Days of world consumption: A warning label for oil and gas discoveries

A few years ago I was speaking before a group shortly after a local oil company discovered what was characterized as the biggest find of oil on land in the United States in 30 years. The president of the company refused to speculate about the size of the find other than to say that it was "significant." The media suggested that it might amount to one billion barrels.

I mentioned this find to my audience and asked them how long they thought one billion barrels would last the world at the current rate of consumption. Guesses ranged from six months to three or four years. The correct answer was 12 days. Naturally, people were astonished and dismayed.

That is why I think it would prove useful for a warning label to come with each public announcement of a large oil or natural gas discovery. I understand that the companies that make these large finds are anxious to emphasize the size of the reservoir since this tends to goose the stock price. And, it is reserves that investors seem to react to, though, as it turns out, reserves are probably the least important factor in deciding whether a find is worth producing. (See my recent piece, "Reserves are bunk" for more on this.)

Now, I don't expect any government agency to issue a regulation requiring a warning label on oil and natural gas discoveries. But the next best thing would be for journalists reporting such finds to put them into perspective using a days of world consumption figure, or if the find is natural gas that will only be marketed domestically, days of domestic consumption. Journalists would also do well to explain that depletion rates for existing oil wells run between 6 and 9 percent and that this depletion must be overcome before any growth in supplies takes place. Providing this context would serve to alert policymakers and the public to the true significance (or insignificance) of each find.

Let's look at how some recent large finds might have appeared with the warning label I suggest:

Date	Description	Type	Recoverable Resource Claimed	Days of World Consumption*
July 2000	Kashagan	Oil	9 to 16 billion bbls	119 to 211
Sept. 2006	Gulf of Mexico Lower Tertiary	Oil	3 to 15 billion bbls	36 to 178
Nov. 2007	Tupi (Brazil Offshore)	Oil	8 billion bbls	94
Sept. 2009	Ngassa-2 (Uganda)	Oil	310 to 710 million bbls	4 to 8
Jan. 2010	Davy Jones (Gulf of Mexico)	Natural Gas	2 to 6 tcf	32 to 95**
Year End 2008	Proven U. S. Shale Gas Reserves	Natural Gas	32.8 tcf	517**

*Based on previous year's consumption   **Days of U.S. domestic consumption, 2008

Keep in mind that I am not quibbling with the recoverable resource estimates. Nevertheless, we should remember that things don't always work out as oil and natural gas production companies would like. Some will say I should include industry estimates of how much shale gas is likely to become available in North America over time. I say that we should wait and see if the industry projections actually work out. Caution should be our watchword when it comes to making public policy based on industry hype that is largely designed to make a company's stock price go up.

This kind of table, though not a perfect tool, would tend to temper the enthusiasm of the public and policymakers for a course that assumes that oil and natural gas will remain abundant for decades to come. If we want to create a robust society that will weather the inevitable energy transition away from fossil fuels, we might start by looking squarely at what recent large discoveries actually amount to. And, we should proceed, as I suggested in a recent piece, to make our society forecast-proof insofar as fossil fuels are concerned. In short, to paraphrase the current chief economist of the International Energy Agency, we should leave fossil fuels before they leave us.

Biophysical economics: Putting energy at the center

My latest column on Scitizen entitled "Biophysical Economics: Putting Energy at the Center" has now been posted. Here is the teaser:

Many scientists have long complained that standard economics fails to account for the biological and physical systems that form the basis of the economy. In short, the economy is a subset of the environment and governed by the same biological and physical laws as every other system on the planet....Read more

Useful work versus useless toil revisited

It was the contention of William Morris, the great progenitor of the modern arts and crafts movement and the historic preservation movement, that the signal qualities of industrial society are waste and useless toil. One hundred and twenty-six years after Morris gave a lecture entitled "Useful work versus useless toil" to a group of workingmen in London, little has changed except perhaps that the amount of waste and useless toil has grown exponentially.

The waste, of course, is obvious: wasteful consumption (tied neither to survival nor beauty but rather status); planned obsolescence as an industrial principle (which helps create repeat sales as well as ever higher mountains in our landfills); and profligate energy use which exhausts finite sources of energy such as fossil fuels.

Useless toil refers to all those tasks which either produce nothing of value for society (even if they enrich some individuals) or which actually detract from the overall public good. Morris had a nascent environmental awareness and decried the destruction of the landscape caused by industrialism in England.

Today, some of Morris's themes may seem passé. He champions shorter working hours so that people can not only rest but also have adequate leisure to enjoy their lives. He thinks work ought to be on the whole pleasurable, that human beings want to work and make things of value and beauty. And, he wants working conditions to be not merely tolerable, but actually pleasant and enticing.

Some of the world's leading companies have striven to make work as Morris had envisioned it a reality. But perhaps the most questionable aspect of modern work is what it produces. Craft was at the core of Morris's philosophy, and so the mass consumerism made possible by industrial production has created a world that is an anathema to Morris's notions of usefulness and beauty. And, it has condemned countless millions of industrial workers in so-called developing countries to live in conditions not far removed from those suffered by the English working class in the 19th century. Think Charles Dickens' Oliver Twist and Friedrich Engels' The Condition of the Working Class in England in 1844, the latter a truly grim accounting.

Another important indictment would be that against the so-called FIRE economy, that is finance, insurance and real estate. Morris would consider these functions parasitic on the true productive output of the economy. He might have advised keeping such functions to a minimum, more like public utilities than central players in the economy. And, the great mass of jobs involving sales, marketing, advertising, public relations, consulting, legal work, accounting and the broad array of desk jobs necessary for any large industrial concern--the jobs we tell college students to prepare for--would also be considered parasitic on the system. Morris would consider practically all the work in these occupations useless toil, no matter how pleasant the working conditions or how good the pay.

How then to run a complex, modern industrial society along principles conceived by Morris? The simple answer is you can't. But in a society beset by the problems of peaking fossil fuels, climate change, deforestation, depletion of water, destruction of fisheries, and erosion of farmland, Morris sounds like a person in the vanguard of the sustainability movement. Even more famous during his life for his novels than for his tapestries and stained glass work, Morris described the kind of society he deemed consistent with his principles in a utopian novel entitled News from Nowhere.

News from Nowhere describes a highly decentralized craft- and agricultural-based society of small towns and villages, one with democratic governance and equality of the sexes. Using the trope of a man visiting the future--200 years into the future to be precise--we get not only a description of the current conditions, but also a history of how the world evolved to that point.

News from Nowhere is not a literary masterpiece. But it offers a useful look into the mind of a man who thought deeply about the relationship between the way we organize the economy and the way we structure society. And, he offered a radical vision that sounds very much like the radical vision of those now proposing the relocalization of human society in response to the myriad challenges we face to our very survival as a species.

For Morris two guiding principles undergirded his social thinking: 1) Nature ought to be the aesthetic guide for society, and 2) pleasure in labor is a necessary condition for the creation of beauty. These principles are not a bad place to start if you are trying to remake all of society. They focus us on nature as we must, and they provide the basis for an appealing vision of a low-energy society that provides high satisfaction for its members.

Making society forecast-proof

The trouble with forecasts is that they are almost always wrong. That's in part because the accuracy of forecasts deteriorates rapidly with time. I might predict quite well what I will be doing tomorrow. But predicting accurately what I will be doing exactly one year from today or exactly 10 years from today is exceedingly difficult if not impossible, even if I already have something planned.

How much harder it is then to predict the state of complex systems such as the world's energy delivery systems 10, 20 or 30 years hence. There are many factors that make such predictions hard including:

• the inaccessibility of audited data such as oil and natural gas reserves for many of the largest producing countries in the world
• the uncertainties about future discoveries
• the uncertainties over the rate of depletion for fossil fuels
• the uncertainties concerning future technological advances in extraction and energy efficiency
• the growth and viability of alternative fuels
• and the future course of energy prices and the world economy just to name a few.

And yet, we have premised our entire future on business-as-usual forecasts made by leading energy consulting firms and government agencies. Strangely, some of these forecasts come without even the slightest hint about how unreliable they may be. A forecast from the highly influential energy consulting firm Cambridge Energy Research Associates tells us we have precisely 3.74 trillion barrels of remaining recoverable oil in the world. It concludes that a peak in world oil production is still at least 20 years off and is to be followed by an "undulating plateau that may well last for decades." Neither a range nor an error bar can be found in this forecast.

Because such forecasts have been embedded in public policy and business planning worldwide, we have made our entire global society dependent on getting these forecasts right. If they turn out to be too optimistic, then we could all be in for serious trouble. Since long-term energy forecasts--and really any long-term forecasts--are difficult if not impossible to get right, perhaps we should consider making society forecast-proof insofar as that is possible.

When it comes to energy supply, the surest way to make that happen would be to power society with 1) solar energy and its derivatives including wind, waves, and biomass, 2) energy derived from gravity such as tidal power and 3) hydroelectricity which is made possible by gravity and the water cycle. These sources fall under the heading of renewable energy, of course, and it more a scientific fact than a forecast that the sun will burn for a few more billion years and that the force of gravity will be with us indefinitely.

A global society powered in this manner would be immune to any forecasts about future supplies of fossil fuels, be they pronouncements of plenty or warnings of imminent supply shocks. Yes, the future of the petrochemical industry might be at stake, and given the current nexus between agriculture, oil and natural gas, this is no small issue. But if food production were also made independent of fossil fuels, then we would create an even more resilient society. (Such a move might mean many more people would be involved in growing food in such places as their yards, community gardens, and unused urban, suburban, and rural lands. But again, the upside would be an agriculture freed from the dangers inherent in fossil fuel supply forecasts.)

Naturally, the industries and interests which benefit from the world's addiction to fossil fuels would not be in favor of such a society. And, that is why they entertain us with their frequent forecasts of fossil fuel abundance far into the mists of the distant future.

If we were to attempt to make all major activities in global society less exposed to forecasting errors, many of those who currently make their living producing essentially defective forecasts would lose their jobs. No doubt they would forecast a tremendous cataclysm if this were to occur.

Forecasts may, in fact, be desirable in many parts of our lives. We like to know what the weather will be today and tomorrow and perhaps for the week. We seem to have an appetite for the weather report regardless of how many times it is in error. Companies need to project what their prospects will be before they attempt a new venture, release a new product or enter a new market. In each case the forecast a company makes may be right or wrong, but a wrong forecast won't bring down all of society!

And, that is my central point. I am not suggesting that we somehow eliminate forecasting. Rather I am proposing that we structure our lives and society so as to make forecasts largely irrelevant. A resilient, robust society would be one that is not dependent on finite, nonrenewable energy sources. It should be highly decentralized, diverse, redundant and mostly small in scale in its critical functions such as the procurement of energy and food.

Under these conditions forecasting would be far less critical, and errors in forecasting would be far less likely to lead to a civilization-wide catastrophe. This is true for two reasons. First, the energy sources for such a society could not suffer depletion. Second, due to the highly decentralized nature of such a society, parts of it could fail without bringing down the entirety of global civilization. Naturally, there should be arrangements for mutual aid when catastrophes occur. But that aid would be much more assured in a system where most of the parts of the system survive and thrive even in the face of a localized tragedy.

Making society forecast-proof doesn't assure us that no problems will arise. It only helps us to keep those problems smaller, more localized and therefore much more manageable when they do arise. This may one day be seen as a virtue in a world experiencing ongoing global financial turmoil borne of the excessive size of financial institutions and the excessive concentration of risk in them, risk that was poorly understood and therefore poorly forecast.

A simpler, more robust world is possible, and we would be wise to choose it before that simplification is forced upon us by circumstances that we may find exceedingly unpleasant.
_____________________________________________________________

The inspiration for this piece was a presentation featuring Nassim Nicholas Taleb, author of The Black Swan, who now seems to be on a mission to make the world safe from forecasters. He discusses his views alongside Daniel Kahneman, a Princeton psychologist who has studied economic behavior and found it to be far different from what neoclassical economics predicts. Kahneman received the Nobel Prize in economics for his work.

The discussion between these two men focuses primarily on the fragility of the current global financial system and how to make it more robust. It is a stimulating hour of listening.

Listeners might want to consider one obvious implication of Taleb's conclusions. The value of one's investment and/or retirement portfolio is entirely dependent on frequent accurate forecasts from today up to the date of planned liquidation. Should nonprofessionals be risking their savings in this way?

                                                                                               --KC

The problem of induction and the blindness of fools

The problem with the future is that it's not always like the past. In fact, were this statement not true, history would indeed be "bunk" just as Henry Ford once said. But, of course, history is a chronicle of what changed and therefore led to a future that was different from the past.

So, it is puzzling that such an obvious truism is so easily dismissed when it comes to the future of oil and energy in general. Enter one Porter Stansberry, an investment newsletter writer, who knows that "peak oil is an economic impossibility." In the linked interview he likens oil to copper. We have found substitutes for copper, namely optical fiber, so we will certainly find substitutes for oil in the quantities we need at the time we need them. He insists though that we won't need them for a very long time.

Stansberry is correct when he states that "[i]t does not naturally follow that a limited supply of oil would limit our production of energy." There are certainly many other known ways to extract energy from the environment. Perhaps some of them such as widespread deployment of thorium-based molten salt reactors might validate Stansberry's observation. But then he states:

The idea that we would lose the ability to create energy in an economic way, in my mind, is absurd. The entire history of the human population is nothing but falling prices for valuable commodities-not measured in dollars, but measured in real terms. I have no doubt in my mind that by the time I'm dead the price of energy in real terms will be far less than it is today.

Here he makes sweeping general statements about the past. It is not true that commodity prices have been falling in real terms for all of human history. There have been sustained bouts of rising prices. It is true that real prices for many commodities have been on a roughly downward trajectory from the beginning of the industrial revolution. This is in part due to the rising availability of cheap fossil fuel energy used to obtain those commodities, whether it is metal from ever lower grades of ore or rising farm productivity largely abetted by fossil fuel inputs such as nitrogen fertilizer from natural gas and pesticides and herbicides from petrochemicals.

So, in one respect Stansberry's analysis suffers from failing to distinguish between sources of energy such as fossil fuels and materials which do not provide energy such as copper. Fossil fuels, our main sources of energy, are the prime movers in the industrial economy. We cannot simply substitute some other materials for them without careful discernment. There are many factors to consider such as energy density, portability, energy return on investment, the requirements of the existing infrastructure and so on.

Still, Stansberry may be right in what he asserts about the future or he may be wrong. But one thing he cannot be is certain. It is a truism that no one can prove anything about the future. So, we often choose to extrapolate current trends. This is what Stansberry does, and it is where he moves from logic to mere supposition. Stansberry, like so many of us, falls into the trap of the problem of induction.

The problem of induction is simple to illustrate. Whenever we notice a recurring pattern in events, we often assume that that pattern will persist, and we sometimes make unwarranted claims usually in the form of a general rule:

Karl Popper (1902- 94) was critical of the inductive methods used by science. The empiricist David Hume (1711-76) had argued that there were serious logical problems with induction. All inductive evidence is limited: we do not observe the universe at all times and in all places. We are not justified therefore in making a general rule from this observation of particulars. Popper gives the following example. Europeans for thousands of years had observed millions of white swans. Using inductive evidence, we could come up with the theory that all swans are white. However exploration of Australasia introduced Europeans to black swans. Poppers' point is this: no matter how many observations are made which confirm a theory there is always the possibility that a future observation could refute it. Induction cannot yield certainty.

And, yet on something as important as energy policy, people with the views exemplified by Stansberry hold sway. They do not accept that their view could be in error. To do so would imply a much different energy policy than the one which most countries are now following. Most policymakers stick to Stansberry's view even though there is considerable evidence that fossil fuel production, particularly oil, may begin to decline soon. And, they seem not to understand that existing alternatives suffer from problems of scalability and energy density and face the all important rate-of-conversion problem.

But, one does not have to know anything with certainty in order to decide on policy. In fact, policy is always based on incomplete information about the past and guesses about the future. What policymaking requires, especially in critical areas such as future energy supply, is humility and therefore caution. The amount of caution required depends on the plausible dangers we face. The range of possible outcomes for oil production five, 10, even 20 years hence is so wide as to require excessive caution when planning the world's collective energy policies.

If the optimists such as Stansberry are correct, then policies suggested by that excessive caution will have put global society on a sound road to an alternative energy economy. That would reserve much of the remaining hydrocarbons for high-value uses such as fertilizers, plastics and pharmaceuticals rather than mere burning. If the optimists are wrong, then such policies will be the difference between stability and chaos, between life and death, for the billions that inhabit the Earth.

These are the consequences that might result from the blindness of fools who do not understand basic logic. And, we cannot count on nature to suffer such fools gladly.

Hope, hopelessness and faith

The trouble with hope is that it is so easy to do and so easy to dash. We hear people say that they hope so and so will get well or will get that scholarship he or she needs to attend college or get the job he or she has applied for. There is rarely a second step in this kind of hope. And, those to whom we pay this lip service hope can through circumstances or poor conduct very easily dash our hopes.

In the political world, we often place hope in the leaders we elect. We hope they will do the right thing, enact the right policies, appoint the right people. While there may be a second step in this process--that is, pressuring our political leaders to do what we want them to do--there is little a modern voter can do when arrayed against the money and lobbyists of the corporate world.

We often hear people say that it is impossible to live without hope, by which they mean hope for something better than the current set of problems we face. There may be something to this. To believe that an unbearable present will only be followed by an unbearable future is truly debilitating. But in a world of constant change we can be virtually certain that the status quo will falter at some point.

For those involved in issues of sustainability, peak oil, climate change, and relocalization it might be better to feel a certain hopelessness in our situation. For hope implies dependence on forces outside ourselves. Once we abandon that hope, we can get down to the tasks at hand, the tasks that need to be done--for which we need to ask no politician or government official permission--tasks that we can get started on today. In this way hopelessness concerning the current political and economic arrangements becomes an ally.

So, what we really need is not hope. Hope can be the enemy of action. Hope can be a drug that maroons us in cafes in long, satisfying conversations that never lead anywhere but back to the cafe the next night. In hope's place I nominate faith. Not religious faith, but what George Santayana calls "animal faith." The great American psychologist James Hillman describes it in his book "Inter Views" in this way:

[Animal faith] is faith in the world: that it is there, that it won't give way underfoot when you take the next step, that you just know which way to turn and how to proceed. It's the faith your hands have and your feet have.....the cat jumps on the tree and starts climbing. The tree is not an object of faith to which the cat gives assent. It is a tree in an ecological field belonging to the cat's climbing. The cat has an animal faith in the tree and it loves the tree, loves itself, loves jumping and climbing--no self-examination there, no introspection about belief.

Hope is part and parcel of our pathology, Hillman writes in "Suicide and the Soul." But faith, animal faith, is commitment to the moment, commitment to putting one foot in front of the other, to getting up in the morning and making breakfast. The day will bring what the day will bring. We do not need to "hope" for anything.

And, as we go through the day, our faith can grow. This is not a faith based on belief, but rather on experience, the experience we gain with each small act and the competence that grows in us as a result of those acts. Our faith can also grow as a result of the trust we build with others as we work with them for mutual goals.

So, as we look to the year ahead let us not "hope" for a better year to come. We will almost surely be disappointed and only rarely pleased as we sit on the sidelines watching. Rather let us focus on putting our "animal" faith to work on the tasks at hand and let our engagement be the joy of the new year.

Why climate change adaptation could make things worse

My latest column on Scitizen entitled "Why Climate Change Adaptation Could Make Things Worse" has now been posted. Here is the teaser:

Because many of the proposals for adaptation to climate change require further extensive release of greenhouse gasses, they will only make climate change worse....Read more

Technology will save us...or not

Technology will save us--it's the mantra heard around the world when it comes to climate change, fossil fuel depletion, and myriad other environmental and resource challenges. But, that mantra rarely comes with the proviso that technology often has unintended and even perverse consequences.

"Yes, yes," you will say, "we know that." Then, why, may I ask, is this almost never mentioned in the same speeches, op-ed pieces, and journal articles that tout the efficacy of one or another technology to definitively solve or at least help solve critical environmental and resource problems? It is because these pronouncements are polemics, or more properly, sermons meant to instruct us in the supposed invincibility of our technology.

Let us take just one example of a technology that is so ubiquitous that people rarely even think about a world without it: the automobile. The automobile was probably the signature technology of the 20th century, one that shaped culture and in turn shaped so many other technologies that serve our automobile-based culture. If humans had understood ahead of time that automobiles would result directly or indirectly in the following, would society have chosen to allow their widespread use?

• Climate change
• Health problems and mortality due to air pollution
• Pollution of groundwater from decrepit gasoline storage tanks
• Urban sprawl
• Hollowing out of many American cities
• Massive traffic jams
• Dependence on unreliable foreign sources of oil
• Serial military conflicts involving access to and control over oil
• Paving and development of prime farmland and forest
• Mass death and disability due to accidents on the world's highways
• An obesity epidemic related to loss of walkable living environments
• Massive public expenditures for roads, parking and other purposes related to automobiles (to the exclusion of other priorities)

I have not tried to be exhaustive. But, I think this list outlines just how deleterious the automobile has been not only environmentally, but also socially and economically. Now, of course, it would have taken exceptional clairvoyance to have foreseen all the perverse consequences I list. But that is just the point!

What allows those who are so confident about the salutary outcomes for their favorite technological fixes to pretend that there will be no perverse and even fatal consequences related to them? How can the technological optimists be sure that their solutions will not lead either to the opposite of what they intend or to other problems perhaps even more intractable than the ones they purport to solve? Perhaps the most readily obvious example is the notion that energy efficiency will result in a reduction of energy use. But the Jevons Paradox tells us that just the opposite happens by making energy cheaper due to a reduction in demand and thus subject to greater demand as more people take advantage of the lower prices.

The technological optimists seem to be unaware of how complex the energy, climate, forest, and other systems with which they propose to tinker are. They do not know the ecological dictum that you can never do just one thing. Each action ramifies outward into any complex system resulting in multiple unforeseen and often unwelcome effects.

But, all of technological optimism can be summed up in one desire: The desire not to have to change any of our current behaviors. And, yet it is our behavior that most of all needs changing. To be sure, even changes in our behavior can have unforeseen and sometimes perverse consequences. But I would venture that these unforeseen consequences would be far less troublesome than those related to new technologies provided that any changes in behavior are guided by two principles: 1) To increase the long-term resilience of human society and 2) to increase the margin of safety in the way in which we exploit the environment. For example, we could decide that the target for carbon dioxide in the atmosphere should be 350 ppm--below where it is today--as some advocate, instead of taking a chance that a much higher reading could put us past the tipping point that will lead to runaway global warming.

It is hubris to believe we can easily and precisely calculate the limits of extraction and pollution and then move right up to our artificially calculated limits and still achieve sustainability. Instead, we should take a path of much greater humility that acknowledges that we must build greater resilience and wider margins of safety into our physical infrastructure and our everyday practices.

Ultimately, I believe, we will be forced to live in a much lower energy society. And, that means that the set of behaviors that need to change most will be those that currently lead to overconsumption.

No post this week

I am on deadline for a large writing project and have been unable to find time to write my usual weekly post. I expect to post again on Sunday, December 20.

Reserves are bunk

Henry Ford is famous for having once said, "History is more or less bunk." He was, in fact, attacking tradition in an age of rapid technological and social change. Almost a century later we have a less ambitious observation which may not achieve the broad visceral appeal of Ford's statement, but one which may turn out to have a good deal of importance, to wit: Oil and natural gas reserve numbers are more or less bunk.

Let me introduce you to B. J. Doyle, vice president of operations for a small Houston-based oil and natural gas exploration company. Doyle's views on the oil and gas business have been on display for more than a year now at The Oil Drum, a site famous for its technical prowess and breadth of coverage when it comes to energy-related issues. On the site Doyle goes by the moniker Rockman, and through his frequent comments he has been trying to educate readers about the realities of the oil and gas business.

Now, he didn't actually say that oil and natural gas reserve numbers are more or less bunk. Nevertheless, that is a fair summary of what he told me when I spoke with him recently. To understand why an insider would cast aspersions on this sacred metric of the oil and gas industry, you need to know two things. First, Doyle doesn't have to please shareholders. The company he works for is privately held. Second, reserve numbers are meaningless unless they are indexed to a price.

Doyle began his explanation with a seemingly astounding statement: "One of the things we're least interested in is the amount of oil and gas that we are going to produce." How can this possibly be true? It turns out that the oil and gas industry uses a method common to nearly every modern business enterprise to evaluate its investments, namely, net present value analysis or NPV.

The concept is actually simple. If you have the choice of receiving $1,000 now or $1,000 three years from now, naturally you'd take the $1,000 today. That's because of what is called the time value of money. If you can invest the $1,000 today, say, in a bank CD, you can at least earn some interest in the next three years. Also, if you were foolish enough to wait for your money, inflation might undermine the purchasing power of that $1,000. The inflation calculator at the U. S. Bureau of Labor Statistics shows that it would take $1,072 in 2009 to equal the purchasing power of $1,000 received in 2006.

Every business knows that there are several ways in which it can invest its capital. So, business owners take the amount of the initial investment in, say, a new factory or a new oil well, and subtract that amount from the present value of what they forecast will be the future cash flows from that investment. If the amount is positive, then the project will be profitable and should be considered. If the amount is negative, the project should be abandoned. Of course, there are many factors when considering an investment, but a project that appears to be unprofitable will certainly not be considered.

Net present value analysis, however, doesn't describe the real world perfectly. This flows from the obvious truth that no one can actually know the future. One has to estimate the expected future cash flows. This is no easy feat when dealing with the uncertainties of yet-to-be drilled underground reservoirs, the challenges of operating producing wells, and the vagaries of the oil and natural gas markets. Then, one needs to apply a so-called discount rate. This process assumes that future cash flows received years down the road must be "discounted" to reflect the time value of money as described above. Doyle explains that discount rates applied in the oil and gas industry often range from 10 to 15 percent per year. He admits it's an arbitrary number, but it's arbitrary in every industry except perhaps as it reflects the presumed risks involved in the venture and the cost of capital (such as interest on loans).

When you work out what this implies for cash flow generated from a well several years after production begins, it becomes clear why the ultimate amount of oil and gas recovered from a well has little relevance to the decision to drill it. Let's do an example to see why. If you invest $3 million to drill a well (not an unusual amount these days) and expect to get cash flow of $1 million per year from the well for 10 years, on the face of it that sounds as if you are reaping more than three times your investment. But when you discount the cash flows appropriately, for example at 12 percent per year, you get an NPV of $5,650,223. That's $2,650,223 more than you are investing, so it's still a positive number even after discounting. And, it's 1.88 times the initial investment, a ratio that will become meaningful below. But the NPV of the $1,000,000 in annual cash flow in years 8, 9, 10 are as follows: $359,634; $316,478; and $278,500. (Remember: Each successive year's cash flow is discounted another 12 percent in this case until you get to the final year.) If the well keeps producing in year 20, the NPV of the cash flow in that year falls to just $77,562. If it is a very long-lived well, the NPV of the cash flow from year 40 is negligible, $6,015. All this serves to illustrate that the further any year's cash flow is from the present, the less valuable it will be to the company and therefore the less bearing it will have on a decision to drill a well.

As it turns out, few companies would even bother drilling such a prospect. Doyle says that right now his company won't even look at a prospect unless, based on seismic data and other information, it reasonably expects that the completed well will produce an NPV six or more times that of the initial investment. When there is keen competition for prospects, companies will drop their expectations down to three to four times the NPV.

This is where things get interesting. Doyle has seen some public companies drop their goal down to one. That's right. They will drill prospects that they believe have no reasonable chance of doing anything other than breaking even. Why will they do this? To boost stated reserves, a number by which Wall Street judges the value of oil and gas companies. They won't, however, make any true profit on these wells. But they will become what Wall Street calls an "asset play." They will be valued on their assets, in this case stated reserves, rather than on their profitability. This strategy has proven especially tempting to those engaged in the hunt for shale gas since drilling success rates are very high. This is a risky strategy, however, that leaves little margin for error. Prices lower than those forecast by such an analysis could quickly bankrupt a company that drills too many wells based on an assumed one-to-one ratio of investment to net present value.

The claims that the United States has 100 years of recoverable natural gas as a result of the newly accessible shale basins has no meaning without attaching a price to it, Doyle contends. The fact that major shale gas producers have trimmed their active drilling fleets to a fraction of what they were during the 2008 boom in natural gas prices proves that price is a critical factor in determining whether to drill. And, where there is no drilling, there are no additions to reserves. The natural gas market has shown itself to be highly volatile which has not surprisingly led to wide swings in natural gas drilling. The notion that somehow there will be a consistent accretion of natural gas reserves from year to year or that all discoveries from previous years will still be considered reserves in a low-price environment is pure bunkum.

The same logic applies to oil discoveries. But these days no one is claiming the United States has enough oil left to supply the entire country for 100 years. And, so hype about oil reserves is less of an issue.

The upshot is that expected cash flow determines what areas will be drilled, not the size of potential reserves. Most companies won't drill a prospect unless they believe they can get their money back within two to three years, Doyle says. If it takes four or five years, the prospect is not very attractive. Cash flow is king.

It turns out that the NPV of the first three years of cash flow from my hypothetical well mentioned above is $2,401,831, less than the initial investment. Most companies would or should pass on such a prospect, and it would therefore never become part of anyone's reserves, he explains. Part of the hype over shale gas has to do with the claim that the wells may be very long-lived, he adds. Even if that turns out to be true--not a certainty as of now--the low flow rates expected after the initial burst of production and the distant payoffs would actually work against any decision to drill such wells. No wells, no reserves.

Doyle says that given modern technology, oil and natural gas are easier to find than ever before. But he doesn't believe that in North America at least, there is that much more to find. He thinks that shale gas in North America my indeed prove to be plentiful. But it will not be both plentiful and cheap.

And, of course, if we succeed at expanding natural gas production to meet the needs of a new natural gas-powered vehicle fleet--an idea advocated by one of the leading producers of shale gas--and expand other current uses such as the generation of electricity, we can expect that natural gas prices will soar. That may provide the necessary incentive (i.e. cash flow) to extract the shale gas that lies below the American landscape. But it will also certainly mean that the 100 years of supply that has been so frequently touted in the media will rapidly shrink to perhaps 30 or 40, and that the peak in production will come much sooner.

A peak in natural gas production in, say, 20 years would not exactly be a useful talking point for those advocating the wholesale conversion of key parts of the U. S. economy to run on natural gas. Just as we would be finishing such a conversion, we could find ourselves on the downslope of the natural gas production curve and faced with the urgent need to adapt our costly and newly completed natural gas infrastructure to run on some other energy source.