Oil Sands Truth: Shut Down the Tar Sands

Independent UK Economist on the Tar Sands

The Indpendent UK offers an interesting perspective on the Tar Sands, yet is somewhat delusional from time to time:

"So it is always going to be within Opec's power to pump its cheap-to-extract conventional oil fast enough to drive the price below the marginal cost of extraction from tar sands."

In fact, even if there were no long term production declines on the horizon, there is a serious lack of cohesion or desire among the OPEC countries to undermine the Tar Sands; Venezuela is unlikely to do so because of their own reserves of the same sort of bitumen while others have their own problems (Iraq, anyone?) akin to disabling that kind of collective response.


Bill Robinson: A bubble waiting to burst or stuck on a permanent high? Oil's non-stop rise has the experts in a spin
The relentless climb has confounded expectations and while prices may be capped, they won't scrape the bottom of the barrel
Published: 22 July 2007

In 2001, during the world recession, oil prices averaged just under $23 (£11) per barrel. Over the past month the price has climbed from just above $70 to $78 and flirted last week with a record high of $78.65.

The recent movements have surprised many analysts. A year ago, oil prices fell quite sharply from their peak and briefly found a floor at around $65. The conventional wisdom in the industry at the time was that prices for the black stuff would gradually return thereafter to something closer to the 2004-05 range of $40-$50 per barrel. The sharp rise in American long-term interest rates in recent weeks – a negative signal for world economic activity – might have been expected to nudge oil downwards towards this floor. Instead prices have risen. Is there any limit to how high they can go? And is the market telling us we may never again see $30-$40 oil?

That would be contested by those who see the current upswing as a cyclical bubble, reinforced by worries about the Middle East. They would argue that when the world economy comes off the boil, and Iraq moves out of the headlines, the oil price will come down.

They have a point. Every big price hike has been associated with Middle East war – Yom Kippur in 1973, the fall of the Shah of Iran in 1978, the Gulf War in 1990. So it is not just coincidence that the present price upswing has coincided with the invasion of Iraq.

However, each of the above episodes led to durable increases in the oil price. The only spike (sharp rise followed by sharp fall) occurred around the Gulf War. In all other cases, political turbulence in the Middle East has had a ratchet effect, taking oil up to a new level.

We are now witnessing another turn of the ratchet. As in the 1973 and 1978 episodes, the rise in the oil price is clearly associated with a strong world economy, with other commodity prices also at cyclical highs. A unique feature of the present cycle is the huge increase in energy demand from China, and that looks like being a very durable phenomenon.

A long-term boost to demand means that over time oil must be extracted at ever-increasing cost from ever more difficult sources. The huge price increase back in the 1970s made it worth drilling under the North Sea and in the Alaskan tundra. The latest world upswing may have taken us up to a new level on the long-term oil supply curve, where exploitation of the tar sands becomes profitable.

However, the experience of the 1970s suggests that although the tar sands option may place a cap on the rise in oil prices, it will not drive them down. When the price rose from under $2 in 1970 to over $11 in 1974, it generated huge interest in new sources of supply. It quickly became part of the conventional wisdom that the oil price could not for long remain above $10 per barrel, because at $8 per barrel it became economic to extract the black stuff from the tar sands. Oil from this source has three great merits: there are no exploration costs; much of it lies in politically stable Canada rather than in the explosive Middle East; and the reserves are vast. There is more tar sand oil in the Americas than there is conventional oil under the Saudi desert.

The sands are attracting attention again for the same reasons, although, since the gen-eral price level today is five times higher than in the early 1970s, the cost of extraction is now in the $40-$50 range. Moreover, there are other obvious difficulties which may push cost a lot higher than that. Getting oil out of the tar sands is more akin to strip mining than to conven-tional oil production. The pro- cess also uses a lot of water. Laying waste vast tracts of wilderness and polluting the rivers is bound to be fiercely opposed by environmentalists, and dealing with their concerns could make the oil very expensive indeed.

This problem is compounded by another: the response of Opec. Developing the tar sands requires a major investment, and for that to pay off, the oil price must remain above the cost of extraction, which is much higher than for conventional oil. So it is always going to be within Opec's power to pump its cheap-to-extract conventional oil fast enough to drive the price below the marginal cost of extraction from tar sands. If the relatively poor oil producers in the Middle East seek to maximise the long-term value of their oil reserves (rather than the short-term value of this year's production), this strategy makes sense. That is why the oil majors have hesitated so long to invest in the tar sands.

Traditionally, oil companies have only wanted to invest in projects that remain profitable even if prices fall as low as $30 per barrel. The longer prices remain high, the easier it is to believe that $30 oil has gone for ever and the more attractive the tar sands look. High prices for the black stuff also stimulate output from alternative energy sources such as wind, waves and biofuels. And the nuclear option – economically competitive but environmentally threatening because of the waste disposal problem – is looking more attractive as the long-term environmental dangers of burning fossil fuels have become better understood.

Changing the patterns of energy consumption and production takes a long time. But the price mechanism does work. High oil prices today call forth more oil, and other energy, tomorrow. That is what ultimately caps the price. But last week's events are another signal that the era of $20 oil (which lasted from the mid-1980s to 2000) is over. The question now is whether the long-term price range has ratcheted up to $50-plus. That may seem high but it is, in real terms, still below the peaks we saw in the 1970s.

Bill Robinson is head of economics, KPMG Forensic

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