Drilling For Value, Appendix A: Energetic Factors of Resource Economics

  • Energy Return on Energy Invested (EROEI) is a popular metric for resource quality which attempts to cut through economic distortions caused by taxes, subsidies, and current market conditions.
  • Energetic factors of resource intensity and efficiency also have practical applications for estimating long-term resource project economics.
  • Declining EROEIs, which have been hyper-politicized by peak oil enthusiasts, have been counteracted by gains in full-cycle energy efficiencies.
  • Though other energetic measures of return incorporate financial metrics, EROEI is still the purest key performance metric which exposes an energy resource’s underlying and long-term profit potential.

Source: Frank Reilly (Illustrator). Oilfield WorkerLiberty Magazine. 10 March 1945.

Although Energy return on energy invested (EROEI) is frequently dismissed as “fringe” or “out of vogue” by the mainstream, due to its hyper-politicization by environmentalists, it can be an indispensable engineering construct which cuts through much complexity in order to expose the energetic factors which drive the underpinnings of economics. EROEI is essentially a proxy for resource quality net of energy efficiency whereby exergy (i.e., net energy available for work) assumes the role of a “universal currency” which is totally free of artifice.1 In a sense, energetic metrics of cost and return can fill a void left by traditional metrics that fail to sate our transcendent needs to balance social, environmental, and economic justice.

EROEI’s popularity is based in two fundamental intuitions: a unit of energy in any given form is fungible another unit energy in the same form; and, that more energy must come out than goes in order for a thing to be self-sustaining.

On some level, a unit of energy is simply that. Comparing any two resource types on an energy equivalent basis is able to cut through much artifice regarding price and costs inputs, which are often the products of cyclical markets forces and economic distortions. Perhaps the purest example of energy equivalence can be typified in an electrical grid in which all kilowatts-hours (kWh) are indifferentiable: they are priced the same, no matter their source or destination. Although energy-equivalence ignores other factors of resource quality (e.g., environmental and social impacts), disregarding short-term capital intensities can actually reveal many things about a resource’s long-term economic viability.

The intuition that more must come out than goes must go in is given by first law of thermodynamics (i.e., the efficiency rate of converting energy to exergy is always less than one).  For example, the energy efficiency of an internal combustion engine (ICE) — which on average converts 25% of chemical potential energy to work — dictates that 4x EROEI must be achieved to result in positive exergy. Further assertions that EROEI must exceed 5-7x in order to yield any future potential economic benefit are premised on compounding additional loss/efficiency rates, such as buffering effects due to storage and cycling requirements. Acknowledgement of these basic precepts strongly lends credence to “fringe” views that the rise and fall of civilizations is strongly related to energy efficiency.

Figure 14: EROEIs of Popular Energy Sources

Source: D. Weißbach, et all. Energy intensities, EROIs, and energy payback times of electricity generating power plants. Energy. 6 April 2013

Practical Application: Estimating Ultimate Recovery
As applied to petroleum economics, the precepts of EROEI simply state that “when the energy cost of recovering a barrel of oil become greater than the energy content of the oil, production will cease no matter what the monetary price may be.

Therefore, one practical application of EROEI is estimating ultimately recoverable resources (URR). Reserves, defined as the amount resource that can be recovered under explicit economic and technological assumptions, are typically estimated as the portion of technologically recoverable resources in which future estimated cash flows have a positive expected value (i.e., a well reaches the terminal economic limit when the expected present values of future operating plus retirement/disposal costs exceed the expected present value of future net revenues). Future cash flows and costs, however, are exceedingly uncertain — actual URR will have been determined by unknown future conditions. Fortunately, EROEI eschews these expectations, and instead sets a theoretical upper limit to economic return based on scientific first principles. So, in engineering parlance, the energetic limit will be reached by or before the point at which EROEI is less than one. Or, according to one academic source, “production is stopped when the economic/energetic limit is reached, i.e. when keeping the equipment running requires more money and/or energy than it yields“. EROEI is therefore simply a key performance indicator which exposes the energetic factors which underlie the economics.

In order to estimate the energetic limit of typical well, consider how many barrels of daily oil production are required to maintain a one horsepower-hour pump dedicated to secondary recovery. Such as example should be extremely indicative of marginal production since it is estimated approximately two-thirds of global oil wells run on sucker-rod lift. The stochiometric formula may proceed as follows:

For grid consumption:
(0.0204 ga/hp-h) * (24 h/d) * (.0238 Boe/ga)2   ÷ (.75MMBtu/Boe ÷ 5.7MMBtu/Boe)3 = .1165 Boe/d/hp

For self consumption:
(0.0204 ga/hp-h) * (24 h/d) * (.0238 Boe/ga)4 ÷ (25%5)  = .0466 Boe/d/hp

Therefore, a typical 50 hp-h sucker-rod pump should require between about 2.3 to 5.8 barrels per day of production just to compensate for the energy expended (or sustain self-consumption). Although other geological (e.g., well depth and pressure; permeability, porosity, and saturation; reservoir drive mechanism; etc…), energetic (e.g., waste water treatment and disposal; gas processing and treatment), and economic factors (e.g., land, capital, tax, labor, and maintenance costs) should affect the current financial reality, empirical evidence converges to a similar result. Wikipedia cites that the cost of running a typical stripper well (i.e., a well that is approaching its economic limit; or, for tax accounting purpose, a well that produces less than 10 to 15 Boe/d) is between $10 and $30 per Boe, which for a typical marginal well, averages to about $2000 per month per well. At current prices, this equates to an energy equivalent cost currently between 2.22 to 6.67 Boe/d/well — in relation to which our stochiometric estimate comes very close.

Indeed, at current prices ($50 handle for WTI; $3 handle for HH), the market appears to be compensating marginal production at barely above $0. A market which provides zero monetary compensation for a zero net-energy system is, by definition, efficient. If, however, the market provides any monetary compensation to net energy depleting production, the market is inefficient or imbalanced. Unless there is a breakthrough in efficiency, oil at $90 to $100 per barrel provides an economic incentive to energy inefficient resource production. At current prices, however, the market seems efficient. Sorry, OPEC.

In general, first principles (i.e, time and situation invariant precepts based on natural laws) can be utilized to construct more robust estimates than traditional economic methods which rely on a vast assortment of assumptions. Robust assumptions facilitate long range planning and more efficient capital allocation — conferring an edge to resources planners, economists, and investors.

A Globalized Extrapolation
Declining Energy Returns on Energy Invested (EROEI) for petroleum resources have been meticulously and consistently documented. Given that EROEI can expose a given project’s or well’s long-term economics, some have suggested that declining EROEIs are indicative of the world’s remaining petroleum resources. Proponents of Hubbert’s Peak Oil Theory frequently cite that when the mean global petroleum EROEI drops below 4, the world will have reached peak oil production. Peak Oil Theory will eventually be proven correct, but the outcome is not necessarily Malthusian.

“What profit is even possible when a resource produces barely more energy than it consumes?” is more than an existential question. Indeed, the long-term push towards increasingly energy and capitally-intensive, and more inhospitable resource frontiers supports the idea that the “easy stuff has already been had”. While advances in recovery methods (e.g., fracking, horizontal drilling, seismic imagery and modeling, enhanced recovery) have unlocked tremendous amounts of additional and less energy intensive on-shore resources, many onlookers see recent advances as small perturbations of the longer-term trend and inevitable Malthusian outcome.

The salience of this alarmism is questionable. Given that petroleum is a finite resource, Peak Oil Theory will eventually be proven correct. However, the preponderance of “enthusiasts” who speak with certainty about the time and place of peak oil production speaks more to their inabilities to think on a geological time scale than it does to their understanding of hard science. The “experts” are fully wary of the importance of the complex tug-of-war between geology and technology, but have consistently failed to provide accurate models6. Yet, I must echo an important caveat, “That the alarmists have regularly and mistakenly cried “wolf!” does not a priori imply that the woods are safe”.

Even if long-term field-level declining efficiency is inevitable, efficiency gains to refining and power generation processes offset, and at times reverse, declining returns. Moreover, the efficiencies of renewables and other unconventional production techniques will only get better with time. So here we see that the question is, and has always been, one of economics.

Figure 15: Estimated energy return ratios for the California oil industry, 1955–2005Estimated energy return ratios for the California oil industry, 1955–2005
Source: Adam R. Brandt. Oil Depletion and the Energy Efficiency of Oil Production: The Case of California. Sustainability. 1 August 2011.

Indeed, researchers at the Library of Economics and Liberty found that, adjusted for inflation, commodities prices have been in secular decline since the industrial revolution, leading them to conclude that “rising productivity… may actually augment humanity’s stock of natural resource capital instead of depleting it, and may be able to do so, for all practical purposes, forever”. I cannot vouch for “forever”, but I can say with near certainty that there is a whole lot more global petroleum to had if prices reach $90 to $100 again even if one assumes no additional technological advances… maybe it’s decades, centuries, or even millenia. Again, no one really understands Earth’s true resource potential.

But more consequentially, the economics of depletion will force humanity onto the next rung of the resource ladder well before the last drop of oil is squeezed from the Earth. The only feasible alternative is the protracted secular decline of humanity. In the Switch Energy Project movie, Scott Tinker, director of the Bureau of Economic Geology at the University of Texas, makes a compelling argument that humanity has a very good chance of making the switch to renewable energies well before its exhausts even the most conservative estimates for remaining discovered and undiscovered petroleum resources. I highly recommend that anyone with an inkling of interest in natural resources watch this movie.

Other Energetic Measures
Energetic measures expose fundamental qualities of energy resources, but people generally make decisions based on current or extrapolated financial market conditions. Other measures of return and efficiency further incorporate financial concepts.

For example, the levelized costs of energy (LCOE), defined as the full life cycle cost per kilowatt-hour, untangles modern society’s interwoven energy web by filtering every resource through the lens of a fungible kWh. LCOE suffers, however, from an assumption that all energy outputs are intended for the electrical grid; benefits of self-consumption and co-generation are not considered. In addition, the all important time value of money principle is disregarded.

“Wells-to-wheels” life cycle assessments (LCAs) attempt to untangle hidden regulatory, subsidized, and environmental costs in order to expose the underlying economics. The main intuition of LCAs is fundamental complexity; no real system is totally closed off or isolated from the effects of interconnected systems. Since the Renewable Fuel Standard (RFS) was passed by Congress in 2005, recent LCAs which take into account impacts on the food chain and emissions footprints due to indirect land use have shown that there is little to negative environmental benefit from the domestic use of ethanol7. There is a certainly a bright future for renewable sources of energy and hydrocarbon materials, but their actual effects on the environment, energy security, and the food chain are unresolved.

Other recent attempts to expose the true costs of carbon (e.g., through carbon accounting) are often agenda bound. For example, the IMF’s 2015 report, How Large Are Global Energy Subsidies? estimated that global fossil fuel subsidies were $5.3 trillion in 2015. Of that, the combined sum of producer (i.e., pretax) subsidies and tax incentives (i.e., “foregone consumption tax revenue”) — what the rest of world calls a subsidy — was far less at $646 billion. The remainder was pooled into external costs (e.g., pollution, traffic congestion and accidents, and carbon emissions, etc…) which, in theory, society either has to pay for now or in the future. Global trends favor the implementation of increasingly onerous Pigouvian (i.e., “corrective”) energy policies (i.e., carbon taxes or an emissions cap-and-trade program in addition to existing pollution and environmental laws)8. In any case, the most likely outcome of a global carbon policy is likely to result in many unintended consequences without solving the core problems of over-population, depletion of finite resources, and unworkable bureaucracies.

It’s almost as if the IMF, along with other United Nations (i.e., IPCC) and central banking (e.g., World Bank, ECB, etc…) entities, are pushing an agenda of certainty regarding climate change, in spite of the underlying uncertainty9.

In any case, while rolling back subsidies and distortions in order to expose a thing’s true economic costs is a good thing for the world economy, the almost guaranteed outcome of hyper-legislation is a very strong argument for free market principles. Most liberal economists still agree that free markets are still the most efficient price discovery mechanisms. I would simply add that the best policy solutions going forward will tend to reduce complexity rather than add to it.

Resource economics can be complex. Although profit still reigns supreme as king of all econometrics, it is also the metric most targeted by tax, regulatory, and accounting distortions. In a perfectly free and efficient economy, profits accumulate where society perceives the benefits to be the greatest (i.e., gets the most value added). These perceived benefits are a product of many factors: cost, cost avoidance, financing availability, environmental impact, convenience, cognitive dissonance, and more. However, economic distortions (e.g., progressive tax codes, punitive regulations, national protectionist policies, subsidies, et cetera) fundamentally alter natural economic incentives and thereby also fundamentally alter the distribution of profits. Accounting minutiae often further drive the wedge between accounting profits and actual economic earnings power. The results of our meddling confound the potentially purest metric for economic value add.

Since no perfectly free market exists, energetic measures of return will appeal to us for their abilities to “illustrate fundamental qualities of the resource that can be obscured by economic or environmental metrics“.

Footnotes   [ + ]

1. There is no generally agreed upon method to estimate EROEI due to disagreements regarding boundary conditions for given resource types. In a theoretical closed system, exergy and Gibb’s free energy are equal to one another. But because real-world energetic systems are interconnected, differences in opinion arise regarding how to measure net energy. If defined purely by exergy produced divided by total energy expended, EROEI is a purely energetic metric. If, however, it is weighted by other qualitative factors (i.e., inefficiencies other than initial anergy, externalities, etc…), it becomes a hybrid econo-energetic metric.
2, 4. There are 42 gallons in one barrel
3. .75MMBtu/Boe ÷ 5.7MMBtu/Boe = 13% heat efficiency; also approximated to 90% energy intensity of a modern oil refinery
5. 25% is the approximate work efficiency rate of a typical ICE
6. Reference Appendix B for a more detailed analysis on the perils of forecasts.
7. Brazil’s outlying success in transitioning to an ethanol-based energy economy is attributable to its well-developed renewable infrastructure and its access to an efficient feedstock (i.e., sugarcane)
8. While the notion that consumer energy costs should reflect “all the costs” is appealing, the implementation of a workable Pigouvian tax system requires two conditions be met: the current patchwork of complex and interwoven regulations and subsidies be completely dismantled; and, better science that can accurately quantify current and future economic impacts of environmental actions. But if hyper-politicization of carbon causes governments to rush to a solution without due consideration of these conditions, the result could allow autocratic environmentalism to effectively reduce the modern standard of living to feudal ecological serfdom — all in order to “efficiently” offset any and all externalities of human society.
9. One possibility is that the theory of anthropogenic climate change is being exploited in order to justify a global tax on productivity. For decades, economists at the central banks have promoted an efficient global tax policy, but knew that the general population — being brainwashed by classically liberal free market principles — would never accept one presented as such. Perhaps all the research dollars pouring into climate science is one way of getting the population to beg for a global tax. It may be instructive to think of this issue from an environmentalist’s perspective (who may or may not hold regard for free market principles): “If the anthropogenic climate change hypothesis is wrong, no harm, no foul. If it’s right, we save Earth”. From this perspective, the price of deluding the public into a false sense of scientific certainty is worth the potential rewards. However, there is a core cadre who fundamentally oppose what is, in their view, a potential abuse of science. Independent contributors to the blog Watts Up With That? (WUWT) have consistently documented how mainstream scientific organizations have doctored raw climate data in order to strengthen the case for anthropogenic climate change. WUWT contributors have dubbed this alleged global conspiracy Climategate. The conspiratorial viewpoint does not seem all that fringy considering that the IMF openly promotes a global carbon tax right on its webpage.