grandeur of their assets. To quote a statistic, consumption in the United States increased at an annual average rate of 3.9% between 1995 and 2003: in real terms, this figure almost doubles the rate of 2.2% recorded in the rest of the world.55 Speaking personally as a man who grew up in the Maryland suburbs, I believe that I know the United States as I know my own country because I lived there in three different decades (had just turned 12 when I first arrived in the early 1970s and left a few months before my 23rd birthday, only to come back briefly in the mid 1980s and again as a Diplomat in the mid 1990s for a few years), I can assure anyone that these opinions on the American person, of being an almost compulsive expender of material goods, mostly with borrowed money, is mostly true but with a very important qualification: And that is that they behave this way when they know they are not hurting anybody else, least of all their own children‘s future. In fact, they believe that the opposite is true, that their free spending helps the economy and the world. 54

The Arctic National Wildlife Refuge reserves in the Alaskan slopes have been estimated to contain anything between 4.8 billion to 29 billion barrels of oil with anything between 600 million and 9.2 billion of recoverable oil. However, these estimations were done with aeromagnetic technology and winter seismic, which, as its results clearly imply, are very vague. We will never know for sure until ―Dr. Drill‖ has its voice heard; and that depends on the U.S. Congress. At least according to the ANWR web site, 75% of the good people of Alaska are in favor of developing this area. 55 See U.S. Department of Labor (2005).

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The American people have not been told properly that their excessive addiction to oil is detrimental to their country, to other countries, to their descendents, and to their planet and unless this is explained to them clearly, they will never fully understand the magnitude of the problem until after a severe shock to their system; like now. Notwithstanding, I am confident that when the American is told in a understandable manner that their actions can generate serious consequences on their loved ones and strangers, they will be the first to get together and request a change of direction and make the necessary sacrifices for that to happen. It may be that they cannot always rely on the political leadership that they deserve, and possibly that is related to the fact that their leadership has an excessively shortsighted perspective for these objectives. This was summarized by an editorial as early as 2004 by The Washington Post:

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Unfortunately, politicians and bureaucrats have ignored Hubbert peak and do not have plans to face it: If it 56 is beyond the next elections, forget it .

Examples of their capacity to change the course of history are plenty, and there is no need to list them all. The hippie movement that ended the Vietnam war; the environmentalist movement that has successfully requested strict ecological standards with the manufacture and distribution of products; the Afro-American movement, that also successfully requested a fair treatment of their race; the anti-smoking movement; the women‘s-lib movement, which achieved fair treatment for their gender; the pro-animals movement, which managed to save from extinction such majestic species as elephants, dolphins, whales, and the maritime turtle, among others. Their decisive incursion in two world wars to save Europe from the genocide fascists tyrants; the indigenous movement that has assured fair treatment and successfully requested sovereign land from some of the western states (today, except for the Federal Government, there is no group of people that owns a larger portion of land in the U.S. than the ―native Americans‖). It can be stated that the whole environmentalist movement, old and new, from the times of Henry David Thoreau in the XIX century until today, was an original creation by the United States. These are but a fraction of examples of recent positive historical shifts of tectonic proportions that were engineered by the united consciousness and actions of the people of the United States. That is to say, when the Americans really put their mind to doing something in favor of mankind there is no hill too high to climb, and he/she goes against all odds, period. The issue on the imminent oil shortage has simply not been explained well to the regular American, and he lives in a fool‘s paradise, naively thinking that oil is infinite, even though the technocrats of their oil companies and specialized magazines do acknowledge the problem. With respect to the government, the professionals do seem to be acquainted with this problem that they are about to face, and some of their top officers, among them, the Vice President, the Secretary of State, and even former CIA Directors have described it as ― a problem of national security‖. As it was said by the oil experts Randy Udall and Mathew Simmons of ASPO in the aforementioned article: ―With respect to oil, the United States has already been wandering around towards disaster for 20 years.‖57 In this graph we see the breakdown of the oil consumption by sector in the United States. As can be observed, the biggest chunk to tackle is in the transportation sector, and this does 56 57

See Jordan & Powell (2004). See Udall and Simmons (2006).

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not only mean urban driving, but it also includes food transport from the vast and far rural areas to the completely dependent urban metropolis on its coasts. In the other sectors, like industry, electric power, residential and commercial, oil can be more easily replaced because it requires less movement, but the fact that it is so vastly used in these sectors is only because it is much more efficient than alternative fuels. As oil progressively becomes less cost efficient, it must be gradually replaced, at first by other fossil fuels of the hydrocarbon variety like gas and coal, which also face depletion as non-renewable natural resources as well as other challenges we will tackle in the next chapter.

Graph 14. U.S. Petroleum Consumption by Sector.

POWER TO THE PEOPLE I firmly believe in the people. If you give them the truth, you can trust that they can endure any national crisis. The big fact is that you have to give them true facts… Let us have faith that reason gives strength, and that said faith gives us, at the end, the courage to carry out our duty as we understand it. —Abraham Lincoln.

The question is: What can the government of the United States do in the short and middle term to stop a tragedy of unthinkable proportions. The first thing to have in mind is that we still have some range of action, some maneuvering room; Hubbert´s Peak does not mean that we have run out of oil. Having this in mind and using the media to advertise it, the citizens would have to be warned that they necessarily have to change their consumption habits, especially in transportation, which is at the core of the problem. To educate, without frightening the American consumer, that inexpensive energy is one of the fundamental pillars that has supported western civilization in

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the last century of its history, and that it is still essential for its sound performance, would undoubtedly be a good start. A second step would be to employ the automotive hybrids technology that already exists in a massive way. This would even double the amount of MPG and improve automotive efficiency and therefore reduce oil dependence. Ford and GM have already announced that early in the next decade almost half of its fleet will be composed of hybrid and electrical cars. A third measure would be to dismiss, progressively, the transportation of food by trucks and adopt electric trains that are much more efficient in fuel consumption. To use the technology available in computers through teleconferences and reduce the need to attend offices daily would also reduce gas consumption. A fourth and decisive step would be to slow down world economic growth until the scientists have the time to progressively replace oil, and the way to do this is the subject of Chapter 7. These measures should not be completely permanent, as it will be explained further on. Its design is just to ease a transition phase because, if we do not do it, if the U.S. does not take a leadership position to do it, we will not have the necessary time to go through this period without making larger sacrifices, including an extended and irreparable cycle of economic depression. If the price of oil becomes more expensive than the bearable limits (in 2008 we learned the perils of this), in which the poor start to suffer within the rich countries and where tension builds up over the few countries left with large reserves the damages will be severe and our descendants would never forgive us. Quoting a report from the U.S. Department of Energy:

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Even though we do not run out of oil, the Federal Government admits that it could become astonishingly expensive…Is the world going to run out of oil? No, but only because eventually it will be too expensive in the 58 absence of less costly alternatives.

The problem with this quote is, in my opinion, that it assumes a kind of Darwinian selection for survival, where first, the oil-endowed nation will survive; second, the strongest and richest oil importing country; third, its closest allies; and last, maybe, the richest social classes within the poor nations and that‘s it. It is impossible to think that this scenario can happen without severely destructive wars between and within the countries of the world. As was perfectly summarized by the honorable Roscoe Bartlett, a Republican Congressman from the state of Maryland, who headed the formation of a committee (caucus) on oil peak in the U.S. Congress, set out the alarm: The world has never had to face a problem like this one.59

FINANCIAL METASTASIS Not only have financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient…it seems superfluous to constrain trading in some of the newer derivatives and other innovative financial contracts of the past decade, the worst have failed; investors no longer fund them and are not likely to in the future. —Alan Greenspan

58 59

Cited in Silverstein, February 10, 2006 Cited in Gopinath, Deepak. ―Peak oil forecasters win converts on Wall Street to $200.00 Crude.‖ Bloomberg, U.S., August 31, 2006, www.energybulletin.net

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As I write these lines, in the heart of Washington DC, the United States just finished its absolute worst financial performance week in the 112 year history of Wall Street (it would continue to worsen afterwards). About a week before that I had published a full page article in a prestigious Venezuelan newspaper and in an equally prestigious online petroleum magazine in Caracas in which I gave my perspective on this unprecedented crisis. Although this is not the place to fully disclose what this perspective is, it suffices to say that in my opinion at its essential core this is mostly energy related; or more specifically, peak oil related which occurred at the same time U.S. investment banks were way overstretched and exposed in their bizarre derivative markets. How else would you explain that iconic Wall Street institutions like Lehman Brothers, Merryl Lynch, or Bear Stearns, who had more than a century in the business and had even survived the decade long Great Depression could not stay afloat one month in this crisis?. Peak oil theorists, like myself, have always stated from many years ago, (witness the Hirsh and the ASPO scientists‘ reports, speeches and presentations, and even my own speech at the launching of my previous book in October 2007) that the United States was in a very vulnerable position regarding its financial stability because its economic system is crucially dependent on quarterly growth, which in turn is very dependent on personal consumption (the U.S. GNP depends on consumption for 66% of its growth) and that consumption is critically dependent on stable income flows and wealth effects that in turn depend on the growth of Wall Street‘s indicators that make the financial funds available for the companies to invest and lubricate their growth (economists may link this reasoning to Milton Friedman‘s permanent income hypothesis; more on this in the conclusions). Many people in the U.S., if not most, live in a post-industrial globalized society that translates into service related and unstable jobs (the days where you started working at GM or Ford at 22 and left at 65 are long gone). But this very people want—and mostly deserve— to live the American dream of owning a house that, along with Wall Street, increases their personal wealth. With peak oil added into this mix that increased the costs of oil by a factor of four times (real terms) since 2003 and with it all the commodities that depend on its ever increasing supply at affordable prices, you have the perfect recipe for a disaster. When you then add into this very same mix the unscrupulous behavior of many financial institutions and the negligent behavior of many federal watchdogs, then this disaster turns into a time bomb. The cost of oil imports in the U.S. has increased by over 450% since 1998, and this has caused many firms to cut back on contracts, fire people, or at best freeze their income. These events caused these people to be unable to continue the payment of their homes and the banks had to foreclosure many of them, which sent the value of their houses, and the Dow Jones, into a free fall, to the point that many went into negative equity (the value became less than the mortgage owned). Since these people rely on the value of their homes and the Dow Jones for their lifetime investments, their wealth effect was negatively affected which sent the value of their assets falling even more rapidly. Some economists link this to pressing the accelerator of your car when you are already driving downhill. Now, what were hidden by Wall Street from all were the derivative positions of their investment banks, or future bets on the underlying value of assets today, which also came crashing down because the value of these assets collapsed. Alongside the impact of globalization in the labor force and peak oil, which is largely the result of the non-conscious dynamics of the market system, next in line in the blame game for this meltdown is the all too conscious behavior of the banks, especially the investment banks

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and their insurance companies, and specifically for their ultra wild/bizarre derivatives exposure to the (uninsured) mortgage-backed security positions that they hedged with what they called ―Credit Default Swaps,‖ or CDS. These instruments were designed and sold as insurance contracts between the parties to hedge risk in case of default in the payout of the security, and thus make these ruinous securities attractive (the banks intentionally used the word ―swap‖, instead of ―insurance‖, to purposely keep it away from good insurance laws that require capital ownership to cover the insured security). The values of these swaps are anyone‘s guess, but figures in the $62 trillion dollar range have been divulged.60 These iconic Wall Street institutions are also to blame because when they saw this coming they should have restricted their mortgage-based loans to consumers and also to themselves, and instead they increased them by 11% in the 2002–2006 period (far larger than growth in the U.S. economy), according to the Wall Street Journal, because they knew that they could repackage them with other loans and sell them to other banks in the secondary market at fat commissions. Something that they did over and over again by overstating their true worth, which in turn made the derivatives markets less stable and more vulnerable. The interbank loans were purposely coated under complex sophisticated mathematical formulas designed to keep them from the scrutiny of not just the buyer but from the regulators like Fanny Mae, Freddy Mac and, more importantly, from the SEC. This derivative markets trade in asset swaps, interest and currency, and the over-thecounter market, at values have been estimated to be over $531 trillion dollars, an increase of over 400% since their estimated value in 2002. This is a gargantuan number that is 39 times the U.S. Gross National Product, equivalent to $1.45 trillion dollars a day: no wonder investor Warren Buffet called them ―financial weapons of mass destruction, carrying dangers that are potentially lethal.‖61 Aside from this outrageous behavior of many banks and the negligible behavior of the supervising agencies, it is doubtful to me that this whole Wall Street mess would have occurred at all if the oil price had stayed, say, at $25 per barrel. Little wonder people get nervous when they read Alan Greenspan stating: ―I am saddened that it is politically inconvenient to acknowledge what everyone knows: The Iraq war is largely about oil.‖62 Bottom line: To solve the current global financial meltdown, the United States has to incorporate tight financial regulation on all banks, even if it means partial nationalization of the bigger and most exposed ones and solve the peak oil problem by mathematically relating the supply of energy measured in BTU to the monetary supply in coordination at the international level. Shortly after 2030, if current trends continue, the United States will be close to 100% dependent on foreign sources for its oil consumption; that is, 100% vulnerable in its energy security. We will offer recommendations on how to do this later. But we need first to comprehend the sheer magnitude of the problem before, and China is a big piece of this puzzle.

60

See Engdahl, F.W., ―Credit Default Swaps, The Next Crisis,‖ Financial Sense Editorials, June 6, 2008 Quoted in The New York Times, October 9, 2008. 62 Greenspan, Alan: The Age of Turbulence; New York, Penguin Press, 2007. pp 463 61

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CHINA China is a sleeping giant, the day that it awakens, the World will tremble. —Napoleon Bonaparte

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China has the biggest population of all countries on the planet but is one of the lowest energy consumers per capita. Recently, and thanks to market policies supervised by a communist government with a progressive/productive outlook, China has vigorously awakened in a very strident manner; and true to the old frenchman‘s predictions, the world has trembled. This country, which only one or two generations ago had nearly 90% of its population plowing behind bullocks in the countryside and the rest riding bicycles in the big cities, today maintains an industrial revolution that will overtake all other Asiatic tigers when they finish their expressways. It is considered that in this generation, more than 200 million Chinese have moved out of poverty.

Graph 15. China, Production and Consumption.

The awakening of the People‘s Republic of China has coincided with globalization and the millennium, and between the late 1970s and 2007, the economy had grown by the astonishing figure of 9.8%, according to the World Bank, while its oil imports have increased in that same period by over 400%. China became a net importer of oil in 1993, but it was in 2004 when the energy planners of the whole planet fell off their seats because that year, as it was mentioned before, the country grew by 9.4%, its energy demand by 15.8% and its oil demand in 900,000 BPD, which was all satisfied by imports. This caused the world oil demand to grow faster than it had since 1987 and the entire world demand of primary energy (oil, natural gas, nuclear energy, hydroelectricity and coal) grew by 4.3%, which was the highest increase ever

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registered in terms of volume. Three years since, the energy demand of China has grown 65%, which accounts for more than half of the global growth for that period. Today, China consumes around 13.6% of all the energy produced in the world and that amount of consumption is 8.2% of all the oil consumed in the world, which makes China the second biggest consumer, behind the United States.63 The problem is that China has over 20% of the world population, and that it has given signals that it believes that, at the very least, its people should consume a proportional share of energy and world oil, except that they only have 1.4% of the world reserves64. Since 2003, its demand for automobiles has increased by 70% (more than two million units) and experts foresee that this pace will not stop shortly. According to a publication, by 2010 there will be 90 times more cars in China than in 1990, and if this pace continues until 2030, it will pass the United States in the absolute number of automobiles65. Some analysts think that by 2025 this giant will be consuming 10 MBD (over 6.7 MBD than now) if this kind of economic growth continues unabashed. It is precisely here where China confronts its big bottlenecks. Where are they going to find all that oil and who is going to build that vast amount of infrastructure of state of the art technology in ports, terminals and refineries that are needed for this consumption?. During the last decade, its refining capacity has increased annually in for an average of 5%, which represents about 87% of the total consumed in 2004. Currently, China relies only on 58% of the refining capacity that it will need in 2025, and in accordance with a report issued by the State Commission for Reform and Development (Xinhua), China still needs a refining capacity of 17 million tons to satisfy its current demand.66 This is the problem that arises when you are a late comer to the capitalistic-globalization game, because while the OECD countries started to build their civilization based on cheap oil at the end of the 19th–early 20th century, China, who had been asleep for the better part of this era with an increasing population, slowly wakes up in the late 1970s and gets off and running on the eve of globalization with declining reserves and increasing oil prices67. Does this mean that China has its back against the wall? Not necessarily. In the first place, contrary to other countries, China may have some unexplored promising fields in their south sea and western region in the Himalaya Mountains close to Tibet. Also, China is actively exploring in the Sea of Bohai and in the entrance of Perla River and is actively negotiating with the Middle East, Venezuela, and the countries of the Caspian Sea to increase their imports, and has also held conversations with Russia to construct pipelines from that country. The global recession will undoubtedly reduce its economic and industrial growth and doubtless will dampen the dreams of many people in the rural as well as in its sprawling cities. China is in third place in coal reserves in the world, and as we will see later, the technology for extracting liquid fuel oil and hydrogen from coal while minimizing its environmental impact already exists; but with problems in scale and costs that need to be 63

See BP (2005). Also see Cook (2005). See Aleklett (2001) 65 See Luft, Gal. Fueling the Dragon: China‘s Race into the Oil Market, in Institute for the Analysis Global Security, Washington, D.C., 2005. 66 Quoted in El Diario de Caracas (14-02-2006) 67 As I sometimes joke with my students, it‘s like coming to a party with 20% of the guests four hours late and complaining why half the beer is gone. 64

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addressed. Finally, their strategy for energy security with the OPEC countries has been very successful, like their recent agreement of assuring 1MBD from Saudi Arabia for the next 20 years, and for the fact that Venezuela‘s PDVSA has already opened an office in Beijing and started to export around 160,000 barrels in its effort to diversify its exports to that market68. Consider also this phenomenon from the prism of the extra-populous nations like China and India, where the ratio of vehicles per person ranges between 10 and 20 vehicles per each 1,000 inhabitants, compared with more than 500 vehicles per the same number of inhabitants in the countries of the OECD or the 77% ratio in the U.S. Imagining what would happen to this planet in matter of energy supply and the environment if either one of these two countries tries to emulate the same consumption mode of the U.S. or Great Britain chills the spine of everyone. Dr. Lester Brown of the Earth Policy Institute, eloquently considers this scenario in an exercise that assumes an annual 8% GDP growth rate of the Chinese economy up to the year 2031: Could the American dream in China become a nightmare for the world? For China‘s 1.3 billion people, the American dream is fast becoming the Chinese dream. Already millions of Chinese are living like Americans—eating more meat, driving cars, traveling abroad, and otherwise spending their fast-rising incomes much as Americans do. Although these U.S.-style consumers are only a small fraction of the population, China‘s claims on the earth‘s resources are already becoming highly visible.

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With energy, the numbers are even more startling. If the Chinese use oil at the same rate as Americans do now, by 2031 China would need 99 million barrels of oil a day. The world currently produces 79 million barrels per day (it‘s now 86) and may never produce much more than that. Similarly with coal, if China‘s coal burning were to reach the current U.S. level of nearly 2 tons per person, the country would use 2.8 billion tons annually—more than the current world production of 2.5 billion tons. Apart from the unbreathable air that such coal burning would create, carbon emissions from fossil fuel burning in China alone would rival those of the entire world today. Climate change could spiral out of control, undermining food security and inundating coastal cities. But this is not simply a conjecture from our part, it is a fact that on August 27, 2008 China became officially the worlds greatest polluter, churning out more CO2 out of their electric coal fired plants than the United States. But certain signs of ecological sensitivity from China are emerging, like its signing of an emission reduction agreement with India and its high level meetings with green scientists. And what about cars? If automobile ownership in China were to reach the U.S. level of 0.77 cars per person (three cars for every four people), China would have a fleet of 1.1 billion cars in 2031—well beyond the current world fleet of 795 million. The paving of land for roads, highways, and parking lots for such a fleet would approach the area now planted with rice in China. The competition between automobile owners and farmers for productive cropland would be intense. The point of this exercise of projections is not to blame China for consuming so much, but rather to learn what happens when a large segment of humanity moves quickly up the global economic ladder. What we learn is that the economic model that evolved in the West—the fossil-fuel-based, auto-centered, throwaway economy—will not work for China simply because there are not enough resources. If it does not work for China, it will not work for India, which has an economy growing at 7 percent per year and a population projected to surpass China‘s in 2030. Nor will it work for the other 3 billion people in the developing world who also want to consume like Americans. Perhaps most important, in an increasingly integrated global economy where all countries are competing for the same dwindling resources, it will not continue to work for the 1.2 billion who currently live in the affluent industrial societies either. The sooner we recognize that our existing economic model cannot sustain economic progress, the better it will be for the entire world. The claims on the earth by the existing model at current consumption levels are such that we are fast depleting the energy and mineral resources on which our modern industrial economy depends. We are also consuming beyond the sustainable yield of the earth‘s natural systems. As we overcut, overplow, overpump, overgraze, and overfish, we are consuming not only the interest from our natural endowment, we are devouring the endowment itself. In ecology, as in economics, this leads to bankruptcy. China is teaching us that we need a new economic model, one that is based not on fossil fuels but that instead harnesses renewable sources of energy, including wind power, hydropower, geothermal energy, solar 68

A different story evolved when it tried to acquire Unocal.

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cells, solar thermal power plants, and biofuels. In the search for new energy, wind meteorologists will replace petroleum geologists. Energy architects will be centrally involved in the design of buildings. In the new economy, the transport system will be designed to maximize mobility rather than automobile use. This new economy comprehensively reuses and recycles materials of all kinds. The goal in designing industrial processes and products is zero emissions and zero waste. Plan A, business as usual, is no longer a viable option. We need to turn quickly to Plan B before the geopolitics of oil, grain, and raw material scarcity lead to political conflict and disruption of the social order on which economic progress is based.69

To conclude, China did make a large contribution to put the Hubbert Peak on the map, which is good, and it will also contribute to get a solution to it. It is my impression, nevertheless, that the Chinese will contribute to this solution only if it perceives that other consuming countries are doing the same; that they too are biting the bullet and making the necessary sacrifices. Nothing else can be asked from this millennial nation with enriched history, culture and industrious people. In the following chart we can see the profiles of two big countries that have determined and will continue to determine the behavior of the crude oil demand.

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China versus the United States: A Tale of Two Countries (percentage weight over the rest of the world) I. II. III. IV. V. VI. VII. VIII. IX.

World Population Urban and Rural Population GDP growth 1994–2007 GDP proportion Oil Reserves Oil Production Oil Consumption Oil imports Refining capacity

United States (%) 4.6 80.8–19.2 3.1 28.3 2.5 8.5 24.9 26.8 20.1

China (%) 20 40.5–59.5 9.8 4.3 1.4 4.5 8.2 7.1 6.9

Note: Items II and III correspond to the situation and performance of these two countries. The others correspond to a specific weight of the U.S. and China over the rest of the world. Source: United Nations, World Population Prospects 2004; CIA, The World Factbook 2006; IMF-WEO, 2005; British Petroleum Statistical Review of World Energy, 2005.

ECONOMIC IMPLICATIONS Almost daily, new evidence is emerging that progress can no longer be taken for granted, that a new Dark Age is lying in wait for ourselves and our children...The first big problem is our insane addiction to oil. It powers everything we do and determines how we live. But, on the most optimistic projections, there are only 30 to 40 years of oil left. One pessimistic projection, from Sweden‘s Uppsala University, is that world reserves are massively overstated and the oil will start to run out in 10 years. That makes it virtually inconceivable that there will be kerosene-powered planes or petroleum-powered cars for much longer. Long before the oil actually runs out, it will have become far too expensive to use for such frivolous pursuits as flying and driving… Oil is one diminishing resource, and fresh water is another, even more vital one. Wars are virtually certain to be fought to gain control of these precious liquids…. People generally assume that we will find our way round this using hydrogen, nuclear, wave or wind power. In reality, none of these technologies are being developed anything like quickly enough to take over from oil…. if innovation is the engine of economic progress — and almost 69

Brown, Lester, ―Learning from China: Why the Western Economic Model Will Not Work for the World.‖ Earth Policy Institute, March 8, 2005.

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everybody agrees it is — growth may be coming to an end. Since our entire financial order — interest rates, pension funds, insurance, stock markets — is predicated on growth, the social and economic consequences may be cataclysmic. —Bryan Appleyard

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―Waiting for the Lights to Go Out‖ (London Times, October 2005)

Throughout this chapter we have already warned about the potential economic calamity to civilization if a shortage of oil would commence. Civilization as we know it, in all of its dimensions and facets, rests on social and physical pillars, meaning philosophic, economic, democratic, historic, cultural, religious and technological pillars. But, our civilization also rests on pillars of the material-physical nature that organizes our progress and in the same way imposes on us limitations that can or can not be overcome. The civilization that we have known for over 150 years has relied on the energy pillar and none of them is more important than the cheap oil. When the world reaches its Hubbert Peak, if it has not already done so, the reserves of conventional oil will start to drop at the same rate that the world consumes it, and consumption will change to the extent the oil price rises and/or economic growth stalls and declines. It is possible that after reaching the highest peak of production, this level could be held for a short period of time except that by that time the world economy would have stopped growing and should start to contract its progress first in the nations with no reserves or that have no access to them, like the poor non-OPEC nations, then the other non-OPEC nations in the OECD club, and then on those that do have some oil reserves but that depend on dwindling oil production for almost their entire foreign exchange earnings. No one benefits from a worldwide depression. In the best of cases, this would be an unbearable situation at the diplomatic relations level. The following graph from the US energy consulting firm WTRG Economics and the Hirsh report correlates US economic growth and recessions with sharp turns in the oil price. Notice that in all cases recessions were preceeded by high oil prices, that the recession itself lowered the oil price for every downturn, except in this last case, were in spite of the continuing recession the oil price has actually increased again. The reason for this anomality is not demand, but supply shortages and long term concerns about its availability.This information of the U.S., and by extension, the industrial world, cannot be more compelling.70 Consider what would happen if oil were to suddenly disappear without us being prepared for it. Almost every industry of transportation, autos, trucks, ships, trains and planes would be paralyzed. Without fertilizers and insecticides made of oil base, food production and transportation would drop and millions of city people would have to move to the countryside and produce food through mules and bullocks (if they find them). The production of any kind of manufactured goods, from reinforcing rod to plastic tools, and a great part of the medical industry, would also be paralyzed. In Nordic countries millions of people, especially the poorest and neediest, would freeze and would migrate to the South. The value of the financial capital in the Stock Exchange, whose determining factor is its growth rate, would also disappear if the world comes into an inevitable depression.

70

The graph was updated to account for 2009 oil price increases by this author.

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09

17

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Graph 16. Economic Recessions in the U.S. Have Been Always Preceded by High Crude Oil Prices: The Last 30 Years.

Tensions between the countries and frictions between classes and economic groups will be kindled until they reach unimaginable proportions. Truly speaking, this would be a disaster impossible to contemplate or exaggerate. We would simply go back to the Middle Ages. When could this happen? Some pessimists argue that it is unavoidable and will start after we reach the Hubbert Peak. The optimists think there will be an easy transition to other sources of energy and that we should not be worried. The ones in the middle think that there will be a transition, but it could only be possible if we worry about the worst effects now. When will we reach the Hubbert Peak? All Bets are on the table71. I. Daniel Yergin from CERA says that the peak will be reached in 2020 and will be maintained on a plateau without decreasing for a long time. II. Shell thinks that it will be after 2025. III. In accordance with PFC Energy, the peak will be in the range of 100 MBD in 2020. IV. World Energy Council says that it will be after 2010. V. Geologist Kenneth Deffeyes, author of a book on the Hubbert‘s Peak, says that the peak arrived in 2005. VI. The U.S. Energy Department says that the peak will be in 2037. VII. Lord Browne, CEO of BP, considers that it will be in a very long term if the known reserves are developed. VIII. Mathew Simmons said that the peak will be within 2007–2009. IX. Professor Kjell Alekett says that it will be within the next 10 years. X. Exxon Mobil says in a recent study that it will be in 5 years (conventional no OPEC). 71

Different sources: (I) Washington Post, 31-7-2005; (II-VI) see Cox (2005); (VII) Browne (2004); (VIII) Simmons (2005); (IX) Aleklett (2005); (X) Bulletin of Atomic Scientists (2005); (XI) Energy Bulletin.

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XI. Chevron has said in different television commercials that the world has used over half of the conventional oil in site. XII. Sadad al Husseini, former chief of exploration and production of Saudi Aramco, State Corporation of the Saudis, says that it will be in 2015. XIII. The Association for the Study of Peak Oil believed oil production peaked in 2004. XIV. According to the International Energy Agency, crude oil from existing fields peaked in 2004 and crude from known fields yet to be developed will peak shortly after 2010. However, non conventional crude oil and natural gas liquids will not peak for the foreseeable future well beyond 2030. XV. The german based Energy Watch Group (EWG) announced in 2006 that the the world had reached its oil production peak. XVI. Carlos A. Rossi; as we will see at the end of the book, I also believe that conventional oil peak arrived in 2006 because oil producton has not been higher since and because world wide depletion rates have increased inspite of the world recession. I also agree with the Energy Department of the United States and the International Energy Agency that total oil peak, including the nonconventional oil and all the oil based gaseous liquids will probably peak in the 2030s, but that depends mostly on two factors: The first being the aggressive development of the nonconventional reserves in the Americas. The second factor is the rate of economic growth, which we will need to slow down in order to rein in world oil consumption.

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Colin Campbell, a noted English geologist, founder of the ASPO and with a broad experience with some of the most prestigious oil corporations, such as BP, Texaco, Shell, Exxon and Fina, points this out: Around 944 bn oil barrels have been extracted, something like 764 bn is left for extracting in known fields, or reserves and 142Bn of reserves are classified as ―to be discovered,‖ which means the quantity of oil 72 that is expected to be found. If it is so, then the peak of oil will be next year (2006) .

Therefore, the estimate on the precise date of the world Hubbert Peak is an inexact science primarily because we do not know for certain the amount of Middle Eastern oil reserves nor do we know the amount in the ultra deep basins in the gulf of Mexico and in the Atlantic Ocean; but no one denies its approaching arrival, and although the economic factors affect the demand side as well as the supply, there will be a moment when the influences of economic or monetary influences will not be relevant. Robert L. Hirsh, from Science Applications International Corporation and first author of the report prepared to the USA government about the oil production peak, which has been amply quoted in this chapter, said in 2005 that whatever the year the announced peak arrives, 2005 was the year to start moving with energy policies. In accordance with this expert, the actions have to be taken at least 10 years ahead, and preferably 20 years before the arrival of the world peak.73 I conclude this chapter with a quote from the man who started it all, Marion King Hubbert, in a seminar given at MIT in 1981. The thrust of this important speech is crucial to the later chapters of this book. 72

Quoted in Vidal (2005)

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The industrial civilization of the present is being condensed by the coexistence of two intellectual systems that at the same time are universal, superimposed and incompatible—the accumulated knowledge during the last four centuries on the properties and interrelations of matter and energy, and the money-based society that has evolved from pre-industrial origins. The first of the two systems has been responsible for the impressive growth, especially in the last two centuries, of the current industrial system, which is essential for its ongoing existence. The second is an inheritance from the pre-scientific past; it operates with its own rules that have little in common with the ones that regulate the substance-energy system. …It is impossible that the substance-energy system keeps on sustaining an exponential growth for over some tenth of duplications, and this phase is about to conclude. The monetary system has no such restrictions and in accordance with one of its more essential rules, it has to grow consistently by compound interest. This disparity between a monetary system that keeps on growing exponentially and a physical system that cannot do so, leads to growth with time, in the relationship between money and the product of the monetary system, which is expressed as inflation of prices. A monetary alternative that would correspond to a rate of zero physical growth would have to be of zero growth in the interest rate. The result of each case would mean a financial 74 instability at great scale.

73 74

Quoted in Cox (2005) Hubbert (1981)

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Chapter 3

ALTERNATIVE ENERGY ‗‘Countries on every corner of this earth now recognize that energy supplies are growing scarcer, energy demands are growing larger, and rising energy use imperils the planet we will leave to future generations. And that‘s why the world is now engaged in a peaceful competition to determine the technologies that will power the 21st century. From China to India, from Japan to Germany, nations everywhere are racing to develop new ways to producing and use energy. The nation that wins this competition will be the nation that leads the global economy. I am convinced of that. And I want America to be that nation. Its that simple…The Best use of resource we have in abundance, through clean coal technology, safe nuclear power, sustainable growth in biofuels and energy we harness from wind, waves and sun.‘‘.

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Barack Obama, President of the United States MIT, October 23, 2009 .

If the objective of the previous chapter was to offer views from the pessimists‘ side of the oil peak debate, the objective of this chapter is to offer the perspective of the other side, the optimists. First, the coincidences: The optimists do not discuss the fact that petroleum has been essential in the building of modern civilization, nor do they argue that it will continue being so for prosperity to continue; they do not disagree that it is a finite resource and that some day we will have to live without it. They do not even question Hubbert‘s peak, at least the ascending part of the curve. The strong differences from the optimists begin with the zenith of the curve and the asymmetry of its declining segment that, according to them, will not happen for a long time and, when it does happen, it would be almost imperceptible if enough political courage were mustered from the world to begin to do something right now. What both sides assume to know is that the world has consumed around a trillion barrels of petroleum and has approximately this same quantity in reserves, along with more 5,500 tcf of gas that we have not used, and this equals about a 40-year petroleum supply and a 60-year supply of gas, assuming present consumption rates. Moreover, according to the U.S. Geological Survey, another 800 billion barrels of petroleum exist underground as well as 4.500 TCF of gas that are estimated to be found sooner than later, since the investment in exploration and production has risen to $100 billion per year.1 And this includes only conventional petroleum; we have not mentioned nonconventional petroleum or the energy alternatives. 1

See Browne, Lord, former CEO BP. Speech at the Empire Club, Toronto, Canada, 10-12-2004.

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Carlos A. Rossi

But what has alarmed almost everyone in recent years has not been the fall of the supply so much as the increase in the demand, especially in the first half of the first decade of this millennium. In the period 2003–2005, petroleum demand rose, as previously mentioned, to an unprecedented rate in the last 30 years, which almost equaled the growth of the world gross domestic product. Each year, the world population grows by more than 80 million people, or around 9,130 per every hour, which means that by the year 2030 there will be about 8.4 billion souls to whom the basics of life must be provided, including food, water, education, productive work and energy. Also, the fact that many of the most populous countries have now discovered material prosperity means that their demand for energy will grow, with the end result that there will be ―tens of millions of new commercial energy clients every year.‖2 According to the International Energy Agency in Paris, the global demand of total of energy will grow from its current levels of around 190 mbd of oil equivalent to near 240 mbdoe by 2015, or a growth of 26%. Can this added demand be delivered just in time? It is here where the pessimists and optimists break apart. The most important difference is that the optimists do focus on four elements that, to their judgment (and mine), have been much underestimated by the pessimist side. The first is that the countries of the OECD, plus China and India, do have the capacity to coordinate a slower rhythm of economic production in order to reduce the growth of global energy and ultimately oil demand to less than 1.5% annually; this helps to buy critical time for the development of more conventional sources and/or alternatives. The second is the alternative to conventional petroleum, or the nonconventional variety, where Canada, Venezuela and the United States and perhaps Brazil have a predominant role (to be discussed in Chapter 4). The third element is that non-fossil energy alternatives, called renewables, do exist and can be developed further; the expectation is that these will slowly but surely play an increasingly determinant role. Finally, human ingenuity will play a role in developing more energy-efficient end-use products, like electric cars and solar/wind transmissions, that can be mass-produced profitably and in an ecologically sound way. This graph, from the Washington-based Energy Information Administration (EIA), reviews the consumption and projections of all sources of energy until 2030 in the U.S., as it predicts large growth in non-fossil sources of energy but which nevertheless will not cause a large overall impact (about 10%) in the total consumption of primary energy because of the addiction of the economy to fossil fuel sources. These projections, it should be added, imply that the economic growth of the United States maintains the same rate of growth as it has in the recent past, meaning around 3% per annum. A slowdown of these rates of growth along with aggressive investment in alternatives will certainly alter these projections. In the current state of affairs, the renewables will also grow, but given that they begin from a very reduced base with technological impediments, they are not expected to have great significance in the near- to mid-term future for their massive and widespread deployment, as most are now in the initial stages and concentrated in a few specific places. The following chart maps these projections of world energy use from the EIA in 2005-2025.

2

Ibid.

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Source: Energy EIA. EnergyAdministration Information Administration EIA. Graph 1. U.S. Energy Consumption by Fuel (1980–2030) (quadrillion BTUs).

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World Energy Consumption Projections According to Primary Source (billion BTUs)

In this chart, we observe that the energy proportions stay the same in time, with a slight increase in natural gas displacing coal in next the two decades. More importantly, it is observed that the hydrocarbon sector (petroleum + gas) will increase their participation from 62% to 64%, about two thirds of the primary power consumption the world-wide level. Even though the other renewable will doubtless increase their production, because the total energy consumption of the world will increase as well, the overall proportional significance of renewables in the primary energy consumption is expected to remain at about 8% in the period under consideration.

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GAS America faces a major energy supply crisis over the next two decades. The failure to meet this challenge will threaten our nation‘s economic prosperity, compromise our national security, and literally alter the way we lead our lives. —Spencer Abraham, U.S. Energy Secretary, 2001

Natural gas is a close cousin of petroleum and shares much of its attributes. It is fossil, not renewable, located in almost all the same or near to the countries which also have petroleum reserves and its uses in electrical generation, transports, fertilizers and other petrochemicals are also similar. The world-wide proven reserves surpass 6,400 BCF, and total production exceeds 101 BCF, which gives for a reserves/production ratio of almost 70 years, supposing same technology, prices and present rates of consumption, today at about 100.6 BCF. The reserve number is still considered large by some specialists unless a sudden increase in the demand arises, as it is expected. The advantage of gas over petroleum is overall in the atmosphere, because it contains (generally) half the CO2 by hydrogen molecules as its cousin. The technology of exploration and production is the same but less expensive (less wells are needed) and because of its relative abundance the reflected gas price is considerably lower for the consumer. The United States and Russia are the two largest consumers of gas in the world, with 22% and 15% of the world‘s total consumption, respectively. Problems inherent in gas and petroleum include the following: 1

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2

3 4

5

3

Like the typical orphan, natural gas has been always sold very cheaply and has hence badly accustomed the consumer into considering it a kind of infinite gift from Mother Nature (see Graph 2). Transport: The handling of gas occupies lots of space, it is dangerous because it is highly inflammable, and it is especially expensive if transported by sea. The need arises to build expensive Liquified Natural Gas (LNG) trains for plants that freeze it to more than negative 200 degrees Celsius, place it on specialized tankers (also very expensive,) for ocean transport towards specialized ports built for this purpose, then re-gasify it and put it in the gas pipelines that are thicker and much more expensive than traditional oil pipelines. That is to say, their physical characteristics jeopardize their commercial value. All of these processes consume much energy, generally in the form of gas and petroleum. Gas renders less energy than petroleum if we apply equivalencies. A barrel of petroleum has the same power content of 6,000 cubic feet of gas (CFG); and in regards to transport a gasoline tank in an automobile can more than duplicate the yield of a gas tank, because of its relative low density. The infrastructure that is required for the massive use of the natural gas is not yet developed. According to Chevron, the cost to construct it to the world-wide required 3 level is $2.7 trillion American dollars, larger than the annual GDP of France.

See The Economist, June 10, 2006. pg. 5.

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The majority of the oil countries, as we have seen, have mature oil fields and to maximize their recovery potential they need to inject much gas in secondary and tertiary recovery processes. The great gas reserves are concentrated in few countries. Russia, Iran and Qatar contain 56% of all the reserves of the world. 72% of the world-wide gas reserves are concentrated between the Middle East and the former Soviet Union FSU. In 2007, according to the IEA, Russia was the largest exporter of Natural Gas, accounting for 21.3% of total exports. In spite of its abundance relative to petroleum, its rate of exhaustion is superior. In the United States, for example, 30% of the new gas discoveries are used to replace existing production. Some analysts consider that the Hubbert peak of the world-wide gas will arrive between 10 and 20 years after it arrives to petroleum.

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If a world-wide gas deficit does not exist so far, as soon as its use is increased to replace oil and to cope with increasing demand for electricity generation, heating and fertilizer feed, a Hubbert peak for gas will appear sooner than later. To give an example, in 1980 the worldwide consumption of gas was approximately 50 BPC; by 1990 it already increased beyond 70 BPC and by 2007 it was over 100 BPC. The projections for 2025 aim at 158 BPC, which represents an increase of 58% from present levels. Many specialists agree that gas will be the primary energy source of greater incremental growth at the world level and that 15 or 20 years from now it will place itself at second place behind petroleum. Due to the high price of petroleum, the price of gas has also risen and the major oil companies have increased their 4 exploration budgets in gas, so far with good results. The following quote from the National Petroleum Council is telling: Current higher gas prices are the result of a fundamental shift in the supply and demand balance. North America is moving to a period in its history in which it will no longer be self-reliant in meeting its growing 5 natural gas needs; production from traditional U.S. and Canadian basins has plateaued.

As expected, the prices of gas and of petroleum are closely related, as these correlation coefficients amply demonstrate. Natural gas will play a role of increasing importance in our period of transition towards renewable non-fossil energy sources, and its use will be increased in line with Graph 1 in the U.S. and possibly even by a greater amount in other countries that do not have large quantities of coal. In the United States, its Energy Information Agency predicted in 2005 a sevenfold increase of its LNG imports by 2025, when the proper terminals are build on both sides of the supply and demand equation.

4

Matt Simmons (2005) predicts that the Hubbert peak for gas will come 10 years after petroleum. In fact, it is presumed that the reserves of gas in the United States, Canada and the great part of Europe are declining. In January 2006, Russia shook Europe when it decided to cut gas provision to the gas pipelines of Ukraine through which a great part of Europe‘s gas is fed for its consumption. 5 National Petroleum Council. Balancing Natural Gas Policy—Fueling the Demands of a Growing Economy: Volume I—Summary of Findings and Recommendations. September 25, 2003. Quoted in the Hirsh report, 2005.

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Correlation Coefficients between the Prices of U.S. Imported Oil 6 and Imported Natural Gas 1985–2007

0.891

1990–2007

0.886

1995–2007

0.877

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Source: EIA, author‘s calculations.

Graph 2.

The LNG trains are specifically important because they solve the greater obstacle of sea shipping for gas commercialization when being used for the adaptation of GTL (gas to liquids- like gasoline) that is made possible by the chemical method known as the FisherTropsch conversion, which is applied to enrich the gas with hydrogen and carbon monoxide by partial oxidation or steam, which is in synthetic gas. Here is another example of the problem that arises scale-wise when an experiment is taken from the lab to the factory at a world wide level, which is neither cheap nor easy to accomplish; but luckily it is not

6

Refers to the prices of natural gas imports US$ per thousand cubic feet; and U.S. FOB cost of OPEC countries‘ crude oil.

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impossible either. For example, according to Cambridge Energy Research Association (CERA) by the end of the 2005 only 160 thousand oil equivalent barrels per day were built with this conversion at the world-wide level, a very small fraction of total consumption. Nonetheless, considering that companies of the stature of Exxon-Mobil, Shell and Statoil have invested much capital in this area implies that there is hope that production could be elevated to a million GTL daily barrels by 2015, which would still be far off in making a decisive impact in projected world wide demand. The investigation continues. One physical derivative that could also arise from this hydrocarbon is what is called Gas Hydrates, that are combined natural gas molecules (generally methane) with water that are trapped in frozen crystals of much abundance under marine subsoils specially in the ―permafrost‖ areas of the Arctic regions. The investigation of this resource is in its infancy because is known that this gas, when released from the ice trap in standard temperatures expands and has great potential to become a powerful energy source. Although many Nordic countries are investigating gas hydrates and in fact have invested much capital in the certification of its accumulations and commercial monetization, an obstacle they will have to surpass is the environmental impact of greenhouse effect that would mean the liberation of all this immense amount of methane into the atmosphere, something that already has been linked to melt the ice layers of parts of Siberia that produced so much methane that some of its lakes could not be frozen on the winter; this could happen at a much larger scale if this gas is processed industrially or if the world temperatures continue on the rise in the oceans. Natural gas by itself will not be able to alleviate the oil peak problem, but it is an important part of the solution 8 To conclude, three quotes from the Hirsh report section on natural gas are in order :

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• •

•

High prices do not a priori lead to greater production. Geology is ultimately the liming factor, and geological realities are clearest after the fact. If experts were so wrong on their assessment of North American natural gas, are we really comfortable risking that the optimists are correct on world conventional oil production, which involves similar geological and technological issues? If higher prices did not bring forth vast new supplies of North American natural gas, are we really comfortable that higher oil prices will bring forth huge new oil reserves and production, when similar geology and technologies are involved?

COAL It may seem a strange principle to enunciate as the very first requirement in a Hospital that it should do the sick no harm. —Florence Nightingale

7

Cambridge Energy Research Associates (CERA), World Oil Production to Increase Up to 25% by 2015. Press Release Dec. 7, 2005. 8 See the Hirsh Report, op. Cited, 36 The Completion of the Oil Era : The Economic Impact, Nova Science Publishers, Incorporated, 2009. ProQuest Ebook Central,

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It is very difficult to imagine a worse fuel than coal, which preceded petroleum as the premier power energy source by almost three centuries and whose environmental side effects are well known. Its deposits are still abundant in many parts of the world especially in countries of high energy consumption, like the United States, Russia, China and the European Union. Coal is a cheap distant organic cousin of petroleum and is therefore considered within the family of hydrocarbons, and it comes in two forms, vegetable and mineral, and this last 9 one is the most important if not for its calorific value, because of its abundance. World War II produced scientific and technological advances that in the end have served much to the industry of energy. One was the radar; a British discovery of radial waves that was transformed for the search of German submarines which later was transformed for the seismic study that the science of geophysics uses for petroleum discovery. Another was nuclear fission. Other advances were in the petrochemical industry, as we already saw in the extraction of liquids of the natural gas that would serve as fuel for the warlike effort of the allies. But the Nazis, who were the ones that instigated the war and whom by far incorporated its most brutal component, also were inventive with the application of the Fisher-Tropsh conversion (invented in Germany in the 1920s) a method designed to extract gasoline from coal by means of a no longer complex process (coal to liquids-CTL). German panzers used this fuel. Given the present circumstances, the countries mentioned with great coal reserves have uncovered this conversion from the lab libraries and have also reminded themselves of the usefulness of coal in power generation for industry and electricity. But, as it is widely known, the Achilles‘ heel of coal is its high CO2 content, which is blamed as the main culprit behind global warming. While petroleum and diesel average about two hydrogen molecules for each unit of coal and gas doubles that average, coal is almost all carbon with a dangerously high content of CO2. in the atmosphere, that has increased by more than 30% in the last 100 years, causing an increase of global temperature that has produced environmentally related land slides in many vulnerable places, and threatens to shrink the ice cap in the polar regions which will in turn elevate sea level and threaten the coastal cities and tropical islands of the world. Also coal has been fingered as one of the main causes of respiratory diseases in the cities and regions that are mostly exposed (CO2 is heavier than the air, and therefore it gravitates displacing oxygen on the surface). With respect to global heating, this it is a capital problem that the humanity must face and it cannot afford to delay any more because the risks are colossal as much for the inhabitants of the countries that massively produce coal as well as for those innocents nations, especially the regions with little elevation of its coasts from the sea, Bangladesh and the majority of the tropical Antilles in the Caribbean, for example. According to the Energy Information Administration of the United States Department of Energy in 2005, non-OECD emissions of carbon dioxide exceeded OECD emissions by 7 percent. In 2030, carbon dioxide emissions from the non-OECD countries are projected to exceed those from the OECD countries by 72 percent because they are projected to average

9

Mineral coal is physically composed of carbon, hydrogen, nitrogen, sulphur, ash, and other elements of lesser quantity, like potassium, calcium, sodium, magnesium ect.. The vegetal coal variety contains some useful and not too contaminating elements, like hulla and antracita which are used in electrical generation but in small quantities due to their relative high scarcity.

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2.5% annual growth. Coal‘s share of world carbon dioxide emissions grew from 39 percent in 10 1990 to 41 percent in 2005 and is projected to increase to 44 percent in 2030.

Sources: History: Energy Information Administration (EIA). International Energy Annual 2005 (JuneOctober 2007), web site www.eia.doe.gov/iea. Projections: EIA, World Energy Projections Plus (2008).

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Graph 3. World Energy-Related Carbon Dioxide Emissions by Fuel Type, 1990-2030.

According to the same source, in its 2008 reference case, world carbon dioxide emissions are projected to rise from 28.1 billion metric tons in 2005 to 34.3 billion metric tons in 2015 11 and 42.3 billion metric tons in 2030. According to the International Energy Agency, 97% of the projected increase in emissions between 2008 and 2030 will come from non-OECD 12 countries, 75% of which will come from China, India and the Middle East alone. Even though non-OECD nations are already leading their OECD counterparts in world wide CO2 emissions, and are expected to increase that lead substantially in years to come, at the per capita level it is the OECD nations that are ahead by far, as the following graph indicates: Last, coal also has a zenith. Just like its enegy cousins oil and gas, coal is also non renewable and finate, and as such it does have a discovery peak and consequently, also a production peak. The following quote from a report by the german based Energy Watch Group and commented upon by Dr. Richard Heinberg in his recent book Blackout is revealing:

10 11

See Energy Information Administration, Report #:DOE/EIA-0484(2008) Release Date: June

2008

Ibid. 12 International Energy Agency, World Energy Outlook 2008 The Completion of the Oil Era : The Economic Impact, Nova Science Publishers, Incorporated, 2009. ProQuest Ebook Central,

Carlos A. Rossi

70 14,00

WORLD CARBON DIOXIDE EMISSIONS PER CAPITA 1990-2030

12,00 10,00 8,00 6,00 4,00 2,00

19 90 19 93 19 96 19 99 20 02 20 05 20 08 20 11 20 14 20 17 20 20 20 23 20 26 20 29

0,00

EIA 2008

OECD

Non-OECD

Graph 4.

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‗‘The report concludes: ``Present and past experience does not support the common argument that reserves are increasing over time as new areas are explored and prices rise.‘‘ This conclusion is supported by the fact that even the world‘s in situ resourses of coal have dwindled from the 10 trillion tons of hard coal equivalent (hce) in 1980 to 4.2 trillion tons in 2005---a 60% downward revision in 25 years. The EWG group perfomed a peaking analysis of world coal, and arrived at the conclusion that world production will reach a maximum level around 2025, decline slowly for about two decades, and then fall off more rapidly beginning around 2050.‘‘13

NATURE STRIKES BACK It is not the strongest of the species that survives, or the most intelligent that survives. It is the one that is the most adaptable to change. —Charles Darwin

It is known that the emissions of coal in the atmosphere of our planet are growing at a rate of 1.5%–2% per year and that this molecule concentration if unabated will arrive at levels 14 that will put the climatologic balance at risk . The words of former British Prime Minister Tony Blair, are illustrative:

13

Quoted in Heinberg, Richard, Blackout: Coal, Climate and the Last Energy Crisis. New Society Publishers, Canada, pp 23-25 14 See Browne, Lord. Speech at Trinity House, London, England, Feb 27, 2006. The Completion of the Oil Era : The Economic Impact, Nova Science Publishers, Incorporated, 2009. ProQuest Ebook Central,

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Risks of climatic change are greater than we thought…it is now certain that greenhouse gas discharges, that are associated with the economic growth and the industrialization of a world-wide population that has 15 grown by six times in 200 years, are causing global warming at a rate that is not sustainable.

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These commentaries are the preface of a report that was completed in Great Britain in January of the 2006, commissioned by the English government and the British Weather Bureau, in which very disquieting scientific documents were revealed. One of them alerts that in this century the global warming ―will elevate the levels of the sea, will intensify storms, will expand diseases towards new areas and will move climatic zones, possibly causing more 16 droughts in fertile land and more rains in dessert lands.‖ Another report, written by Dr. Chris Rapley, notices that the formidable western layer of the Antarctic is about to 17 disintegrate itself, elevating the level of the ocean in 192 inches. James Lovelock, the English scientist who invented the instrument to measure the continuous erosion of the ozone layer published a work in which he concluded that is already too late because humanity has already emitted as much CO2 in the atmosphere that is inevitable that a global warming will 18 cost the life of million of people in this century . James Hansen, a NASA climatologist, says that new calculations on the instability of the ice in Greenland suggest that we have less than 10 years to revert the course of our history or to undergo such drastic changes that our planet 19 would constitute ―practically another planet.‖ The also recognized British biologist and Prof. Christopher Thomas published chilling projections on the effect of climate change in the animal species and plants of the planet. According to him, the carbon dioxide levels will be highest in the last 24 million years and the average globe temperatures will be the highest in the last the 10 million years, which puts us in conditions not seen since the times of the great dinosaurs putting in risk of extinction of 50% of all the Earth species. The reason is that the majority of the species that live today evolved after that time and therefore were never subject to this type of climate. As a result: Perhaps we are perfectly on the brink of a wave of massive extinction… we are beginning to put these things in an historical perspective. These are conditions not seen in a million years so none of these species have been subject to similar situations… we estimate that between 15% and 37% of the species can jeopardize their possible extinction as a result of the climatologic warming that is factually occurring (in estimations of medium rank) for year 2050.

20

In this conference, the biologist Thomas also said that much evidence exists that shows that up to 80% of the species, among them animal, insects, birds and even vegetation have begun to move from their habitat, but that the change is so fast that it does not give the majority of them time to adapt their Darwaniana evolution. For example, he mentions the fact that the climatic change has caused the bud of a pathogenic fungus and this has been linked to

15

See Jill Lawless, Associated Press, ―Blair: Global Warming Is Advancing,‖ January 28, 2006 Ibid. 17 Ibid. 18 Ibid. 19 See McKibben, Bill, August 2006. 20 See Thomas, Christopher: ―Global Warming Will Send the Planet to the Era of Dinosaurs.‖ Annual conference of Great Britain for the Advance of Sciences, Norwich, R.U. Reuters, Sept. 7, 2006 16

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Carlos A. Rossi 21

the extinction of 1% of the amphibious species of the planet . The renowned environmentalist Bill McKibben, wrote:

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Historians, I think, will see this moment in which the negation finally began to destroy itself. When finally we began to understand that the planet we know as is was in danger… not by nuclear war but by the consumption of coal, petroleum and the gas that energize the majority of the actions of our lives. This is new. 22 The human being never has had to face a challenge of the scale of all civilization.

Finally, in his world-acclaimed and provoking documentary An Inconvenient Truth, the former vice president of the United States and probable winner of the popular vote in the presidential elections of 2000, Al Gore, brings up evidence of really catastrophic consequences for the world if the persistent CO2 emissions in the world are allowed to continue. According to the evidence collected by Mr. Gore, the overwhelming majority of scientists agree that the embroidered CO2 emissions are the great cause of global warming and its devastating consequences. When asked why the politicians of their country have not confronted this problem, Gore simply mentioned the famous phrase of the American socialist philosopher and author, Upton Sinclair: ―It is difficult to get a man to understand something when his salary depends upon his not understanding it.‖23 Does this mean this that we would have to reject coal as an energy source completely? The answer is: Preferably yes. But not necessarily; and again the ingenious human brain can come to our rescue. British Petroleum, for example, leads a project where it uses the energy form coal indirectly to separate hydrogen from the water and then, by means of a complex chemical reaction process it ―captures and sequesters‖ the CO2 emissions and sends them through a terrestrial tunnel (like a dry oil well already exhausted) towards the depths of the earth. A partnership between Swiss and German states is experimenting with something similar. If this can be made successful on a large scale, the transition towards renewable energies would be much less traumatic. As the by-product of this technology is water, then the impact on the atmosphere would be also very beneficial. Problems? Yes there are three big ones. First, CO2 is a gas, which by its very nature it does not stay buried; it floats back up into the atmosphere. Second, to keep it buried is very expensive because you would need to find a site with hard impermeable rocks, like granite, to trap the gas permanently but these are very difficult and costly to drill through. It is at best a very expensive project because on a large scale the mining and processing of coal may be a long distance away from its burial site. At worse, the project may fail. According to a recent 21

Ibid. See McKibben, Bill, August 2006 23 See Gore, Al, An Inconvenient Truth, documentary, 2006. In fairness, many of his conclusions have not gone unchallenged; other scientists think that the causes of global warming could also be linked to cycles of the Sun, which, of course, is what warms our planet. These cycles intensify the heat of the sun and also intensify the heat on our planet and interfere with rain, causing the levels of the sea to warm up, thus releasing the CO2 beneath into the atmosphere. According to this theory, there is logical evidence to suggest that there is reverse causation; that it is global warming that is causing elevated levels of CO2 instead of the other way around. When asked for real evidence for this theory, some scientists point out to the magnetic fields in the Sun noted by the large amounts of sun spots. Regardless, it is undeniable that excessive fossil fueled industrialization has also contributed to global warming and that this is one aspect us humans can do something about. After all, Gore‘s evidence was backed up by over 2,500 scientists, and that is hard to argue against. 22

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issue by the Economist, the one serious attempt to investigate its use in an actual power station, the FutureGen project, based in Illinois, was cancelled….because the expected cost had risen from $830 million to $1.8 billion24; but, in other places like Denmark, France, Algeria as well as in North America have all shown progress even though all of them are still to generate electricity. The third problem is scale; the United States electrical industry produces alone 1.5 billion tons of CO2 per year, and the combined capture of all of these sites is but a tiny fraction of this.25 According to a recent study by the U.S. Department of Energy, this technology would have the potential to increase by five times the reserves of that country via the process of coal liquefaction which would be feasible given the great coal reserves that country owns.26 To make this happen, many technological breakthroughs, all in the works with the aid of massive investment, must be coordinated and patiently instigated. Foremost the scale problem must be addressed, because as any scientists know, what works well in a lab may not work all that well in a large factory. As it was indicated coal will continued to be used incrementally (necessity always surpasses political opposition) and it is anticipated that it will be the second fuel of greater use by 2020. Its use as described by BP, once the three obstacles above are dealt with effectively should not cause any further problems, and its abundance and location are all very good for the time being and into the foreseeable future. But otherwise, it does have clear and severe destructive climatic problems. As Neal Fergunson of the newspaper The Daily Telegraph of London wrote:

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In 400,000 years, the atmospheric concentration of CO2 fluctuated between 180 and 280 parts per million (PPM). In 2005 it arrived at 380PPM. The evidence of increases in the globe temperature as a result of it is 27 incontrovertible…. Only an idiot would think that it would not have global effects in the climate.

ALTERNATIVES TO CONVENTIONAL PETROLEUM In geological terms, one hundred years is instantaneous. —Christopher Thomas, University of York

It is possible to conclude from the previous section that the non-oil primary sources of fossil energy will be able to contribute, as a whole, towards partially softening the balance of world-wide oil dependence in the long term. Also it is possible to be conclude that this contribution, even in its most optimistic assumptions, will be insufficient to reduce the risks of economic recessions, disturbances, and high political tensions between the great consuming and producing countries with great surpluses of export (OPEC). It should be known that we are only referring to conventional oil and have not yet spoken of non conventional oil, tar sands, nor the non-fossil alternatives. 24

See The Economist, ―A Special Report in the Future of Energy,‖ England, June 21, 2008 Ibid. 26 See Techlines News, U.S. Dept. of Energy, March 3, 2006. 25

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Still some conventional petroleum sources exist in the world that could alleviate the structural imbalance in the oil supply, and in fact some of them have planned to enter in line before finishing this decade, which would slightly alleviate the prices in the short term. The Gulf of Guinea in deep super waters of the Atlantic is perhaps one of the best options at the moment. Non-OPEC giants include Canada, Angola, and the colossals of the Caspian Sea like Kazakhstan and Azerbaiján. These countries count on 7% of the conventional petroleum reserves. Assuming a projection of the world-wide demand of up to 120 mbd in 2030, each of them would have to increase their production levels by 50% just to maintain their present proportional levels in world wide production. Unless more reserves are obtained or technology increases the recovery factor significantly, which is possible in some cases but expensive, the projection of these countries, some of which already are experiencing declining reserves, would seem very optimistic and its contribution towards the improvement on supply would be limited. Brazil has been discovering elephant fields in its pre salt ultra deep waters of the Atlantic basin, which have been grossly estimated to have the potential of another north sea (100 billion barrels) but as to this date none have been certified into proven reserves. Petrobras, its giant quasi state/semi private oil company and the one responsible for its discovery (it remains to be seen who will be allowed to produce it) is at this moment sending appraisal wells to delimit the field size and, to their good fortune, keep finding more oil. But, technically, since us economists are taught to only count on things that officially exist, for the rest of this book the upside of the very precious Brazilian discoveries must be delayed until a further update. The gross estimates of all the reserves of the current world wide on going projects however could yield between 20 to 30 million barrels of conventional oil if one chooses the optimistic fold scenario. This could be a great news for our energy debate if only we could find fields like these once every two months, not once a year, given the worlds current consumption. However, even though we cant officially count the Brazilian discoveries in our economic modeling, nor the recent elephant discovery deep in the pre salt waters of the Gulf of Mexico by British Petroleum and Chevron, two factors must be pointed out. First, that drilling technology has increased in quantum leaps, allowing oil companies to perforate the crust of the earth to depths equivalent to the distance between the highest altitude of a conventional airplane and the ground. Second and more important, that this drilling technology has discovered oil in depths were it was previously thought oil could not possibly abound, given the heat and pressure from the earth‘s mantle. Knowing now that large oil deposits can in fact reside that deep is indeed fantastic news because it allows for a new oil frontier to be opened up in nearby and far away fields. The fact that it is below large layers of salt does complicate things a lot, because geophysical seismic data is confusing (the salt reflects the radar) and because it complicates the movement of the oil itself. Nonetheless, human ingenuity to overcome this obstacles is in the works, and that has seldom failed before. The challenge is then twofold. First, that there is indeed more promising oil fields deep below the earths mantle like the ones in the Brazilian coast and the Gulf of Mexico, and the second that we can actually get there 27

Fergunson, N. The Daily Telegraph, 30-04-2006.

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and drill it out on time. Economist cannot help in the first hurdle, but we can buy the scientists more time to overcome the second, and thus is the principal objective of this book. Geology is a science with a time frame that its measured in millions of years while petroleum engineering is measured in decades. Politics in two-four years while economics in quarters of a year. As we will see in Chapter 5, one of the critical steps we all need to make to solve this energy problem from the demand and supply side is to synchronize our watches.

ALTERNATIVES TO THE HYDROCARBON FAMILY I believe that water someday will be used like fuel; that the hydrogen and the oxygen that constitute it, either in solitary or altogether, will provide an inexhaustible source of heat and light with an intensity which coal is incapable… Science, my lad, is made up of mistakes, but they are mistakes which are useful to make, because they lead little by little to the truth —Jules Verne

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When accessing the economics of energy there are several variables that come into play on both the demand and supply side whose movement will determine its ultimate consumer price (a list is detailed later in this book). One of them is key, it is called by scientists EROEI, or Energy Returned On Energy Invested, that measures the units of energy returned for each unit of energy invested. When this ratio falls below one, the energy source yields net negative energy, or a ‗sink‘, and thus it is pointless to produce. You can see from this that oil is one of the most efficient energy sources by this measure, because it wholly justifies investing energy into it by a factor that can be as much as 40 to one. Even though it has not the highest EROEI, its low cost versatility and BTU content makes oil the must efficient primary energy source by far. The following graph provides the current EROEI content of each source: Coal

+/- 20

Wind

+/- 20

Global Oil

+/- 10

Hydropower

+/- 10 +/- 4

US OIL Nuclear

+/- 4 +/- 2

Tar Sands

+/- 0.5

Ethanol (corn) 0

5

10

15

20

25

30

35

40

45

Graph 5. EROEI Units of Energy Return on Energy Invested

Some brief comments on the renewable energy sources. Nowadays only about 3% of the worlds energy demand is satisfied by renewables, and the vast majority is bio-mass (burning The Completion of the Oil Era : The Economic Impact, Nova Science Publishers, Incorporated, 2009. ProQuest Ebook Central,

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Carlos A. Rossi

firewood). As Graph 1 showed, the impact of these in the foreseeable future towards 2030, assuming optimistic settings is practically negligible. The reason is that almost all of these projects are now found in the traditional cycle of the inventor, which begins in his or her head and personal computer, and then must go to the PCs of his/her colleagues, grants, R&D laboratories, environmental and sanitary permissions, technical and feasibility studies, lawyers, patents, bureaucracies, banks, pilot projects, small-scale manufacture, local politics, marketing, more permissions, operational procedures, qualified hiring, big machines with cutting-edge technology (some of which have yet to be invented), more banks, larger scale manufacture, international trade, more lawyers, more permissions by foreign governments, international politics, and international factories. Talk about a long and winding road. Most are still in the turf of promise land with tons of growing pains and limitations ahead, but most show great promise of playing a big role in dis-intoxicating and un-addicting the world from its dependence on fossil fuels. But not today or tomorrow; they are at best two to three decades out of our time zone. Not surprisingly, it is the Big Oil companies, contractors of some of the best applied energy scientists there are, that are among the leaders in the private world in alternative energy research. Aside from money, geography, technical and environmental challenges (and patience/luck), time and scalability are the greatest hills to climb. Economists can help formidably with two of these—money and time. We will make some very brief comments on the most renowned. Hydrogen is an element of nature that is present in almost all parts but it is never alone. It is found in hydrocarbons and water, but its process of extraction is at the same time expensive, complicated, and energy consuming. It is known that to extract it from water is more expensive than extracting from petroleum and gas, although its environmental impact by the end user is almost zero. It suffers from problems of transportation that requires special pipes and storage, that according to the U.S. Department of Energy is the number one priority to solve before its large scale commercialization. Its yield with respect gasoline is smaller; for example, in a sports car a gallon of gasoline equals to 14,500 gallons of uncompressed hydrogen, and although the technology to compress is known, it is currently unable to compete at face value with petroleum for now. At present some 45 million tons of this source is produced and to produce more of it to impact the projections of demand is a formidable challenge. According to a Spanish scientific source, in the year 2040 the United States would consume alone three times the current world production to satisfy its auto mobile park28. Nevertheless, while prices of hydrocarbons are dearer and the auto technology enhances in the self-propelled phase, it is very possible that this renewable fuel passes by a really giddy period in its capacity and contribution to the energy problem; but not for many years. In fact, the same technology mentioned above on the ―capture and the abduction‖ of CO2 in the coal industry would also be capable to separate hydrogen from water. If it is carried out without contaminating the environment then the use of coal and hydrogen would be very useful for energy relief. Geothermal energy is exactly what the name implies. It is basically water vapor that it is heated by the earths crust at about 200°Celsius and seeps out of the ground through natural fissures in the earth and the oceans. It is as natural and clean energy as it can be. It is usually found in areas close to volcanic formations, like the pacific rim, the Philippines, Italy, etc. (the city of San Francisco relies on this type of energy). But it does not have to be. 28

See ―Hidrógeno, El Gran Combustible Alterno,‖ El Economista, México, 24-05-2006

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The earth‘s crust is hot everywhere if you dig deep enough. So some scientists are thinking that if you dig two parallel holes anywhere that are only a few hundred meters apart and are deep enough to heat water at that temperature, then all you do is pump cold water into one of them and wait for its vapor to come back up the other hole. But this is not as easy as it sounds. First, this cannot be done just anywyere; this must be done where there are impermeable rock formations, like granite, that are dry enough to capture heat. The problem is that this type of very hard rock is difficult to drill, and because there is no oil in it, oil companies avoid these formations. The drilling bits would get destroyed very early if they try to pummel fissures from granite. The good news is that as hard and expensive as this is, it is not impossible to make an impermeable rock permeable; scientists just have to find a cheap and effective way to do this and economists, once again, got to buy them that time.

ETHANOL If the misery of the poor be caused not by the laws of nature, but by our institutions, great is our sin.

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—Charles Darwin

Ethanol is another renewable fuel that stems from sugar, cereals like wheat and some non edible vegetables, like switch grass. Its use in cars is well known (Henry Ford‘s original Model T used it); is not contaminant, and is in a development phase of a lot more advanced than hydrogen. But it has two large disadvantages, both probably surmountable but in the long run. In the case of the cereals, an enormous quantity of energy is required to develop its production to great scale (ENROI), which, with the technology that we know, is around 1.5 to 1, that is to say, the energy in is only slightly smaller than the energy out. In the case of sugar this ratio is 9 to 1, which is a lot better. The other is the immense quantity of land that is required for the sowing, which tends to be overcrowded by food crops. For example, if the United States proposed itself to replace only 10% of its 2020 projected gasoline consumption with ethanol, it would have to plant with wheat all the area of Illinois, Indiana and Ohio and that amount of land is already been used29. Switch grass faces an equally dramatic hurdle. The yield form ethanol is also lower than gasoline. In the case of wheat, in the United States, humans and farm animals roughly share the same consumptions proportions; but if the wheat is used for cars rather that the farms, then the price feedstock of the farm animals spikes up, which has doubtlessly contributed to the increasing prices at the supermarket. One institute that has made strides in analyzing this fuel alternative is the Earth Policy Institute, based in Washington D.C. This is an excerpt from a longer letter written by its current president Dr. Lester Brown: We are witnessing the beginning of one of the great tragedies of history. The United States, in a misguided effort to reduce its oil insecurity by converting grain into fuel for cars, is generating global food insecurity on a scale never seen before. The world is facing the most severe food price inflation in history as grain and soybean prices climb to alltime highs. Wheat trading on the Chicago Board of Trade on December 17th breached the $10 per bushel level for the first time ever. In mid-January, corn was trading over $5 per bushel, close to its historic high. And on 29

See Raymond, Lee, 2004. ―Facing Some Hard Truths about Energy.‖ Conference dictated in the Woodrow Wilson International Center for Scholars, Washington, DC, June 7, 2004

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Carlos A. Rossi January 11th, soybeans traded at $13.42 per bushel, the highest price ever recorded. All these prices are double those of a year or two ago. As a result, prices of food products made directly from these commodities such as bread, pasta, and tortillas, and those made indirectly, such as pork, poultry, beef, milk, and eggs, are everywhere on the rise. In Mexico, corn meal prices are up 60 percent. In Pakistan, flour prices have doubled. China is facing rampant food price inflation, some of the worst in decades. In industrial countries, the higher processing and marketing share of food costs has softened the blow, but even so, prices of food staples are climbing. By late 2007, the U.S. price of a loaf of whole wheat bread was 12 percent higher than a year earlier, milk was up 29 percent, and eggs were up 36 percent. In Italy, pasta prices were up 20 percent. From 1990 to 2005, world grain consumption, driven largely by population growth and rising consumption of grain-based animal products, climbed by an average of 21 million tons per year. Then came the explosion in demand for grain used in U.S. ethanol distilleries, which jumped from 54 million tons in 2006 to 81 million tons in 2007. This 27 million ton jump more than doubled the annual growth in world demand for grain. Historically the food and energy economies have been largely separate, but now with the construction of so many fuel ethanol distilleries, they are merging. If the food value of grain is less than its fuel value, the market will move the grain into the energy economy. Thus as the price of oil rises, the price of grain follows it upward. A University of Illinois economics team calculates that with oil at $50 a barrel, it is profitable—with the ethanol subsidy of 51¢ a gallon (equal to $1.43 per bushel of corn)—to convert corn into ethanol as long as the price is below $4 a bushel. But with oil at $100 a barrel, distillers can pay more than $7 a bushel for corn and still break even. If oil climbs to $140, distillers can pay $10 a bushel for corn—double the early 2008 price of $5 per bushel. The World Bank reports that for each 1 percent rise in food prices, caloric intake among the poor drops 0.5 percent. Millions of those living on the lower rungs of the global economic ladder, people who are barely hanging on, will lose their grip and begin to fall off. Since the budgets of international food aid agencies are set well in advance, a rise in food prices shrinks food assistance. The U.N. World Food Programme (WFP), which is now supplying emergency food aid to 37 countries, is cutting shipments as prices soar. The WFP reports that 18,000 children are dying each day from hunger and related illnesses. As grain prices climb, a politics of food scarcity is emerging as exporting countries restrict exports to limit the rise in domestic food prices. At the end of January, Russia—one of the top five wheat exporters—will impose a 40-percent export tax on wheat, effectively banning exports. Argentina, another leading wheat exporter, closed export registrations for wheat indefinitely in early December until it could assess the condition of the new crop. And Viet Nam, the number two rice exporter after Thailand, has banned rice exports for several months and will likely not lift this ban until the new crop comes to market. Rising food prices are translating into social unrest. It began in early 2007 with tortilla demonstrations in Mexico. Then came pasta protests in Italy. More recently, rising bread prices in Pakistan have become a source of unrest. In Jakarta, 10,000 Indonesians gathered in front of the presidential palace on January 14th this year to protest the doubling of soybean prices that has raised the price of tempeh, the national soy-based protein staple. When a supermarket in Chongqing, China, where cooking oil prices have soared, offered this oil at a reduced price, the resulting stampede when doors opened killed three people and injured 31. As economic stresses translate into political stresses, the number of failing states, such as Afghanistan, Somalia, Sudan, the Democratic Republic of the Congo, and Haiti, which was already increasing before the rise in food prices began, could increase even faster. Whereas previous dramatic rises in world grain prices were weather-induced, this one is policy-induced and can be dealt with by policy adjustments. The crop fuels program that currently satisfies scarcely 3 percent of U.S. gasoline needs is simply not worth the human suffering and political chaos it is causing. If the entire U.S. grain harvest were converted into ethanol, it would satisfy scarcely 18 percent of our automotive fuel needs. The irony is that U.S. taxpayers, by subsidizing the conversion of grain into ethanol, are in effect financing a rise in their own food prices. It is time to end the subsidy for converting food into fuel and to do it 30 quickly before the deteriorating world food situation spirals out of control .

Should we reject ethanol as unfeasible? At current state of affairs, the answer is unequivocally yes. Few people have the stomach to morally confront the problem of choosing cars over stomach. But that does not mean we should stop doing research. Though some countries would have serious problems establishing this strategy inside their territories at a 30

Brown, Lester, ―Why Ethanol Production Will Drive Food Prices Even Higher in 2008,‖ Earth Policy Institute, January, 24, 2008

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great scale, there exists other with large extensions of land that are very sub-utilized. The south of Argentina, almost all Australia, the majority of the Central African continent, Kazakhstan and its neighbors in the former Soviet Union, the south of Venezuela and Colombia, and the middle-western areas of the U.S. come to the mind. Although most of these stretches of land are grossly under populated for good reason, mainly due to little access of fresh water, an evaluation of the capacity of the land to produce ethanol could bring very good surprises but only in the long run. For example, the U.S. Energy Department estimates that by 2030 ethanol could be able to reduce the demand for gasoline by a good 30%. In the U.S., around 5 million cars and trucks are qualified with this technology but, at the same time, the stations to supply this fuel don‘t even represent half of a percent of the total number of gas stations.31 But all of this can change, already legislation exists in the United States that requires that 3% of all the fuel sold from 2006 stem from alternate sources to petroleum, and that ratio will double in 2012. With this type of legislations and with greater fiscal incentives, the U.S. would be able to seriously reduce its dependence in petroleum; although because of its late start, only far into the future. Investigation continues. Brazil is a truly surprising example. This country that depended on on oil imports for over 80% of its total consumption just three decades ago now it‘s a net oil exporter. Brazil has pushed the use of this technology since the 1970s and now employs sugar base ethanol (that is highly productive) in more than the 40% of its cars that run with flex fuel oil, or simultaneous flexible fuel in 18% ethanol, 55% diesel, 22% gasoline and 5% gas. In the 2005, 73% of the cars sold included this technology.32 Their impressive achievements with this renewable fuel and in deep water drilling of the Atlantic coast have reduced its energy dependence form the 1970‘s to almost zero today, with a bigger population and greater industrial growth33. I should hope other examples like Brazil exist, because to paraphrase an old saying, to save energy is the same as find it. According to Chevron, a global reduction in the use of energy of barely 5% would save the world the equivalent of 10 million barrels of petroleum per day.

ALTERNATIVES OF ABSOLUTE INFINITY No scientists or engineer has that solution: escaping from the energy crisis by resorting to other energy sources: nuclear, wind and solar would be a possible Miracle with 50 million human beings, but not with 9,000 millions within 20 years. —Jean-Marc Jancovici

31

The most popular mix is E85: 85% ethanol, 15% gasoline. See Lashinsky A. and Schwartz N. ―How to Beat the High Cost of Gasoline Forever,‖ Fortune, New York, January 24, 2006 32 Ibid. 33 Wall Street Journal, Dec 6, 2008. I once published a brief paper on Brazil, which was largely based on the conclusions of a much larger paper I had to turn in as an assignment in my undergraduate course in Development Economics at American University in Washington. I was truly amazed to learn that prior to the first oil shock in 1973, this Latin American behemoth had been growing at a torrid economic pace for the better part of the previous decade, achieving mid double digit growth rates in the last 3 years. It was not uncommon to hear Brazil in the same breath as the newly industrializing tigers of East Asia. Truly the oil shock was a tidal wave to that nation, one that was repeated, much to its demise, in 1979. Their motivation for the energy security that they have conquered with much tenacity is a truly remarkable phenomenon. See ―Brasil, Coloso de America del Sur;‖ Metroeconómica, Informe Mensual, Febrero 1992.

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Solar energy, the sea and the wind also contain many of the same virtues and defects of their rivals mentioned above. They are renewable, they do not contaminate the environment, and their primary sources are always present in absolute infinity. Their large defects or challenges are their low energy density, storage, and the immense quantity of area and investment that their technology requires. If the Sun is always around it is never in equal proportions, as the northern countries know all too well through their seemingly endless winter months. The photovoltaic panel is the technology that bears and stores the solar power, and is in the initial stages because the ones that exist are too expensive with little versatility. The transmission of solar energy from the tropical countries towards the frost belt nations is not feasible in the foreseeable future. What has been catching the attention of solar energy scientists is a project that some countries, notably Russia, are mulling over through advanced space technology. It involves a large satellite (called Space-Solar-Power [SSP]) that is able to capture solar rays and produce energy for 365 days per year, on a capacity five times the low earth‘s panels since there is no atmosphere in space to disturb it, and transmit it via microwave beams to a desolated plant on the earths turf which then transmits it to a series distribution plants and ultimately to end users electrical generators in the industrial sector. Indirectly, if the auto industry finally develops the right type of electrical motor, this solar technology could help solve the all important and elusive transport sector. It may even be powerful enough to help produce Canada‘s thick tar sands. According to some studies, there is no insurmountable technological gap to bride here but the economics is another matter; because even optimistic scenarios put its unit cost (measured in kilowatt hours [kwh]) about 13 times over the cheapest form of attaining electricity (hydro-electric) and up to five times over the most expensive kind (coal fired generation). This cost can be lowered with future research, but, unfortunately, not just yet.34 Investigation continues. The ocean‘s waves are another potential source that can be galvanized energetically, and many established businesses are competing and collaborating in technologies that develop this source rapidly, among them General Electric, Norsk Hydro and the German giant Eon, all of which have invested lots of capital and scientific hours; there even exists a study center developed in England as well as various pilot projects in several parts of the world. Its problem is that this type of technology is in the pre-infant stage and can cause problems with the marine life, since it involves immense electrical machines, the majority of which are placed deep beneath underwater floors. Nevertheless, its potential is enormous. According to one study, California and especially England would be able to generate up to 20% of its energy from this source, but again very much in the long term.35 With regards to wind, the problem is the quantity of area that is needed for the establishment of its turbine technology and because it is intermittent (although, because the wind doesn‘t just stop but winds down slowly), it does give one time to switch to something else. This could be a good source of energy for windy cities, like Chicago, several coastal cities, England, etc. Former oil chairman Lee Raymond of Exxon Mobil puts no doubt on the growth potential of wind and solar power, but his chief concern is the minute overall impact (given its late start and technological challenges) of these alternatives when it mostly matters; that is, when oil hits its peak. 34 35

See The Economist, December 6, 2008 Timmons, H. ―Energy from the Restless Sea,‖ New York Times, Dec 07, 2005.

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Although little doubt exists that wind and solar energy will grow quickly, these begin from a very reduced base, and even with an extreme fast growth they will supply around half of a one percent of the worlds energy 36 in the 2020.

This is a drop in the bucket. Speaking of all the renewable sources, Lord Browne, former CEO of BP said: We believe that the renewables will supply the material supply of energy in the long term. But the long term may be 20 or 30 years in the future. As it is acknowledged by the International Energy Agency that for the 37 year 2015 these sources will provide barely 3.3% of total demand.

NUCLEAR Science without religion is lame and religion without science is blind.…Imagination is more important than knowledge.

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—Albert Einstein

Nuclear energy is not exactly a renewable resource because its main intake, uranium-235, is also a mineral that erodes, although very much in the long term (just seawater uranium, which is more abundant than in the earth‘s crust, has been touted to be able to supply energy in sophisticated reactors anywhere from thousands of years to millions).38 It is not surprising that it is this source of energy that is garnishing almost all of the attention as a fossil fuel replacement, especially in the non-OECD nations (Russia, China, India, etc.) which are set to total up to 75% of the new nuclear power added in the decade between 2010–2020.39 Today there exist more than 400 nuclear plants on the planet that provide around 7% of the demand of world energy (17% of world electricity) and still many deposits of the material exist, although at times in unstable countries. Nuclear energy is possible by the physical laws of the nuclear fission which, according to Einstein‘s famous equation, is capable of generating incredible quantities of energy by breaking the nucleus into two or more fragments (fissions) whose sum of their parts is smaller that the original mass. According to this equation, the missing mass (0,1% of the original) is what has become energy. The problems with nuclear energy are well recognized and, in my opinion, probably exaggerated. Although it cannot correct the problem of transportation directly, an extension of its use for the industrial sector and electric generation would free more hydrocarbons which can be destined to the transportation sector. In the far distant future, if we are able to massively employ the technology of electric cars for example, then we could use nuclear technology for the transportation sector directly. If controlled well, nuclear energy does not need have environmental impacts in the terrestrial surface, but controlled badly, the impact can be disastrous. 36

Raymond Lee, 2004. See Browne, L 2004. 38 See Cohen, Bernard, ―Breeder Reactors: A Renewable Energy Source,‖ Journal of Physics, 1983. 39 See the Web page, www.nextbigfuture.com 37

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Aside from its high cost, the problems with nuclear reactors are three. First, consider its reputation. Although accidents in nuclear plants are extremely rare, the two famous that have occurred, in Three Mile Island on the outskirts of Philadelphia in 1978 and Chernobyl, in the Soviet Union (now Ukraine) in 1986, still brings chills up our spine to those of us who remember the live television broadcasts of helicopters collecting snow form the ground and discharge them upon chimneys to cool down the toxic bubbles. In the case of the incident on the outskirts of Philadelphia the luck was with the world because there happened to be snow on the ground that day and because of it the engineers were able to control what ended up being a partial meltdown of one of its reactors. But the bad luck was also with the nuclear industry and that came from, of all places, Hollywood. It so happens that they had just released a movie called The China Syndrome with famous actors (including Jane Fonda, Jack Lemon and Michael Douglas), which coincided almost to the date of the incident and whose main theme was the explosion of a nuclear reactor in California. When the audience, meaning everybody, realized that the movie may have been too real an experience, it ended up stapling in their brains the risks of having one of those reactors close to home. The incident in Three Mile Island was blamed to errors in the plant design, which have already been corrected to quasi perfection a long time ago thanks in part to the quantum leap computer and sensor technology that is now available. Unfortunately, not before the general psychology was affected. Since that incident, the United States has not built another nuclear plant (they have expanded some) although at present they have 103 in operation that provide 20% of their electric demand (in France that number is 78%). The incident in Russia was quite more serious because there was an explosion bravely controlled, but explosion nonetheless that freed radioactivity some 200 times the two atomic bombs dropped on Japan in 1945 (contaminating large areas of Belarus, Ukraine, Russia, extensive zones of Asia and Europe) that cost, and continues to cost, lives to those affected. The cause in this case was human error that has since also been corrected but not before affecting the reputation of these plants. Thanks to this and the fall of the oil prices in the 1980s, the construction of nuclear plants was paralyzed. The second problem that affects nuclear energy is waste disposal, i.e., all radioactive and therefore potentially harmful to the subsoil in the long run. In the wrong hands, the degraded uranium is able to be enriched and become the ultra toxic element, plutonium, which is the prime commodity for the atomic bomb. It is true that just not anybody has the know-how of nuclear physics to carry out this process, but it is equally certain that the information gaps among the universities of the world has been diminished. Nowadays at least ten countries in the world have this know how; and more want to. The third problem is closely related to the second and it has to do with terrorism. Up to this date there have been no sinister terrorist plots that have remotely targeted a nuclear plant, because all these are very well guarded by specially-trained units; and also because all these have instantaneous shut down mechanisms build inn in case any hint of intrusion is detected. Nevertheless, one must never let their guard down at any time because terrorists can be astute, and that explains why after the 9/11 episode no one likes to have them in their neighborhood. Nevertheless, given the energy supply problem, and because accidents in nuclear plants are extremely rare and in fact none has occurred in 20 years, many are anticipating more nuclear plants, especially in the populous countries as China that plant to multiply for almost 7 its electrical generation by way nuclear energy, or India, that already possesses 15 nuclear reactors and plans to put in promptly 8 more. In the well to do countries of the OECD one can

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also expect a sudden increase in this alternative. In fact in Canada some expects the construction of one or two nuclear reactors near its bituminous sands in Alberta, which are capable of heating the water that needs to separate the sand from of the petroleum, thus freeing its gas reserves for other energy uses.(see next chapter for a full discussion on the tar sands of Canada). Another interesting aspect to consider is contrary to nuclear fission, called nuclear fusion, which joins the atoms of two nuclei of low mass to form a single heavy nucleus and to utilize the energy that it frees (which is exactly how the Sun provides us with life every second for, well, several millennia past and future). This process is very promising because it is estimated that a kilogram of fuel generated by nuclear fusion would be the equivalent one to 10 million kg of fossil fuel. The problem is that the control of this process and the energy that it releases for the routine generation of mass energy is physically very complex on a great scale, because the nuclei that it contains have positive charges of electricity which reacts between themselves and one would need a capable alternate force to surpass this repulsion. To give an illustration, the scientists reckon that for the control of the reactions of the nuclear fusion it is needed to heat gas to temperatures of over 100 million degrees Celsius, which is a lot hotter than center of the Sun. The investments in this process are enormous (10 billion Euros for the experimental reactor) and scientists have been working on it for decades. But the intention to see it through very much exists. At the end of May in 2006 in the city of Moscow a multi governmental consortium representing 50% of the world population, conformed by the European Union, United States, China, Japan, South Korea and Russia, agreed to build, in the city of Cadarache in the south of France, an experimental reactor called ITER (International Thermonuclear Experimental Reactor) that should be completed by 2015. This energy has the potential to be less costly in the long term, more secure, clean, sound and above all super abundant. Just like nuclear fission, when it is well controlled it does not contaminate the environment and its toxic waste are a lot smaller. The problems that it currently has are the large quantities of time and investment that are needed for its fruitful evolution. For example, if all goes well, in this same city the first demonstration plant would be built in 2040. And if all goes well with that, it is projected that nuclear fusion could be supplying between the 10% and the 20% of all the energy consumed in the planet by the end of this century.40 The investigation continues. The scientists and engineers are working very hard to eliminate the risks and dangers of nuclear fusion and fission to provide the world with cheap, massive, versatile, abundant, long lasting, renewable and environmentally friendly sources of energy; its just about time that us, the economist, begin to do our part in lending them the help that they need (if its not too much trouble).

THE AUTOMOTIVE INDUSTRY We have learned to live in a world of mistakes and defective products as if they were necessary to life. It is time to adopt a new philosophy in America. —W. Edward Deming 40

See BBC News, May 24, 2006

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As we have mentioned, the supreme client of the petroleum industry is transportation and its great emblem is the automobile, the machine that better symbolized the twentieth century for its movement, versatility, massive spread across the population, and above all, for the liberty that offers whomever drives it. For the rich classes and middle classes of all the countries of the world it is almost impossible to imagine a world without this prized machine. Today there exist around 800 million vehicles in the world, and if we add the quantity of motors that are energized based on petroleum (ships, airplanes, lawn mores, motorcycles etc.), the number surpasses one billion. In the course of this chapter, we have already mentioned the use of technologies in this industry, and although with few exceptions, like the E85 or flex tech in Brazil, the advancements have been more in the environmental direction than to make them efficient in the consumption of crude oil. Fortunately, there is a large room of improvement in this industry. It is hard to conceive that the petroleum and refining industries precede the automobile industry by almost half a century. The advancements in both industries, in efficiency, security, comfort, and environment have been truly amazing in recent years and they have grown parallel to each other because they are complementary industries that mutually need each other; so much so that contribution among their scientists is quite common. Part of the problem, far from lack of ingenuity from both parts has been the reverse; both industries have progressed so much that people can‘t seem to have enough of them. Moreover, a car is seen as a symbol of comfort, liberty and status, giving its owner freedom to choose as prices and brands differ between brands even in the same company. Although ground breaking technologies like anti lock brakes, air conditioning, fuel injection, power steering and unleaded gas are quite common and have been incorporated at advantageous economies of scale that reduce unit costs, hydrocarbons and autos have also been victims of their own success because that has led to enormously increased sales that became harder to upgrade in a highly populated world. To cite an example, according to the American Petroleum Institute in the United States, a car bought today is, on average, 97% cleaner than a similar one bought in 1970, thanks to the cleanest combination of gasoline and more efficient motors. During these 35 years, the average mile traveled has increased 175%, but even so, the CO2 emissions related to cars have been reduced by 41%.41 The problem is not only in the environment, the problem is in the high consumption of gasoline and in the immense quantity of cars in the world. In 2007, a total of 71.9 million new autos were sold in the world, with the U.S. and Canada representing 27% of the total. In the United States alone, about 251 million vehicles exist in the roads which outpace by yearly increasing numbers the licensed drivers. Around the world, there were about 806 million cars and light trucks on the road in 2007, and if you add the motorcicles, motor boats, farm trucks, lawnmotors ect, the number eclipses 1 million. All together they burn over 260 billion gallons of gasoline and diesel fuel yearly.42 As I mentioned previously, 99% of the cars in the U.S. run with the conventional production of based on internal combustion pistons and they are manufactured mostly by three companies all of which have very delicate financial and management structures, that make it very difficult for them to transform towards a radically 41 42

www.wilkipidia www. Reporsure.com

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different manufacturing concept, even if they are induced to do so through higher taxes and incentives. The U.S. government has already set a $25 billion dollar long term financial deal for them through the Department of Energy to help them breach the transition period towards more gasoline efficient cars, but due to internal and external factors, like the financial crisis that has hit them with the twin punches of a recession and credit crunch from banks to customers this amount of money will most certainly not be enough. The problem is that if any more is required, the U.S. Congress may demand temporary stake holding of the companies (which, may not be a bad thing at all).43 The good news is that unlike the problem facing prime energy renewables, there is not much technological gap to surmount because an extensive margin for improvement exists that has already been breached elsewhere; notably Japan and Europe. In most European nations, the number of cars that still run with traditional conventional engines total 50%; that is to say, the technology already exists. According to Exxon Mobil, by 2030 the new cars of the U.S. will have an improvement in the efficiency of its use of 38 mpg, instead of the 21 mpg that a lot of their automobiles now register. If we compare it with Europe, this goal is even modest because the cars sold there average now 35 mpg, and many arrive at 40–43 mpg. In other words, the technology already exists to reduce the consumption of gasoline in the United States by almost half. Now the hard part of actually convincing their gas-guzzling culture to use this technology. This is one area where us economist can be helpful. Automobile companies are mulling over which technology to invest in, and that is no easy task at all because once they make their decision and start to throw hard to get borrowed money and time into it, it is very hard to switch back. That is, the world is full of examples of venture capitalist or even established firms going bankrupt in a growing industry because of wrong decisions of this nature. For now, two types of automobile technology exist besides the E85 that can go very far. One of them it is the one that runs based on the fuel cell, which employs hydrogen as the main resource but which is at least two decades away from large-scale manufacturing because it involves, among other requirements, batteries that are at least 2,000 times more powerful than those of a portable computer, which greatly elevates its operating risks, especially that of fire due to its high content of inflammable liquids, oxygen and coal. The majority of the large auto companies, like GM (Hydrogen3), Toyota (FCHVSUV-Prius) and Honda (FCX), already have cars and minivans or small trucks that are very efficient but that have limited markets because none of them are going to be sold on a great scale unless the customer is convinced that he can pull up to a gas station in the neighborhood and stuff it with hydrogen. This type of infrastructure does not exist and will cost billions of dollars to build, and it is unlikely (but not impossible) to happen any time in the next two decades even with the 43

As I write these lines, the ―Big Three‖ automakers were shunned by the U.S. Senate when they begged for emergency loans or credit lines to keep them afloat. Their failed pyramidal business structure, the fact that their labor unions overtook their management productive concerns, the financial crisis that affects their sales and the fact that they did not adequately read the reports on Peak Oil which would otherwise had compelled them to make smaller cars (as Japanese do), is what did them inn. One man who tried to change this from within as recent as the 1980‘s was Texan native Ross Perot, whose political views one might question but whose business genius no one does. Perot came from sales in the marketing department, meaning that he knew exactly how to feel what people want, how to make it, and how to sale it to them. When he made is voice heard first at GM‘s board of directors and later, out of frustration, in the national media, he encountered resistance and was eventually forced out of town. Personally from experience I have always had the opinion that the CEO of every company involved in mass-consumption goods should be, in his heart as well as in training, a salesman.

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assistance of the federal government. According to a source, if United States invests the sum of $100 billion (what it cost to put a man on the Moon) during the next decade in cars and hydrogen infrastructure, by 2016 half of the new cars sold in the U.S. would be hydrogenbased if half the gas stations are reconfigured to dispense hydrogen.44 This would imply, among other outcomes, a reduction in the dependence on petroleum if, and only if, hydrogen extraction can be done with economies of scale in cheap and massive production. As mentioned above, even though hydrogen covers 70% of the planet, its costs are greater, for now, than petroleum. The other is hybrid, which has the potential of being cheaper to produce in the long term and even more convenient for the consumer. Best of all, these already exist in the highways. The hybrids (gasoline/electrical) are reloaded by an electric motor that utilizes the majority of its power from a common electrical socket, where the consumer simply plugs in their car at nights. The car can travel 30–50 miles per day before it needs gasoline, which is more than the 20–30 miles that the average American drives every day; and if on any day a person needs to surpass that mileage, the car automatically switches to gasoline. According to The Economist, this technology has the potential to elevate the efficiency of fuel at more than 80 mpg if the problem of the enormous battery weight is resolved.45 According to the Electric Power Research Institute of Palo Alto, California, these types of hybrids can last as long as 100,000 to 150,000 miles, which increases their efficiency and reduces their operating and maintenance costs in the long run. In this period, it is estimated that improvements in technology will make the battery more compact and efficient in its storage, and when economies of scale kick in to reduce costs and when government aid helps out to diminish leverage financing, it is possible to imagine a cost structure low enough to be more competitive than conventional automobiles in the long run.46 The problem with the hybrids is that market share begins from a very reduced base, and to reach even a small proportion of the entire market of a growing population is a formidable task, to say the least. In 2007, the total hybrid market sales in the U.S. was estimated at 360,000 units, up over 40% from 2006 and from zero sales prior to the millennium, which is a remarkable achievement by any standards, far outpacing every other model (Toyota has 75% of that market). However, that number still represented about 2.2% of the entire U.S. car fleet of 2007, but their prospects look good. It is remarkable when you account for the fact that total car sales in 2007 were inferior by 3% over 2006, the lowest sales number since 1998. So, while the total pie is shrinking, the hybrid space is increasing over 40%.47 The U.S. government is giving fiscal incentives (to reduce the price difference with the conventional car) for any citizen who decides to buy this type of vehicle and is leaning hard on the Big Three to sell more of them. The hybrids are a reality, and they will continue to be so given the enormous technological and economic incentives.48 Some think (and it is hard to disagree) that hybrids could be the intermediate temporary solution between the automobile based on energy fossil fuel and the car based on hydrogen. 44

Goswami, Darshan., ―How to Eliminate American Addiction to Oil,‖ EnergyPulse 28-Aug-2006 www.energypulse.net 45 The Economist, Inglaterra, Enero 28, 2006 46 Ibid. 47 See www.hybridcars.com 48 The Economist, Inglaterra, Enero 28, 2006

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The urgent need for these vehicles is demonstrated in the statements of David O‘ Reilly of Chevron, who said: ―We should work more aggressively on the side of demand by increasing taxes on gasoline consumption to help reduce demand, or in the making of more efficient cars (in fuel consumption).‖49 It is not common at all to hear the CEO of any corporation publicly discussing ways to reduce the sales of his own product. Time will tell, and the investigation continues.

PRELIMINARY CONCLUSIONS [In the United States] . . . You can increase the price [of petroleum] from $25 to $40, and people can absorb it. If the price rises above $60, they become unhappy. They start to adjust, they move to smaller cars, drive a little bit less. At $100 or $120, there are major changes in lifestyle. The sales of cars will plummet. Poor people will be facing real problems of heat versus food.

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—Joseph Stiglitz, Nobel Laureate in Economics

The purpose of this chapter has been to separate the reader (and the writer) from the inexorable pessimism that Chapter 2 left us with which, if true to predictions, would carry all of known civilization towards a Middle-Age abyss, but not before prolonged, unimaginably painful and unprecedented military, political, and economic cataclysms. Up to now, what we have seen has the potential to alleviate us from this crisis if we comply with two fundamental premises: First, that humanity can wait for the long run, maybe by the first third of this century, so that different alternate resources have had enough time to flourish. Second, it is important to understand that none of the alternatives discussed can save us from these problems by themselves; we need all of them to do their part in an optimum combination. That is, if there were ever a cause for teamwork, this is it. As we will unveil in a later chapter, a strategy is needed for a coordinated plan for all countries so that time is adequately handled, along with ingenuity, diplomacy and the necessary resources for investment so that these different technologies can flourish in all their splendor. In the next chapter, we will see that the world still has a bridge to use to get this time; it is not a big bridge, nor is it cheap or easy, but it is there and it is crucial.

49

O‘Reilly, David, interview in USA Today, June 13, 2006

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Chapter 4

THE BRIDGE: THE NONCONVENTIONAL RESERVES Our passions, our prejudices and dominating opinions, by exaggerating the probabilities which are favorable to them and by attenuating the contrary probabilities, are the abundant sources of dangerous illusions.

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—Pierre Simon de Laplace

The first chapter was dedicated to revealing the all-too-vital importance of and dependence on petroleum for the economy and civilization as we know it. The purpose of Chapter 2 was to uncover all evidence that points to a direction that we certainly must avoid, which is total disaster if and when the incremental capacity to produce oil ceases, as it appears to be happening without anything viable to replace it. The third objective, as outlined in the third chapter, was to diagnose the state of the art regarding the wide dispersal of nonfossil fuel renewable alternatives (which may or may not be ecologically friendly) in order to appreciate the different challenges and, more importantly, to gauge how much time they need to overcome these many challenges. The answer is, as you recall, a lot of time—time that we economists/politicians must be able to buy at any price. The good news is that there is still somewhere else to go, at least temporarily. That is, there is a middle ground between here and there, a bridge or second chance, if you will, one that (given the population explosion, industrial development and material aspirations of the extra-populous nations) is not nearly as large as the first but, we hope, is large enough to carry the energy requirements of the entire planet towards the non-fossil renewables. This is what energy scientists call the nonconventional oils (for reasons I will explain later). Before we get there, however, we have to delve into two areas that need further explanation. We have to talk about the companies that first conceived, labored, gave birth to and raised the oil revolution in the first place; thereafter, we need to talk about three complex countries, two which still harbor the conventional variety of oil but whose very complexities seem to be limiting their full potential, and the other which no only harbors social complications of its own but that also contains the largest known non conventional hydrocarbon structure that its left in the world. .

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THE NOCS How sharper than a serpent‘s tooth it is to have a thankless child.

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—William Shakespeare, King Lear, Act I, Scene IV

In Chapter 2, we mentioned the all-out importance of the Big Oil companies in the transformation of the world‘s energy industry and, indeed, the world itself. Offspring or byproducts of Big Oil are the service companies like Schlumberger, Halliburton and Baker Hughes. They differ from Big Oil because they never claim ownership of the resources nor even aspire to own the land that they are contracted to work in; they are hired guns, if you will, because their strength is derived from their willingness to ―get their hands dirty‖ by providing the manpower, tools and technical expertise from around the world to push the oil from the depths of the ground into the refineries. Their scope in the business is incomplete but large enough and their finding risk is zero because the oil is there in plentiful quantities before they even get a call. They are not cheap by any means and, because of their lack of desire regarding any type of ownership control, they are the darlings of what has now become Big Oil‘s greatest competition—the National Oil Companies, or NOCs. The National Oil Companies, like Saudi Aramco, NIOC, Pemex, Gazprom, CNPC and PDVSA, are the new big boys on the block. Brazil‘s Petrobras is a mixture of both, which has worked very well, and Russia‘s Lukoil is a profitable and well-managed private holding that emerged after the fall of the Iron Curtain but is protected from international competition in their home turf. Today, according to the Paris-based International Energy Agency, by far the most incremental oil and gas supply will have to come from the NOCs of the world in nonOECD countries, ―resulting in mayor structural changes in the energy industry and increased imports in the OECD.‖1 Much like Shakespeare‘s fictional King Lear, who patiently raised his daughters with all the advantages and luxuries that a king can provide only to see them dethrone him and force him to live out the storms outside the comforts of his castle, the NOCs mantled themselves with the blanket of nationalism and progressively chipped away the revenue sharing in their respective countries. (It was Mexico that drew first blood with its 1938 nationalization and constitution, a factor that is weighing heavily right now; see below.) Some say Big Oil was a victim of its own success, others that they were victims of their own arrogance, still others point that they ended up securing their respective position by backing—and corrupting—dictators whose personal wealth eclipsed the rest of the population and thus bore deep resentment from others who just wanted to become them; others that big oil brought with them cultural hangups that collided with local customs. Whatever the truth may be, or a combination of all of the above, the fact remains that big oil does not nearly control the reserves that they used to. In fact, they control, freely, just seven percent. Exxon Mobil may be the worlds greatest investor owned oil company, but it produces only about 3% of the world‘s crude oil. In contrast, most proven reserves, over 81% of them are in the hands by national state run companies in places like Saudi Arabia, Russia and Mexico. The ultimate challenge for Big Oil in the years ahead is not money (the combined earnings of Exxon Mobil+BP+Chevron+Shell+ConocoPhillips was $44.4 billion in the third quarter of 2008, up 1

See the International Energy Agency, World Energy Outlook, November 12, 2008.

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58% from the same period a year earlier) but rather it is finding virgin areas to explore and produce. As we saw in Graph 2 in the Introduction of this book, this has proven to be a difficult and expensive task indeed. But that‘s not stopping them from spending big. According to a news release from the Associated Press, ConocoPhillips and Trans Canada have spend over $7 billion to double the pipeline flow off their field in Alberta‘s tar sands to the United States; Exxon Mobil plans to spend between 25 and 30 billion dollars in the next five years in upstream activities and BP is planning to widen its energy portfolio by spending $8 billion in alternative energy sources.2 Others are not far behind. Another possibility for Big Oil is to buy out some of the promising exploratory areas that belong to smaller companies that cant develop them because of newly found financial stress that makes it harder to fund the capital, but even buying those has its limitations. A new wave of M&A will buy Big Oil some badly needed reserves, which are after all the lifeblood of their entire asset structure, but it will not be enough to alter the limitation predicament.

Source: International Energy Agency, 2006. Graph 1. Big Oil Access to Global Oil Reserves.

From the viewpoint of the resource-owning nations, kicking out Big Oil meant: • •

2

A gain: a better share of the total revenues and the priceless feeling and nationalistic political capital that the country ‗‘owns and operates‘‘ the resources beneath its feet. A price: technical efficiency, highly qualified personnel, sufficient capital investment, unforeseen delays and cost overruns.

See Porretto, John, ―Analysis: Oil Companies Spending Money on Investment Instead of New Resourses,‖ Associated Press, July 21, 2008

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But most of the technical shortcomings (except capital, some geological knowledge and long-term commitment) can be outsourced from the service companies mentioned above. Indeed, in many—if not most—cases, the service companies are the ones that helped made the NOCs successful. Perhaps an analogy will help shed some light on this. Back in the Old West, when oil and the car were still far distant into the future, power, status and success was often measured by the power and energy of the horse. The more horses you had in your stable or corral, the better off you were. Horses are tamable, strong, noble, fast, and versatile, they can pull the load, gallop the distance, take the workload on their back, transport the family, and are inexpensive to maintain. Little wonder they often were considered part of the prize in the winnings of battles back then, if only because their presence often made the difference in the results of the battle. But once you have the horse, there are five conditions that must be met to make it useful.

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i. Domestication: A horse must have been tamed before you ride it. ii. Blinders: A horse must wear blinders that shade the corner of their eyes, so they see only the things you want them to see. iii. Adaptability: A horse must be adaptable to different types of terrain. If a mountain pony cant adapt to the plains, get a bronco. iv. Rider: The most important, a horse must always have a rider on top of it that guides it through and points to the direction and speed of where the horse goes. There must not be any confusion on who‘s the boss (not the horse). v. Feeding: The feeding mechanism of a horse is a delicate process. If you feed it too much it gets fat and lazy, if it is undernourished it can‘t harness the energy to do the work. The trick is to do what they do just before the bugle sounds off at the beginning of a horse race. They feed the horse just enough so he knows he is hungry. If he wins, he gets a lot more; if he doesn‘t… Governments are supposed to be nationalistic. They are required to maximize profits whether they are economic profits or from the political variety. But they are also expected to create the right environment for the most efficient business undertaken from their productive agents, from wherever they may be. This calls for the right mixture of these two extremes because they both need each other. That is, there is a big gray area between 0% and 100% control and all it takes is corporate imagination and trial and error to come up with the ideal formula, one that may be redefined according to the particulars of the idiosyncratic culture, as well as the oil reserves and its selling price, of that particular country. The Brazilian formula was already mentioned, that basically works with what is called a ‗‘golden share‘‘ that gives the government a strong and decisive presence in the board but that leaves operational ―details‖ on the hands of the companies technical staff. As I said, it has worked well; Petrobras is clearly one of the big boys now. But it is not the only method, as we shall see. We will come back to this later in this chapter.

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NONCONVENTIONAL RESERVES History does not give us confidence that private interests alone would adequately safeguard the national interest. —Henry Cabot Lodge

We shall now turn our attention to the nonconventional petroleum reserves, which as I said, given the depletion of the conventional ones, can be regarded as a second opportunity that must be used as a bridge towards other forms of energy. Our success in doing this, given a whole host of challenges cannot be assured if only because it has only been tried at a relatively small scale that needs desperately to be enlarged enormously, but our failure to do it is not an option given our dependence and the all too real economic risks involved. The two types of non conventional reserves discussed first belong chiefly to two ―conventional‖ countries in that they do not depend on oil revenues for the survival of their entire fiscal and budget structure, although it helps.

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The following is a direct quote from the 2007 report from the National Petroleum Council, which they prepared at the bequest of the US Department of Energy. ‗‘The IEA (Energy Information Administration) estimates that there are 6 trillion barrels of heavy oil worldwide, with 2 trillion barrels ultimately recoverable. Western Canada is estimated to hold 2.5 trillion barrels, with current reserves of 175 billion barrels. Venezuela is estimated to hold 1.5 trillion barrels, with current reserves of 270 billion barrels. Russia may also have more than 1 trillion barrels of heavy oil. Heavy-oil resources in the United States amount to 100 to180 billion barrels of oil…Heavy oil in Venezuela, oil sands in Canada and oil shale in the USA account for more that 80% of unconventional reserves in the world‘‘3 The United States and Canada, adhere to private ownership of their respective energy industry, and that has brought them excellent results for more than a century but not without its costs. In the case of the first, which is the very country were oil was first found to have energy value and was first successfully drilled, industrialized and massively produced, it is also the country that is mostly depended on oil on everything because they are the ones that use and import most of it. The second country is also the second largest nation in the world although relatively scarcely populated, and it depends on its southern neighbor for over 90% of its exports. Both are developed and industrialized nations and both owe their enviable status and well being to their democratic, fair play traditions, sound economic management of their vast natural resources and competitive technological breakthroughs, as well as to the employment of oil as its chief primary energy source that has allowed them to expand their industry and financial prowess.

SHALE OIL Failure is a part of the process of success. People who avoid failure also avoid success. —Robert T. Kiyosaki 3

National Petroleum Council entiled ‗‘Facing the Hard Truth about Energy‘‘, Washington, DC, July 2007

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At the beginning of twentieth century, when the western railways were being constructed on the population of Green River in the state of Wyoming, the workers decided to rest the night in front of a bonfire, as they always did. Imagine their surprise when, after joining the rocks in a circle to start the bonfire, that the rocks themselves caught fire. Since they were not using coal, the only other explanation was that the intensity of the fire broke up the rocks (the technical term physicists use is thermal cracking) causing the petroleum inside to spill and burn flames. These gentlemen, without knowing it, had discovered the Green River formation, or the rest of a prehistoric lake that had long ago disappeared for millions of years but that it contains, according to some estimates, more than two trillions of equivalent barrels of petroleum, that are approximately twice what humanity has consumed so far it its history. That is, the greatest oil accumulation in the world.4 The problem is that it is not exactly petroleum. Or to put it differently, it is petroleum in fetus (kerogeno, a precursor of oil) that was never completely formed because the rocks were never buried at the necessary depth for the geological pressure to cook it into liquid petroleum. The question is: Can this embryonic oil be produced on a large scale? The answer is, with the existing technology no; in the best case scenario only in the long term but with high financial, environmental and energy cost. The rocks, that only contain between 5%–25% of kerogeno, have to mined in the open sky, transported, pulverized, warmed up to more than 500 degrees Celsius to separate it from the dust and transform the kerogeno into petroleum. A great amount of gas and water is needed (up to 4 barrels of water for each barrel of oil produced), and these immense amount of contaminated water and sand waste has to be properly disposed of before the process can be started again.5 Since the water is highly contaminated, an option would be to recycle it, but this cannot be done continuously because the more contaminated it is the less it can separate the sand. It is there where the environmental problem is created. As far as its power use, estimates that the fraction of energy produced on energy consumed in all this process (the well used ENROI ratio) is 3.5 to one in the best of cases. The ENROI in conventional petroleum is 30 to 1 and larger. To sum up oil shale is a promise in the very in the long term. Exxon Mobil does not even contemplate an important impact of this energy source in its long term scenarios before the year of 20306. But oil shells are also part of the solution. The investigation continues. One unlikely snag that oil shale is suffering comes from, of all places, the U.S. Congress. On May 2008 the Senate Appropriations Committee voted narrowly 15–14 to defeat a bill that would have ended a moratorium on enacting rules for oil shale development on federal lands, which is where the best oil shale is positioned. With oil prices what they were at the time, that move is one that surprised most people. Unless you are one of those who believe that the U.S., as some other countries, prefer to import oil than to run out of it by using its own. More likely, environmental concerns may have weighted heavily on the minds of the legislators. In its mid 2008 outlook, the EIA released this good news-bad news comment about the short term perspectives on oil shales. 4

This formation also includes the states of Colorado and Utah, and some refer to it as Rocky Mountain oil. Only parts in Utah were buried deep enough and two mid-sized fields have been developed that are now producing oil. 5 In fact, oil companies working this area once contemplated diverting the entire flow of the Green River to solve this problem. Environmentalist stopped them. 6 Bulletin of Atomic Scientists, 2005.

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‗‘Oil shale liquids production is not resource constrained because approximately 400 billion barrels of petroleum liquids exist in oil shale rock with at least 30 gallons per ton of rock.…Because the in-site process is still at the experimental stage, and because the underground mining and surface retorting process is unlikely to be environmentally acceptable, the oil shale liquids production projections should be considered highly uncertain‘‘.7

TAR SANDS The people who think that the peak of petroleum will occur are only looking at conventional petroleum. We must think beyond this. We must think about all the other hydrocarbon sources, the oil sands of Canada, the natural gas. We must think about all those remote areas of the world that have still not been explored: all the east of Siberia, in the Arctic, deep waters of the ocean… —David O‘Reilly

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CEO, Chevron Corporation.

If oil shale is petroleum in fetus, the bituminous tar sands, better known as Tar Sands, is moribund petroleum. This type of petroleum was formed when the original petroleum in site did not find a stable trap in the subterranean depths of the earth and began to migrate upwards between the fissures and cracks of the subsoil, dragging enormous amount of soil garbage along in the way, like sulphur and metals, which increased its specific weight and diminished its original quality. Sometimes it finds another impermeable sand formation, or trap, and it remains there until it is discovered and drilled, as was and is the case of Venezuela‘s Orinoco Belt formation, and other times it does not find traps and dissolves in the sands of the surface, as it is the case with the Alberta providence in Canada. After million years of exposure to the elements in the terrestrial epidermis (oxygen, sun and water) the lighter molecules, the ones we want, evaporated into thin air while the ones of lesser quality degraded until forming a solid bitumen that is so extra-heavy, dense and viscous that the engineers (until recently) not even called it petroleum deposits, but bituminous sands or `tar sands'. The study of tar sands is much more advanced than the oil shale, and its amount considered in site is similar (two trillion barrels of petroleum, or twice more than the world has consumed, sufficient for several hundred years of production). The most abundant deposits, over 80%, are in Athabasca, in the province of Alberta in Canada and this country, through their companies and others has invested strongly for their development with promissory results. According to the U.S. Geological Survey, these deposits place Canada second behind Saudi Arabia on the list of total oil reserves with 173 billion barrels of reserves. The capital outlay and investment costs however have been skyrocketing recently, from every input in the forms of metals, gas and qualified engineers. Andrew Potter, a petroleum analyst at Union Bank of Switzerland (UBS) said recently that the rising costs may put the floor price of these projects in the $100 range.8 Petro Canada, which has a large project in Fort Hills, Alberta, announced in mid September 2008 that its front engineering 7 8

See Energy Information Administration, Short Term Energy Outlook, November 12, 2008 See The Upstream Journal, September 18, 2008.

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plans of expansion of synthetic fuel will run them 50% higher than originally planned to over $26 billion dollars.9 Former U.S. Vice President Al Gore, in a Rolling Stone magazine interview, had other concerns: For every barrel of oil they extract there, they have to use enough natural gas to heat a family‘s home for four days. And they have to tear up four tonnes of landscape, all for one barrel of oil. It is truly nuts. But you know, junkies find veins in their toes. It seems reasonable, to them, because they‘ve lost sight of the rest of their

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lives.

10

According to Exxon Mobil, one of the companies in this project, assuming an average recovery rate between 20 and 25%, a recovery rate of 800 billion of oil equivalent barrels of tar (or approximately 85% of what humanity have consumed so far) could be hoped for, but very much in the long term. In fact, in its report on worldwide oil perspectives, Exxon Mobil only considers a four million barrel average daily production of these Canadian sands by the year 2030, which will only represent 3.5% of the total projected demand of 113.3 million barrels for that year. The U.S. Geological Survey thinks that because the conventional reserves of Canada are declining rapidly, the exports of tar sands, which today represent onethird of total Canadian exports, could increase up to 70% by 2025.11 If the study of these oil sands is more advanced, the difficulties in production are almost as hard as the oil shale. Typically, since these deposits are located in the thickness of sands of 6 to 10 meters, its process of production is complex and laborious. According to the EIA, only 20% of these reserves are sufficiently reachable for mining, which leaves the vast number of them buried too deeply in the thickness of the subsoil to extract them with conventional technology. Analogous to collecting the low hanging fruit first, which is easy to start, but when these run out the ones higher up in the tree are much harder to reach. Because these deposits are too solid to move by conventional means, meaning they don‘t shoot up to the earth‘s surface when the drilling bit destroys its traps like conventional crude, some ingenious process of artificial lift and strip mining are required. It includes a process called SAGD (Steam Assisted Gravity Drainage), which consists of injecting steam to warm up the bitumen and dilute it with solvents to increase its fluidity in order to gravitate it to the surface. Afterwards, open-sky mining techniques are employed, which consist of immense trucks and dredges that pick up tons of bituminous soil, at the rate of two tons of soil per each barrel of petroleum that must be separated from each other by means of injection of rivers of water which have to be pre-warmed by gas to very high temperatures. Their ENROI has been considered 2–3 to 1. The cost to develop this type of oil is very high and thus requires a high price of oil to make it profitable. The oil-specialized online magazine Upstream quoted Petro-Canada stating to Reuters that the price of its 140,000 barrel per day project at Fort Hills on the oil sands had risen by at least 50% from a year earlier, estimated at C$21 billion (US$20 billion); and that company placed the blame on rising material input costs, such as steel, a tight labor supply and higher project management expenses. In total, more than C$50 billion has already been spent to tap these tar sands and twice that much has been pledged on new projects. 9

Ibid. Rolling Stone magazine, June 28, 2006 11 Silverstein 15-2-2006. 10

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United Bank of Switzerland analysts estimates that crude prices need to remain above the $100 per barrel threshold to turn a decent profit.12 The viscous bitumen found is hardly 10–12% of the sand, whereas 80–85% is disposable mineral that includes clay, sulphur, sand and water. o Separating these components is expensive and anti-ecological. It is estimated that for each barrel of petroleum produced, four barrels of water are consumed. The environmental problems are very strong for large-scale operation because the rejection of sulphur is required, at great refining costs. Thereafter, the oil must be mixed with diluents to convert it into synthetic fuel for transport and then reforest the landscape. Also in the process, enormous open-cast of contaminated water lakes are created, which may take centuries to settle. Their CO2 emissions are very high. Nonetheless, these grand difficulties have not stopped the Canadians from producing about one million MBD, which represent a third of all the production of Canada. The tar sands are replacing the conventional petroleum fields of Alberta, whose reserves already are in frank decline. Without a doubt, the most important impediment in its continuous operation has to do with the supplies of gas available, which is its principal outside input as much for the heating of the water as for the separation of the oil from the sand, and the gas supplies in much of Canada and the United States are falling. In fact, in a study prepared for by IFC International in March 2007, it was estimated that since traditional internal gas supplies are declining in the mature fields of the U.S. and Canada, and demand is expected to increase sharply, new frontier gas supply sources for these two nations will account for 34% and 43% of total gas available in 2017 and 2025, respectively. These new supplies would come in the form of new Rocky Mountain and Alaska gas fields, as well as LNG imports.13 All this has caused its prices to triple since the late 1990s. Sometimes it seems that it makes more sense to sell the gas directly to the final consumer than to subject it to all this process of bitumen extraction and purification that also involves contaminating drinkable water. But, as I said previously, the investments in tar sands mining plants are very strong and, perhaps with economies of scale and higher prices of petroleum, along with technical advances that help diminish the environmental impact, this process will generate very beneficial medium- term results for Canada and for the world. One of these technical advances, for example, would be to incorporate a nuclear plant in Alberta that replaces the gas used; but, even if the environmental obstacles are surpassed, this nuclear plant would not be ready in less than a decade. In summary, these sands are also a big part of the solution, but on the long term end of it. The investigation continues. Because of its high operating costs, and the complicated nature of its investment schedule which often runs into reverse scale economies (where unitary costs increase with expansion), the projects in tar sands have been very sensitive to the current turmoil surrounding the world‘s finances, as the following press excerpt from Bloomberg states: Global crude-oil output is falling faster than expected, leaving producers struggling to meet demand without extra investment, the Financial Times said, citing a draft of an International Energy Agency report. Annual production is set to drop by 9.1 percent in the absence of additional investment, according to the draft of the agency‘s World Energy Outlook obtained by the newspaper, the FT reported. Even with investment, output will slide by 6.4 percent a year, it said. 12 13

See Upstream On Line, press release 21. October, 2008 See Petak, Kevin R., ―Gas Supply and Demand in an Uncertain Environment.‖ Presentation prepared by Energy and Environmental Analysis, Inc., ICF International, Inc., 2007

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Carlos A. Rossi The shortfall will become more acute as prices fall and investment decisions are delayed, the newspaper said. The IEA forecasts that the rising consumption of China, India and other developing nations requires investments of $360 billion a year until 2030, it said: Financial Crisis May Lead to Oil Supply Crunch IEA Executive Director Nobuo Tanaka participated in the Ministerial Panel at this year‘s Oil & Money conference in London on 28 October. In his remarks, Mr. Tanaka said that the financial crisis may delay oil 14 projects and lead to a serious supply crunch. He emphasized the need for maintaining investment.

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Clearly, the lower the price of oil at the market, the longer it will take to recover from the recession because once the economies of the world are ready to resume growth, the oil will not be there and neither will the alternatives because these are far more expensive to develop given their late start and largely experimental basis. The following graph, taken from the U.S. EIA is telling on the ultimate importance of the tar sands and the much more friendly and easier heavy oil resources to which we now turn. Clearly the demand is there, the problem will be getting the supply to meet it. The investigation continues. In the next graph, we observe that in the case of the biggest consumer of oil in the world, the adaptation towards the heavy oil variety is not only in full swing, but that it has overtaken its imports of light crude.

* Measured in American Petroleum Institute degrees, which compare crude‘s weight with water; the lower the API, the heavier the oil. Source: Energy Information Administration. Graph 2. Sticky Situation. U.S. crude-oil imports by Gravity.*

For now, we need to address two non conventional countries, Mexico and Russia, whose complex makeup, plus the fact that they owe much of the worlds energy resources, is what helps define their non conventionality; but, at the same time, it is what limits their full potential for good reason and not so good. Later, we will describe the makeup of the nonconventional reserves that are owned by so-called ―conventional countries‖ like Canada and the United States, meaning those that are not heavily dependent on oil for their export or fiscal revenues. Given its singular importance, in this chapter we will also take an in- depth 14

Macdonald-Smith, Angela, ―Global Oil Production Is Falling Faster Than Expected,‖ Bloomberg, October 29. 2008

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look at Venezuela, which is also a nonconventional country if only because it has been blessed with 90% of the known nonconventional petroleum resources of the world. After explaining in some detail how these resources will be exploited. (In my current job, I have a front seat in all of the negotiations leading towards the current status of mixed enterprises and the new legal framework that underpins it.)

RUSSIA Russia is a riddle wrapped in a mystery inside an enigma.

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—Winston Churchill

If there has ever been a nation that has pondered itself between its past, present and future, that is Russia. One of the most complex nations to analyze for its enormously vast space, its divergent cultures and idiosyncrasy all products of an enriched history. It is by far the largest country in the world, contains one of its harshest climates and it expands into two different continents. It is also a hard working nation that has withheld numerous invasions in its long history; as is one of the most intellectually ambitious countries on earth, home to some of the greatest minds in all science fields and arts. It is not a country with strong democratic traditions but it is one with phenomenal resilience. In the energy field, Russia ranks second to none in energy production in the world. Peter the Great and Catherine the Great in the seventeenth and eighteenth centuries, respectively, tried to modernize their beloved mother Russia but only succeeded in expanding it, because each failed to create and foment the appropriate institutions to carry on their goals past their own personal desires; and also perhaps, because they tried to accomplish and force their changes with too much speed, generating a backlash from the bearers of the traditional values.15 The medieval dynasty of the Romanovs, triumphant in WWI at an unbearable cost was pulverized by the Bolsheviks in 1917 and these implanted a communist system that in the end turned out to be nothing more than state feudalism in the farms and forced industrialization in the cities, at least with regards to the virtual slavery of its citizens. Its emphasis was in income distribution and forced industrialization, largely disregarding the best practices of the production of goods and services and of the political and religious freedom of its people. But where Tsars Peter and Catherine failed, Joseph Stalin did not. This is because the ruthless man of steel preferred to use radical forms of motivation. Communism was challenged from its birth; first by the renegade imperial army of the old guard (the white army) then by the horrible and formidable onslaught of Hitler‘s panzers and later by its efforts to breach the weapon-technological gap with the U.S. in the Cold War. Because of this, the Communists convinced its people of the importance of industrialization and they did it through massive ideological propaganda, a forceful emphasis on production targets on all fronts—especially heavy manufacturing—and by accelerating the education of their people in 15

Peter the Great, the ambitious autocrat who expanded Russia for access to the Baltic Sea at the expense of Sweden and later built a spectacular city on that site that bears his name, tried to force changes so fast that he even provoked a rebellion in which his own son was involved. After his capture, at Peter‘s bequest, his son was tortured and eventually died in prison.

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all the branches of science to the point that they competed feverously with the very best in several key areas, like military hardware and space technology (its worth noting that Russia entered the twentieth century with 90% of its people in the farms and largely illiterate). Notwithstanding its formidable losses in farms and factories in WWII which Russia and its allies also won, Russia managed to emerge as the second most industrialized country in the world ahead of its destroyed neighbors in Europe, although several layers behind the United States (it is also worth noting that the Russians were the first to put a man in space and later a spacecraft on another planet—Venus). Stalin managed to do this by stimulating on its people that only a strong Soviet Union could withhold another devastating invasion from the West (the horrific Russian death toll in WWII was 23 million, far exceeding anyone else), and he did it through a series of five-year industrial plans that built immense factories—at the expense of agricultural surplus—that kept very tight and ambitious schedules and whose productions targets were met under nationalistic ferment and under fear of punishment (like purges or Siberia relocations) rather than material gain.16 These enormous factories were never subjected to the open price mechanisms that a market economy provides to signal abundance, preference, scarcity, obsolescence or distaste; nor, as importantly, they were never subjected to open competition from the international level, which impaired any necessity to upgrade its technology and improve its quality except in the reduced sectors where outside competition was forced upon them; like the mentioned space, energy and the military (where the Soviets also made enormous, but eventually fruitless, advances). Although the huge size of the factories did provide ranging economies of scale that reduced unitary costs, the sheer size of them also precluded the introduction of new leading edge technological advanced machinery because of the high investment cost that it commanded. Ultimately, the State apparatus bureaucracy became way too large to handle, with huge planning projects interspaced in an interrelated web of input-output tables that emanated from the heights of the Kremlin only to dissolve in thin air before it hit the realm-terrain of micro economics. In the massive consumption goods of light and flexible manufacture, as well as heavy durable goods like autos, washing machines, stereos, fridges, televisions, etc., the soviet experience was, comparatively, notoriously ineffective. As time wore on, the differences in the living standards of the average Russian and its Western counterparts in the revived Western European nations and the U.S. became glaringly obvious in spite of the closed media. As a new generation of Russians and Eastern Europeans came about in the 1980s, which had no memory of WWII but a too-vivid intrigue on Western material gains, the Soviet experiment entered its final phase. The death of Stalin in 1953 was followed by a succession of old political autocrats that had spent their entire life infighting for position in the politburo but that had progressively lost touch with its people‘s wants and expectations.

16

This is not to infer that Stalinism was the optimal solution to Russia, or even a temporary one. Although there is no doubt that the Romanov dynasty was backwards, decadent and in desperate need of an overhaul, there is also no doubt that if a social democracy had emerged-instead of complete totalitarian communism-that Russia would have fared many times better. What is intended here to point out merely is why Russia is a largely populated industrial country with an equally large demand for primary energy.

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THE FINAL COUNTDOWN

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Stalin, Khrushchev, Brezhnev and Gorbachev were all travelling together in a railway carriage, when unexpectedly the train stopped. Stalin put his head out of the window and shouted, ―Shoot the driver!‖ But the train didn‘t start moving. Khrushchev then shouted, ―Rehabilitate the driver!‖ But it still didn‘t move. Brezhnev then said, ―Comrades, Comrades, let‘s draw the curtains, turn on the gramophone and pretend we‘re moving.‖ Gorbachev finally said, ―Comrades, let‘s get out and push.‖ —Political humor in the underground culture of the Soviet Union (author unknown [to me])

The ascent of Mikhail Gorbachev to head the Kremlin in 1985 (much younger than his last predecessors and who thus exuded more vigor and was much more open minded) coincided with a brutal collapse of the price of oil the following year, to the point that these fell even lowered in real terms than 1973, the year of the first oil shock. Since the Russian economy depended for at least 70% in the petroleum exports for hard currency income, and given the aforementioned inflexibility and antiquity of its productive apparatus, Mr. Gorbachev was left with only two choices at hand. Either proceed business as usual like his predecessors would have done, which is to choose guns over butter, increase repression and pretend everything was OK, or, risk a gamble and open its economy and politics to foreign investment and political ideas. Mr. Gorbachev made the right choice in selecting the latter, and he did it through the implantation of two complementary policies that were called glasnost and perestroika. The results are well known. As soon as the lid of the pot was cracked and the pressure of the gas of freedom was exposed to open air, the whole Communism/feudalism kitchen exploded in a social and largely bloodless uproar that destroyed the whole iron curtain of Europe and disintegrated the Soviet Union in the historic years of 1989 and 1990. The world would never be the same and Russia would never look back. After a decade long transition period, with all the growing pains that accompanied it, Russia today is a mayor developed nation and, to a lesser level, so are the countries we call today the Former Soviet Union.17 Russia also enters the twenty-first century as the second largest petroleum producer in the world and with the greatest gas reserves (27% of the total). Combining everything, Russia is the largest producer of energy of the planet. Because of its enormous population, nevertheless, its petroleum reserves/production ratio is 21% compared with 70.8% in the case of Venezuela. In the 1990s, the Russians privatized the majority of its oil industry and reorganized the state ones, although they retained their reserves of gas. But the times have changed again and petroleum prices have gone upwards in the new millennium, a factor that makes the Russian State all powerful again. As a result of this increase, and thanks to the investments of the multinational companies in its oil infrastructure, Russia returned to reclaim its levels of production before 1990 although inferior to other years, as the following graph demonstrates, and now is able to produce about 9.5 MMBD which places it in second place right behind Saudi Arabia. Nevertheless, since 2004 the growth of its production has stagnated. There are energy experts who insist that Russia already tapped its Hubbert Peak in production, perhaps in the late 1980s as the following Graph suggests, and that since then increases in production are simply the results of ―legal bounces‖ (positive changes in its 17

Although this is hardly the time to recount the recent history of Russia, one factor that is worth mentioning that contributed to the ultimate fall of the Soviet Union was the tenacity of U.S. President Ronald Reagan.

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hydrocarbon laws) that facilitated investment and reclaimed temporarily old production levels. But, given the inescapable sword of Damocles that Peak Oil represents, Russia‘s production from its tired spigots has then descended just like its discovery peak faltered about 40 years ago. This would explain the conservationist policy the Kremlin has been pushing regarding the restrain in production to avoid a rapid exhaustion of the resource.18

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Graph 3. ASPO, Campbell, 2006.

The oil multinationals that know Russia very well for having explored and produced in their turf for decades say (for reasons that I cannot reveal) that Russia could possibly have much more petroleum reserves in its Siberian territory and, especially, in its offshore region, if only they (the Kremlin) would allow them to re-explore the region with the latest technology that these companies have since developed. Russia also needs to upgrade their investments in infrastructure to bring their whole hydrocarbon value chain up to speed, which is something that they are doing but at a slower pace than required. Most of their reserves are only opened de facto to Russian companies. (To be fair, some of these critics forget to mention that large consuming nations like the United States are also holding back their last oil reserve frontiers in Alaska and in the offshore in both its ocean coasts by prohibiting drilling.) Some experts point out that Russia must have enormous amounts of extra heavy petroleum reserves in Siberia (also home to the bulk of its gas reserves) which are comparable to those of Alberta and Colorado. The problem of Russia, in my opinion, is three fold: climate, ideological and political. In the first place, even though geologically Siberia is an ideal place to explore for hydrocarbons as far as the underground goes, above it is something else entirely. This huge track of mostly Eurasian frozen land that stretches east of the Ural mountains all the way to the artic and the pacific has over 13 million square miles, contains over three quarters of all of Russian territory harbors just 25% of its population, usually has in mid winter deep double digit negative celsious temperatures. In the north, where the summer only lasts a month, the hydrocarbon reserves are sometimes located hundreds of kilometers from any town, and to build a pipeline to transport its oil and gas reserves through semi frozen water or freezing ice patches pushes both technology and human endurance to the limit. Second, the government of 18

See Reynolds, Douglas, Scarcity and Growth Considering Oil & Energy: An Alternative Neo Classical View. University of Alaska Fairbanks, 2002.

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Vladimir Putin—whose hard stance ironically contrasts the more liberal position of the leader who appointed him,—has made international investment a very hard chore for the multinationals; he has not only increased the government take (every producer has) but also the tariffs in the ports, restricting access to the pipelines, raising unrelated tax levels and creating a climate of legal uncertainty to the point that the majority of companies in Russia have left the country, and oil investment has become paralyzed (the two-year tax conflict with its number two producer, Yukos, doubtless had an impact). The production of Russia jumped 11% in 2003, 9% in 2004, and 2% in 2007 and has since settled in the 9.9–10 MMBD range. Meanwhile, government take jumped from 68 cents for every dollar above the $25 range in 2003 to 89 cents now.19 This has had a negative impact in the exploration and production. Several major oil companies have complained publicly that their engineers and staff have had to leave Russia because of work visa complications; after they had contributed to kick off the oil production and given the Russian treasury billions of dollars in tax bills and more billions of dollars in dividends. Of course, there are two sides to every story. That is, if you are inside Russia, the world looks a bit different. As mentioned, Russia is a gigantic industrial nation with over 140 million inhabitants, which must endure bitter winters that forces it to consume more than 130 million tons per year of oil for both its industrial, agricultural, petrochemical and residential needs (Siberia is far away from its consumption centers). Their internal consumption will grow in parallel to their continued economic expansion. Given the increasing prices of the crude oil and the exhaustion of its reserves, its new conservationist attitude can be well understood in perspective. The Russians are also responsible for the gas (energy) provision of many of its neighbors, some of which are the Former Soviet Union nations in Eastern Europe, and some of which are not, like Austria and China, where the Russians are involved in building very costly gas lines. Nevertheless, business logic holds that it is always praiseworthy to maintain all options opened towards the best practices of production; and there is almost consensus that the Russians can increase the capacity of their exploration levels and production, if the capital and technical expertise is aided by the multinationals. The important thing to keep in mind for the purposes of this book is knowing that nothing of Russian history will subtract from the fact that the world needs a great part of its hydrocarbons to replace the reduction of the conventional reserves.

MEXICO The incomprehension of the present is fatally born out of the ignorance of the past, but it is futile to attempt to understand the past if nothing is known about the present. —Marc Bloch

If Russia is the most complicated country to analyze in Eurasia, Mexico certainly takes that role in Latin America, and for much the same reasons. It is a vast country, with a large population of mixed ethnicity (about 110 million—9% white, 30% Amerindian and 60%

19

See Business Week, July 25, 2005.

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mestizo20) and bearing many brands of cultures and idiosyncrasies, a factor that, just like Russia, is richly manifested in its variety and diversity of folklore literature, songs, paintings, ideology, and all varieties of plastic arts. However, this does not apply to religion or language, where Christianity and Spanish are by far the predominant features. Like Russia and China, Mexico has had more than its fair share of foreign interventions. Although this is not the space to provide even the briefest summary of the history of this fascinating nation, four features must be addressed that go to the heart of this book because they explain the super nationalist sentiment that this country has regarding foreign intervention. The first relates to its colonial period, the second to its economic policies for much of the twentieth century; the third to its relationship with the United States and the fourth with the state of its flagging oil industry. Unlike what happened on the majority of the American continent, including the United States—where the native Amerindian population was exterminated either by the policy of the conquistadores or their victors, or by the infectious deceases they brought with them—in Mexico, the immense indigenous population was never eliminated, but conquered. The Aztecs, much like the Incas in the south, had a very orderly pyramid-like structured society that had long before settled and developed advanced agricultural techniques and had even promoted the art of writing (unlike the Incas), which enabled them to construct a far-reaching civilization that did not depend on hunting or fruit gathering, but on intense farming and fishing, in sharp contrast to the case of the primitive cultures in the Caribbean islands or the Apache Indians in the north. Rather, the social structure of the Aztecs was much more hierarchically arranged; and because they had no real enemies before 1492, its communal structure was inflexible with Montezuma comfortably resting at the top. Their only worry seemed to be weather-related or to satisfy the extremely exigent demands of their gods, which included ritual sacrifices of their young. One of the greatest ironies of this period is that it was precisely because of the rigidities of this social structure that Hernán Cortez found it so easy to defeat this whole empire in 1521, one that vastly outnumbered his forces, and he did it encountering light resistance. (Some historians have pondered that part of the reason may have because Montezuma was not a very popular dictator.) All Cortez had to do was to aim at the top, conquer the leading brass with the speed of his horse given energy and artillery and the rest automatically fell under the command of his white minority. In the later centuries, Mexico did lose the majority of its indigenous population but more because of contagious diseases than anything else. A very unjust and infamous slavery system was imposed on them on an encomienda feudalistic agrarian structure, but there never was an explicit policy to exterminate them. This is a big part of the reason behind the ethnic and cultural characteristics that make Mexico rich and poor, calm and contradictory, complete and separated, nationalistic and internationalist. Their strategies of development can rarely be unique because different ethnic groups do not necessarily agree in what the country needs. The bridges between the different social groups, although far better that in other places because in Mexico racism is scowled and illegal (i.e., there is no apartheid in Mexico, formal or informal), are nevertheless disconnected, as if two separate countries existed in the same territory. The independence movement in the nineteenth century, like much of Latin America, simply dethroned the Spanish in favor of the local white minority; and the wars against the ruthless dictator Porfirio 20

See CIA, The World Factbook, on CIA Web page.

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Díaz in the beginning of the twentieth century, was led by a peasant revolt in the south (Zapata) and in the north (Villa) was not completely settled for years because of internal infighting for central authority, except that the nation state garnished much nationalistic power. In 1938, President Lázaro Cárdenas nationalized the oil industry in México and lawfully underpinned its total ownership in the Mexican Constitution, a fact that still stands unaltered today and which is bitterly defended by its whole popular political class. The following statement from the talented Cuban-born and Yale-educated economist, Carlos Diaz Alejandro (1937–1985), about the general relationship of the rich classes in Latin America with the state of their countries, is expressed with much clarity:

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Internationalized households can control the uncertainties of under-development and erratic governments.… More and more, the international system offers the high and middle class of Latin America the comfortable possibilities of personal and capital exit doors thus reducing their incentive to express their voice in the national affairs and eroding their loyalty to the State, of whom, nevertheless, the countries of the OECD nations expect that this very State tax them to serve the debt and provide a friendly climate to investment, 21 commerce, and government.

The important element of this quote is that it was written in the 1980s, long before the PC, the Internet, and the integration of the financial markets. That is to say, long before globalization was derived from the womb of capitalism. All this facilitates the top classes to slip out of the low points of economic cycles and take control of the upside; and this ability has increased exponentially as a result of the phenomenon of globalization, to the detriment of the indigenous and racially mixed class of Latin America if not by design, by result. In the case of Mexico, however, globalization has also brought much-needed foreign investment (especially the energy- intensive kind, like automobile manufacturing), and this has released the pressure of overpopulation through migration to the north. Another important side effect to acknowledge is that the rich class in our continent has more affinity with their rich counterparts in the OECD countries than with the poor people of their own. According to the World Bank, Mexico has the second largest gross domestic product of the continent and the first in per-capita terms, and less than 10% of its population is illiterate. Mexico also contains one of the most pronounced indices of poverty and inequality of the continent, with 53% living on less than $2.00 a day and 24% on half of that. The top 10% of the population, virtually all with white skin and famous last names, controls 40% of the total income, while the bottom 10% controls 1.1% of the national income. According to the same source, there are deep ethnic and regional disparities in access to the basic services.22

THE SUBSTITUTION Blessed are the poor in spirit…blessed are the meek, for they shall inherit the earth. —Jesus Christ

21 22

See Rossi, Carlos (2000) Caída y Auge de América Latina: Del Fracaso al Exito, Caracas, Panapo, 233-234. See World Bank, ―Mexico Country Brief‖ on its Web page at www.wb.org

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In my first book,23 which dealt with the failed economic history of Latin America in the second half of the twentieth century in contrast to the successful example of the Asian tigers (South Korea and Taiwan), one of my main conclusions was that it had much to do with the economic policies chosen by each region (inward-looking import substitution industrialization [ISI] in the failed case and outward-oriented export promotion in the victorious case), I decided to grant medals to the three champions of that failure: Mexico received bronze, Venezuela silver and Argentina gold. Although for space considerations I cannot delve deeper into the reasons that compelled me to arrange these questionable awards this way, it suffices to say that the failure of Latin America was embedded in a strategy that put too much emphasis on the distribution of goods and in protecting nationalistic production with tariffs and subsidies while too little emphasis was placed on the best practices of production that well-supervised foreign interest can provide. The strategy of ISI reinforced the worst elements of our economic history: • •

•

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•

colonialism (the all-powerful State); communism (over emphasis in the sphere of distribution, under emphasis in the production sphere with syndicated unions protecting nominal wage hikes in spite of low labor productivity); nationalism (excessive tariff protection to products made by plutocrat elites that the local market guaranteed, which in the end distorted the distribution of income, sacrificed the efficiency of international competition, fostered monopolies, and quelled export capacity while increasing dependence on foreign inputs that had to be brought in with hard currency, mostly borrowed; everything to the detriment of the consumer). overtaxing of agriculture in favor of industry, which stimulated the excessive ruralurban migration that eventually collapsed the cities and its social services while fostering an underproductive informal urban sector.

Even though it became more than obvious that this ISI strategy was coming unglued at its seams in the mid 1970s, when even its original mentor (the Argentine economist Raúl Prebish) had denounced it publicly, the Latin American nations could not rid themselves out of it in favor of a more outward strategy (as the Asian nations had) because they were literally trapped in it, much like a jungle explorer who falls into quicksand, where the more that he moves the deeper he sinks. The ISI model finally imploded when the debt crisis of the 1980s exploded first in Mexico in 1982 and soon thereafter in all of the Latin American region and all nations were forced to render their economic strategies of debt rescheduling to the IMF, who rightfully but painfully dismantled ISI leading to the infamous ―lost decade‖ of the eighties. In the following decade there was some hope of economic progress when the U.S. treasury department finally decided to implant the Brady Plan, which basically guaranteed (by Uncle Sam) new desperately needed cash loans to the region. But when the Latin American countries finally got out of the emergency room of the IMF and walked across 19th Street in Washington, D.C. to the World Bank to get long-term infrastructure loans and business credits under a newly-invented scheme, the so-called ―Washington Consensus,‖ the rules of the game suddenly changed on them when the 23

Caida y Auge de America Latina (Caracas, Venezuela, Panapo 2000)

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economic system of capitalism was largely replaced by the more loose system of globalization which, while keeping most of the genes inherited from its predecessor (like private property security), nonetheless brought some unexpected new rules of its own that ultimately undermined the whole consensus. Among other things, globalization facilitated enormously the transfer of capital to far way banks in Europe and the U.S. (with just a few clicks in the computer), through a revolution in information and computer technology that was only available to the upper crust of the elite of these countries. So even if the economies grew, the distribution of income faltered in parallel to the outflow of capital. The poor resented this especially when they were told by so-called ―pundits‖ that ‗‘globalizaton was unstoppable‘‘. This phenomenon, not unexpectedly in perspective, brought in another financial crisis in the region also led by Mexico in 1994–1995, so called the Tequila effect, but which affected the whole ‗‘submerging markets‘‘ and as soon as that was surpassed another crisis erupted except that this time it occurred in the middle of the successful Asian tigers (the heroes of my book) and that spilled over much of the Latin American region, affecting badly mono exporting countries with fixed currencies at the end of the millennium, like Argentina, Brazil, Bolivia and Venezuela.24 This should be the subject of another topic, but what is important to realize in this juncture that the reactions the popular classes have displayed in Latin America is a consequence of their fear of the challenges of Globalization (which, I insist, is not capitalism, and it is not necessarily bad for any one if it is properly tamed) provoking the rise of populist nationals of leftist persuasion like Daniel Ortega, Hugo Chávez, Lula Da Silva, Evo Morales, Rafael Correa, Tabare Vazquez, Kirhner-Fernández, Alan Garcia, Michelle Bachelet, Fernando Lugo (―The Bishop of the Poor‖) and, very closely, Andrés Manuel Lopez Obrador, the Mexican leftist nationalist who barely lost the presidential elections in 2006. At the very least, they do not want the majority of the fruits of the produce from their national resources to settle in international bank accounts that do not, in principle, belong to the nation state. The vague policy of endogenous development that some if not all of these countries are applying is a reaction to all of this; and regardless of their low level of productive efficiency, it is also what is shaping the minds of the policy makers in their respective energy industry. Resource ownership comes above everything else.25 Back to Mexico, in the twenty-first century the disparities in income and prosperity have become more serious by courtesy of globalization and the rise of China, which reduced the attractiveness of NAFTA. We shall now turn to the third and final characteristic discussed in this book, México‘s proximity to the United States, a country nourished with a much different history and culture, predominantly Anglo-Saxon and Calvinistic.

24

Although this is neither the time to settle why the Asian crisis started in the first place and why it spread over so fast in the region and beyond, two factors are worth mentioning which in my own personal view mattered a lot. First, the set of circumstances that compelled the major automobile companies in Japan to move their production facilities to the United States, and second the much controversial policy prescription of the IMF that worsened the crisis. Nonetheless, Asia recovered very quickly. 25 As a colleague from a big oil company put it to me, ―Fifty-one percent of $100 is much preferred to them than 30% of one million dollars.” Clearly, money isn‘t everything to them.

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MEXICO AND THE UNITED STATES Poor Mexico, so far from God and so close to the United States. —Porfirio Dìaz

The relations of Mexico with its northern neighbor have improved drastically from absolute worse to never better throughout history. The current economic recession has doubtlessly affected their commercial relationship, but that came on the heels of a truly great phase in their liking of each other which has not been affected, albeit with some immigration issues that are solvable. The lowest point was without a doubt the surrender of one-half of its territory to the north of the Rio Grande in the U.S.-Mexican War of 1846–1848, a war instigated by the United States because of its ideology of the time, a monstrosity called ―Manifest Destiny‖ (literally, the divine right of God to expand its borders ―from sea to shining sea‖) granted to the government of James K. Polk, a southern religious fanatic. With no evident sense of accountability, his war annihilated all of the Indians in the way, along with more than 70,000 Mexican and American families. This glorious undertaking, which ended when the better trained, equipped and organized army of the United States occupied the Mexican capital through the port of Veracruz and forced them to surrender, would seem to some a long forgotten bad historical epoch with little relevance today. The problem is that it is almost impossible to find a Mexican child that does not know this history. (They are taught this in their history classes from a very early age.) An example of this was the declarations of the former Mexican Energy Secretary, Fernando Canales Clariond, in 2006:

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There exists fear of long history in Mexico that if we open our energy industry to foreign partners, we will lose our sovereignty.…these are emotional arguments that are rooted in our experience in the nineteenth 26 century.

As a peculiar outcome, Polk was never reelected even though he fulfilled his promise to break Mexico and expand the United States; and he culminated his mandate alone with a very low popularity, dying desolate a few months later. Nowadays, his historical legacy is considered very obscure by many historians of the United States, who not without reason accuse him of conducting brinkmanship diplomacy first and later a predatory war against a poorer nation, in the end contributing to distrust from the north and the Civil War of the United States. Because of his extreme religious fanaticism, the United States has always kept its guard very high in case another person of this type emerges and seeks election. But that is not the end of Mexico´s ill fated run with foreign powers. Except that this time the trouble would come from Europe. The malign episode with manifest destiny caused the downfall of the government in Mexico and initiated the Reform revolution of the mid XIX century when the humanitarian reformer of Indian descent Benito Juarez (1806-1872) assumed presidential powers and spearheaded sweeping legal and liberal economic reforms in favor of the poor in Mexico that 26

Cited in Piller, D. ―Mexico Could Lift PEMEX Restrictions,‖ Latin Petroleum, Feb 9, 2006. See www.latinpetroleum.com

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put him at opposite ends with the conservative oligarchy and the clergy. The ensuing costly civil war induced the collapse of the economy impeding the Government of Juarez to honor its foreign debt obligations. That provoked an invasion from three European nations, Britain, Spain and specially the monarchy of France‘s Napoleon III, who, unlike the other two nations, actually ordered the invasion of his troops inside Mexico conquering the country and, after running Juarez into internal exile, he duped the Archduke of Austria Maximilian I (1832-1867) into accepting the role of Emperor of México in 1864; a post he regally held for three years, much to the resent of the people of the country. The United States, who vehemently disagreed with this invation and who supported Juarez from the start, had its hands tied in its own civil war and could not intervene but as soon as that was over the US told France in no uncertain terms that they recognized Juarez as the legitimate President of Mexico and reminded them of the Monroe Doctrine. The resulting diplomatic pressure on France from the US and the rest of Europe convinced Napoleon III to withdraw his troops out of Mexico, which immediately caused the reign of the naïve Austrian to fold ending with his death in front of a firing squad in July of 1867. Even though the presidential authority was restored to Juarez after this, the whole episode marked yet another scar on Mexico‘s distrust on foreign powers on their soil and interests27. But throughout the 160 subsequent years the relations between both countries have improved remarkably, except for some hiccup periods now and then, for the benefit of both. Its highest point is now, with their trade agreement NAFTA now matured and with an understanding in immigration laws which have placed the Latino, of which by far the majority are Mexicans, as the second most numerous ethnic group of the United States. Nowadays it is difficult to speak of one country without mentioning the other. The contribution of both nations in the mutual benefit of each other both in economics and the arts is widely recognized, guaranteed and promoted on both sides of the border. Notwithstanding the above, it is not difficult to imagine why a country that lost its Colonial civilization to one foreign power and half its territory to another would be reluctant to open its precious energy resources to foreign powerful companies (the war with the United States began when the government of Mexico invited American colonists to help them populate a desolated northern providence called Texas). It is also not surprising that nationalism, patriotism and sovereignty are always the main subjects debated in Mexican politics.

THE MEXICAN GULF Companies cannot function properly if they isolate themselves from the world that surrounds them. The more a company gets involved in the social enhancement with its daily business activities, the bigger its leadership will be towards the generation of economic benefits. —Michael Porter

27

As the reader will see, Mexico‘s experience with European foreign intervention in the 19th century and the ensuing US meditation to ended proceeds the Venezuelan experience in the early part of the 20th centuty.

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Source: BP, 2008.

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Graph 4. Mexico‘s Dwindling Oil Reserves.

In 1938, under the leadership of President Lazaro Cardenas, Mexico nationalized its petroleum and expelled de facto all foreign oil companies. This action, worth mentioning, had a very important influence in Venezuela and Latin America. Since then, the operation and crude oil reserves of the entire nation have been handled by Petróleos Mexicanos-PEMEX, the state oil company, with the very typical result of bureaucratic state-run companies in Latin America: often, it has had to cover the expenses of the rest of the public bureaucracy with its own resources and even with its own debt (beyond the high taxes, royalties and dividends) which reduce investment capital to negligible terms while accounting for more than 40% of the government‘s annual revenues. The lack of investment by PEMEX in the oil industry is not only reflected in lackluster upstream activities, but also in a notorious under-performance of its downstream sector as well. For instance, Mexico is forced to import $4.5 billion dollars worth of gasoline each year, as well as over $10 billion in petrochemical imports, both mostly from the United States, where it also imports almost all of the gas it needs for its northern industrial sector—a fact that is changing now because the United States, as we know, needs that gas for itself. The U.S. has 3% of the proven gas reserves in the world but it consumes 24% of the total, forcing it to import more than 100 billion cubic meters per year from Canada. As the graph above indicates, in roughly two decades Mexico has witnessed its total oil reserves diminish by more than 75% while its production has stagnated and even fallen in recent times. Most of this reduction came when a so-called ―correction‖ was made in 1997 on data that had been blatantly inflated. Eight-five percent of the Mexican reserves come from the Bahía de Campeche in the Gulf of Mexico. The greatest field of this site is the Cantarell

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reserves (55% of Mexico‘s total production in 2008), in honor of its discoverer Rudesindo Cantarell, a humble fisherman who once complained loudly that his fishing nets were empty because the waters where he was sent to fish were ―too oily.‖ What he discovered was an offshore oil complex with reserves in excess of 11 billion inside more than 15 thousand square kilometers that began producing in 1979 and peaked its production in 2004 a bit over 2.1 MBD, and it has since descended to a bit over 1MBD in 2008. In this Millenium Cantarell has provided almost 55% of Mexico`s total oil production. At its highest, the Cantarell field was second in the world, but now, it is clearly over the hill: Some time ago, a geologist friend in Houston showed me a satellite photograph of the Gulf of Mexico, and with a pen she demarcated the marine borders between the two countries that share it. The American part could barely be more developed and colonized with platforms, while the opposite happened on the Mexican side. If one judges by the amount of investments that the multinational companies are realizing in their zone, as well as the recent success that they are having the conclusion of its enormous potential cannot escape attention. Otherwise, it would be inexplicable that companies the likes of Chevron successfully perforated the deepest well in the history of this zone, 34,000 feet in the Tahiti platform where Total, the French multinational, has participation. Exxon Mobil operates several platforms, one of which perforated through 4,350 feet of water, also successfully. Or BP and its famous Thunderhorse platform and its giant Tiber discovery on September 2009, which cost more than four billion dollars, or Shell with its Mars platform with similar costs (many affected strongly by the twin hurricanes of 2005). The perforation in deep waters and ultradeep turf on the American side of the Gulf must offer very good results in the medium term. But on the Mexican side calm reigns; in fact, until the beginning of 2006, Mexico never had perforated a well of more than 3,000 feet. There is every geological reason to expect that that if on one side of the Gulf there exists a great amount of petroleum, chances are very good that the same is true on the Mexican side. The problem is two-fold: 1) PEMEX does not have the capacity for investment nor the required technical experience to perforate in deep waters; and 2) the multinationals that do have it are prohibited from doing so. For example, according to the Short-Term Energy Outlook (STEO) from the Energy Information Administration (EIA) of the U.S. Department of Energy, offshore production from the Federal Gulf of Mexico—on the U.S. side (GOM)—is projected to make up twothirds of the overall U.S. increase in oil production in 2009, over half of which will come from new production (the rest from hurricane recovery). Overall, U.S. oil production is expected to be 8% higher in 2009 than in 2008, the first such increase in over a decade, while the GOM is projected to be 11% higher. The reason cited by STEO is as follows: Continuing technological improvements for deep water sources where about 80% of both offshore production and proved reserves were from deep water sources in 2007. EIA-STEO estimates of proved reserves plus estimated resources (probable + possible) imply that ―there is considerable potential for increasing GOM offshore production, especially over time. A majority of the offshore resources are in deep water and consequently further off shore.‖28 Nonetheless, it is important to point out that aside from geological uncertainty, which is always the case with unproven reserves, there is also above-ground uncertainty in the form of economic, political and weather-related environmental risks. But is the risk worth taking? Big 28

See Energy Information Administration, Short Term Energy Outlook, November 12, 2008

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Oil, with its enormously costly undertakers in offshore platforms, says ―yes.‖ PEMEX and Mexico say ―no.‖ The Gulf of Mexico, once considered a dead zone by many experts with a Hubbert Peak on its near horizon, is now completely revived and without doubt one of the most attractive exploring areas worldwide. Mexico plays no part in this. Quite the opposite. According to The Wall Street Journal, in an internal study of PEMEX it was revealed that the Cantarell wells have shown that the gas and water levels have risen more than expected in what could accelerate its exhaustion rate in the next few years. Moreover, according the EIA (November 2008), the 2009 production from Cantarell is expected to barely eclipse 700,000 bpd, when just four years ago it was producing two million bpd. In a well-researched article in 2008, Business Week concludes with several local energy experts that ―At current rates of consumption, that oil will last only 9.2 years, which means Mexico could stop exporting oil within a decade.‖29 In a few years‘ time it would become a net oil importer, a fact that would stress out the already highly delicate world energy balance. The following statement from former President Vicente Fox, made in obvious frustration, is revealing:

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It is incredible that there are those who continue with that absurd nationalism, and in defense of the sovereignty which is totally outdated in the form in which it is presented, that these people do not have the vision to realize that today‘s magic formula is to associate the investment of the private sector with the public 30 sector without losing sovereignty.

Here the experience of Venezuela could serve as a good starting point for Mexico. As we will see in the appendix, with its opening in the nineties and the migration to a mixed enterprise scheme in the last two years, in which the state is majority stakeholder and thus always retains the control of all the oil business, it is producing more with greater investment through the contracts with the multinationals. In the next paragraph, we reproduce the testimony of Karen Harbert of the U.S. Department of Energy in testimony before the U.S. Congress Subcommittee on the Western Hemisphere on March 2, 2006. Mexico also has great potential to increase its product. Nevertheless, articles in their constitution prohibit the investment from the private sector in petroleum and gas and in the access to new technologies that would increase this product. The Fox administration has proposed numerous energy reforms to attract private investment and to develop these resources. Until now, these efforts have come short, and progress in this area will take its time. Mexico is in fourteenth place in proven petroleum reserves with 12.9 billions barrels, but it must import much gasoline as well as 25% of its natural gas needs from the United States, even though it has the potential of being a gas exporter, given its enormous reserves. While Mexico owns the seventh greatest gas reserves in the Western Hemisphere, its demand for natural gas (especially for its electrical generation) has surpassed its production, and the projections suggest this country will continue importing natural gas for the rest of the decade. It will have to look for LNG imports, and also gas piped from the United States, to satisfy its demand.…Significant opportunities exist at the exploration and production off shore, but private investment is 31 essential for Mexico to realize its full potential in its hydrocarbon reserves.

It is interesting to note that, in this testimony, Dr. Harbert places the reserve potential of Mexico (unproven) at more than 50 billion barrels (nearly four times its proven reserves) and, if that is verifiable (proven), it would easily place this great nation as a key power player in 29

See Gery Smith, ―Mexico‘s Oil Dilemma,‖ Business Week, April 28, 2008 Cited in Latin Petroleum, Issue 10, Oct. 2005 31 Testimony before Subcommittee on the Western Hemisphere, March 2, 2006 30

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the oil business and, more importantly, as a key country collaborating in the transition towards a post-fossil society with minimal repercussions. A 2006 announced discovery of a an ultra deep field in its waters is proof. But, sadly, before something happens in particular that allows major changes in the legal framework for foreign participation in its upstream activities, including reserve access and technology imports, the world cannot count on Mexico to ever develop these reserves in a timely fashion that would lighten the worldwide energy crisis. As I write these lines, Mexico has just approved seven energy reform bills in its Congress, most of which create regulatory institutions and give PEMEX a bit more authority in its contracting ability, but none address the issue at hand of private participation for upstream development in deep offshore waters. These bills might be a step in the right direction, or not, but in any case they are a very tiny step. The important thing to know is that nothing in all of Mexican history can detract from the fact that Mexico and the world needs its petroleum to replace the depletion of the conventional reserves.

APPENDIX TO CHAPTER 4 Venezuela Those who do not remember the past are condemned to repeat it.

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—George Santayana

We shall now turn our attention to another unconventional country, albeit for very different reasons. Its complexities do not come from divergent cultures or religions or even its racial mix, for it is fairly typical for a large Caribbean nation of Spanish heritage. Rather, it emerges from its beleaguered early history, its mono exporting rent-seeking society and its failed economic policies. It is important to discuss these in the briefest of terms because all of them matter in the country‘s hydrocarbon policy implementation. In its 916.445 km2, Venezuela embodies the four themes of upper importance that keep the world busy in this young millennium. In first place, there is oil, the most important energy source of the planet and the most determinant factor in the quantum leap in technology and industry that the twentieth (or any other) century experienced. With the largest oil reserves of the Western Hemisphere and—pending certification—of the world as a whole, and with a prolonged situation of high prices given its inevitable and irreversible physical depletion due to a natural decline and the increasing demand from rich and poor countries alike, Venezuela finds itself right in the middle of this clash. The second and third themes are essentially related and refer to human poverty and the iniquity in the distribution of wealth, which in the Latin American case has increased in the last 25 years in a dramatically and disproportionate manner. At the same time, in Venezuela and in all of Latin America, both of these themes—poverty and iniquity—are the result of historical development underlined by the failed economic policies applied throughout the continent from the end of the Second World War up until the debt crisis explosion of the

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1980s, a factor that was further aggravated when the standard recommended policy cures for these malaises were confronted by the arrival of globalization in the mid 1990s. The fourth theme is globalization itself in relation to the economical, business and financial factors. This term, which was nonexistent some 15 years ago, at one point had more than 100 million hits in Google and it could not be otherwise, since it comprises an evolutionary mutation of the traditional capitalist system towards a different economic system—one that is more competitive, dynamic, internationally-oriented and hard to manage—which defies most known rules and manages to change its impact over the welfare of the majority of society. At first, without proper legislation, globalization in its most raw shape matches the perception of a Darwinian survival of the fittest, a winner-take-all society, along with cultural materialism and environmental degradation. In its more domesticated and tamed form, however, globalization does have the enormous potential for the benefit of all, as it is exemplified by the near equalization of universal knowledge across the world due to instantaneous Internet access to on-line journals, blogs, and chat rooms. The rapidly rising living standards of the overpopulated nations of the world is another great illustration of this potential; however, as we will see in these pages, this last globalization effect does not come without a hefty weight that exerts pressure upon scarce resources. Without the increasing availability of this miraculous liquid or reliable substitutes, globalization will turn on its heels and quash its magnificent potential, abandoning the many people whose dreams it awakened. These factors—oil, poverty, rent distribution and globalization—are what make Venezuela a country worthy to be studied and analyzed in the most serious but separate manner. But there is still another dimension worth mentioning, related to the paradox of wealth and its impact upon society. Due to its strong democratic and highly participative electoral traditions, and because all of its oil and gas deposits are owned constitutionally by the nation and managed therefore by the empowered elected officials, whoever they may be, Venezuela is among the very few countries in the world where the lower class is actually on the receiving end of jealousy and resentment from the upper class, if not for their money, but for their power. As opposed to most other countries, where the means of production (capital, land, labor) are the sole property of the dominating rich class or of ruling families such as in the Persian Gulf countries, Venezuela‘s democracy has achieved the paradoxical upshot that members of the poor class, through the ballot box, are able to take possession of the most lucrative means of production of the country, whereas the rich class attempts to claim its access with the most strident and brazen means, sometimes with pro-coup tendencies. If we add to this scenario the reality that Venezuela is currently being governed by an unorthodox political doctrine that defines itself as socialist, and that the same has the power and operating range to influence the international price of the most important resource for the industrial civilization and the world‘s living standards, then we are dealing with a very unusual and interesting case. It is the oil resource that makes Venezuela stand out over the majority of countries in the world. As we have mentioned, it is this resource that transformed humankind in such a manner that some analysts have gone as far as to write, with forcible and convincing arguments, that oil has created a kind of separate emtity in the human race (the ―Hydrocarbon Man‖) that is so dependent on this source for its whole industrial and agricultural civilization and any form of its life standard that this human race can be distinguished and separated from any other previously-known race that existed before, and, possibly after. To understand Venezuela better, a bit of history is in order.

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HUMBLE BEGINNINGS History repeats itself, first as tragedy, second as farce.

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—Karl Marx

A poor country for all of its colonial history because it lacked the gold, minerals and Indian civilization of its Andean neighbors, Venezuela was thus degraded by the Spanish Crown to a trading post of minor importance. But it was Venezuela that was the cornerstone of the independence movement for much of South America and that was led by a formidable generation of men who were barely around their thirties when they started it. Four men stood out: Francisco de Miranda, whose exploits in the United States and in the French Revolution became legendary and inspiring; Simón Bolívar, the Libertador, the most important of all if not for his relentless leadership and commitment but also for his intelligence, education and eloquence; Antonio Jose de Sucre, whose military geniality brought him immortality in the southern Andean nations of Bolivia and Ecuador; and José Antonio Páez, the greatest battleground general, the hero of its principal independence battles and Venezuela‘s first president when Bolívar overplayed his cards (when he unsuccessfully tried to unify the countries that were liberated under his leadership and backed the idea of himself as a President for life) which soon forced him out of favor everywhere, leading him to lose his grip and to die almost alone and in hiding soon afterwards at the young age of 47. But it was Páez (1790–1873) who survived Bolívar for more than four decades and ultimately became the strongman of the country for the better part of the nineteenth century. Páez had the unenviable task of starting a blood bathed country from scratch, and during his tenure he did manage a progressive, pacific and relatively law-abiding government. But hard as he tried, he did not build the necessary institutions for this to last beyond his own personal reign and thus failed to bring lasting peace to a country ravaged by decades of civil wars that brought illiterate drifters on horseback with machetes who only knew how to make war and profit from their exploits. Even though Páez governed with the most capable man of his time, he spent most of it protecting himself and his successors from coups and was successful only part of the time; when he wasn‘t he was either jailed or exiled only to be begged to come back to restore some measure of order.32 What is interesting is that all of the coups against Páez, and even beyond him all the way to the twentieth century, they all followed a similar pattern or vicious circle: An established order is perceived to became oligarchic and corrupt, a yearning for social justice breeds a generation of idealistic coupsters who eventually overthrow this established order and, 32

Venezuela still hotly debates Páez‘s historical legacy. Some accuse him of betraying Bolívar‘s dream of a unified Gran Colombia, while others think, like myself, that this would be an impossible dream to accomplish even today, much less back then. Bolívar later admitted that he was alone in this desire while Paéz was practically forced by everyone in his country to break it up. Gran Colombia would soon also loose Ecuador and Perú, and Perú would loose its highlands for a new country called Bolivia, in honour of Simón Bolívar. Also, in my opinion and that of others, Páez, although not flawless, did the best he could, and even better, under the dire circumstances he was forced to lead. Besides what is mentioned, he also relaxed greatly the slave laws of which the poor economy depended on. Unfortunately for Venezuela, it was not enough. Also, contrary to the perception of many, Páez was not a corrupt man. During his long exiles in New York, Argentina and Perú, he was so short of money that he was forced to live under the generosity of monthly hand outs from the governments that granted him exile. There Páez was recipient of the highest honours by all the nations that took him and many others, like Mexico and England. He died in New York in 1873 a month before his 83rd birthday.

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because they lack an effective economic or institutional plan of what to do after they come to power, they soon become themselves the new oligarchs; this is followed by incompetence and corruption in government policy, leading to more resentment, more idealistic social justice yearnings by a new generation of dissatisfied wannabes, and more coups. Then the cycle repeats itself. In each case, the name of Bolívar is flaunted as window dressing by both sides of the conflict. Another interesting element is that Páez, despite his blond, European-looking physical appearance, was anything but an aristocrat, having spent much of his life shoulder to shoulder with the poorest clans of the country; sleeping, eating, warring and talking like them. (Early in his youth he had even labored for a wealthy land owner who put him under the orders of a black slave who treated him harshly and humiliated him by having him wash his feet and rock him to sleep in his hamaca. Páez would later became his boss and friend during the independence wars.) That meant that in Venezuela no one felt that the highest office was socially beyond him. Venezuela, even today, has one of the most classless and swiftest mobile social structures of any country in Latin America. (As evidence, for example, it is common for the son of a wealthy lawyer to sit next to the son of a poor janitor in a university hall.) Indeed, the nineteenth century was nothing short of a disaster for Venezuela. The twentieth century did not start any better when still another coup, this one lead by an Andean caudillo named Cipriano Castro, successfully overthrew what little remained of the previous order (the Guzmansismo, whose leaders had all died enviably wealthy) and established what can only be regarded as a horrendous order. Castro inherited a badly indebted country where from every corner there were still men on horseback wielding machetes, some of whom were even financed by wealthy bankers and companies from abroad, who tried to overthrow him. With the help of his chief general, Juan Vicente Gomez, he defeated them. But, to top it all, a worldwide recession collapsed the price of coffee, Venezuela‘s chief export crop then, which forced Castro to drastically reduce imports, thus creating dissatisfaction in the population. He then resorted to first ignore his debt obligations and later to negate it all together. That provoked a military invasion from three of his creditors, especially from an ambitious German empire which, flanked by England and Italy, sent their ships late in 1902, blockaded the principal ports, disembarked on the beaches and demanded repayment. Theodore Roosevelt was President of the United States at the time and, knowing that Venezuela could not possibly defend itself against that kind of power and fearing an outburst of excessive European influence in the region (the Panama Canal was under construction), invoked the Monroe Treaty and successfully mediated the conflict through his chief diplomat, Mr. Bowen, who drafted the Washington Protocol and had it approved in the international court of The Hague. That protocol required Venezuela to pay up to 30% of its tariff duties for debt obligations. To assure compliance, the European powers left Venezuela but sent Belgian emissaries to collect it in the Venezuelan ports. Three good things came out of that episode. One, the Venezuelans finally learned that they were not alone in the world and that actions bring consequences. Two, the invasion united the country and played a crucial part in finally bringing to closure the endless regional warfare that had ravaged Venezuela for so long. Indeed, it united the country around its leader; but (three) it would not be the erratic Castro. A few years later, after many diplomatic feuds with several European countries and even the United States (with whom he broke off relations), Castro fell ill in 1908 and went to Germany for an operation. In charge he left his

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chief collaborator, Juan Vicente Gomez, who was not only from his own home state but also his long-time friend and compadre,33 and Gomez repaid Castro by perpetually exiling him and taking over the government permanently. He would rule unopposed until his death for the next 28 years. Indeed, if Páez was the principal figure during the first century of Venezuela, Gomez definitely took that role during the first half of the second century34.

THE BIRTH OF AN OIL COUNTRY In the late 1940s and early 1950s, oil companies and governments grappled continually over the financial terms upon which the postwar petroleum order would rest. The central issue was the division of what has been called ―that uneasy and important term in the economics of natural resources‖—rents. The character of the struggle varied among countries, but the central objective of those initiating the struggle in each country was the same: to shift revenues from the oil companies and the treasuries of the consuming countries that taxed them to the treasuries of the oil-exporting countries. But money was not the only thing at stake. So was power.

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—Daniel Yerguin

If the Páez legacy is still hotly debated in Venezuela, the legacy left by Gomez is also hotly debated. I will not do it here, but it suffices to say that there is no doubt that the country he left was much better in almost all respects than the one he found. However, there is also no doubt that it could have been a lot better and that he did not have to stick around for almost three decades to do it. Gomez, who was scarcely educated and brought up as a farmer in the mountains of one of the most remote and isolated areas of the country, was unexposed to the winds of freedom and progress sweeping the international scene; and became thus a common run of the mill caribbean dictator with a small mind vision who managed Venezuela as his own private feud while being tyrannically ruthless to all political opposition. In my opinion, Gomez was exactly what Venezuela needed during approximately the first half of his tenure, because he formed a national army, improved the unexacting infrastructure, unified the country and restored lasting peace and order throughout (what Páez failed to do). During the second half the story is different, for he ostracized Venezuela from any progress and ruled in a closed rural mediaeval fashion that was clearly outmoded long before he died. But Gomez also kept his country out of trouble and international feuds that had all but destroyed Europe in WWI and he did it by fully paying all of Venezuela‘s debts down to the last cent. He got the revenues from a new source of income that only a handful of people vaguely suspected might exist in Venezuela but none in the vast quantities that were eventually found. It was under Gomez iron fist that Venezuela became an oil rich country. Although at the end of the nineteenth century Venezuela had already experienced timidly with asphalt residuals the northeast and even exploited a small field in the south west, it was not until well into the twentieth century when Venezuela bursts into the international scene with its oil production. As I said it is not the intention of the book to recapitulate the origins of this turbulent history but only to mention the aspects that mostly affect its hydrocarbon policies. The most salient features were the following:

33 34

Said of a man who is godfather to your child. The flawed Castro recovered from his operation and spent the rest of his life trying to re-enter Venezuela. He was unsuccessful each time, dying poor and alone in a Caribbean island in 1924.

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Carlos A. Rossi About 200 million years ago, all the world‘s continents formed one single huge land mass, called Pangea, where the north half of Venezuela was submerged inside a colossal lake adjacent to Nigeria, which is believed to have been vastly rich in plants, minerals, proteins nutrients, etc.; this is why the animal species of the time had gigantic proportions. It is considered by geologists that the origin of petroleum comes from the remains of those fossils and especially plants that were buried in depths of up to 25,000 meters and ―cooked‖ by the high temperatures and underground pressures. The geological study conducted between 1911 and 1916 by the oil company Caribbean, later a subsidiary of Shell, covered the Venezuelan territory from east to west discovering, among others, the large Menegrande field in 1914 in the western state of Zulia, which led to more and more discoveries in this extremely fertile 35 state . The explosion of the field Barrozo 2 in late 1922 (100,000 BOPD in their first 10 days). This gave a green light to more exploration and bigger discoveries in the Zulian fields of Lagunillas (1926); Tia Juana (1928) and Bachaquero (1930).

Predictably, the initial reaction of the despotic Gomez, when hearing of these enormous discoveries, was one of incomprehension, because neither he nor anyone else in the nation could imagine what a gooey black liquid from the depths of the earth could be good for. When told that companies would actually pay a lot for long-term concessions and how that would ease his debt burden, make him and his vast family extremely rich, and help consolidate is tight grip on power, Gomez changed his mind. The respected Venezuelan historian Manuel Caballero summarizes it this way:

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The Venezuelans perceived the exploitation of petroleum as something absolutely distant belonging to other people, as if the hydrocarbon flows from their fields were located in Singapore or in the Islands Mauricio, not in Lake of Maracaibo.…And there is not anyone in Venezuela, neither abstract or concrete, that is, neither the State or Gómez, that had enough money to begin the exploitation of petroleum.…All accounts united this way. A financially and technologically disabled country incapable of undertaking on its own account, private or public, the exploitation of a resource that requires multimillionaire investments: the general conception which not only links petroleum to mining but that conceives it as a source of rent and not industry; a weak State that needs an independent source to finance political endeavors; and finally, an authoritarian and nepotistic regime whose legal and political deficiencies all combine, before the presence of such fabulous wealth, to 36 incompetence and corruption.

Gomez‘s reaction was none other than to grant concessions to the multinationals corporations either directly or indirectly through his relatives and close friends who, without the technical or financial capacity to use them, sold them to the multinationals. (Romulo Betancourt, Venezuela‘s president in the 1940s and 1960s referred to this period as ―the dance of the concessions,‖ criticizing them for their generosity in its terms and recipients.) But the truth is that Gomez had very few alternatives. Gomez had to cancel the foreign debt or risk another invasion and his country was still vastly agrarian with backward production methods that just didn't have enough prepared engineers, much less a competitive petroleum industry capable of running efficient production in Lake Maracaibo. Former Venezuelan Ambassador Simon Alberto Consalvi, a respected journalist and historian, summarized this contrast as such:

35

To give credit where is do, the geologist that led the expedition from Caribbean company was Ralph Arnold; his team explored de east and found several promising fields, most notably the Quiriquire formation. The geologist who first thought to drill over water in Lake Maracaibo (and in the world) was Charles Eckes and was enormously successful. On the Venezuelan side, the businessman who first drilled for oil in Venezuela and traveled to the United States to learn about drilling techniques was Manuel Pulido. It is possible that it was his bragging that first attracted the Americans and British to Venezuela to quest for oil. 36 Caballero Manuel, ―Cuatro notas sobre la historia venezolana en el siglo petrolero,‖ in Testimonios de una Realidad Petrolera, BCV Fundación de una Venezuela Positiva, Banco Occidental de Descuento, Caracas,

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This socio-economic anomalism resulted from the relationships between a rural dictatorship and the oil exploitation by foreign capital out of which two distinct profiles of Venezuela were born in the twentieth century. The rural and backward profile and the oil industry managed with modern resources and techniques. Venezuela was a country where its leaders allowed that foreign lawyers or ambassadors intervened in the drafting of its laws. The oil companies were the only ones that knew were the oil was, how to explore it and exploit it…truth be told the oil companies had all the power of the world, and made their decisions unilaterally. They were true empires. They dominated the politics of their own countries, and much easily dominated those 37 in other nations.

Back then the rates of illiteracy and malaria were unbearable, and the training and education of oil professionals took place belatedly. It was not until 1930 that Venezuela obtained its first geologist and not until the mid 1940s (Gómez died in 1936) that the first schools of oil engineering and geology were created in Caracas, followed in the later decades in the oil rich regions of Zulia and Anzoátegui. Thanks to a forward initiative from the patriotic development minister in 1930, Doctor Gumersindo Torres, Venezuela began to train professionals overseas, mainly in Oklahoma.

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THE DAWN OF THE ORINOCO If only the income of petroleum had been used to prime the pump, this industry would have led to the development of a prosperous rural economy. It is also false that many workers were taken from agriculture to work in the oil fields. Not even one half of one percent of the total working population found employment there. What happened was that an avalanche of dollars and pounds sterling rolled down upon a little country that had not democratized or modernized its system of production. It was using eighteen century methods to produce in the twentieth century and was governed by a coarse and rapacious tyranny incapable of carrying out economic reforms or using the oil income—even the inadequate share then received—as a springboard for collective progress. The overwhelming presence of oil did act, indirectly, to deform the economy and national life. Privilege sectors of the population began to acquire the mining mentality of newly rich spendthrifts. The uninterrupted flow of dollars encouraged imports and expanded commerce to such a degree that the nation became primarily a consumer of foreign products. We began to appear too much like that chaotic California—the paradise of 38 adventurers and thieves—during the days of the gold rush.‖ —Rómulo Betancourt

But regardless of how Venezuela spend its oil windfalls, the truth is that its laissez-faire policy of live and let live with the multinational corporations paid off handsomely in terms of oil production and the development of a mature oil industry. Except for a short-lived democratic experience led by the former radical students of the so-called 1928 generation, Venezuela had a string of three military dictatorships (all born in the Andean region of Castro and Gomez) but with a much more advanced mentality than the medieval Gomez; for they expanded infrastructure in the form of highways, constructed schools, promted some industrial development in light manufacturing and improved the standard of living of the people, although not in an egalitarian way. By the time the democratic coup against the last one, Marcos Perez Jimenez, was completed in January of 1959, Venezuela did indeed have one of the most modern and highest standards of living in Latin America. 2002. Pp 12, 7 15. Interestingly, Caballero arrives at an interesting mathematical relationship in this work: P+P=C. (Petroleum plus power is equal to corruption.) 37 Consalvi, Simon Alberto., El Petróleo, Caracas, Fundación Bigott, 2004, 55, 96 38 Betancourt wrote this quote while in exile in Costa Rica in the early 1950s in his seminal book, Venazuela Política y Petróleo. In my opinion, he could have written it today.

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But Venezuela, once in possession of minimum economic prowess (taking into account its dimensions), wanted desperately to be free politically, and in that year embarked on a democratic experiment and yearning for progress that it is still trying to perfect today. It will not accomplish it fully unless oil rent can be converted into a springboard for industrial and agrarian production. After a brief transition period, the Venezuelans again elected Romulo Betancourt, who returned from exile more politically mature and, despite a difficult start (courtesy of Fidel Castro and of right- wing plots from within) he nevertheless managed to lead what was then the biggest oil exporter in the world, and he did it by balancing a delicate thread of socialist impulses in the middle of the Cold War. History doesn‘t lie for long. It was thanks to the multinational corporations that oil was discovered in the oil basin of Lake Maracaibo. In 1917, the first refinery of the country was built. Five years later, in December of 1922, the Barroco 2 oil well exploded with 100,000 bpd; in 1926, in Lagunillas, also in Lake Maracaibo, the biggest oil field in the world in its time was discovered. That same year, petroleum became the first export item, and in 1929 Venezuela became the first oil exporter of the world, a position that they would hold for no less than four decades up to 1970. To compensate this educational breach and close it, the multinational oil companies, in an agreement with the Ministry of Energy and Mines (which by then had capable oil professionals with strong nationalistic credentials) created and maintained for more than four decades scholarship programs overseas and then agreed to employ its graduates in their same companies. In fact, when Venezuela‘s petroleum was nationalized in 1975, the affiliate companies of PDVSA that acquired the operations already had a fleet of educated national professionals with experience and technical know-how worthy of the best international companies of the world.

The Venezuelan petroleum historian Efraín Barberii recognizes this:

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Petroleos de Venezuela (PDVSA) received from the concessionaires a mature industry, worldwide recognized for its involvement, progress, development and for their large contributions in production, handling 39 and commercialization of the hydrocarbons.‘

The following chart summarizes the involvement of Big Oil in Venezuela. Chart 1. Realization of the Oil Multinationals in Venezuela, 1914–197540 (MMBD) Produced petroleum Processed petroleum Exported petroleum Exported products Wells producing petroleum Wells producing gas Dry wells

31,947.2 8,563.2 23,310.2 6,758.8 86.6% 0.9% 12.5%

39

Barbieri, Efrain., ―La industrializacion Venezolana de los Hidrocarburos en el Siglo XX,‖ Testimonios de una Realidad Petrolera, BCV Fundación de una Venezuela Positiva, Banco Occidental de Descuento, Caracas, 2002. 40 Ibid. The Completion of the Oil Era : The Economic Impact, Nova Science Publishers, Incorporated, 2009. ProQuest Ebook Central,

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THE NATIONALIZATION Human problems are not abstract, as they are in chemistry or astronomy. They are problems of maximum concretion, because they are historical.

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—Jose Ortega y Gasset

The 1975 Venezuelan oil nationalization occurred for four fundamental reasons. First, because that had always been the yearning of the Venezuelan leaders of the time, especially Rómulo Betancourt and Juan Pablo Perez Alfonzo, both of whom had passed over in body and soul the philosophical tendencies of socialism in their youth but who had also matured from their calamitous brief experience in power during the triennium of 1945–1948 and their exile in 1959. But they never let go of this dream and never lost their sensibility and nationalist pragmatism of nationalizing the first industry of their country. The second reason was because the War of Yom Kippur in 1973 had quadrupled oil prices, causing a world recession with inflation, and the multinationals felt more than a bit uncomfortable having to explain to the world that they were getting rich as a result of this from the very mouth of the oil well. When they were called to testify in the U.S. Congress to explain their behavior, they could say at least with half truth that it was not their decision, but OPEC‘s, which was now the legitimate owner of their petroleum—―it is their oil‖ was their answer (the other half they were producing in the Talco States, i.e., Texas, Alaska, Louisiana, California and Oklahoma). The third reason refers to what we have commented on; Venezuela in 1975 was very different from the Venezuela of 1914, because the industry already had the well- trained Venezuelan professionals with a lot of experience in the whole chain of the hydrocarbon process, without a doubt one of the most complicated of the world. The last reason was that by now everyone in Venezuela had awakened to its vast hydrocarbon wealth and was thus a hugely popular move with the electorate, because they were told that now their government would get to keep all of the proceeds from oil‘s large revenues. Venezuela today has 313 billion of oil proven reserves of which 262 billion are certified, about 50 billion of which belong to the light and medium crude category and the rest to the heavy and extra heavy variety most of which belong to the Orinoco Belt formation. It is important to bear in mind two things. One, this certification is done on a field- by-field basis by a team that involves Venezuelan specialists and world-recognized international specialists as well, and by the specialists from the companies that have been allotted a stake in a particular area within the Orinoco Belt. This is as open and transparent as it gets, in contrast to some other countries we have mentioned that do not allow anyone else but their own to look at their reserves data. Two, the final number is a best estimate that involves, besides crude reserves availability, current recoverable technology as well as economic profitability. If any of those variables change, so does the reserves figure. As we have noted, there is ample improvement room in the recoverable factor in the Orinoco Belt. Now, in round numbers and supposing an annual production of 2.8 MMBD and knowing that approximately 70% of production comes from the light crude reserves and the remaining 30% from the heavy and extra-heavy reserves, the light fields have a life span of 34 years while the heavy fields have a life span of 172 years, for a weighted average of about 70 years of oil still left in Venezuela. This is without taken into consideration the huge reserves of the Orinoco Belt.

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It is worthwhile to point out that these are proven reserves that are quasi-synonym of recoverable reserves. It is also worth pointing out that the technology exists, has been tried and proven and is in use today to upgrade the low API quality of this oil towards medium and light oil acceptable to be refined into all its multiple uses, including transport and petrochemicals. Luis Vierma, former senior vice-president of PDVSA, said in his speech during the announcement of the Plan Siembra Petrolera (the oil plan to develop Venezuela‘s vast remaining resources of oil) in 2005: In what refers to our fields of light and medium crude oil we have recovery factors of 30.23% which seem, when we compare this to the international level, that we could improve them and arrive to recovery factors in the range of 60% and in the Orinoco Belt, where we have already said that we will make important efforts to increase these recovery factors from today‘s levels, which average 11.05%, to a national average of 15.45%, 41 that evidently fall inside our business plan which we are determined to improve.

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Chart 2. Figures of the National Petroleum Industry, 1976–1999 Crude produced Light (> 30 API) Medium (22–29.9 API) Heavy (< 21.9 API) Total MMB Condensed MMB Natural gas liquids MMB Crude processed MMB Crude exported MMB Sold products in domestic market MMB End 1999: Total active wells/wells Fiscal participation 1976–1998 MMBs

6,068 6,200 5,923 18,191 2,073 885 8,274 11,726 3,204 31,593/17,916 8,207,180

DUTCH DECEASE A reasonable man adapts to the world. An unreasonable man is persistent in trying that the world adapts to himself. Hence, all human progress depends on the unreasonable man. —George Bernard Shaw

Another factor that is worthwhile mentioning briefly that was affecting the economics and political situation of Venezuela refers to the badly named economic term Dutch Decease. This rare event occurs when for what ever reason a country‘s resource becomes dearer and it is actively involved in international market with a flexible exchange rate, it causes the currency to become more in demand from other countries which need it to buy the resource; thus overvaluing. When that happens, the other products that the country trades becomes relatively more expensive and thus vulnerable to import competition and, at the same time, 41

See Vierma, Luis, Exploracion y Producción, PDVSA, Planes Estrategicos, Plan Siembra Petrolera, Caracas, Venezuela, 8-18-2005

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they become less attractive abroad. In absence of some protective measures, it will get swamped by cheap imports, much like the Dutch realized from the fruits from Denmark and France when their currency overvalued in tandem with the price of gas (which they have) during the oil shocks in the 1970s. Moreover, when the labor force sees that they cannot compete with the lower priced— currency wise—goods from neighboring countries, they usually abandon that activity and try to find work in the more lucrative other activity that suddenly became dearer. This effect may even spill to the international sector, which, in absence of effective border patrol, people will flock towards the newly rich country to try to find work, which leads to a sudden increase in the population, a collapse in the social services and urban unemployment if these new lucrative activity, like oil, is capital intensive and is only restricted to hiring highly qualified professionals. Last, as investment flocks the dearer activity at the expense of the others, inflation from the rich is spilled to the poor, thus banging them in the head once more. Venezuela suffers from all of the above, to the point that some economic historians in the country even debate weather Holland should be the recipient of the honor to put their name in front of this decease, when it should be Venezuela.42 The political effects of Dutch Decease are also noteworthy because they also affect Venezuela. As a democracy with the oil reserves constitutionally under the mantle of the State, it means that whoever is governing the country has a key to those huge deposits. But since there are much more poor people than rich people given the above described Dutch decease phenomena, it means that the politician must necessarily appeal for their vote in order to have a hand in that fabulous wealth. If the poor people decide to elect one of their own to the highest office, and he/she flocks the cabinet and oil industry with people loyal and trustworthy (other poor people) this means that the rich people must necessarily lobby the poor people for access to the countries wealth. If that wealth keeps increasing in value and the poor people keep denying the rich access, a social conflict may ensue on the reverse; meaning that the rich, envious of the poor‘s power, want to topple them. Given this, the effects of a sudden influx of petrodollars is never easy to absorb productively, as the renowned Stanford University professor Dr. Terry Lynn Karl, in her landmark book The Paradox of Plenty, found out in her extensive research on Venezuela and other petro-states: Petro-states find themselves incapable of absorbing their surplus, even if they quickly generate new public-sector projects. But, facing the impending threat of massive inflation, worried about depletability, accustomed to seeing the state as the leader in development, and eager to put their new wealth to immediate use, oil governments rely on their standard operating procedures: they reach for large-scale, capital-intensive, long gestation projects, or if such projects are already underway, they increase their scale and accelerate their completion dates. These projects epitomize a resource-base industrialization strategy; they emphasize processing and refining, petrochemicals, and steel. Not surprisingly, in the face of a powerful push to absorb petrodollars rapidly and a general relaxation of fiscal discipline, they are often wasteful and poorly conceived. The boom not only provokes a grander, oil-led economic model but also simultaneously generates new demands for resources from both the state and civil society. Policymakers, once torn between their twin preoccupations with diversification and equity, now think that they can do both. The military demands modernized weapons and improved living conditions; capitalists seek credit and subsidies; the middle class calls for increased social spending, labor for higher wages, and the unemployed for the creation of jobs. As demands rise, unwieldy and ineffective bureaucracies, suddently thrust into new roles, find themselves incapable of

42

Some credit Perez Alfonzo for having mentioned something along these lines in the 1940s in what he labeled ―The Venezuelan Effect.‖ But Perez Alfonzo was a lawyer, not an economist, and thus could not prove his theory with the necessary economical/mathematical rigor.

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scaling down expansionist public- sector programs or warding off private-sector requests. Thus they ultimately 43 contribute to growing budget and trade deficits and foreign debt.

On of the crucial phrases of the above paragraphs is Dr. Karl‘s reference to the petrostates as ―accustomed to seeing the state as the leader in development‖ which, of course, was not the case of Texas or Norway when it struck oil. Productive development occurs rarely, if at all, under noncompetitive conditions, because it is competition that breeds the juices of innovation, organization, inventiveness and creativity. Technological and productivity prowess is and has always been a product of company competition in a fair play and open market environment, and living standards have increased because of it. We will get back to this point in the next chapter. It is noteworthy that in the preface of her book, Dr. Karl recounts a conversation she had with Juan Pablo Perez Alfonzo, the creator of OPEC, in which he told her the following prophetic message: Don‘t study OPEC…it is boring. Study what oil is doing Venezuela, what oil is doing to us.…Ten years 44 from now, twenty years from now, you will see. Oil will bring us ruin.

THE BASINS What is the reason for the imperialist aggression? Venezuela possesses the greatest petroleum reserves in this planet and oil has the tendency of running out.

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—Hugo Chavez

I always tell my students that God was in an uncharacteristic good mood when he made Venezuela. Here is why: The Venezuelan petroleum reserves can be divided it into six sedimentary basins, the three more important being the Maracaibo, the Oriental and the Orinoco Belt which together comprise 95% of total production. Of these, the only one that represents a sustained growth in the last decade is the Orinoco Belt (shown here as the Faja Petrolífera del Orinoco), the one which, as we will see now in detail, grew from zero production in 1997 up to nearly over 850 MBD in 2008. The other ones are in the process of steady depletion, especially the Maracaibo basin as it is the oldest, the one that has produced the longest, and the one that was first hit by Hubbert‘s Peak. For instance, the Lagunillas field, historically the most fertile area in the history of Venezuela, topped 940,000 bd in 1971 and, according to data provided by the Ministry of Energy and Petroleum, had already gone down to 190,000 bd in 2003. The oil opening of Venezuela in the decade of the 1990s contains a history of shy beginnings, dynamic acceleration, temporary stability and, as reflected at present, strategic planning in a completely different change of paradigms to re-strengthen its dynamism with other actors, besides the ones already there. The important thing to discern is that its prime motives were events unrelated to the petroleum industry and more related to internal and external political forces.

43

Karl, Terry Lynn, The Paradox of Plenty: Oil Booms and Petro-States, Berkeley, University of California Press, pp 64-65 44 Ibid., Preface xv. The Completion of the Oil Era : The Economic Impact, Nova Science Publishers, Incorporated, 2009. ProQuest Ebook Central,

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Source: Instituto Geografico de Venezuela, Simón Bolívar. Graph 1. Venezuela‘s Oil Basins.

This is not the place to fully account for the political and economic history of this process, but the salient features should be mentioned briefly to set things in the right context. As with the case of Mexico described in the last chapter, Venezuela was also a victim of the failed development model of import substitution industrialization and thus a horrific victim of the infamous lost decade of the 1980s, especially after the oil collapse of 1986 which, due to poor government management, also collapsed its international monetary reserves to zero.45 In the elections of 1988, the popular Carlos Andres Perez (the same leader who, in the 1970s, nationalized oil and proclaimed the ultimately disastrous Venezuela Saudita Nation Plan) regained power and with it the popular expectation that happy days were here again. When he could not deliver and instead had to swallow an IMF stabilization plan, which included the all-too-familiar drastic measures that hurt the poor temporarily (especially because of higher unemployment through the reduction of wasteful fiscal subsidy and

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currency realignment that also raises prices of basic staples), at that very moment three days of very bloody riots engulfed the country and drastically weakened his presidency.46 In 1989, the first year of his presidency, the GDP dropped a ghastly 7.8% and inflation topped 90%, unheard-of numbers for Venezuela. All assistance to the poor segments of the population was reduced to the minimum as per capita income collapsed to half the levels it had been a decade earlier. That is an impossible pill to swallow when you live in a rentseeking society of a supposedly rich country.47 When things did not get any better in the next couple of years, the people in Venezuela openly supported an attempted military coup in February of 1992 (led by Hugo Chávez) and again in November of that year. This spelled the end of Mr. Perez and his Gran Venezuela experiment, and with it the type of democracy that Venezuela had endured for 32 years. It would stick around a bit longer, but severely weakened and in need of an economic miracle to save it. It did not come. Carlos Andres Perez, who was widely perceived as corrupt, was driven out of office on a trumped-up charge of ―secret fund misallocation‖ and was replaced temporarily by the ancient but respected historian, Ramon Velazquez, who had no political background (there was no vice president then) and thus governed weakly. In 1993, another ancient figure of respectable political weight was elected, Rafael Caldera, who ran against the traditional political parties including the one he had single-handedly founded. Caldera had been president of Venezuela in the 1969–1973 period and had governed respectably (as when he offered peace to the leaders of the failed guerrilla movement) but with severe flaws (like accelerating the import substitution model, militarily intervening in universities, and inexplicably closing down the technical schools). But oil prices held steady and people‘s living standards improved with renewed business confidence and capital formation now that the country had reached political maturity (it is worthwhile noting that his first term was the first in Venezuela‘s history in which power was transferred peacefully from one faction to another). This time he wasn‘t lucky. A severe financial crisis greeted him in his first month in office that wiped out more than half the banking system, and when that was badly handled, it forced him close accounts and impose unpopular exchange controls. As soon as that was about over, the Mexican tequila financial crisis submerged just about every emerging market in Latin America (Venezuelan inflation toped 100% in 1996) and when that was about over, the Asian crisis of 1997–98 struck with vengeance which collapsed the price of oil to single digits and deeply affected the countries that either depended on a single export crop or had their currencies to tightly overvalued; thus sending the Venezuelan economy to a tail spin. But Caldera did do two things that were popular; one at home and the other abroad. At home

45

Truth be told, the international reserves went negative when the hapless Lusinchi government of the mid 1980s ended. This is because the government owned foreign banks over $6 billion in short-term letters of credit for crucial imports such as medicine and foodstaples. 46 Carlos Andres Perez hailed from the same political party as Betancourt and Lusinchi that had governed Venezuela for much of its democratic experience since 1960. 47 The late Arturo Uslar Pietry, possibly Venezuela‘s most celebrated intellectual for the better part of the twentieth century, never stoped reminding us that Venezuela had spent the equivalent of 7–8 Marshall Plans and could only boast of over 80% poverty rate.

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he fulfilled one promise that he had made in the campaign. He released from jail the coupsters of 1992, Hugo Chavez included, and permitted them to bid for electoral office.48 The second was the oil opening. To this we shall now turn.

DESPERATE MEASURES The perpetual obstacle for human progress is custom.…Every great movement should go through three stages: ridiculous, discussion, adoption.

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—John Stuart Mills

The utter desperation of the Caldera government led him to alter what for almost twenty years had been taboo in Venezuela. He opened a window for multinational investment in the oil business. Or, more exactly put, he used a small window that was already in the Nationalization Law for other reasons to push through it massive international investments in the marginal fields (fields that PDVSA was either uninterested or did not have the money to develop, including the Orinoco Belt). As soon as it was announced, it opened a floodgate for 120 companies that flew to Venezuela in quest of positioning a beachhead in the oil negotiations. Later on, the Congress of Venezuela, its Supreme Court and President Caldera himself signed documents that legalized this opening. In the year 1998, Venezuela held a historic presidential election that elected the socialist Hugo Chavez to the presidency of the Republic. Chavez, knowing well that his election marked a new period in Venezuela and a definite break from the past, introduced many sweeping changes in the political scenery of the country which brought him a realm of enemies from the traditional forces, especially after the oil price started to increase from the single-digit figure when he took office. Among the many changes he brought, all through electoral democratic means, were a whole new Constitution (which he had approved in three different electoral stages), a new Gas Law approved in 1999 (which was desperately needed given its nonexistent investment) and a New Hydrocarbon Law which he had approved in 2001; the first of its kind since 1943. Concretely, Article 18 of that new law reads: Article 18. The primary activities indicated in Article 10 will be able to be carried out by the State, either directly or by means of companies of their exclusive property. Equally it will be able to realize them by means of mixed companies in which the State has control of their decisions, by keeping a minimum participation bigger than fifty percent (50%) of the capital stock. The companies that are devoted to the realization of primary activities are denominated operating companies.

The strategy of the oil opening has been really successful from all points of view, especially in private investment, produced barrels, technological transfer, sustainable development, multiplier effect, motivating national industrial components, security, international reserves, increased import capacity, professionalism, and effectiveness. From

48

There is virtually no one in the opposition in Venezuela that has ever forgiven Caldera for doing this, to the point that he retired to a hermit-like solitude lifestyle avoiding being seen any where, on both sides of the conflict. Some still keep asking ―What was he thinking?‖ My own theory is that he remembered that during his first government he pacified the country by offering the former guerrilla warriors the chance to form political

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their beginnings until the end of 2005, the total production, including the Belt, has been rising until reaching 1,087 MBD. Since 2005, production declined somewhat as investment has tapered off due to the beginning of the process of migration negotiations that started in 2003 but did not end until 2006 and 2007, which kept the legal framework of the investments in limbo. This is because in 2003 the Venezuelan Government announced a migration of all previously agreements in the traditional areas and in the Orinoco Belt towards a new business framework where the State would form a mixed enterprise in which it would have 60% control of all operations, while the minority partner would have 40% but would have decision for leveraging the finance and in the operational engineering, including technology transfer when necessary. All companies except two accepted this new framework, and the two that did not, ExxonMobil and Conoco-Phillips, decided to leave the country and start an international legal conflict againts the government for the value of their assets in Venezuela.49

THE ORINOCO BELT In the energy order that transition should take us from an energy system dependent on petroleum to one where it is less important and even stops being an energy element, to be substituted by renewable sources that are non polluting.

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—Manuel Pérez Guerrero

We now land in the famous Orinoco Belt, which can well be the angular stone that facilitates the transition that the late Dr. Pérez-Guerrero was referring to in the last quote, from fossil energy to renewable energy in the distant future. Without this transition, one runs the risk of falling in the conclaves of the Middle Ages (after economic and war cataclysms) which we referred in the two previous chapters. The Orinoco Belt was discovered by the middle of the 1930s, but given its extra-heavy and high content of sulfur and metals, it was not given any importance and was abandoned as the companies preferred other cheaper and cleaner fields. As I sometimes tell my students, in a certain way this Belt plays the role of the ugly girl in town whom no one calls or invites to the prom dance until one Sunday morning she hits the biggest multimillionaire jackpot on earth and now her phone won‘t stop ringing. The respected Venezuelan geologist and university professor Aníbal Martínez, in his book on the Orinoco Belt, recounts this period well: In the decade of the 1930s, what the international oil companies looked for exclusively was crude petroleum of light specific weight. It was like bad luck to find natural gas and it was considered almost an absolute failure the discovery and finding liquid fluid, or any substance that was not crude oil, the lighter the 50 better, not beyond a clear brown color, very flowing, clean and sweet.

However, because of Hubbert‘s Peak (exhaustion of conventional reserves = economic growth + population's growth + globalization + awakening of extra populous countries + natural depletion of existing fields-alternative energy) the international oil companies + parities. They all did, but this effort never amounted to anything significant in any election. Chavez won by a landslide. This proves that sometimes historical lessons have their limitations. 49 Exxon Mobil sought a court settlement in this dispute. 50 Martinez, Anibal, La Faja del Orinoco, Ed Galac, Caracas, Venezuela, 2004. Pp 168

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government enterprises + consumers have begun to look at this vast region with different eyes. And vast it is: 53,314 km2; 700 kilometers long and a width that goes from 32 to 100 kilometers. For reference, if we added the total area of Belgium and Israel we would come out more than 2,000 km2 short in filling the Orinoco Belt. Its topography is virtually completely uninhabited, bordering the small cities and neighboring towns such as Ciudad Bolívar, El Tigre, Anaco and Maturín. It has warm climate, shallow depths, high-porosity sands with easy access to pipelines, terminals, refineries and ports of the Caribbean. But it has extraheavy viscous oil. The renowned scientist, J.C. Boué, recognized as much in 1993: ―The field of the Orinoco Belt is the biggest deposit of hydrocarbons in the world.‖ In fact, Boué affirmed that the bituminous sands of Canada are dwarfed in comparison to the vast dimension of the oil strip of the Orinoco, ―without discussion the biggest in the world.‖51 David Nelson, a geologist working for Chevron (one of the companies developing the Orinoco Belt), who has 27 years of experience in the development of heavy crude, was quoted in The New York Times as saying: We know that the Orinoco Belt is underdeveloped and that the resources of the Middle East are at their midpoint.…These projects are big, they are complicated, they have many movable parts, they imply many 52 complicated negotiations with the government, it is not a business of instant gratification.

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The professor Barbierii describes it: Geologically, it is in the south part of the Maturín basin to its west, and geographically it has been given the name Orinoco because its southern limits are along the long and close to the river…very characteristic of the mechanics and behavior of the production of the fields of heavy crude is that its initial removable volume is between 3 and 10%. However, even in this case, in the phenomenon of the Belt, given the immense figure of petroleum in place, the primary extraction runs between 30 billion and 100 billion barrels. Moreover, if by means of the application of methods of enhancement of production (for example the injection of vapor) is possible to duplicate the primary extraction, then the volume producible would be between 60 billion and 200 billion barrels. This figure will be appreciated better when it is compared with the 46.4 billion barrels of all type 53 of crude oil that has taken place in Venezuela during seventy seven years (1917–1994).

Graph 2. 51

Ibid. See Forrero Juan, ―For Venezuela, a Treasure in Oil Sludge,‖ The New York Times, 6-1-2006 53 Barbieri, 1998. 52

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As shown in the graph, the Orinoco Belt has been divided into four large regions, all of which have names of the most famous battles fought in the independence wars in the Andean region. Now it is important to keep in mind that four projects already existed in this area since the early 1990s which produced at its height a combined 630,000 bpd. So that the Belt originates in the eastern basin of Maturín, an extremely rich area in hydrocarbons and supplier of most of the production of Venezuela at present and, through the centuries of formation, it emigrates towards the south and upwards until colliding with a gigantic trap in the skirts of the biggest river in the country. In its long and winding road this oil finds a lot of geologic garbage, especially sulfur and metals that mixed with the molecules of the crude changes and thickens its composition to a heavy crude oil thus increasing its viscosity and worsening its quality and fluency, which scares away its original discoverers towards the search of other fields of more profitability that they also found in great amounts in Maracaibo. The further you go south, the worse the quality (5–6 API) gets but the north area is lighter (12–16 API). As time goes bye towards the 1970s when PDVSA begins to detect depletion in the traditional fields of Maracaibo it orders some exploratory perforations in the Belt. But it was not but at the end of last century that the interest truly begins for the Belt as oil companies, faced with depletion rates all over, decide to take another look at the Belt and helped with the technological advances in production, upgrading and distribution, agree to form Strategic Associations with the Venezuelan government in the Oil Opening, which is when we first begin to see huge investments and later production flow in the Belt fields. With around 2000 perforated wells so far and with a certification in process, it is now when the Orinoco Belt places Venezuela in the center of the energy focus. According to the Venezuelan oil engineer Diego González: The Orinoco Belt is the most important movable accumulation of petroleum of the world....Beginning with the premise that the Belt is the only significant source of substitution for the declining ‗traditional‘ oil fields of Venezuela, it is necessary to develop it completely if one wants to continue being the reliable supplier that has represented the country from the beginnings of the exploitation of its hydrocarbons in 1914. Another reason of importance is the opportunity to take advantage of replacing an important part of the growing energy demand at the world level. And the most essential thing, it is the source to generate the necessary foreign 54 currencies to leverage the necessary funds to escalate the country towards modernity and progress.

The Orinoco Belt has an estimated 1.3 trillions barrels of oil in situ (more than what humanity has consumed thus far), and its target is to increase its recovery factor from a current 8% to 20% in the long run. Any way you slice it, it is a lot of oil. These reserves are at the moment in the international certification process using the latest seismic technology, like 3D and 4D that will allow to make the best estimates of the underground interconnections of the hydraulic flows and of the geologic flaws and at the same field depth locations (it is known that most of the crude oil in place is relatively shallow). As said, its probable and removable reserves are in the order of 262 billions with a target recovery factor in the order of 20%. At the moment this factor is between 6% and 11.8% for an average of 8.4%, and it is expected that very soon this will increase on average between 11% and 12% when the production techniques (SAGD) the same one explained in the case of the Canadian tar sands).

54

Gonzalez, Diego, ―El futuro de la Faja Petrolifera del Orinoco,‖ Seberania.org, Paradigmas XXI, Caracas, 3-212006

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In the next graph the projected recovery factor is observed between the prospective production of the Belt, according to different scenarios presented by PDVSA in the city of Houston in 2004, that go form 8.5%, 12%, 16% and up to 20% to reach productions peak from 3 to 8 MBD corresponding to the years 2030, 2050, 2060 and 2065 respectively. However, this does not preclude technological improvements that go beyond this; like some of the fields in the North Sea with wells that are much deeper but that have recovery factors of 60%. In relation to the costs of production, these technologies have reduced them with time and economies of scale until descending them from US$/Bbl 3.0 in 1991 at 0.95 in 2003, and of passing from traditional cold production towards more modern the horizontal wells, vapor injection and electro-submergible pumps, which increases the production of the wells. The technology provided by the French company Total developed in Venezuela, along with some own Venezuelan techniques like Acua-Conversión® and HDHPLUS® for the repulse of coal and the injection of hydrogen respectively facilitates this process. However, the recent geometrical increase in the cost of imput materials and in the international price of drill bids, along with the increase in the cost of international finance, does complicate the initial investments; but long run industrial economies of scale still apply, albeit from a much higher figure. For example, one of the companies involved in one of the four projects already in place in the Belt that begun in the mid 1990‘s, told me that if they were to do the same exact project today, that they would have to spend at least twice as much. Aside from PDVSA itself and some other companies working these fields in the Belt, a host of other oil related companies are working around the clock to come up with ways to improve the recovery factor of extra heavy crude oil. I will not mention all the techniques here because most if not all are still in the experimental phase facing challenges of all sorts.

Graph 3. Production and Investments in Venezuela Privately Owned Oil Companies.

In the graph above, one can observe the relationship between investment and production in both the traditional areas and the Orinoco Belt from its beginnings until the end of 2005 when investment tapered off due to the migration process towards mixed companies as well as the long certification process, which has lasted over three years. During this entire period, the companies have produced more than 805 million barrels of crude oil and have invested

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more than $11.7 billion, investment that arrived to its natural decline and which needs to be reactivated in order to increase production, which is in fact the goal of the government‘s Plan Siembra Petrolera 2006–2012. One area in which advancement has been noted, however, is the upgrading and refining stage, where the oil in the Faja is extracted and taken to an upgrading facility where its API grade is improved in several stages to 32 degrees, which prompted one PDVSA executive to boast, not erroneously, that Venezuela contains the lightest reserves in the world, and according to OPEC, these technological improvements in heavy oil has confused the difference between light and crude oil, which might soon be irrelevant. The problem is that these upgrades are not exactly perfect, meaning that they lose about 10% of the product, mostly in the form of coal (coquer) and sulphur, none of which is environmentally friendly. A big obstacle along the way is financial leveraging which, after the investment bank meltdown on Wall Street, is hard to come by, much less in the required amounts. Another is the escalating costs of material inputs, brought up by the increasing (energy related) costs of making steel and other metals, which have also increased the costs of acquiring a drill bit to almost stratospheric proportions. Still another is the difficulty in hiring qualified personnel, which seems to be lacking all over the world.55 None of this is insurmountable. 800

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*America excludes Venezuela and Canadian Tar Sands

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19

BP Statistical Review of World Energy, 2008; PDVSA, 2009

Graph 4. Total World Reserves, 2008 (billion barrels).

55

I once jokingly told an American reporter from Business Week that I personally blame Bill Gates for this. This is because so many brilliant mathematically-oriented people want to emulate him, hardly anyone takes up a geology or petroleum engineering course any more. It just isn‘t easy to get rich in this business any longer.

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In this graph, whose information is extracted from the annual British Petroleum Statistical Review of World Energy 2008 and Venezuela‘s state oil company, PDVSA, one can observe that, with the additions of the reserves of the Orinoco Belt, Venezuela does have the largest oil reserves in the world, not counting the Canadian tar sands, which, as we saw, have severe limitations in large-scale production. I will finish this section with the following quote from a PDVSA press release which makes reference to a Wall Street Journal article of early in 2006. It read: Thanks to the technological advances in the petroleum industry, especially in the recovery area of crude oil, Venezuela occupies first place in the classification of the countries of the world with the largest reserves of hydrocarbons. Thus affirms it The Wall Street Journal in a work presented in the first page of its edition of Monday March 27 2006. The publication points out that the reserves of heavy and extra heavy oil of Venezuela, estimated in more than 235 billion barrels of petroleum, are technically easier to produce than in other countries 56 due to the their physical state which allows for better mobility.

Thanks to the Orinoco Belt, Venezuela truly has the largest accumulation of liquid hydrocarbons in the world and—together with the reserves of four or five countries in the Middle East, North America and, possibly, Brazil, Russia and Mexico—Venezuela is in the privileged position of supplying the world the necessary bridge for a happy transition towards renewable energy sources for future generations.

PLAN SIEMBRA PETROLERA

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Most forecast project that unconventional oil, together with coal to liquids (CTL) and gas to liquids (GTL) is unlikely to exceed 10MBD in 2030…In the EIA (Energy Information Administration) 2007 reference case Canadian Oil Sands and Venezuelan Heavy Oil supply 5.2 MBD in 2030 provided sustained investment development. National Petroleum Council, 2007

In August of 2005, the Government of Venezuela unveiled the Plan Siembra Petrolera, in honor of twentieth-century intellectual Arturo Uslar Pietry who, in a famous 1936 article, wrote that Venezuela must plant its oil into the soil for productive purposes57 If the oil opening occurred because the government was thrown into a canvas of moral, financial and economic failures, forcing it to negotiate from a weak posture comparable only to Gomez‘s concessions, the Plan Siembra Petrolera is implanted from a very strong posture on the part of the current government. Contrary to his predecessor, Chávez won Venezuela‘s election with 56.5% of the vote in full youth and vigor, as ―a people‘s man‖ of humble origins who had bravely challenged the old order and who turned literally overnight into a popular hero who channeled the hopes of many dissatisfied people who had borne the brunt of decades of misguided policies that a rent-seeking society should never endure. He was, in the eyes of many, what the doctored ordered. 56 57

See PDVSA, Press Release, March 28, 2006 Uslar Pietry did not go into the detail regarding exactly how to do that. He apparently left it for us economists to figure it out. Thanks to a variety of factors, like import substitution, rent seeking, Dutch decease, and socialistic cooperatives development, we still have not. But it is a catchy phrase that suggests that we should not just sit on oil wealth.

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With a military background and with a cunning political savvy rarely seen in the history of Venezuela, he set off to change his country from the boots up in any way he could. Not only did he alter the Constitution (allowing for six year periods of governance and reelection) and the hydrocarbon laws in both crude oil and gas, he was also able to change the patriotic symbols of the nation with little, if any, resistance—like the name of the country itself, its flag, its coat of arms, its currency and even its time zone. His tools were basically five (besides the savvy mentioned above). • • • •

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•

great charisma, linked to a tireless ability to communicate to the poor segments in their lingo a bad choice of reference (the precceding past experience was truly disastrous) a genuine feeling of sensitivity to the plight of the poor (I feel your pain message) a disarrayed and disunited opposition with no credible political parties or leaders to turn to. exceptional luck in the price of oil

With respect to the last, this was partly Chavez‘s doing, at least in the early stages, when he almost single-handily unified OPEC in the year 2000 by holding in Caracas their first heads-of-state conference in a quarter of a century (after traveling half the world to their countries to invite each of them personally). What he could not have possibly imagined is the quadrupling of the oil price in the 2002–2007 period, which sent his coffers soaring to unprecedented levels. But that is not all good news. Realizing well that he may be looked at as possessing the last remaining water hole in the planet for a while, which is not a comfortable position in his eyes, Chavez ordered a plan to be drafted that would include as many countries and international oil companies as possible in the Orinoco Belt, including those from the United States58. In what remains of this appendix, I will only comment on the objectives of the Plan itself, but not the specific figures or time limit, because those have all changed with the rise of materials and the change in the economics (the recession and financial meltdown). Basically, the Plan engulfs in scope the whole hydrocarbon chain, from E&P all the way to its final end user. It contemplates riskless exploration, production targets, refinery locations, building of upgraders, number of wells to be drilled, amount of gas to be found and needed for oil related industrial activities, pipeline infrastructure, shipping, port facilities, petrochemicals for fertilization and plastics, etc. The original objective was to increase total production by 76% in a span of seven years. Although the time scope has shifted, the target is certainly considered reasonable if all goes well.

THE PLANTING OF THE BELT The principal part of education does not lie in the acquisition of the facts, but in how to enliven these facts. —Oliver Wendell Holmes 58

Which is the exact opposite strategy that Sadam Hussein implanted in Iraq. Much to his demise.

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Here the Orinoco Belt plays a crucial role because, as mentioned earlier, it is the area where almost all of the potential for growth exists. The plan divides the Orinoco Belt into 29 blocks, each with an average of 500 km2 that so far have been distributed to 19 different countries from all over the world, and many have operations elsewhere in the country. The original plan was to almost double the production of the Orinoco Belt in a span of seven years. Regarding gas, Venezuela also contains fantastic reserves to the tune of 150 TCF of proven gas reserves, plus at least that much in unproven reserves in its offshore Caribbean zones (Pataforma Deltana, Mariscal Sucre and Rafael Urdaneta, in that order) which are largest reserves in the Western Hemisphere after the U.S. and one of the largest in the world. An LNG plant in the eastern side of the nation, its first ever, is under construction with the help of international investment. Also an added bonus, the certifying of reserves in the Orinoco Belt has turned up good surprises regarding gas deposits, amounting to four times the quantity originally estimated (although it is low-pressure gas) to be used in the upgraders to increase the quality of the oil and its recoverable factor. That frees northern gas for exports to lucrative markets such as Japan. The privately-owned companies that have been through years of bidding process and have won a block inside the Orinoco Belt know that it gives them only the right of first refusal when PDVSA sits to negotiate with them the terms and conditions once the project of certifying the reserves is complete. If the negotiations take place directly with established oil firms, they will take a specific turn. It they are with countries or with companies with little or no experience in heavy oil production, they will take another turn, allowing them to outsource an experienced operator. It‘s a very flexible plan, but one that has not been put to the test yet.59 This is all contemplated under the framework of a master plan that must also include basic infrastructure, like a town with all of its services in hotels, hospitals, schools, houses, modern highways, shopping malls, bridges and recreational facilities. As I said, the Belt region is completely under populated with small towns that are few and far between and it must start from scratch. The widely spaced out regions of the Faja suggests that one or two towns may not be enough, although a refinery is planned for the scarcely populated town of Soledad, just a bridge away from the old city of Ciudad Bolivar across the Orinoco River. But it is good to mention that Venezuela has had experience in building cities from scratch. An example is Puerto Ordaz in the southeast of the country, which was built on the heels of the steel boom of the 1970s and is now one of the largest and most modern of all Venezuelan cities. But it did not happen overnight. Nor was it cheap. And neither is this one. According to the original plan, which, like I said, has gone up tremendously in costs since 2005, private operators are expected to come up with the lions share of the total investment outlay, while the State is expected to put up the rest. This only means that the private operators must have a very active role in this whole process. The execution of this plan will not be linear or easy. It will have its ups and downs and turnabouts. Many of the problems that will arise may be homegrown and thus solvable, and

59

But it is moving. On November 30, 2008, PDVSA unveiled open bidding for three blocks inside the Carabobo region that the Brazilian company Petrobras had originally won but partially returned, and these had the added

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others will be completely external in nature and may take international coordination to solve, like the ones we are experiencing now in the financial world that are affecting the leverage capacities of some companies. However, the fact that PDVSA is backed up by the largest oil reserves of the world that are not only certified but that can be extracted with proven technology within a legal framework that includes a multicompany and international presence does make that company, in my view and others, as the most fundamentally and financially sound in the world. I have said throughout this whole book and will say again, failure is not an option.

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BIBLIOGRAPHY International Agency of Energy, Monthly Report, March 2006 Venezuelan Association of the Hydrocarbons, AVHI, June 2006 Central Bank of Venezuela. Web page. Barberii, Efraín. The Cultured Well (Editorial Fund of the International Center of Education and Development-FONCIED) PDVSA, Edition #4, Caracas, 1998 Barbieri, E. ―The Venezuelan Industrialization of the Hydrocarbons in the XX Century. In Testimonies of an Oil Reality, in BCV, Funcación of the Positive Venezuela, Western Bank of Discount, Caracas, 2002 Boué, J.C. Venezuela: The Political Economy of Oil. Oxford University Press, Oxford, United Kingdom, 1993. Mentioned in Martínez Anibal (2004). British Petroleum, Statistical Review of World Energy, June, 2005 Gentleman, Manuel. ―Four Notes on the Venezuelan History in the Century of the Petroleum.‖ In Testimonies of an Oil Reality in BCV, Funcación of the Positive Venezuela, Western Bank of Discount, Caracas, 2002 Chávez, Hugo. Inaugural speech of the Plan Oil Siembra, PDVSA, Strategic Plans, Caracas, August 18, 2005 Of the Pine, Eulogio, ―Bands Oil of the Orinoco,‖ PDVSA Plans of Business, August 18, 2005 Forero, Juan. ―For Venezuela, to Treasure in Oil Sludge.‖ The New York Times, 01-06-2006 Official gazette of the Republic Bolivariana of Venezuela N° 37.076 13-11 - 2000 González, Diego. ―The Future of the Oil Strip of the Orinoco,‖ Sovereignty. Org, XXI Paradigms, Ca. 21/03/2006 Martínez, Anibal. The Strip of the Orinoco, Ed Galac, Caracas, Venezuela, 2004; p. 168 PDVSA Strategic Plans of Business: Plan Siembra Oil Company, August 18, 2005 PDVSA, Notices of Press, 28-03-2006 Rossi, Carlos. ―It‘s Cheating for the IMF to Pass the Torch,‖ Daily Journal, Oct 27, 1998 Rossi-Guerrero, Félix. Newspaper of an Oil Diplomat, Caracas, Ministry of External Relationships, 1987, p. 185 Rossi Guerrero F. ―Twilight in the Desert?‖ Metroeconomica, Caracas, April, 2006 Vierma, Luis. ―Exploration and Production,‖ in PDVSA, Strategic Plans, Plan Siembra Oil Company, Caracas, August 18, 2005 attraction that its reserves were already fully certified with no geological risk. The dates have been set for the bidding to start and conclude, and this is the first test of this Plan Siembra Petrolera. The Completion of the Oil Era : The Economic Impact, Nova Science Publishers, Incorporated, 2009. ProQuest Ebook Central,

Chapter 5

THE ECONOMISTS’ CHALLENGE We cannot always build the future for our youth, but we can build our youth for the future.…The only limit to the realisation of tomorrow will be our doubts of today. If civilization is to survive, we must cultivate the science of human relationships—the ability of all peoples, of all kinds, to live together, in the same world at peace.

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—Franklin D. Roosevelt

During the course of the previous chapters, we described the immense problem that the men and women of the hard sciences are confronting in trying to satisfy the energy thirst that will come from the twin combination of diminishing supplies of crude oil and the increase in the demand from an industrialising world that is growing in numbers and needs. But the truth is that these people, the scientists, cannot face this unprecedented task alone because they only control one-half of the equation of the energy balance in the markets. They represent the supply side. The purpose of this chapter is to try to understand what is happening to the other half of the equation—with the demand, with the half that economists and politicians control. The reasons for incorporating these people into the themes of the energy debate at this late stage in the game are two: Education. Economists have neither been trained in the topics related to the formation, readiness and development of primary energy—and hence they are generally unaware of its overall impact on the production of goods and working relationships—nor in the prosperity and dependence that energy implies for society. While not denying the importance of energy, the standard belief is that as any other commodity forms of energy can be replaced or substituted through the price signals and by throwing enough money into it with minimal, if any, repercussions for society.1 Help. Notwithstanding their lack of energy education, economists represent the side of consumer demand, which we do study obsessively, especially regarding the demand for money. Hence, we are in a position to greatly help the human species by devising ways to slow down the growth rhythm of the world‘s economy, which is the prime demand source of fossil energy, until the supply group/scientists have managed to develop the energy transition 1

I used to joke to my students that one fundamental difference between engineers and economists is that while engineers live under Murphy‘s Law, we economists live under the law of Yhprum (Murphy spelled backwards). That is, ―if anything can go right, it will go right.‖

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bridges towards massively renewable, affordable, and environmentally-compatible energy sources.

QUALITATIVE CHANGES Irreproachably I lived as a monk, and I felt myself in the presence of God like a sinner with a very restless conscience.

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—Martin Luther

There are three similarities that economists share with geologists, those men of science who dedicate their life to finding oil locations with those of us who dedicate our life to the economic development of nations. The first is that in both cases we live in a world of uncertainty and hence we are both forced to think in probabilistic terms. The second is that we are both optimistic. In fact, I don‘t know any colleague, or geologist, who would do his or her work well without a strong dose of hope and illusion. The last is that, in both cases, mistakes are made, but we both know how to learn from them. It is truly sad that this is where our similarities end. When I decided to work in the planning division of the exploration department of Venezuela‘s oil company at the end of the 1990s, I had to necessarily enter the world of geologists, install my office in their midst and take as many study courses in the terrestrial sciences as possible, bombarding my new friends with as many questions as I could (there were no chapters on geology in my economics textbooks). I would never regret this decision. While the rest of my colleagues had veered off in the financial department of the company, I was the only economist then that dared immerse himself into the depths of the earth‘s crust (figuratively) and accept that challenge, and today I can say with sureness that it was one of the periods of greatest intellectual progress in my career. Geologists are scientists, economists are not; we belong to the branch of the philosopher. The difference is in two words, ―qualitative changes.‖ The scientists always study changes. Sometimes, like the chemists, they are the ones who force change; but in the case of the geologists, they study the changes of nature and try to take advantage of them. The engineers are also scientists but, in a more commercial sense; they are forced to make changes in technology and innovation while at the same time keep one eye on the economic cost and the other eye on the quality of their product, balancing one with the other with adroitness. Economists see changes, but only at the margin and very much in the short term. They study how changes in monetary policy affect the relationship with the interest rate and the effect of that in the value of the stock market, employment, inflation and productivity. But if we are speaking beyond two or three quarters, forget it. For the economist, no change can be qualitative enough to question the direction of our economic system and by no means its fundamental addiction to grow by compound interest indefinitely. But if there is even a relatively minor interruption in this growth process, and the banks are overexposed, the whole financial pyramid could collapse. Maybe a personal anecdote will help. At a Christmas party, a geologist friend approached me and said: ―You know, Carlos, after much pondering, I have reached the conclusion that economists are the type who think that one can simply grab a bag, fill it up with money, take it to heaven, knock on God‘s window and shout: ‗Hey, God, here is your money, now put

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more oil in the ground!‘ I hate to be the one to break this news to your colleagues: GEOLOGY DOESN‘T WORK LIKE THAT.‖ Not surprisingly, perhaps, on the Web site of British Petroleum in its explanation of reserve classification, there is a comment similar to that of my friend, although written a bit more diplomatically: Economists frequently deny the concept of Ultimate Recoverable Reserves (URR) because they consider that the recovery of the resources depends upon the unpredictable changes of the economy and on the evolution 2 of technologies.‖

In a few words, the physical limits of nature simply do not exist in our profession.

GAPS IN THE FRAMEWORK Economics, through the years, has become more and more abstract and divorced from the events of the real world. Economists, generally, don‘t study the behaviour of the current economic system. They speculate on it. As Ely Devons, an English economist, said in a meeting, ―If economists wanted to study the horse, they would not go out and see the horses. They would sit down in their studies and ask themselves, ‗What would do if I were a horse?‘‖

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—Ronald Coase, Nobel Laureate in Economics

The bible of our profession is The Wealth of Nations by Adam Smith, who published his greatest work at the infancy of the Industrial Revolution the same year that the United States declared its independence. But neither Smith, Washington, Franklin nor anyone in these times ever saw a light bulb, an automobile, aeroplane, television or computer. They never saw petroleum. If the physical sciences can achieve their qualitative changes to alter the whole of humanity, economists also have to recognise our qualitative changes because our study is no other than the social relationships of human organisation to obtain prosperity and increase our standard of living and as we saw, petroleum was and still is responsible for most of it. Adam Smith and his successors were discovering capitalism, explaining its inner workings and suggesting policies that would make it work better, like laissez-faire, but they were not inventing it. As we will mention here, capitalism grew on the back of available supplies of energy, coal in his time and petroleum later, because it is energy that underlines the precondition for the expansion of the economy and with it the increased possibilities of national and international trade, finance, competition, technology, income distribution, consumption, savings, investment, private profits and rising standards of living. In short progress; it was energy that underlined the whole economic system when the pioneers of the Industrial Revolution discovered its prowess. Granted, as we will also see, energy is not all that you need; other factors like proper economic policy play an important role, but at the base you need power, and energy is it, as it was epitomised brilliantly in the previouslymentioned White‘s Law. In fact, as will also be explained in this chapter and more thoroughly in the conclusions, the whole concept of money was revolutionised by energy because it allowed banks to lend beyond their equity and deposits, using economic expansion as collateral for the loans themselves with energy acting as the main propulsion of that expansion. Before the energy revolution, this process of lending beyond a bank‘s means was next to impossible in 2

See the Web site of British Petroleum.

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peacetime and perilously dangerous in wartime (meaning, your country had better win the war and acquire more land and slaves to farm it to increase output to pay for the loans). Economists in general have never admitted the connection between money, energy and their connected role in the surge of industrialization. The old paradigm that based the Industrial Revolution from its beginnings early in the eighteenth century, through which each decision was judged by the question ―will this make our profits and economy grow?,‖ recognises that this endless growth is cemented in the capitalist philosophy, but it doesn‘t recognise that it was also based upon the biophysical fact of the abundance of cheap coal and petroleum. Back in the 1870s, the economic world was led by the ―marginalist revolution,‖ which was headed by the likes of Jevons, Bastiat, Menger and, especially, Leon Walras, all of whom based their analysis on abstractions such as ―subjective utility.‖ Frederick Bastiat once summarized the whole argument with the following statement: ―exchange is political economy,‖ which ignores de facto all the biophysical elements that go into production. This branch of economics is called now neoclassical economics. Its main contribution to economic theory might have been its study of man‘s relationship to the market, i.e., to the distributional sphere of economics. But an unnecessarily hefty price was paid for it by ignoring nature and the Malthusian notions of physical scarcity. Land, meaning all of nature, was ignored from all neoclassical production functions by the early twentieth century.3 With the passing of time and unheralded progress, things have changed and matured. The capitalist system is no longer what it was because it experienced mutant alterations towards another system, called globalization, which, although it maintains most of its fundamental premises (like the concept of private property, juridical security and democracy—the DNA of capitalism), it is also undeniable that this new economic system has characteristics of its own that contradict many of its more elementary foundations—for example, the ownership of the means of production, the production of value and the distribution of rent. The other base support of the industrial capitalist revolution, cheap petroleum, is depleting, and with it the growth rhythms of capitalism/globalization are being drained; it is our job, as responsible economists, to acknowledge this and design an economic strategy that it is simultaneously conservative and energy efficient with the objective of buying the necessary time for scientists to be able to structure and build these transition bridges into renewable energy that is ecologically focused. We desperately need this to be able to mitigate, as much as possible, the worst social effects that this transition can generate because it could end in an economic, financial and global political crisis of unimaginable proportions. The following paragraph, written by two concerned professors in New York, gives us a cue to the next section: For starters, one question rarely asked in economics is the relation between energy and any economic activity. In most of the world‘s economies, be they capitalist, communist or anything else, there are no increases in economic activity without a more or less commensurate increase in the use of energy.…What is less likely to be asked by economists is the degree to which ANY economic ―law‖ or policy can be made to ―work‖ simply because additional cheap, high-quality energy could be pumped out of the ground readily to make it work. Since the ready availability of cheap energy is unlikely to continue, it is critical that we develop a new, more realistic

3

For an excellent discussion on this issue, see Hall, C., & Klitgaard K., ―The Need for a New, Biophysical-Based Paradigm in Economics for the Second Half of the Age of Oil‖ in International Journal of Transdisciplinary Research Vol. 1, No. 1, 2006 pp. 4-22

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paradigm for economics for the second half of the age of oil, that is, for the inevitable downward trend of postpeak oil and gas that is likely to be upon us soon.

4

WHEN SIMPLICIY IS A START The epoch of the fossil fuel as a major source of industrial energy can only be a transitory and ephemeral event—and event nonetheless, which has excised the most drastic influence experienced by human species during its entire biological history.

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—Marion King Hubbert

Simplicity is not necessarily a bad thing; it often leads to gross mistakes but it has also been known to lead to fantastic scientific achievements when disciples of later generations complement them with more accurate observations through sophisticated tech-tools that were unavailable before. Nicolas Copernicus and Galileo will always be regarded deservedly as immortal geniuses for all seasons, as da Vinci, but their Renaissance accomplishments in today‘s world is primitive at best. That is, if an astronomer today only knows what these leviathans knew you could rightfully wonder if he/she ever made it through high school. The same can be said of Newtonian mechanical physics, which only went as far as explaining two celestial bodies attracting each other, noting that a adding a third celestial body into the equation was beyond anyone‘s comprehension, to say nothing of the nine celestial bodies interacting with each other, which is the minimum you need to grasp the behaviour of the planets of our solar system. (If you add everything else—moons, asteroids, comets and whatever piece of rock is out there—this number could be one million.) René Descartes, who preceded Newton and in good measure made him possible, invented analytical geometry, but only in a simplified two-dimensional space, and we know now that there are at least three. Finally, Niels Bohr and some of his followers were probably guilty of simplifying atomic physics when they tried to describe it as a minuscule solar system gyrating around a tiny sun. Their ambitions of finding a ―grand unified theory of classical physics,‖ as Einstein also believed existed but could never prove, have so far crashed to the point that some are beginning to doubt whether there is indeed a unified theory or if we will ever find it. But what physics has never done is to blatantly assume that a unified theory exists, or behave and walk the streets as if it did. Economists, or at least some of us, are guilty of this— just look what the IMF has done by prescribing what essentially amounts to as the same ―one size fits all‖ policy prescription regardless of the fact that the patient might be large and living in Africa, or small and residing in the Caribbean. In this case, their simplicity led to disastrous results in Argentina at the turn of the millennium, in Asia and Russia three years before, and in Africa many times. Where energy matters (and it matters everywhere), it has been much worse; economists have not even incorporated energy into their factors of production or monetary equations. Their simplification is extreme; they have ignored it. This is an error we hope to correct, in this chapter and in the conclusions. But first, we need to drive this point further home.

4

Ibid., p. 5.

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WHEN SIMPLICIY IS INSUFFICIENT Success is 99% failure.

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—Soichiro Honda

By not acknowledging the connections between energy, money and economic expansion, the economic profession has ruled itself out of making positive contributions towards a solution to this problem. And, as the wise saying goes, ―if you are not part of the solution, you are part of the problem.‖ The reason is due to the simplicity of our productive economic models that have their roots in the concepts that our mentors developed by the middle of the nineteenth century and that ended up with the label of ―neoclassical economics.‖ This school of thought, which still preserves a lot of influence today, especially in the realm of microeconomics, was focused mainly in the derivative concept of value decisions and the intrinsic administration of the markets (the invisible hand). In fact, the initial concern of neoclassical economics was never in the sphere of production, but rather in the distribution of the rent and in the ―efficiency of the markets,‖ dedicating almost all of its effort into explaining the exchanges of goods with almost zero consideration as to how these goods had to be produced. Later on, in the middle of the Great Depression in the 1930s, the economic sciences were forced to carry out a deep revision of their thoughts and paradigms which in some ways considered the sphere of production, although only superficially and at the margin. This is when the branch of macroeconomics was born, and it was principally the work of one brilliant British intellectual named John Maynard Keynes. Although this is hardly the space to expose in any meaningful form the economic revolution that he led, it suffices to say that his contribution was so important that modern economics was taught for a time as ―before and after‖ Keynes. His works exposed some clear weaknesses in economic science (e.g., supply does not necessarily create its own demand and all income is not necessarily spent5) and concluded that governments should play a very active role in helping fix all of the spheres it can influence (monetary, fiscal, trade, exchange rate, finance, and even R&D grants) to help restore and maintain confidence in the productive agents so they can expand profitability ventures thus rescuing capitalism. The role of macroeconomics is to make sure conditions are optimal for the productive agents of microeconomics to work in the short term as well as the long term (the distinction is important, because sometimes short term growth runs into inflationary pressures and is therefore ―macroeconomically‖ reduced for long-term expansion). Keynes devised countercyclical recommendations of increasing autonomous government expenditure and easing the monetary supply in times of recession and doing the exact opposite otherwise, and these policies are still applied today even though they have been much refined and modified to properly account for four dimensions: 1) monetary (Friedman); 2) rational expectations (Lucas/Sargent); 3) fiscal (Laffer), which occurred since the second half of the twentieth century, mostly from the University of Chicago, and 4) globalization, which in turn is

5

Both assertions are attributed to the French economist Jean Baptiste Say in the early part of the nineteenth century. Keynes spent a lot of his time refuting the so-called ―Say‘s Law.‖

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modifying yet again all of the above. One effect is that the monetary part is coordinated by large OECD nations.6 But post-Keynesian economics never went into any depths regarding the bio-physical requirements that economic growth necessitates in its production sphere. There was no peak oil problem in either Keynes or Friedman‘s time. Here, the faith of economists in the engineers and the scientists of the world is complete because every time that a problem arises in this area technology would magically come to the rescue. Their reasoning and solution could not be simpler. As oil reserves dwindle in the open market the price alarms would pick it up, thus making it more profitable for the good scientists of the world to provide more petroleum or substitute it and voilà, problem solved. Their solution in a nutshell: just throw real money into the problem, the more, the better. It is good to illustrate this with two prominent economists: Paul Samuelson, the first American Nobel Prize economist and one of the most influential Keynesians in last century; and Alan Greenspan, the notably naïve former chairman of the Board of Governors of the Federal Reserve System of the United States (FED). First, according to Professor Samuelson in his famous textbook, Economics, Note as well that the isoquant hits the vertical axis at point A, indicating that we can produce a future output level Q without petroleum or gas. How is this possible? With the greater scientific and technical knowledge represented by point A, society can develop and introduce substitution technologies like clean coal or solar energy to replace the exhausted oil and gas. The curve hits the axis to indicate that in the long run oil and gas are not essential.

7

Now, as stated by Alan Greenspan, If history serves as guide, petroleum will eventually be overcome by less expensive alternatives before the conventional reserves run out.…We should begin the transition process towards the next larger sources of energy, maybe before mid century when the production of the conventional reserves are projected to reach their

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zenith.

8

It is perceived from both of these quotes that the ignorance and underestimation by the whole of economic theory about the importance of primary energy in the workings of the production sphere of economics is almost complete. So is their faith in engineers and geologists. How is this possible? Because the cycle of economic growth had engraved in its commandments the following: 1) These resources, like water and oxygen, would always be available; and if they are not, 2) money would make sure that they would be found, or 3) technology would take care of substituting them for something better and cheaper. In fact, one of the most important foundations in the neoclassical pattern of production is the perfect 6

As a personal anecdote, at an embassy party in Europe I once ran into a high-level Chinese official while the G7 nations were having a meeting in that country. I jokingly asked him if China had been invited, and he turned around with a very serious face said, ―No, we were not, were you?‖ to which I said, ―No, Venezuela and OPEC were not invited either.‖ He then said, in perfect English, ―And yet, all they ever do is talk about us.‖ 7 Samuelson, P. and Nordhaus, W, Economics, McGraw-Hill, 1998 pp. 328. Professor Samuelson is obviously not an energy expert, as twenty-first-century economists should be. However, it is fair to say that the renowned Keynesian is an expert in many, if not most, other fields of economics and that he made in the twentieth century lasting achievements in its scientific endeavors. We will discuss one of his contributions again in Chapter 7.. 8 Greenspan, Alan, interview by the National Italian American Foundation, Washington DC, 10-15-2004. What history Greenspan is referring to is beyond me. As I have said repeatedly, the crisis of running out of the most efficient energy resource without a viable alternative available is unprecedented in mankind.

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substitution of productive inputs, meaning that machines and technology substitute labor force and natural resources.

THE GREAT DEBATE In all intellectual debates, both sides tend to be correct in what they affirm and wrong in what they deny. —John Stuart Mills

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The following flow graph depicts well the neoclassical version of the system of production. This is an adaptation from the well-known nineteenth-century closed equilibrium model of the French-born mathematical economist, Leon Walras, who taught at the University of Laussane.9

Start at the circle in the bottom and follow the arrows.

So the more investments are made, the more costs and prices are reduced and productivity enhanced, the more consumers respond favourably to this, which makes earnings and government coffers grow which in turn lures in competition, reducing prices, increasing investment and technology and making profits and then this endless and ever growing virtuous loop repeats itself for the benefit of all. Now, lets imagine a debate between a scientists and economist on this flow chart. The scientist, after seeing this would immediately notice that something smelled bad. In the first place, he would ask: When does this finish? The economist‘s answer is reduced to a single word: never! One might add: ―unless, of course, the government screws up something.‖ The reason is that this is a virtuous circle that can never finish or be still, it always has to grow and become bigger and faster ‗'beyond infinity‘‘. If the economist was of the Keynesian variety he or she would be more cautious 9

The starting point of this illustration is the circle at the bottom. After the first round, substitution of goods may occur there. The adaptation I have added is the boxes at the right side which depicts the importance of the nation state and banks in economic affairs. There is no strong capitalist country that has a weak state or a passive banking system.

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and say that the rhythm of the growth process of this circle might slow down either for market corrections in the business cycle, like bubble deflation, or because of government induced policy to quell overheating and starve off inflation, but it would not be in anyway related to the lack of physical or technological resources because in the cycle‘s flow chart above there is a full proof built in system that guarantees incentives for product substitution and productivity (technological breakthroughs). In any case, if a mayor deficiency is detected it could be corrected by the good economists and politicians with minor pain. The scientist, when listening this explanation, would still be unsatisfied and would remind the economist that his virtuous circle contradicts the laws of thermodynamics; specifically the most famous (and terrible) of all them: The Second Law of Thermodynamics.10 This law, denominated ―entropy‖ by its discoverer (the German physicist Rudolf Clausius in 1850), explains, in simple terms, that ―in all systems of energy exchanges, if no type of energy enters or leaves the system, the potential energy of this system will always be smaller than what once was at the beginning.‖ In other words, for our case, this law indicates that in a closed system where a dynamic energy exchange is in place, it is impossible that the energy of this system grows or stays the same unless another external source of energy is able to nurture it. If our car runs out of gasoline, the only way it will move again is though the injection of more gas from an external source. The economist would respond that ―economics is not a physical science per se but one that rather treats the behaviour of human relations in their productive quest for progress, tackling the issue of scarcity through product replacement as the flow chart indicates.‖ In any event, that external source of energy can be acquired with international trade and with the advances in technology. The scientists would remind the economist that ―international trade has its limits (our planet is alone) and that technology has not yet replaced oil, and where it could also uses and spends a lot of primary energy to develop and run it.‖ The scientist would also prompt the economist: ―You can‘t always count on technology to help replace the goods in the markets at the specific time that the market requires it; many times, especially when they involve advances that affect the whole of humanity, these can take a long time to develop regardless of what price of market signals are out there.‖ The slowness of medicine to deliver permanent cures for cancer, or AIDS are glaring examples.

THE CHEMICAL BESTOWAL Ignorance more frequently begets confidence that does knowledge: It is those who know little, not those who know much, who so positively assert that this or that problem will never be solved by science.…In the long history of humankind (and animal kind, too) those who learned to collaborate and improvise most effectively have prevailed. —Charles Darwin

The scientist would also cautiously warn the economist that creating money out of thin air is a dangerous practice if that creation has taken absolutely no consideration of the physical capital or energy supplies out there. Because without sufficient abundance of energy 10

Thermodynamics is the science of energy.

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to propel the production of goods the expansion of the economy stalls and declines, and that is what sustains growth and loan repayment. Moreover, the scientist would probably be prepared enough to suggest to the economist to take his cue from another scientist, but this time from the chemical field of knowledge, the 1921 English Nobel Laureate, Frederick Soddy (1877-1956) a man who spent much of his life analyzing human behavior from the biophysical sphere. Soddy noted the following as early as 192611:

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Debts are subject to the laws of mathematics rather than physics. Unlike wealth, which is subject to the laws of thermodynamics, debts do not rot with old age. On the contrary, they grow at so much per annum, by 12 the well known mathematical laws of simple and compound interest.

What Soddy was saying is that if we live in a world where the financial lending of banks is completely unconnected to our capacity to produce physical wealth, then we are living dangerously if ever that capacity becomes compromised; say, for lack of sufficient resources to power it at the same time that the banks are overexposed in their lending. The fact is that banks now can lend all the money they want, even money they don‘t even have, as long as the fractional reserve requirement system imposed by the central banks is satisfied. They loan their money at compound interest and have neither physical ceiling nor an adequate supervisory agency to keep an eye on them; especially after all the arcade of purposely designed (mathematically) complex derivatives were composed allowing them to create money and lend it arbitrarily while collecting commissions at every turn. Case in point, the $62 trillion credit default swaps to ―insure‖ the mortgage-backed securities (the GDP of the U.S. is only $13.8 trillion). Derivative trading, including the over the counter variety, grew 36% from the late 1980‘s to over 514 Trillion dollars in 2008; over a trillion dollars per each day of the calendar. Soddy noted that the physical wealth cannot keep up with that; that it cannot grow forever at compound interest as the laws of thermodynamics clearly imply. This led Soddy to postulate that at some point debts would outstrip wealth, causing the banking system to collapse if and when it becomes clear that it is irrational to expect further growth in the biophysical sphere. One remedy that Soddy proposed was a 100% reserve requirement with the FED.13 The purpose of this chapter has been to try to discern who has the last word in this debate, one that could not be more interesting given the worlds current circumstances. I strongly argue that it is the scientist who are right. Knowing this it is up to economist to qualitatively modify one of our most cherished and oldest notions, none other that the definition of money. Moreover, it is also time for us to modify one of the oldest and also most cherished equations, the equation of exchange, which is by far the most important mathematical relationship our profession has ever divised. We will try to do just that in the conclusions of this book. Before that we need yet more evidence. Let start with the following 11

In his youth Soddy was the assistant to New Zealand‘s Ernest Rutherford, the 1908 Nobel Laureate who is widely regarded as one of the greatest experimental physists of all time, fathering the study of nuclear physics and advancing the study of radioactivity. Soddy won his Nobel Price for his achievements in the study of isotopes and radioactive chemistry. 12 See Cleveland, Cutler, ―Biophysical Economics: From Physiocracy to Ecological Economics and Industrial Ecology,‖ Center for Energy and Environmental Studies, Boston University, 1999 13 A measure which of course would be tantamount with complete nationalization of the banking system.

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quote from five respected and modern scientists that is extracted from a work that tries to reconcile these two disciplines, economics and the natural science: The wealth that is distributed in the market has to be produced in the hard sphere of the material world where all operations have to obey the laws and principles of physics, chemical, and biology. Our concern is that most of the production models of economics are not based in the laws and principles of biophysics; in fact, its 14 tendency is to ignore them.

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The following graph brings this point home.

Source: EIA: Short-Term Energy Outlook, Sept. 2008; IMF World Economic Outlook, Oct. 2008. Graph 1. World GDP and Oil Demand Fluctuations (Yearly Percentage Variations).

This graph illustrates the strong relationship between world total output or GDP and its demand for the most potent primary energy, oil. It also gives a vivid idea of what could happen if the supply of oil, the gray line, begins to wane and disappear. Obviously, an understanding between the scientists and economists of the world is overdue.

DEMAND MEETS SUPPLY All the great truths begin as blasphemies. —George Bernard Shaw, Nobel Laureate in Literature

14

See Hall, C., Linderberger, D., Kummel, R., Kroeger, T., Eichhorn W., ―The Need to Reintegrate the Natural Sciences with Economics,‖ BioScience, August 2001, p. 663.

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On May 22, 2006, OPEC and the International Monetary Fund held their first meeting of all time in the city of Vienna, Austria, headquarters of the Secretary of OPEC. According to OPEC‘s Web site:

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The purpose…was exploring how these two intergovernmental institutions can work closely in the future at the more senior level to foment order and stability in the international oil market, in support of solid world 15 economic growth.

The transcendence of this meeting is important, if not for its concrete results for they basically exchanged business cards, mission objectives, and each others outlooks, but for the far more significant fact that finally the organisation that represents the worlds foremost monetary institution of the great energy consumers, rich and poor alike, humbled itself to recognise that the worlds foremost institution representing the energy providers were important enough to be brought at the table. OPEC assured that its member countries control nearly 80% of the worlds crude oil reserves, more than 900 billion barrels (which, as we will see in the next chapter, is not as much as it sounds) and that the market will be well provided ―for the years to come‖ (without specifying how many years). OPEC further conveyed that in the future the growth of the reserves would be a very expensive process that would have to be leveraged by much capital investments to assure market supply. In other words, that from now on and for the whole foreseeable future, it will be the supply of petroleum which will determine demand. Given that petroleum is the most important energy source of the planet, this also means that it will be the supply of petroleum that will determine the economic growth of the world. In a nutshell, supply will determine demand, as oppose to the other way around as it always has been. This historical asseveration will be more detailed in the next chapter when we examine the production simulations and world economic growth. But aside from this, the symbolic significance of the meeting between OPEC and the IMF is that for the first time in a formal setting, the men of the geologic sciences and those of the economy saw each other face to face in a strictly formal meeting. The subtitle of this meeting should have been ―Demand Meets Supply.‖ Why it had not happened before is anyone‘s guess. At the end of this chapter the reader is provided with the 18 supply-demand variables that mostly influence the oil price formation and its tendency to move. For us the economists, this meeting cannot be more important because it gives us a slap in the face with reality check. In our profession we were taught in principle that the factors that motivate the economic growth are three: earth (the above-ground natural resources); capital (financial leverage); and labor (manpower). Then a brilliant gentleman from Austria with the name of Joseph Shumpeter (1883–1950) came in and added him a fourth factor, on which he based all his ―methodological tolerance,‖ highlighting the relevance of the enterprising ability for expansion and growth, for business cycle, and for the survival of capitalism. His main concern was to try to explain the human reasons that impelled innovation, leadership and organizational skills, that is to say, that induced the ventures and productive transformations that increased the value of companies and this is what he called enterprising ability. Without a doubt, his investigations on this phenomenon places Dr. Shumpeter among the distinguished elite of our profession for all time.

15

See the OPEC Web site, www.opec.com

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THE INSTITUTIONAL FRAMEWORKS The decisive mistake of traditional economics… is the disregard of energy as a factor of production. —Biswanger and Ledergerber

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With the passing of the years, especially in failed countries, these four factors by themselves stopped being enough and had to be injected with yet a fifth factor of production. This is none other than sound economic policy because, sadly, there are countries that have all the factors above (as in energy-independent Latin America), yet still come up with dismal economic performance. I will not go into the details of why this happens, but in the case of Latin America, I already mentioned some of them when we talked about Mexico in Chapter 4, and it was the main theme of my first book. It even becomes more important today when we are forced to deal with globalization. The impact of these five factors of production contributed to the development capitalism for much of the nineteenth and twentieth centuries because it could incorporate these best practices and, with the appropriate legislation, it could also incorporate fair institutional frameworks. These can be also be summarised in five distinct but related institutional frameworks all of which foster: I. Freedom and democracy

Creativity Honest governments Sound economic policy Education and health care Fair income distribution

II. Juridical security

Administrative practices from both public and private sectors National, international investment Nondiscrimination practices

III. Political stability

National and international savings

IV. Large and open markets

Competition Technology Productivity Economies of scale Capital markets

V. International trade

Specialisation Efficiency Cultural exchanges Reinforces all above points

However, the years have continued to pass and now we are surely at another crossroads where the planet and its human race are faced with the necessity to add two more factors of The Completion of the Oil Era : The Economic Impact, Nova Science Publishers, Incorporated, 2009. ProQuest Ebook Central,

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production that assure continuity and reinforcement of the above institutional frameworks towards the achievement of economic growth and prosperity. These are: VI. Energy: Available and affordable supply of primary energy on a worldwide massive scale that is renewable, expandable and un-exhaustive. VII. Environment: All economic and production policies, including its raw energy power, must be environmentally focused. The inclusion of these additional factors of production will go a long way in the thinking of economists to signify a qualitative change of supreme importance in their paradigm and methodological process. The first of them is in essence one of the main objectives of this book. The other, Factor VII, is very much related, for the consumption of primary energy throughout the whole industrial value chain, both as input and as end use, is a prime reason for the potentially calamitous ecological disaster that may occur if a ―business-as-usual‖‘ attitude is taken. We get back to them in the conclusions.

IMMORTALITY SYNDROMES Dig a well before you get thirsty.

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—Chinese proverb

Even so, to end this section, it is wise to keep in mind that economists are not trained to believe in the evolution of economic systems or in the genetic mutations within the system, although these evolutions, mutations and alterations have the potential to transform the entire system into something very good and positive for the freedom and productivity of corporations, as well as to improve the standard of living of many, if not most, people on earth (witness China and India). When it is not properly assessed and supervised, the exact opposite may occur. I used to tell my students that this was something like a Moses syndrome, whereby a long time ago some wise man engraved in stone all of the economic principles and laws that we must obey today or face the worst. Without completely changing my opinion, I tell them now that it is more like a Pythagorean syndrome where, in our unending quest to become an immortal scientist (like Pythagoras), we write universal laws and hope they will stand the five tests of immortality. They are:16 • • • • •

16

truthfulness usefulness geography time (most important) memorability (least important)

This would only apply to the sciences.

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This five tests may hold for Pythagoras or Newton, but they certainly do not hold immutably true for economics all of the time because of the mutations in the dynamics of its production factors, the preconditions that power its growth, and the effects of that in the distribution of income will upset previously-held rules and principles to the point that forces qualitative changes in our paradigm. Like I have said before, the energy test in front of us is unprecedented and nothing of our past experience can help us with it. Economic theory does have one relationship-equation that fits most of the above, until now. This is the old monetary equation of exchange: MV=PT—quantity of money (M) multiplied by the number of times it was spent in a given time period (V) would necessarily be equal to the average price level (P) multiplied by the total number of transactions (T)— which dates back to the 19th century and possibly earlier. In our conclusions, we will spend plenty of time dissecting this equation and rewriting it in energy terms. The reason for this is crucial to our final objective of incorporating the science of economics into the Peak Oil paradigm debate for our vital help in resolving this imminent all-important and unprecedented energy crisis. Whether it is because of these two syndromes or some other reason, most economists in academia seemed to be trapped in the black hole world of abstract mathematics, almost obsessively, because, as Nobel Laureate Paul Krugman once said: ―Without a doubt there is too much mathematics in the economics journals, because mathematical elaboration is a timehonoured way of dressing up a banal idea.‖17 In a more recent article published in the New York Times, Krugman tries to assess how economist did not forsee this crisis, and drives this point much further when he writes: ‗‘Few economists saw our current crisis coming, but this predictive failure was the least of the field‘s problems. More important was the profession‘s blindness to the very possibility of catastrophic failures in a market economy. During the golden years, financial economists came to believe that markets were inherently stable—indeed, that stocks and other assets were priced just right…the central cause of the profession‘s failure was the desire for an allencompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.‘‘18 . To further drive this point home, Krugman notes that the Chief Economist of the IMF, Oliver Blanchard, said in 2008 (when oil prices per barrel were approaching the mid 130‘s) that ‗‘the state of macro is good‘‘ (meaning world wide economics). Obvioulsy Dr. Blanchard thinks petrol prices and economics have no relationship whatsoever19. Little wonder why Lula Da Silva, Brazil`s President, told the United Nation‘s Assembly in September of 2009 that: ‗‘Developed countries—and the multilateral agencies they run— had been unable to foresee the approaching catastrophe, much less prevent it‘‘20 But I would respectufully ask him: ‗‘How could they possibly?‘. If they do not take energy into account on their economic models, how could they have predicted this crisis, let alone prevent it? Interestingly. The Walrasian equilibrium we saw above was built with abstract products, and never tested empirically anywhere.

17

Krugman, Paul, Peddling Prosperity, W.W. Norton & Co., London, 1994, Preface. Krugman, Paul, ‗‘How did Economists get it so wrong??‘‘ New York Times, September 6, 2009 19 Ibid. To be fair and give blame were blame is due, in this long article, Dr. Krugman somehow manages to avoid mentioning the following three words: energy, oil and hydrocarbons. 18

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This is almost the equivalent of the endless discussions in the monasteries in the medieval Holy Roman Empire, where the monks spent centuries translating the scriptures into latin and discussing the existence of wings on guardian angels. Little wonder that a religious realist like Luther left them. We may thank God that the branch of the natural sciences, including geology, opted for a different road in dedicating all its intellectual prowess to solving the practical earthly problems, and it is to its scientists that we owe most of the impressive advances that have been made for the benefit of the world‘s prosperity.21 It is fair to recognise that economics is a philosophical science that is impossible to apply with exact degrees of accuracy, especially now with the changing paradigms that imply having globalization in full swing when we don‘t completely understand it either in abstraction or much less in practical form. But throughout the years, we have developed a set of principles in certain areas that provides a certain light into how things are and may be moving. But it doesn‘t subtract from the fact that these qualitative changes that I mentioned can be applied by economists in alliance with the political will.22 As it happens however, as was well understood by Keynes himself, an economic catastrophe has to occur first before politicians and most influential economists consider other options. Regrettably, an energy- related catastrophe has no other options at hand right now. All that it is left for economists is the paramount and crucial task to try to hold the world long enough so scientists can develop alternate forms of energy. This is the focus of the next chapter.

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THE PRICE OF OIL Whomever pretends to find ideal models excent from any conflict is because this person has no experience in life or because he never learned to assimilated it Ali Rodriguez, former Secretary General of OPEC. Predicting the price of oil has been known to be very frustraiting and reputation bashing for all energy economists who have attempted it; and for good reason, to the point that many have ceased to try. I will not attempt to do it here, but I will provide the reader to a peek at my own personal list of the factors that influence the tendency and direction ot its movement. There are 24 factors in total, 12 which fall on the supply side and 12 which fall on the demand side. Aside from the first of each column, which I regard to be the most important, the rest are there in no particular order because its relative importance changes with time. The plus or

20

President Lula Da Silva‘s speech, 64tth Session of the General Assembly of the United Nations, September 23, 2009. 21 This is not to imply that economists haven‘t. Just that the list is not as long as it should be. If we had to make one for the twentieth century alone, certainly the names I have mentioned here would qualify, including foremost Keynes and Friedman. But here is yet another difference between scientists and economists: For scientists the exception doubts the rule, for economists it confirms it. 22 Prof. Krugman had an anecdote in his book describing an Indian professor who would jokingly threaten his wicked economics students into reincarnating them as sociologists instead of engineers. The message was that the social sciences are much harder than the physical sciences because the former involves human creatures whose behavior cannot be accurately predicted with mathematics, as electrons are. Both Krugman and his Indian colleague are right. However, the science of statistics has helped economists (and geologists) map out ranges of behavior which have proven, with limitations, very useful in our analysis.

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minus signs that is reported to the right of each item indicate the influence with increasing (+) or decreasing (-) the oil price. These are:

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Supply Factors 1) PEAK OIL+ 2) REPLACEMENT COSTS, INCLUDING PROFITABILITY, OF HIGH RISK FIELDS (ULTRA DEEP REGIONS/HIGH VISCOSITY BITUMEN).+ 3) ENHANCED OIL RECOVERY TECHNOLOGY4) OPEC SPARE CAPACITY5) NEW OIL DISCOVERIES & DEVELOPMENT6) EROEI IN ALTERNATIVE SOURCE DEVELOPMENT7) RESOURCE ACCESS BY IOC‘S8) INVENTORIES+ 9) POLITICAL TURMOIL+ 10) RESOURCE NATIONALISM+ 11) CONTANGO EFFECT (ESPECULATION)+ 12) REFINERY GAINSDemand Factors 1) WORLD ECONOMIC GROWTH (OECD AND EXTRA-POPULOUS NATIONS)+ 2) TIGHT MONETARY POLICY3) VALUE OF US DOLLAR4) WORLD POPULATION INCREASE+ 5) ENVIROMENTAL CONCERNS+ 6) S&P 500+ 7) END USE EFFICIENCY8) PRICE & INCOME ELASTICITIES9) NATURAL CATASTROPHES+ 10) MATERIALISTIC CONSPICUOUS CONSUMPTION HABITS+ 11) EXPANSIONARY FISCAL POLICY+ 12) ECONOMIC INTEGRATION+ As I write these lines it is my belief that the international oil price lies within a band of $95-$100 in the upper end, which is governed by the demand factor, and $70-$75 in the lower end, determined by the supply factor. Because oil is priced at the margin of the most costly barrel that the economy needs, if the price of oil falls beneath that range for a considerable period that barrel will not be produced, investment will fall and the price will subsequently rise. Conversely, if the price of oil goes beyond the upper tier dictated by demand, then people will stop buying it and another recession will quickly follow. I know that the worlds tolerance of pain in this regard has been notably higher, at prices nearing $150 the barrel, but back in 2008 the economy was a lot stronger; now, I regretfully believe, the world will be stretched to tolerate prices above $100 for long. This however is not a stable equilibrium price, because peak oil problems will cause supply concerns eventually driving the lower band upwards until it meets the upper band, and, if no international macroeconomic policy is put in place, then both bands will keep driving upwards until they cause another catastrophic recession and a subsequent drop in oil demand and investment.

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Carlos A. Rossi If alternative sources are found, if non conventional oil sources are timely developed, and if the ultra deep pre salt fields live up to their most optimistic potential, the story will be different. But we need a safety plan and economists are the ones that need to provide it. Thus the objective of this book.

BIBLIOGRAPHY

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British Petroleum, Web site. Cleveland, Cutler. ―Biophysical Economics: From Physiocracy to Ecological Economics and Industrial Ecology,‖ Center for Energy and Environmental Studies, Boston, University 1999 The Economist, June 1999 Greenspan, Alan. Oil Interviews, with the National Italian American Foundation, Washington D.C., October 15, 2004. Hall, C., Linderberger, D., Kummel, R., Kroeger, T., Eichhorn W. ―The Need to Reintegrate the Natural Sciences with Economics,‖ BioScience, August 2001 Krugman, Paul. Peddling Prosperity, W.W. Norton & Co., London, 1994 OPEC Web site Samuelson, Paul and Nordhaus, W. Economics, McGraw-Hill

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Chapter 6

AN OIL PLAN World energy demand expands by 45% between now and 2030—an average rate of increase of 1.6% per year.…Production reaches 104 MB/D in 2030, requiring 64 MB/D of gross capacity addition—six times the current capacity of Saudi Arabia—to meet demand growth and counter decline.…The production weighted average decline rate worldwide is projected to rise from 6.7% in 2007 to 8.6% in 2030 as production shifts to smaller fields, which tend to decline quicker.…The world’s energy system is at a crossroads. Current global trends in energy supply and consumption are patently unsustainable….environmentally, economically, socially.

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—International Energy Agency, World Energy Outlook, November 2008

The sword of Damocles that Marion King Hubbert hung over us more than 50 years ago will fall one day. The precise date on which this will occur no one knows exactly, and only a selected few—possibly all in the Middle East or some big national oil companies—can predict it with any gradient of certainty because they are the only ones who know for sure how much recoverable reserves they have. As said previously, there are those who think that the crude produced from existing conventional fields are already past their peak, and that is the main reason for the U.S.-led world economic recession that began in December 2007, collapsing its (extremely) overexposed financial system. The geologists at ASPO had been warning of this perplexing certainty for years, although I doubt seriously that they were aware of the extent of this derivative overexposure that mantled not only the investment bankers but some commercial banks and industrial institutions as well. Nevertheless, much to our collective regret, as the good scientists of ASPO have also reminded us for years, it is an incontrovertible fact that conventional oil is a finite resource and will some day be depleted just enough to make incremental production impossible, as will gas and its distant cousin, coal (if that one doesn‘t deplete humanity first). One way or another, future generations, maybe as soon as ours, will have to live without increasing amounts of petroleum and without all of the benefits and liberties it has brought us for so long. As we have seen, in the most realistic terms, we cannot count on the luck of greater discoveries of conventional crude oil. Some are indeed occurring, as is the case with the ultra deep offshore elephantine discoveries of the Atlantic and the Gulf of Mexico (GOM), but these reserves are not yet proven and will take at least a decade to be commercially produced; by then, expected demand for it may have increased to a larger degree than their expected output. But the reserves are there, and some measure of them must be included in any production simulation, as we will do in this chapter.

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These Brazilian reserves, together with the ones in the Orinoco Oil Belt, the Canadian tar sands, the American oil shale, the ones that we can feasibly extract through EOR methods, as well as the liquids we can engineer from natural gas will, in optimal circumstances, have to do to bridge ourselves towards the next generation of primary energy resources. But it cannot be a business-as-usual scenario; we need economists to devise an economic growth plan that is worldwide, slow enough and painless enough to see these through. (Some pain is inevitable; we just have to figure out how to share it as equitably as possible.) On the side of efficiency, all efforts towards building affordable energy-efficient appliances, especially automobiles and industrial generators, must be made. As it has been said, this is unprecedented in the history of mankind. But, for the United States and FDR, so was building, financing, mobilizing and replacing the hugely expensive armies of World War II on two ocean fronts on the heels of the Great Depression. The scale of this problem is probably bigger and as urgent, but the lesson is there. No effort or human ingenuity can be spared. In this chapter, we do not pretend to reach a scientific conclusion on the specific date of peak oil in the world. This is impossible to do without knowing the amount of recoverable reserves out there or the exact level of technology to be developed to maximize the recovery factor. And that is only speaking about the below-ground problems. Other problems lie above the surface (resource nationalism and wars), in the waters and the sky (environment), and they, too, must be dealt with, but not in this book. Having said this, as economists we cannot resist the temptation to realize long-term projections through simulation exercises with the information that we do have about the proven reserves of the world, the state of the extracting technology, and the reserves that are not yet proven but that we know have an excellent chance of being positively certified. By combining this information with several conservative economic growth scenarios (the most relevant demand factor and the only one considered here), we can map out a time range for peak oil, and thus alert our scientist friends on the supply side of the equation about how much time they can count on. But what we cannot do, as responsible economists, is to count on things that are not here yet, that haven‘t been proven to work on a large-scale setting, or that are either too dirty or expensive to use.1

WHO’S THE BOSS? For the fulfillment of victory one has to pass through the corridor of sacrifices.…God gives victory to perseverance.… If nature opposes us, we will fight it and will make it obey us. —Simón Bolívar

Right from the start, one very important paradigm change must be affirmed and accepted. That is, until we solve the energy problem, it is the man and woman of the physical sciences who will inform us, the economists, on the state of affairs so we can react by either tightening 1

I always tell my students of the terrible experience my family had with my late cousin, Miguel. As beloved as he was by all who met him, his flaw was that he could never stop smoking cigarettes. When scolded by his relatives, including me, he always would say that ―technology is just around the corner in inventing a cure for lung cancer, and sooner than later it will be reduced to a common cold.‖

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the reins of demand (economic growth) or, in the best of cases, loosening them. In other words, it is they who are in the driver‘s seat now because it is the supply of oil that will dictate its demand, not the other way around as it has always been. Hence, it will also dictate world economic growth. This is a very important set of rules that must be accepted, even if it is humbling for some of us. As we noted in the last chapter, it is the providers of the physical capital that should set the cue for the monetary capital. To this point, the interrelationship of these two types of capital, we will return in our conclusions; even if we have to rewrite one of the oldest and most accepted economic equations of all time. Having affirmed this, the purpose of this chapter is to realize simulation exercises upon the estate of the petroleum reserves of the world that can conceivably be commercialized in a realistic/optimistic setting in order to recommend world economic growth scenarios that will minimize expansion sacrifices while at the same time facilitate the transition towards nonfossil, affordable and environmentally renewable sources of energy that can be massively marketed to accommodate the increasing world population. This is, to be sure, a large task, but one that must be attempted. At the very least, it is my hope that it will stimulate further research among economists on the energy field (instead of taking it for granted) as well as to bring economists together with the energy scientists of the world. The intellectual synergies of these two very different mindsets are unlimited. The methodology of this study will be explained fully, but the whole of the various mathematical simulations will not be exposed here for obvious space limitations, as they cover several interrelated spread sheets of crude oil reserves, production and economic scenarios. In order to keep the data as honest and manageable as possible, the sources of information have been kept to a minimum. These come from the Statistical Review of World Energy from British Petroleum, the Annual Energy Outlook of the Energy Information Administration of the U.S. Department of Energy, the World Energy Outlook of the International Energy Agency and the World Oil Outlook from OPEC.

THE BALANCE: DEMAND The era of easy oil is over.…The world has taken more conscience of the importance of non-conventional crude, and 90% of the known reserves of extra heavy crude oil are in Venezuela. —Ali Moshiry, Chevron Corporation

As we can see from this graph, which comes from the World Energy Outlook 2008 of the International Energy Agency, the world‘s currently-producing fields are either at their peak or past it. In order to keep the total available supply curve moving upwards, its replacements must come from nonconventional sources such as heavy and extra-heavy crude oil, natural gas liquids, and more oil of the conventional type that has yet to be certified, extracted through enhanced technology methods, or found. At the end, as this graph illustrates, by 2030 the world will be consuming 104 MBD, although OPEC‘s World Oil Outlook 2008 still has this figure at 113 MBD in 2030, the difference imbedded into their own regression analysis between world economic growth and oil demand, as well as their particular projections of what that economic growth is likely to be (ceteris paribus).

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Source: International Energy Agency, WEO, November 2008.

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Graph 1. Demand: World Oil Production by Source Reference Scenario.

Keep in mind that in other older scenarios by this institution and others, including OPEC, this figure was as high as 120 MBD only one year ago. The difference is that this new specific scenario was published after the financial meltdown in the United States that forced everyone to revise downwards their projected demand schedules. The older projections were almost all based on an average of 3% yearly world economic growth; and these were released after the IMF had revised its 2009 world economic growth to 2.2% and the World Bank to 1%. Also, in the scenario by the IEA, it is taken into consideration that mature fields are depleting faster than originally thought, as quoted in the opening page of this chapter. So this reference scenario is indeed realistic, albeit far gloomier than we are used to. Measured in BTU terms, which is the standard measuring yard for all primary energy emissions, the National Petroleum Council NPC peged in 2005 world demand at 446 quadrillion BTU 40 % of which was supplied by oil; 24% by gas; 24% by coal and 9% by renewables. In 2030, according to the expert Nansen Saleri, former Saudi Aramco Reservoir Management Chief and currently CEO of Quatum Reservoir Impact LLC in Houston, said that liquids production could be in the range of 75 and 90 MBD provided global recovery factors increases to 50-60% and even 80% from the current 35% average, and efficiency in the harnessing and end use of energy increases to 20-30%, since according to him only 13% of reservoir barrels are converted to usable oil2. Both assumptions seem quite on the optimistic side since most of the increase in production will have to come from non conventional oil, extra heavy, tar sands and oil shales, which are much more difficult to handle. 2

See The Oil & Gas Journal, October 29th, 2009

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Source: BP and author‘s calculations.

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Graph 2. Oil Demand Scenarios Based on Distinct Trends of World Economic Growth (thousands of barrels per day).

The graph above is the first result from the simulation model. On the left-hand side is the history of world oil demand and on the right-hand side of the black vertical line are the different oil demand growth scenarios according to world economic growth assumptions. The lowest economic growth scenario will yield no growth in oil demand, even though the world would still be consuming, and thus depleting, about 30 billion barrels per year from the total oil reserves. Conceivably negative demand is possible, but it is not modeled here because it would be unsustainable for the world economy. According to the model, a 3% growth in world economic growth would yield a 1.58% growth in total world oil demand. Note that this simulation have been modeled through 2030, which is the longest possible foreseeable future one can make today without losing sense of developments. All of the rest of the simulation will also be modeled up to the year of 2030.

SUPPLY Global oil production is approaching a peak, followed by a permanent decline. It will radically change the way our societies are run: our transport systems, how we produce food, where we work and live. …There are a great many things that councils must do, and policies that need to be changed, if we are to have any chance of mitigating the economic effects of peak oil. On the plus side, some of these initiatives already exist (recycling, road pricing, etc.) but these efforts need to be significantly expanded, and there remain entire areas of policy that have yet to be addressed... —The Oil Depletion Analysis Center

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BP: Statistical Review of World Energy 2008. OPEC: Annual Statistical Bulletin 200.7

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Graph 3. Supply: Total World Proven Oil Reserves; (millions of barrels).

The supply side is demonstrated by this graph for proven conventional reserves. We see that the two sources, the private oil company, British Petroleum, and the multilateral organization, OPEC, are very much similar and in tandem with each other, meaning that we can take either figure for our simulations. Two interesting observations follow: First, the average rate of increase in proven reserves for the total period between 1987 and 1999 was 19.4%, whereas for the period between 2000 and 2007 it was 11.2%. The second is that, in 1987, the proportion of total proven reserves that belong to the OPEC countries was 75.7%, and in 2007 that figure grew to 78%. But the problem we have at hand is not peak reserves but peak production. We saw in Chapter 2, Graph 7, also from BP, that the additions of reserves from 1999 have come from existing fields of the nonconventional nature which were previously ignored because they were considered ―bitumen‖ reserves. Technology and necessity have ―upgraded‖ these to oil reserves and are therefore now included in the total world oil supply equilibrium. So, in the simulation models these reserves count. Five types of total reserves are included. First, the conventional reserves that we know are recoverable because drilling has occurred and have been credibly certified with standard methods (exception: as has been noted, in the Middle East there is no international certification or auditing). Then come the nonconventional reserves, which we know with a reasonable degree of certitude that a significant number of them can be exploited with proven technology, which in all cases is being improved as we speak. These are, in order of importance, the reserves in the Orinoco Belt in Venezuela, the tar sands in the providence of Alberta in Canada, the oil shale reserves in the United States and the ultra-deep reserves off the Brazilian Atlantic coast. Absent from the simulation exercise, for being considered too speculative and uncertain or risky at this time, are the following:

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The Caspian Sea (new projects) The ANWR reserves The U.S. offshore reserves (including undiscovered projects in the Gulf of Mexico) the probable reserves in the Gulf of Mexico (Mexico side) the probable reserves in Russia (Siberia) and offshore the proven reserves that theoretically could be increased through enhanced oil recovery methods the probable reserves in the Gulf Guinea in Africa the undiscovered reserves that lie in the desert surrounding the borders of Iran and Iraq the alternative sources of energy that were not considered in this analysis

In all probable circumstances, all of these reserves exist and this is why they are labeled ―probable reserves.‖ But they cannot be included in the simulations because they have not been developed or, in some cases, even found, or which extraction technology has yet to be proven on a large scale. These are mostly included in the light blue shaded area in Graph 1. Before we delve further into the results of the simulation exercises, a cautionary word about oil depletion is in order. As mentioned in Chapter 2, oil depletion is what keeps awake everyone in the oil industry. Most oil depletion has to do with extraction and production, but not all of it. Other factors play a role, and this varies greatly from basin to basin. Some of these factors are field aging, loss of natural pressure, over exploitation, size, water content, human error, rock porosity and cost considerations. Sometimes enhanced oil recovery methods can lengthen the time before which these factors kick in; other times, it cannot do so without going through unacceptable economic and/or environmental sacrifices. But nothing can never postpone depletion indefinitely. In the simulation, these factors are considered to play a significant role, increasing with time but, more importantly, with the level of extraction. The rest of the depletion is assumed to be all from production. Table 1. Assumed 2030 Production Targets and Increased Annual Production Trends in Nonconventional Proven Crude Oil Resources Source Alberta (Canada) Orinoco (Venezuela) GOM/Oil shale (U.S.) Brazil (deep water) Natural gas liquids

Average Annual % Rate of Increase in Production 6.5% 10% 20% 20% 3%

Estimated Level of Production in 2030 (barrels per day) 3,996,606 6,992,496 931,817 770,351 21,077,137 (BOE)

Other nonconventional reserves were not included for lack of information, or because of legal or other ―above-ground‖ problems. Table 1 shows the estimated production targets of the nonconventional sources we can reasonably estimate and use to complement the 1.2 trillion barrels of conventional reserves (BP figures).

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THE RECOVERY FACTOR

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Nothing ages faster than the future. —The Economist

Note that here we are not adding the Oil in Place (OIP) of these reserves, which have been estimated to be very large but not feasibly recoverable within the time span of the model. What we are adding is the reasonable recoverable production in accumulated from what can be extracted with known means established factors of recovery. For instance, in the case of the Orinoco Belt, the actual recovery factor, as we saw in the Appendix on Venezuela, is on average 8.5% now in a cold production scheme. PDVSA, after a long period of study with its R&D department (INTEVEP) and in joint effort with the established companies that have been processing crude oil in that region, most notably the French giant Total, have estimated that this recovery factor can be increased to an average of 20% of synthetic oil, after the planned upgraders and the necessary investment are in place, including specialized deep conversion refineries. When all of this is available, including huge pools of water, hot production can begin aided by steam and gas and as needed nitrogen; and when the geology of the fields are better known (which is why PDVSA has spent three years certifying the fields of the entire Orinoco Belt region) and techniques like electrical submergible and multifaceted pumps, and thermo recovery (SAGD, Thai Capri, in site combustion, etc.) are in place, then the recovery factor can be increased. Because of reasons discussed above, doing this in heavy and extra heavy crude is a lot more difficult and expensive than in the light crude variety. This is specially true with the tar sands bitumen in the Alberta region and the Oil Shale formation in the US mid west, where economies of scale in large size production is either minimal, non existent or runs in the reverse, not least because of added energy imput requirements and environmental degradation. Note the low hanging fruit analogy expressed earlier. So the figure cited for PDVSA includes a 20% recovery factor from its certified reserves in the Orinoco Belt. The other sources are estimations of the same nature; they only include accumulated production from what can reasonably be expected from them given their particular basin geology and technology. It is possible to imagine that technology will increase the recovery factors of all these sources to the average levels that the conventional reserves enjoy now (about 31%), and even beyond, like some of the North Sea wells; but, unfortunately, this is only imagination now.3 The graph above illustrates the supply side of the equation, before we chip it away with production schedules (observe the slight decline of the conventional oil due to geological factors not related to production; whereas the nonconventional oil increases because the largest of them are too young to be subjected to depletion factors). It assumes no more additions in conventional oil, and that the only increase in the total stock of the supply side will come from nonconventional sources, as scheduled in Table 1 above. According to this, there will be about 1.4 trillion barrels of oil available from the 1.2 trillion barrels we had at the end of 2007 as reported by BP. This is the total amount of oil that can be produced and available to the planet by 2030. 3

INTEVEP managers informally told me that it is possible that the recovery factor in the Orinoco Belt can be increased to 30% in the future. But this might be a bit too optimistic for our analysis here. PDVSA is telling the companies involved in the Orinoco Belt to plan for a 20% recovery factor.

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Source: BP and author‘s calculations. Graph 4. Conventional Oil Reserves and Protected Accumulated Nonconventional Oil Production.

THE PLAN Learn from the people, plan with the people, begin with what they have, build on what they know.

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—Lao Tzu (Chinese sage)

Having the demand and supply schedules in place, we are ready to combine the simulation models in a plan form. The plan is to aggressively increase production from known nonconventional sources, within reasonable limits, in order to complement the decaying existing fields that we know are declining between 4.5 and 6.7% annually, a rate that is likely to increase for the reasons we discussed. Since the objective is to gauge the range of time we need to buy the energy scientific community to develop the alternative non-fossil energy fuels, the model must also include the assumed demand and supply scenarios from what we know and can reasonably assume. The results from the simulation model that combines the effect of world economic growth to project oil demand growth against the known available supply of conventional oil resources complemented with the aforementioned realistically-assumed production from the nonconventional resources is summarized in Graph 5. The IEA depletion rates of the reserves are also incorporated, increasing with time as well as with levels of production. We can see from these results that there are indeed wide differences in oil reserve depletion with the levels of oil production. Although in all cases the peak oil paradigm applies, the more oil we consume the faster the depletion accelerates and the less oil is there. In no case is production increasing, because we only ran the reserves that we know are there to be exploited or are reasonably sure will be.

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Author‘s calculations. Graph 5. Result from Simulation: Crude Oil Reserve Depletion from Different World Economic GrowthInduced Oil Production Scenarios.

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In all cases, especially in the high growth scenario, it is proven that there is indeed a case for demand reduction and accelerated supply increase, and both can only be accomplished with less economic growth. At the very least, these results are consistent with the reference scenario by the International Energy Agency, not including their assessment of ―crude oil yet to be developed or found.‖ (For an economist, that is hard to bank on.)

ALTERNATIVE SCENARIOS We may brave human nature, but we cannot resist natural ones. —Jules Verne

It was mentioned before that most energy think tanks have shied away from modeling beyond 2030. I did, too, in my model here and perhaps for the same reasons, the foreseeable future beyond 2030 is either too blurry to speculate with hard numbers at the moment (even if they are expressed in ranges) or, a bit too chilling to contemplate with all information at hand. There is one organization that does look far ahead, even in the twenty-first century, and that is no other than the Energy Information Administration of the U.S. Department of Energy. This is the result from their model. Long known as one of the most respectable energy think tanks in their short-term analysis (All its publications, but specially its monthly Short-Term Energy Outlook are professionally regarded as can‘t-miss in the industry), the EIA is a very capable organization with enough experts and computer power to provide informed scenarios.

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Note: U.S. volumes were added to the USDS foreign volumes to obtain world totals.

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Graph 6. World Conventional Oil Production Scenarios.

They, of course, are the official keepers of the U.S. oil reserves statistics in all of its categories, but most rely on outside sources for international information on reserves and, as the graph indicates, their source is the U.S. Geological Survey which is long known as one of the most optimistic energy think tanks worldwide. USGS not only keeps track of proven reserves, but also of probable and possible reserves of the world that can be expected at some point to be produced—unlike BP or OPEC which only publish proven reserves. Now the problem with summing all reserves is that probable and possible reserves are highly speculative in nature. (As said before, some people even doubt the proven reserves of some countries.) What the USGS does, as is standard in unpublished internal geostatistical histograms that oil companies create (I did this at PDVSA), is to assign probabilistic figures to these types of reserves (proven are sometimes given a P90, or 90% probability that the reserves are there; probable are given a P50, and possible a P10, but this varies). Proven reserves are the ones that are available after the basin is drilled, often several times, with exploratory wells first. Appraisal wells and advanced wells are done to get information as to the content and geographical extent of the basin. Afterwards, if all goes according to plan, all of these wells become production wells with horizontal and multilateral technology. The other types of reserves are the ones that state that oil might still be out there beyond what can be read from the drillings; and sometimes, as is the case of ANWR in Alaska, for example, speculative figures are given in dispersed ranges even before the drilling occurs through sophisticated multidimensional seismic techniques. But, as the saying goes, it is ―Dr. Drill‖ who always has the last word. In the case of the graph above, which I believe is a necessity because we all need at least some figures to think through in our models for specific recommendations, the USGS has assigned an ultimate recovery rate (URR) of 2.248 trillion barrels in their low scenario (but with a 95% probability) and a very distinct figure of 3.896 trillion in their high scenario (with a 5% probability). The weighted mean is about three trillion barrels. This includes conventional and nonconventional reserves. But that is the total URR that the world has ever had, which we must subtract from what we have consumed so far, which is, as we have said, about one trillion, most of it in this generation. The green line is the most optimistic, but far less probable, outlook, and the blue line is the gloomier, but most probable, scenario. We may use the red line as the mean or reference scenario.

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Depending on the preference scenario that you choose, we can have either a peak oil occurring in the year 2021, or one that occurs as far as one hundred and three years from now. As appealing as that last figure sounds, if you look closely you will notice that this will imply banking all our hopes on a horse that has only a 5% probability of winning, and it must do so with 0% demand growth for all of that time which, of course, the world cannot afford to do without alternatives at hand. A far more realistically appealing outlook is the red line which, like the others, has several peak oil scenarios depending on the oil demand growth of production assumed. The higher the oil demand growth, the sooner it peaks. A 0% oil demand growth, but with a lot lower in reserve than the green line scenario, will have a peak in the year 2075, while with a 3% growth it peaks at about 2030. We see this better in a related graph.

Note: U.S. volumes were added to the USGS foreign volumes to obtain world totals.

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Graph 7. Annual Production Scenarios for the Mean Resource Estimate Showing Sharp and Rounded Peaks.

Here we see two oil peak scenarios depending on the rate of oil demand growth. A 2% oil demand growth will have a peak oil year in either 2030 or 2037, depending on the rate of depletion decline, which, in turn, depends on the usage of appropriate technology that would soften the fall, or that will allow it to collapse. If we assume a business-as-usual composure, and let oil peak at the latter date (with an R/P ration of 10 years), then we should be prepared for the ensuing collapse later on. If, conversely, we assume a well-managed position, oil will still decline and probably even earlier, but the landing will be a bit softer. In either case, the news is not good.

INVESTMENTS If you torture statistics enough, she will confess. —Ronald Coase

A quick word on investments is necessary. In order to bring all of this to the market, and the alternatives, huge investments must be made by the wealthiest institutions of the world, including the governments, and the money must keep on coming and stay unprofitable for a

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very long time. The following quote from the report from the National Petroleum Council, which quotes statistics from the International Energy Agency and other sources, depicts it. The projected increase in energy demand through 2030 will require massive new investments in largescale projects to develop and deliver energy. The International Energy Agency (IEA) World Energy Outlook 2006 estimates that $20 trillion will be required over the next 25 years—$3,000 per person alive today. Over half of this amount is for electricity generation and distribution. Building new, multi-billion dollar oil platforms in water thousands of feet deep, laying pipelines in difficult terrain and across country borders, expanding refineries, constructing vessels and terminals to ship and store liquefied natural gas, building railroads to transport coal and biomass, and stringing new high-voltage transmission lines from remote wind farms—all will require large investments over decades. Higher investments in real terms will be needed to grow production capacity. Future projects are likely to be more complex and remote, resulting in higher costs per unit of energy. A stable and attractive investment climate will 4 be necessary to attract adequate capital for the evolution and expansion of the energy infrastructure.

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To put this number in perspective, the amount cited is about 45% higher than the GDP of the United States. The following graph from the IEA gives an idea of where this figure will be spent.

Source: International Energy Agency, 2006 Graph 8. Energy Investment Destination 2006-2030 Total Estimated Investment: $20 Trillion Dollars.

Observe that most of the money will be spent on electricity generation and that is mostly in the extra populous nations of the underdeveloped world. Also observe that the amount required for oil and gas is over $3 trillion each, or $200 billion annually for all this time, all in places where the oil reserves are known. Third, also note that the total number was initially about $17 trillion in their 2004 report, but it grew to the present projection of $20 trillion due to higher material costs in steel, drills and other inputs in this report. The question that remains to be answered is obvious: Who is footing this bill? In Chapters 2 and 4 we noted that Big Oil has free access to about 7–8% of the world‘s total reserves and limited access to about 12%, while the NOCs have total access to the rest. So this gives a proxy idea as to who is going to make this unprecedented investment outlay. But it comes in well short because neither Big Oil nor the NOCs have anywhere close to the amount needed to cover this. Neither do governments. The answer, in my view, goes back to 4

See the National Petroleum Council draft report, ―Facing Hard Truths about Energy,‖ July 18, 2007, pp. 21–22.

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World War II. None of the nations involved in that war had anywhere near the capital it took to fight it, which implied upgrading World War I technology in military hardware to WWII requirements, plus inventing and mobilizing troops and financing all the armor, ships, submarines, tanks, aircraft carriers and state-of-the-art bomber airplanes that did not even exist in the Great War—all of this on the heels of the Great Depression. The energy crisis demands nothing less. It is a war against Hubbert‘s Peak. To win it, the real enemy to beat is not money—it is time. Two quick points before we finish this chapter: First, observe the comment written by the EIA on the upper right hand corner of Graph 6. It states that the 900 billion barrels of oil will move the peak oil date about a decade from 2037. That is not good news because a decade is not long at all and that amount of recoverable oil is very difficult to find. Second, and related, notice that in all cases, without exception, all the curves in the EIA graph fall drastically after the peak is reached, which leaves no room for flat plateaus in uncoordinated settings. This is because this scenario does not imply that the world is actually capable of sitting together at the United Nations to work out a coordinated strategy of output ceilings based on coordinated reduced economic growth and aggressive investment in all energy alternatives, starting with the nonconventional oil and, in parallel, with the non-fossil and renewable. The purpose of the next chapter is to provide some analytical tools for international negotiations to coordinate output ceilings in game theory framework. The purpose of the conclusions is to provide the macroeconomic environment so the microeconomic productive agents of the world can have the confidence they need to see this through.

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Chapter 7

STRATEGY AND CONCLUSIONS The absence of a high degree of economic collaboration among the leading nations will…inevitably result in economic warfare that will be but the prelude and instigator of military warfare on an even vaster scale.

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—Harry Dexter White

This book is written for the general public, especially economists. We need economists to help control the demand for oil so the good scientists of the world can have time to gradually phase it out with feasible alternatives. This has been the chief message of this book. In this conclusion, I will attempt to provide a working strategy for how this can be done. The first two chapters were written as informative episodes to bring the public and economists to the same page as scientists regarding the all-important liquid energy in our daily lives and our complete dependence on it, and its imminent depletion. Chapter 3 provides us with the immense task ahead of scientists in converting all alternative dreams into reality. Chapter 4 and the Appendix on Venezuela give us a ray of hope, not of permanent bliss but rather that there is a medium-sized bridge within the fossil framework that we can use to get us to the non-fossil and renewable world. Economists, or the demand side of the equation, arrived in Chapter 5, which was intended to expose some of the gaps in their methodology regarding why they have ignored energy—and all other less important biophysical aspects of production—in their framework. In the simulation exercises done and exposed in the energy equilibrium balance of Chapter 6, which interrelated the supply-science side with the demand-economics side, we learned the range of possible scenarios predicting when peak oil may happen, which is what gives economists an idea of the level and time length of restraint we have to put on world economic growth. What we need to do in these conclusions is to devise a concrete strategy demand restraint through economic growth slowdown, and to do this properly we have to go into the framework of the economist‘s mind, specifically the monetary persuasion, because this task cannot possibly be done in the traditional invisible hand framework. I have chosen to cite two quotes from two very distinguished economic professors. The first, from Harvard economic historian David Landes, who in his seminal book The Wealth and Poverty of Nations made the fundamental observation in his recount of the medieval economic history of Europe:

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‗‘ This prolonged moderation that was concretized throughout several centuries (10001500 AD)was supported in an economic revolution, a transformation of the whole production process, garnishing and expenditure, such as the world had not experienced since the so called Neolithic revolution (8000-3000BC), which had taken thousands of years for concretion. The central issue had been the invention of agriculture and domestication of livestock; and both challenges increased the disposable energy for work considerably (all economic revolutions— industrial—bestow in essence an increase in the supply of energy, since this feeds and modifies all aspects of the activities of human beings)…Europe, more than any other place, was a civilization supported by energy.1‘‘ The second quote from a German born economist who, unlike most of his colleagues, did have some hands on energy experience in his life time; E.F. Shumacher: There is no substitute for energy.…The whole edifice of modern life is built upon it. Although energy can be bought and sold like any other commodity, it is not ―just another commodity,‖ but the pre-condition of all commodities, a basic factor equally with air, water, and earth….The twilight of the fuel God will be upon us in 2 the not very distant future.

BRETTON WOODS DÉJÀ VU? In some negotiations don‘t try to win so much, don‘t be too smart… Winning many points is not as important as building a partnership.

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—Shimon Peres

In July 1944, barely one month after the Allied invasion on the beaches of Normandy on D-Day, with Hitler still alive and WWII raging on two ocean fronts, 730 representatives from 44 Allied nations huddled in the small New England town of Bretton Woods, New Hampshire, U.S., with the objective of designing a monetary and financial plan at the world scale through which the sister multilateral institutions—the International Monetary Fund (IMF), and the International Bank for Reconstruction and Development (the World Bank), as well and the seeds of the General Agreement of Tariffs and Trade (GATT) now known as the World Trade Organization (WTO)—were all born. This historical unprecedented gathering also occurred approximately fifteen months prior to the official creation of the United Nations (the fulfillment of one of FDR‘s greatest dreams). The purpose of this meeting was none other than to construct the international economic framework that would install investor confidence to propel world prosperity and rising living standards under democracy and the market system and thereby impede another Great Depression and another fascist movement, all forces that contributed to unleash World War II. Also, in no small measure, was their overriding concern to create the economic conditions that would inhibit another Bolshevik Revolution. The principal protagonists of this historical event were, surely, the two most eminent economists of their generation, the Englishman John Maynard Keynes (1883–1946) and the

1 2

Landes, David, The Wealth and Poverty of Nations; New York: W.W. Norton, 1998., pp 70-71, 78 Cited in Yergin, Daniel, The Prize (1992), p. 559.

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American Harry Dexter White (1892–1948), a senior official of the U.S. Treasury Department and a premier expert in monetary policy.3 They succeeded beyond anyone‘s wildest expectations. It was the plan of these two masterminds that cemented the essence and paved the road to unprecedented industrial prosperity, technological breakthroughs and growth in the post-war era. The United States, the only country to emerge richer from WWII than it was when it started, took the role of creditor; England became a debtor. The centerpiece of the plan took advantage of the enormous gold reserves the U.S. had accumulated (more than two-thirds of the world‘s total—roughly the same percentage OPEC nations have in conventional oil reserves today), so the U.S. agreed to peg the U.S. dollar to $35 per ounce of gold, allowing its central bank, the Federal Reserve, to use this price to trade its reserves with other central banks which would in turn peg their respective currencies to the dollar at different assigned parity values plus/minus 1% variability. In essence, what was established was an indirect gold standard, except that this time the almighty dollar was effectively, if not officially, the world currency because it was the only one backed by gold; the dollar became the standard reserve currency by which all other currencies were pegged and by which most international transactions were denominated. Between 1950 and 1973, the average annual growth in world GDP was 2.9%, inflation was kept to negligible levels and international commerce increased by a factor of six, leading to an equally amazing growth in international financial transactions and middle-class prosperity. Economic historians commonly refer to this period as a golden age. Later on, at the beginning of the 1970s, Bretton Woods was overcome by its own success, because of the economic growth it shored up along with the international transactions that followed (and spurred), international trade overtook the physical quantities of gold that were available in the world, forcing the U.S. into deficits in its balance of payments to the point that these deficits became the very source of liquidly that fueled world economic growth (at the expense of long-run erosion in the confidence of the U.S. dollar). When the U.S. had accumulated more than $55 billion in external deficit (the military expenditure on Vietnam and other social expenditures had a lot to do with it), this situation became unbearable and, on August 15, 1971, U.S. President Richard Nixon officially unplugged the U.S. dollar from its official convertibility into gold, thereby eradicating the Bretton Woods system for good. Nevertheless, there is very little doubt that it had accomplished its objective, and its disappearance into the history books is testimony to its success, which was doubtless much greater than any one of its designers ever dreamed of.4 3

Unfortunately, in his later years, Harry Dexter White fell victim to communist spy accusations during the infamous McCarthy hearings, which ultimately stressed his already feeble heart condition, causing several heart attacks and his death. The irony is impossible to miss. The institutions he helped build first-hand, along with the Bretton Woods monetary/exchange rate system he architected and helped design, were major contributions towards saving the capitalist system from the temptations of the Cold War era. With respect to Lord Keynes, it just suffices to say that modern economics is taught before and after Keynes in all the mayor universities. Leading to the Bretton Woods conference, Keynes tirelessly emphasized ―the importance of rulesbased regimes to stabilize business expectations.‖ 4 Bretton Woods was also victim of internal contradictions, most notably the fact that its members refused to surrender, for understandable sovereign reasons, the autonomy of their national economic policies which often failed to concord with the exchange rigidity of their currencies. During its existence, there were several financial crises, the majority of which were resolved without any trouble, but as time went on these became ever more difficult. Its disappearance in 1971 was also fortuitous because the rigid pegged currency system would hardly have survived the oil shocks that began in 1973.

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The Bretton Woods system was the first conscious effort of a fully-negotiated monetary order intended to govern monetary relations among independent nation-states. It was neither perfect nor flawless; it contained the seeds of its own destruction because, in the long run, it became sort of a straight jacket that restricted commerce and growth. But its successes were much greater that its failings, and its disappearance was but proof of its triumph (analogous to a hospital that releases its patients after successful operations). The success of the Bretton Woods system was accomplished with flying colors, but it was an extremely hard test that the economists of that generation necessarily had to pass. The coordinated monetary/exchange and fiscal policy initiatives were designed to spur economic growth via the generation of business confidence of its productive agents that only free enterprise and democracy could provide. This confidence build-up unleashed unprecedented dynamic productivity of all factors of production and living standards for the majority, albeit with inequality in the distribution of its income among the participant nations. This inequality, however, had very little to do with Bretton Woods or with the market system in general, and more to do with the social stratifications of the internal history of the countries and, also, with its disastrous economic policies that some of these nations (as in Latin America) applied after the war that only reinforced these stratifications.5 In the case that now confronts us, it can be argued that, in many ways, we face a harder task than the ones tackled by our Bretton Woods ancestors for at least four reasons: 1

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2

3 4

5

Fossil energy, like oxygen, was assumed infinite in nature, and because of this nonscarcity character it was not deemed important enough to be considered a factor of production. The globalization spin-off from capitalism has awakened the previously dormant dreams and prosperity aspirations of the extra-populous states, which currently use but a fraction of the energy employed by their Western trading partners. In all cases, for Western OECD members, developing nations, the former USSR, and OPEC ―providers,‖ globalization has strengthen the market addiction for oil and its byproducts and, therefore, it has unmasked the world‘s vulnerability to it. Alternative sources of energy, for all of the reasons explained in Chapter 3, are not ready to substitute oil in any meaningful manner for a long period of time. Perhaps the most daunting difference comes from the overall objective of the plan it self. Whereas in Bretton Woods economists were concerned with coming up with a plan to install confidence in the productive agents of a market society to spur growth and wide-ranging prosperity, in this case we are still trying to install confidence in the productive agents but this time to slow economic growth and minimize its adverse impact on prosperity also for a temporary time frame until the optimal combination of alternative energy sources are in place to gradually substitute oil and its by-products in massive, affordable, renewable, safe and environmentally-friendly manners.

By ―disastrous policy,‖ I am referring to the import substitution industrialization policy. See my book, Caida y Auge de America Latina (Caracas, Venezuela, Panapo, 2000) for a full account of these failed policies in Latin America compared to the much successful East Asian development policies of the post-WWII era.

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The story of Bretton Woods and its happy ending is but a preamble to the plan I am conceiving which is another ―conscious effort of a fully-negotiated monetary order intended to govern monetary relations among independent nation-states,‖ but with totally different objectives, goals and means, which can be summed up by the following three phrases: 1

2 3

―We desperately need to buy the physical scientists the time that they need to build the transition bridges towards alternative sources of energy or face unimaginable consequences worldwide; and to do this we must SLOW DOWN world economic growth in a conscious and mutually acceptable coordinated fashion that minimizes worldwide social and economic disruptions.‖ ―Failure is not an option.‖ ―This will be based not on the gold standard, but on the black gold standard or, more precisely put, through the BTU standard (this last crucial idea I will develop through the remainder of this book).‖

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THE MONETARIST REVOLUTION ‘‘The elemental truth is that the Great Depression was caused by bad public policy…the monetary authorities of the United States pursued highly deflationary policies‘‘ -----Milton Friedman When the Bretton Woods system collapsed in the early 1970s, it also mortally wounded the traditional Keynesian framework in favor of the monetarist school of thought which, at the time, was headed by Dr. Milton Friedman (1912–2006). The reason was that as the dollar became de-linked from the gold standard, there was no ceiling that would check the emission of that or any other currency, which theoretically could mean runaway inflation. Friedman, who had been a long-time critic of the later years of Bretton Woods, had updated the Fisherian notion of money to the events of his time, recommending first that money should be given the importance it deserves and that government authorities should concentrate on controlling the money supply to quell inflationary pressures, thus paving the way for further growth in future investment in the long run. According to Friedman, there was no greater evil for future progress than today‘s inflation, because that affected everything and acted as a regressive tax on the poor, and as a source of unemployment later on. The first oil shock in 1973 created the phenomenon of stagflation, a simultaneous occurrence of cost-push inflation and unemployment, which sealed the original Keynesian revolution for good. By the time the second oil shock came around at the end of the 1970s, their disappearance was all but complete, although some later renamed themselves neo-Keynesians. This is, of course, not the place to open this can of worms, as the debates between Keynesians and monetarists have filled as many pages in economic journals as needed to sink the Titanic without icebergs. But an introduction to the matter, which is vital to the strategies recommended for this book, is in order. It was said before that Keynes was such a paramount figure in the study of economics that the modern teaching of the subject was taught in most universities as ―before and after‖ Keynes. This is true, but only up to the early 1970s. When Richard Nixon unplugged the life support of the Bretton Woods system and set the dollar adrift into ―In God We Trust‖ land,

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the only way that the money supply could be controlled in a tangible framework was through monetary policy, and that could only be achieved if money itself were correctly diagnosed in the context of the central importance that it deserved. Before Bretton Woods, there was an allout World War II—or war economy—and before that the Great Depression, the devastating experience of huge numbers of worldwide unemployment, deflation, bank failures, farm foreclosures, industrial collapse, trade restraint and social unrest. Fascism and WWII were a direct product of this. The fear of returning to this once Germany and Japan surrendered had every economist back then suffering from insomnia. The extraordinary achievement of Bretton Woods was to cure this by reinstating investment confidence in the productive agents (Keynes was explicit on this goal) because, as I said before, it is the job of macroeconomists to make life easier for microeconomists, for the ladies and gentleman who actually produce things. But Bretton Woods had run its course, and the world has never been better since, recording record productive growth and quantum-leap development indexes up until now, when supply shortages of one of its pre-condition energy sources has become all too real. With no gold standard to fix the price and distribution of currencies and with Keynes fallen from his pedestal, there was one thing left to do: reel in and tame the runaway inflationary horse. But first it had to be caught, and the only cowboy with the rope to do it, the only economist savvy enough who had studied monetarism to its fullest and had the adroitness for the job, lived at the University of Chicago. Bretton Woods was abolished in 1971; the first oil shock occurred in 1973; Milton Friedman was awarded the Nobel Price in 1976; the Iranian Revolution, the second oil shock, the election of Paul Volcker for the U.S. FED and of Margaret Thatcher as prime minister in England all occurred in 1979; Ronald Reagan was elected president of the United States in 1980 and, after two hard years of growing pains, monetarism was in full swing in 1982.

THE EQUATION OF EXCHANGE Everything reminds Milton Friedman of the money supply. Well everything reminds me of sex, but I just keep it out of the paper. —Robert Solow, Nobel Laureate in Economics

But Friedman chose a very old rope to do it, a rope whose first threads date as far back as the seventeenth century at least. And if you are a history buff like me, the verbal implications of this rope, which express the meaning and relationship between money and the price of goods, can be traced as far back as when the gold coming from the first voyages to the new world began to disrupt the supply-demand balance equilibrium in sixteenth-century Europe. Monetarism relates to the oldest and most important mathematical identity in the profession of economics, formally known as the equation of exchange. As we will see, Friedman never actually expanded the rope; he just tightened its principal knot. Its most modern statement was expressed as follows in 1885 by Simon Newcome:6

6

J. Locke (1691), J. Law (1705), R. Cantillion (1735), and D. Hume (1752), were the pioneers of the Equation of Exchange, followed later by the classical economists of the likes of D. Ricardo and J.S. Mills. See Bordo

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The Case for Economic Cooperation MV = PT

175 (1)

This equation is regarded as a truism (obviously true), a tautological statement that the quantity of money (M) multiplied by the number of times it was spent in a given time period (the velocity of circulation, V) would necessarily be equal to the average price (P) level multiplied by the total number of transactions (T). So, total expenditure in the economy is viewed by both sides of the equation. M = Money supply, the stock of money available in the economy for transactions. V = Velocity of circulation, the number of times the stock of money changes hands in purchasing transactions over a period of time. P = Price level. T = Transactions, the number of goods transacted over a period of time. The term PT on the right-hand side of the equation is referred to by some as ―nominal income.‖ As Irvin Fisher defined it:

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The equation thus has a money side and a goods side. The money side is the total money paid, and may be considered as the product of the quantity of money multiplied but its rapidity of circulation. The goods side is made up of the products of quantities of goods exchanged multiplied by their respective prices.7 Since it is a tautology by definition, throughout time the equation has remained essentially as is, and economists at different times have simply changed the emphasis of its elements and its short- and long-run implications. In the twentieth century several revisions— not rewritings—of the equation occurred, most all of them before the Great Depression. The first came from a brilliant but ultimately mortified economist, Irvin Fisher (1867–1947), who popularized it in 1911 and 1922 when he began to worry about the effects of nominal and real value of assets as inflation and interest rates fluctuate, as the latter might be affected by the differences in real effective interest rates (after the event) and anticipated interest rates (before the event). Fisher further believed that it was safe to assume that V was an institutional datum, assumed to be constant over the relevant time frame, and aggregate real output was assumed at real employment level in concert with Say‘s law. So, in direct reference to Equation (1), V and T were assumed to be given so that any changes in M would reflect themselves in changes in P. In the 1920s, a group of equally brilliant economists (A.C. Pigou, A. Marshall and J.M. Keynes) from the University of Cambridge in England introduced what was called the ―Cambridge balance approach,‖ which essentially viewed the money supply not just as a medium of exchange continually ―in motion‖ but as an asset in and of itself, as a temporary ―abode of purchasing power‖ forming part of the cash balance at rest. This new approach Michael D., ―Equation of Exchange,‖ in Eatwell, J., Milgate, M., & Newman, P., eds., Money: The New Palgrave, Macmillan Reference Books, United Kingdom, 1989 7 Quoted in Bordo, p. 154. The Completion of the Oil Era : The Economic Impact, Nova Science Publishers, Incorporated, 2009. ProQuest Ebook Central,

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made a fundamental difference in the way economists of later generations perceived the equation of exchange. First, Pigou restated the equation as such: MV = PY

(2)

where Y = national income expressed in constant dollars, P = the implicit price deflator, and V = the income velocity in circulation defined as the number of times a unit of currency turns over in the course of financing a year‘s final activity. Note that this is not a rewriting of the original Equation (1); it is just focusing on the fact that the term T on the right-hand side of the equation could best be labeled Y, to stand for national income. So T = Y (other authors prefer to use the prefix Q, to mean quantity of goods produced). The Cambridge balance approach restates Equation (2) as such: M = kPY

(3)

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where k = 1/V. As it can be seen, there is no arithmetical difference between Equation (3) and Equation (2), except that in this last form (3) money is viewed not just as defining the instruments people use to exchange for things, like currency and checkable deposits, but, in addition to these items, non-checkable deposits and possibly other liquid assets as well. The importance of including explicitly this new definition of money as in Equation (3) is that it encompasses both a theory of money demand and money supplied. As Bordo summarizes it: In this approach the nominal money supply is determined by the monetary standard and the banking system while the nominal quantity of money demanded is proportional to nominal income, with k the factor of proportionality, representing the community‘s desired holding of real cash balances. k in turn is determined by economic variables such as the rate of interest in addition to the factors stressed by the Fisher approach. The 8 price level (value of money) is then determined by the equality of money supply and demand.

Now, in practical terms, some economists like myself prefer to use a less abstract terminology, like GDP, or real gross domestic product, for no other reason except that it is much easier to collect adequate statistics on national products than national income. So a further restatement of this equation can be written as: MV = pGDP

(4)

Where GDP= the real gross domestic product of the country in a given time, usually a year, and p is the same definition as the implicit price deflator above while M and V stand as defined in Equation (3). We will come back to (4) in a moment,

8

Ibid., 153

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BACK TO THE FUTURE FOR MONETARISM (Classical theory represents) the way which we would like our economy to behave. But to assume that it actually does is to assume our difficulties away.…In the long run we are all dead.

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—John Maynard Keynes

The Great Depression threw a bucket of ice water into monetarism. Economists back then found its receipts of little use, some using the analogy of a rope, which is good if you want to pull something but of no use if you want to push. Government fiscal incentives to stimulate aggregate demand as recommended by Keynes took the spotlight because they were seen to work much faster and more effectively than supply-side economics which, as Keynes described, had fallen into a ―liquidity trap‖ wherein monetary policy was rendered useless (that is, when interest rates were so low that banks would not lend, and further cuts are irrelevant). And, in spite of its challenges back then like the famed Pigou effect (where deflation induces consumers to buy again), all were seen to work at a snail‘s pace. So monetarism and the Fisher-popularized equation of exchange lost favor and were ditched as abstract academic insights best belonging to the backwaters of oblivion. The question is this: What could possibly have caused Milton Friedman to revive the equation of exchange? The answer is the bread and butter of monetarism, albeit in an incomplete form as he himself knew and admitted but never amended (as we will do here). For one thing, he had a very different reading of the Great Depression, as did Keynes, a reading which was helped by the never-failing element of hindsight. It happens that Friedman was about three decades younger than Keynes and survived him for a full 60 years. His best works came in the midst and after the Bretton Woods agreement, beginning in the 1950s, while Keynes‘ works were written in the midst of the Great Depression itself. So while Friedman was writing history, i.e., his celebrated A Monetary History of the United States (1963), Keynes was writing as history was being made. And he was petrified of the effects of the Depression on the well-being of mankind, on the outgrowth of fascism/Stalinism in Europe, on the growing leftist inclination in the United States, and on the prospects of another World War.9 In Keynes‘ eyes, liquidity traps were strangling the banks, and to wait for them to pick themselves up from the ashes was eternity in itself. He focused on consumption, or rather why people were not spending enough—under consuming—and advocated what in economists‘ jargon is called autonomous spending, mostly government direct spending on building projects, public works, military buildup, etc. to make up the difference in private spending on factories, even if it is deficit spending. But the results are similar: pump more money into the system, create investment and employment opportunities. In fact, much of the argument between the two sides is based on the speed of policy prescriptions. The Keynesians regarded monetary policy as working too slowly, while Friedman was saying just the 9

But that, far from clouding his deep intellectual insight and cool head analysis, motivated it. This ―petrified‖ mind-set is what the people at ASPO, and myself, find ourselves in when we see the energy data in front of us and link it to the world‘s economic growth. It also motivates our cool-headed analytical ability. It is not inconceivable that someone like Friedman comes up three decades later and, again with the benefit of hindsight, questions our approach and methodology. But that will happen only if our most optimistic scenario flourishes—that the world manages a transition to affordable, massive and ecologically-friendly non-fossilfuel technology—with minimal disruptions to its economy and standard of living. In this blissful event, rest assured that in spite of what may be said of us, we will all be wearing the widest possible smile in our faces, much like Professor Keynes did at the signing of Bretton Woods.

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opposite. When the Austrian school of thought, notably Hayek and Von Misses, who were sympathetic to the views of Friedman and had even predicted the economic collapse in the 1920s, questioned Keynesian economics as being potentially inflationary in the long run, Keynes and his disciples (there were many) simply reminded them of the real emergency facing Keynes at the time and his long-term predictions for the life of mankind. But Friedman thought differently. Back then, he reasoned, the United States and much of the world were using the gold standard, meaning that the whole monetary structure was under the thumb of the amount of gold the country possessed and, by extension, so was the amount of money and credit that banks, business, and individuals were allowed to have. After the stock market crash as the banks collapsed in the fateful years between 1929 and 1933, the money supply, as measured by M2, declined by a full third (and so did the banks in existence) even though the amount of gold inside the vaults had remained the same or even increased. According to Friedman, the FED forgot the rules; they should have kept the monetary supply in consonance with the amount of gold there was, or even increased it further, and the fact that they did just the opposite had a devastating domino effect throughout the rest of the economy, starting and ending with its productive components. Friedman really regarded that the stock market crash of October 1929 and the subsequent Depression that followed were caused by the outrageous behavior of the FED for not having been more aggressive in increasing the supply of money through the transmission mechanisms available to them, like emergency credit to the banks and open market operations. So when Keynes critiqued monetary policy in the Hoover years as ineffective and useless, Friedman, who had the data in front of him decades later, disagreed for only one reason: he said that it is not that monetary policy did not work, but that it wasn‘t allowed to work! According to Friedman, the FED under Hoover had made the catastrophic error of letting the money supply collapse because the banks (more than 9,000 of them, notably the New York Bank of the United States) had also collapsed, causing widespread panic. Otherwise, the Great Depression would have been contained as just another recession. But neither Keynes nor Friedman questioned the equation of exchange per se. In fact, Milton Friedman not only unburied and revered the equation, he tightened the principal knot and left the rest intact. His primary weapon was on the M factor of the left-hand side of Equation (1) or (4), while Keynes, on the other hand, had his eyes set on righ-hand side, specifically, the T of Equation (1) or GDP of Equation (4). But Keynes did regard the equation of exchange as useless for short-term policy prescriptions. On one hand, he regarded T or GDP on the right side, defined in full employment output level, as unreal in the short term (i.e., Say‘s law does not apply), as mentioned in Chapter 5. On the left side, Keynes believed that V, or the velocity element, was not constant but adaptable; that is, when the money supplied increased, the velocity of circulation decreased in the opposite direction and nothing would occur to the price level or production on the other side of the equation. Presumably, this hypothesis was by virtue of people‘s propensity to save a relative consistent portion of their income. According to Friedman, Keynes had made a mistake on this part. After examining the data from the Great Depression with the prism of hindsight, it was revealed that:

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Changes in velocity tend to reinforce the (changes) in the quantity of money instead of offsetting them. When the quantity of money fell one their between 1929 and 1933 in the US, velocity also declined. When the quantity of money increases rapidly in practically every country, velocity also increases rapidly. Velocity, far 10 from offsetting changes in the quantity of money, reinforces them.

However, under normal circumstances, that is taken aside the peaks and valleys that undue expansions and depressions bring, the velocity of money is still considered by some in the Keynesian and Monetarist world as relative constant phenomenon. A big part of the problem is that the velocity element of circulation is a very elusive element to snare. So much so, that it is usually presented as the ex-post quotient that would make the other three elements consistent. That being said, subsequent data on the USA does appear to demonstrate that the income velocity does increase in good times-business cycle expansions-and decreases in business cycle contractions. When business is expanding and V peaks up speed, a monetary stringent policy like interest rate hikes follows, which caps on the speed limit of V; but when business recovers V also recovers rapidly its upward trend, leading to the conclusion that the velocity of circulation does follow a reinforcing mechanism as explained by Friedman.11 By far the biggest difference between the two regarded the definition on the monetary supply (M). While in Keynes M is defined in line with the Cambridge balance approach of which he himself was the most important person, i.e., liquid balances assets and not much else, in Friedman‘s land M has a broader meaning to include everything nailed down and even tangible stuff that is not nailed down. This is one of his sharpest critiques against Keynes and his disciples, their neglect to account for what he labeled ―the wealth effect.‖12 Specifically, Friedman meant present and expected future income—i.e., the individual‘s lifetime earning capacity (in line with his permanent income hypothesis)— plus the whole deal in his/her personal portfolio, like equity stock and bonds, and durable goods he/she can trade that can provide some flow of additional income. Crucially this also differed from Keynes because it specified a direct transmission mechanism between the money stock and physical assets. In fact, Friedman believed that returns on equity and bonds (which he correctly diagnosed to move in tandem) are fundamentally driven in the real market by real factors. Interest rates are not determined in the money market. So, for Friedman, it is productivity and frugality that keep interest rates in check in the long run, while monetary disturbances are only transitory. Clearly, to Friedman, money is not just a means to buy assets, but an asset in and of itself, which means that people not only hold money out of consideration for risk and returns but also to assure them a steady stream of safety and purchasing power. So the M in the equation 10

See Friedman, Milton: ―The Counter Revolution in Monetary Theory.‖ London, Institute of Economic Affairs, Occasional Paper No. 33, 1970. 11 See Ritter, Lawrence. S ―The Role of Money in Keynesian Theory‖ in Mueller, M.G. Readings in Macroeconomics, 2nd ed., Illinois, The Dryden Press, 1971, pp. 161-172. There is a quote by Friedman in this article stating that V is relatively constant with too small variations to matter. But it is a 1952 quote, and he changed his opinion to the self-enforcing mechanism later, as evident in the last footnote. 12 As said before and to be fair, Keynes lived the Great Depression and almost went broke with it, although he managed to recover quickly. Milton Friedman was a young man back then and saw his father lose his textile company in New Jersey due to the crash, forcing him to wait on tables to pay for his education. The people both standing in the bread lines and living in Hoovervilles did not appear to have that much in the way of ―wealth effects‖ with them. This is another aspects wereby Keynesians‘ critiques of Milton Friedman have done the most damage: his apparent insensitivity to the plight of the poor as he calls for fewer taxes and less government spending on social welfare. Friedman defended himself by stating that it is inflation, the result of too much government spending, that hurts the poor the most (in the long run).

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of exchange takes the spotlight front and center. The value of money is money itself and its ability to beat inflation by growing in value by compound interest. Increases in the money stock influence expenditure not only through a portfolio effect but directly through the consumption function. But that had to be backed up in the real market by physical products, rather than just gold or, worse, ―an accountant‘s pen,‖ as he once critiqued in a publicized video. The problem arises, according to Friedman, at the natural level of output, beyond which any increase in expenditure generates an increase in prices and not output. Both views on the importance of money in policy prescriptions were later to be much refined by the disciples of each trend. The Keynesians seemed to be vindicated for a while by the statistical relationships of the Phillips curve (the inverse relationship between unemployment and the rate of money wages, contrived economically by Samuelson and Solow in 1960 by transforming it as the interaction of inflation and unemployment) while the monetarists counteracted with the Lucas critique in the mid 1970s and the subsequent revolution of expectations theory that eventually indicated a Phelps type of a vertical-looking Phillips curve suggesting no tradeoff between inflation and unemployment. Friedman himself never went this far, he believed in a short run Phillips curve, not in the long run) So one conclusion one may gather is that Keynes is correct in the short term while Friedman is right in the long haul. After all, it was Keynesianism—autonomous government spending—that eventually beat the Depression, and not monetarism. A conclusion like that would not be accepted by Friedman, for he argued relentlessly that the Great Depression should never have happened in the first place had the FED been awake in those years; and that the Keynesian receipt had given governments the green light, through a rigorous scientific theory, of overspending oftentimes beyond their means. After all, taking a cue from Keynes himself, wages are sticky downwards, especially public sector wages, meaning that once the spending starts it is hard to stop it altogether.

THE MISSING ELEMENT When the well‘s is dry, we know the worth of the water Benjamin Franklin

But something is critically missing from all of this, isn‘t it? The following paragraphs from the work of the New York-based professors whom we cited in Chapter 5 will give us an insight into what is missing and on what we may do in the next section. Why should the current discipline of economics be a social science at the expense of a biophysical science? There are many who, like us, believe that this choice is worse than arbitrary because it is only cheap energy that has allowed us to essentially ignore over the last century the biophysical world that was the focus of early economists. It is only through energy that is cheap in the market, but not at all otherwise, that we have been able to generate such enormous wealth at so little cost to our individual salaries or time. Many economists argue that since energy costs are equivalent to only some three percent of GDP then they are trivial in importance compared to the rest of the economy and also that we need not be too concerned about future possible energy shortages. But what if this cheap energy declines in abundance, as seems inevitable to many of us? Energy and minerals increased to 12 percent of GDP in the oil-constrained and economically-devastated decade of the 1970s, as is likely to occur again, perhaps soon. One can argue that if the present 3 percent of GDP energy cost is subtracted from the current economy, most of the other 97 percent of GDP will cease to exist.

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In other words, we are extremely lucky that we have to pay only the extraction costs, rather than the fullvalue production, value-to-society or replacement costs that Mother Nature might charge if there were mechanisms to do so. The full price would have to include the costs of natural capital depreciation, including both the fuel itself and the nature destroyed by its extraction, shipping and use, as well as the military costs of assuring resource availability. These we are hardly paying at present. If and when we run out of luck, and these costs come due, as will likely be the case, economics will become a whole new ball game in which the focus will return again to production and which will result in a new way of thinking about monetary and energy investments. Thus there are good reasons to examine economies from a biophysical and energy perspective as well as from a social- and market-based perspective. This may be a difficult leap initially, but the shift in 13 perspective should become obvious and desirable once the idea is broached.

THE QUALITATIVE THEORY OF MONEY Let the truth confront falsehood. Has anyone ever seen truth to be defeated in a fair and loyal confrontation.

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—John Milton

In light of this discussion, and in view of what we know now that eluded both Keynes (and Keynesians) and Friedman (and monetarist) alike, meaning that energy is the precondition of all goods produced and that we are running out of ways to produce it in everincreasing forms with affordable substitutes at hand, what effect does all of this have on the equation of exchange and on the policy prescriptions that this implies for future economic policy—especially regarding our goal of buying the good energy scientists of the world the time that they desperately need to build these non-fossil and ecology renewable substitutes? The answer to this question is the culmination of this book. Let us now take a closer look at Equation (4), MV = pGDP. We can think of this equation as a building block for a general theory nominal income. The right-hand side of this equation reflects the money demanded (to make the total output) while the left side reflects the money supplied to it.14 On the right-hand side, the level of p is determined by the supply-and-demand dynamics of each product and substitutes, much as in the Marshallian tradition, and the GDP side by the real level of output—at low unemployment. The left-hand side of the equation is determined by the monetary supply as defined in the wide scope of Friedman, while the V as the velocity of circulation as observed in the data mentioned. That is increasing (and reinforcing) expansionary business cycles, and decreasing in contraction business cycles. Energy is nowhere to be found on either side of the equation. This is because energy is treated like sausages, socks or soda, just something else deserving no special treatment. One could stretch the argument that energy is implicitly there in the right side of the equation, i.e., no energy, no sausages (at least not the frozen kind). But there is a tremendous difference between the words implicit and explicit. Whereas the former might be confused with ―minor importance‖ or ―taken for granted,‖ explicit treatment assures otherwise. In fact, Friedman‘s critique of Keynes was not that they forgot about money, it is that they never gave it the 13

See Hall, C., & Klitgaard K., ―The Need for a New, Biophysical-Based Paradigm in Economics for the Second Half of the Age of Oil‖ in International Journal of Transdisciplinary Research Vol. 1, No. 1, 2006, pp. 8–9 (emphasis mine). 14 Other authors, like Joseph Shumpeter (1966), preferred to look at it backwards, with MV as the aggregate demand and T or Y as aggregate supply and P determined by the Marshallian way. See Bordo, op. cit., 153. For our purposes, we will stick with the above-mentioned classification.

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center front-row, active and explicit treatment it richly deserved. Before going any further, we have to redefine money.

WHAT IS MONEY?

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The first lesson of economics is scarcity : There is never enough of anything to satisfy all those who want it. The first lesson of politics is to disregard the first lesson of economics. Thomas Sowell Economic theory has us to believe that money covers three functions. Foremost it is a legal tender of medium of exchange, lubricating the whole economic spectrum. It is illegal for anyone not to accept it and everything has a price tag on it, meaning anything that is posted on the market is measured and expressed in money and nothing else. The second function is its unit of account. This is a very important function because all balance sheets of all companies and banks, public and private alike, are measured with money and, if they happen to have assets in different countries, these are calculated in convertible currencies also measured in money. The third function is what Friedman spent much of his time discussing (although emphasizing to some extent what had been earlier exposed in the Cambridge balance approach), that money is an asset itself and therefore a store of value—meaning that having money stored, not just the things that it buys, is also of great value as long as it is earning compound interest that beats the cost of living. Granted, money is not the only thing that increases with value nor is it necessarily the best; a van Gogh original would beat any return by a wide margin but, much to the world‘s misfortune, there was only one Vincent van Gogh and he made only so many of paintings. But money is much more efficient because it is less scarce and thus more accessible to people‘s pockets and bank accounts. As we saw, one of the critiques of the Bretton Woods agreement was that its indirect reliance on the (scarce) Gold Standard was suffocating the world‘s capacity to grow its total output. But there is a fourth function not covered here. Stated simply: ► MONEY IS A PERMIT TO USE ENERGY ◄ The support for this assertion has been made throughout the book, most notably in Chapter 5. Summarized briefly here, economic expansion is the collateral of bank lending, which is how banks create money backed up with real goods fabricated by public and private companies productively. But that expansion itself rides on the back of energy, particularly oil, and it is completely dependent upon it, as we have seen in all respects, whether at the industrial level or at the farm level. Therefore: MONETARY LENDING & MONEY CREATION THROUGH PRODUCTIVITY IN ECONOMIC EXPANSION IS THE DIRECT RESULT OF ABUNDANT AND AFFORDABLE ENERGY. The industrial expansion, population increases and agricultural output, as revealed in Chapter 1, are all the proof this statement needs. Any historical research with this in mind will find, as Nobel Laureate in Chemistry, Frederick Soddy, geologists Herbert Hubbert and Colin Campbell and a few others involved in the ASPO group have been trying to tell us for many

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years now. In a nutshell, ENERGY IS EMBEDDED AS A DIRECT COMPONENT IN THE DEFINITION OF MONEY, along with the other three factors mentioned. But in order to be able to use energy in the monetary equation of exchange, we need a way to measure it. This is done easily through the concept of BTUs, or British Thermal Units. Technically, it is defined as the ―amount of heat required to raise temperature of one pound of liquid water by one degree Fahrenheit from a constant pressure of one atmosphere.‖ It is commonly used to describe the heat value (energy content) of fuels. So, ceteris paribus (other things being the same), the greater the BTU content of a fuel, the better. Normally, for our purposes, a BTU is measured in quadrillions, where a ―quad‖ = 1015, although other equivalent easily-convertible measures, like joules, are also used elsewhere. The following graph, from the Energy Information Administration of the U.S. Department of Energy, gives us a glimpse of the BTUs the world is now consuming and is projected to consume in their reference-based scenario.

Sources: History: Energy Information Administration (EIA). International Energy Annual 2004 (MayJuly 2006), web site www.eia.doe.iea. Projections: EIA, System for the Analysis of Global Energy Markets (2007). Graph 1. World Consumption of Energy, 1980–2030; (quadrillion BTUs).

THE MONETARY EQUATION REVISITED I would say among America‘s most serious concerns, you could consider national security, which is now intimately tied to energy security and access to energy, the long term economic competitiveness of the United States, and the dangers of global warming. And I believe that this energy issue is at the center of all these concerns, and thus I think it‘s the single most important problem that science has to solve. If you compare it to other things that we invest heavily in—for example, investments in medicine, cures for heart disease, stroke, cancer—if we don‘t solve these problems, it would be tragic. But life would go on as we know it. If we don‘t solve this problem, life really could change. —Steven Chu, US Secretary of Energy, Nobel Laureate in Physics

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Milton Friedman knew that something was amiss in the monetary equation of exchange, even after he tightened the monetary knot. He knew it was incomplete. He knew it when he wrote: The quantity theory is the first instance of a theory of the demand for money. It is not a theory of output, or of money income, or of the price level. Any statement about these variables requires combining the quantity theory with some specifications about the conditions of supply of money and perhaps about other variables as 15 well.

He just never got around to telling us what these variables could be. As we saw in Chapter 5, there are two new factors of production that must be accounted for separately from the ones we already know. These are Energy and the Environment, which we will call Nature (so as to not confuse the E in the notation). In this book, we account for one of them, Energy, because the other is, as far as I know personally, not completely measurable in standard formation to account for all of its elements (atmosphere, sea beds, deforestation, extinction, ozone layer, global warming, etc.). Since some of the damages may be irreversible but most are not (trees can be replanted, the pollution in the troposphere can be mitigated with electric cars), and since the common denominator for all of these measurements, to my knowledge (I may be wrong) may not exist according to everyone‘s consensus, I dare not, at this time, include it in the monetarist equation of exchange.16 Here is the energy version of the quantity theory of money.

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(5)  M = Money supplied, as re-defined in its four dimensions, including the Wealth Effect.  V = Velocity of circulation in the observed form, increasing with expansions in the business cycle and deceasing with business cycle contractions. However, measurement problems may force short-term assumptions of velocity in constancy.  E = Energy stock measured in BTUs (includes efficiency).  P = Price deflator.  GDPe = The Energy embedded Gross Domestic Product at constant prices (Consumption + Investment + Government Spending + Trade Balance), where Investment and Government Spending are in positive correlation with the BTU. The right-hand side of the equation is expressed as we know it. This is the demand side of the equation, the one that economists can influence through the mechanisms that affect the 15

Friedman, Milton, ―The Quantity Theory of Money: A Reinstatement‖ in Mueller, M.G. Readings in Macroeconomics, 2nd ed., Illinois, The Dryden Press, 1971, p. 147 16 Unlike BTUs or joules, which can measure energy content in equivalent form for all energy sources, like biomass, solar, nuclear, wind, and fossil fuel and thus having the capacity to add up. Hopefully, further thoughts in this issue will yield an equivalent yardstick, or common denominator, that is capable of measuring all of Nature‘s depletion and expansion to allow for an explicit total additive measure to incorporate it in the new form of the monetary equation of exchange. But it is imperative that we do.

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price level, especially the demand for money. Keep in mind that in this part energy is implicit in the products produced with it, not just as any other commodity summed with all of the rest (as in the earlier versions of Equations [1]–[4] above). In this case, Energy is valued as the intregal reason that all the other commodities exist. However, even though abundant energy is required for the production of all other commodities, its mere existence does not always mean that they have to be produced. Case in point: During the industrial collapse of the Great Depression, energy shortage was not a problem at all; quite the opposite, FDR‘s interior minister, Harold Ikes, had to use the old Texas Railroad Commission to organize quota systems among producers to prevent them from slipping on their backs over the surplus of oil. For this reason, it must be recognized that GDP is embedded with energy content as the precondition of virtually all goods produced, but it cannot be placed in a more explicit formation inside the right-hand side of the equation. The left-hand side is a totally different story. In this version, energy is completely present because we now know that it is an integral part of the formation of money and of its very definition. That is, all the money in stock in the world, as measured in its traditional three M components described above, has the DNA of energy completely over its structure. Thus we incorporate a capital explicit notion of energy. Energy is placed as the denominator of the digit ―1,‖ and that is placed as the denominator of M, as the equation shows. It is done in order to weight down the Monetary Supply to account for the Energy Factor. So, as Energy grows, measured in BTUs, so will the potential Money Supply to enhance GDP, whereas the actual growth of M will depend on the central bank authorities. This by itself will not enhance P. If M grows by more than the growth of E, then P will increase if GDP cannot keep pace. The converse will be true if E decreases in value; M will decrease and, if V is assumed to remain constant for the relevant time frame, then the GDP will decrease due to its positive correlation with E. Prices may increase or decrease depending on the supply demand balance. The expression in Equation (5) also has the added advantage that it takes care of the concern that some of us have regarding the economists‘ neglect of the biophysical sphere, because Energy encompasses this through the numerator in GDP. In the case whereby E stock comes down, and M and V remain constant, the left side would also came down. To keep the equation in check, the right side will also come down. But we know that P would increase in such an event, so that would push the GDP down even further because there is less energy and the price of that, as well as other commodities, will increase, causing the total output to fall. The equation would hold if all of this were proportional. But, if GDP overshoots downwards—that is, if it falls too hard causing some demand destruction—P will fall later and M will have to fall to accommodate less demand for money. Another variation could be that E stock falls and M increases to compensate; if V remains relatively constant, the value of the left side of the equation will remain as is. But that would only be transitory, because a decrease in E would also decrease GDP on the right side and increase P; an increase in M would also increase P and thus would collapse the value of GDP further down, eventually decreasing M. Recent data from the FED shows that increases in oil prices (due to a fall in E) has been met with short-term increases in M (or the amount of dollars and other currencies needed to pay the oil suppliers). As the equation would predict, the world GDP has collapsed to the point of some demand destruction, causing P and M to

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fall. But since by definition not all demand can be destroyed, or the oil substituted, this situation has resulted in a recession state of affairs. Clearly, progress depends on E to be increased either by more oil fields, better recovery factors, faster and swifter oil substitution by alternatives or through end-use efficiency. But that will not be soon, unfortunately. An algebraic manipulation of Equation (5) would yield the value of E. E=

P * GDPe MV

(6)

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This means that Energy is expressed as quotient of the nominal income divided over the product of the Monetary supply and its velocity of circulation. Under this expression, an increase in the monetary supply that does not corresponded with an equivalent increase in the GDP will decrease the amount of energy available through waste, a factor that will invariably feed through the price mechanism, causing inflation. It also states that increases in the GDP, which can only occur with increases in Energy (BTU) itself by the above definition of GDP, will increase the energy balance if the Monetary Supply and/or its Velocity increase by a smaller margin. This relationship, as in Equation (5), has powerful policy implications. But Equation (6) also contains the great disadvantage that, noting precisely that Energy is a nature-given element currently in finite and nonrenewable-depleting stages, it is wise not to express it as the quotient of any sort of clever algebraic manipulations. Therefore, for our purposes in policy implications, Equation (5) is the correct form of expressing the monetary equation of exchange.

STRATEGY IMPLICATIONS However beautiful the strategy, you should occasionally look at the results. —Winston Churchill

I believe that the incorporation of Energy into the monetary equation of exchange, whose latest version is at least 123 years old and possibly much older, has wide-ranging implications in monetary policy. Excluding E from Equations (5) and (6) above implies that energy is either unimportant or that it is infinite, and we know that this is devastatingly wrong. As recalled from Chapter 2, the global financial meltdown of the United States that is spreading through much of the Western world was predicted by many in the peak oil theory wagon shortly before it happened, including myself (in a public speech), because we knew that as soon as oil production hit a peak and could not increase any further, all economic growth would halt and with it the financial capital that had backed up that growth. Little did we know, however, or even suspect, in my own case, that the U.S. banks and investment houses would be so overexposed in their derivative markets that they would knowingly sell what later became infamously known as ―toxic loans‖ (or NINJNA) to themselves in the inter-bank market and to the banks of their closest allies. This is outrageous behavior in the

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extreme. The following quote, taken from a 1999 issue of The Economist and reproduced in my first book, is revealing:

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It is an amazing feat of marketing and public relations that banks haven‘t yet disengaged themselves from that image of sober respectability. Time and time again, in recent years, they have proven to be a public menace. In all parts of the world, if you observe an acute economic malaise, chances are that the banks are implicated, not as innocent bystanders but as perpetrators. When you consider the incentives that they have, it is 17 not surprising that this occurs.

What is noteworthy, however, is that outrageous behavior is not common in capitalism, but it is not unheard of either, but when it does happens, it occurs to one or two companies at once and when the issue is corrected usually through jail time and hefty fines, it is the end of it. LTCM, Enron, WorldCom, etc. were isolated incidents that rocked the stock market for an instant, but when people realized that their industrial competitors were all right, business as usual resumed for everyone except for those very few rogues who perpetrated the incident. This time the story is different; everybody in the investment banking industry and many of the iconic banks, along with some of the iconic manufacturing companies that had financial houses of their own, also collapsed or had to be bailed out. Some like Merril Lynch had histories well over a century, meaning that they survived the decade long Great Depression. But they could not survive two months of the 2008 recession. They simply betted their money on future expansion based on blind faith, not fact. When oil supply wasn‘t there anymore in the increasing quantities it required, their house of cards was blown over.18 Could this crisis be remedied? Keynes would use autonomous spending and Friedman would fall on the monetary supply side. But it was too much money in the wrong place, plus peak oil, that caused this crisis. So a third route is being used, one that falls between the prescriptions of both of these giants of economic thought: Increase autonomous spending on the government side by buying out liabilities (bad debt) in exchange for a large and sometimes controlling portion of the assets in extreme cases, like the large commercial banks and mortgage lenders, even automakers. This means that the U.S., unlike what occurred in the Great Depression, is becoming a stakeholder—it is nationalizing troubled companies instead of letting them fold. This increases the confidence people have in lending to those institutions because they are sure the government will not let the company go bankrupt because they own a large portion of it. On the supply side, the government is doing all it can to replenish the vaults of the banks and encourage lending to the private sector—the reverse of Hoover‘s FED—and the collapse of the oil prices (because of demand destruction, not supply additions) can be of temporary help until the cost dynamics of the hydrocarbon sector, and energy alternatives, force it to increase again. But, as I said in Chapter 6, if investment in these specific sectors is treated separately as it would be in a war economy (and it deserves nothing less), these investments can largely be made ―out of budget.‖ The Energy version of the monetary equation was built in this book to stabilize monetary supply via an energy weight down explicit incorporation. It helps mostly because it provides a 17 18

The Economist, June, 19, 1999. Emphasis mine. According to the Bank of International Settlements, the total derivatives market, including the OTC market, closed in 2007 at close to $600 trillion, far bigger than the world GNP. This argument brings to memory the famous Malthusian theory of population outstripping the productive capacity to feed it. In any case, economics is the study of society dealing with scarcity, not imaginary surplus.

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believable structure to the productive agents that the macroeconomic framework is where it is supposed to be. This gives confidence to investors, as was the case of Bretton Woods, that the money they are borrowing and lending for future economic expansion is real, and so will be the expected returns. If macroeconomists can provide a believable blueprint framework of monetary policy to the microeconomists of the world, one that accounts for all of its elements, that is what the productive agents of the world need. That is what it is all about.

THE BLACK GOLD STRATEGY—NEO BRETTON WOODS Economists are the trustees, not of civilization, but of the possibility of civilization.

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—John Maynard Keynes

Having the new monetary equation in place, and knowing what we know from the preceding chapters of this book, most especially from the results of the simulation exercises presented in Chapter 6, we find ourselves now in the position to culminate this book with a concrete strategy. I call it the black gold strategy for the good reason that it should resemble the successful conscious efforts that the brilliant economists of Bretton Woods, notably John Maynard Keynes and Harry Dexter White, designed for us 65 years ago in New Hampshire. As said, this is a war against time. We know that we depend on energy for our survival and continued well-being; we know that our primary conventional energy sources are waning and cannot be replaced; we know that we can eventually substitute them and we know that it is going to cost us plenty, both in terms of resources and in terms of growth sacrifices; we also know that nonconventional fossil resources can provide us with a temporary but urgently-needed bridge to carry all of us to the other side of non-fossil, affordable, massive and nature-friendly energy sources. We don‘t exactly know how much time that is going to take. We also know that failure to do so is not an option. We must win this. We could start by extrapolating the presumption that these new sources will not be ready on time everywhere simultaneously, and that they will be ready first in the industrialized countries and thereafter, when they become cheaper through economies of scale and better technology, in the underdeveloped nations, starting with the richest classes and in time percolating through the middle and ultimately the lower echelons of these countries. For example, in the automotive sector, it can be presumed that the electric cars will be first accessible, generally speaking, to the richest classes, then the middle classes, then the richest classes of the poor nations, then the poorest classes of the rich countries, and much after to the middle and poorest segments of the poor countries as technology and scale economies kick in. This means that in order to avoid intolerable social conflicts, it should be the richest countries that cross the energy transition bridges first, while the poor countries can dispose of fossil fuels until they too can cross these bridges towards renewable energy sources. But we cannot trust the invisible hand to guide us through this. The size of the economic ―sacrifice‖ in this strategy proposes to decrease the rhythm of world economic growth, measured in GDP, to a range between 2.0% and 2.5%. In this range, it is estimated that the annual oil added to the world‘s diet will be on the order of 1.0–1.21 MMBD. According to the simulations, this will yield an oil demand of about 109 MMBD by

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the year 2030, which the world can meet only if the nonconventional oil resources of Canada, Venezuela, the U.S. and Brazil, plus the gas resources of other countries, particularly Russia, can complement the proven conventional reserves in the Middle East and elsewhere. Also, according to the simulations, at this rhythm of economic growth, we will be buying the world at least two decades of time in which to build the transition bridges that are needed to gradually de-intoxicate itself from its oil addition. What is needed is a peak oil paradigm to accompany a peak addiction paradigm on the consumption side. The question is, is this range of economic growth too painful for humanity to bear? It will certainly impair sacrifices because, according to the World Economic Outlook of the International Monetary Fund, the average annual percentage growth of the world‘s GDP at constant prices between 1995 and 2007 was 3.8%. We are proposing here to cut this rhythm by almost one-half. But, seen from another angle, this level of sacrifice appears to be on the modest side. The following chart will tell us why. World Population Growth Rates % Medium Variant 1990–1995 Medium Variant 1995–2000 Medium Variant 2000–2005 Medium Variant 2005–2010

1.54% 1.37% 1.24% 1.17%

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Source: United Nations.

As the table shows, notwithstanding the quantum leap increase in population that the world experienced since petroleum entered its energy framework in the mid nineteenth century as shown in Chapter 1, as it can be seen here, the world population growth rate has declined steadily for the last 20 years. The proposal is to cut the economic growth rate of the world‘s GDP to a range level that is still superior at a good margin to the rate of population growth. A reduction of the growth rate of GDP to the level of world population growth is the absolute minimum that we could possibly propose, even though the proposal of 2%–2.5% would still generate sacrifices for many. But the longer we wait before setting out to do this, the harder the sacrifices will have to be in the years to come, even possibly approaching negative world economic growth— something that has never happened to the world since the Great Depression and 2009. In the last 35 years, the world has gone through no less than seven years of GDP growth rates that were equal or inferior to 2.5%. In the years 1975, 1982 and 1991, these rates fell to equal or below 2.0%. I trust that most readers may not remember these years with affection, but that we still managed to survive them. Keeping focused on the overall objective, which is to buy scientists the time they need to build a feasible energy fossil-free society, these sacrifices in economic growth, although not painless, are on the whole bearable. Knowing the task ahead of us, what we need to do is to devise, perhaps with the negotiating tools to be broached in the next appendix or with some others, a new Bretton Woods, that chains and connects mathematically the energy supply of the world with its economic growth to the range of levels developed above. The currencies of the major countries of the world will have to be pegged to a black gold standard, or Energy Standard, and the resulting monetary policies will have to be coordinated on the world scale—a United

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Nations scale—to strictly abide by these new rules. As the monetary equation above indicates, when the energy sources increase, the world economy can also increase. In essence, what this proposal amounts to is to peg all the currencies of the world against the weighted average of primary energy sources consumed in the world . So not only is monetary policy tied to energy, but so are the trading currencies. The first by definition, because energy is the heart of monetary creation, as we have seen. The second, the linkage between the world‘s currency and its BTU content is temporary until the transition bridges are complete. This proposal implies that the USA will have primary weight because they consume more BTU, Japan second and so on. Naturally, the energy source with the most added weight would be petroleum, given its chief preponderance as the world‘s primary energy. Also, naturally, the proportion of energy consumption of the countries today will be kept as is. For example, if there is a need to reduce the energy base because the world BTU availability is decreasing, every nation would decrease proportionally from the energy consumption that they have now. Otherwise, unwanted disruptions will arise. All of these will, of course, be done in parallel with the unprecedented energy investments in the nonconventional resources to extract the maximum of petroleum possible so as to enlarge the bridge scientists need. This proposal then involves the following:

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 aggressive investment in nonconventional oil sources  aggressive investment in alternative energy sources  providing the energy scientists with all of the capital they need to complete the fossil energy phaseout  rewriting the macro-monetary equation to provide productive agents with the confidence they need to plan their productive business ventures  incorporating a Nature element in the monetary equation by first agreeing on allencompassing measuring devices  coordinated economic slowdown via the frameworks discussed above Even though all of the world is involved in this, the countries mentioned in the Western Hemisphere with the greatest nonconventional reserves and consumption patterns are the ones called upon to shoulder most of the weight in this transition, doubtless the most difficult transition the human race has ever endeavored. In times of war, our ancestors enlisted and risked their lives for our independence and for the defense of our nations against the assaults of tyrants, and they did it because they were thinking of the future of their children and ours. They did it because they were thinking of us. It is time for us to begin thinking of our children‘s future. The summary of the strategy to overcome the world peak oil problem and thus help buy the scientists the time they need to bridge the energy transition towards a fossil free world are: I. Rewrite the monetary equation of exchange as shown. II. Coordinate international negotiations to establish a black gold standard that links world monetary supply with BTU. III. Aggressive investmements in non conventional oil. IV. Agresssive investment in alternative energy sources. V. Make people aware of this problem.

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Appendix

THE CASE FOR ECONOMIC COOPERATION Economics is harder than physics; luckily it is not quite as hard as sociology…the economy cannot be put in a box. Physics does very well at explaining simple, contained systems: planets orbiting the sun, electrons jumping between orbits of a hydrogen atom. It has a much harder time when trying to cope with the complexities of nature in the wild: weather forecasting, even with massive expenditure on satellites and computers it remains an inexact business. And when climate modelers are asked to answer a speculative question, like the prospects for global warming, they produce a range of answers (and a set of bitter disputes) as wide as that of economic forecasters asked to assess a policy initiative. Another reason economics is hard is that the critical sociologist is right: it involves human beings, who do not behave in simple mechanical ways.

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—Paul Krugman, Nobel Laureate in Economics, 2008

In the chapter 6 we attempted to map out, via simulation exercises and given what we know and can be reasonably expected to achieve, the supply side of the temporary energy equation. The accomplishment of this supply side is the job of the physical scientists. In the conclusions we offered an economist strategy blueprint on monetary and exchange rate policy through a modified Bretton Woods system that would coordinate an orederly economic slowdown with the sole objective of buying the scientists of the world the `precious time they need to see us through this energy transition phase. In this Appendix we try to build the economic basis for the negotiation framework between the countries to make this possible. We will attempt to prove, through economic insight, that coopration is not only possible but highly desirable To do this we convey the context of the other side of the equation— demand—the one that economists are trained to handle. The superposition of both the supply and demand side will give us the temporary equilibrium framework that we are searching to be able to minimize growth to adequate levels and limit the supply depletion of our energy sources. We need economic theory. In this chapter we will explore through economics how cooperation between parties and/or nation states is the best method to achieve common objectives that otherwise would be only attainable at sub-optimal levels, if at all. This is not economic integration as that term is understood in the successful example of the European Union or NAFTA, nor the unsuccessful case of the Andean Pact. Unlike economic integration, economic cooperation does not necessarily require ‗‘marriage‘‘ between countries, just temporary aligment between key economic instruments. In the case of economic cooperation, as we will now see in several examples, binding agreements are skillfully negotiated in one or more particular areas with complete information of each parties products and negotiating possibilities with the objective of arriving at optimal solutions

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(defined below), without the need to surrender sovereignty in macro policy instruments. The cases we will show manifest how economic theory has advanced, in theory as well as in practice, to prove that in cases were the parties are interdependent of each other, cooperation is superior to non-cooperative behavior for both or all parties concerned. We thus begin with a complicated question: How can economists help? How exactly do we economist buy scientists the time that they need to build the transition bridges towards alternative sources of energy that are non-fossil, renewable, replete with BTUs, massive, cheap, easy to transport, safe, environmentally friendly and able to meet the exigencies and prosperity aspirations of increasing demography and demand requirements of ever growing economies in a globalized and interconnected world? With the exception of the tasks faced by our Bretton Woods ancestors in 1944, a harder task has not been asked of the economic profession.

GAME THEORY You can‘t do serious economics unless you are willing to be playful. Economic theory is not a collection of dictums laid down by pompous authority figures. Mainly, it is a menagerie of thought experiments—parables if you like—that are intended to capture the logic of economic processes in a simplified way. In the end, of course, ideas must be tested against facts. But even to know which facts are relevant, you must play with those ideas in hypothetical settings.

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—Paul Krugman, Nobel Laureate in Economics, 2008

Please don‘t let the name throw you. Game theory is a very serious mathematical/economic negotiating tool with practical decision-making applications in most spheres of economic and financial modeling (although it can also be used for games). It is a relatively new branch of economics and its origins can be traced back to 1944—that year again—when Hungarian mathematician/chemist/party-goer, John Von Neuman (1903–1957), teamed up at Princeton University with the Austrian economist, Oskar Morgenstern (1902– 1976), to author their landmark book, Theory of Games and Economic Behavior, which not only launched game theory but revolutionized the methods of choice and decision making under uncertainty and expected utility. To enter game theory we need first to define the old concept of Pareto Optimality Theorem. Wilfredo Pareto (1848-1923) the French born Italian Economist/Industrialist was the successor of the mathematical economist Leon Walras that we sew in Chapter 5, and he developed his theories in the last decade of the XIX century from the same chair at the University of Lussanna in Geneva that his mentor began to occupy two decades earlier. The similarity of both their works is clear. The concept of Pareto optimality can be defined as: ‗Any combination of distribution of goods which, if changed, will not benefit any individual without damaging the other individual‘. In other words, a society will have reached its equilibrium point of exchange, or Pareto Optimality, if and only if there is no other point that benefits one party(s) without being detrimental to the position of the other party(s). The equilibrium point is not unique, it can occur at any point in the contract curve between the parties.

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Knowing this, game theory may be defined as: ―The study of situations where a set of assumptions or axioms are adopted about the agents (players) that participate in a given interaction (games) and where all try to individually resolve the strategy that would maximize their expected utilities, subject to certain restrictions like available resources, information and production functions‖ (Thakor, 1991).1 Game theory can be modeled in many variations within a cooperative or non-cooperative framework: whether there is complete or incomplete information; whether there is a leader or not; whether the game is a one-shot or sequential; whether the result of one game affects the next game; whether the game is finite or infinite; whether it is a zero-sum game or not; whether the payouts are in today‘s money or in the future; whether contracts are binding or whether cheating is a possibility; whether payouts are obligations or options; whether the payouts are hedged or insured; whether they are in the same currency; whether there are coalition possibilities between players; whether there are saddle point solutions; whether there are different payouts per player, etc.2 In this case, we will only explore the possibility of cooperative games with complete information, which is the simplest and most relevant to our case at hand. Game theory cooperative modeling in economics was the vogue in force when Bretton Woods was active; after its demise in the early 1970s, non-cooperative game theory modeling rolled into fashion. But it was the American John Nash (1928–), the 1994 Nobel Laureate in Economics, whose biography inspired the award-winning 2001 movie, A Beautiful Mind, who made the crucial evolutionary step by developing further the lessons of Von Neumann and Morgenstern into what came to be known as the ―Nash equilibrium.‖ His contribution, written also at Princeton, was not to refute the landmark 1944 book but to expand it to other situations where one or many equilibriums could be arrived in cooperative and, especially regarding Nash‘s concern, in non-cooperative settings. Similar to the Pareto principle, Nash equilibrium can be reached at the strategic point at which no player will benefit further by changing his/her strategy while the other(s) do not change theirs. But Nash equilibriums differ from Pareto optimality in the sense that they are less utopian, or, to put another way, less optimal and more realistic.3 Nash equilibriums can also be Pareto optimal only in desirable but rare circumstances (like with full cooperation, full information, binding agreements and when incentives to cheat are effectively ruled out) but, as we will see, in absence of these assumptions, Nash 1

Thakor, A. (1991): Game Theory in Finance. Unpublished manuscript, Indiana University. Quoted in Gonzales M; and Otero I., Curso Basico de Teroria de Juegos, Caracas, Venezuela, Ediciones IESA, 2007. According to these authors, no less that eight out of the last 24 Nobel Prizes in Economics since 1994 have been awarded to laureates who have contributed to the development of this theory. 2 This last variation, different types of payouts, is common in the oil industry. When I was evaluating exploration opportunities at PDVSA, sometimes I had to employ multivariate criteria incorporating not only the financial payout, expressed in net present value terms or the near equivalent internal rate of return, but also in other payouts indicators like reserve addition. I personally spend a long time evaluating and helped design the software for the oil and gas industry that could handle complex Monte Carlo simulation and decision tree analysis which we later incorporated for support in the development of value portfolios and risk assessment of efficiency frontier tradeoffs. An informal game theory was interacted when the different departments faced off at the endless budget meetings. It always helped if your assessments were backed up by the best risk assessment cutting-edge technology tools available. At the end, we even contemplated software that would treat portfolio mutations in genetic algorithms (a computer Darwanian measurement for portfolio optimization and decision making) that financial managers sometimes use in complex portfolio optimization. 3 Some practical economists believe, with reason, that the whole concept of optimality should be treated as an abstraction, rather than an achievable target.

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equilibriums can still be reached between parties that are believable even though Pareto suboptimal. But the overriding principle still holds: a Nash equilibrium is the strategic point at which each player finds it impossible to improve its position (measured numerically in payouts) when the other player‘s strategy is treated as given. Also similar to the Pareto optimality, there can be multiple Nash equilibriums along a specified payout strategy. Perhaps an illustration will help. Let us take the time-honored case of prisoner‘s dilemma. Two rogues are suspected of a crime but the police do not have enough evidence for conviction, so they decide to interrogate each of them in separate cells, without a lawyer, in quest of a culprit(s). All the police knows is that a crime has been committed and that one or both of the suspects did it. Let‘s suppose that the players involved are Mary and Joe. Their payout plan is as follows: 1 2 3

4

If both accuse each other, each gets five years in prison. If neither accuses each other, each gets two years in prison. If one of them accuses the other but the other one does not accuse, the one that is accused gets 25 years in prison while the other walks free. That is, if Mary fingers Joe but Joe doesn‘t rat out Mary, Mary is free and Joe spends the next quarter century behind bars (and vice versa). If either of them confesses, they get 30 years in prison.

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The payout matrix looks like this. Since confession is the stiffest penalty, it is ruled out of the payout matrix, leaving just four possibilities. Following notation tradition, Joe‘s payout structure is in the header of the diagram, while Mary‘s is in the left. The first number in each parentheses is Joe‘s payout and the second is Mary‘s. A= Accuses; NA= Not Accuses. There are four strategic possibilities: (A,A); (A,NA); (NA, A); and (NA, NA).

Now, players, strategy possibilities and payout ratios have been defined (the negative sign reflects that all possible payouts are negative—jail time—except when either of the players, but never both, walks free). This is an example of a finite, non-cooperative, one-shot game, with both players having complete information. Start with the case in which Joe considers not accusing Mary. Mary‘s choice are two: either accuse Joe, whereby she walks while Joe spends 25 years in a cell, or not to accuse him either, whereby each spends two years in prison. Since 0>-2, there is no earthly reason for Mary not to accuse Joe. But, since complete information is assumed, this means that Joe knows that Mary would not play the (NA, NA) card if he does not accuse her because that strategy in Mary‘s case is dominated by a better alternative.

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So Joe reconsiders and thinks of accusing Mary. In this case, Mary still has two choices, but different ones. She either accuses Joe and spends five years in prison, or does not accuse him and spends 25. Notice that in either case Mary is worse off than the scenario depicted above, but again her choice is clear because -5>-25 by a wide margin. However, because of this, Joe knows that Mary will never play the (A,NA) card either, leaving her with the only other choice (A,A) where each spends five years behind bars. Are we close to a solution? Absolutely. Because by now Joe realizes that if he does not accuse Mary, she will accuse him, and if he does accuse her, she will still accuse him. So Joe is faced with either 5 or 25 years in prison (A,A) or (NA, A) and surely he will choose to accuse Mary and so will she. This is the solution, five years each in the penitentiary; this is the Nash equilibrium because here neither player can improve his/her position given the strategy of the other. But is it the best achievable for both of them? Is it Pareto optimal? The answer is, clearly, no, because the alternative of each spending only two years in prison is still available. That is, the total sum of the Payout ratio: (-2+2=-4) is higher than all the others by a wide margin. The trick is that the only way to arrive at this solution is by relaxing one key rule we had in place when we started this game; which is the non-cooperative rule. Let us say that the police do allow Joe and Mary to cooperate and devise a common strategy. In this case, the solution that they both would arrive is in the (NA,NA) card whereby neither accuses each other and both spend just two years behind bars. So can we conclude here that cooperation is the best strategy in game theory provided that we are allowed to do so? Absolutely. It certainly is in this and most other cases, but with one very important caveat. It only works if the AGREEMENTS ARE BINDING; that is, if the incentive to cheat by either party is reduced to zero. For instance, if Joe lies to Mary telling her that he will not accuse her and Mary believes him, but after he accuses her, he walks and she sits in jail for a very long time. Then this does not work, agreements must be binding and players must be credible. Readers familiar with oligopoly theory or with the behavior of market cartels (OPEC) can readily sympathize with this exercise. The multiple Nash equilibrium solution is a bit trickier, because to choose between them other criteria must be incorporated, like efficiency, risk, and even coalition possibilities between players. We will not explore this variant, but will come back to game theory in monetary policy later in this chapter.

INTERNATIONAL TRADE THEORY: AN APPLICATION Fidem, si poteris, rationemque coniunge. (Unify, if you can, faith with reason.) —Boecio (A.D. 476–523)

Cooperation, as you might expect, is a highly analyzed concept in international trade theory and it has been so ever since the infamous Smoot-Hawley Tariff Act of 1930 that unilaterally raised U.S. tariffs to unprecedented heights at the beginning of the Great Depression and which, by consensus, accelerated and deepened the Depression. The success of the different trade rounds after WWII that began with the General Agreements of Tariffs and Trade (GATT) in 1948 and in the European Union with the Treaty of Rome in 1957 are

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only the two greatest examples of how ―endless‖ trade negotiations in deep cooperation can eventually bear fruit for the progress of humanity. Let‘s look at the following diagram for a simple illustration. Supply & Demand Diagram and Trade Benefits

Price S C

P’

D

Q’

T A

P

B

Q

S

D

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0

X

X’

Quantity

X´´

This diagram depicts the demand-supply schedule of a product, like gasoline (product G), which has no ready substitutes and must therefore represent its demand curve as a vertical line (D-D). Economist call this a perfect inelastic demand, because no matter what the price is (shown in the vertical left axis), it will not affect the quantity consumed. The supply curve (SS) is assumed to be normally positively sloped and the prices are assumed to reflect only domestic or accounting prices of a hypothetical country we call MateriaLand. But MateriaLand is not self sufficient, meaning that at the initial stage it consumes O-X'' of G, but produces only O-X' of G and importing the rest (X'-X'') from another hypothetical country we call PetroLand. At the initial stage the price is at P', which differs from the lower price P by the factor T, which is a tariff that MateriaLand has on imported G. PetroLand‘s potential supply curve is represented by the straight line P-Q, but because of the tariff T, its actual supply curve has shifted upwards to P´-Q´ because the tariff makes it more expensive for them to export. Let us suppose that MateriaLand, after a trade negotiation with PetroLand, agrees to abolish the tariff, so T becomes zero. The result is that the supply curve of PetroLand drops along with the price level to P-Q to arrive to its full potential at lower prices. MateriaLand increases its imports from X'-X'' to X-X'' and scales back its production to O-X from O-X'. So MateriaLand is producing less of G but importing more, with total consumption remaining unchanged. The net gain for MateriaLand from this move is represented by the increased availability of product G at lower prices, which we call consumer surplus, minus the loss of producers surplus because it now produces less of G, and also minus the loss of government revenue because it is not charging any custom duties or tariffs to PetroLand. Graphically we can see this by focusing on the geometry of the above diagram. The consumer surplus is shown as P-P'-Q'-Q. Of this, we subtract the producer surplus, represented by P-P'-C-A, and the government revenue B-C-Q'-Q. The result from this exercise is the triangle A-B-C which is the net gain to MateriaLand by allowing PetroLand to cooperate fully in its G-market. Now, it is important to note that because we are using

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accounting prices and not market prices, the calculation of the net gain is in full consideration of the possible excess capacity and unemployment that may result when international competition is allowed a level playing field in the domestic market. Even though geometric diagrams are powerful visual tools they do not often tell the whole story. There are four other advantages not shown worth pointing out. •

•

•

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•

First, MateriaLand also benefits because its tariffs reduction were not unilateral, that is, it was done through skilled negotiations which presumably contracted its trading partner, PetroLand, to also reduce its tariffs and allow MateriaLand to increase its exports. This helps compensate, or even over compensate, the loss in producer surplus from product G. Second, PetroLand benefits because it can increase production of G to take advantage of a wider market in MateriaLand, and through the multiplier effects and the fact that it does not have to pay tariff rates any more, it expands the productivity of its economy and its living standards. Third, as both countries expand their economies through trade negotiations and cooperation, thereby increasing the world‘s GNP, the governments of each of them also increase their income through the collection of taxes from these increased activities. For both, this tax income has empirically shown in most cases to be much more than the loss of government revenue in the ports of customs.4 Last, but certainly not least, this diagram does not show the effects predicted by the Stolper-Samuelson theorem. For those that may not be familiar with this concept, it takes a bit of explaining.

Professor Wolfgang Stolper and his young student, Paul Samuelson (the first American ever to have been awarded the Nobel Prize in Economics [1970]), wrote a landmark analytical paper in 1941 that describes the possible gains/losses to the factors of production (inputs) when the relative prices of the output varies due to changes in the trade flows between countries. Their concern was not to prove the gains from trade, which they already knew, but to focus upon the impact on the income distribution of the factors of production (land, labor, capital) that resulted from these trade flows. Originally styled under the two factor framework of the Heckscher-Ohlin model and written under certain constricted assumptions, like perfect competition, constant returns to scale, perfect mobility of the factors, and near full employment equilibrium, the theorem holds that:5 A rise in the relative price of a good will lead to an increase in the rewards of the factor of production that is most intensely used in the production of that good, and conversely, a fall in the rewards of the other factor.

The theorem also holds true in the reverse. In our example we assume that the product in question, Gasoline or G, uses both capital and labor in its production process but it is much 4

Provided of course that local taxes can actually be collected, which is not a frequent case in most poor undeveloped countries that often would much rather prefer to depend on custom tariffs at ports because those are more transparent and collectable. 5 The Heckscher-Ohlin model is the general equilibrium mathematical model of international trade, founded upon the principles of comparative advantage that is associated with the English economist, David Ricardo, and emphasizing on the factor endowments of each country.

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more capital intensive. Moving along, as tariffs for gasoline are reduced in MateriaLand, with the corresponding drop in the price level that forces a contraction in the domestic production of gasoline, the Stolper-Samuelson Theorem would predict that the capital factor would see its rewards fall and, conversely, its rewards for the other labor factor would expand accordingly to cover the slack left by the reduction of capital. Because MateriaLand got richer overall by the triangle A-B-C, this means that the rewards to the labor factor would have been larger than the loss of the capital factor. But again, this is not the end of the story. If we assume as we did before that PetroLand also reduced its tariffs, then the labor factor in MateriaLand also expanded to cover the increased demand in PetroLand. This means that the gains in wages from the labor sector in MateriaLand is even larger because of cooperation due to trade liberalization. An analogous analysis holds true from the view from PetroLand. There are three lessons from this theorem that we must keep in mind. •

•

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•

It validates the basic predictions of international trade theory that economies gain from an overall trade liberalization, as the theories of comparative advantage measured in the relative productivity of the factors of production holds. It highlights that even though general gains are the result of trade liberalization that both winners and losers will result from it. It follows that if losers are unable to flock immediately to the ranks of the winners by themselves, that the government should step in and compensate (education/retraining). It also follows that if compensation methods do exist to overcome the effects on the loser factor, that increase trade flows will path trade liberalization on a Pareto optimal course.

Even though the Stolper-Samuelson Theorem was originally developed in a straight jacket, a theoretical laboratory if you will, subsequent works on this theorem has been done under more relaxed set of assumptions and these works have validated Stolper-Samuelson‘s findings.6 To conclude this section, there will be gains from cooperation from each prospective trading partner if maximum efficiency is the overall aim of trade liberalization. Equity concerns (or Fairer concerns, which is a much better concept) should come later. That is, trade liberalization (with outputs/inputs valued at accounting prices) insures that increased cooperation between parties will result in a general gain to both economies even though some sectors may be negatively affected. If compensation methods are found, the path towards Pareto optimal bliss is achievable. If we are ever going to expand towards a multi-country framework, in which cooperation agreements are implemented just like the examples above indicate, the agreements must be binding, the distribution of the gains and loses must be fairer, and the incentives to cheat must be minimized if not abolished entirely. The more that the participating countries are likely to lose from cheating or withdrawal, the more stable the agreement will be. The conditions must 6

For further Reading in this subject, see Stolper, W.F. and Samuelson P.A. (1941). ―Protection and Real Wages.‖ Review of Economic Studies, 9: 58-73. Ehtier, W. (1974). ―Some of the Theorems of International Trade with Many Goods and Factors,‖ Journal of International Economics, 4: 199-206. Jones, R (2000). Globalization and the Theory of Input Trade. Cambridge: MIT Press.

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be the result of meticulous and flexible planning and negotiation. Now we drive this point further by examining monetary policy in a game theory framework.

GAME THEORY IN MONETARY POLICY The mathematician need not concern himself with the particular being or intrinsic nature of his points, lines, and planes, even when he is speculating as an applied mathematician. We may say that there is empirical evidence of the approximate truth of such parts of geometry as are not matters of definition. But there is no empirical evidence as to what a point is to be. It has to be something that as nearly as possible satisfies our axioms, but it does not have to be ―very small‖ or ―without parts.‖ Whether or not it is those things we can, out of empirical material, construct a logical structure, no matter how complicated, which will satisfy our geometrical axioms, that structure may legitimately be called a ―point‖….This is only an illustration of the general principle that what matters in mathematics, and to a great extent in physical science, is not the intrinsic nature of our terms, but the logical nature of their interrelations.

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—Bertrand Russell

In theory, as will be shortly seen, the basic principles of the microeconomics approach are simple in its understanding. In practice, its manifestations are far-reaching in scope. Before we delve into the microeconomic theory of preferences and exchange, let‘s reflect a bit on the above quote, which is crucial to this part. What Bertrand Russell (1872–1970), one of the brightest mathematicians and pacifists of the last or any century, said about ―what matters in mathematics, and to a greater extent in physical science‖ also applies, I would say to a much greater extent, to the social sciences and, particularly, economics. What really matters is that the logical nature of the economic inter-relations conforms ―as nearly as possible‖ to satisfy our axioms. What it does not matter is the exact point itself nor its ―intrinsic value,‖ just as long as the point conforms to these axioms that we are comfortable with as well as to the logical nature of their interrelationships even if the dynamics of the market system (capitalism–globalization) alters these axioms.7 This is not a textbook on standard macroeconomics, so how monetary policy works on invigorating or disincentive the productive factors of an economy will not be explained, except to say that it does work. In fact, the tool is so powerful that the institution that regulates it, the central banks, are autonomous government sponsored institutions but independent from politics, even though its chairman and governors are appointed by the president and confirmed by either congress or parliament (in leading democratic countries). These persons are not only hand picked but are scrutinized in a microscope were not only education and experience are valued, but also their temperament and psychology. Their actions cannot, by law, reflect any partisan interest, and their public statements are carefully screened and parsimoniously delivered. Through monetary policy central banks calibrate the performance of the economy by pre-setting targets, usually inflation and reserves, and even though they do not have a direct influence on factor productivity per se, their indirect influence is enormous. Central banks are basically a twentieth-century phenomenon at least in

7

Bertrand Russell was a prime Welch philosopher/mathematician and recipient of the 1950 Nobel Prize in Literature. His pacifist vocation during WW1 landed him in jail, where he wrote his book, Introduction to Mathematical Philosophy, published in 1919 in London by G. Allen & Unwin. This quote is extracted from the 1993 unabridged version by Macmillan Co., New York., p. 59.

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the Western Hemisphere, but their role really took center stage in the 1970s when the Bretton Woods system was eliminated.8 Let us suppose we have two countries that are both economically interdependent and with identical economic structures, in that their policy objectives affect each others welfare functions. To further simplify, let‘s suppose that they both have a fixed exchange rate system and that their only available policy instrument is monetary policy. The national welfare function of each is given by the following utility function:

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• • • • •

NW= NW= U= Y= R=

U(Y, R) were: National Welfare Utility Income Reserves

The policy structure or the game depend on two variables—Income and Reserves—and on two factors: first, the relationship between each government‘s policy instruments and the final objectives of policy and, second, on the utility or value that each country attaches to each policy objective. Although the countries are mirror images of each other in structure and utility function, their policy objectives may not coincide. Both will like to have a high national income (high Y), but both are worried that too high a Y will trigger inflationary pressures. The presence of R in the utility function indicates that the national welfare or total utility also depends on their respective balance of payments (BOP) history; that is, their commercial interdependence of each other. A deficit in the BOP may indicate that the export sector is non-competitive also hurting the ability of the government to expand, while too high a BOP surplus may be seen as a waste of resources which, if invested, may harm inflationary targets if the economy is unable to absorb it productively (it may also reflect that the currency was fixed at a lower value than its equilibrium price would indicate, which undervalues domestic assets and make the fixed investor unhappy). Now, in order to graphically represent the reactions of each country to fulfill their respective objectives in a game theory format, we must first draw the indifference maps9. It looks like this: 8

At the risk of stirring some controversy, the death of Bretton Woods also delivered a mortal blow to the traditional Keynsian school of thought in favor of the monetarist school that was headed by Dr. Milton Friedman (1912– 2006), the late eminence of the University of Chicago and Nobel Economic Laurate in 1976. The reason is that when the dollar was dislocated from the gold standard, there was no longer an effective physical ceiling or upper limit that would bound the emission of that or any other currency for that matter. It was Milton Friedman (a vocal critic of Bretton Woods in its later years) who had made the modern studies in monetary theory and policy to control the monetary supply and curve inflation, thus inducing rational confidence expectations from economic agents and investors. After some resistance, most Keynesian apostles would ultimately assimilate the important lessons from Friedman‘s Chicago Boys and rename themselves ―NeoKeynesians.‖ 9

For readers unfamiliar with indifference curves, it is trivially simple logics. An indifference curve maps out the utility frontier of every consumer between his/her preferences of goods. How many apples Mary prefers to oranges depends on her preferences, and how many oranges she is willing to trade with Joe for apples depends on his preferences as well as hers. If Mary has a four to one ratio of combination preference of apples to oranges, she is indifferent if she has 8 apples and 2 oranges, but she will prefer 12 apples and 3 oranges and son on. At the market place Mary is never completely satisfied unless her marginal rate of substitution

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The figure above depicts the indifference map in a Y, R plane that not only looks like an archery target but that works just as well. The bliss is the bull‘s eye, which is the higher indifference curve we aim at, while the other ones are lesser desirable objectives which decrease in preference value as we expand from the center. But we need a further step to transform the above diagram into a policy plane to see the workings of monetary policy. This we do by relating it to the demand function of each as to represent them in a demand space, instead of (Y,R). The result is the following funny-looking diagram which, like the others, just looks complicated to the untrained non-economist eye. A bit of explaining is in order.10

between the two products satisfies her preferences; meaning that if she has more oranges than she wants and less apples than she needs, she is willing to trade oranges for apples because her marginal rate of substitution of oranges for apples is high. She will trade as much oranges for apples as need be until the marginal rates of substitution of both fruits are in equilibrium to correspond to her preferences, which in her case is 4 to 1 apples to oranges. When she finds a suitable trading partner, say Joe, they will not stop trading until the marginal rate of substitution for both are equal. The five properties that govern indifference curves are: 1. There is an indifference curve for every point within the space of goods/commodities. 2.Indifference curves are convex and have a negative slope from their geometrical origin (or, at least, they do not have a positive slope). 3.Indifference curves cannot intersect each other.4 Higher indifference curves from their origin are preferred to lower curves.5 Trading partners trade until their marginal rate of substitution are equal. 10

For the economist: The bridge to this graph from the previous one is made by interlocking the relevant multipliers. NW=U(Y,R) is governed by the following multipliers and their respective partial derivatives: dy/dD>0 v. dR/dD0 vi. dR/dD*>0 dy/dD*>0 vii. dR*/dD>0 dy*/dD*>0 viii.dR*/dD*