Warning: now entering the Oil Danger Zone

Since 2005, when oil cost US $40 a barrel, I've been speaking and writing about the end of cheap oil. The message I have been trying to bring to supply chain managers is that the world has reached the peak of conventional, cheap oil production, and supply chains will be one of the first places affected.

Since 2005, world conventional oil production has been stuck at about 75 million barrels a day. Only nonconventional sources like tar sands; ethanol; ultra-deep water; and new, enhanced oil-recovery technologies have added to supply. These are all much more expensive and less productive than conventional oil fields and eventually—as conventional fields continue to be depleted and these nonconventional ones fail to keep up—there will be a permanent decline in supply.

In spite of these warning signs, most of today's supply chains are still predicated upon and designed for cheap oil. Oil still moves 95 percent of the world's freight, and there are no viable substitutes for use in transportation available now or in the immediate future. In short, oil is still the "master resource" that impacts every cost in the supply chain.

Oil prices will almost certainly continue to rise, especially since 75 percent of the proven world oil reserves lies in the hands of the Organization of Petroleum Exporting Countries (OPEC). Most of OPEC's members are located in the Middle East and North Africa—a region awash in political turmoil and in some places civil war. The only constraint on oil price increases and demand, in my view, would be another worldwide recession or depression, and even that would be short-lived until growth resumes.

Occasionally, courageous supply chain leaders invite me to speak to their senior managers about the end of cheap oil and the implications for their supply chains. The senior managers are attentive and interested. The questions are thoughtful and concerned. But I have yet to see anyone but the supply chain leader exhibit a real sense of urgency. The others still seem to believe that oil-price spikes are temporary or that minor tweaks and adjustments will allow "business as usual" to continue.

These experiences have shown me just how hard it is for supply chain professionals to get senior management's attention, and they have left me wondering: What will it take to finally wake people up to the fact that we are not talking about minor tweaks here and there? How can we make them see that the only solution is to massively decrease the amount of oil used? And how can we finally convince senior management that many supply chains will soon be obsolete?

Barely enough
The world's demand for oil is growing strong and shows no sign of slowing. The U. S. Department of Energy (DOE) and the Interna tional Energy Agency (IEA) expect daily global oil consumption to reach 88 million barrels in 2011, an increase of more than two million barrels from the first quarter of 2010.

Do we have enough to supply that demand? In July 2008, when oil prices hit US $147 a barrel, the world was producing 87 million barrels per day, the highest production ever. Every oilfield in the world that could produce was producing. At the time, some experts estimated that Saudi Arabia had about one million barrels per day in spare capacity, but that was all. Based on that assessment, in mid-2008 the world was capable of producing 88 million barrels per day.

During the Great Recession of 2009-2010, demand declined to between 84 and 86 million barrels a day. What happened to supply during that time? My analysis shows that new oil flows in 2009 and 2010 were slightly less than the estimated 5-percent depletion in currently producing fields. Most of the new flows came from the more expensive, nonconventional sources mentioned above. By my calculations, maximum world production capacity for 2011 is around 88 million barrels a day—just about equal to the level of demand forecast by the DOE and IEA.

Has Saudi production peaked?
Earlier this year, there was widespread speculation that Saudi Arabia had spare capacity of between 3 and 5 million barrels per day, enough to give the world a comfortable cushion. However, when Libya's 1.2 million barrels a day went offline in March, the Saudis did not make up the difference, and prices jumped 20 percent in a few weeks.

Saudi Arabia has always been a good supplier and cognizant of its role as a swing producer when it comes to disciplining production and price. However, I am not convinced they have much, if any, spare capacity—or if they do, that they are willing and able to use it. What's changed is that Saudi Arabia's domestic demand has increased. The country now has a larger population than California and is the largest oil-consuming nation in the Middle East. Internal oil consumption is up 50 percent since 2000. They now have less to export.

Jeffrey Brown, an outstanding oil analyst who writes for The Oil Drum website (www.theoildrum.com), has focused on this issue. His analysis shows that in 2005, when average world oil prices were US $57 a barrel, Saudi Arabia exported 9.1 million barrels a day. In 2010, when average prices were US $79 a barrel, exports to the rest of the world dropped to 7.4 million barrels a day. Prices were higher, yet Saudi Arabia seemed to have less oil available to export—not a good sign for world supply.

I have long maintained that when Saudi Arabia's production peaks, world oil production peaks. Although we don't know yet whether that is the case, the decline in Saudi exports could be an early warning sign that this has happened.

In spite of that reduction in net exports, Saudi Arabia still accounts for 17 percent of the world's oil exports and provides the oil for 8 percent of the world's daily usage. Any disruption to Saudi Arabia's oil flows could therefore lead to a rapid and severe oil-price shock and an immediate, worldwide "liquid fuel emergency."

For Saudi Arabia, the recent political upheaval during the "Arab Spring" is cause for concern. At every point of the compass, the country is surrounded by revolt, revolution, chaos, and war. To relieve internal pressure and prevent similar chaos from occurring in its own country, the Saudi government announced that it would distribute US $130 billion in social spending over the next decade. Externally, we can expect the Saudis to bail out several of its neighbors, including Egypt, Syria, and Yemen. This situation— unrest throughout the Middle East and spending to alleviate discord—keeps the pressure on the Saudis to keep both prices and production high.

Even if Saudi Arabia is able to come through this period of unrest with production intact, the situation is so fragile that the loss of production from even a minor producer like Syria (500,000 barrels per day), Yemen (200,000 barrels per day), or Sudan (500,000 barrels per day) will roil oil markets.

No more slack
Clearly the system has no slack, and 2011 could be the year when demand starts to outstrip supply. The knee-jerk price decline caused by the recent release of 60 million barrels (or about 17 hours of world consumption) from strategic reserves, including 30 million from the United States, quickly played out. If the world economy does require 88 million barrels a day, shortages will begin to show up in some parts of the world. Before the end of 2013, expect diesel fuel prices to exceed US $6.50, no matter what happens geopolitically. If events in the Middle East and especially Saudi Arabia deteriorate, then the price run-up will happen faster, and shortages will occur sooner and be more widespread and severe.

We are now entering the Danger Zone. A price of $6.50 a gallon for diesel fuel and worldwide oil shortages should bring the reality of Peak Oil home. It will finally dawn on people in a visceral way that the "Age of Cheap Oil" is really over. The only answers to this crisis will be improved efficiencies and better use of resources. Business as usual will end. Governments must intervene, and the world will never be the same.