The Impact of Energy Supplies on Global Urban Environments

In urban areas, automotive emissions are responsible for at least 50% of air pollution. Vehicles that run on cleaner-burning fuels derived from natural gas, and hybrid and all- electric vehicles, have the potential to reduce these emissions. But the relative abundance and low cost of conventional gasoline means that alternative fuels are unlikely to be adopted more widely in the U.S. without sweeping regulatory and tax policy changes. Peter Wells, Chairman, Neftex Petroleum Consultants, explains the hurdles toward moving toward a cleaner-burning fuel environment.


Introduction by Gordon Feller

So 6.5 billion kilowatt hours of savings over a year in the portfolio, where is the energy going to come from to enable those buildings to keep warm, keep cool, keep lit, and stay healthy buildings? Fortunately, we have the one person in the world who Toyota believes and others believe is really capable of understanding the future and who doesn’t have an ax to grind. He’s a neutral party. His consulting firm is really the premier consultant to the people who are asking this question. Leaders, when they need to understand what’s the future of energy, they call Dr. Peter Wells. We’re grateful that he could join us here from the UK and from his global travels. Peter, thanks very much.

Dr. Peter Wells

After that introduction, probably the best thing for me is not to say anything at all. Cities actually consume most of the world’s energy. The corollary of that is without energy, you can’t have a city. The energy the cities consume, of course, comes in many different forms and it’s evolving all the time. One of the factors in that is the legacy system, not just transport but also the legacy systems. Legacy systems have long lives. In the 19th century, cities were steam-powered and moving into steam-powered turbines, we’re still using that technology for most of our power today. So the future options were going to depend on a number of things. Government’s going to have a role setting the fiscal and regulatory investment regimen in some countries. The price of energy is going to have a role. Consumers make choices not just on convenience but also on price.

I’m going to concentrate on 2 issues. The oil issue which is mainly about transport, what does the future hold, we hear about peak oil, we hear about peak car, what about the supply/demand of prices, what could the future look like. We’re going to look at natural gas. We hear about shale gas, the revolution of shale gas, the game changers we hear about, what actually is going on with it, is gas a potential option for transport.

As an example, these are 3 cities that I just pulled out and have a look at: London, Los Angeles, and Shanghai. This plots the population growth of those cities over time. You can see that London’s main population growth took place in what could best be described as the steam age: rail transport, coal power, and coal powering that transport directly. Los Angeles and Shanghai are much more petroleum-based cities, more related to the automobile. When oil production took off, these cities were just beginning to grow so they’re built around a different kind of legacy. You can’t just unbuild a city from its legacy. The legacy determines how it looks and how energy is consumed in it. These little maps are roughly the same area of scale. You can see how much bigger Los Angeles is because it grew up in the petroleum age whereas London is more compact and it’s based around the railway systems. The little red numbers around the bottom are quite interesting. The number of light vehicles in Los Angeles is over 6 million. London has 2.7 million. The second number next to that is also important: the miles per gallon consumed in most vehicles. Los Angeles is around 17 mpg; London around 32 mpg. The reason for that of course is in London, gasoline costs a lot more. It’s roughly $8 a gallon whereas in Los Angeles, gasoline is rather cheap. In fact, it’s too cheap, I think. None of you would agree with that.

This is some stuff that Exxon Mobil did. I think it’s worthwhile listening to this. I agree with most of this. It’s the expansion number of vehicles. The first thing they say is 90% of transport energy will still be supplied by liquid fuels in 2030. Of course, you would say they would say that. That’s what they produce so that is what they would want. But this is again coming back to the legacy. It takes 12 years to change out the fleet of vehicles, even in a country like the United States. It’s quite a big turnover.

This one is also from Exxon Mobil which shows where that growth in liquid fuel demand is going to come from OECD countries, USA are basically at peak car. Asia-Pacific is not. India and China have a growing middle class with aspirations to own the one thing that defines their status: a vehicle.

This one shows what I would call the first act in the petroleum age. This is the oil production from the 1900 to 2011. Most of this is conventional crude oil produced from oil fields. Natural gas liquids and gels come from gas fields that are also produced by oil companies in a fairly conventional way. So roughly 97% of the current consumption of oil is from conventional oil, oil that we are very familiar with in the oil industry. We’ve been producing it for over 100 years. Just beginning, we see some new things like shale oil, biofuels, and Canadian tar sands but you see how relatively small they are in proportion to the conventional crude oil.

Another interesting aspect about this history is for most of the oil production history, the industry has been regulated. Production has been controlled at a targeted price. The first group to do this is the Texas Railroad Commission from 1932 to the ‘60s. Then OPEC picked up when the Texas Commission decided it was not going to regulate the industry anymore.

Conventional crude oil you can more or less have a look at what it would look like in the future by looking at how it is being discovered. This little diagram shows the volume of oil discovered per year in various field sizes. Fields come in all sizes: small, large, just like cars. Here, we have the biggest fields in the world, mostly discovered in the 1960s, about 50 years ago. We haven’t done terribly well since. The same is pretty much true for the small fields. We’re getting much better at exploration. We’re spending a lot more money. We’re doing the whole job with much better science, much better technology. We’re doing the same number of wells, we’re just discovering less. This points to the fact that this is a finite resource and we’re coming to the last period of discovery of major fields. That doesn’t mean it’s all over. We’ll still be producing that oil maybe 50 to 60 years from now.

Look forward to about a decade. There are a lot of little increments of supply coming around the corner which are going to make life fairly easy for the next decade. We have Brazil – deep water. We have Iraq. The rest of OPEC will producing more. Then there are these little increments which are less conventional: NGLs, shale oil, Canadian tar sands, biofuels, and so on. On the downside of that, we’re going to have a decline in production of non-OPEC fields. Then we have incremental demand. Those roughly balance out. The new increments and the losses roughly balance out.

Where’s the new oil coming from? It’s not coming from a giant oil field discovered in the Middle East. That’s been done. We put a well in it and out comes 20,000 barrels a day for 30 years. It’s going to come from more complex, hostile environments like the Arctic, deep-water Brazil with 6,000 feet of water, the big thing of shale oil in the US. We have to remind ourselves that each well produces at first go is about 1,000 barrels a day. It’s very small. It also declines very quickly. At the end of the first year, it’s producing 300. So you could imagine to keep production going in the shale oil basin, you have to keep drilling. It’s a nonstop drilling process. It’s an industrial process and it’s completely different from what the industry is used to. Tar sands are also an industrial process. It’s mining.

Let’s have a look at demand and have a look at supply. On the demand side, this image shows the oil per capita against GDP per capita. I call this a tree of prosperity. Each national group seems to have a pathway. Mostly, this leads to a reduction in oil consumption per GDP as the economy becomes more service-oriented. Right at the top of this stack, we have the most profligate users of hydrocarbons – the oil producers. Gasoline is virtually free. Gas is virtually free so they consume enormous quantities per head. The next one down is the low tax countries like the US and Canada where gasoline is relatively cheap. Then you have the group below that −Europe, Japan and South Korea− who are on a different fiscal regime of high taxes to try and drive down consumption, which they succeeded in doing. Right at the bottom are emerging countries which are on the edge of this diagram: ASEAN countries, China and India. We think they’re going to have a trajectory below Europe because they’ll adopt all the technologies we already developed. They won’t go for high consumption because that’s against national security interests so they’re going to bumble along somewhere below Europe. That’s the broad picture.

There’s also a micro-picture here which we need to think about. When oil price changes, it impacts GDP and it impacts demand in the short term. This is the recent run-up in price up to 2008. This is the US data for GDP growth and oil demand. You can see there’s an impact. Price has an impact in this period. Before we got hit by the recession, demand was falling and GDP was falling.

So what about the future? How can we use some of this information to project things in the future? The work we’ve been doing with Toyota was to build an integrated model, not just a supply model, not just a demand model, but to put the two together. So we have a GDP-supply-demand-price model which can help us look into the future depending on the scenario we choose. The future is a novel and it’s best not to be too specific about it. But the general pattern we get from all the scenarios we run is governed by the principle you can’t consume more oil than you’re producing. Demand can never exceed supply over a long period. There are buffers in the system. There are stocks but they’re not going to last more than 12 months. After 12 months, demand has to fall. Demand is much more responsive than supply because it takes 10 to 20 years to produce new oil. If you went up to the Arctic today, drilled a well and discovered oil, you’re not going to see a barrel of oil till 10 to 20 years from now, whereas demand reacts very quickly. Demand can move in a year. We think what will happen is when supply starts to be crunched by demand, we have to have a recession to take demand out of the system. In some ways, the recession we just had was very helpful because it took a lot of demand out of the system. We just call it ratchet world. It’s not a very comfortable world.

This is a close-up of the next 20 years or so. We think we’re going to have about 8 years of relatively stable but relatively high prices. These high prices are set by two factors: Saudi Arabia’s wishes and the cost of marginal production, which is Canadian tar sands. Those are roughly the same sort of number. Each new barrel of tar sand costs about $80-$100 a barrel to bring on the market. That sets a kind of floor. We’re going to bump along that floor for a bit. When we start to lose production capacity again, the price will start to spike up. This just tells me the next price hike is around somewhere in the next decade. We kind of got used to this price regime: around $100, around $90, $3.60-$4 a gallon here in the US. We kind of got used to that and that’s the sort of world we’ll live in in the next decade.

What about demand? Let’s look at demand historically. This is OECD and non-OECD on the same chart. This comes out of the model but each country is modeled separately in the model so this is an aggregate of information. We lost about 4 million barrels a day of demand from OECD. Firstly because the price rose, we lost about 2 million. Then because of the recession, we lost nearly 3 million. We don’t see that demand coming back. In fact, it’s still pretty low. This is the peak car OECD. This is the resistance of consumers to drive more, so on and so forth. After a financial crisis, it’s very unusual to see demand for oil come back. OECD is pretty flat. All the demand is coming from Asia, which is the non-OECD. That includes the oil-producing countries themselves.

Here’s another interesting observation that comes out of this integrated model. This is a balance of payments view, just on the import/export of oil, nothing else. On the top half of this, we have all the people who gain money. On the bottom half, those are the ones transferring that money to the upper half. There is unprecedented transfer of money in the oil sector, $1-$2 trillion a year in real terms. It doesn’t look anything like that going back to the beginning of the oil age. That money’s going to have an impact on our lives. It’s going to have an impact on inflation. It’s going to have an impact on asset price inflation. Where that money’s going to go, it has to be recycled, how’s it going to be financed, so on and so forth.

There’s also a strategic shift going on in where the oil is coming from. This is a view of 2011. We can see Middle East is supplying a lot of oil to Asia, quite a lot of oil to Europe, and some oil to North America. In 2025, the Atlantic basin becomes separated. There’s enough oil being produced in it to supply North America’s needs and Europe’s needs, except for some from Middle East. This kind of a separation of North America from the Middle East suppliers looks attractive for some people. But, of course, the US isn’t insulated in a price sense from the Middle East because the oil price isn’t set here in the United States; it’s set in the global market. If something happens in the Middle East, the price is going to come here as well. Also, there are major allies for the United States across Europe and Asia. If they get hit by a supply crisis, they suffer and US suffers as well. So there is no diminishing of the strategic importance of the Middle East just because you become a little bit isolated from it.

Let’s talk about gas. Gas is not like oil. It’s very expensive to transport gas because it’s a gas, not a liquid. The pipelines that are used to transport gas are expensive. They require a lot of backing by large companies and banks. They have complex legal structures. Generally speaking, just like building a tanker, this is a much more complex system. Pipelines have political issues. If you got one pipeline supplying you with gas, that’s not terribly secure. The supply side, in some ways, is just as insecure as the demand side because you want security of demand if you’re a supplier, and you want security of supply if you’re a consumer. Natural gas is extremely abundant. This is just the gas we know about. You see the impact of shale gas. It’s a nice piece to have but it’s still not as big as conventional gas, both associated with oil fields and not. We have a lot of gas in the world and we keep discovering more and more of it. When I started my career in the oil industry with Shell, an old explorer took me to one side and he said, “You think you’re going to find a lot of oil but, mostly, you’ll find gas. We always find gas when we’re looking for oil.” That’s still true today.

Shale gas is going to be very important in the United States because you have the infrastructure for drilling the wells here. You have a whole industrial base. You also have very good geology. The US shale gas is already well underway. Of course, it won’t last forever but it will certainly last another decade and a half or 2 decades.

Natural gas is becoming the choice of power generation. Partly, that’s to do with its less emissions than coal and partly, it has to do with this shift away from nuclear. Germany is shifting away from nuclear because of what happened in Japan. The public said, “No, we don’t want any more nuclear reactors.” Germany which has a lot of nuclear power is going to have to shut all those down and replace them with something. Gas would seem to be the best choice but Germany already imports a lot of gas from Russia. There are issues about how secure is that. Do we just make ourselves more dependent on gas or do we do something else? Coal fire power stations with CO2 sequestration is probably where Germany is going to end up. Japan, on the other hand, is probably going to go only for gas.

This shows the complexity when you start looking at gas markets. This is the European market in 2030 and all these pipeline supplies coming in from different directions and LNG routes and so on. This is a view of what it might look like. Some of this infrastructure is already constructed and some of it isn’t. What this does show is how important Russia’s conventional gas resource is after Europe. If you look at these circles surrounding Europe, the big ones are in the Middle East in Qatar and Iran and Russia. There’s no getting away. If you’re going to be consuming gas in Europe, you’re going to be consuming Russian gas, at least in the eastern part of Europe.

The other thing this picture shows is how separate the western seaboard of Europe is from the center. The western seaboard of Europe has many options for importing gas through LNG so it actually ends up with a cheaper price.

This shows the supply balance against the demand in Europe as a totality. There’s enough gas in this region to comfortably supply Europe with gas way out to 2050 and beyond, but a lot of that gas is going to be Russian gas.

This is the issue about pricing. We talked about the complexity of the LNG systems and pipeline systems. In the past, these have to be underwritten by long-term take-for-pay contracts. The buyer would say, “I will take this for 25 years at this price in this sort of supply range,” usually 85% of the number. Those long-term contracts have built into them a price formula linked to oil. It’s not easy to get all this information because companies are quite secretive about it, but you can get enough information to tell you that Gazprom is charging Germany, for example, almost full oil price parity for its gas. The $100 crude, Germany is paying about $17.50 a million BTUs. Current hub price for US gas is around $2 so US has very cheap natural gas, too.

Coming out of western Europe, LNG starts to impact. LNG used to be in long-term contracts. Now it’s become much more common to have short-term contracts. Either a spot market or a marketer would buy the contract and take the market risk on himself. So in UK, parts of France and Holland, gas is cheaper than in Germany. Retail gas is the same but wholesale gas is cheaper. The separation of east and western part of Europe is quite important because there will be a preference for cheap LNG over expensive Russian gas.

Lastly, I’d like to look at something to do with transport and gas, natural gas vehicles. There are a number of measurements we can look at but the first is what about emissions. It’s hard to beat natural gas on emissions compared to conventional liquid fuels or things like ethanol, coal-to-liquids, and other options. It’s also hard to beat on SOX and NOX emissions as well. Curiously, it’s also hard to beat on price. This is the held price of about $4, which is twice where it is now. It’s actually cheaper to run a vehicle −in energy terms− off gas than it is off gasoline or diesel.

There’s one other city I want to look at which is Tehran, a city I’m reasonably familiar with having traveled around it. It’s a very congested city. It’s a very polluted city. The government decided on 2 things. One, they’ll have a mass conversion to natural gas vehicles. I think Tehran has the highest number of natural gas vehicles than any city in the world, roughly a million out of 3.5 million total vehicles. And they built a metro system which now carries around 2 million people. 89% of the emissions in the city come from vehicles. Everyone thought that’s going to solve the problem but it doesn’t. There are 2 reasons why it doesn’t. First of all, a lot of the vehicles in Tehran are motorcycles, which you can’t convert to natural gas and they’re also two-stroke so they emit an awful lot of smoke. Nevertheless, here’s a city that’s trying to do something with natural gas −because they have a lot of it− to try and improve their environment.

Just to conclude, in oil transport, we think the 2020 oil supply is adequate and largely priced to where they are today, +/- events like something in the Middle East or Europe’s own collapse or whatever. Price will likely be flat at around $80 or $90. There’s a limited price incentive in that for real big change in transport choices. People are not going to change what they do now just because the oil price has gone up. They kind of gotten used to it. This particularly affects cities in the United States where you have really cheap gasoline. Compared to the world scale, gasoline is really cheap here. People are going to be comfortable with that. They’re not going to change something else unless it’s more convenient. This is the cost/convenience trade-off. You can do an awful lot with the internal combustion engine which hasn’t been done yet, taking weight out of the car and improving efficiencies, and so on. But there has to be an incentive for doing so. A price incentive isn’t most effective.

Natural gas is now competitive with coal regardless of whether it’s carbon-sequestered or not. Natural gas is becoming the fuel of choice for power generation. It’s becoming the fuel of choice over wind as well. It’s simply because it’s so convenient. You can turn it on and off. It’s very efficient and it has relatively low emissions. Gas is also pushing into nuclear which has zero emissions and wind which has zero emissions. It’s not all good news for gas on the emissions side. It’s hugely better than coal. We expect China to favor shale gas if it finds enough of it over coal simply because it’s better for its cities.

Natural gas vehicles are a convenient, cost-effective, and viable option but the infrastructure to fuel it has to be constructed. You need purposeful vehicles. Not many people are happy with a giant tank in the back of their car. With the right regulatory push, natural gas vehicles could happen on a reasonable scale. It would still be fairly niche but it would make a difference in the urban environment, particularly somewhere in Asia. I’m thinking of Shanghai, Hong Kong where natural gas vehicles can make a big difference, as they’re trying to do now in Tehran. Thank you very much.

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