Today we take another look at the energy picture and how it will change over the next decade. Just as the world switched from whale oil to kerosene and from coal to diesel, we will see a change in how we find and use energy. That is inevitable. But the transition will not necessarily be easy or smooth. And there are some surprises along the way. The things we "know" and the assumptions we make about conservation of fuel and peak oil are probably wrong, and we need to get some key concepts down as we consider how the world will adjust to rising oil demand but at some point potentially falling production.

We are going to review a most excellent book by Peter Tertzakian called A Thousand Barrels a Second: The Coming Oil Break Point and the Challenges Facing an Energy Dependent World . It is balanced, thoughtful, and well written. Not only dealing with the present problems, Peter takes us back into history to see how humankind dealt with previous energy break points. I highly recommend his book for anyone thinking about investing in energy or for those interested in how energy will affect our lives in the next decade. You can get it at www.amazon.com.

Last March, I wrote about another book on energy called The Bottomless Well , by Peter Huber and Mark P. Mills. It is provocatively subtitled "The Twilight of Fuel, the Virtue of Waste, and Why We Will Never Run Out of Energy." Huber and Mills take a very hard look at the way we normally think about energy and turn conventional thinking on its head. I highly recommend it. You can go back and look at that e-letter here. I highly suggest you get both books when you go to Amazon.

In summary, Huber and Mills describe a bright future where we change our sources of energy and actually use more energy (a lot more!), rather than less. And I think they are spot on with much of their work. The development of electric cars and alternatives to oil, etc. will be a big driver of investment profits. But the transition as described by Tertzakian is not as smooth as one would like.

(Unless otherwise noted, all the facts and numbers below are from Tertzakian's book.)

A Thousand Barrels a Second

In 1997, the world consumed almost 74 million barrels of oil per day. By 2002 that had risen to 78 million. Sometime this year, the world will consume 86 million barrels of oil a day, or 1,000 barrels a second. The growth in demand for oil rises about 1.5 to 2 million barrels each and every year.

China accounts for 23% of that growth, with the rest of Asia adding another 18%. The US only accounts for 11%, with the rest of the world growing demand by 48%. At the current pace of growth, we could see the demand for 100 million barrels a day in less than 10 years. Can we find another new14 million barrels a day while replacing the oil in old and declining fields? What happens if we can't?

Almost half the world's oil consumption ends up in a gas tank. China sees its demand for oil rise about 90% of its growth in GDP, what Tertzakian calls a 90% dependency factor. In other words, if Chinese GDP rises 10%, then its demand for oil rises 9%. The world average is about a 40% dependency factor.

My back of the napkin estimate is that even if the world sees an economic slowdown in the next few years, over the next ten it is likely that world GDP growth will be at the long-term average of 3.5%, or 41% over ten years. If the dependency factor remains at 40, then oil demand will grow by 16%, well over 100 million barrels a day before 2016. But that's a big if.

The reality is that this level of growth in oil production is unlikely. We are pushing the limits of production today. Yes, there are significant potential new sources. Iraq and Iran could double their production. Venezuela has much more oil it could drill. Nigeria has greater reserves, as does Russia. The Steppes of Asia have vast untapped reserves. The Canadian reserves in the form of oil sands are immense. With the exception of Canada, the locations of new or larger sources of oil are not in the most desirable and stable of locales.

But putting aside the political issues, can we grow our way out of the problem? Not according to a report by the US Army Corps of Engineers called "Energy Trends and Their Implications for US Army Installations" by Donald Fournier and Eileen Westervelt.

They suggest "...a shortfall in world oil production of 1 to 2 percent during the next decade. This is a sure sign that the oil world supply picture is changing in ways that depart from 'business as usual.'"

"... In general, all nonrenewable resources follow a natural supply curve. Production increases rapidly, slows, reaches a peak, and then declines (at a rapid pace, similar to its initial increase). The major question for petroleum is not whether production will peak, but when. [Emphasis mine - JFM] There are many estimates of recoverable petroleum reserves giving rise to many estimates of when peak oil will occur and how high the peak will be. A careful review of all the estimates leads to the conclusion that world oil production may peak within a few short years, after which it will decline (Campbell and Laherrere 1998; Deffeyes 2001; Laherrere 2003).

"Once peak oil occurs, then the historic patterns of world oil demand and price cycles will cease. In recent years, the realization of price stability has depended on the effectiveness of nations belonging to the Organization of the Petroleum Exporting Countries (OPEC) to adjust for the production increases and lags of the non-OPEC nations.

"We have now entered a period where production is lagging behind demand. Presumably, potential excess capacity still resides in OPEC nations, thus allowing them to control the price of oil. The current debate is whether OPEC can in fact increase production to stabilize prices, or if the market will have to adjust demand to meet supply through price mechanisms. Saudi Arabia maintains that it has excess capacity and can increase production to meet demand. Unfortunately, Saudi Arabia has not been able to increase supply above its monthly production peak of April 2003 (EIA 2005). Iraq may also have significant excess capacity if it could be brought into production (EIA 2002). Meanwhile, domestic oil production in both the lower 48 states and Alaska continues to decline. Many non-OPEC oil producers have also passed or are currently reaching their peaks of production."

The Coming Break Point

This is leading to what Tertzakian calls a "break point."

"Although the stakes have never been greater, the history of energy shows that a time of crisis is always followed by a defining break point, after which government policies, and social and technological forces, begin to rebalance the structure of the world's vast energy complex. Break points are crucial junctures marked by dramatic changes in the way energy is used.

"During the break point and the rebalancing phase that follows (which can last for 10 to 20 years), nations struggle for answers, consumers suffer and complain, the economy adapts, and science surges with innovation and discovery. In the era that emerges, lifestyles change, businesses are born and fortunes are made." (xiii)

Change after these break points can take longer than you would think. Going from wood to coal power took 75 years. It took oil almost 100 years (1860 to 1960) to take away the bulk of coal's market share in the transportation field.

"Historically, substitutions in the energy world take a long time and there's no reason to think the next substitution is going to happen overnight. While it's likely that we may not run out of oil before a substitute is found, it will be decades or more into the future before any new solutions make a difference."

"In the history of energy break points, we have always been able to avert catastrophe, but that doesn't mean the temporary pain and uncertainty hasn't been significant to the people living through the era." (77)

But that does not mean that changes in national energy use can't happen quickly. Take South Korea as an example. In its high-growth period from 1988 to 1997, growth averaged about 7.7% a year (think China). But their dependency ratio on oil was 250%! That means for every 1% growth in GDP their demand for oil rose by 2.5%. (The US ratio was never more than 100 and today is 45.)

Slowing the Growth in Oil Demand

Then came 1997, and Korea caught Asian flu. South Korea's currency depreciated by about 50% and, since oil is priced in dollars, that meant their oil bill doubled overnight. It is an understatement to say that a break point followed. Economic demand in Korea dropped almost 7% and demand for energy dropped as well.

However, as we know, the country rebounded and economic growth since then has been over 6%. But a strange thing happened. Korea does not consume any more oil than it did in 1997. They have shifted to coal, nuclear, and natural gas. Korea is now the second largest importer of liquefied natural gas in the world.

And Korea is not the only country to grow economically without an increase in oil consumption. Japanese oil consumption has been flat for 30 years. The United Kingdom is down significantly from 1973 and has been flat for decades. The message seems to be that if a country decides to make the change, it can.

China is working on its oil dependency. Large new hydroelectric plants will be coming on line soon. Forty new nuclear plants are planned to be in production within 20 years, and they are pioneering new smaller and lower-cost nuclear reactors. They are building LNG terminals to get access to natural gas.

Can the US control its consumption? Many suggest the answer is in a more energy-efficient automobile. But Tertzakian demonstrates that is not the answer. If every American who will buy a car, SUV, or truck in the next year buys one that is 25% more fuel efficient than the current fleet average, it would still mean that total demand for oil would rise slightly. "Even if every new car and truck sale going forward were a hybrid, it would be at least a decade before our [US] national gasoline consumption would reverse its current growth trend." (195)

It will take a combination of higher prices and legislation to really eat into the growth of gasoline consumption in the US. And what politician wants to run on a platform of driving up the price for oil or SUVs?

And so, politicians will let the market do their work for them. Ever increasing world demand will put a strain on the supply, and gasoline prices will rise. A break point will follow as everyone scrambles to make changes, pass legislation, and adjust.

Ironically, a world economic slowdown caused by slower growth or a recession in the US would mean a probable drop in world oil consumption and a drop in oil prices. Since oil is priced at the margin, a serious slowdown could mean oil drops back into the $40s. Everyone would breathe a sigh of relief and assume that the lower price is now the wave of the future. It would forestall any significant change in legislation or lifestyle in the US and much of the world.

$100 Oil is the Solution

And that would be a mistake. Because as world growth comes back, and it always comes back, demand will once again rise, but traditional oil production will be peaking sometime in the next decade (if not sooner). Oil prices will rise dramatically, well beyond today's $70 range. But $100 or even $150 oil is not the problem. It is ultimately the solution.

Let's be clear. We are not going to run out of fuel for our cars. We are just going to run out of cheap fuel. When it takes $150 for a good old boy to fill up his Ford F-150, things are going to change in the US and the world.

We will start to see substitution of other fuel sources for the light sweet crude oil that we are addicted to. Ethanol, biomass fuels, tar sands, shale oil, natural gas, and gasoline from coal are all possibilities at some price. Hydrogen? It is going to take very high gasoline prices to make the economics work. But for those who long for a hydrogen world, you should be careful what you wish for. Because high prices will come.

It will not be pretty, but we will muddle through, just as we did in the '70s when we had the last break point in energy. And belatedly, we will make changes.

What should we in the US do today? We should aggressively move to nuclear power. It takes a decade to build a nuclear power plant, and the 3-4 that are going to be built under current legislation will not be enough in ten years. Nuclear also has the benefit of being environmentally friendly. Where are the environmentalists when you really need them?

We should mandate LNG (liquified natural gas) terminals strategically sited around the coasts and work with foreign suppliers for long-term contracts. LNG will be needed to produce electricity and can also serve a fuel for transportation. It also has the benefit of being environmentally friendly. The NIMBY (Not In My Back Yard) crowd must simply not be allowed to hold hostage a nation.

Yes, wind and solar power should be increased. But wind will never be a major factor and solar technology is not quite there and may not be for some time, although by the end of the next decade it could be making a major impact in some regions.

At some price, ethanol makes sense, although it is much less efficient per gallon than gasoline. Biomass fuels will start to be produced as prices rise, and cars will convert to LNG if enough is available. Coal can be converted to gas.

All of these things will happen, but the transition will be one of several decades. And during that time, price will be volatile but generally rising

That will force changes in lifestyles. Later next decade, when it costs double the currently already high price for gas, long commutes will become prohibitive for the average worker using current automobiles. We will see a shift to far more efficient smaller cars, as well as in where we live and work. Combined with more efficient communications (especially real-time realistic video, not the herky jerky cameras of today) we will see an even larger rise in those who work from home or in nearby offices.

The coming break point will be disruptive for many individuals and companies that think energy costs are going to moderate or go back down. Remember, as Huber and Mills point out, as our "tools" (cars, computers, gadgets, etc.) become more efficient, we use more energy, not less, as it becomes more affordable to use them.

I believe that you should read both The Bottomless Well and A Thousand Barrels a Second . I did not do justice to the latter, as Tertzakian tells the story of previous break points in energy usage. We tend to think that the transitions were easy. What appears to be obvious technology today was not as obvious as we developed steam, coal, kerosene, and even whale oil. The technology to convert and use whale oil for illumination developed over decades. The changeover from coal gas for lighting to electric lights took decades, even though electric lights were cheaper and less polluting.

One last point by Tertzakian: "Why was the substitution of coal over wood the fastest switch we've seen in energy? First and foremost coal is a much more compelling fuel than wood. It packs more energy per unit volume, burns hotter and doesn't rot. Less obviously, but more important, coal didn't have to overcome a large infrastructure of supply chains entrenched with standards. Edison's success in the lighting industry showed that adoption of new energy supply chains is not all about better technology. Edison made it happen only after understanding and overcoming barriers of incumbent standards and competition. Sometimes those competitive forces are formidable. Candle makers declaimed whale oil as a fuel. Edison fought [and lost!] against alternating current. When electric refrigeration emerged as a technology that could displace the ice harvest in the early twentieth century, the ice harvest industry lobbied furiously to have refrigeration banned with claims that it would poison food."

It is a mistake to think that the speed of change in the technology world will be mirrored in the energy sphere. DVDs will replace videotapes in another few years. Start to finish for DVD's reign will be about 15 years. It took longer than that to replace whale oil lamps. "The fastest substitutions of energy devices were probably diesel engines over steam engines, and jet engines over propeller engines, each of which took over 35 years."

But while there are going to be a lot of problems and hassle, for on-top-of-it investors and entrepreneurs it will be a time of opportunity.

Bowling, Summer Movies, and More

I am aggressively working on my book. My deadline to get it finished and to my editor is the end of November, and I do intend to try and make that schedule. Wiley has said they are going to fast track the publication and have it out in the first quarter of next year. But this weekend I will take a little time off and go bowling with some of my kids, hit the gym a few times, and do some recreational reading.

Normally, this time of year I like to go to the movies. But where are the summer hits? There have been a few, but mostly it has been a slow summer season. Maybe it will pick up in the fall. But the good news is, that it leaves more time for family dinners and reading.

It is late and time to hit the send button. Have a good week.

Your needing some more personal energy analyst,

John Mauldin

P.S. If you like my letters, you'll love reading Over My Shoulder with serious economic analysis from my global network, at a surprisingly affordable price. Click here to learn more.

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