Peak "Cheap" Oil

Former Toyota CEO James Lentz noted in 2009 that oil production would peak "sometime in the neighborhood of 2017 or 2020." In hindsight, this observation was extremely prescient: world liquids production is -1.1 mmb/day less than the November 2018 peak level, and crude plus condensate production is -3.9 mmb/day less than in November 2018 (Art Berman). The question is whether or not the November 2018 peak will be surpassed (if it even can be).

The "peak 'cheap' energy" question opens up a Pandora's box of what motivated COVID-19, Net Zero objectives since then, and European deindustrialization which also peaked in 2017 — all of which are examples of demand destruction that restricts prices from moving prohibitively higher. Barring the banking crisis in late 2019, there was already a concurrent and arguably more significant crisis of energy.

This post describes peak oil theory in terms of peak EROI, suggests that a collapse in cheap energy prices would threaten global debt and FX markets, and speculates that it is therefore a plausible motive for COVID-19 and the state policy actions taken on since.

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Peak EROI

Peak oil is the theorized point in time when the maximum rate of global oil production will occur, after which it will embark on an irreversible decline. "Peak oil" is best understood not as peak resource but as peak energy return on investment (EROI) for its production.

Energy Return on Investment is a ratio used to measure the amount of usable energy that can be extracted from a particular energy source compared to the amount of energy required to extract, process, and distribute that energy source. You can think of it as an energy expended-to-energy returned ratio.

"Oil" can be thought of in four distinct categories: conventional oil, light-tight oil (LTO; aka shale), extra-heavy oil (XH; aka tar sands), and other liquids (primarily natural gases NGLs). URR stands for "Ultimate Recoverable Reserves" and represents the estimated total quantity of energy that can be economically recovered from a resource over its entire lifespan.

Conventional oil did reach its resource-limited global production plateau in 2005, at least for oil prices up to well above $100/bbl. To meet global oil demand since 2005, the world has had to increasingly rely on production of LTO (shale), which is yielded from fracking — a technique that has contributed to 85% of global oil supply growth since and delayed peak oil by almost 15 years.

Per estimates from a variety of studies, global production output (U) will not surpass the 2018 peak but for gas and liquids.

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Energy-backed World

Declining oil production in the face of constant (or rising) demand would not only risk resource wars and/or famine, but the loss of cheap energy which could spillover into global debt markets. Debt, private (like a business or personal loan) and sovereign (issued by a nation), exists primarily with the expectation of future growth. The last century of growth has been one of industrialization, built on cheap energy.

To illustrate this crisis, we can imagine an example:

As previously noted, conventional oil reached its resource-limited global production plateau in 2005, at least for oil prices up to well above $100/bbl. Oil prices "well above $100/bbl" would necessarily be expensive for import-dependent nations and prohibitively so in emerging markets. Since the global oil trade is priced in USD, the demand for USD would increase and, to the detriment of the rest of the world, strengthen the dollar FX rate.

A global balance of payments crisis could unfold where a nation's increase in dollar demand to pay for higher-priced oil drains their dollar reserves. Dollar reserves are typically held as US Treasuries, and access to dollars can be obtained readily in Treasury repo or by Treasury sales. If an nation's dollar reserves are insufficient to cover the trade deficit, it would face difficulties in meeting its external payment obligations — leading to a vicious cycle of currency depreciation, capital flight, and economic contraction.

Thus, such a scenario playing out over an extended period could ultimately create a marginal incentive to de-dollarize, purchasing energy in foreign currency or in repriced gold. De-dollarization would necessarily collapse US debt markets, as foreign demand for US Treasuries (who own 30% of US debt) declines.

*This scenario is a dramatic simplification that describes only one example, and there are nuances/alternate scenarios that cannot be fit onto this post.

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