Who here remembers the days when we all worried about peak oil? I certainly do, but for those who don’t: for many years, various folks propounded the idea that the world would one day hit peak oil – a period in which oil extraction was at its maximum – and that once peak oil had been reached, oil production would begin to decline until eventually it was insufficient to sustain our oil-reliant way of life.

The idea obviously makes sense: there’s only so much oil in the world, we are using it up, and it takes billions of years to replace. So, logically, we’re eventually going to run out. The big question, then, is when will we run out?

For the more pessimistic types, the answer was that it would happen between 2004 and 2008. But, as it turns out, that didn’t happen. In fact, global oil production has actually been increasing since 2009 (see chart below).

So if we didn’t hit peak oil, then what is happening in oil markets? As it turns out, instead of hitting peak oil, we’ve hit the age of tough oil (something I have previously written about).

According to Philip Mause, senior advisor at the Pacific Economics Group, the new era has two key characteristics. First, the new oil that is coming into the markets is being extracted at a much higher marginal cost of production. Most of the new sources of oil that have been exploited over the last few years are things like tar sands and shale oil extracted via fracking. These sources of oil are a lot more expensive to exploit than traditional oil fields like those in Saudi Arabia. Second, as a consequence of the rise in the marginal cost of production, oil prices are stabilising at high levels that are very unlikely to fall over time (see chart below).

Mause explains: “Conventional oil production generally involved extensive discovery and exploration work and then relatively low marginal production or ‘lifting’ costs. Once the field was discovered, production costs were low and production would continue even if the price of oil declined dramatically. On the other hand, it was not so easy to produce more oil in response to a higher price because a new field had to be found and developed and that took time or was simply impossible.”

“As a result, if some production came off line due to weather or war, the price could skyrocket before the market would clear. This higher price would then slowly induce more production, which would tend to build up a surplus which, in turn, could drive the price down when the offline production returned to the market because wells would continue to produce and still be profitable at much lower prices so that supply would not contract in response to a lower price.”

“The market is becoming very different. It is likely that most new sources of oil production involve relatively high marginal costs. Shale fracking is expensive and tar sands production is very expensive. A decline in the oil price will lead to a reduction in production from these sources relatively quickly. As more expensive oil production plays a bigger role in the market, the amount of production that will be driven off line by a price decline will increase. In economists’ terms, the supply of oil will become more price elastic - especially on the down side. As a result, prices will tend to stabilise with a floor set by the price incentive necessary to sustain this more expensive production. This price level is probably somewhere in the $65 - $80 range today. It is unlikely that we will ever see $30 a barrel oil again unless there is a major global economic depression.”

In other words, the oil market has changed a lot. Consumers can expect oil to remain at the relatively high prices it is currently trading at. There will be fewer oil shocks in the future, and oil and gas companies will be less exposed to the vagaries of the oil price. Extraction technology will become more important than finding oil fields, and companies with a technological advantage will outperform. Finally, the spectre of peak oil now seems much more distant, as we are able to exploit new sources of oil. It’s a brave new world.

www.moneyweb.co.za/