December 20, 2007

Oil Depetion in Mexico

The Economist wrote about the problems that the world is facing with the rapidly depleting Mexican oil fields, especially the giant field Cantarell:

This flawed behemoth is now in “a race against time” to compensate for Cantarell, says Fabio Barbosa, an energy specialist at Mexico's National Autonomous University. It is a race that Pemex seems likely to lose. In a document released in December setting out its strategy for the next five years, the energy ministry forecast that total oil production would decline to 2.5m b/d unless policies were reformed, and would remain roughly constant even if the industry were liberalised.

This is partly the result of two wasted decades in which governments have milked Pemex of cash which it might otherwise have invested. That has begun to change: investment in exploration and production doubled between 2000 and 2006 (though much of the increase came through federal debt guarantees to private contractors). Mexico's president, Felipe Calderón, has pushed through a reform of public finances that will cut the royalty Pemex pays from 79 centavos on every peso of oil it extracts to 71.5 centavos by 2012. The company expects its capital spending to rise in 2008 by 20% in real terms.

This is correct in a certain sense. Additional investments might have kept up the trend of production levels. But think about this: Does it really make much sense to spend enormous amounts of money to accelerate the already high rate of depletion? Does it make sense for Pemex to invest heavily so that it can drain its reserves dry even faster?

Crude oil is a non-renewable resource with a finite supply. At some point there comes a time when it doesn't make any sense to keep increasing up the output, as this would have a negative effect on the return to investment. A higher flow rate from a heavily depleted resource base means a lower flow rate later on, with an ever increasing cost for keeping up the rate up.

Many oil producers are entering a phase where additional investments to uphold rates of extraction just don't make any sense. It will actually make economic sense to leave as much oil as possible to the future, where prices will be significantly higher. The producers will ultimately try to maximize the total value that they can extract from the remaining reserves, and all investments will be directed at increasing the ultimate volume of recovery instead of maximizing the rate of production.

Many economists are feverishly trying to debunk the idea of a global peak of oil production in the near term. They claim that developments in engineering and economic incentives will keep the rates of extraction on an upward slope virtually forever. This is a fallacy of demand driving the supply, which was true in the earlier years of oil production. Nowadays, the roles of supply and demand are rapidly reversing, and there is a whole new situation of increasing competition for a stagnating supply.

The truth is that it makes perfect economic sense for individual producers to let the flow steadily wind down from a peak level, which is determined by economic and geological circumstances. From that point on, the rate of extraction can be increased through political decisions that have nothing to do with economics and everything to do with geopolitics.

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