Stephen Leeb & Charles Hall on EROI & Investing

Stephen Leeb. 5 Jun 2013. Dangerous Times As Energy Sources Get Costlier To Extract. Forbes.

The optimists believe that our energy problems have been largely solved. I wouldn’t bet on that. The real issue with oil isn’t how much we have or even whether we can continue to increase production. 

What really matters is the cost of resources, in terms of resources required, including energy resources, to keep producing oil.  On that front, the U.S. is losing ground at an alarming pace.

Simply put, it takes energy to get energy. In today’s world, it takes rising amounts of energy to get all the new energy sources out of the ground and ready to use.

The critical concept is “energy return on investment,” or EROI.

This means the amount of energy obtained from each unit of energy invested.When oil first began to flow, its EROI was around 100, according to State University of New York professor Charles Hall.

Drillers would use 1 barrel to extract 100 barrels from the ground.

Today, it takes about 1 barrel of conventional U.S. oil to produce the equivalent of 9 barrels.

Even worse is the EROI for non-conventional oil from shale and tar sands, stands, which is about 4.

The lower the EROI, the less energy is available for the economy. If EROI were 1, the economy would be channeling all energy produced into making energy. In other words, it would be curtains for our civilization.

SUNY professor Hall estimates that for an industrial society to function and grow, EROI should measure at least 5 to 9. Oil from tar sands and shale does not make that cut.

Based on 12-month averages, oil prices today are only some 5% below their all-time peaks, although, according to the Energy Information Agency, per capita consumption of oil has decreased 17% from its 2007 high. Why don’t we see a larger price decline? Economics 101 would suggest that greater supply coupled with lower demand should produce tumbling prices. That isn’t happening, since we funnel much of the extra oil made available by lower demand and rising production into oil production itself.

Why do non-conventional energy resources have such low EROI? 

  • The drilling apparatus and infrastructure needed to extract oil from shale demand large quantities of steel, derived from iron ore, whose production and refinery in turn require energy.
  • Huge energy costs to transport of water, chemicals and other materials essential to fracking.
  • Tar sands likewise require mining equipment whose manufacture and transport consume still more energy. Mining tar sands, moreover, also uses natural gas.

Lending money to oil and gas companies is the fastest-growing part of banking.  According to Schlumberger, capital expenditures for oil and gas have grown by about 12% annually over the last decade, yet oil and gas production grew less than 2% a year.

One vicious cycle playing out in America starts with the consumer, who has had to cut back on energy use. Less energy translates into less mobility, less shopping, and in general fewer consumer expenditures. Fewer consumer expenditures mean less demand and more pressure on corporations, which are also squeezed by higher resource costs. Wages in turn get squeezed, but resource prices remain high, and the vicious circle is completed. It is no surprise that this century has seen a 10% decline in real median income, which when measured in time and depth is probably the most protracted on record.

Things may be even worse than that.

  • Resource-intensive production of oil and gas increases the scarcity and costs of other resources such as water and therefore of food, which also depends on water.
  • Resources like copper and iron ore that use a lot of water and energy are also squeezed, and you have another vicious, potentially catastrophic, cycle.

Oil and gas producers critical metrics are:

  1. Free cash flow. Negative free cash flow used to mean investment in growth, now it suggests the company is running in place.
  2. Growing production.   Slumping production, especially in non-conventional hydrocarbons, will probably require ever greater spending to sustain that growth, which to me is a recipe for long-term disaster. In fracking especially, another factor contributing to the lower EROI ratio is the high depletion rate of the wells. In an earlier era, producer growth related closely to the number of wells drilled. Today, oil production from a new well often declines sharply after the first year.

Some producers do satisfy my dual criteria. Among the larger companies Chevron and Occidental Petroleum stand out. The more  speculative small fry we like include Denbury Resources DNR and recently recommended Energy XXI. Denbury has outperformed the SPDR S&P Oil & Gas E&P ETF (XOP) year-to-date, but EXXI is down 23% so far this year.

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