THE RUN-UP in gasoline and other energy prices-with its impact on consumers' purchasing power-has captured the public's attention after two decades of relative quiescence. Though energy mavens argue energy issues endlessly, it is only a sharp rise in price that captures the public's attention. A perfect storm-a combination of the near-exhaustion of OPEC's spare capacity, serious infrastructure problems (most notably insufficient refining capacity) and the battering that Hurricanes Katrina and Rita inflicted on the Gulf Coast have driven up the prices of oil and oil products beyond what OPEC can control-and beyond what responsible members of the cartel prefer. They, too, see the potential for worldwide recession and recognize that it runs counter to their interests. But the impact is not limited to economic effects. Those rising domestic energy prices and the costs of fixing the damage caused by Katrina have weakened public support for the task of stabilizing Iraq, thereby potentially having a major impact on our foreign policy.

What is the cause of the run-up in energy prices? Is the cause short term (cyclical) or long term?Though the debate continues, the answer is both.

Clearly there have been substantial cyclical elements and "contradictions" at work. For several decades, there has been spare capacity in both oil production and refining. Volatile prices for oil and low margins in refining have discouraged investment. The International Energy Agency, which expresses confidence in the adequacy of oil reserves, urges substantially increased investment in new production capacity and has recently warned that, in the absence of such investment, oil prices will increase sharply.1 Such an increase in investment clearly would be desirable, but it is more easily said than done.

In the preceding period of low activity, both the personnel and the physical capacity in the oil service industry have diminished-and it will take time to recruit and train personnel, to restore capacity and to produce equipment. It is interesting to note that the capacity of OPEC itself has shrunk in this last quarter-century from 38 million barrels per day (BPD) to 31 million BPD. The bulk of the shrinkage occurred in Iran, Iraq and Libya, which have been the targets of both U.S. and international sanctions. Though knowledgeable people were aware of the shrinkage of spare capacity, it was still thought to be adequate-until the recent surge of demand, especially from China and the United States, brought us to the point that it was insufficient to satisfy the growing demand at prevailing prices.

Three additional points should be kept in mind. First, crude oil production capacity has not been wholly exhausted. The minister of petroleum of Saudi Arabia, Ali Naimi, points to the unutilized 1.5 million BPD in his country and states that he stands ready to serve additional buyers. The minister is making something of a rhetorical point: For the moment, that additional crude oil production capacity is unusable. There is a mismatch between the types of crude available and what refiners are able to process. For many decades there has been a marked excess of refining capacity-and very low margins in refining. There has been only a modest incentive to invest in additional capacity. With sufficient light crude apparently available, there has been little incentive to invest in capacity to process the heavy, sour crudes of the sort still available in Saudi Arabia. That is not to say, however, that there has been no investment. Here in the United States, far too much of the investment has been channeled into the capacity to produce the numerous boutique blends of gasoline, some thirty at last count-a foolishness mandated by the different state regulatory bodies.

Second, it is the international oil companies (IOCs) that have lots of cash. Their inclination has been to invest in new production capacity, counting only on prices being in the range of $20 to $30 per barrel-and not necessarily expecting the current high prices to be sustained. But while the IOCs have the cash, it is basically the national oil companies (NOCs) that have the reserves. The IOCs seek equity oil, and for the most part, equity investment in reserves controlled by NOCs has not been permitted. So, there exists another mismatch between those who have the resources to invest and the availability of suitable places to invest.

Third, when gasoline prices are rising, public anger rises at least correspondingly. Public anger immediately draws the attention of politicians-and here in the United States it elicits a special type of political syndrome: wishful thinking. It is notable that in the last election both candidates talked about "energy independence", a phrase that traces back to the presidency of Richard Nixon and the reaction to the Arab oil embargo. One should not be beguiled by this forlorn hope-and this brings us to the real problem for the foreseeable future. What is the prospect for oil production in the long term? How does it bear on the prospects for "energy independence"?

The Day of Reckoning Draws Nigh

AT THE end of World War II came the period of the opening-up and rapid development of Middle East oil, notably in the Arabian Peninsula. Both Europe and the United States embraced the shift from coal to oil as their principal energy source. The beginning of flush production in the Middle East coincided with and fostered the tremendous expansion of world oil consumption. In the 1950s and 1960s, oil production and consumption more than doubled in each decade. Annual growth rates in consumption of 8, 9 or 10 percent were typical.

By contrast, no one, not even the most optimistic observers, expects a doubling of production in the decades ahead. The present expectation is markedly different. In increasing numbers, now approaching a consensus, knowledgeable analysts believe that the world will, over the next several decades, reach a peak-or plateau-in conventional oil production.2 Timing varies among these observers, but generally there is agreement on the outcome.3

The implication is clear. Even present trends are unsustainable. Sometime in the decades ahead, the world will no longer be able to accommodate rising energy demand with increased production of conventional oil.

It should be emphasized that that would pose not a general "crisis in energy", but instead a "liquids crisis." Problems in energy other than oil are infrastructure problems, solvable through appropriate investment. To talk of a general "energy crisis" aside from oil is to divert attention from the central long-term problem. Advocating the construction of nuclear plants, for example, may be desirable, but it does not confront the critical issue of the liquids crisis. Basically, there is no inherent problem in generating and transmitting electric power, for which the resources are available. The intractable problem lies in liquid fuel for land, sea and air transportation.

We get clear indications regarding oil's future from those in the industry. Though the United States and other consuming nations seem to believe that Saudi Arabia can and should increase production as demand rises, when he was asked at a recent conference whether oil production would peak, Ali Naimi, the long-time head of Saudi Aramco, responded that it would reach a plateau. It is quite telling that when, in 2004, the Energy Information Administration (EIA) projected Saudi production in 2025 of some 25 million BPD to satisfy world demand, the Saudis demurred-and quite politely indicated that such figures were "unrealistic." The Saudis have never discussed a figure higher than 15 million BPD.

This is why David O'Reilly, CEO of Chevron, has stated that the "era of easy oil is over." Projections by Shell and BP put that plateau several decades out. BP now says that its initials stand for "Beyond Petroleum." Others, more pessimistic, suggest that the peak is much closer at hand-in the next decade. It is interesting to note, in light of the recent discussion of Chinese ambitions in acquiring oil assets, that the Chinese seem to believe that world production will reach a peak around 2012.4 So any indication of relative optimism is greeted with sighs of relief: The peak is not that near. For example, when Daniel Yergin of Cambridge Energy Research Associates recently stated that the peak will not come until after 2020, it was greeted with something approaching cries of elation: The threat is not that immediate!

What lies behind this now-changed view? In brief, most of the giant fields were found forty years or more ago. Only a few have been found since 1975. Even today the bulk of production comes from these old and now aging giant fields. The Ghawar oilfield in Saudi Arabia, discovered in the 1940s, is by itself still producing 7 percent of the world's oil. Would that there were more Ghawars, but, alas, that is probably not to be.

Moreover, the announcement by the Kuwait Oil Company in November that its Burgan field, the world's second largest, is now past its peak output caused considerable consternation. The field's optimal rate is now calculated at 1.7 million BPD, not the two million that had been forecast for decades ahead. In addition, that announcement has called into question the EIA's estimate in its reference case that Kuwait would be able to produce five million BPD; it now appears likely that the emirate will not be able to produce over three million BPD.

Recent discoveries have typically been relatively small with high decline rates-and have been exhausted relatively quickly. With respect to the United States, it has been observed: "In the old days, we found elephants-now we find prairie dogs."

A growing consensus accepts that the peak is not that far off. It was a geologist, M. King Hubbert, who outlined the theory of peaking in the middle of the last century, basing it on the experience that as an oilfield passes the halfway point in extracting its reserves, its production goes into decline. Hubbert correctly predicted that production in the United States itself would peak out around 1970. Dissenting from that view are the economists, who have a deep (and touching) faith in the market mechanism-and a belief that over time market forces can adequately cope with any limits on oil supply.5 In the extreme, some economists have regarded oil supplies as almost inexhaustible.

The optimistic view is held by the Energy Information Administration of the Department of Energy, as well as the International Energy Agency. What lies behind it? While it is conceded that we have not been finding many new giants, it is contended that "additions and extensions" of existing fields will sustain growth. There is some truth in that contention-in that new technologies have been the basis of many of the additions to existing fields-and the hope is always there that we can increase overall recovery from the already discovered fields.

Optimists are buttressed in their views and are fond of pointing to the many earlier statements about "running out of oil." Perhaps the most notable example was one by the director of the U.S. Geological Survey, George Otis Smith, who suggested in 1920 that we had already used up 40 percent of the oil to be found here in this country. That was a decade before the discovery in 1930 of the vast East Texas field, a bonanza that made oil supply so available that it drove oil prices below a dollar a barrel during the 1930s. A recent Chevron advertisement makes this substantive point quite dramatically: "It took us 125 years to use the first trillion barrels of oil. We'll use the next trillion in 30."

Such past failed predictions are far less comforting than the journalists who cite them believe. The future may actually be different from the past. The optimists, mostly non-experts, seem unable to think quantitatively. Things are different now. In 1919 the world consumed a modest 386 million barrels of oil. Today the world is consuming some thirty billion barrels of oil each year. Statements like that of Director Smith were made before we had something approaching a billion automobiles worldwide, before we had aircraft and air transportation, before agriculture depended upon oil-powered farm machinery.

Hubbert's peaking theory, based on observation of individual oil fields, was static in that it abstracted from improvements in technology. It also dealt strictly with conventional oil supplies. One notes that today those who are challenging Hubbert's Peak are changing the rules of the game. They rightly point to dramatic improvements in technology, most notably deep-sea drilling. Somewhat less legitimately, they include in their projections all sorts of unconventional oil, like the Canadian tar sands and the prospects for shale oil. For example, of late, estimates of Canadian oil reserves have jumped by 180 billion barrels, now including the tar sands of Alberta. This is not a refutation of Hubbert's theory (though it is frequently treated as such); it is simply a change in the rules that does not gainsay the fear that we will reach a plateau in conventional oil production.

We must bear in mind that earlier estimates suggested that there were some two trillion barrels of conventional oil in the earth's crust. Now the estimate has grown to around three trillion. We have now consumed over a trillion barrels of oil. As indicated, we are consuming oil at the rate of thirty billion barrels a year. If one accepts Department of Energy projections, worldwide we will be consuming forty billion barrels of oil by 2025.

At such rates of consumption, the world will soon have reached the halfway point-with all that implies-of all the conventional oil in the earth's crust. At that point, the plateau or the peak will be near. And such calculations presuppose what cannot be assumed, that all the nations with substantial oil reserves will be willing to develop those reserves and exploit them at the maximum efficient rate. Both the Russian Federation and Saudi Arabia seem to intend to reach a plateau that they can sustain for a long time-the Russians at around ten million BPD, the Saudis up to but no more than 15 million BPD.

In thinking about the problem, we need not more rhetoric but, instead, quantitative reasoning. We also need to add political wisdom. The inability readily to expand the supply of oil, given rising demand, will in the future impose a severe economic shock. Inevitably, such a shock will cause political unrest-and could impact political systems. To be sure, we cannot anticipate with any precision the year or even the decade that we will reach that plateau. Yet, as Justice Potter Stuart suggested, in seeking to define pornography, we shall know it when we see it.

That brings us to the question of the transition away from conventional oil as the principal source of energy for raising the living standards of the world's population. That transition will be the greatest challenge this country and the world will face-outside of war. The longer we delay, the greater will be the subsequent trauma. For this country, with its 4 percent of the world's population, using 25 percent of the world's oil, it will be especially severe.6 The Day of Reckoning is coming, and we need to take measures earlier to cushion the shock. To reduce the shock, measures to ameliorate it should start ten years earlier at a minimum, given the length of time required to adjust the capital stock-and preferably much longer. The longer we delay, the greater the subsequent pain.

Both people and nations find it hard to deal with the inevitable. Even though it was long recognized that a Category 4 or Category 5 hurricane would inevitably strike New Orleans, a city substantially below sea level, Hurricane Katrina reminds us that political systems do not allocate much effort to dealing with distant threats-even when those threats have a probability of 100 percent.

We should heed a lesson from ancient Rome. In the towns of Pompeii and Herculaneum, scant attention was paid to that neighboring volcano, Vesuvius, smoking so near to them. It had always been there. Till then, it had caused little harm. The possibility of more terrible consequences was ignored-until those communities were buried in ten feet of ash.

1 See World Energy Outlook 2005 (International Energy Agency, 2005)

2 See, inter alia, Robert L. Hirsch, "The Inevitable Peaking of World Oil Production" (Atlantic Council of the United States, October 2005), which includes a range of different estimates for the peak year. For a more comprehensive analysis, see Robert L. Hirsch, Roger Bezdek and Robert Wendling, "Peaking of World Oil Production: Impacts, Mitigation and Risk Management" (National Energy Technology Laboratory, February 2005).

3 One exception is a different view of oil's origins developed by Soviet scientists. Contrary to the standard view that oil, like coal, was laid down long ago and there is a finite amount available, the Russians argue that oil is a primordial product continuously produced deep in the earth's mantle. It comes to the surface when it can find a route to do so. Thus, there may be more oil to be found outside sedimentary basins. The theory remains highly conjectural. While this alternative view needs to be explored, it is notable that even the Russian Oil Ministry pays little attention to it in developing projections of Russian production.

4 See Pang Xiongqi, et al., "The Challenge Brought by the Shortage of Oil and Gas in China and their Countermeasures", a presentation at an international seminar in Lisbon in 2004. One may assume that such presentations do not depart significantly from the views of the Chinese government.

5 Many economists take great comfort from the conviction that there is always a price at which markets will clear, and that the outcome determined by supply and demand is not only inevitable, but is also politically workable and acceptable. An outcome in which the price of a crucial commodity like oil rises to a level causing widespread economic disruption, along with the political consequences that flow from such disruption, turns out to be a secondary consideration, if considered at all. One is reminded of the phrase used by Wesley Clair Mitchell and Arthur F. Burns in their classic, Measuring Business Cycles (1946), in which they spoke scornfully of the "Dreamland of Equilibrium."

6 The high percentage of world production consumed in the United States is used by critics to point to our presumed wastefulness. It is, however, misleading in that the United States also produces between 20 and 25 percent of the gross world product. Nonetheless, it does appropriately point to our greater vulnerability to a future period of oil stringency.

James Schlesinger is chairman of the Advisory Council of The National Interest. He has served as secretary of defense, secretary of energy and director of central intelligence. He is currently chairman of the MITRE Corporation.

WANT MORE TNI?Click here to order a print subscription to The National Interest and get free electronic access to the current issue and TNI's archives. International readers can also click here to get an electronic-only subscription.