Oil Prices to Hit $375 by 2025- Exxon Invests $.6 Billion in Biofuels

The dynamics of oil production is no mystery to oil giant Exxon Mobil. Based on their thorough understanding of global oil resources, they announced a significant first investment in biofuel production. To understand why the oil industry stalwart took this action, we turn to mathematics, and specifically a model of future oil production.

Previously we used STELLA modeling to document the flaw in capitalist credit markets, which turned out to be our second most popular article after the discussion of pandemic flu. Today we’ll introduce you to a STELLA model of peak oil in China and related global price and energy implications. For an explanation of STELLA, please refer to the previous post or just Google “STELLA modeling”. The outcome of that modelling is the input to Exxon's alternate fuel investment strategy.

Let’s begin by stating the obvious: Oil is a limited resource that is being consumed rapidly, mostly for energy but also for chemical feedstock. The rate of oil consumption is dependent on the number of people on the planet and the efficiency with which we use oil’s energy content. Because the rate at which oil is naturally produced is insignificant when compared to the rate of consumption, global oil reserves are being depleted. Eventually, the quantity of oil available from conventional oil reserves relative to consumption will cause oil production declines and an increase in the price of oil. The price of oil will then decouple from the consumer supply-demand markets and be determined by large oil trading markets, resulting in large, volatile, and destructive swings in oil prices. These fluctuations will further cripple capital markets unless alternative energy sources are satisfying a significant portion of consumer and industrial demand.

The discussion here is based on the model of Tao and Li (2007, Systems dynamics model of Hubbert Peak for China’s Oil, Energy Policy v. 35, pages 2281-2286). The model presented here as well as the data used come from that paper and are explained and referenced there. I reproduced their STELLA model (see Figure 1) and added a simple price model. You can download the model if you like (it requires the STELLA player program to run), examine the model parameters and equations, and run the model using a model player (to run the model file).

Figure 1- Model of China peak oil re-created from Tao and Li (2007). The key variables include cumulative proven reserves, ultimate reserves, and Hubbert production.

Though the peak oil model is simple, its detractors frequently attack the model as “unproven”: in fact –part of the model works like your bank account balance. You have a certain amount in the account (reserves), you withdraw a certain amount every year (consumption), and you deposit some money (new discoveries). The only uncertainties in the model are the rates of consumption and discovery, and these can be varied within realistic limits to see how sensitive the model is.

Based on this model for China Peak Oil, Tao and Li reasoned that by 2040, China’s crude oil production would have fallen back to the levels of 1990, despite increased demand (see Figure 2). Their sensitivity analysis suggests that the Hubbert Peak for China Oil production will happen between the years 2010 and 2022, and is roughly the inflection point in the cumulative production curve.

Figure 2- Model results showing the time series predicted for cumulative oil production (blue), Hubbert annual production (red), and annual increase in proven reserves (purple). Note the clear Peak in Hubbert oil production which marks the point where production declines begin.

As a general rule sentient beings try to envision natural systems in ways that mimic their own sentience. So while at the Hubbert Peak about half of the world’s oil supply remains in the ground, people imagine this is a great deal of oil and there is no immediate problem. But scale and rates are where the human brain generally fails to correctly match intuition to reality, and mathematics are needed to determine the truth.

The mathematics of Hubbert Peak Oil are so simple and results so dramatic that its implications are difficult to believe or assimilate. But recall, the implications of the mathematics of leverage in the credit markets was hard to believe, until that is all you read about for 2 years.

So what does this all mean for oil prices, energy prices, and civilization? For beginners, take a look at Figure 3, which shows an oil price model that is only coupled to the relative abundance and scarcity of the resource. Because the rate of oil consumption is dependent on the number of people on the planet and the efficiency with which we use oil’s energy content, fluctuations in consumer demand are generally short lived departures from the overall population trend. The model suggests that as the Hubbert Peak approaches, the price of oil will ascend dramatically, and by 2025, oil prices will be about $375/barrel. And then oil prices go through the roof, the stratosphere, and finally into space.

Figure 3- A simple model of oil pricing based on the relative scarcity and abundance of oil. The less oil that remains in the global oil reservoirs, the more expensive the price. You can download the model here.

Clearly, every large industrialized nation of the world, unlike most readers and investors, know this, and are taking dramatic steps to fund and support alternative energy technologies, and to promote conservation (including cap and trade). As the price of oil accelerates, large pools of capital via commodity trading markets will provide feedback to the prices system and decouple the pricing market from true consumption demand. Traders will cause volatile and gut wrenching fluctuations in oil prices. But what needs to be strongly emphasized is the stress this acceleration of oil pricing will put on capital markets. I can only hope that the financial system recovers in time to face its next challenge.