Is oil industry repeating a critical error

Ten years ago this week — July 11, 2008 to be exact — the price of a barrel of oil on the New York Mercantile Exchange hit an intraday high of $147.27, its highest price ever.

By the following autumn the world economy was in shambles and the price of oil was tumbling. The oil price eventually bottomed out around $34 per barrel in mid-february the following year, according to oilprice.com.

Oil prices started 2002 at around $20 per barrel and then rose almost continuously until mid-2008. As they rose, the world’s best known critic of peak oil* prognostications, Daniel Yergin, began to look so foolish for having predicted ample supplies for decades to come that his firm finally reversed itself in mid-2008 and began to forecast higher prices. That should have been read as a contrarian signal; just two months later the oil bull market ended.

Peak oil thinkers at the time believed that their forecast of a nearby all-time peak in the rate of world oil production had been fulfilled. The official numbers seemed to confirm this. Petroleum geologist Kenneth Deffeyes’ had made a half-serious prediction that Thanksgiving Day 2005 would mark the all-time high for production. Production of crude oil including lease condensate (which is the definition of oil) was slightly more than 74 million barrels per day (mbpd) in December 2005, but thereafter declined.

Despite high and rising prices, oil production failed to exceed that number for two years. In December 2007 production inched above the previous high mark and stayed there through July 2008, the month the oil price peaked. That month the world produced slightly more than 75mbpd.

In August production fell by more than one million barrels and did not surmount 75 mbpd until two years later.

Robust demand in an era of stagnant supply had sent prices spiraling upward. Those high prices became a contributory cause of the worst economic calamity since the Great Depression. A moment of high drama seemed to coincide with the peak oil moment in world history.

But what if peak oil is a process rather than a moment, a process with a series of twists and turns filled with sometimes ambiguous and counterintuitive signals? If so, it might look something like what followed.

When the economy rebounded and oil prices rebounded with it, the peak oil thesis seemed reconfirmed. The International Energy Agency had noted in its 2010 World Energy Outlook that the rate of production of conventional oil had, in fact, peaked in 2006 and that unconventional supplies would thereafter have to provide the world’s oil supply growth.

As it turned out, world oil production plateaued bouncing between 73 and 76mbpd until late 2013. Not surprisingly, this constrained supply brought on high prices. In fact, the years 2011 through 2014 experienced the highest ever average daily prices for crude oil, higher than the average for the year of the price spike.

This fact, however, was obscured by the fawning media coverage of increasing supplies of shale oil in the United States (properly called tight oil) which did little to stem the price rise.

One lonely voice, petroleum geologist and consultant Art Berman, pointed out that the companies drilling for this oil were almost all free cash flow negative — even as oil prices levitated over $100 per barrel and stayed there. (Free cash flow is operating cash flow minus capital expenditures.)

Berman said the economics just didn’t support bringing the shale oil out of the ground. But investors didn’t listen and kept handing new investment capital in the form of both equity and debt financing to the drillers. Without this capital the drillers would not have been able to continue growing their production since their operating cash flow from existing wells came nowhere near the amount needed to grow production.

Today, we know that Berman was right. This fact became more apparent when oil prices declined in 2014 and kept going down. Several drillers went bust. But even as much of the industry remains on life support, those companies currently drilling in the Permian Basin in Texas are involved in yet another bizzare free-cash-flow-negative boom. The Permian has become a Wall Street darling even though it’s actually the latest place where capital goes to die.