The Hindu Business Line : Oil: On the skids

In any activity, the initial phase usually yields the greatest profit or advantages. In the case of oil, a new well yields oil readily. As the reservoir becomes depleted, more energy has to be used to extracting the oil.

CONSIDER this: When violence flares up in West Asia and a Russian oil giant gets embroiled in a mess, the price of crude shoots up to ever-increasing and unprecedented levels.

And then, consider this: If acts of violence in a region grown prone to violence and the travails of an oil company domiciled in a country where the record of corporate governance is not normally associated with capitalism at its transparent best are sufficient to wreak havoc with the economics of energy, what will happen when fossil fuels finally run out?

The scenario is so frightening that the man on the street would rather not consider it at all.

As for the experts, who are paid to consider it, they concede that the supply of oil is finite — but insist that we have till 2035 or so before it peaks... And then goes into decline.

This is a lie perpetuated, predictably enough, by American entities, such as the Energy Information Agency and the US Geological Survey, presumably in order to serve the interests of the oil majors. The lie is not challenged because most people do not understand that the depletion of oil is not reflected in its market price.

Oil is, in most cases, extremely easy to extract and the extraction costs are, therefore, not linked to its depletion — but to profits. As and when people get around to figuring this out, pressure will build on governments to introduce a system of rationing till an alternative source of energy is commercialised.

A rationing system run by government and bureaucracies will, most certainly, not be acceptable to the oil majors which would rather make as much money as they can for as long as they can.

Conservation, which may receive the grudging support of the oil companies, will not work because of something called the Jevon's Paradox. Oil companies know all about Jevon's Paradox and its implications, which have been explored with great lucidity in a Congressional Research Service report titled "Energy Efficiency and the Rebound Effect: Does Increasing Efficiency Decrease Demand?" by Frank Grotton. (July 30, 2001).

Grotton pointed out that, intuitively, it would seem obvious to most observers that increasing energy efficiency will ultimately reduce demand for an energy resource such as electricity. Paradoxically, economic theory suggests that this decrease in demand and subsequent decrease in cost of using the resource could cause a rebound in demand.

"A commonly cited example is an increase in the efficiency of home air-conditioning which may reduce the resident's monetary incentive to conserve. The resident may opt to change the thermostat setting to keep the amount he pays constant, but living at a more comfortable temperature. When actually measured, this "rebound effect" is generally acknowledged to lower predicted reductions in electricity demand by 10 per cent to 40 per cent, depending on the device that is made more efficient."

The rebound effect (also referred to as the "take-back" or "snap-back") was first described in 1865 when William Stanley Jevons, one of the originators of the marginal utility theory of value, observed in The Coal Question that the introduction of the new efficient Watt steam engine as a replacement of the preceding Newcomen engine initially decreased coal consumption, which led to a drop in the price of coal. However, it also meant that more people could afford coal and that, with coal becoming economically viable for new uses, consumption increased greatly.

More recently, analysts have focussed on the rebound effect in the electricity and gasoline markets and have found it to hold good. Returning to the contention of the industry cheerleaders that we still have a good 30 years or so before we run out of oil, it is really not important, from an economic point of view, when this will happen.

The relevant question here is: When will production peak and then decline? This is important because, when oil production starts to taper off, prices will soar — unless, of course, demand falls in tandem with supply.

Elementary arithmetic based on energy return on energy invested (EROEI) suggests that the world will be in trouble in about a decade.

This is how the arithmetic works out: When a source of energy — oil, for instance — with an EROEI ratio of 4:1 is substituted with another energy source with an EROEI ratio of 2:1, there has to be a doubling of the gross energy produced in order to get the same net amount of resulting usable energy. Thus, when we move to energy sources which have lower EROEIs, the net amount of energy available for use will diminish.

By way of illustration, let us take an energy source which has an EROEI of 1 — which means that for every unit of energy spent, you get back one unit of usable energy. When the EROEI exceeds one, you are actually burning up more energy than you are getting for use.

Now, factor in the law of diminishing returns, which essentially says that, in any activity, the initial phase usually yields the greatest profit or advantages. In the case of oil, a new well yields oil readily. As the reservoir becomes depleted, more energy has to be used to extracting the oil.

Eventually, the oil EROEI just will not work out — which is when people will start looking to other sources of energy such as coal and tar sands. Coal will be a viable substitute until its EROEI turns negative too... At which point the energy industry will have to turn to extracting oil from tar sands.

According to current data, the returns on extracting oil from tar sands works out to roughly three barrels of oil for every two consumed, representing an EROEI of about 1.5. And that is without taking into account the massive environmental costs involved in terms of water pollution, the degradation of land and so on.

West Asian oil is relatively easier to extract and, therefore, has a significantly better EROEI than oil from the North Seas or the Venezuelan oils.

Apparently, the Bush Administration is not as dumb as it seems.