18 February 2010 | David Matthews
A peak in global oil production is fast approaching. David Matthews explores what buyers should do to keep business running smoothly
Fossil fuel buyers have a lot on their plate. Energy efficiency schemes in the UK and the prospect of carbon taxes are pushing many away from oil and towards gas. The uncertainty of energy security also means buyers have to keep one eye on geopolitics.
And at the end of last year, another daunting prospect reared its head: “peak oil”, the point in time at which the world’s oil output reaches its maximum and either plateaus or goes into terminal decline.
This could happen over the next couple of decades. So what can buyers can do to prepare for it?
Peak point?
In November the UK’s Guardian newspaper carried an interview with two whistleblowers with connections to the International Energy Agency (IEA), the body that advises 28 countries of the Organisation for Economic Co-operation and Development including the UK and US on oil stocks. The whistleblowers claimed the agency, under pressure from the US, was deliberately overestimating the world’s reserves to avoid panicking the markets. One said: “We have already entered the ‘peak oil’ zone. I think the situation is really bad.”
The IEA says it is not influenced by the Americans and maintains its estimates are made independently. But its predictions will hardly comfort buyers who are planning for the medium to long term. Last year Fatih Birol, the IEA’s chief economist, predicted that output of conventional oil – the easy-to-extract reserves that make up most of the world’s current output – will peak around 2020.
The IEA hopes the development of “unconventional” oil sources, such as Canadian tar sands [deposits of oil-rich bitumen in northern Alberta, Canada], will make up for some of the dwindling supplies of conventional oil, but these difficult-to-extract reserves currently make up only a tiny fraction of the world’s output. And doubts remain whether their production can be expanded in time.
In its 2009 World Energy Outlook, released in November, the IEA predicted that oil prices would reach $100 a barrel by 2020 and $115 a barrel by 2030 (in 2008 prices) – and stay there. Deutsche Bank predicts that oil will hit $175 a barrel by 2016.
The UK Energy Research Centre, which advises the government on energy issues, had already weighed into the debate in October, stating in a report that “a peak in conventional oil production before 2030 appears likely and there is a significant risk of a peak before 2020”.
There are also warnings of a possible shortfall around the middle of the next decade as a result of oil and gas companies cutting back on well drilling, refineries and pipelines following the economic crisis (and subsequent crash in oil prices). The time lag means oil production may not be able to keep up as global demand recovers.
So what can buyers do to protect their companies from shocks over the next two decades? The answer is a combination of buying ahead, switching away from oil-based fuels and pressing governments to help them weather the storm.
Buying ahead
Procurement should be looking to buy “blocks” of oil-related products for the future to insulate themselves against market volatility, says Martin Rawlings, director of UK energy consultancy Blizzard Utilities and chairman of the CIPS energy group. “If you’re sensible, and a big buyer – for example, a transport company – you should be looking at a flexible market-related deal,” he says.
A key buyer at Virgin Atlantic, who did not want to be named, agrees, and says that while longer-term deals might be more expensive than buying in the short term, they will protect companies from disruptions further down the line. For example, buyers can use “over the counter” (OTC) financial instruments, which allow trading to take place directly between two companies rather than through a market. This limits their exposure to fluctuations in price.
“OTC [deal]s are not as good a price as you can get on the spot market at the moment,” he says, “but they protect you from severe fluctuations.”
Purchasers will have to forge even better links with providers, he says. “One of the key things is to have strong relationships with your suppliers. As resources become scarcer you’ve got to be able to rely on them. In addition, there has got to be collaboration between suppliers and users to look at alternative fuels.”
However, purchasers may be unable to prepare for rising oil prices because markets offer relatively short-term contracts. This is because although it is technically possible to buy oil up to 10 years in the future, the further you buy in advance the less liquidity there is in markets and the higher the price, says the Virgin purchaser. “There is the possibility to trade out [buy in advance] for a decade, but it is difficult to find someone on the other side of a deal. If you’re a buyer, and there’s only one seller, they’ll test you to see how desperate you are,” he adds.
Damien Cox, a researcher at energy procurement consultancy EnergyQuote, says his clients are focused on buying one, two or three years in advance, rather than decades ahead. “Your average buyer is unlikely to be thinking about peak oil, because you just can’t buy that far out.”
Rawlings thinks purchasers are concerned about peak oil, but cannot buy for the long term. “Peak oil is on the mind of the average buyer – it’s whether he or she can do anything about it which is the problem. The best contract I could ever do was five years in advance.”
David Strahan, a business and energy journalist who warns of a peak in oil output before 2020, is doubtful that buyers can ever be fully certain of a supply.
“There’s no way as a supply manager you will be able to say, ‘I’ve got my guaranteed oil supply.’ It depends where the shortage is, but I find that hard to see,” he says.
So although companies may be able to insulate themselves from a possible “oil crunch” in the middle of the next decade through prudent buying, many are betting that they will need to reduce their oil consumption to withstand the next 20 years.
Reducing consumption
Already faced with the triple pressures of climate change, energy security and price volatility, many companies are looking at alternative fuels. “You’ve got to reduce your volume of [fossil fuel] consumption to reduce big shocks,” says Rawlings, who has a major client looking to wean its fleet off petrol.
“Transporters have got to look at hybrid engines, or even running lorries on autogas [liquefied petroleum gas]. One big customer is looking at changing its engines to autogas or hybrid, and for very short journeys they’re thinking about totally electric vehicles.”
Train operators say they are well placed to deal with peak oil because they expect the government to electrify the remaining 60 per cent of the UK’s rail network before peak oil becomes a major issue. One head of procurement at a major UK train operator, who did not wish to be identified, said that the remaining 30 per cent of the company’s diesel stock would switch to electric before the oil price became a major issue.
“We are not very concerned about peak oil,” he said. “Our current franchise has two years to run and, longer-term, our fleet would probably be replaced with all electric trains before peak oil is reached.”
It will be more difficult for other sectors, notably the aviation industry and plastics manufacturers, to move away from oil. Electric aircraft are not a possibility, partly because batteries are so heavy; and the hydrocarbons locked up in oil are still essential to plastics manufacturing. Both sectors are investigating the use of biofuels from plants, but the development of this idea so far is negligible.
Chris Brown, a spokesman from the British Plastics Federation, admits an alternative raw material for plastics is a long way from being commercially viable. “Materials using hydrocarbons based on biomass from rotting plants are emerging but in volume terms are tiny and it is still unclear the extent to which they will develop.”
Existing plastic will have to be reused, he explains: “There is an enormous amount of work going on to develop all aspects of sustainability in the industry from improving recycling levels to designing new products that use less material.”
Another option is to make oil from coal or gas, the buyer at Virgin Atlantic explains, but both methods have drawbacks. To produce one barrel of oil requires up to two tonnes of coal, and the process emits double the carbon dioxide compared with conventional oil.
Creating synthetic oil from gas is cleaner than using coal, but it is still not a sustainable source, the Virgin buyer argues. Both processes will be hit by rising carbon taxes over the next two decades, he explains, so the aviation industry needs to look at sustainable biofuels to replace conventional jet fuel.
“We want to develop a carbon-neutral source of fuel. It’s got to be financially viable – as fossil fuels become more expensive it’ll become more palatable in terms of cost.”
However, using grain-based biofuels is not an option, he adds, because it would mean diverting it from food supplies. “It must be sustainable from a global food and water perspective.”
Certain oil-based plants can be grown in deserts, and algae that feeds on carbon can also be turned into a viable biofuel, he adds. “The general consensus is that algae is the way forward,” he says. However, there are no large-scale farms for biofuel algae, with prototypes so far confined to small test sites.
Nonetheless, he believes that airlines can adapt to dwindling oil supplies. “I’d like to think the aviation industry will be using 25 per cent biofuels by 2020,” he says.
Government action
Buyers can only do so much to adapt to peak oil on their own. Many say they need governments to help speed up change. According to the buyer at the train operator, complete electrification of the UK rail network should be a priority, partly so that companies have other ways to move stock if rising oil prices force them off the roads.
“Train operators are able to do little to protect themselves against peak oil as the UK government controls long-term fleet and infrastructure electrification strategy at present,” he says.
“Government needs to invest in an infrastructure that can cope with likely future demand – more high speed rail and more capacity in local and freight routes.”
The testing of new aviation biofuels by regulatory bodies of all governments also needs to be quickened, according to the Virgin purchaser. “The biggest thing preventing the adoption of biofuels is getting the fuels approved by government bodies. I don’t want to see any relaxing of the testing process, but the sense of urgency should be sped up. There’s a lot of bureaucracy,” he says.
Industry is already lobbying for a crash plan for peak oil. The UK government must also urgently roll out renewable energy projects to avert a peak oil-induced economic crisis as early as 2011-13, according to the UK Industry Taskforce on Peak Oil and Energy Security.
The taskforce, made up of transport and energy companies including Virgin, Stagecoach Group, Scottish and Southern Energy and FirstGroup, recommended a huge increase in energy efficiency and an expansion in oil and gas production in its 2008 report The oil crunch: Securing the UK’s energy future.
“The problem is in the developed world our power and transport infrastructure is based almost entirely on fossil fuels,” the report says. “With the best will and the best technology in the world this will take decades to change.”
If buyers are to prevent their companies from grinding to a halt as the lifeblood of the world economy begins to dry up, they need to be part of this change.
CASE STUDY
STAGECOACH GROUP
PREPARING FOR THE FUTURE
With a coach, bus and rail empire spanning the UK and some of North America, Stagecoach Group is heavily dependent on fossil fuels. Fifteen per cent of its bus business expenditure goes on 300 million litres of diesel a year, so the company is looking at how it can adapt to an oil squeeze, says spokesman Steven Stewart.
The company protects itself against short-term price shocks by hedging its diesel around 18 months in advance – in other words, ensuring a fixed price. But hedging in the medium to long term is not yet economically viable, says Stewart, so “the focus is on what we can do in terms of alternatives and lobbying government”.
Fifty-six hybrid buses are being introduced in Manchester and Oxford later this year. Stagecoach is investing £11 million in the vehicles and has also been awarded £5 million from the Department for Transport’s “green bus fund”. However, without subsidies hybrid vehicles are difficult to justify economically because they cost about 50 per cent more than standard buses.
Stagecoach also runs 30 “BioBuses” on recycled vegetable oil and animal fat, but biofuels are limited. “There just isn’t enough supply to power our whole fleet,” he says. Hybrid and biofuel vehicles therefore make up a very small proportion of Stagecoach’s 7,000-strong UK bus and coach fleet.
Using braking energy from trains to make electricity for the National Grid could save as much as 20 per cent of Stagecoach’s rail energy bill, says Stewart. But it would be easier to move away from diesel if the remaining 60 per cent of the UK rail network was electrified, he says.
Stagecoach is keen to move away from oil, but Stewart says that potential buyers of cleaner vehicles and fuels are constrained by hybrid manufacturers, technology and the government. This was one of the reasons the group joined the UK Industry Taskforce on Peak Oil and Energy Security.
“We felt it was important to have a debate about these issues – peak oil is going to be an issue the next UK administration will have to face up to,”he says.
