Breakdown Street

One Thousand Barrels A Second by Peter Tertzakian provides excellent insight into the workings of the oil economy. Although it was written a few years ago (2006), the message is very relevant today as oil prices approach $140 a barrel. The author is the chief economist for ARC Financial, a Canadian company that invests in early stage energy companies.

The book based on Mr. Tertzakian's experience and research in the field. His analysis relies heavily on the concept of the energy "break point", an epoch which is rapidly approaching for petroleum. A break point when a specific source of energy enters a crisis period that ends with the reshuffling of the energy sources that serve as the main driver for an economy. This degree of change is wrenching and results in much dislocation. However, it is his assertion that the world is a better place after the shocks have died down.

Mr. Tertzakian goes on to describe the historical experience of breakpoints with whale oil and coal. The whale oil analogy seems somewhat stretched at times during the book, but the description of whales hunted to near extinction in the 1870s as whaler's chased them to the ends of the earth has interesting parallels with our own search for oil today in the nether regions of the world with chaotic prices and uncertain supplies.

He then covers the introduction of oil as the main energy source for industrial economies in the early 20th century. The coal breakpoint was driven primarily by the technical superiority of oil as a power source. Winston Churchill was an early proponent of shifting the British Navy from coal to oil before World War I because it offered a 33 percent improvement in the operating capacity (speed and range) of warships. It also showed similar technological and economic superiority for industrial applications but took many years to fully supplant coal in most of those because of existing investments (railroads are cited as the primary example of the long timeline for technical substitution of capital assets).

The scramble to secure resources of light, sweet crude oil (the easiest to refine and use) was on in full-effect by the end of World War I. Initially, the British dominated oil in the Middle East with their national oil companies, but America's independent oil companies had joined them by the end of the Second World War. The Seven Sisters (Standard Oil of New Jersey (Exxon), Royal Dutch/Shell, British Anglo-Persian (BP), Standard Oil of New York (Mobil), Texaco, Standard Oil of California (Chevron) and Gulf Oil) continued to dominate production until the rise of Arab nationalism and OPEC started to crack their domination. Mr. Tertzakian's description of this history is interesting and concise.

The OPEC-driven price rises in the 1970s inspired a first oil break point in the 1980s. In this breakpoint, oil was driven out of electricity production in the United States and replaced with coal and nuclear power by both government regulation and the price mechanism. In other countries, the reaction was more far reaching, with Japan and the United Kingdom imposing high tariffs on gasoline. Both of those countries use less oil today than in 1973.

Mr. Tertzakian measures the dependency on oil in an economy with the GDP elasticity of oil demand (how much more oil a country uses as it's economy grows) and notes that all industrialized countries have seen this oil dependency factor fall from the 1970s. However, the newly industrializing countries exhibit dependency factors that are similar to those shown by the United States in the 1960s. This is why the economic growth in China is having such a dramatic effect on the oil markets. Not only is China growing fast, but it's oil consumption is growing even faster than it would in the US if we were to have a similar rate of growth. He does not fall victim to linear thinking that China could actually continue on this pace, but even on realistic estimates of Chinese consumption, the world oil markets are going to be very tight. This tightness will precipitate chaotic pricing and supply issues that will ultimately result in the reshuffling of our energy consumption away from oil.

The coming oil break point (the subtitle of the book) will not be met with a pure technological solution in the near term. The infrastructure and technical requirements for replacing oil with, say, hydrogen are just too formidable. Instead, Mr. Tertzakian believes that the mix of oil usage in our economy will change through a mixture of conservation, life-style changes and technological evolution. He sees more efficient use of oil in transportation as one of the first things to change: smaller cars, more diesels and more hybrids. Far-flung suburbs will have to form more cohesive units to facilitate less travel and more telecommuting. Lastly, introduction of different sources of oil (bitumen, shale, sands, etc.) from a reliance on the more and more elusive light sweet crude will curb the price gyrations, albeit at a higher price level than before. Eventually, we may have technological replacement for oil, but certainly not in the next 10 years.

These shifts will not be pleasant and will not be driven wholly by the pricing mechanism. In his view, governments will have to mandate some changes (as they did in the 1970s and 1980s) to make it work. In the end, he believes that we will have a more healthy mixture of energy consumption, less reliant on the availability of cheap oil for growth and stability. In many ways, this will be a good thing and create new opportunities for riches along the lines of Edison, Rockefeller and Gates.

Overall, this was a good read if you are interested in the dynamics of oil markets and energy sources. The arguments are well-written, credible and backed with data. If I had read this two years ago and followed the advice given (basically, invest in energy efficiency and energy production as the break point approaches), I would be better off. This book has strengthened my resolve not to replace my older car until I see something that will dramatically improve my fuel economy and to make sure that energy efficiency is taken into account when making major decisions (e.g. all of the new appliances in our house will be Energy Star from here on out). It has also made me believe even more firmly that the gasoline excise tax in the United States needs to be raised dramatically with the funds used for both infrastructure projects and incentives to help push the pace of the changes. The break point is coming. How will it affect you?