Thursday, November 10, 2011

EROEI and Peak Oil

A Forbes blogger by the name of Tim Worstall wrote one of the most technically illiterate posts that I've ever seen about peak oil theory and its connection to EROEI. Even though his example - showing EROEI has no bearing on the price or quantity produced of a nonfuel, premium value product - is completely irrelevant and total "nonsense," as he put it, he does demonstrate one thing very clearly: the linkage between a declining EROEI and smaller quantities of dearer oil is not intuitive. I'm going to try and explain it.

EROEI, energy return on energy invested, is a number that covers the amount of energy that a product can release compared to the amount of energy invested to recover it. EROEI is fundamentally about fuels. It is also a fact that EROEI for liquid hydrocarbons, mostly oil, is decreasing as deposits become harder to access or must be heavily upgraded to be processed into saleable products - no amount of new technology has changed this. What does this mean for peak oil theory, and for price?

Recall the definition of peak oil:
Peak oil is an increase in the marginal increase of the price of oil required for the economical extraction of a marginal barrel of oil. Eventually, the price required to extract more oil will be too high for society to bear.
So peak oil is all about price elasticity of supply, or, to put it more simply, the price of a marginal barrel. Where EROEI matters is in the cost of production for a barrel of oil.

Note that energy is a major input component to the production of liquid hydrocarbons. These include the sources of electric power used for drilling operations, gasoline and diesel used for transportation, the embedded energy in drilling mud, pipe ingredients, and drilling platform, and any energy (usually from natural gas) used to upgrade the crude so that it can be processed by existing equipment. It is a major observation of peak oil theory that, because you are producing an energy-bearing fuel but spending similar fuels to obtain it, as the EROEI of your product approaches 1, the profit margin on your product decreases to an insignificant amount such that extraction is no longer viable.

To illustrate why this might be the case, let us assume a hypothetical scenario in which only diesel and gasoline are used as energy inputs into an oil drilling operation. This is not so far out of the realm of possibility, particularly when one considers how much drilling is in remote locations. Let us further assume that the oil is intended only for fuel use (exceptions to this case will also be discussed). Now, if the EROEI of this operation approaches 1, then what we are doing is essentially trading high quality liquid fuels for other high quality liquid fuels of (presumably) identical value. At the same time, we are incurring overhead costs, drilling costs, and other extractive fixed costs. What this implies is that the price point of oil extracted in such a manner will have to be higher than its value for the operation to make a profit. Since the operation will never make a profit in that circumstance, no firm will ever undertake that operation.

Let us take a slightly different case for illustration. Suppose all energy inputs to the extractive operation are natural gas, and the EROEI approaches 1. In this situation, oil will likely be sold at a profit, but this profit margin will be razor thin: since we are using the oil for fuel, the only price premium available will be the spread between natural gas and liquid transport fuels.

That spread will also be relatively low, because natural gas can be converted into liquid transport fuels, either through the Fischer-Tropsch process ("a sign," one of my professors once told me, "of desperation") or into methanol or DME, and I do not doubt that any profit opportunity will have been ruthlessly exploited. If we assume that only F-T is being used, the price spread between natural gas and oil will be precisely the additional cost relative to the natural gas feedstock of one barrel of Fischer-Tropsch hydrocarbons. In other words, the value of oil over natural gas will be exactly equal to the liquid fuels premium. Those are slim pickings indeed. Extraction will continue until even the price spread is exploited, at which point it will stop - and remember, just because we have reached an EROEI of 1 does not mean it will stop decreasing.

Alternatively, compressed natural gas can be used as a vehicular fuel directly - in which case at an EROEI of 1, if you are using extracted oil for fuels, extraction will never make sense.

Notice that in none of these situations have I mentioned an absolute price - only relative price. Since there are a variety of factors at play in when this situation comes about, I cannot and will not predict the price level at which this comes about, only that the price will be high.

I mentioned that the situation might be different if we started talking about the ways in which oil is used for nonfuel uses. Petrochemicals - that is, all non-biobased plastics, synthetic rubbers, and resins - are highly value-added products that need oil products as feedstocks. At an EROEI of 1, in each of those situations I described above, the value premium on petrochemical products will almost certainly be enough for extraction of oil to continue. However, what I noted about fuel products still stands: in those situations, none of the oil will go to fuel use. Demand for fuels will compete against demand for ultra-high value-added chemicals, and it will lose.

I might add some diagrams to this post if I get the time.

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