Oil An Introduction

Oil
An Introduction for New Zealanders

by Ralph D. Samuelson
Illustrations by Christen Stewart
Comments
Comments on this book are welcome, and may be sent to:
[email protected]
Glossary
Note that words in italics are defined in the Glossary, Appendix B.
IMPORTANT
Crown Copyright 2008.
Use of this Oil: An Introduction for New Zealanders publication in paper or
electronic form implies acceptance of the conditions of its release, which are
that if the information is made available to others:
Its source must be acknowledged as Ministry of Economic Development
2008 or by reference to the publication title and date; and
No charge is made other than to recover the direct costs of dissemination.
Although every attempt has been made to ensure the information is accurate,
neither the Crown nor any Minister, employee or agent of the Crown:
Warrants the accuracy, completeness or usefulness for any particular
purpose of the information contained in this publication in paper or
electronic form; or
Accepts any liability for any loss or damage however caused from the
reliance on or use of that information or arising from the absence of
information or any particular information in this publication in paper or
electronic form.
Contents
Acknowledgements
Introduction
1 The Fundamentals of Oil

1.1 The Chemistry of Oil
1.2 Oil Products
1.3 The Geology of Oil
1.4 Oil Production
1.5 Oil Refineries
9
9
13
17
20
23
2 World Oil Resources

2.1 Reserve Estimates
2.2 Resource Estimates
2.3 Concentration of Oil in a Few Countries
2.4 Unconventional Oil
2.4.1 Tar Sands and Bitumen
2.4.2 Extra-Heavy Crude
2.4.3 Oil Shales
2.5 Alternatives to Oil
2.5.1 Fossil Fuel Alternatives
2.5.2 Biofuels
2.5.3 Electricity and Hydrogen
2.6 Summing Up The Uncertain Future of Oil
27
27
29
31
33
34
34
35
35
36
36
38
40
3 Exhaustible Resource Economics

3.1 Decision Making for a Renewable Commodity
3.2 Decision-Making for an Exhaustible Resource
3.3 The Impact of Extraction Costs
3.4 The Impact of Higher Extraction Costs
3.5 The Impact of Rising Oil Prices
3.6 The Impact of Lower Interest Rates
3.7 The Impact of Technological Improvement
3.8 The Real World
41
42
43
44
45
46
46
47
49
4 Oil and Financial Markets

4.1 Oil Trading
4.2 Market Efficiency and Financial Markets
4.3 Oil Futures Markets as Predictors of Spot Oil Prices
4.4 Oil Futures Markets and Normal Backwardation
50
50
53
55
56
5 New Zealands Oil Industry

5.1 New Zealands Crown Estate
5.2 New Zealands Undersea Jurisdictions
5.3 New Zealands Oil Resources
5.4 The New Zealand Oil Product Market
5.5 Investigations of Market Competitiveness
58
58
60
61
65
67
6 Oil: The Consumer Side

6.1 Elasticity of Demand
6.2 Fuel Taxation
6.3 Price Monitoring and Reporting
6.4 Product Quality Regulation
70
70
71
73
74
7 Oil Security and the International Energy Agency

7.1 The International Energy Agency
7.2 The IEA and Oil Security
7.3 New Zealands Oil Security
76
76
77
78
Appendix A Example Tables Illustrating Exhaustible Resource

Decision Making
A.1 Impact of Extraction Costs
A.2 Impact of Higher Extraction Costs
A.3 Impact of Increasing Oil Price
A.4 Impact of Interest Rates
81
81
82
83
84
Appendix B Glossary
85
Acknowledgements
The author owes a special debt to Barrie Wilkinson of East Harbour Management
Services, whose initial draft of a New Zealand Oil Primer in 2006 provided the starting
point and inspiration for this book. The author is also grateful to the many individuals
and organisations that provided information and gave generously of their time to
assist with the work reported here. These include Roger Fairclough, Tony Fenwick,
David Buckrell, Pene Burton Bell, Richard Cook, Mark Aliprantis, Joanne Canavan,
Sarah Price, David Wilkinson, Simon Lawrence, and my colleagues in the Energy
Information & Modelling Group at MED, Craig Wadsworth and Trevor Johnson at EECA,
Stuart Badger at MoT, Ian Twomey at Hale & Twomey and Linda Guinness of Wordset
Enterprises. However, the responsibility for the material in this book, including any
errors of fact, interpretation or analysis, remains with the author.
The author is also grateful for the support of MED in the development and
publication of this book. However, the views and interpretations presented are
those of the author alone and not necessarily those of MED or the New Zealand
Government.
Introduction
Oil is New Zealands largest and arguably most problematic energy source. Policies
related to oil have wide impacts, including those on the economy, the environment,
consumers, foreign relations, and transport planning. Because of their wide impact,
issues related to oil frequently attract great public interest and, sometimes, con
tentious debate. Yet oil is also a sophisticated business, and to usefully contribute
to the dialogue requires a certain level of technological, economic, and institutional
knowledge that can appear daunting to the newcomer.
The original concept for this book was to provide a background briefing for policy
analysts at MED and other New Zealand government agencies who were going to be
dealing with oil-related policy issues. However, we at MED quickly realised that the
material would also be useful to elected officials, industry leaders, non-governmental
organisation leaders, researchers, students, and concerned citizens. Although the
potential audience has broadened, the goal remains the same: to provide the needed
background, for those who want to better understand the oil-related policy issues
facing New Zealand. This book does not attempt to analyse any policy issues, but
rather to provide basic information that will be useful to anyone who does.
We at MED believe this publication is unique in providing an introduction to the
oil industry from a policy perspective. While most of the material here should be
common knowledge to those who have been exposed to oil policy issues for some
time, it has not been very accessible to newcomers. By drawing the material together
in one place, we hope to make it possible for newcomers to build their knowledge
more quickly and with greater confidence.
Although this publication is designed to be read as a freestanding document, it
complements the introduction to New Zealand energy provided in the Ministry of
Economic Developments New Zealands Energy Outlook to 2030.1 The author has
sought to minimise the overlap between the two publications. As the title implies,
Energy Outlook focuses on the future outlook for all forms of energy, and the choices
that New Zealand faces. Energy Outlook Chapter 4 on Climate Change, Chapter 5 on
Transport Demand, and Chapter 6 on Oil and Transport Fuel Supply are especially
recommended for those interested in oil, and are not duplicated here.
Available for download at http://www.med.govt.nz/energy/eo/2006/
Although oil and natural gas are often found together, this publication is limited in
scope to oil, and discusses gas only to the extent that it impacts on the oil industry.
Ralph D. Samuelson
Energy Information and Modelling Group
Ministry of Economic Development
The Fundamentals of Oil

1
Today, practically everyone is aware of the challenges that oil presents to the
industrialised world, including rising prices, environmental impacts such as climate
change and toxic emissions, risks of supply disruptions, and questions about long-term
resource sustainability. Each of these challenges is ultimately framed by the natural
characteristics of oil resources and the technology that has helped us to overcome
some of oils natural limitations. This chapter looks at oils natural characteristics and
at oil-related technology, since together they form the basic backdrop against which
policies related to oil must be formulated.
Discussions of the oil industry often distinguish between the upstream and
downstream segments, where upstream refers to exploration, drilling, and production
and downstream refers to transportation, refining, and marketing. One also some
times sees references to midstream, referring to transportation and processing.
These terms make sense if one thinks of the oil industry as a river of oil flowing from
oilfields to consumers. This chapter discusses the oil industry in a generally upstream
to downstream sequence.
1.1 The Chemistry of Oil

Like coal and natural gas, oil is a hydrocarbon; that is, it is made of molecules primarily
composed of hydrogen and carbon. In fact, crude oil is a mixture of hydrocarbon
molecules of various sizes and shapes. The composition of the mixture varies widely
from field to field, and will affect the cost and difficulty of both the production
technology that must be used to extract the oil and the refining technology that must
be used to turn it into products.
There is a natural order to hydrocarbon molecules from small to large, which as
we shall see, also corresponds to light to heavy. The smallest hydrocarbon molecule
is that of methane, CH4, which is the principle component of natural gas. It has one
carbon atom, and looks like this:
H
|
H C H
|
H
10
Chapter 1 The Fundamentals of Oil
The next smallest hydrocarbon is ethane, C2H6 with two carbon atoms. It looks like
this:
H H
| |
H C C H
| |
H H
Make it a chain of three carbons and we get propane, C3H8:
H H H
| | |
H C C C H
| | |
H H H
In fact, we can keep adding carbons to get a variety of compounds, as shown in
Table 1 opposite. Motor petrol is a mixture primarily of molecules with five to 12
carbons.2 As the number of carbons increases, the molecular structure can get more
complicated. Possible arrangements other than straight chains arise in these larger
molecules, including side branches and rings. In fact, there are around 300,000 natural
hydrocarbon compounds.3 But we wont be discussing them here.
There are several interesting patterns in Table 1 worth noting. First, as the number
of carbon atoms increases, the state of the compound goes from gas to liquid to semisolid or solid. At the same time, the boiling points and melting points tend to rise. And
perhaps most obviously, the molecules get bigger, resulting in the product getting
denser. This brings us to the most basic method of classification of hydrocarbons, by
what is casually called their weight, or, more accurately, their density. The smaller
molecules are known as light hydrocarbons, while the larger molecules are known as
heavy hydrocarbons.
Engineers in the oil industry could measure the density of hydrocarbons using
specific gravity, which is simply the weight of some volume of the compound divided
by the weight of an equal volume of water (or, equivalently, number of kilograms per
litre). Indeed, in NewZealand and other metric countries, this is how the densities
2
3
See Charles E. Ophardt, Elmhurst College Virtual Chembook, 2003, What Is Gasoline? page, ,
http://www.elmhurst.edu/~chm/vchembook/514gasoline.html.
See the hydrocarbons page of the Oppenheimer Technology website
http://www.obio.com/hydrocarbon%20chains.htm
Oil: An Introduction for New Zealanders
Table 1 Hydrocarbons4
API
Specific
Gravity
Gravity
(Density)
Formula
Boiling
Point
C
Melting
Point
C
Normal
State
C1
CH4
-161
-182.5
Gas
C2
C2H6
-88
-183.3
Gas
Propane
C3
C3H8
-46
-189.7
Gas
0.51
146o
Butane
C4
C4H10
-1
-138.4
Gas
0.58
112o
Pentane
C5
C5H12
36.1
-129.7
Liquid
0.626
95o
Hexane
C6
C6H14
68.7
-95.3
Liquid
0.658
84o
Heptane
C7
C7H16
98.4
-90.6
Liquid
0.682
76o
Octane
C8
C8H18
125.7
-56.8
Liquid
0.702
70o
Nonane
C9
C9H20
150.8
-53.5
Liquid
0.717
66o
Decane
C10
C10H22
174.1
-29.7
Liquid
0.728
63o
Kerosene
C12C16
200300
Liquid
0.79
47o
Distillate Fuel
C15C18
Up to 360
Liquid
0.82
41o
Lubricating Oils
C16C20
350 up
Liquid
0.89
27o
Residual Fuel Oil

and Grease
C20 & up
Semisolid
0.93
21o
Pitch and Tar
C26 & up
Residue
1.2
-14o
Petroleum Coke
C26 & up
Residue
1.35
-27o
Compound
Carbons
Methane
Ethane
Except as noted, all data is from the table Hydrocarbon Chains on the iSOC Technology
website http://www.isocinfo.com/DocumentRoot/10/Hydrocarbon_Chains.pdf. Upper cut
point for kerosene changed from 315 to 300 degrees based on statement in Roy J. Irwin et al,
Environmental Contaminants Encyclopedia; Kerosene Entry, National Park Service, Washington, DC,
July 1997, http://www.nature.nps.gov/hazardssafety/toxic/kerosene.pdf, p.25 (of PDF file) that
The final boiling point specification [for straight-run kerosene] was raised to 300 degrees C in
the early 1980s. Upper cut point for distillate fuel changed from 375 to 360 degrees based on
Ministry of Economic Development, Petroleum Products Specifications Regulations 2002, July 2002,
http://www.med.govt.nz/templates/MultipageDocumentPage____10182.aspx#P560_21331,
which shows the Distillation 95% volume recovered at (C) (T95) point for diesel fuel in New
Zealand as 360C. Density figures for propane, butane, pitch and tar, and petroleum coke
are from Nathaniel B. Guyol, Energy Interrelationships; a Handbook of Tables and Conversion
Factors for Combining and Comparing International Energy Data, Federal Energy Administration,
Washington, DC, 1977, Table 15. Figures are norm values. Density figures for hexane,
heptane, octane, and nonane are from the Engineers Edge website, fluid characteristics page,
http://www.engineersedge.com/fluid_flow/fluid_data.htm, based on a temperature of 20 C.
Density figure for decane is from the SImetric.co.nz website, Specific Gravity of Liquids page,
http://www.simetric.co.uk/si_liquids.htm, based on a temperature of 25C. Density figures for
kerosene, distillate fuel, lubricating oil, and residual fuel oil and grease are from Mieke Reece, Special
Issue Paper 9; Densities of Oil Products, Energy Statistics Working Group Meeting, IEA, Paris, November
2004, http://www.iea.org/Textbase/work/2004/eswg/SIP9.pdf, table of Country Specific Information,
column for New Zealand. Distillate fuel figure shown is for Gas/diesel oil, residual figure fuel shown
is for Fuel Oil (Incl. Bunker fuel). API gravity figures are calculated from the corresponding density
figures using the formula given in this section.
11
12
of oil products are generally measured.5 But in the United States, and for crude oil
worldwide, that would be too easy. In these cases, engineers generally use the
American Petroleum Institute (API) Gravity scale, which for some obscure reason uses
a unit of degrees, and is defined to be:

141.5
API =
131.5.6

specific gravity
API Gravity is the first of several odd American measurements we will be
encountering in this book. The formula implies that water has an API gravity of 10
and that as the product gets lighter, the API gravity increases. Since most oil and oil
products are lighter than water, they have an API gravity greater than 10.
There is one more important trend to note in Table 1. The third column shows
that as the number of carbon atoms increase, the ratio of hydrogen atoms to carbon
atoms tends to decrease from 4:1 to around 2:1. Since the carbon atoms oxidise into
carbon dioxide when they burn, while the hydrogen atoms oxidise into water vapour,
this explains why heavier fuels tend to have higher emissions of carbon dioxide per
unit of energy than lighter fuels. The third column stops after C10 because there are
many alternative molecular structures for these larger molecules, but the trend to
lower hydrogen to carbon ratios continues. The heavier hydrocarbons tend to contain
ring structures, with hydrogen to carbon ratios closer to 1:1. Coal, the heaviest of
the hydrocarbons, contains lots of these rings, and may have a ratio of hydrogen to
carbon in the 1.2 to 1.0 range.7
Since the composition of crude oil varies greatly from field to field, the price of
crude oil also varies from field to field and thus (contrary to the impression one would
get from reading most newspapers) there is no single price of oil. Light crude oil
(API gravity greater than 338) is the most valuable, since it contains more of the light
hydrocarbons. These light hydrocarbons can be blended directly into liquid fuels.
Heavy crude oil (API gravity less than 28) is less valuable, since it contains more
heavy hydrocarbons that must be further processed to produce compounds useful as
liquid fuels (see Section 1.5).
5
6
7
8
Thanks to Ian Twomey for pointing this out to the author.

See William L. Leffler, Petroleum Refining in Nontechnical Language, Third Edition, PennWell Books,
Tulsa, Oklahoma, 2000, p. 15.
Many thanks to Stephen Goldthorpe, Energy Consultant, for helping me with this hydrocarbon
chemistry.
There appears to be no uniformly accepted definition of light and heavy crude.
These definitions are from Platts, a leading provider of energy market information.
Seehttp://www.emis.platts.com/thezone/guides/platts/oil/glossary.html#l.
Crude oil also can contain various impurities, which must be removed. Clearly,
the less pure the oil is, the lower the value of the oil. The most common impurity
is sulphur, which is often chemically bonded to the hydrocarbons so it is not easily
removed. Sweet crude is low in sulphur (generally less than 1% by weight)9, while sour
crude is high in sulphur. These terms developed in the early days of the oil industry,
when people used to actually taste the oil to determine if it had too much sulphur..10
1.2 Oil Products

Oil is important to us because there are so many useful products that can be made
from it. Each product has properties which make it useful for certain applications, and
which determine how it must be processed, distributed, and consumed.
Due to its high energy density, convenient liquid form, and historically low cost, oil
has a special role as a transport fuel. In New Zealand, 86% of oil is used in the transport
sector and oil products provide 99% of transport energy.11
Natural Gas Natural gas is not an oil product. However, since it is the lightest of the
hydrocarbon fuels and often found in association with oil, it is a good place to begin a
discussion of oil products. The natural gas used by consumers is generally well over 90%
methane (C1, see Table 1), with smaller amounts of ethane (C2) and other hydrocarbon
and non-hydrocarbon gases.12
Natural gas is commonly used in New Zealand as an electricity generation fuel, in
home and commercial heating appliances, and as a heat source in various industrial
processes. It is also used to make methanol (a feedstock to the chemical industry) and
urea (primarily used for fertiliser).13 Compressed natural gas (CNG) was a significant
transport fuel in New Zealand in the 1980s, but this use has declined to negligible
levels since government subsidies were removed in 1987.14
9 See definition of sweet crude in http://www.businessdictionary.com/definition/sweet-crude.html.
10 See William L. Leffler, Petroleum Refining in Non-Technical Language, Third Edition, PennWell Books,
Tulsa, Oklahoma, 2000, p. 17.
11 See Ministry of Economic Development, New Zealands Energy Outlook to 2030; Final Publication,
September 2006, http://www.med.govt.nz/energy/eo/2006/, p. 48.
12 See the statistics on average U.S. natural gas composition in slide 6 of William E. Liss and David M.
Rue, Natural Gas Composition and Quality, Gas Technology Institute, 2005 at

http://www.energy.ca.gov/2005_energypolicy/documents/2005-02-17+18_workshop/presentations/
GTI_rue_liss_pan_1_2005.ppt#1. There appear to be no comparable statistics available on average
composition of consumer natural gas in New Zealand.
13 See Ministry of Economic Development, New Zealands Energy Outlook to 2030; Final Publication,
September 2006, http://www.med.govt.nz/energy/eo/2006/, Section 10.3.
14 See Ministry of Economic Development, New Zealand Energy Data File, June 2007,
http://www.med.govt.nz/energy/edf/2007/, p. 71 and Table E.6.
13
14
Methane and ethane are gases, and like to stay that way. In fact, no amount of
pressure can liquefy them at ordinary temperatures.15 Consequently, natural gas
must typically be transported and distributed in gaseous form by pipeline. However,
methane may be liquefied by super cooling it to around 161C to produce liquefied
natural gas (LNG). LNG occupies about one six-hundredth the volume of the gas,
allowing it to be conveniently transported in special insulated tanker ships.16 LNG
has thus allowed an intercontinental trade in natural gas to develop. New Zealand
currently has no LNG facilities.
Liquefied Petroleum Gas (LPG) LPG is typically a mixture of propane (C3), butane
(C4), and isobutane (which has the same chemical formula as butane, but has one of its
carbon atoms on a side branch), but may sometimes consist of pure propane.17 In New
Zealand, LPG is generally extracted from raw natural gas,18 but it may also be produced
from oil in a refinery.19 LPG is a gas, but will readily liquefy under pressure at ordinary
temperatures. It can therefore be transported and marketed in liquid form in simple
pressurised containers. LPG should not be confused with LNG, discussed above.
LPG in New Zealand is commonly used in home and commercial heating
appliances, as a heat source in various industrial processes, and as a fuel for forklift
trucks.20 As with CNG, LPG went through something of a boom and bust as a vehicle
fuel in the 1980s, but still powers about 10,000 vehicles.21 Because it can be delivered
in pressurised containers, LPG is a convenient alternative to natural gas in rural areas
and cities not served by the natural gas distribution network. LPG is also reticulated
by pipeline to some areas of the South Island.22
15 See the discussion of Chemistry of Natural Gas in George A. Burrell, et al, The Condensation of
Gasoline from Natural Gas, U.S. Department of the Interior, Bureau of Mines, Bulletin 88 Petroleum
Technology 20, 1915, http://www.distillationgroup.com/distillation/H001/H001.htm, p. 26.
16 See the California Energy Commission Frequently Asked Questions About LNG web page,
http://www.energy.ca.gov/lng/faq.html.
17 See the How Liquefied Petroleum Gas Works page on the How Stuff Works website http://auto.
howstuffworks.com/lpg1.htm.
18 See the LPG Association of New Zealand About LPG web page, http://www.lpga.org.nz/info.php.
19 See the How Liquefied Petroleum Gas Works page on the How Stuff Works website http://auto.
howstuffworks.com/lpg2.htm. Thanks to Ian Twomey for pointing out the propane is frequently sold
as LPG in New Zealand.
20 See the Statistics New Zealand Manufacturing Energy Use Survey web page
http://www.stats.govt.nz/products-and-services/hot-off-the-press/manufacturing-energy-use-survey/
manufacturing-energy-use-survey-yemar06-hotp.htm?page=para003Master.
21 See the LPG Association of New Zealand home page http://www.lpga.org.nz/.
22 See Ministry for the Environment, Warm Homes Technical Report; Detailed Study of Heating Options in
New Zealand, http://www.mfe.govt.nz/publications/energy/warm-homes-heating-options-phase1nov05/html/page4a.html.
Petrol Motor petrol is a mixture of hydrocarbons in the C5 to C12 range.23 It is also

known as gasoline, especially in North America, where the word is often confusingly
shortened to gas in casual usage. In fact, petrol is a liquid, but it does need to vaporise
easily, since in a petrol engine the fuel is vaporised and mixed with air (either by a
carburettor or fuel injector) before it is ignited.
Petrol generally comes in two grades: regular and premium. Contrary to popular
belief, premium petrol does not contain significantly more energy than regular petrol.
In fact, the major difference between the two is that premium petrol is harder to
ignite. This is because in a petrol engine, the combustion of the air and petrol vapour
mix is supposed to spread smoothly though the cylinder following ignition by the
spark plug. However, as the mix gets compressed when the piston reaches the top of
its cycle, it heats-up, much like the air in a bicycle pump. If the fuel ignites too easily,
this heat of compression will cause the mix to ignite prematurely in some parts of
the cylinder. The result will be pressure waves that reverberate through the cylinder,
known as engine knock or ping. Engine knock causes an annoying noise, reduces the
engines power, and can cause damage to the engine.
Premium petrol is formulated to be less prone to knocking. Octane is a measure
of how resistant a fuel is to knocking: the higher the octane the more resistant the
fuel is to knocking. Since high-performance engines are designed to compress the
air and petrol vapour mixture more (that is, they have a higher compression ratio),
they have a greater tendency to knock and are more likely to need premium fuel.24
However, many consumers waste money buying premium fuel: if their engine
does not knock on regular petrol, premium petrol will not noticeably improve their
engines performance.25
Adding further to the confusion about grades of petrol is the fact that there are two
accepted methods of measuring octane, the Research Octane Number (RON) and the
Motor Octane Number (MON). MON is determined under a more stressful test, and
tends to be 8 to 10 points lower than RON. In New Zealand, and most other countries,
the posted octane is usually RON. However, in the United States, regulations require
the posted octane to be an average of RON and MON. Hence, in the United States,
23 See Charles E. Ophardt, Elmhurst College Virtual Chembook, 2003, What Is Gasoline? page,
http://www.elmhurst.edu/~chm/vchembook/514gasoline.html.
24 See the discussion of engine knocking and octane numbers in William L. Leffler, Petroleum Refining in
Non-Technical Language, Third Edition, PennWell Books, Tulsa, Oklahoma, 2000, pp. 134-139.
25 See the U.S. Federal Trade Commission The Low Down on High Octane Gasoline web page
http://www.ftc.gov/bcp/edu/pubs/consumer/autos/aut12.shtm.
15
16
posted octane ratings run 4 or 5 points lower than they would be for the same fuel
elsewhere.26
Jet Fuel Jet fuel is generally a kerosene-type fuel composed of hydrocarbons in
the C8 to C16 range.27 It is a liquid, and it needs to stay that way, even at the extremely
low temperatures encountered at high altitudes. This requirement has been a major
obstacle so far to powering jet aircraft with biofuels (see Section 2.5.2), since todays
biofuels tend to solidify at low temperatures.28
Diesel Fuel Diesel fuel is a middle distillate, generally a bit heavier than jet fuel
(C14 to C2029). Diesel engines have no spark plugs, and rely on heat of compression
(discussed under Petrol above) to ignite the fuel when it is injected after the air in the
cylinder is compressed by the piston. That is what makes diesel engines different from
petrol engines. They, therefore, need a fuel that self-ignites easilythe very opposite
of what a petrol engine needs. One measure of the quality of diesel fuel is its cetane
number. Cetane is very much the opposite of octane: the higher the number the more
easily the fuel self-ignites.30
Furnace Oil Also known as number 2 oil or heating oil, it is essentially the same
thing as diesel fuelin fact, it often is the same thing.31 It is commonly used for heating
homes and businesses in many parts of the world; however, its use is practically
unknown in New Zealand.32
Residual Fuel Oil Residual fuel oil comes in several grades, often identified as
fuel oil numbers 4 through 6.33 These products are blends containing a large amount
26 See Ministry of Economic Development, Resource Document (a detailed discussion of the Petroleum
Products Specifications Regulations 1998 and the context in which they exist), August 2001, Section 7.1
Octane Number,
http://www.med.govt.nz/templates/MultipageDocumentPage____10301.aspx#P1396_141578.
Seealso the Wikipedia article, Octane Rating, http://en.wikipedia.org/wiki/Octane_rating.
27 See the Wikipedia article Jet Fuel, http://en.wikipedia.org/wiki/Jet_fuel.
28 For a discussion of these and other issues related to bio jet fuel, see the
Aviation Week article Alternative Fuels for Jet Engines, September 17, 2007,
http://www.aviationweek.com/aw/generic/story_generic.jsp?channel=bca&id=news/bca0907p3.xml.
29 See The Institute of Petroleum Coryton Refinery Refining Process web page, Figure 14,
http://www.energyinst.org.uk/education/coryton/images/column.gif.
30 See William L. Leffler, Petroleum Refining in Nontechnical Language, Third Edition, PennWell Books,
Tulsa, Oklahoma, 2000, pp. 154-155.
Tulsa, Oklahoma, 2000, pp. 153.
32 See Statistics New Zealand Census of Population and Dwellings 2002 data table on home
heating type at http://www2.stats.govt.nz/domino/external/web/prod_serv.nsf/
092edeb76ed5aa6bcc256afe0081d84e/5605ab881ace7506cc256bc5007c97eb?OpenDocument.
33 See the chart of fuel oils in William L. Leffler, Petroleum Refining in Nontechnical Language, Third
Edition, PennWell Books, Tulsa, Oklahoma, 2000, pp. 157.
of residue, the stuff that is left at the bottom of the distillation tower (see Figure 2).
Often shortened to resid, residual fuel oil is really heavy stuff, in the C20 and up range.
Residue and some residual fuel oils are so thick they have to be heated before they
can be pumped through a pipeline. Although it can be difficult to handle, residual
fuel oil is generally the cheapest of the oil-based fuels because residue is the least
desirable component of crude oil. 34 Residual fuel oil was, and still is in some parts of
the world, popular as an industrial boiler fuel. However, the market for residual fuel oil
went through a sharp decline worldwide after the oil price shocks of the 1970s, since
it is generally easy to switch to coal or gas for boiler fuel.35 In New Zealand its use
has also declined, and today it probably accounts for less than 3% of New Zealands
domestic oil product consumption.36
Residual fuel oil is also used in special heavy duty diesel engines that power large
ships and, in some countries, electricity generators.37 However, New Zealands only
remaining oil-fired power station, Whirinaki, has gas turbine engines and runs on
diesel fuel.38
That covers the major oil-based fuels. To these we must add some significant nonfuel products derived from oil, including tar and bitumen used for roads and buildings,
lubricating oils, plastics, waxes, and a wide variety of chemicals.
1.3
The Geology of Oil39
New Zealands oil and gas generally has a different geological origin from oil and
gas in other parts of the world. To start with, most of the worlds oil and gas is derived
Tulsa, Oklahoma, 2000, pp. 157 and 165.
35 See Francisco Parra, Oil Politics; A Modern History of Petroleum, I.B. Tauris, London, 2004, pp. 243.
36 See Ministry of Economic Development, New Zealand Energy Data File, January 2007,
http://www.med.govt.nz/energy/edf/2007/, Table D.12 shows 8.69 PJs of consumer energy from fuel
oil (light and heavy combined) in 2006, while Table D.5 shows 259.37 PJs of consumer energy from all
oil products total.
Tulsa, Oklahoma, 2000, pp. 166-167,
38 See the Whirinaki electricity generation plant case study
brochure on the website of Power Measurement Ltd.
http://www.pwrm.com/library/literature/case_studies_and_articles/Contact_Energy_Case_Study.pdf.
39 The discussion of the usual story in this section is drawn from Charles F. Conway, The Petroleum Industry;
A Nontechnical Guide, PennWell Publishing, Tulsa, Oklahoma, 1999, chapters 1-3 and Norman J. Hyne,
Nontechnical Guide to Petroleum Geology, Exploration, Drilling, and Production, Penn Well Publishing,
Tulsa, Oklahoma, 2001, chapters 11,12, and 14. The discussion of the New Zealand story is based on
discussions with Dr. Richard Cook, Chief Petroleum Geologist, Ministry of Economic Development
and the Ministry of Economic Development publication New Zealands Petroleum Basins, 2004,
http://www.crownminerals.govt.nz/cms/petroleum/publications/#nz-petroleum-basins, pp. 4-5.
17
18
from microscopic plants in the ocean, such as plankton and algae. In NewZealand,
however, most oil and gas is derived from the remains of lowland forests. The con
version processes that produced the oil and gas are quite different as well. This
section starts by looking at the more usual story, then looks at how the situation in
New Zealand differs.
In the usual story, oil and gas begins with microscopic ocean plant material that
settles to the bottom of the ocean, and gets buried in sediment there. The plant
material has to be buried quickly in sediment to prevent bacterial decay, the fate of
most dead organic matter.
Over many millions of years, more layers of sediment settle on top of the organic
material and the sediment in which it is buried, increasing the pressure on it, and
causing it to harden into rock, typically shale. As the rock is buried deeper, temper
atures rise, causing the organic matter in the rock to be converted to oil or gas. This
rock in which oil or gas is formed is known to petroleum geologists as source rock.
The deeper the organic material is buried, the higher the temperature, and the lighter
the oil. This is because the heat tends to crack the oil molecules, as in a refinery
(see Section 1.5 below). If source rock that is buried too deeply, all the oil will be
converted to gas.
Source rock is normally impermeable. However, the creation of the oil and gas
causes a large increase in volume. This volume increase stresses the source rock,
causing it to fracture, allowing the oil or gas to escape. The oil or gas is thus released
(see Figure 1).
What happens next depends on the nature of the rock above the source rock.
Assuming it is porous and permeable, the oil and gas will migrate. Porous rock is
composed of granular material with lots of microscopic spaces between the grains that
can hold oil. But for the oil to flow, it is not enough for the rock to be porous. The spaces
must be linked together, making the rock permeable for the oil. Petroleum geologists
devote a great deal of effort to analysing the permeability and porosity of reservoir rocks,
that is, rocks through which oil and gas could potentially flow.
Since the reservoir rock was originally formed under the ocean, the pores in it will
initially be filled with seawater. Since oil and gas is lighter than sea water (oil floats on
water), it tends to rise through the reservoir rock. As the oil and gas rises, it eventually
either leaks out onto the surface as a gas or oil seep (and is soon lost) or hits a layer
of some impermeable rock that stops it, known to petroleum geologists as cap rock.
If the cap rock has any slope to it, the oil will continue to rise along the underside of
the slope. Over millions of years, the oil and gas can migrate some distance. Instances
Figure 1 Migration of Oil from Source Rock to Trap
where oil has migrated as much as 80km have been recorded, and gas can move
hundreds of kilometres.
If there are places where the cap rock stops rising and starts falling, the oil and
gas will tend to accumulate at the highest point in the structure, known as a trap.
Basically, a trap is like an upside down bowl that prevents the oil and gas from rising
any further. There are a number of kinds of traps; they are what petroleum geologists
look for.
In New Zealand, the oil and gas story more commonly begins in lowland forests on
coastal plains adjacent to the ocean. These were areas that might be casually referred
to as bogs or swamps, since the land under them is saturated with water. Dead
plant material in these forests falls into the water-logged soil. Because the soil is low
in oxygen, the plant material does not decay. Over an extended period of time, this
vegetable matter may build up into a layer tens of metres thick.
However, over geological time, things change. Movements of the earths crust
(tectonics) may or may not cause the land to sink under the ocean. In any case, the
land somehow ceases to be a forest, and other types of sediment can now accumulate
19
20
on top of the layer of vegetable matter. As the sediment accumulates, the resulting
pressure and heat on the vegetable matter cause it to be converted to coal.
This coal is, however, a bit different from most of the coal found in other parts of the
world. The New Zealand coal is geologically much youngeronly about 50150 million
years old compared to 280 to 360 million years old elsewhereand thus originates from
more highly-evolved plants. Because of the different chemical composition of these
plants, the coal contains a waxy oil, as well as gas. So instead of marine rock, it is this coal
that becomes the source rock for much of New Zealands oil.
The coal is slightly permeable. The oil and gas therefore does not need to fracture
the coal to escape from it; it can just very slowly (over geological time) soak through it
and enter the reservoir rock above. Even if the reservoir rock was not originally formed
under the ocean, its pores will still be filled with seawater since the rock is permeable
and below sea level. The oil can thus rise through the reservoir rock. From here, the
story is similar to the rest of the world: the oil and gas migrates through the reservoir
rock and may eventually accumulate in a trap.
Petroleum geologists today most commonly seek out traps using seismic surveys.
These involve generating some intense sound on the earths surface, such as with a
small explosion. By capturing the reflected sound waves from the rocks below and
analysing them with computers, it is possible to plot out a quite accurate picture of
the rock layers. There are even seismic techniques that can detect the presence of
gas-filled porous rocks. But the only way to find out for sure just what is down there
is to drill.
1.4 Oil Production

Let us suppose you have now drilled into a new structure. Where is the oil and
gas? The odds are good you will not find any at all. Most wildcat (or exploration) wells,
that is, wells drilled in hopes of finding a new oil or gas field, do not find marketable
quantities of oil or gas.40 That is a big risk for oil producers. But if you do find oil or
gas, it will, of course, be in a trap under the cap rock. Free gas, if any, will tend
accumulate above the oil, if any, since gas is lighter than oil. The old seawater that
originally filled the pores in the reservoir rock will be on the bottom, since it is heavier
than oil.41
40 See Charles F. Conway, The Petroleum Industry; a Nontechnical Guide, PennWell Publishing, Tulsa,
Oklahoma, 1999, Chapter 3, p.41.
41 See Norman J. Hyne, Nontechnical Guide to Petroleum Geology, Exploration, Drilling, and Production,
PennWell Publishing, Tulsa, Oklahoma, 2001, Chapter 11, p. 154-155.
The bad news here is that an oil and gas reservoir is not a big pool, like a water
reservoir, that one can just pump out. Rather, the oil and gas is still in the reservoir
rock.42 Fortunately, the oil and gas is under considerable pressure, which will tend to
push it through the rock toward the lower pressure of the well. How quickly it flows
depends upon many factors. But it will always take time to produce the oil.43
As the oil and gas is produced, the pressure in the reservoir tends to dissipate.
This causes the flow of oil to slow down, and may allow increasing amounts of
water to mix with the oil (the water cut).44 Inevitably, much of the oil is left trapped
in the reservoir rock. Although oil production technology is continually improving,
the industry typically leaves about two-thirds of the original oil in the ground.45
Petroleum engineers develop production plans so as to maximise the production,
which involves producing the oil in a way that preserves the natural pressure for as
long as possible. They may then use secondary recovery techniques to help restore the
pressure, typically by injecting water into the reservoir.46 Tertiary or enhanced recovery
techniques may also be used to loosen up the oil, typically with steam, chemicals, or
carbon dioxide.47
The use of carbon dioxide for this purpose is of special interest, since it provides an
inadvertent demonstration of the potential for carbon capture and storage to mitigate
greenhouse gas emissions. The carbon dioxide used today for tertiary recovery is
found in underground reservoirs, often mixed with natural gas, from which it must be
separated before the gas can be sold.48 However, in the future, it could be extracted
from the flue gases of power plants and other fuel-burning facilities.49
Oklahoma, 1999, Chapter 2, p.24-25.
43 See Martin Raymond and William Leffler, Oil and Gas Production in Nontechnical Language, PennWell
Publishing, Tulsa, Oklahoma, 2006, Chapter 8, pp. 163-165
Publishing, Tulsa, Oklahoma, 2006, Chapter 8, pp. 167-168.
45 For a discussion of this issue, see Institut Franais de Ptrole Pushing back the boundaries in oil and
gas production web page, http://www.ifp.com/axes-de-recherche/reserves-prolongees/repousserles-limites-de-l-exploration. See also Norman J. Hyne, Nontechnical Guide to Petroleum Geology,
Exploration, Drilling, and Production, PennWell Publishing, Tulsa, Oklahoma, 2001, Table 26-1, p. 432.
Oklahoma, 1999, Chapter 2, p.88 and Chapter 12, p. 225.
49 See the World Coal Institute website page on Carbon Sequestration,
http://www.worldcoal.org/pages/content/index.asp?PageID=414.
21
22
Oil typically has some natural gas dissolved in it when it first comes out of the
ground. In producing oil, as the oil reaches the lower pressures and temperatures on
the surface, the gas bubbles out of it much the way it does in a fizzy drink.50 This gas
may be recovered and sold if the oil field is located near a gas pipeline. If not, the
gas may be reinjected to help keep up the pressure in the reservoir. In the past, this
gas was often simply burned-off (flared). Like many countries,51 New Zealand today
does not permit flaring except under exceptional circumstances, such as mechanical
breakdowns or the initial set-up and testing of a new well.52
On the other hand, in producing natural gas, the gas typically comes out of the
ground containing the vapours of various liquid hydrocarbons. These include propane,
butane, and a light crude oil-like liquid known as condensate. In New Zealand, some
condensate is sold separately as naphtha, and reported separately from condensate
in MEDs statistics. All these natural gas liquids may be separated from the gas in gas
processing plant and sold separately. Indeed, it is usually necessary to separate the
liquids, since if this is not done, they will tend to condense out in high pressure gas
pipelines and cause operational difficulties. But since the liquids tend to be quite
valuable, gas producers usually want to recover the liquids in any case.53 Wet gas
is gas with a high liquids content.54 The raw gas as it comes out of the ground may
also be mixed with carbon dioxide, which generally also needs to be removed by the
gas processing plant. New Zealands Kapuni gas, for example, is around 42% carbon
dioxide.55
Analysing quantities of oil can sometimes be confusing as there are two standards
of measurement for oil and oil products in international commerce. Oil in the United
States is generally measured in a rather strange unit: barrels (or bbl) of 42 US gallons,
or almost exactly 159 litres. The origins of this measure are rather obscure, but two
Internet history sites report that in the early days of the U.S. oil industry, oil actually
was shipped and sold in barrels of varying sizes. Eventually, the industry standardised
PennWell Publishing, Tulsa, Oklahoma, 2001, Chapter 25, pp. 432
PennWell Publishing, Tulsa, Oklahoma, 2001, Chapter 25, pp. 426.
52 See Crown Minerals, Minerals Programme for Petroleum, 1 January 2005, http://www.crownminerals.
govt.nz/cms/pdf-library/petroleum-publications-1/mins-prog-for-petroleum-2005.pdf, Section 6.1.
PennWell Publishing, Tulsa, Oklahoma, 2001, Chapter 1, pp. 11-12 and Chapter 21, pp. 368-369.
Publishing, Tulsa, Oklahoma, 2006, Chapter 3, pp. 61.
55 See Ministry of Economic Development, New Zealand Energy Greenhouse Gas Emissions 1990-2006,
http://www.med.govt.nz/energy/ghg/2007/, p. 23
on the 42 gallon barrel as a unit of measure.56 In Europe, oil was generally transported
in seagoing vessels, so weight (displacement) in metric tonnes (or t) became the
standard for commerce.57 To add to the confusion, there is no standard conversion
factor between barrels and tonnes. As we have seen, crude oil and oil products vary
in density, so the conversion depends upon the type of crude oil or oil product. The
BPStatistical Review of World Energy puts the worldwide average conversion factor for
crude oil at 7.33 barrels/tonne.58
1.5 Oil Refineries59

So now that we have produced the oil, how do we transform it into oil products
that people can use? Recall that crude oil is a broad-ranging mixture of hydrocarbons.
The oil products that people can use each consist of a much more narrow range of
hydrocarbons. How can we separate the various hydrocarbons? Table 1 gives a hint as
to the answer: the different boiling points of the different compounds.
One way to separate hydrocarbons would be to use something akin to a
moonshiners still. We could, say, heat the oil to the boiling point of pentane (36.1
C), capture the vapours, and then condense them to obtain molecules that have
predominately five carbons. Then we could heat the oil further to the boiling point of
hexane (68.7 C), capture the vapours, and condense them to obtain molecules that
have predominately six carbons. The word predominantly is used here, since crude
oil contains many compounds other than those listed in Table 1 (recall that there are
300,000 hydrocarbons), each with a different boiling point. Also, we will never be able
to achieve a perfectly uniform temperature in our still, so there will always be some
molecules that vaporise too early or too late. However, subject to these imperfections,
we could continue this process of raising the temperature and capturing the resulting
vapours to obtain each heavier fraction of the oil.
The moonshiners still approach would work, but it is not very efficient. The way
the separation is done commercially is to boil the crude oil at a high temperature and
56 See http://www.sizes.com/units/barrel_petr.htm and http://www.oil150.com/essays/2007/08/the-42gallon-barrel-history.
57 See William L. Leffler, Petroleum Refining for the Non-Technical Person, Second Edition, PennWell Books,
Tulsa, Oklahoma, 1985, pp. 11-12.
58 See BP, Statistical Review of World Energy 2008,
http://www.bp.com/productlanding.do?categoryId=6929&contentId=7044622, p.44.
59 Unless otherwise noted, the discussion in this chapter is drawn from William L. Leffler, Petroleum
Refining in Non-Technical Language, Third Edition, PennWell Books, Tulsa, Oklahoma, 2000. Another
useful source is the Discover Petroleum pages of the Association for School Science, Schoolscience
website, http://resources.schoolscience.co.uk/Exxonmobil/infobank/4/2index.htm?2home_f2.htm.
23
24
Figure 2 Distillation Column
send the vapour up a distillation column (or tower) with a set of trays in it, as shown in
Figure 2. The trays are stacked in the column much like drawers in a chest of drawers.
Each tray is cleverly designed to hold liquids that are kept at a given temperature, with
the temperature of each tray getting cooler as one moves up the column. The vapour
is forced to bubble through the liquids in each tray. As the vapour bubbles through,
hydrocarbons that have a boiling point higher than the temperature of the liquid in the
tray tend to condense. Hence, we can draw-off from each tray the crude oil fraction with
a given range of boiling points. This process is known as fractional distillation.
Distillation can get us raw versions of each of the major oil products. However, here
we encounter a serious problem. The market wants mostly the lighter products
petrol, diesel, and jet fuel, in particularbut most crude oils contain a lot of heavier
hydrocarbons that are much less in demand and much less valuable. For example,
straight distillation of even a light crude oil would generally yield only about a 2025%
petrol fraction. To solve this problem, the next stages of refining are typically cracking
processes that chemically break-up the molecules in the heavier fractions into lighter
molecules. There are a number of ways this can be done, generally involving some
combination of heat, catalysts, and hydrogen. Using such processes, a sophisticated
refinery can produce 60% or more petrol.60
There is a lot more to refining than this, including processes for the converting of
hydrocarbon gases into hydrocarbon liquids (the reverse of cracking), for removing
impurities such as sulphur, and for altering the chemical structure of some molecules
in order to meet product specifications such as octane and vapour pressure. In
general, the refining industry has had to become increasingly sophisticated as, on
the one hand, government regulations and vehicle manufacturer specifications have
required petrol and other oil products to meet higher standards, while on the other
hand, the average crude oil being produced worldwide is getting heavier and higher
in sulphur, and thus more difficult to process.61
New Zealand has reflected this trend, as government regulations have progressively
reduced the allowed level of sulphur in fuels since 2002. The limit on sulphur is 50 parts
per million (ppm) in petrol effective January 1, 2008 and 10 ppm in diesel effective
January 1, 2009.62 The maximum sulphur content of diesel was as high as 3000 ppm
as recently as 2004 although it typically averaged about 2000 ppm.63
Sulphur in oil products has been a problem for two reasons. First, it contributes
directly to at least two pollutants, particulates and sulphur dioxide, which can pose
60 See the graphs of typical distillation yields and typical refinery yields on the U.S. Energy Information
Administration website at http://www.eia.doe.gov/pub/oil_gas/petroleum/analysis_publications/
oil_market_basics/ref_image_simple.htm.
61 See the Refining page of the U.S. Energy Information website at http://www.eia.doe.gov/pub/oil_gas/
petroleum/analysis_publications/oil_market_basics/refining_text.htm#Downstream%20Processing.
62 See press release from Hon. Harry Duynhoven, Consumers to get cleaner petrol and diesel, August3,
2006, http://beehive.govt.nz/release/consumers+get+cleaner+petrol+and+diesel+0.
63 See the Ministry of Economic Development, Lower Sulphur DieselWhat Does This Mean?, February
2004, http://www.med.govt.nz/templates/Page____10375.aspx. Thanks to Ian Twomey for providing
the 2000 ppm average estimate.
25
26
health hazards.64 Sulphur dioxide is also the cause of acid rain, which damages
forests and ecosystems. Acid rain has been a major problem in Northern Hemisphere
countries, but because of our island geography, does not occur in New Zealand.65
Second, sulphur can reduce the effectiveness of vehicle pollution control systems
against other pollutants, sometimes permanently.66 For this reason, manufacturer
standards are increasingly requiring lower sulphur levels in fuel.67
64 See Ministry of Economic Development, Review of Permitted

Sulphur Levels Beyond 2006, May 2005, Section 3.1,
65 See the Ministry for the Environment Sulphur Dioxide web page,
http://www.mfe.govt.nz/issues/air/breathe/sulphur-dioxide.html.
http://www.med.govt.nz/templates/MultipageDocumentPage____10381.aspx, and Section 3.1,
http://www.med.govt.nz/templates/MultipageDocumentPage____10381.aspx, and Section 3.2,
27
World Oil Resources

2
Most oil importing countries, including New Zealand, are concerned about the
security of their oil supply. These concerns over security have at least two dimensions,
both of which stem from some basic facts about oil resources.
First, there is the ever-present danger of short-term disruptions to supply. Much of
the worlds oil is produced in hostile or remote natural environments, such as offshore
and in the arctic, and is therefore vulnerable to disruption from natural disasters and
other types of breakdowns in the supply chain. However, of perhaps greater concern is
the fact that much of the worlds oil resources are concentrated in a few oil exporting
countries, where the potential for political disruption is also high. This disruption risk
will be examined further in Chapter 7.
Second, there is concern about the long-term sustainability of oil supplies. There
are basic questions about the quantity of the worlds oil resources that remain
unanswered. Part of this problem is natural: we have no way of knowing how much
oil remains to be discovered and what tomorrows exploration and production
technologies will bring us. Another part of the problem, however, are the limitations
of the available data. With the right kind of international cooperation, these limitations
could be greatly alleviated.
The issue of the long-term sustainability of oil supplies is very controversial, and
analysing it is beyond the scope of this book. However, this chapter attempts to pro
vide some basic background on world oil resources that anyone who wishes to follow
this debate should understand.
2.1 Reserve Estimates

The most common measure of oil resources that one encounters in the oil policy
debate are proved reserves or in more casual contexts, reserves. Several organisations
publish estimates of oil reserves by country, including Oil & Gas Journal, World Oil,
and the BP Statistical Review of World Energy.68 Another is the U.S. Central Intelligence
Agencys World Factbook.69 The BPStatistical Review of World Energy is the most easily
accessible, and tends to be the most widely quoted in policy analysis.70
68 A table showing most recent reserves according to all three of these sources is
published in the U.S. Energy Information Administration, and may be found at
http://www.eia.doe.gov/emeu/international/reserves.html.
69 https://www.cia.gov/cia/publications/factbook/rankorder/2178rank.html.
70 BP, Statistical Review of World Energy 2008,
http://www.bp.com/productlanding.do?categoryId=6929&contentId=7044622, p.6.
28
Chapter 2 World Oil Resources
Precise definitions of reserves vary, but the basic concept behind all of them is that
they are supposed to be oil that is known to exist and likely to be producible with a
high degree of certainty. For example, BPs definition states that reserves represent
oil that geological and engineering information indicates with reasonable certainty
can be recovered in the future from known reservoirs under existing conditions.71
The term proved reserves is sometimes used interchangeably with P90 reserves,
which indicate there should be at least a 90% probability that the quantities actually
recovered will equal or exceed the estimate.72
There are also other classes of oil reserves; however, these are mostly of interest to
petroleum geologists. One does occasionally encounter others in policy analysis, such
as P50 reserves (50% probability), also known as proven plus probable. Interestingly,
the New Zealand oil reserve statistics given in the Ministry of Economic Developments
Energy Data File are P50 reserves.73
The major organisations that publish reserve estimates are generally reasonably
consistent with each other. They differ primarily in their treatment of unconventional oil,
such as Canadian tar sands and Venezuelan extra-heavy crude (see Section 2.4 below).
The consistency of the reserve estimates should not be taken to indicate that the
numbers are precise. Rather, each of these organisations relies on the same primary
sources for their data. Primary sources for the reserve estimates are usually the
respective national governments.74
Ultimately, reserves are estimates, and despite efforts to standardise definitions,
there is a considerable amount of judgement that must be used to resolve the many
uncertainties. Some observers have questioned whether this judgement is exercised in
a truly objective fashion. For example, in the early 1980s several Middle East countries
revised their reserve estimates upwards significantly despite a lack of new discoveries.
These revisions occurred in the midst of OPEC negotiations over production quotas.
A number of other countries have failed to revise their reserve estimates downward,
despite ongoing production and a lack of new discoveries.75
71 See the BP Statistical Review of World Energy 2008, Definition and Explanatory Notes web page,
http://www.bp.com/sectiongenericarticle.do?categoryId=9023796&contentId=7044130.
72 A recent document, Petroleum Resources Management System, 2007, prepared jointly by the Society
of Petroleum Engineers, the American Association of Petroleum Geologists, the World Petroleum
Council, and the Society of Petroleum Evaluation Engineers standardizes these definitions of proved
reserves. See http://www.spe.org/spe-site/spe/spe/industry/reserves/Petroleum_Resources_
Management_System_2007.pdf, p. 10-11.
73 See Ministry of Economic Development, New Zealand Energy Data File, June 2007, Section H,
http://www.med.govt.nz/energy/edf/2007/.
74 See International Energy Agency, World Energy Outlook 2004, p. 90.
75 For a more complete discussion of the issues involved in estimating oil reserves, see International
Energy Agency, World Energy Outlook 2004, pp. 87-93.
There is no international process for independent verification of reserve estimates.

In many countries, such as Saudi Arabia, the underlying engineering and geological
data are considered to be proprietary or even a state secret.76 Unfortunately, this
unwillingness to share data leaves a major gap in our understanding of the future of
the oil market, which impacts both policymakers and private sector investors.
2.2 Resource Estimates

Oil reserves are often used in the policy debate as indicators of the sustainability of
a countrys oil production. In particular, a countrys reserve-to-production ratio (or R/P
ratio) tells how many years a country would take to produce all its existing reserves at
current production rates. In Saudi Arabia, this R/P ratio is currently around 70, in Iraq
and in Kuwait it is over 100. On the other hand, in the U.S.A. and China the R/P ratio is
around 11 and in the U.K. it is around 6.77 But is oil production in the U.S.A., China, and
the U.K. really less sustainable than in Saudi Arabia, Iraq, and Kuwait?
Although R/P ratios are somewhat indicative of the sustainability of a countrys oil
production, there are a number of factors that come into play, even putting aside the
issue of the accuracy of the reserve statistics. Proving up reserves requires investment,
since despite all that modern technology brings to oil exploration, the only way to know
if the oil is really there is to drill wells. No oil company deliberately sets out to create a
high R/P ratio, since this indicates investment that must sit idle for many years. Countries
with high R/P ratios generally get that way because their oil is in a few very large fields
that they cannot, or choose not, to produce quickly. Countries that lack these large fields
can still produce sustainably if they can continue to discover and develop new fields.
Reserves, unfortunately, tell us nothing about the prospects for a country being
able to make new discoveries. What we really want to know is the countrys ultimately
recoverable resources (or URR). Unfortunately, formulating such estimates involves
dealing with considerably more uncertainties than estimating proved reserves.
Geologists can use available geological data to assess the likelihood of finding more
oil in a region but, as noted above, short of drilling wells, there is no way to know
for sure what is out there. Much of the world has not been well-explored for oil. For
example, only about 9,000 oil and gas wells have ever been drilled in Saudi Arabia,
and only about 600 have ever been drilled in New Zealand. The comparable figure for
the United States is about 4 millionand they are still finding oil there.78
76 See Mathew Simmons, Twilight in the Desert; the Coming Saudi Oil Shock and the World Economy, John
Wiley & Sons, 2005.
http://www.bp.com/productlanding.do?categoryId=6929&contentId=7044622, p. 6.
78 Statistics for Saudi Arabia and the United States from International Energy Agency, World Energy
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30
Further complicating the assessment of ultimately recoverable resources are

assumptions about technology and the future price of oil. As BP notes on their
BPStatistical Review of Energy web page:
Whilst some consider URR to be fixed by geology and the laws of physics, in
practice estimates of URR continue to be increased as knowledge grows, technology
advances and economics change. Economists often deny the validity of the
concept of ultimately recoverable reserves as they consider that the recoverability
of resources depends upon changing and unpredictable economics and evolving
technologies.79
One key area of uncertainty where economics and technology come into play
is the level of recovery. As noted in Section 1.4 above, the industry currently leaves
an average of about two-thirds of the oil resource initially in place in the ground.
Rising prices and technological improvements should make higher levels of recovery
possible in the future.
Several organisations prepare assessments of ultimately recoverable resources. The
most prominent in the policy debate, probably because it is the only detailed scientific
assessment that is available publicly, is the World Petroleum Assessment 2000 of the
U.S. Geological Survey (USGS).80 However, the USGS data suffers from three severe
limitations for use in policy analysis.
First, one important class of ultimately recoverable reserves, reserve growth, is not
estimated at any level other than for the entire world.81 Reserve growth is additional
oil to be added to reserves in existing fields. Reserve growth is expected to be a key
component of ultimately recoverable reserves. In fact, on a world-level, USGS estimates
that future reserve growth will be almost equal to the amount of undiscovered
conventional oil, that is, oil from new fields.82 Thus, there are no estimates of total
ultimately recoverable reserves by country to be had from this source.
Second, the range of uncertainty in the USGS estimates is, not surprisingly, huge.
Fortunately, the USGS does give explicit estimates of this uncertainty by providing
three assessments. An F95 assessment represents a 95 percent chance of at least
79
80
81
82
Outlook 2005, p.131. Statistic for New Zealand supplied by Mark Aliprantis, Manager, Petroleum and
Minerals Investment Unit, Crown Minerals, Ministry of Economic Development.
See http://www.bp.com/sectiongenericarticle.do?categoryId=9023799&contentId=7044111.
See U.S. Geological Survey World Petroleum Assessment 2000 Description and Results available at
http://pubs.usgs.gov/dds/dds-060/.
See U.S. Geological Survey, Analysis of Assessment Results, Chapter AR,
http://energy.cr.usgs.gov/WEcont/chaps/AR.pdf, Table AR-1.
See U.S. Geological Survey, Analysis of Assessment Results, Chapter AR,
http://energy.cr.usgs.gov/WEcont/chaps/AR.pdf, Table AR-1.
the amount tabulated, an F50 assessment represents a 50% chance of at least the
amount tabulated, and an F5 assessment represents a 5% chance of at least the
amount tabulated.83 The F95 assessment of undiscovered conventional oil for the
entire world outside the United States is 334 billion barrels, while the F5 assessment is
1,107 billion barrels. The F95 assessment of reserve growth outside the United States
is 192 billion barrels, while the F5 assessment is 1,031 billion barrels.84
Third, the assessment covers only conventional oil. Yet unconventional oil may
become an important component of future world supply (see Section 2.4 below).
2.3 Concentration of Oil in a Few Countries

One factor that has made oil so problematic is that oil resources are heavily concen
trated in a few countries. Although, as we have seen, there are many uncertainties
with the statistics, there is little dispute that the world oil market will be increasingly
dependent upon these few countries for the foreseeable future.85
Figure 3 Oil Reserves and Production86
Reserves
(Billion Barrels)
300
Production
(Million Barrels/Day)
35
30
250
25
200
20
150
15
100
10
2006 Oil Reserves
83
84
85
86
All Others
Qatar
China
USA
Nigeria
Libya
Russia
Venezuela
United Arab
Emirates
Kuwait
0
Iraq
0
Iran
5
Saudi Arabia
50
2006 Oil Production
See the region reports at http://pubs.usgs.gov/dds/dds-060/.

See http://energy.cr.usgs.gov/WEcont/world/woutsum.pdf.
See International Energy Agency, World Energy Outlook 2007, p. 81 and Table 1.3.
Data from BP, Statistical Review of World Energy 2008,
http://www.bp.com/productlanding.do?categoryId=6929&contentId=7044622, pp. 6 and 8.
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Figure 3 (above) shows the end 2006 proved reserves and 2006 production of
the countries with the 12 largest oil reserves according to the BP Statistical Review
of World Energy. Saudi Arabia alone has larger reserves than the rest of the world
outside these 12 countries.87 Looking at this list of countries it may be noted that
all of them except the USA, China, and Russia have economies that are dominated
by oil production. Most of them are developing countries, or would be considered
developing countries were it not for their oil. For these reasons, they have a definite
national interest in seeing high oil prices. This would not be as true of an oil
producing country with a more diverse economy (for example, Australia or Canada),
where high oil prices cut both ways.
The concentration of oil in a few countries, combined with a strong national interest
in higher oil prices, has made it possible for these countries to significantly influence
the price of oil (market power). The most well-known change in the oil market since
the 1960s has, of course, been the rise of the Organization of Petroleum Exporting
Countries (OPEC), and their efforts to promote higher oil prices. OPECs membership
includes 9 of the 12 countries shown in Figure 3Iran, Iraq, Kuwait, Qatar, Saudi
Arabia, the United Arab Emirates, Libya, Nigeria, and Venezuela. Algeria and Indonesia
are also members.88 Russia, the USA, and China, are not members, with the USA and
China being two of the worlds largest oil importing countries.89
A less well-known, but at least equally important change during this period, has
been the almost complete replacement of multi-national oil companies by national
oil companies, usually state-owned, in most of the major exporting countries. This has
put the pace of oil development and production directly in the hands of the exporting
country governments, further increasing the market power of these countries.90 In
2006, the worlds five largest oil companies by petroleum liquids production were all
national oil companies, led by Saudi Aramco with production of around 11 million
barrels/day. The largest multi-national oil company by petroleum liquids production
88 See the OPEC website www.opec.org.
89 According to the U.S. Energy Information Administration Country Profiles page,
http://tonto.eia.doe.gov/country/, in 2006, the U.S. was the largest oil importer in the world,
and China was the third largest (Japan was number two). This information is quoted at
http://www.infoplease.com/ipa/A0922041.html.
90 The classic book on oil industry history is Daniel Yergin, The Prize; The Epic Quest for Oil, Money, &
Power, 1993. The more recent past, especially the rise of OPEC since the 1960s, is documented in
Francisco Parra, Oil Politics: A Modern History of Petroleum, I.B. Tauris, 2004. Parra is a former General
Secretary of OPEC.
was BP, ranked number six, with production of about 2.6 million barrels/day.91 Today,
multi-national oil companies find that the lions share of the worlds most promising
oil resources are simply off-limits to them.92
With national oil companies in exclusive control of the oil resources in many oil
producing countries there is a risk that these companies may lack the financial and
managerial capabilities needed to increase or even maintain oil production. The
International Energy Agency (IEA) has repeatedly expressed concern that levels of
investment in oil producing countries will be insufficient.93 In particular, they note
that in countries with national oil companies:
Often political and social spending needs grow to the point where oil exploration
and development investment is compromised, in turn reducing oil and gas
exports.94
The upstream oil industry is going to require enormous levels of investment in

coming years. Modelling by the IEA estimates that around US$125 billion per year will
be required. Three quarters of this will be needed just to maintain current levels of
capacity in the face of natural declines as oil is depleted.95
2.4Unconventional Oil
Most reserve and resource statistics that one sees quoted in policy discussions are
for conventional oil, and include little or no unconventional oil. While the distinction
between conventional and unconventional oil is not a sharp one, today there are
three very significant classes of oil that are generally considered to be unconventional.
Although each one occurs in a number of countries, the best deposits of each one are
heavily concentrated in a single country. And although each one is more expensive,
and more energy-intensive, to produce than conventional oil, the quantities available
could potentially change the oil resource picture quite dramatically.96
91 See Robert Pirog, The Role of National Oil Companies in the International Oil Market, Congressional
Research Service, 21 August 2007, Tables 1 and 3, http://fas.org/sgp/crs/misc/RL34137.pdf.
92 See International Energy Agency, World Energy Outlook 2006, pp. 104-105 and Figure 3.12.
93 The risk of insufficient investment was a theme of International Energy Agency, World Energy Outlook
2005; Middle East and North Africa Insights; see especially pp. 160-163 and Chapter 7, and was also
discussed again in their World Energy Outlook 2006, pp. 104-107.
94 See International Energy Agency, Medium-Term Oil Market Report, July 2007, p. 32
95 See International Energy Agency, World Energy Outlook 2006, p. 102.
96 This section draws heavily on the paper Alternative Liquid Fuels: Availability, Economics and
Environmental Impacts by Michael Taylor available on the Ministry of Economic Development website
http://www.med.govt.nz/templates/MultipageDocumentTOC____26587.aspx.
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2.4.1 Tar Sands and Bitumen

Bitumen is viscous (or tar-like) oil that will not flow in economic quantities to a
conventional oil well. In order to extract it from the rock or sands in which it is found,
it must first be softened-up, either with heat or chemical solvents. If the ore is located
close to the surface, it can be mined and the bitumen separated externally. Extraction
from deeper deposits is possible using in situ techniques, which generally involve
injecting steam or solvents into the ground. Once the bitumen has been separated
from the rock or sand, it must generally be further processed to produce a synthetic
crude that can be shipped by pipeline.
At least two-thirds of the worlds bitumen in place is believed to occur in the
province of Alberta, Canada.97 Production is currently around 1.1 million barrels per
day (about 1% of the worlds oil supply) and growing rapidly.98 The resource base is
enormous by any measure, with a total resource estimated at 2.5 trillion barrels by the
International Energy Agency,99 and an ultimately recoverable component estimated
by the Alberta Energy and Utilities Board to be around 310 billion barrels.100 To put that
number in perspective, the proved reserves of Saudi Arabia are 264 billion barrels.101
2.4.2 Extra-Heavy Crude

Like bitumen, extra-heavy crude is viscous stuff, but not as viscous as bitumen. It
will flow to an oil well, but needs special pumping and heat or chemical stimulation to
get a good recovery. Like bitumen, the heavy oil must be further processed once it is
extracted in order to obtain a product that can be shipped by pipeline.
Nearly 90% of the worlds extra heavy crude is believed to occur in the Orinoco Oil
Belt of Eastern Venezuela.102 Production capacity is currently around 580,000 barrels
per day although production is somewhat less than this amount, reportedly due
97 See the World Energy Council Survey of Energy Resources 2007; Natural Bitumen Resource
Quantities and Geographical Distribution web page at http://www.worldenergy.org/publications/
survey_of_energy_resources_2007/natural_bitumen_and_extraheavy_oil/654.asp.
98 See the Province of Alberta web site Oil Sands page
http://www.energy.gov.ab.ca/OurBusiness/oilsands.asp.
99 See International Energy Agency, Resources to Reserves; Oil & Gas Technologies for the Energy Markets of
the Future; 2005, http://www.iea.org/Textbase/publications/free_new_Desc.asp?PUBS_ID=1568, p. 75.
100 See National Energy Board, Canadas Oil Sands; Opportunities and Challenges to 2015: An Update,
June 2006, http://www.neb-one.gc.ca/clf-nsi/rnrgynfmtn/nrgyrprt/lsnd/pprtntsndchllngs20152006/
pprtntsndchllngs20152006-eng.pdf, p. 2.
102 See the World Energy Council Survey of Energy Resources 2007; Natural Bitumen Resource
Quantities and Geographical Distribution web page at http://www.worldenergy.org/publications/
survey_of_energy_resources_2007/natural_bitumen_and_extraheavy_oil/654.asp.
to cutbacks to meet OPEC quotas.103 As with Canadian bitumen, the resource base
is potentially enormous, with a total resource estimated at 1.5 trillion barrels by the
International Energy Agency,104 and a recoverable component currently thought by
the Venezuelan government to be around 250 billion barrels.105
2.4.3 Oil Shales

Oil shale does not actually have any oil in it at all. Rather the rock (which may
be, but does not have to be, shale), contains an organic solid material called kerogen.
The kerogen would have turned into oil if it had been buried deeper and subjected
to high temperatures and pressures. However, if the rock is heated to about 500C, it
will produce a low-grade oil known as shale oil. Shale oil may be produced by either
surface mining or various in situ techniques.
Oil shales occur around the world, but over half are believed to be concentrated
in the Western United States, especially the state of Colorado.106 Oil shales were the
subject of an extensive set of U.S. government-sponsored demonstration projects in
the 1970s, however, production was found to be not competitive with conventional
oil and the projects were shut down in the 1980s.107 Today there is no commercial
production in the U.S., although there are some small operations in other countries.108
In the U.S., the resource in place is estimated to be 2 trillion barrels.109
2.5 Alternatives to Oil

There are a number of potential alternatives to oil. These alternatives are largely
beyond the scope of this book. It is, however, worth taking a brief look at those that
could be close substitutes for oil as a transport fuel.110
103 See U.S. Energy Information Administration, Country Analysis Briefs; Venezuela, October 2007,
http://www.eia.doe.gov/emeu/cabs/Venezuela/pdf.pdf, p. 6.
106 See the World Energy Council Survey of Energy Resources; Oil Shale Resources web page at
http://www.worldenergy.org/publications/survey_of_energy_resources_2007/oil_shale/649.asp.
108 See the World Energy Council Survey of Energy Resources 2007; Table 3.1 at
http://www.worldenergy.org/documents/shale_table_3_1.pdf.
109 U.S. Department of Energy, Strategic Significance of Americas Oil Shale Resource, Volume 1, March 2004,
http://www.fe.doe.gov/programs/reserves/npr/publications/npr_strategic_significancev1.pdf, p.2.
110 These fuels are discussed in the paper Michael Taylor, Alternative Liquid
Fuels: Availability, Economics and Environmental Impacts, March 2007,
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36
Alternative transport fuels can be loosely divided into three categories. The first
are the more exotic fossil fuels, including liquefied petroleum gas (LPG), compressed
natural gas (CNG), and liquids made from coal or gas. The second are biofuels. The
third are the alternative energy carriers: electricity and hydrogen.
2.5.1 Fossil Fuel Alternatives

As noted in Section 1.2, LPG and CNG are used today in some modified conventional
vehicles. In New Zealand, these fuels are exclusively (in the case of CNG) or primarily
(in the case of LPG) sourced from locally-produced natural gas.111 Since they are
lighter fuels than petrol or diesel, they can also offer some greenhouse gas emission
reductions compared to conventional oil products.
Diesel or petrol that is compatible with unmodified conventional vehicles can be
manufactured from coal or gas using the Fischer-Tropsch process. This process was
originally commercialised in Germany starting in the 1930s and further developed in
South Africa starting in the 1950s. Both Germany and South Africa are oil-poor but
coal-rich countries, and both faced curtailment of oil imports due to war (in the case
of Germany) and international boycott (in the case of South Africa).112
New Zealand has large reserves of lignite (soft) coal in Southland, which could
potentially be used to produce liquid fuels at a cost that could be competitive with
oil products. The greenhouse gas emissions in producing liquids from coal would be
considerably higher than for producing and refining oil products. However, carbon
capture and storage technology could potentially help to mitigate this.113 Since the
liquids from coal are chemically similar to oil-based fuels, vehicle emissions are similar.
2.5.2 Biofuels
Biofuels are fuels derived from present-day plant or animal matter (biomass). The
most common biofuels generally fall into two categories: bioethanol and biodiesel.114
111 See Ministry of Economic Development, New Zealand Energy Data File, June 2007, Table D.15,
http://www.med.govt.nz/energy/edf/2007/.
112 For more on the history of the Fischer-Tropsch process, see the brochure Sasol 50 Years of Innovation
on the Sasol website http://www.sasol.com/sasol_internet/downloads/Sasol%2050%20year%20Broc
hure_1039069422306.pdf.
113 For an examination of the potential costs and greenhouse gas emissions of producing
liquid fuels from lignite in New Zealand with carbon capture and storage, see Martin
Garrood and Tony Clemens, Liquid Fuels from Lignite, CRL Energy, November 2007,
114 For more information on biofuels in New Zealand, see Energy Efficiency and Conservation Authority,
Fact Sheet 8 Biofuels at http://www.eeca.govt.nz/eeca-library/renewable-energy/biofuels/fact-sheet/
biofuel-fact-sheet-05.pdf. For further background on biofuels production economics worldwide
see Michael Taylor, Alternative Liquid Fuels: Global Availability, Economics and Environmental Impacts,
March 2007, Chapter 4, http://www.med.govt.nz/templates/MultipageDocumentTOC____26587.aspx.
Unless otherwise noted, the material in this section is drawn from these sources.
Bioethanol is a type of alcohol that may be blended into petrol in small quantities
(generally 310%, depending upon the vehicle) and used in unmodified petrol
vehicles,115 or used in proportions up to 100% in modified petrol vehicles. Bioethanol
is made today in New Zealand from whey, a by-product of milk processing. Overseas,
ethanol is produced from a range of feedstocks containing sugar and starch, including
corn, wheat and sugar cane.
Biodiesel, the popular term for fatty acid methyl esters (FAME), can be blended with
conventional diesel oil and used in most unmodified diesel vehicles in concentrations
up to 5%. Modern diesel engines are basically compatible with higher concentrations of
biodiesel as well;116 however, many engine manufacturers currently do not recommend
their use. Biodiesel is produced from vegetable oils and animal fats. in New Zealand
biodiesel could be made from tallow, an animal fat by-product of the meat industry.
Overseas, biodiesel is usually made from vegetable oil, such as rapeseed and soy oils.
Both bioethanol and biodiesel are already being offered commercially in many
countries. Biofuels can potentially reduce greenhouse gas emissions and dependence
on oil. Carbon dioxide released from the burning biofuels was originally extracted
from the atmosphere by growing plants, so net carbon emissions from biofuels are
potentially very low. For this reason, the New Zealand government has proposed a
biofuels obligation that will require companies that sell petrol or diesel to include
a percentage of biofuels in their products. The percentage will increase over time,
reaching 3.4% by 2012.117
However, the benefits of biofuels have been the subject of controversy. Biofuels
require energy to grow and process the feedstocks. Much of this energy currently
comes from fossil fuels, which offsets at least some of the environmental benefits.118
Furthermore, biofuel production may compete with the food production for crops and
cropland, thus driving up the price of food and working a hardship on the worlds poor.
It may also lead to deforestation and other environmental damage, especially in tropical
115 For a discussion of vehicle compatibility issues, see Transport Engineering Research New Zealand
Limited, Enabling Biofuels; Risks to Vehicles and Other Engines, Ministry of Transport, April, 2006,
http://www.mot.govt.nz/assets/NewPDFs/Vehicle-and-Engine-Risks-report-v3.1.pdf.
116 For a discussion of vehicle compatibility issues, see Transport Engineering Research New Zealand
Limited, Enabling Biofuels; Risks to Vehicles and Other Engines, Ministry of Transport, April, 2006,
http://www.mot.govt.nz/assets/NewPDFs/Vehicle-and-Engine-Risks-report-v3.1.pdf.
117 For more information on the biofuels obligation, see Biofuels Sales Obligation
Final Policy Questions and Answers on the Ministry of Transport website
http://www.transport.govt.nz/biofuels-sales-obligation-final-policy-questions-and-answers-1/.
118 See International Energy Agency, Biofuels for Transport; an International Perspective, 2004, Chapter 3,
http://www.iea.org/Textbase/publications/free_new_Desc.asp?PUBS_ID=1262.
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countries.119 Finally, the amount of land that would be required to grow biofuels crops
severely limits the potential for todays biofuels to offset oil on a world scale.120
Some of the todays problems with biofuels may be solved with improved
technology. Cellulosic biofuel technology could allow ethanol to be produced from
the stalks and stems of almost any plant, significantly reducing the amount of land
required and allowing the use of land that is unsuitable for food production.121
Biofuels (biodiesel or bioethanol) could also be produced from algae. The algae could
be grown in special ponds that would produce much more fuel per hectare than
conventional biofuels.122 A variety of alternative chemical and processing approaches
are also possible, including using the Fischer-Tropsch process on biomass.123 The
latter would allow the production of a range of fuels that would be chemically almost
identical to oil products.
2.5.3 Electricity and Hydrogen

Electric vehicles running on renewable electricity are another potentially low
emission alternative to oil. The development of electric vehicles has historically
been held back by the limited range of their batteries, but a modified version of the
conventional hybrid vehicle, the plug-in hybrid vehicle, overcomes this limitation.
Plug-in hybrids are similar to todays hybrid vehicles, which are powered by
batteries and electric motors as well as internal combustion engines. However, in
todays hybrid vehicles the electric motor merely provides extra power for acceleration
and hill climbing, allowing use of a smaller, more efficient internal combustion engine
that also charges the batteries for the electric motor. In a plug-in hybrid vehicle, the
batteries are larger, allowing the vehicle to be exclusively powered by electricity over
a limited range. Vehicle users can charge the batteries using ordinary house current,
reducing their need for liquid fuel.124
119 See Richard Doornbosch and Ronald Steenblik, Biofuels: Is the Cure Worse than the
Disease?, Organisation for Economic Cooperation and Development, September, 2007,
http://www.oecd.org/dataoecd/9/3/39411732.pdf.
120 See International Energy Agency, Biofuels for Transport; an International Perspective, 2004, Chapter 6,
121 See the article Will Cellulosic Ethanol Take Off?, Technology Review, 26 February 2007,
http://www.technologyreview.com/Energy/18227/.
122 See the article Algae Based Fuels Set to Bloom, Technology Review, 5 February 2007,
http://www.technologyreview.com/Energy/18227/.
123 See International Energy Agency, Biofuels for Transport; an International Perspective, 2004, Table 3.7,
124 For a description of hybrid vehicle technology, see the International Energy Agencys Hybrid Electric
Vehicles website, http://www.ieahev.org/hybrid.html.
Plug-in hybrids can be powered by their internal combustion engine when their
batteries run low, avoiding the problems with limited range that have historically
hindered the acceptance of electric vehicles. But since most vehicles are not regularly
driven far, the potential saving in liquid fuel is quite large even if the electric range of
the vehicle is limited. A study by the Electric Power Research Institute in the United
States found that a plug-in hybrid with a battery range of only 32km could reduce
liquid fuel consumption by 60%.125
The technology needed for plug-in hybrids is available today. Hobbyists are
already converting production hybrid vehicles into plug-in hybrids by installing larger
batteries.126 So far, car manufacturers have been reluctant to market plug-in hybrids
because the larger batteries would add several thousand dollars to the cost of the
vehicle. However, General Motors has announced that it may begin production of a
plug-in hybrid as early as 2010.127
A common misconception is that because the transport use of energy is large
relative to electricity use, a large fleet of electric vehicles would be burdensome to
NewZealands electricity system. However, because of their high efficiency and
potential to charge during off-peak hours, the impact of electric vehicles on the elec
tricity system could be surprisingly modest.128
Hydrogen vehicles would be another low emission alternative to oil. They could
be powered by either modified internal combustion engines or fuel cells (which produce
electricity from hydrogen through a chemical process). Since hydrogen oxidises to
produce only water vapour, hydrogen vehicles would potentially emit no harmful green
house gases. Furthermore, hydrogen fuel cell vehicles are 2 to 3 times more efficient
than fossil-fuelled vehicles in terms of energy use per kilometre travelled. (Hydrogen
powered internal combustion vehicles are of similar efficiency to petrol powered
125 See Lucy Sanna, Driving the Solution; The Plug-In Hybrid Vehicle, EPRI Journal, Fall 2005, pp. 8-17,
http://mydocs.epri.com/docs/CorporateDocuments/EPRI_Journal/2005-Fall/1012885_PHEV.pdf.
126 See Take This Car and Plug It, IEEE Spectrum, July 2005,
http://ieeexplore.ieee.org/iel5/6/31432/01460339.pdf?tp=&arnumber=1460339&isnumber=31432,
pp. 10-13. There are do-it-yourself plug-in hybrid conversion kits offered commercially. For more
information, see the California Cars Initiative website http://www.calcars.org/howtoget.html.
127 See press release Saturn Vue Green Line Plug-in Hybrid SUV May Begin
Production in 2010, 14 January 2008, on the General Motors website
http://www.gm.com/explore/fuel_economy/news/2008/hybrids/plug_in_vue_011008.jsp.
128 See Erwan Hemery and Bruce Smith PowerPoint presentation
Electrons for Petrol; Impact of Plug-In Hybrids on the NZ Electric Grid at
http://www.electricitycommission.govt.nz/pdfs/opdev/modelling/vehicles/PHEV.pdf.
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vehicles.)129 Honda has announced plans for retail marketing of a fuel-cell hydrogen
vehicle in Southern California in 2008 on a limited basis.130
Like electricity, hydrogen must be produced from other sources of energy. There
fore, the overall environmental benefits of hydrogen vehicles depend upon how the
hydrogen is produced. There are at least three potential ways to produce hydrogen
in New Zealand: from coal, from gas, or from electricity. For the coal and gas options,
carbon capture and storage technology could be used to minimise emissions. Actual
production of hydrogen could take place either at centralised plants or at the filling
station.131
2.6 Summing Up The Uncertain Future of Oil

This chapter has given the reader a taste for some of the issues that make the
long-term sustainability of oil production such a controversial issue. The key issues in
assessing the situation probably boil down to the following four questions:
ow much oil is out there? Oil does not become reserves until the wells are
H
actually drilled. There are huge ranges of uncertainty in ultimate recoverable
resources (URR) estimates.
Are published statistics accurate? Proved reserve statistics are inconsistently cal
culated, and in some cases of dubious accuracy. There is usually no way to inde
pendently verify these figures.
How feasible is unconventional oil? There are enormous resources of uncon
ventional oil, including tar sands from Canada, extra-heavy oil from Venezuela,
and shale oil from the United States, some of which is already being commercially
produced. But how much of these resources can be economically developed?
How soon will alternatives to oil become economic? Major technological advances
could make the whole question of oils exhaustibility a moot point.
129 See Ruben Smit and Andrew Campbell, Cost and Impacts of a
Transition to Hydrogen Fuel in New Zealand, CRL Energy, June 2007, p. 3,
130 See press release Honda Debuts All-New FCX Clarity Advanced Fuel Cell Vehicle, 14 November 2007,
on the Honda website http://world.honda.com/news/2007/4071114All-New-FCX/.
131 For an analysis of each of these options, see Ruben Smit and Andrew Campbell, Cost
and Impacts of a Transition to Hydrogen Fuel in New Zealand, CRL Energy, June 2007,
41
Exhaustible Resource Economics

3
Many people assume that markets tend to under-value exhaustible resources by
failing to give due recognition their exhaustible nature.132 The assumption is a natural
one to make, since if markets for exhaustible resources worked the same way as the
markets presented in most introductory economics classes, they would have this
defect. But exhaustible resource markets are different, and the differences are not
generally taught in introductory economics classes. Therefore, it is worth stepping
back and taking a look at the basic economics of exhaustible resources here.133
The key message of this section is that markets for exhaustible resources can, in
fact, work. How well they work in practice depends, like all markets, upon the presence
of the proper prerequisites, including the existence of enforceable property rights,
sufficient numbers of participants to permit competition, and the unimpeded flow of
market information. But there is no fundamental reason why markets for exhaustible
resources should fail.
This in-principle lack of market failure for exhaustible resources is a significant
insight to bear in mind when analysing energy policies. It explains why economists
tend to be sceptical of arguments that government intervention in energy markets
is needed if these arguments are based simply on the fact that oil is an exhaustible
resource or a belief that its production is about to go into decline. There are other
market failures, however, which provide grounds for intervention that are quite
respectable with economists. These include the fact that greenhouse gas emissions
are not properly priced by the market, as well as several barriers that lead to
insufficient incentives to invest in energy efficiency.134 The general topic of when
government intervention in a market is or is not justified is the central question of
the branch of economics known as welfare economics, and is clearly beyond the
scope of this book.
132 For a rare example of an academic who appears to take this view, see Bob Lloyd, The Commons
Revisited: the Tragedy Continues, Energy Policy, 2005, pp. 5806-5818, http://www.physics.otago.
ac.nz/eman/documents/commons%20revisited%20tragedy%20continues.pdf.
133 The basic theory presented here was first published in Harold Hotelling, The Economics of
Exhaustible Resources. Journal of Political Economy, April 1931, 39(2), pp. 137-175. For this reason it is
often referred to as Hotellings Theory of Exhaustible Resources.
134 For a brief discussion of these market failures see Ministry of Economic Development,
Benefit-Cost Analysis of the New Zealand Energy Strategy, November 2007, p. 2-2,
42
Chapter 3 Exhaustible Resource Economics
The model laid out in this chapter describes how people should behave to make
best use of their available resources. It does not purport to describe how people
actually go about making resource development decisions, which is usually quite
different. The fact that there are significant differences between the two does not
invalidate the model. The same discrepancies exist throughout economics. For
example, introductory economics classes teach that producers should seek to set
marginal revenue equal to marginal cost. However, if one suggests this approach to a
real-world marketing manager one is likely to get funny looks (the author experienced
this first-hand in his younger days as a consultant).
3.1 Decision Making for a Renewable Commodity

Due to the exhaustible nature of oil, the forces that set its price are quite different
from an ordinary renewable commodity like, say, wheat. With a renewable commodity,
the more of it that must be produced, the more it will cost per unit. To grow additional
wheat, for example, one must draw in land that is increasingly less suitable for growing
wheat, or give the existing wheat-growing land increasingly intensive, and expensive,
care and handling.
Figure 4 Supply and Demand for a Renewable Commodity
Price
Supply
Demand
Quantity
There is also a demand response to price. The more wheat that has to be sold, the
less people are willing to pay per unit. As the price drops, more people are willing
to buy, or existing buyers are willing to buy more. If we plot the supply and demand
for wheat (see Figure 4), the point where the two curves intersect is where supply
equals demand. This will be where the market sets the price and quantity of wheat
produced.
If you are a wheat farmer and you expect the price for wheat to be P, you will
increase your production of wheat until the last unit of wheat you produce has a
cost equal to P. You wont produce any more, since you would lose money on each
additional unit of wheat beyond this point. This is what is taught in Economics 101.
There is one point about markets for renewable commodities that deserves special
mention here though, since it also transfers over to exhaustible commodities. In a
properly functioning market there are never any shortages. That is, anyone who can
afford to pay the going price can always buy. This implies that, at least as long as the
market is allowed to function freely, there can never be a shortage of oil, no matter
how quickly the supply depletes.
The belief that oil markets do not function is often reinforced with recollections of
car-less days in New Zealand or images of cars queuing up for petrol in the United States
during the oil crises of the 1970s. Those situations clearly represented a true shortage.
However, these shortages were the result of government price controls on petrol in both
countries,135 which did not allow prices to rise to the point where supply could equal
demand. Once these price controls were removed in the early 1980s, the shortages
disappeared, and have not reappeared despite several significant supply shocks.
3.2 Decision-Making for an Exhaustible Resource

The situation gets a little more complicated if you are an oil producer rather than a
wheat farmer. To keep it simple, let us assume you have inherited an oil well capable
of producing a cumulative total of 1,000 barrels of oil at no cost. How much oil should
you sell? At first glance the answer is not obvious the way it was for the wheat farmer.
You have no cost to compare to the current price and you will make the same profit
per barrel no matter how much you sell. The trick here is to recognise that for an
exhaustible resource, you have to ask a subtly different question. Unlike the wheat
135 These price regulations in New Zealand are discussed in Michael Pickford and
Cameron Wheeler, ThePetrol Industry: Deregulation, Energy and Competition, NZ Trade
Consortium Working paper No. 12, New Zealand Institute of Economic Research, 2001,
http://www.nzier.org.nz/Site/Publications/NZTC/NZ_trade.aspx, p. 9-11.
43
44
farmer, there is a time dimension to your decision. The question you should ask is how
much should you sell now? This being an exhaustible resource, you can sell now, or
you can sell later, but you cant do both.
A rational businessperson will do a calculation. First, you estimate the amount of
money you would have at various points in the future if you sold the oil now and
invested the proceeds as best you could. Then you estimate what you think will
happen to the price of oil in future years and calculate what is going to happen
to the value of your 1,000 barrels at these same points in time if you leave it in the
ground. If the amount of money you expect to make by waiting for the oil price to
rise is greater than the amount you could make on the alternative investment, you
should leave the oil in the ground. If you could make more on the investment than
by leaving the oil in the ground, then you should sell the oil now. This is the basic
oil in the ground vs. money in the bank calculation that drives all rational business
decisions on exhaustible resources, although clearly, in the real world, there are a lot
more complications.
3.3 The Impact of Extraction Costs

Let us examine one such complication now. Suppose you own the mineral rights to
some land. You believe you could drill on it and produce 1,000 barrels of oil at a cost
of $50 per barrel. For simplicity, let us assume you could sell all the oil the minute the
drilling is completed and there is no uncertainty as to whether you will find oil. The
question then becomes, should you drill now?
Again, you estimate the amount of money you could make each year over the next
few years if you drilled now, sold the oil, and invested the money in something else.
This time, the amount you would have left to invest for each barrel you sold would
be the price of the oil per barrel minus the $50 it cost to produce it. Let us call this
value, the price minus the production cost, the rent on the oil. Rent may seem like a
funny term to use, since it has nothing to do with the rent one might pay on a flat. The
rent here is something more akin to what most people think of as profit. However,
profit is not the right word either, since it is the net proceeds you are going to get
from selling your interest in a valuable non-renewable assetoil. Thats why we need
a different word, and economists have chosen to call it rent.
To determine if you should drill now you need to calculate how much you could
make from drilling now and investing the rent. Then you calculate how much you
could make from waiting and drilling later when you may expect the oil price to be
higher. As a rational businessperson you should do whichever alternative makes you

more money. If you expect the price of oil to go down, or at least not to go up, you
should definitely drill now. If you expect the price of oil to rise rapidly, then holding
your oil in the ground becomes the best investment you could make and you should
definitely drill later.
To make this calculation a little clearer, here is a numerical example. Suppose the
price of oil is currently $100.00 per barrel and you expect it to increase by $5.00 a
barrel each year for the foreseeable future. Suppose that the cost of drilling is $50
per barrel and that the best alternative investment you could make would pay an 8%
return each year. Under these assumptions, you should drill in Year 4. In Year 4, the
rent will be worth $65 per barrel ($100 initial price + $5 x 3 years $50 drilling cost),
which means that if you drilled in Year 4, by Year 5 your investment will grow to $70.20
per barrel ($65 + 65 x 8%). This is just slightly better than the $70 it would be worth if
you left it in the ground for another year and drilled in Year 5. (See Appendix Section
A.1 for a more conclusive demonstration.)
Notice that the market did not have you simply ripping the resources out of the
ground as quickly as possible with no regard for the future. Instead, you made a
rational decision, trading off the future return you could earn by leaving the oil in the
ground against the future return you could earn by investing the proceeds. The future
has been properly taken into account.
3.4 The Impact of Higher Extraction Costs

This numerical example can be used to illustrate three more interesting features
of exhaustible resources. First, if the cost of drilling is higher, you should wait longer
to drill, and vice versa. To see this, assume the cost of drilling is $55/barrel rather than
$50. Now you will want to drill in Year 5, as it takes an extra year to get to the point
where the rent is $65 per barrel ($100 initial price + $5 x 4 years $55 drilling cost)
and the calculations work out as they did in the previous example. (See Appendix
Section A.2 for a more conclusive demonstration.)
Waiting longer when extraction costs are higher is a universal property of
exhaustible resources. It is a sensible market property in that it says that it will be
most profitable to extract the cheaper resources first, while the more expensive
resources will be deferred to later. This is a result that makes good intuitive sense, in
that it accords with our notion of efficiency, and also accords with what we observe in
the real world.
45
46
3.5 The Impact of Rising Oil Prices

Second, if you expect the price of oil to rise more rapidly, you should drill later,
and vice versa. Assume that you expect the oil price to increase in the future at a rate
of $10 per year, rather than the $5 per year originally assumed, and that the cost of
drilling is $50/barrel as originally assumed. Now, you should wait and drill in Year 9
rather than in Year 4. In Year 9, the rent will be worth $130 per barrel ($100 initial price
+ $10 x 8 years $50 drilling cost), which means that if you drilled in Year 9, your
investment would grow to $140.40 per barrel ($130 + 130 x 8%) in Year 10, just slightly
better than the $140 you could get if you waited a year and drilled in Year 10. (See
Appendix Section A.3 for a more conclusive demonstration.)
Again, waiting longer when prices are rising more rapidly is a universal property of
exhaustible resources. A more rapid expected increase in the resource price increases
the percentage growth in the rent each year, making holding oil in the ground more
attractive relative to other investments, and leading resource owners to defer drilling.
This, too, is a sensible property, since it tells us that the market naturally provides
a greater economic incentive to conserve resources for the future if the resources are
expected to become more valuable in the future. If resources are being exploited in an
unsustainable manner, such that prices are bound to rise quickly in the future, rational
resource owners will see that they can make money by deferring their production
until prices rise. While this withholding of production has sometimes been given a
bad reputation in the popular press, in a properly functioning market, it serves a very
valuable conservation function. The lower supply today will drive up prices today,
reducing demand, and thereby insuring that resources will continue to be available
for the future.
There is another useful property of exhaustible resource markets that falls out of
this analysisas resource owners defer production, prices today will rise to reflect the
anticipated higher prices in the future. After all, no rational businessperson is going
to sell something cheaply today that he/she knows is going to be worth a lot more in
the future. Todays price therefore reflects tomorrows anticipated price. There should
be no sudden changes in price except for causes that market participants never
anticipated.
3.6 The Impact of Lower Interest Rates

Finally, consider what happens if the interest rate on the alternative investment
were lower. This makes holding your oil in the ground more attractive relative to
investing it in something else, again causing you to defer drilling. Assume that you
expect the interest on your alternative investment to be 6% instead of 8% and that
oil prices are rising by $5 per year as originally assumed. Now, you should wait to Year
8 to drill. In Year 8, the rent will be worth $85 per barrel ($100 initial price + $5 x 7
years $50 drilling cost), which means that if you drilled in Year 8, your investment
will grow to $90.10 per barrel ($85 + 85 x 6%) by Year 9, just slightly better than the
$90 it would be worth if you waited and drilled in Year 9. (See Appendix Section A.4
for a more conclusive demonstration.)
Waiting longer when interest rates are lower is perhaps the most surprising and
non-intuitive result of exhaustible resource economics. It is also a bit harder than
our first two relationships to immediately label as a sensible effect. However, from a
broader social perspective, it does make sense. High interest rates mean that financial
capital is in short supply and if you have some capital the market can use it very
productively. So you should convert more oil into financial assets today. Low interest
rates mean just the oppositefinancial capital is in abundant supply and more of it
cannot be used very productively. So you should hold more of your oil for the future.
Here interest rates refers to real interest ratesthat is, interest after subtracting off
inflation.
Although there were clearly other precipitating factors, an economist might argue
that it may be no coincidence that the price spikes for oil in the 1970s came at a time of
double-digit inflation worldwide and low or negative real returns in financial markets.
Many producers, including some Middle East governments, may have decided quite
rationally that oil in the ground was a better patrimony than dollars in the bank.136
And today, oil prices are again rising rapidly in the face of low or even negative real
interest rates in Japan, the U.S., and Europe. Is there a cause and effect relationship
here?
3.7 The Impact of Technological Improvement

Another complication worth mentioning is technological improvement. The story
as presented so far would lead one to believe that prices of exhaustible resources
must rise over time, otherwise no one would have any reason to hold them for the
future. However, technological improvements change the picture, making stable or
declining prices consistent with orderly exploitation of an exhaustible resource. To
136 Thanks go to Dale Nesbitt for this insight. See his paper, Realities of North American and
World Natural Gas Markets or Nesbitts Maxims About Gas Markets, 2002, available at
http://www.altosmgmt.com/pub.asp.
47
see this in the example, just note that a drilling cost that declines by $5 per year in the
face of a stable oil price has exactly the same impact on resource rent as a price that
increases at a rate of $5 per year in the face of a stable drilling cost. So, in addition to
the original assumptions, the example discussed in Section 3.3 (and Appendix Section
A.1) also shows what happens if the oil price is stable at $100 and drilling costs start at
$50 and decline by $5 per year thereafter. Again, the rational businessperson should
wait to drill in Year 4, even though prices are not rising.
This, too, is a sensible result. Improvements in technology mean that exhaustible
resources are not quite as exhaustible as one might initially think, nor must they
necessarily rise in price over time. Actually, the history of the oil industry is one of a
continuing tug-of-war between resource exhaustion and improving technology. The
cheap, close-to-market oil discovered in the early years of the industry has depleted.
However, improvements in technology have continually enabled the industry to
exploit resources in more remote or difficult to access locations, to exploit lower
quality resources, and to improve the recovery rates of all resources. As a result,
there have historically been long periods when oil prices have declined, at least after
adjusting for inflation.
Figure 5: Historical Oil Prices 18612007137
120
100
2006 US$ Per Barrel
80
60
40
20
2001
1991
1981
1971
1961
1951
1941
1921
1931
1911
1901
1891
1881
1871
0
1861
48
Year
137 Data taken from historical data downloadable from the Statistical Review of World Energy page on the
BP website at http://www.bp.com/liveassets/bp_internet/globalbp/globalbp_uk_english/reports_
and_publications/statistical_energy_review_2007/STAGING/local_assets/downloads/spreadsheets/
statistical_review_full_report_workbook_2007.xls, except for 2007, which was the 31December
2007 closing price for the near-month NYMEX light sweet crude oil contract, as per the U.S. Energy
Information Administration website http://tonto.eia.doe.gov/dnav/pet/hist/rclc1d.htm.
Figure 5 shows historical oil prices since 1861, adjusted to 2006 US dollars. As can
be seen, prices of oil were fairly stable in the US$10-25 range for around ninety years
up to 1970. Technology was clearly winning over depletion in this interval. Since the
1970s, prices have been higher and much more volatile. Some of this is the result of
the shift in control over oil resources to the oil exporting countries discussed in Section
2.3, but one might also argue that depletion has been winning over technology.
3.8 The Real World

One can properly argue that the theory outlined in this section is significantly
different from the ways things work in the real world. Very few countries have privatelyowned mineral rights for oil (as we will see in the Chapter 5, not even New Zealand).
Rather in most countries, the timing and pace of resource development is politically
determined. The dominance of a few national governments and their national oil
companies over crude oil production discussed in Section 2.3 mean that the oil
market is arguably less than fully competitive. And, as we have seen in Section 2.1 and
2.2, there are serious limits on the resource information available. Nevertheless, the
theory presented in this section suggests that, if oil markets do not properly value the
future, the problem lies in real-world departures from market principles, rather than
anything inherent in the operation of markets themselves.
It is not obvious what impact these departures from market principles have on the
pace of resource exploitation. One might argue that short-term political pressures,
and an immediate need for cash in many oil producing countries, would lead to a
faster pace of oil development than would be economic.
However, it is difficult to make a compelling case for overexploitation. The rise of
petroleum nationalism, the ability of oil producing countries to exercise market power
either individually or through OPEC, and the funding and managerial limitations
faced by many national oil companies (see Section 2.3), all tend to slow the pace of oil
exploitation relative to what would be economic.138
138 See the discussion of national oil companies in the Middle East and North Africa in International
Energy Agency, World Energy Outlook 2005; Middle East and North Africa Insights, p. 161.
49
50
Oil and Financial Markets

4
Prices of crude oil and oil products are quite volatile, yet the firms that produce
and consume them have huge medium- and long-term commitments that must
be planned around a certain level of prices. For example, a company thinking of
developing an oil field (and their financial backers and lenders) may not be willing to
accept the risk that crude oil prices could plunge. On the other hand, an airline or a
trucking company may not want to accept the risk that oil prices might soar. A refiner
or other intermediate processor is doubly exposed to volatility in both their input and
output prices.
Clearly, there are deals that can be done here to reduce the risks for both parties.
And indeed, there is a whole sector of the finance industry designed to serve the
market for energy risk management. The information that comes out of this sector can
provide insight into what is happening in the oil industry, and what the market thinks
may happen in the future.
4.1 Oil Trading

Spot markets are the simplest, but most risky, market for crude oil or oil products.
Spot markets are very much akin to the way most consumers buy oil products
participants buy for immediate delivery at the current price. There are dozens of
active spot markets around the world for various grades of crude oil and various oil
products. The prices in these markets tend to be closely linked, since traders quickly
find any opportunities to profit from price differentials that do not accurately reflect
transport costs or other differences in value.139
The spot markets for certain crude oils, known as marker crudes, tend to act as
barometers for the overall market level. Prices for other crudes are typically negotiated
with reference to the quoted prices of these marker crudes.140 Three marker crudes
are especially prominent. The first is West Texas Intermediate (WTI), which (despite the
name) is a light sweet crude oil, delivered at Cushing, Oklahoma, USA. The second
139 Spot markets are discussed in Energy Information Administration, Derivatives and Risk
Management in the Petroleum, Natural Gas, and Electricity Industries, October 2002, Chapter 3,
http://www.eia.doe.gov/oiaf/servicerpt/derivative/chapter3.html.
140 For a discussion of the use of marker crudes see the Crude Benchmark Analysis pages of the
Platts website, http://www.platts.com/Oil/Resources/News%20Features/crudeanalysis/index.xml.
See also the International Crude Oil Pricing page of the Australian Institute of Petroleum website,
http://www.aip.com.au/pricing/crude.htm.
most prominent is Brent Crude, also a light sweet crude (but not as light at WTI), from
the UK North Sea, deliverable at the Shetland Islands.141 The third is Dubai crude,
also known as Fateh, a medium heavy sour crude from the Middle East.142 However,
production of Dubai crude has been in a steep decline in recent years, so Oman crude,
also a heavy sour crude,143 has become increasingly prominent in price calculations.144
A less-prominent marker crude worth mentioning because of its importance in Asia,
Australia, and New Zealand is Tapis, a light sweet crude from Malaysia.145
Key oil product spot markets serve much the same role for oil products that marker
crudes serve for crude oil. They provide a reference that tends to influence product
prices over a wide region. Key oil product spot markets centre on the New York
Harbour, Northwest Europe (primarily Rotterdam), and Singapore.146 Spot market
crude and product prices are sometimes quoted in the financial news media, but
more comprehensive compilations are available in specialised publications such as
Platts147 or Argus,148 as well as the website of the International Energy Agency149 and
the U.S. Energy Information Administration.150
At the other extreme from spot markets, futures markets provide a highly structured
method to manage risk. These markets allow participants to contract for future
delivery of oil or oil products at a price agreed-upon today. If the spot price at the time
141 See the Pricing Differences Among Various Types of Crude Oil web page on the website of the U.S.
Energy Information Administration, http://tonto.eia.doe.gov/ask/crude_types1.html.
142 See Jorge Montepeque, Sour Crude Pricing: A Pressing Global Issue, Middle East Economic Survey,
v XLVIII, no. 14, 4 April 2005, http://www.mees.com/postedarticles/oped/v48n14-5OD01.htm. The
author is Global Director, Market Reporting, for Platts.
143 See the Introduction to the Oman Contract page on the Dubai Mercantile Exchange website
http://www.dubaimerc.com/omancontract.html
144 See Jorge Montepeque, Sour Crude Pricing: A Pressing Global Issue, Middle East Economic Survey, v
XLVIII, no. 14, 4 April 2005, http://www.mees.com/postedarticles/oped/v48n14-5OD01.htm.
145 See the discussion of Australian benchmark crudes in Reserve Bank of Australia,
Statement of Monetary Policy, Box B: Recent Developments in Oil Prices, August 2007
http://www.rba.gov.au/PublicationsAndResearch/StatementsOnMonetaryPolicy/
Boxes/2007/2007_08_b_box.pdf. See also presentation by Richard Hale on the Hale
& Twomey website, The Market for New Zealand Oil, Petroleum Conference 2006,
http://www.haletwomey.co.nz/publications/docs/060307-market-nz-oil.ppt#1, which mentions Tapis
as the key marker crude for the region.
146 See Energy Information Administration, Derivatives and Risk Management in
the Petroleum, Natural Gas, and Electricity Industries, October 2002, Chapter 3,
http://www.eia.doe.gov/oiaf/servicerpt/derivative/chapter3.html.
147 http://www.platts.com/.
148 http://www.argusmediagroup.com/.
149 See http://omrpublic.iea.org/pricescrude.asp?cruderegion=%25.
150 See http://tonto.eia.doe.gov/dnav/pet/pet_pri_spt_s1_d.htm.
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Chapter 4 Oil and Financial Markets
of delivery turns out to be lower than the contract price, then the seller comes out
ahead; if the spot price at the time of delivery turns out to be higher than the contract
price, then the buyer comes out ahead. The terms for each futures contract (including
commodity specifications, delivery date, and other conditions) are standardised, and
the commodity price for each contract is continually adjusted through trading on
exchanges, much like share trading. As with the share market, buyers and sellers deal
with each other anonymously. The exchange or its clearinghouse guarantees contract
performance. Futures markets are government regulated in order to assure honesty
and financial integrity.151
No money changes hands when a futures contract is initially established, although
both the buyer and the seller must post a substantial cash margin to ensure that
they can meet their financial obligations. The funds in these margin accounts often
earn interest.152 At the close of each day, if the price of the contract has increased,
the buyers account is credited with the corresponding gain while the sellers account
is credited with the corresponding loss. If the price of the contract has decreased,
the payments flow the other way. This daily process is known as marking to market.
Typically, buyers and sellers will close out (by selling or buying back, respectively) their
positions prior to the delivery date. Physical delivery of the contracted commodity is
rare in futures markets (one reference says less than 2% of the time).153 In some futures
markets, physical delivery is not even a possibility as a cash settlement is made at the
cessation of trading based on the spot market price.154
The most prominent crude oil futures contract is the New York Mercantile Exchange
(or NYMEX) Light Sweet Crude contract, for which WTI is one of the deliverable
crudes.155 Because NYMEX prices are easily accessible, the price for the NYMEX light
sweet crude contract closest to delivery is frequently quoted in the news media as
the price of oil. Another futures contract, this one for Brent Crude, is traded on the
151 For an overview of futures markets, see National Futures Association, Opportunity
and Risk; an Educational Guide to Trading Futures and Options on Futures, 2006,
http://www.nfa.futures.org/investor/OppRisk/OppRisk.pdf.
152 See Theodore E. Day and Craig M. Lewis, Margin Adequacy Standards: An Analysis of
the Crude Oil Futures Market, The Journal of Business, v. 77, no.1, 2004, footnote 12,
http://www.journals.uchicago.edu/doi/pdf/10.1086/379863.
153 For a description of the mechanics of oil futures markets see Steven Errera and Stewart L. Brown,
Fundamentals of Trading Energy Futures & Options, PennWell Books, Tulsa, Oklahoma, 1999, Chapter 2.
154 See, for example, the description of the ICE Middle East Sour Crude Futures Contract on the ICE
website https://www.theice.com/productguide/lookupProduct.do, which settles based on the
Singapore spot price for Dubai crude.
155 See the Pricing Differences Among Various Types of Crude Oil web page on the website of the U.S.
Energy Information Administration, http://tonto.eia.doe.gov/ask/crude_types1.html.
Intercontinental Exchange (or ICE) in London.156 A recent addition, as of 1 June 2007,

is the Oman Crude Contract, traded on the Dubai Mercantile Exchange (DME).157 All
three contracts can be traded 56 years ahead of delivery.158
Beyond futures contracts, there are many over the counter (OTC) risk management
products. These products are the result of private arrangements between buyers
and sellers, usually facilitated by brokers or other financial intermediaries. They are
largely unregulated, and buyers and sellers must generally manage the counterparty
credit risks themselves. OTC products include forward contracts, options, and swaps,
all of which are types of derivatives.159 Some crude oil and oil product options are also
traded on exchanges.160 The major advantage of the OTC products is that they are
available in a huge variety to meet virtually any need.
4.2 Market Efficiency and Financial Markets

Quotations from oil futures markets provide us with a ready potential source of
forecasts of future crude oil and oil product prices. But how good are they as price
forecasts for policy analysis? This answer to the question hinges heavily on ones views
about the efficiency of financial markets.
The efficiency of financial markets is one of the central questions of financial
economics. A financial market that is efficient is defined as one in which everything that
is known about the potential future price of a security is already reflected in its price
today. Therefore, in an efficient market, one cannot expect to benefit from analysis.
Market efficiency has been most widely studied and discussed in the context of the
share market. Here, the efficient market hypothesis would hold that everything that
is known about the future value of a companys shares is already reflected in the price
of the shares. This implies that, even though shares in some companies may have
more risk than others, after adjusting for the risks (that is, after recognising that riskier
shares should have correspondingly higher returns), the outlook for future returns on
156 See the ICE website https://www.theice.com/homepage.jhtml.
157 See press release Dubai Mercantile Exchange Announces First Official Selling Price (OSP) After
Historic Launch, 1 June 2007 on the DME website http://www.dubaimerc.com/archives_2007.html.
158 See the description of the NYMEX light sweet crude contract on the NYMEX website
http://www.nymex.com/CL_spec.aspx. See the description of the Brent crude futures contract on
the ICE website https://www.theice.com/homepage.jhtml. See the description of the Oman crude
contract on the DME website http://www.dubaimerc.com/contractSpecOq.html.
159 A description of these products may be found on the Platts website at
http://www.platts.com/Risk/factfile/index.html. See also Energy Information Administration,
Derivatives and Risk Management in the Petroleum, Natural Gas, and Electricity Industries, October 2002,
Chapter 2, http://www.eia.doe.gov/oiaf/servicerpt/derivative/chapter2.html.
160 See Steven Errera and Stewart L. Brown, Fundamentals of Trading Energy Futures & Options, PennWell
Books, Tulsa, Oklahoma, 1999, Table 1-2.
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the shares of every company should be the same. How can this be, one might ask?
Clearly, some companies have more favourable outlooks than others. However, the
efficient market hypothesis would hold that the market will push down the market
value (share price x number of shares) of the companies with poor prospects, and
inflate the market value of the companies with good prospects, to the point where
the risk-adjusted outlook for future returns on their shares are much the same.
Although the hypothesis seems a bit counter-intuitive at first, the logic as to
how things could work out this way is quite compelling. Suppose that someone has
developed a new method for share trading that allows him or her to systematically
beat the market. Before too long, word of the method would become generally
known and lots of people would be using it. But once lots of people start using the
method, share prices in companies favoured by the method would rise and share
prices in companies not favoured by the method would fall. Once this adjustment
happens, the risk-adjusted outlook for all shares becomes the same again, and the
method would cease to beat the market anymore. Conclusion: it is impossible to
sustainably beat the market.
If the efficient market hypothesis is really true, the implications for the finance
industry are profound. Investors can be comfortable picking shares at random,
or more sensibly, buying shares of low-fee index funds that simply buy and hold a
cross-section of the shares in the market, and thereby mimic the performance of the
broader market. They can stop wasting their time and money on advice from people
who claim to help them beat the market.
There is a great deal of empirical work that tends to support the efficient market
hypothesis for the share market. The most compelling is perhaps the extensive
evidence that actively-managed mutual funds, that is, those run by managers who
seek to beat the market, generally deliver performance no better or even worse than
a broad share index, despite their much higher fees.161 On the other hand, there have
been a number of studies that have shown apparent anomalies with the efficient
market hypothesisfor example that small company shares tend to do better, after
adjusting for risk, than large company shares, that value shares do better than growth
shares, or that shares do better in January than in other monthsalthough it is not
clear that one can actually make money exploiting these apparent anomalies.162
161 For an entertaining discussion of this literature, as well as the efficient market hypothesis generally, see
Burton G. Malkiel, A Random Walk Down Wall Street; The Time-Tested Strategy for Successful Investing, W.W.
Norton & Company, New York, 2007, especially pp. 164-170 and 267-270. The author is an economics
professor at Princeton University and former member of the U.S. Council of Economic Advisors.
162 See Burton G. Malkiel, A Random Walk Down Wall Street; The Time-Tested Strategy for Successful
Investing, W.W. Norton & Company, New York, 2007, Chapter 11.
The market efficiency question is, of course, not a black and white onethere are
varying definitions and possible degrees of market efficiency. It is the authors view
that markets are at least efficient enough in practice that one should be very sceptical
of anyone who claims to have a method to beat the market. As a more cynical
acquaintance puts it There are only three places left in the world where they dont
believe markets are efficient: North Korea, Cuba, and Wall Street.
4.3 Oil Futures Markets as Predictors of Spot Oil Prices

Oil futures markets are also financial markets, and one might also hypothesise that,
like the share market, oil futures markets are reasonably efficient as well. The underlying
logic is, again, fairly compelling. Specifically, assume someone has developed a method
to systematically predict oil prices better than the futures markets. Anyone who uses
the method can, of course, make lots of money trading oil futures. Due to its obvious
profitability, word of the method is likely to become known, and attract a wide
following. Once it does, however, the futures market prices for oil will adjust to match
those of the new method, and the method will lose its advantage. At that point, the
futures market is once again restored to efficiency in the sense that there is no method
that can systematically predict oil prices better than the futures market itself.
Market efficiency provides a compelling argument for using futures prices as a
basis for oil price forecasting in policy analysis. Basically, one can argue that futures
market prices should already reflect the best information and analysis that is out
there. This certainly does not mean that futures prices will always turn out to be
right in the sense that they are accurate predictors of the spot price. The future
is inherently uncertain. What it does mean is that one should be very sceptical of
anyone who claims to be able to predict future spot market prices better than the
futures markets.
There is one frequently-raised objection to the use of oil futures prices in policy
analysis that needs to be addressed. This stems from the observation that at any given
time, the entire strip of futures prices for oil tends to move in line with the current
spot prices, so futures prices never predict a spike in the spot price even when one
eventually occurs. This is true, and there is a good reason for it. If futures prices ever
showed a big spike relative to the current spot price, a guaranteed method for beating
the market would immediately become possible.
The method is to simply use the futures market to lock-in a sale at the high future
sale price, and at the same time buy oil in the spot market today to cover the sale.
Now store the oil and deliver it when the futures contract expires. As long as the spike
in price is at least large enough to cover what it will cost to store the oil and make a
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normal return on the capital invested in the oil, one could make a market-beating
return with no financial risk at all.
Clearly, the futures market cannot allow such a market-beating opportunity to
develop. If it ever did, lots of people would attempt to profit from it, and as they did
so, either the price for the future would be bid down or the spot price today would be
bid up. The futures price and the spot price would then move back into alignment.163
The fact that oil prices in the futures markets never show price spikes can leave
the misleading impression that the futures markets are simply ignoring upcoming
tightness in the physical market that analysts may be generally expecting. This is
not the case. Rather, the way futures markets reflect expected upcoming tightness
is through a rise in the entire strip of prices, including the current spot price. For
although we are accustomed to thinking of the futures market as a derivative of the
spot market, the actual causality often works the other way: expectations about the
future (as reflected in futures prices) drive the current spot price.
There is another way to look at this lack of price spikes in the futures market
quotations that is even more intuitive. Suppose you own a barrel of oil, and the market
(as reflected in the futures market prices) is expecting its price to rise rapidly. You
would not be very smart to sell it cheaply today. Instead, you will hold out for a higher
price, thus helping to drive up the spot price. And so it is that todays spot prices may
already reflect any upcoming tightness that is widely expected, even though it is not
obvious from looking at the strip of futures market quotations.
4.4 Oil Futures Markets and Normal Backwardation

There is, however, one more objection to oil futures markets as predictors of the
spot price which has more substance. The beginning of this chapter discussed how
companies that produce oil or oil products might want to use futures markets to
guarantee the price they will receive in the future, while companies that consume oil
or oil products (such as airlines and truck lines) might want to use futures markets to
guarantee the price they will have to pay in the future. Both are hedging their risks,
and are therefore known as hedgers. But what if there is an uneven match between
buyers and sellers who need to hedge their risks? One reason this might be the case
is that companies that sell oil and oil products are very exposed to price risk, since oil
and oil products are usually their principle output. On the other hand, for companies
(not to mention consumers) that buy oil and oil products, they are just one of a
163 This arbitrage between spot and futures prices is discussed in Hendrick S. Houthakker and Peter
J. Williamson, The Economics of Financial Markets, Oxford University Press, New York, 1996, Section
10.2.2.
number of inputs, often a minor one. Also, companies that sell oil and oil products
are more exposed to risk because they face costs that are largely fixed if the price of
oil drops, while companies that buy oil and oil products can generally pass through
some or all of the increase to their customers if the price of oil rises. Hence, hedgers
are more likely to want to sell in the oil futures markets than to buy.
Whenever there is an uneven match in the futures market between hedgers who
wish to take buy and sell positions, the gap can be met by speculators. These are
people who are taking positions in the futures market only in hopes of making money.
This sounds bad, and indeed speculators have often been given a bad name in the
media. But speculators serve a valuable role in making up for any uneven matches
between hedgers, and thereby allowing the market to operate much more smoothly.
However, speculators will accept risk only if they expect to be rewarded. In
particular, speculators will only be willing to buy in the oil futures market if they
believe the current futures price is less than what the corresponding spot price will be
on the delivery date. Hence, the Theory of Normal Backwardation argues that futures
prices should systematically under-predict the spot price.
The empirical evidence for the Theory of Normal Backwardation for futures markets
in general is mixed.164 The authors interpretation of the specific research devoted to
oil futures is that there is evidence to support the theory for oil futures, although it is
certainly not conclusive.165
Does this mean that futures prices are not good predictors of spot prices? Clearly,
the answer depends upon how large the downward bias in futures prices tends to be.
The author would argue that the bias should be fairly small in the long run. After all, if
it were large, buying oil futures would become an easy way to beat the market, which
would attract lots of speculative buyers, which would drive down the size of the bias.
Conclusion: while downward bias due to normal backwardation is worth noting, its realworld significance to the price projections used in policy work is probably limited.
164 The Theory of Normal Backwardation is discussed in Hendrick S. Houthakker and Peter J. Williamson,
The Economics of Financial Markets, Oxford University Press, New York, 1996, Sections 10.3 and 10.4.
165 See Cindy W. Ma, Forecasting Efficiency of Energy Futures Prices, Journal of Futures Markets,
v. 9, no. 5, 1989, pp. 393-419; Richard Deaves and Itzhak Krinsky, Risk Premiums and the
Market for Crude Oil Futures, Energy Journal, v. 13, no. 2, 1992, pp. 93-117; Neil Kellard, et
al, The Relative Efficiency of Commodity Futures Markets, Journal of Futures Markets, v. 19,
no. 4, 1999, pp. 413-432; Sergey V. Chernenko, Krista B. Schwarz, and Jonathan H. Wright,
The Information Content of Forward and Futures Prices: Market Expectation and Market
Risk, International Finance Discussion Papers, Federal Reserve Board, Number 808, June 2004,
http://www.federalreserve.gov/pubs/IFDP/2004/808/ifdp808.pdf; Mark W. French, Why and
When Do Spot Prices of Crude Oil Revert to Futures Price Levels, Finance and Economics Discussion
Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, June 2005,
http://www.federalreserve.gov/pubs/feds/2005/200530/200530pap.pdf.
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New Zealands Oil Industry

5
Although New Zealand is heavily dependent on imported oil, it does have a modest
indigenous oil industry. In 2007, New Zealand produced about 14.9 million barrels of
oil and another 1.4 million barrels of LPG.166 This is less than Saudi Arabia produces
in two days,167 but since New Zealands population is small, it does still meet about a
third of New Zealands demand.168 New Zealands production is growing rapidly, how
ever, with 2007 production roughly double that of 2006.169 There are two new fields,
Pohokura and Tui, which entered production in 2006 and 2007, respectively. There
are two additional fields expected to be in production by 2010: Maari and Kupe. The
four fields together are expected to add 140 million barrels of reserves.170 And there is
good potential that significantly more may be discovered over the next few years.
5.1 New Zealands Crown Estate

In New Zealand, the Crown today owns all petroleum resources regardless of the
ownership of the land. Under English Common Law, rights to petroleum were held by
the landowners where the land was privately owned. However, the Petroleum Act of
1937 effectively nationalised these rights.171 Privately-owned mineral rights still exist
in New Zealand for some minerals, but not for petroleum, gold, silver, and uranium.172
166 The 2007 oil production figure will be published in Table D2.b of the upcoming 2008 edition of MEDs
New Zealand Energy Data File. Oil includes crude oil, condensate, and naphtha. LPG are figures from
the Energy Data section of MEDs website, http://www.med.govt.nz/upload/37370/A-oil-tables-14.xls,
which shows 2007 LPG production as 118.1 kt. According to MED, New Zealand Energy Data File,
June 2007, http://www.med.govt.nz/energy/edf/2007/, Table L.2b, LPG 60/40 has a density of 0.534
kg/litre. This implies 2007 production of 118.1 kt x 1,000,000 kg/kt / ( 0.534 kg/litre x 159 litres/barrel)
= 1.39 million barrels.
http://www.bp.com/productlanding.do?categoryId=6929&contentId=7044622, p. 6, which shows
that in 2007 Saudi Arabia was producing about 10 million barrels per day.
168 A self-sufficiency figure of 32% will be published in the introduction to the oil section of the upcoming
2008 edition of MEDs New Zealand Energy Data File. Oil includes crude oil, condensate, and naphtha.
http://www.med.govt.nz/energy/edf/2007/, Table D.2b, which shows 2006 oil production as
6.8million barrels.
170 See press release from Rt. Hon. Helen Clark, Tui Area Oil Development, 16 August 2007,
http://www.beehive.govt.nz/speech/tui+area+oil+development.
171 For a legal history of petroleum mineral ownership in New Zealand, see the Waitangi Tribunal,
Petroleum Report, http://www.waitangi-tribunal.govt.nz/reports/view.asp?reportid=a181419d-48ad4ecf-98bc-439454654765, especially chapters 3 and 4.
172 See Rob Harris (editor), Handbook of Environmental Law, Royal Forest and Bird Protection Society of
New Zealand, Wellington, 2004, p. 279.
Petroleum rights have been a sensitive issue for Maori, with the Waitangi Tribunal
concluding that the expropriation of the pre-existing Maori rights to petroleum
arose from a context riddled with breaches of the Treaty, and recommending that
the Crown and affected Maori groups negotiate for the settlement of petroleum
grievances.173 The government did not accept this recommendation arguing that
Crown policy and legislation regarding petroleum were a valid exercise of the Crowns
Treaty rights in 1937 and remain so.174
The Crown mineral estate, including petroleum, is administered by the Crown
Minerals Group in the Ministry of Economic Development. Crown Minerals administers
a three-stage permitting process, with separate permits required to prospect,
explore, and mine for petroleum. Winning an exploration permit is probably the key
step for any company wishing to produce oil in New Zealand, since the holder of an
exploration permit is generally entitled to an exclusive right to explore for petroleum
on a given block of land, and to apply for a mining permit to produce any oil it may
discover. Prospecting permits, on the other hand, are not exclusive and do not grant
the holder any subsequent rights. 175
Crown Minerals offers exploration permits for specific blocks of land on an irregular
basis, as authorised by the Minister of Energy.176 An Indicative Petroleum Exploration
Permit Blocks Offers Schedule is published on the Crown Minerals website giving
areas of proposed future block offers but not the actual blocks or specific timing of
the block offers.177
The blocks are allocated by competitive tender. Generally, blocks are allocated by
staged work programme bidding, which means that bids are evaluated based on a
variety of criteria related to the quality of the applicants proposed work programme
and the ability of the applicant to carry it out successfully.178 For areas of high
173 See the Petroleum Report Summary Page on the Waitangi Tribunal website http://www.waitangitribunal.govt.nz/reports/summary.asp?reportid=%7BA181419D-48AD-4ECF-98BC-439454654765%7D.
174 See press release from Hon. Pete Hodgson, Government Response to Waitangi Tribunals Petroleum
Report, 21 November 2003, http://www.beehive.govt.nz/release/government+response+waitangi+tr
ibunal039s+petroleum+report.
175 See the What are the different types of permits page on the Crown Minerals website http://www.
crownminerals.govt.nz/cms/petroleum/permits-content/permits-how-do-i-apply-faqs-1/what-arethe-different-types-of-permits.
176 See the Minerals Programme for Petroleum 2005 available on the Crown Minerals website at
http://www.crownminerals.govt.nz/cms/pdf-library/petroleum-legislation-1/mins-prog-forpetroleum-2005.pdf, sections 5.4.5-5.4.15.
177 See http://www.crownminerals.govt.nz/cms/petroleum/blocks-offers/indicative-petroleum-explorationpermit-blocks-offers-schedule.
178 The allocation process for Staged Work Programme Bidding is described in the Minerals Programme
for Petroleum 2005 available on the Crown Minerals website at http://www.crownminerals.govt.
nz/cms/pdf-library/petroleum-legislation-1/mins-prog-for-petroleum-2005.pdf, sections 5.4.14-5.4.38.
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Chapter 5 New Zealands Oil Industry
prospectivity, the rules also allow a cash bonus bidding system, where the block is
allocated to the applicant making the highest cash bid.179
Applications for exploration permits are also accepted for available land not
already under permit, block offer, or in the Indicative Petroleum Exploration Permit
Blocks Offers Schedule. Provided the proposed work programme is satisfactory, these
will be awarded on a Priority in Time basisthat is, first come, first served.180
If oil is found, and a mining permit obtained, a royalty of 5% of the net revenues
or 20% of the accounting profit, whichever is higher, is generally charged on any oil
production.181 In addition to a mining permit, there are several other requirements
that a company seeking to produce oil must satisfy: if the land is privately-owned,
access to the land must be secured from the landowner or the company must own the
land themselves; all necessary resource consents under the Resource Management
Act must be obtained; and any other necessary permits (such as building consents)
must be obtained.182
5.2 New Zealands Undersea Jurisdictions

Crown Minerals has a lot of land on which to potentially issue exploration permits.
Most of this is not land in the ordinary meaning of the word but undersea territory.
Under the United Nations Law of the Sea Convention, New Zealand administers a
sequence of jurisdictional rights over its surrounding waters:
Territorial Waters (12 nautical miles from land) Here New Zealand has full
sovereign rights subject to a few restrictions, such as the obligation to allow vessels
from other nations innocent passage.
Contiguous Zone (24 nautical miles from land) In this part of the Exclusive
Economic Zone (see next bullet) New Zealand may continue to enforce laws related
to customs, taxes, immigration, and sanitation.
179 The allocation process for Cash Bonus Bidding is described in the Minerals Programme for Petroleum
2005 available on the Crown Minerals website at http://www.crownminerals.govt.nz/cms/pdf-library/
petroleum-legislation-1/mins-prog-for-petroleum-2005.pdf, sections 5.2.1-5.2.2.
180 The Priority in Time application process is described in the Minerals Programme for Petroleum 2005
available on the Crown Minerals website at http://www.crownminerals.govt.nz/cms/pdf-library/
petroleum-legislation-1/mins-prog-for-petroleum-2005.pdf, sections 5.4.39-5.4.44.
181 See the Royalty Regime page on the Crown Minerals website http://www.crownminerals.govt.
nz/cms/petroleum/legislation/royalty-regime?searchterm=Petroleum%20Royalty.
182 See Rob Harris (editor), Handbook of Environmental Law, Royal Forest and Bird Protection Society of
New Zealand, Wellington, 2004, p. 281-282.
Exclusive Economic Zone or EEZ (200 nautical miles from land) Here NewZealand
has sovereign rights a more limited jurisdiction than sovereignty for the
purposes of exploring and exploiting, conserving and managing natural resources
of the waters, seabed, and subsoil.
Continental Shelf (to outer edge of continental margin) Sovereign rights (as for
the EEZ) for the purpose of exploring and exploiting the natural resources of the
seabed and subsoils (including immobile organisms which live on or under the
seabed/subsoil), but not fish or the water itself.183
In all of these areas, New Zealand has ownership of any petroleum. Because
NewZealand is surrounded by water with no nearby neighbours, this is a huge area.
New Zealands EEZ and Continental Shelf are approximately 20 times New Zealands
land area, or about three-quarters the size of Australia.184 Comparing nations of the
world by land area combined with territorial waters and EEZ, New Zealand would rank
as the tenth largest country in the world.185 New Zealand recently completed a 10year project to delineate its Continental Shelf boundaries, and submitted these to the
United Nations Commission on the Limits of the Continental Shelf (CLCS) in 2006. The
Continental Shelf around New Zealand extends out quite far, and is expected to add
almost another 50% to New Zealands area.186 The CLCS is not expected to conclude
its consideration of New Zealands submission until mid-2008.187
5.3 New Zealands Oil Resources

The big question is, of course, how much oil is there in this huge area? This is not an
easy question to answer.
183 See the chart Jurisdictional boundaries and areas defined by the United Nations Convention on
the Law of the Sea (UNCLOS) and under domestic legislation on the Ministry for the Environment
website http://www.mfe.govt.nz/issues/oceans/jurisdictional.html.
184 See NZs Offshore TerritoryTurning Uncertainty Into Opportunity, CAE InfoDirect,
New Zealand Centre for Advanced Engineering, Issue 42, November 2007,
http://www.caenz.com/info/publications/newsletters/other_pubs.html#Back, p. 6-7; see
also Introduction to Offshore Options page on the Ministry for the Environment website
http://www.mfe.govt.nz/publications/oceans/offshore-options-jun05/html/page3.html.
185 See the chart in the Wikipedia article Exclusive Economic Zone
http://en.wikipedia.org/wiki/Exclusive_economic_zone.
186 See the Land Information New Zealand New Zealand Continental Shelf Report, Newsletter 8, April 2006,
http://www.linz.govt.nz/docs/hydrography/currentprojects/continentalshelf/newsletter-apr06.pdf.
187 See the MFAT New Zealands Continental Shelf and Maritime Boundaries web page at http://www.
mfat.govt.nz/Treaties-and-International-Law/04-Law-of-the-Sea-and-Fisheries/NZ-Continental-Shelfand-Maritime-Boundaries.php.
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Figure 6 Taranaki Oil and Gas Fields188
All of New Zealands oil production today is from the Taranaki region. Figure 6 shows
the oil and gas fields of the Taranaki region. In 2007, over 90% of New Zealands oil
production came from the Tui, Pohokura, Maui, and Kapuni fields.189
The Taranaki Basin is only moderately explored compared to basins worldwide,
despite evidence that there is significant potential for further discoveries.190 The
Taranaki Basin covers about 100,000 square kilometres, but there have only been
about 350 exploration wells drilled there since 1955.191 One paper by Christopher
188 From the Crown Minerals website http://www.crownminerals.govt.nz/cms/images-old/petroleum/
full-size-images/taranaki_infrastructure_basin_map.gif.
189 The 2007 oil production figures will be published in Table D2.b of the upcoming 2008 edition of
MEDs New Zealand Energy Data File. Oil includes crude oil, condensate, and naphtha.
190 See the Crown Minerals Petroleum Basins web page
http://www.crownminerals.govt.nz/cms/petroleum/petroleum-basins.
191 See the Crown Minerals Taranaki Basin web page
http://www.crownminerals.govt.nz/cms/petroleum/petroleum-basins/taranaki-basin.
Figure 7 New Zealand Petroleum Basins192
192 From the Crown Minerals website

http://www.crownminerals.govt.nz/cms/pdf-library/petroleum-basins-1/NZ_hydrocarbon_basins.pdf.
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64
Uruski of the Institute of Geological and Nuclear Sciences and Peter Baillie of TGSNOPEC Geophysical Company193 suggests that the Deepwater Taranaki Basin could
contain as much as 20 billion barrels of trapped oil. Uruski was quoted in a media
article as saying that If 50 percent is ultimately discovered, perhaps five billion barrels
may be produced from that basin.194 This would give New Zealand an amount of oil
larger than the UKs current North Sea reserves.195
As shown in Figure 7, there are several other petroleum basins. However, to quote
a Crown Minerals publication,
Northland, the offshore West Coast, Canterbury, Western Southland and the Great
South Basin are barely explored yet have strong similarities with Taranaki in their
petroleum systems and the quality of structural leads.196
The number of exploratory wells drilled outside Taranaki so far is extremely small.
There have been 38 wells drilled in the East Coast Basin, only two of them offshore.
In none of the other basins have more than 11 total wells or 8 offshore wells been
drilled.197 However, even with the limited exploration, an onshore gas discovery was
made in the East Coast Basin in 1998, while sub-commercial discoveries have also
been made in the offshore Canterbury and Great South basins.198
Given the apparently attractive geology in New Zealand, why the low level of
exploration? Much of it probably relates to the limited size of the gas market in New
Zealand. Oil and gas are generally found together, with gas being commonly viewed
in the industry as the consolation prize when oil is not discovered. A modest New
Zealand gas discovery would find a ready market in New Zealand, but, if the gas were
outside the Taranaki Basin, only after an extensive investment in pipeline infrastructure.
Such an investment might or might not be economic. A larger gas discovery might
depress gas prices in New Zealand too much, making it more attractive to invest in a
liquefied natural gas (LNG) plant to allow the gas to be exported. However, the cost of
building and operating the LNG plant would significantly cut into the value of the gas
193 Chris Uruski and Peter Baillie, Petroleum systems of the Deepwater Taranaki Basin, New Zealand,
presentation to the New Zealand Petroleum Conference 2002, http://www.crownminerals.govt.
nz/cms/petroleum/conferences/conference-proceedings-2002-1#taranaki.
194 See Deep Kiwi Waters Hold Promise, AAPG Explorer, October 2006,
http://www.aapg.org/explorer/2006/10oct/new_zeal.cfm.
http://www.bp.com/productlanding.do?categoryId=6929&contentId=7044622, p.6, which shows end
2007 UK oil reserves of 3.6 million barrels.
196 See Ministry of Economic Development, Crown Minerals, New Zealands Petroleum Basins, 2004, p. 3,
http://www.crownminerals.govt.nz/cms/petroleum/publications.
197 See the Crown Minerals Petroleum Basins web pages on each basin
http://www.crownminerals.govt.nz/cms/petroleum/petroleum-basins.
198 See the Overview page of the Crown Minerals website
http://www.crownminerals.govt.nz/cms/petroleum/overview.
at the wellhead. Thus a gas discovery in New Zealand is perceived in the industry as
having considerably less value than a gas discovery where a large market for the gas
is close at hand. This is an important consideration, since the industry tends to view
New Zealands geology as gas-prone, rather than oil-prone.199
An additional impediment is that many of the best potential drilling sites in
NewZealand are distant from shore, in deep water, and exposed to severe sea and
weather conditions. These factors, combined with New Zealands general remoteness,
make drilling in New Zealand an expensive proposition. However, rising oil and gas
prices worldwide and improved industry technology combine to make the economics
of New Zealand exploration more attractive than it has been in the past.200 Currently,
interest centres on the Great South Basin southeast of the South Island, where Crown
Minerals recently awarded exploration permits to two consortiums of oil companies
who are expected to spend $1.2 billion on exploration.201
5.4 The New Zealand Oil Product Market

The New Zealand market for oil products is supplied by four major oil companies,
BP, Chevron (marketing as Caltex), Mobil (an affiliate of ExxonMobil) and Shell, as well
as one independent, Gull.202 Oil products are supplied by New Zealands only refinery
situated at Marsden Point near Whangarei203 and from direct imports, primarily from
Australia, Singapore,204 and North Asia.
The Marsden Point refinery205 is owned by the New Zealand Refining Company
(NZRC). NZRC is 73% owned by the four major oil companies, with the remaining
27% held by institutional and individual investors (the company is listed on the
NewZealand Stock Exchange). The refinery is unusual for the Asia-Pacific region in
199 For a discussion of New Zealands current exploration situation, see Geoff
Cumming, Black Gold or a Fools Errand, New Zealand Herald, 28 July 2007,
http://www.nzherald.co.nz/author/story.cfm?a_id=88&objectid=10454288.
200 For a discussion of issues inhibiting exploration in New Zealand see GNS News Release
Comparisons Stack Up Well for Offshore Taranaki, Geoscientist Says, 27 March 2003,
http://www.gns.cri.nz/news/release/taranaki.html.
201 See press release from Hon. Harry Duynhoven, Great South Basin oil and gas quest set to begin, 11 July
2007, http://www.beehive.govt.nz/release/great+south+basin+oil+and+gas+quest+set+begin+0.
http://www.med.govt.nz/energy/edf/2007/, Figure D.1 for an overview of the New Zealand oil
product supply chain.
http://www.med.govt.nz/energy/edf/2007/, p. 33.
205 Unless otherwise noted, information about the Marsden Point refinery is quoted or drawn from
Covec, Hale & Twomey, and Exergi Consulting, Heavy Industry Energy Demand, August 2006, Chapter 5,
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66
that it is a tolling operation that charges a fee for its customers (primarily the four
major oil companies) to process their oil. This is in contrast to the usual arrangement
where each oil company owns a refinery and it is an integrated part of the processes
involved in getting the oil products to market. In 2006 products sourced from the
NZRC refinery provided about 70% of New Zealands demand.206
While the refinery is significant in the New Zealand market, it is a small refinery by
international standards. NZRC capacity is approximately 110,000 bbl/day, which is a
fraction of the size of some of the major Asian export refineries: South Korea has one
with a capacity of 817,000 bbl/day, for example.207 However NZRC has an advantage
in the New Zealand market due to its location. Crude oil is imported into New Zealand
on ships of up to 140,000 tonnes. While these often come from a greater distance than
product imports (the Middle East is a major supplier), product imports are typically
supplied on ships of 35,000 tonnes. The greater scale of crude shipments means
that it is more cost effective to ship crude than product giving NZRC a competitive
advantage for supplying New Zealand of between US$0.50US$1.00/barrel versus a
refinery in another location. However this competitive advantage tends to work in
reverse if NZRC exports, which is why it is commercially prudent for NZRC to avoid
investment in capacity surplus to the New Zealand market requirement.
Of the crude and feedstock processed at NZRC typically around 50-60% will come
from the Middle East, 3040% from the Far East/Northern Australia with the balance
supplied by domestic production. New Zealands domestic production tends to be
lighter and sweeter (and therefore higher price) than needed by NZRC.208 Therefore,
in 2007, 86% of New Zealand-produced crude oil, condensate, and naphtha were
exported.209
A refinery-owned pipeline transports about a third of the refinerys production to
bulk storage facilities at Wiri in South Auckland to supply the Auckland area, which
is New Zealands major market for oil. Another pipeline carries jet fuel from Wiri to
Auckland International Airport. Most of the rest of New Zealand receives its oil
http://www.med.govt.nz/energy/edf/2007/, Table D.5. This calculation includes International
Transport in New Zealand demand.
207 See the U.S Energy Information Administration South Korea Oil page,
http://www.eia.doe.gov/emeu/cabs/South_Korea/Oil.html.
208 See Covec and Hale & Twomey, Oil Security; Final Report, February 2005,
http://www.med.govt.nz/upload/25065/adjusted-final.pdf, p. 12.
209 Based on 2007 oil production and export figures to be published in Table D.3 of the upcoming 2008
edition of MEDs New Zealand Energy Data File. Oil includes crude oil, condensate, and naphtha.
products from coastal tankers supplying port depots. Each port depot has storage
facilities from which the products may be distributed by truck to service stations and
other major users.210 Direct product imports are delivered to these same locations.
Gull has its own storage facilities at Tauranga.211
Oil companies compete with each other in the consumer market. However, they
do have some common interests. Oil product shipped from the refinery is carried
in two ships. These are scheduled and managed by a single company, Coastal Oil
Logistics Limited, on behalf of the four oil majors.212 The four oil majors also pool their
storage throughout the country, with each company allowed to draw product from
any location subject to limits primarily related to each companys contribution to the
combined stock.213
5.5 Investigations of Market Competitiveness

Naturally, with so few competitors supplying the oil product market, as well as
the shared use of the refinery and the other common interests described above,
the oil companies must be very careful to avoid any appearance of anti-competitive
behaviour. With the exception of one apparently isolated incident, they have so far
avoided any problems with the law.
Competition law in New Zealand is governed by the Commerce Act of 1986, with
enforcement handled by the Commerce Commission.214 The Commerce Commission
itself has conducted only one inquiry into the overall oil products market since the
mid-1990s. This was an investigation of petrol price increases between July and
November 1999. The timing of the companies announcements of the price increases,
and the manner in which they were communicated, apparently raised suspicions of
collusive behaviour. However, the Commissions report concluded:
that there is no evidence of collusive behaviour amongst the oil companies and that
their respective price rises, though closely following or matching each other, can be
justified by the substantial increases in the cost of crude oil and imported petrol, and
212 See the Coastal Oil Logistics Limited website http://www.coll.co.nz/Article.aspx?ID=119.
214 See the Commerce Commission website Business Competition page,
http://www.comcom.govt.nz/BusinessCompetition/Overview.aspx.
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68
the operation of competitive pressures. However the time period between some of
the announcements of price increases and the implementation of those increases
might be argued to be price signalling.215
Another investigation with a more limited scope, but the only one that resulted
in the Commission actually charging the oil companies with wrongdoing, was a case
alleging that three of the major oil companies had colluded in 1996 to withdraw an
offer of a free car wash to customers who spent $20 or more on fuel at some of their
Auckland service stations. The High Court ordered the companies to pay a combined
total of $1.175 million in penalties for price-fixing.216
Two other official investigations into the competitive situation in the New Zealand
oil industry are worthy of note. In 1997 the Ministry of Commerce (a predecessor
agency to the Ministry of Economic Development) engaged Australian consultants
ACIL Economics and Policy Pty Ltd to investigate whether a perceived lack of price
competition in the New Zealand market for petroleum products could be explained
by barriers to entry for new competitors. Examples of such barriers might include
access to port storage facilities and contractual arrangements with independent
retailers.217 However, the study concluded that:
there are no persistent long run barriers to entry into the New Zealand downstream
oil industryAny intervention to facilitate entry would introduce inefficiencies into
the market.218
In 2001, the Ministry of Economic Development (MED) received complaints that

independent petrol retailers were having difficulty remaining in business due to
inequitable wholesale pricing by the oil companies. The MED responded by engaging
the New Zealand Institute for Economic Research (NZIER) to examine the role of
independent retailers in the retail petrol market.219 NZIERs report acknowledged
215 See Commerce Commission memorandum J3484 from Nicky Beechey to Geoff Thorn, Investigation
Report into Petrol Price Increases July-November 1999, 20 December 1999 available from the
Commerce Commission Library.
216 See Caltex, Mobil and Shell were price fixing: High Court imposes $1.175 million penalties in the
Commerce Commissions newsletter Fairs Fair, Issue No. 61, March 2000, http://www.comcom.govt.
nz/Publications/ArchivedPublications/ContentFiles/Documents/ffmar2000.pdf, p. 3. A more detailed
summary of the case of Commerce Commission vs. Caltex New Zealand Ltd, (1999) 9 TCLR 305, is
available from Brookers On-Line, http://www.brookersonline.co.nz.
217 See ACIL Economics & Policy Pty Ltd, Barriers to Entry to the New Zealand Downstream Oil Market,
Ministry of Commerce, August 1997, http://www.med.govt.nz/upload/20284/acil2.pdf, p. 9.
218 See ACIL Economics & Policy Pty Ltd, Barriers to Entry to the New Zealand Downstream Oil Market,
Ministry of Commerce, August 1997, http://www.med.govt.nz/upload/20284/acil2.pdf, p. 7-8.
219 See the Review of the Role of Independent Petrol Retailers page on the Ministry of Economic
Development website http://www.med.govt.nz/templates/ContentTopicSummary____10384.aspx.
that independent retailers were disadvantaged in terms of pricing arrangements

compared with wholesaler-owned retailers, and that most of the low volume sites
could close.220 However, NZIER took the view that the closure of low volume sites,
which were primarily owned by independents, was economically efficient. They
concluded that:
the rationalisation of petroleum retailing is not reducing overall competition and
thus not wasting resources or harming consumers. As a result, no intervention is
warranted.221
220 See New Zealand Institute for Economic Research, The Decline of Independent Petrol Retailing;
Rationalisation or Predation?, Report to the Ministry of Economic Development, April 2002,
http://www.med.govt.nz/upload/20465/report.pdf, Section 3.5.
221 See New Zealand Institute for Economic Research, The Decline of Independent Petrol Retailing;
Rationalisation or Predation?, Report to the Ministry of Economic Development, April 2002,
http://www.med.govt.nz/upload/20465/report.pdf, Executive Summary.
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Oil: The Consumer Side

6
Some basic statistics illustrate the importance of oil to New Zealand consumers
and explains why oil has become so problematic. New Zealand currently relies on
oil for 51% of its consumer energy. 222 Spot prices for crude oil in current U.S. dollars
have increased by more than a factor of eight between 1998 and 2008.223 Liquid fuels,
virtually all of which are derived from oil, account for 51% of New Zealands greenhouse
gas emissions from energy use.224
6.1 Elasticity of Demand

The response of demand for a product to a change in price is typically measured
in terms of elasticity of demand. Elasticity of demand is the percentage change in
demand that results from a one percent increase in price. So, for example, if a one
percent price increase in a commodity results in a one-half percent decrease in
demand, the elasticity would be -0.5. Products which are necessities typically have
small (nearer to zero) elasticities of demand, while products that are luxuries have
bigger (that is, more negative) elasticities of demand. Another factor which makes oil
so problematic is that transport fuel tends to fall into the necessity category for many
people, and therefore displays a notoriously low elasticity of demand. This implies that
if a policymaker wishes to limit transport fuel demand with price-based mechanisms,
such as fuel taxes, the price increases will have to be quite large to have a significant
impact on demand.
A recent review of New Zealand consumer response to petrol price changes for
Land Transport New Zealand by consultants Booz-Allen-Hamilton225 (BAH) provides
the first comprehensive study of petrol price elasticity in New Zealand. BAH estimated
the elasticity of demand for petrol at -0.15 for the short-term (less than 1 year) and
http://www.med.govt.nz/energy/edf/2007/, Table A.4a.
223 1998 WTI spot price of US$14.39/barrel from BP, Statistical Review of World Energy
2008, http://www.bp.com/productlanding.do?categoryId=6929&contentId=7044622,
p.16. Price quote of US$129/barrel as of 21 May 2008 from Bloomberg.com
http://www.bloomberg.com/markets/commodities/energyprices.html.
224 See Ministry of Economic Development, New Zealand Energy Greenhouse Gas Emissions 1990-2006,
http://www.med.govt.nz/energy/ghg/2007/, Table 2.1
225 David Kennedy and Ian Wallis (Booz-Allen-Hamilton (NZ) Ltd.), Impacts of Fuel Price
Changes on NewZealand Transport, Land Transport Research Report 331, 2007,
http://www.landtransport.govt.nz/research/reports/331.pdf.
-0.20 for the medium-term (greater than two years). One would expect the medium
and long-term elasticity to be larger (more negative) than the short-term elasticity,
since consumers may respond to price increases by making changes that take time,
such as buying a more fuel-efficient vehicle or moving closer to where they work.
Elasticities are useful in that they can be used to provide rough estimates for how
consumers will respond to a change in price. One might assume that if the elasticity
indicates that a one percent increase in price results in an e percent decline in
demand (that is, an elasticity of -e), then a 10 percent increase in price would result
in a 10e percent decline in demand. This is not, however, correct. The reason is that
the percentage changes in demand have to be compounded, much like bank interest.
The correct calculation is:
New Demand/Old Demand = (New Price/Old Price)e.
So, for example, if the short-term elasticity is -0.15 (as the BAH study found), then one
might estimate the impact of doubling petrol prices as:
New Demand/Old Demand = 2.0-0.15 = 0.9013.
That is, a doubling of petrol prices (a 100% increase) results in only about a 10% (100
90.13%) short-term reduction in petrol demand! Even over the medium-term, where
the elasticity of demand would be -0.2:
New Demand/Old Demand = 2.0-0.2 = 0.8706,
or about a 13% reduction in demand.
The BAH demand elasticity estimates tend to be low compared to estimates for other
countries.226 However, one would expect demand elasticities in New Zealand to be
lower than in many countries, since New Zealanders have fewer attractive alternatives to
driving (such as public transport and cities suited to walking and cycling) than residents
of many other countries. These elasticities suggest that attempting to limit demand for
transport fuel through price-based measures would be challenging.
6.2 Fuel Taxation

New Zealand is unusual in having very different tax regimes for petrol and diesel
vehicles. Petrol vehicles are taxed primarily through cents/litre taxes on petrol.
Current levels of these taxes are as shown in Table 2. Beginning 1 July 2008, all petrol
226 See the discussion of fuel price elasticities in Ministry of Economic Development, New Zealands
Energy Outlook to 2030; Final Publication, September 2006, http://www.med.govt.nz/energy/eo/2006/,
Section6.4
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Chapter 6 Oil: The Consumer Side
tax revenue will be dedicated to the National Land Transport Fund, rather than a share
being used as general Crown revenue.227
Table 2 Petrol Taxes in New Zealand as of 30 June 2008228
Tax
Amount
Use of Funds
Excise Duty on Motor Spirits
42.524 cents/litre
18.708 cents/litre Crown

Revenue
23.816 cents/litre National
Land Transport Fund for roads
and public transport
Petroleum Fuels Monitoring

Levy
0.025 cents/litre
Fuels Quality Monitoring and

Enforcement
(see Section 6.4)
Accident Compensation
Corporation (ACC) Levy
7.33 cents/lire
ACC
Local Authority Petroleum Tax
0.66 cents/litre
Local Authority General

Revenue
LPG and CNG used by road vehicles are also subject to cents/litre taxes, although
at a considerably lower rate,229 reflecting a historical policy preference for these fuels
for energy security and air quality reasons. All fuels are subject to 12.5% goods and
services tax (GST) on the sale price, including any cents/litre taxes.230
Diesel fuel, on the other hand, is subject only to a 0.33 cents/litre Local Authority
Tax, a 0.025 cents/litre Petroleum Fuels Monitoring Levy,231 and 12.5% GST on the sale
price. This explains why diesel fuel is generally significantly cheaper than petrol when
227 See press release from Hon. Annette King, Fuel Excise Duty
Will Revenue Will All Be Used on Land Transport, 25 July 2007,
http://www.beehive.govt.nz/release/fuel+excise+duty+revenue+will+all+be+used+land+transport.
228 Tax rates are taken from Ministry of Economic Development website Duties, Taxes, and Direct Levies
on Motor Fuels page, http://www.med.govt.nz/templates/Page____12961.aspx. The Petroleum Fuels
Monitoring Levy is explained in Ministry of Transport, Biofuels Sale Obligation Discussion Document,
September 2006, Glossary, http://www.transport.govt.nz/glossary/. Other use of funds are explained
in speech by Roger Toleman, Deputy Secretary for Transport, Fund and Deliver, 5 September 2003,
http://www.transport.govt.nz/toleman050903/.
229 See Ministry of Economic Development website Duties, Taxes, and Direct Levies on Motor Fuels
page, http://www.med.govt.nz/templates/Page____12961.aspx.
230 See the AA Website Petrol Tax page,
http://www.aa.co.nz/about/issues/fuel-taxes-fines-charges/Pages/PetrolTax.aspx.
231 See the Ministry of Economic Development website Duties, Taxes, and Direct Levies on Motor Fuels
page, http://www.med.govt.nz/templates/Page____12961.aspx.
sold in New Zealand. However, all diesel vehicles are subject to Road User Charges
(RUC) based on the type of vehicle and distance travelled on public roads. Electric
vehicles would also be subject to RUC, as their fuel is not taxed at the source like
petrol, LPG, and CNG.232 For a light vehicle (two axles with single tyres 3 tonnes or less
in gross weight) the current RUC is $32.79 per 1000 km including GST.233 For vehicles
subject to RUC, a distance licence must be purchased and displayed in the vehicle
windscreen covering the kilometres currently shown on the vehicles odometer or (for
heavy vehicles) hubodometer.234
Fuel taxes and road user charges are a primary (although not the only) source
of funding for building and maintaining road and transport facilities.235 However,
discussing New Zealands transport funding policies is well beyond the scope of
this book. In general, New Zealands petrol taxes are significantly lower than most
European countries and South Korea, roughly comparable to Japan, Australia, and
Canada, and considerably higher than the United States and Mexico.236
How did New Zealand end up with such disparate systems for taxing petrol and
diesel? RUC was introduced in 1977 to replace a conventional tax on diesel fuel
that had become difficult to administer due to the fact that roughly half of all diesel
fuel was used off-road. These off-road users had to pay the diesel tax and then seek
a refund. The RUC system is much more amenable to excluding this off-road usage
from tax: non-vehicle use is not subject to RUC and hubodometers may simply be
switched-off when a vehicle is used off-road (although it is estimated that some 46%
of RUC revenue is lost due to evasion).237
6.3 Price Monitoring and Reporting

Section 4.1 discussed the role that key oil product spot markets serve in providing
a reference for product prices over a wide region. Prices for fuels in New Zealand,
232 See Land Transport New Zealand, Factsheet 38: Road User Charges: 1-6 Tonne Vehicles, November 2007,
http://www.landtransport.govt.nz/factsheets/38.html.
233 See Land Transport New Zealand, Road User Charges, April 2007,
http://www.ltsa.govt.nz/publications/docs/road-user-charges.pdf, Tables III and IV.
234 See Land Transport New Zealand, Road User Charges, April 2007,
http://www.ltsa.govt.nz/publications/docs/road-user-charges.pdf, p.7.
235 See the Land Transport New Zealand website How Land Transport NZ is Funded page,
http://www.ltsa.govt.nz/funding/nltp/funding.html.
236 See the MED website for a chart of Petrol Prices and Taxes in OECD Countries,
http://www.med.govt.nz/upload/35799/Graph%20-%20International%20-%202007-12.pdf. This chart
is updated regularly as a part of the International and Domestic Petrol and Diesel Price Comparisons
shown at http://www.med.govt.nz/oil/prices/weekly/.
237 See speech by Roger Toleman, Deputy Secretary for Transport, Fund and Deliver, 5 September 2003,
http://www.transport.govt.nz/toleman050903/.
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Chapter 6 Oil: The Consumer Side
and the entire East Asia-South Pacific region, are generally based on the price of
the product in the Singapore spot market. Singapore has developed this role as it is
one of the worlds largest refining centres, and thus generally the marginal supplier
to countries such as New Zealand that cannot refine all the products they need
locally. One would thus normally expect product prices in New Zealand to equal the
Singapore spot price, plus freight and insurance from Singapore, plus importers costs
and margin, plus the taxes discussed in the preceding section. As a rule of thumb, the
import cost, which includes the Singapore price plus freight and insurance to New
Zealand, accounts for about 50% of the retail price of petrol. Taxes account for another
roughly 40%. Importers cost and margin, which includes domestic transportation,
distribution, and retailing costs, as well as wholesalers and retailers profit, accounts
for the final 10%.238
MED calculates and publishes estimates of import cost, importers margin, and fuel
taxes on a weekly basis.239 Consultants Hale & Twomey publish similar data weekly
on their web site.240 Estimates of import cost are based on published price quotes
for product in Singapore, plus estimated shipping and insurance costs. Retail price
estimates are based on Statistics New Zealand surveys. Taxes are based on actual tax
rates. The residual is the importers margin.241 New Zealand product specifications do
not exactly match those of the products for which prices are published in Singapore,
so adjustments to reflect quality are required. The emergence of supermarket
discounting schemes and biofuels242 also tends to cloud the picture slightly.
6.4 Product Quality Regulation

Fuel quality in New Zealand is governed by a set of regulations243 as well as by the
industrys own specifications. These regulations include factors that affect the
performance of fuel, such as the octane number, as well as limits for components that
238 See the table of Weekly Average Components of Regular Petrol
Price Graph on the Ministry of Economic Development web site at
http://www.med.govt.nz/templates/MultipageDocumentPage____20158.aspx.
239 See the International and Domestic Petrol and Diesel Price Comparisons on the Ministry of
Economic Development website at http://www.med.govt.nz/oil/prices/weekly/.
240 See the Hale & Twomey Market Update page, http://www.fuelpricemonitor.co.nz/demo.html.
241 For a discussion of the methodology, see Hale & Twomey, Review of Importer Margin Calculations,
prepared for the Ministry of Economic Development, March 2006 (unpublished).
242 See Hale & Twomey, Importer Margin Review, August 2007,
http://www.med.govt.nz/upload/52044/Importer-Margin-2007.pdf.
243 See the Fuel Quality page on the Ministry of Economic Development website
http://www.med.govt.nz/templates/StandardSummary____350.aspx.
could be harmful to the environment or to public health, such as lead and sulphur.
The regulations are the Petroleum Products Specifications Regulations.244
Monitoring the nations fuel quality is the responsibility of the Energy Safety
Service, a group within the Ministry of Economic Development. It routinely tests
petrol and diesel samples from around the country to ensure that the fuel available to
consumers complies with the regulations.
New Zealands product quality standards, such as for sulphur (see Section 1.5), put
New Zealand among the countries with the highest product quality standards in the
Asia-Pacific region (the others are Australia, Hong Kong, Japan, and South Korea) and
are similar to the European and American standards. Since refineries are generally
only upgraded when their home markets require improved products, there are
currently only a limited number of refineries in the region from which New Zealand
can import product. This limitation complicates the logistics of importing product
from overseas, especially in the event of a supply disruption. However, in the event
of a severe disruption, there would be some room to address the problem with a
temporary modification of product specifications.245
244 See the Parliamentary Counsel Office website New Zealand Legislation: Regulations page
http://www.legislation.govt.nz/regulation/public/2002/0210/latest/DLM136661.html.
245 Covec and Hale & Twomey, Oil Security; Final Report, February 2005,
http://www.med.govt.nz/upload/25065/adjusted-final.pdf, Section 2.3.1.
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Oil Security and the International Energy

Agency
7
The world oil market has experienced a number of oil supply disruptions since the
early 1970s, including the Arab Oil Embargo of 197374, the Iranian Revolution of 1979,
the subsequent Iran-Iraq war beginning in 1980, the Gulf War of 1990-1991, the Iraq
War beginning in 2003, and Hurricane Katrina of 2005. The world oil market remains
inherently vulnerable to disruption. This vulnerability is driven by heavy dependence
upon politically unstable countries, as well as long and fragile supply chains that can
be disrupted by both man-made and natural events. International efforts to manage
this vulnerability for the OECD countries are coordinated by the International Energy
Agency (IEA) of which New Zealand is a member. This section introduces the work of
the IEA, and New Zealands obligations as a member.
7.1 The International Energy Agency

Recognising that the vulnerability of the oil market to disruption was an issue that
needed to be addressed through international cooperation, sixteen of the worlds
major oil consuming countries agreed on an International Energy Program (IEP) in
November 1974. The key goals of the agreement were:
To maintain and improve systems for coping with oil supply disruptions
To promote rational energy policies in a global context through co-operative
relations with non-Member countries, industry and international organisations
To operate a permanent information system on the international oil market
To improve the worlds energy supply and demand structure by developing
alternative energy sources and increasing the efficiency of energy use
To promote international collaboration on energy technology
To assist in the integration of environmental and energy policies.246
The agreement established the International Energy Agency (IEA) to coordinate
these efforts.247
New Zealand was not an initial signatory, but acceded to the agreement in December
1976.248 Today, the IEA has 27 member countries, all of which are also members of
246 See International Energy Agency, IEA; an Overview, 2007, http://www.iea.org/about/docs/iea2007.pdf.
247 The text of the International Energy Program agreement may be found at
http://www.iea.org/about/docs/IEP.PDF.
248 See Richard Scott, The History of the International Energy Agency; the First 20 Years; Volume 1,
International Energy Agency, http://www.iea.org/textbase/nppdf/free/1990/1-ieahistory.pdf, p. 75.
the Organisation for Economic Cooperation and Development (OECD).249 All member
countries are industrialised countries, and most of them are significant importers of oil.
Today, the wider functions of the IEA include:
Monitoring oil and gas markets to help member countries respond promptly and
effectively to changes in market conditions; well-known IEA publications include,
the annual Medium-Term Oil Market Report, Natural Gas Market Review, and World
Energy Outlook, as well as the monthly Oil Market Report.
Performing a peer-review of member countries energy policies every four years;
Undertaking analysis and cooperative efforts in the development of policies for
energy efficiency, energy diversification (electricity, natural gas, coal, renewable
energy sources) and the integration of environmental concerns into energy
policies.
Performing studies of energy-related developments in energy producing and
consuming countries throughout the world in order to examine the global context
for policy decisions.
Through IEA Implementing Agreements offering a framework for cooperative energy
research and development efforts;
Performing policy and technology analysis related to climate change;
Producing a comprehensive database of energy statistics on 130 countries (the IEA
publishes 10 annual and 2 quarterly statistical publications, as well as a variety of
electronic services).250
7.2 The IEA and Oil Security

However, the IEAs most basic function remains its original one of promoting prepared
ness for oil supply disruptions. The three major elements of this effort are as follows:
Reserve Stocks. Each member country must maintain an emergency selfsufficiency in oil supplies. This is typically achieved by holding emergency reserve
oil stocks equivalent to at least 90 days of net oil imports.
Demand Restraint. Each member country must have ready a program of oil
demand restraint measures that will enable it to rapidly reduce its final consumption
in an oil supply emergency situation. The International Energy Programme (IEP)
249 A list of IEA members may be found on the IEA website at
http://www.iea.org/Textbase/about/membercountries.asp. This page notes that all are members of
the OECD.
250 See International Energy Agency, IEA; An Overview, 2007, http://www.iea.org/about/docs/iea2007.pdf.
77
78
Chapter 7 Oil Security and the International Energy Agency
provides for two levels of demand restraint: a 7% reduction in demand if supply is

reduced by 7% and a 10% reduction in demand if supply is reduced by 12%.
Allocation Plans. In the event of a 12% reduction in supply, oil sharing arrange
ments are triggered, whereby all IEA members share available supplies to ensure
equal pain.251 Under the International Energy Agreement, every IEA member is
required to have a National Emergency Sharing Organisation (NESO). It exists to
make arrangements for sharing oil supplies between member countries in the
event of a severe emergency. In New Zealand, this is a committee of oil industry
representatives chaired by the Ministry of Economic Development. New Zealand
also uses the NESO committee to assist with invoking lower level or non-IEA
emergency measures.252
There have been only two times when a significant stock drawdown has been
orchestrated by the IEA: the Gulf War in 1991 and Hurricane Katrina in 2005.253
Historically, the IEA has tended to deal with disruptions informally in a manner
tailored to each situation. The IEA has developed responses through consultation and
cooperation, and avoids allocation except as a last resort.254
7.3 New Zealands Oil Security

In principle, threats to New Zealands oil security could come from events internal to
New Zealand or external to New Zealand. A 2005 review of New Zealands oil security by
Covec and Hale & Twomey concluded that the risk of a major disruption to NewZealands
internal oil infrastructure was well below 1% per year (less than 1 in every 100 years). 255
However, the risk of an external disruption is up to 10 times greater.256 The IEA would
normally be expected to respond to the latter type of disruption.
http://www.med.govt.nz/upload/25065/adjusted-final.pdf, pp. 2-3. See also Cabinet Paper on Oil
Security, March 2005, paragraph 33, http://www.med.govt.nz/upload/25128/cabinet.pdf.
252 See Ministry of Economic Development, Discussion Paper: Options for
Government Response to an Oil Supply Disruption, September 2006, paragraph 4.3,
http://www.med.govt.nz/upload/40000/oers-discussion-document.pdf.
253 See International Energy Agency, Summary of IEA Collective Action of 2005, 8 March
2006, IEA/SEQ(2006)5, p. 2 (not available publicly on line) and International Energy
Agency Fact Sheet on IEA Oil Stocks and Emergency Response Potential, 2004,
http://www.iea.org/Textbase/Papers/2004/factsheetcover.pdf.
http://www.med.govt.nz/upload/25065/adjusted-final.pdf, p.4.
http://www.med.govt.nz/upload/25065/adjusted-final.pdf, Section 2.6.6.
http://www.med.govt.nz/upload/25065/adjusted-final.pdf, Section 2.6.
Regardless of the type of event, the New Zealand government has broad emergency
powers to deal with oil supply disruptions. The Petroleum Demand Restraint Act 1981
authorises regulations for the purpose of restraining demand, reducing consumption,
or ensuring the equitable distribution of petroleum products in New Zealand. The
government may introduce these regulations if petroleum products are or are likely
to be in short supply in New Zealand or within any specified part of New Zealand. The
International Energy Agreement Act 1976 provides for maintaining reserve supplies.
It also provides for ministerial directions and emergency regulations to control the
production, acquisition, distribution, supply, or use of petroleum, if it appears that
New Zealands IEA obligations require the taking of emergency measures. The latter
Act even states that no emergency regulation made under the Act shall be held
invalid because it is, or authorises any act or omission which is, repugnant to, or
inconsistent with, any Act (other than this Act). 257
The government is currently in the process of developing an oil disruption response
plan. A September 2006 discussion paper258 proposed possible measures. On the
supply side, these included drawing down stocks, a surge in domestic production
(assuming this is possible), and a relaxation of fuel specifications. On the demand side,
these included voluntary measures, a fixed sales requirement to discourage hoarding
(consumers must buy a minimum amount of petrol each time they fill up), lowered
speed limits, fuel switching, and (in extreme situations) rationing.
Until 2006 New Zealand relied on indigenous oil production and normal commercial
stocks to meet the IEA reserve stocks requirement. However, declining indigenous
production and increasing demand left New Zealand well short of the 90 day require
ment. The government decided that New Zealand would meet its IEA storage obligation
by tendering for companies to hold stock on behalf of the Crown. The reserve stocks
are in addition to normal commercial stocks and are controlled separately. Criteria for
the release of reserve stocks ensures that the stocks may only be released to meet New
Zealands obligations to the IEA or because there is a reduction or threatened reduction
of petroleum supplies in New Zealand. The reserve supplies are not available where the
primary purpose is for price management or for assisting any particular supplier.259
257 See Statutes of New Zealand, International Energy Agreement Act 1976,
http://www.legislation.govt.nz/act/public/1976/0155/latest/DLM440510.html.
Government Response to an Oil Supply Disruption, September 2006,
http://www.med.govt.nz/upload/40000/oers-discussion-document.pdf.
Government Response to an Oil Supply Disruption, September 2006,
http://www.med.govt.nz/upload/40000/oers-discussion-document.pdf, p. 15.
79
80
Chapter 7 Oil Security and the International Energy Agency
The first tender was held in 2006 and as a result stock was held in Australia, the
UK, and the Netherlands in 2007. No tenders to hold stock in New Zealand were
received. A further tender was held in 2007 and in 2008 stock is also being held in
Japan. The Government entered into bilateral arrangements with the governments
of Australia, Japan, the UK, and the Netherlands to ensure the stocks will be available
in an emergency and to enable the stocks to be counted towards New Zealands
IEA obligations. 260
260 See press releases by Hon. David Parker Oil Reserves Target Met, 19 December 2006,
http://www.beehive.govt.nz/release/oil+reserves+target+met and Oil Stocks Agreement Signed with
Japan, 5 November 2007, http://www.beehive.govt.nz/node/31199.
81
ap
pe
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ix
Example Tables Illustrating Exhaustible

Resource Decision Making
A
This Appendix demonstrates the results discussed in Section 3 more compre
hensively with tables.
In each table, the diagonal shows the rent (value of oil in that year per barrel minus
drilling cost per barrel) one would get that year from drilling in that year. Each cell
below the diagonal shows the value one would have in subsequent years if one
invested that rent at the assumed rate of interest. The bottom row is the key result
the value of the investment at the end of year 10 if one drilled in each year. The
optimum decision is to drill in the year that gives one the highest value in year 10.
A.1 Impact of Extraction Costs

Table A1
Initial oil price
$100/barrel
Drilling cost
$50/barrel
Annual increase in oil price
$5.00/barrel
Return on alternative investment
8.00%
Value of investment at end of year per barrel produced
Year
valued
Year of Production
1
10
50.00
54.00
55.00
58.32
59.40
60.00
62.99
64.15
64.80
65.00
68.02
69.28
69.98
70.20
70.00
73.47
74.83
75.58
75.82
75.60
75.00
79.34
80.81
81.63
81.88
81.65
81.00
80.00
85.69
87.28
88.16
88.43
88.18
87.48
86.40
85.00
92.55
94.26
95.21
95.51
95.23
94.48
93.31
91.80
90.00
10
99.95
101.80
102.83 103.15
102.85
102.04
100.78
99.14
97.20
95.00
Table A1 above corresponds to the assumptions of Section 3.3. Oil is initially priced
at $100 per barrel, and increases in price by $5 per barrel each year. There is a drilling
cost of $50 per barrel. Once one has produced the oil, the rent earns interest of 8%
per year. The table shows that one obtains the highest value at the end of Year 10
82
Appendix A Example Tables Illustrating Exhaustible Resource Decision-Making
by waiting three years and drilling in Year 4. Drill earlier than this and one loses out
because the value of the rent on oil in the ground is rising faster than 8%. Drill later
than this and one loses out because the value of the rent on oil in the ground is rising
more slowly than 8%.
A.2 Impact of Higher Extraction Costs

Table A2 below corresponds to the assumptions of Section 3.4. The assumptions
are the same as in section A.1, except this time, there is a drilling cost of $55 per barrel
instead of $50 per barrel. The table shows that one obtains the highest value at the
end of Year 10 by waiting four years (instead of three) and drilling in Year 5. Due to the
higher extraction costs, one should wait an additional year.
Table A2
Initial oil price
$100/barrel
Drilling cost
$55/barrel
$5.00/barrel
8.00%
Year
valued
Year of Production
1
10
45.00
48.60
50.00
52.49
54.00
55.00
56.69
58.32
59.40
60.00
61.22
62.99
64.15
64.80
65.00
66.12
68.02
69.28
69.98
70.20
70.00
71.41
73.47
74.83
75.58
75.82
75.60
75.00
77.12
79.34
80.81
81.63
81.88
81.65
81.00
80.00
83.29
85.69
87.28
88.16
88.43
88.18
87.48
86.40
85.00
10
89.96
92.55
94.26
95.21
95.51
95.23
94.48
93.31
91.80
90.00
A.3 Impact of Increasing Oil Price

are the same as Section A.1 except this time the oil price is assumed to escalate at a
rate of $10 per year, rather than the $5 per year originally assumed. Now, one should
wait eight years and drill in Year 9 rather than in Year 4. The more rapid expected
increase in the resource price makes holding oil in the ground more attractive relative
to other investments, and leads one to defer drilling for five extra years.
Table A3
Initial oil price
$100/barrel
Drilling cost
$50/barrel
$10.00/barrel
8.00%
Year
valued
Year of Production
1
10
50.00
54.00
60.00
58.32
64.80
70.00
62.99
69.98
75.60
80.00
68.02
75.58
81.65
86.40
90.00
73.47
81.63
88.18
93.31
97.20
100.00
79.34
88.16
95.23
100.78
104.98
108.00
110.00
85.69
95.21
102.85
108.84
113.37
116.64
118.30
120.00
92.55
102.83
111.08
117.55
122.44
125.97
128.30
129.60
130.00
10
99.95
111.06
119.97
126.95
132.24
136.05
138.57
139.97 140.40
140.00
83
84
Appendix A Example Tables Illustrating Exhaustible Resource Decision-Making
A.4 Impact of Interest Rates

are the same as Section A.1 except that a lower rate of interest on the alternative
investment of 6% instead of 8% is assumed. Now one should wait seven years and drill
in Year 8 rather than Year 4. The lower interest rate makes holding oil in the ground
more attractive relative to other investments, and leads one to defer drilling for an
extra four years.
Table A4
Initial oil price
$100/barrel
Drilling cost
$50/barrel
$5.00/barrel
6.00%
Year
valued
Year of Production
1
10
50.00
53.00
55.00
56.18
58.30
60.00
59.55
61.80
63.90
65.00
63.12
65.51
67.42
68.90
70.00
66.91
69.44
71.46
73.03
74.20
75.00
70.93
73.60
75.75
77.42
78.65
79.50
80.00
75.18
78.02
80.29
82.06
83.37
84.27
84.80
85.00
79.69
82.70
85.11
86.98
88.37
89.33
89.89
90.10
90.00
10
84.47
87.66
90.22
92.20
93.68
94.69
95.28
95.51
95.40
95.00
85
ap
pe
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ix
Glossary
B
API Gravity
A measure of the density of a hydrocarbon. Defined as:

141.5
API =
131.5
specific gravity
Barrel of Oil
42 US gallons or about 159 litres
Bbl
Barrel of oil.
Biodiesel
Diesel fuel derived from present day plant or animal sources.
Bioethanol
A form of alcohol derived from present day plant or animal

sources. May be blended in low concentrations with petrol
and used in conventional petrol vehicles, or used in higher
concentrations in especially modified petrol vehicles.
Biofuel
Usually refers to liquid fuel derived from present day plant or

animal sources, including biodiesel and bioethanol.
Biomass
Present day plant or animal matter that can be used as fuel.
Calorific Value
The energy content of a fuel can be measured as the heat

released on complete combustion. It can be expressed as
an upper (or gross) value and a lower (or net) value. The
difference between the two is the energy consumed in
evaporating the water created in the combustion process.
Cap Rock
Impermeable rock, which prevents oil from migrating further.
Carbon Capture and

Storage
A technology under which carbon dioxide is extracted from

raw natural gas or the flue gases of power plants or industrial
facilities and injected back into geological structures, such
as depleted oil and gas reservoirs, un-minable coal beds, or
deep saline aquifers.
Carbon Dioxide
CO2, a naturally occurring gas, which is also a by-product

of burning fossil fuels and biomass, as well as of land-use
changes and other industrial processes. It is the most
important of the man-made greenhouse gases.
Carbon Sequestration
Any process for removing carbon dioxide from the

atmosphere. May be natural (such as forests) or artificial
(see Carbon Capture and Storage above).
Cellulosic Biofuels
Biofuels produced from cellulose found in the stalks and

stems of most plants.
86
Appendix B Glossary
Cetane Number
A measure of the tendency of a fuel to self-ignite when

heated; an attractive characteristic for diesel fuel.
CH4
Methane. The simplest hydrocarbon and the principle

component of natural gas. Also, a greenhouse gas released
from some natural and man-made sources.
CNG
Compressed Natural Gas.
CO2
Carbon dioxide, which is the most important man-made

greenhouse gas.
Commercial
In energy statistics, the commercial sector usually includes

non-manufacturing business establishments such as
hotels, motels, restaurants, wholesale businesses, and retail
stores. It also includes health care, social, educational, and
government establishments.
Compressed Natural Gas
Or CNG. Natural gas which has been compressed, or

contained under pressure, in a small volume. CNG is used
as a fuel by some vehicles. It is also a potential competitor
to LNG as a way of shipping natural gas over relatively short
distances, such as from Australia to New Zealand.
Compression Ratio
In an internal combustion engine, the ratio of the volume of

the cylinder at the bottom of its stroke to the volume of the
cylinder at the top of its stroke.
Condensate
A liquid similar to a light crude oil that is produced in vapour

form with natural gas, and may be condensed from the gas.
Consumer Energy
Energy in the form consumed by final users. Also sometimes

known as Final Energy. Not primary energy.
Cracking
A chemical process for breaking-up heavier hydrocarbon

molecules into lighter molecules
Crude Oil
Oil as it is originally produced.
Derivative
A financial security whose value depends upon the value of

something else (such as the spot price of crude oil).
Distillation Column
A device for separating oil into its fractions by fractional

distillation; typically the first stage of a refinery.
Downstream
The transportation, refining, and marketing side of the oil

industry.
EECA
Energy Efficiency and Conservation Authority.

Seewww.eeca.govt.nz.
Efficient Market
Refers to the degree to which the market prices reflect

everything that is known. In a perfectly efficient market, it is
impossible to profit from analysis.
Elastic Demand
Refers to a situation where demand is highly responsive

to changes in price, usually either because there are other
products that are close substitutes or because the product is
not considered by buyers to be that essential.
Elasticity
A measure of the responsiveness of demand to price.

Measured as the percentage change in quantity demanded
in response to a one percent increase in price. Usually
negative in sign.
Energy Risk Management The sector of the finance industry that helps clients manage
the risk of energy price fluctuations.
Enhanced Recovery
More sophisticated techniques for improving recovery

from an oil reservoir than secondary recovery; these include
injection of steam or chemicals; also known as tertiary
recovery.
Exploration Well
A well drilled to explore for oil or gas; also known as a wildcat

well.
FAME
Fatty Acid Methyl Esters
Fatty Acid Methyl Esters
A family of biofuels made from plant or animal fat; the

scientifically correct term for biodiesel; often abbreviated
FAME.
Flaring
Burning-off gas that is produced with oil; typically done

when there is no nearby market for the gas.
Fischer-Tropsch
A well-known chemical process for synthesising liquid fuels

from gas, coal, or biomass.
Fossil Fuels
Coal, natural gas, LPG, and fuels derived from crude oil
(including petrol and diesel). They are called fossil fuels
because they have been formed over long periods of time
from ancient organic matter. Not Renewable.
Fraction
The range of compounds in crude oil that vaporise between

any two temperatures.
Fractional Distillation
The separation of oil into fractions through a distillation

process. Accomplished using a distillation column.
87
88
Appendix B Glossary
Forward Contract
A privately-arranged agreement under which a commodity

will be delivered at a future date for a predetermined price.
Futures Contract
A standardised agreement transacted on a futures market

under which a commodity (or its cash value) will be delivered
at a future date for a predetermined price.
Futures Market
An exchange where futures contracts are traded.
Gas Processing Plant
A plant for treating raw natural gas; may remove marketable

hydrocarbons like ethane and natural gas liquids, as well as
impurities such as carbon dioxide.
GJ
Gigajoules. 109 joules. A generic unit of energy. See Metric

System Multiples.
Greenhouse Gases
Atmospheric gases that increase the earths temperature

by absorbing outgoing infrared radiation from the earths
surface. Man-made greenhouse gases that have a direct
effect are carbon dioxide (CO2), methane (CH4 ) and nitrous
oxide (N2O). Indirect greenhouse gases, which react to form
direct greenhouse gases in a relatively short time, include
carbon monoxide (CO), other oxides of nitrogen (NOx),
and non-methane volatile organic compounds (NMVOCs).
Water vapour (H2O) is also a greenhouse gas, however, its
concentration in the atmosphere is naturally regulated.
Gross Energy
See Calorific Values.
Heat of Compression
Heat generated when a gas is compressed.
Heavy Hydrocarbon
Hydrocarbons composed of larger, chemically heavy,

molecules, such as coal, heavy crude oil, and heavy fuel oil.
Hedger
One who takes a position in a financial market in order to

reduce his/her risk. Not a speculator.
Hydrocarbon
In policy analysis (as opposed to chemistry) this term refers

to fossil fuels, including gas, oil, and coal. These substances
consist primarily of hydrogen and carbon.
IEA
International Energy Agency.
IEA Implementing
Agreements
An agreement among IEA member and non-member

governments and other organisations to pool resources to
foster research, development and deployment of particular
technologies.261
261 See the International Energy Agency Technology Agreements web page
http://www.iea.org/textbase/techno/index.asp
Impermeable Rock
Rock which is not permeable; that is, through which oil and
gas cannot migrate.
Inelastic Demand
Refers to a situation where demand does not respond

much to changes in price, generally because the product is
considered a necessity.
In Situ
Describes a technique for recovering a resource, such as

bitumen, without having to physically dig the resourcebearing material, such as tar sands, out of the ground.
International Energy
Agency
This IEA helps coordinate the energy policies of its member

countries. Membership consists of 26 primarily oilimporting industrialised countries including New Zealand.
Seewww.iea.org.
Kerogen
The scientifically correct name for the organic material in oil

shale from which synthetic crude oil may be produced.
Kilowatt (kW)
A unit of electrical power equal to 1000 watts. See Metric

System Units.
Kilowatt-hour (kWh)
Unit of electrical energy equal to 0.0036GJ.
Light Hydrocarbon
Hydrocarbons consisting of smaller, chemically light

molecules, such as natural gas, condensate, light crude oil,
and petrol.
Lignite
Low grade coal. Also known as soft coal or brown coal.
Liquefied Natural Gas
Or LNG. Natural gas which has been converted to a liquid

by chilling it to extremely low temperatures. Natural gas
is frequently moved by ship in the form of LNG. Not to be
confused with Natural Gas Liquids or Liquefied Petroleum Gas.
Liquefied Petroleum Gas
Or LPG. A generic name for mixtures of propane butane,

and isobutene, or pure propane. LPG is a gas at room
temperature, but is a liquid under pressure.
LNG
Liquefied Natural Gas.
LPG
Liquefied Petroleum Gas.
Margin
Collateral deposited to guarantee that a party to a financial

agreement, such as a futures contract, will meet his/her
obligations under the agreement.
Marker Crude
A type of crude oil whose spot price commonly serves as a

reference for pricing other types of crude oil.
89
90
Appendix B Glossary
Market Power
The ability of a market participant to influence the price of a

product.
Marking to Market
Settlement of any gain or loss incurred by participants in a

futures contract; generally performed daily.
MED
Ministry of Economic Development. See www.med.govt.nz.
Megawatt (MW)
One million watts. One megawatt is enough power to supply

the peak electricity needs of about 500 houses. See Metric
System Multiples.
Methane
CH4, the simplest hydrocarbon and the principle component

of natural gas. Also, a greenhouse gas released from some
natural and man-made sources.
Metric System Multiples
1,000 = 103 = kilo (k)

1,000,000 = 106 = mega (M)
1,000,000,000 = 109 = giga (G)
1,000,000,000,000 = 1012 = tera (T)
1,000,000,000,000,000 = 1015 = peta (P)
1,000,000,000,000,000,000 = 1018 = exa (E)
Metric Tonne
1000 kilograms
Migrate
Natural movement of oil through reservoir rocks away from its

source rock.
Mt
Million tonnes. See Metric Tonne and Metric System Multiples.
Natural Gas
Consists mainly of methane occurring naturally in

underground deposits.
Natural Gas Liquids
Liquids that come out of the ground in vapour form with

natural gas; may include propane, butane, and condensate.
Not to be confused with Liquefied Natural Gas.
Net Energy
Refer to calorific values.
New Zealand Refining

Company
Owner and operator of the Marsden Point Refinery.
NZES
New Zealand Energy Strategy.
NZRC
New Zealand Refining Company.
Nitrous Oxide
N2O, a greenhouse gas.
Octane Number
A measure of the tendency of a fuel to resist self-ignition

when heated; an attractive property for petrol.
OECD
Organisation for Economic Co-Operation and Development.
OPEC
Organization of the Petroleum Exporting Countries. This is an

international organisation that helps coordinate the energy
policies of its member countries. Membership consists of
Algeria, Angola, Ecuador, Indonesia, Iran, Iraq, Kuwait, Libya,
Nigeria, Qatar, Saudi Arabia, the UAE, and Venezuela. See
www.opec.org.
Option
An agreement that gives one party the right (but not the
obligation) to buy or sell a commodity at a future date for a
prearranged price.
Organisation for
Economic Co-Operation
and Development
An international organisation whose membership consists

of 30 industrialised countries including New Zealand.
Seewww.oecd.org.
OTC
Over-the-Counter
Over-the-Counter
A privately arranged financial transactionnot through a

futures market or other organised exchange.
pa
Per annum.
Permeable
A rock with well-connected pores, thus allowing a fluid, such

as oil, to migrate through it.
Plug-In Hybrid
A hybrid vehicle with an extra large battery so it can be

charged from the grid and operated entirely on battery
power when desired.
PJ
Petajoules. 1015 joules. A generic unit of energy.

Approximately:
1PJ = 278 GWh of electricity
1PJ = 44,000 tonnes of sub-bituminous coal
1PJ = 21,000 tonnes of petrol
1PJ = 26Mm3 Maui gas.
Porosity
A measure of the amount of void spaces in a rock. A rock

must be porous and permeable for oil to migrate through it.
Primary Energy
Energy as it is first obtained from natural sources. Does not

include electricity or refined petroleum products.
Reinjection
Pumping the gas that was produced with the oil back into
the reservoir to help maintain pressure and increase oil
recovery
91
92
Appendix B Glossary
Renewable
A form of energy that can be produced indefinitely without

depleting the supply. Includes hydro, wind, geothermal,
wave, tidal, and solar energy. Not Fossil Fuels.
Rent
The payment received for some asset net of its cost of

production.
Reserves-to-Production
Ratio
The ratio of proved reserves of oil to annual production of oil.

Same as R/P Ratio.
Reservoir
A subsurface pool of oil and/or gas contained in reservoir

rock.
Reservoir Rock
Porous and permeable rock through which oil and gas can
migrate.
R/P Ratio
The Reserves-to-Production Ratio.
Secondary Recovery
Initial measures to help maintain the pressure in an oil or gas

reservoir, and thereby improve recovery, typically by injecting
water. Compare to tertiary recovery.
Seep
A place where oil or gas naturally escapes to the surface of

the earth.
Seismic Survey
A technique for determining the structure of the rocks in a

particular area through analysing how they reflect sound
waves.
Sour Crude
Crude oil that is high in sulphur.
Source Rock
Rock in which oil or gas is formed.
Speculator
One who takes a position in a financial market in hopes of

profit. Not a hedger.
Spot Market
A market where a product is sold for immediate delivery.
Swap
An arrangement where the parties agree to a future

exchange of cash flows; for example, they may agree to pay
each other based on the difference in the spot price between
two types of crude oil on a certain future date.
Sweet Crude
Crude oil that is low in sulphur.
Takeback Effect
The tendency of consumers to increase their purchases

of energy when energy efficiency is improved due to the
perceived lower cost of energy services (such as kilometres
driven or warmer homes)
Metric tonne of oil (see Metric Tonne)
Tectonics
The geological process by which large scale motion of the

earths continental and oceanic plates affects the structure of
the earths crust.
Terawatt-hour (TWh)
Unit of electrical energy, equal to 1000 GWh. See Metric

System Units.
Tertiary Recovery
More sophisticated techniques than secondary recovery

for improving recovery from an oil reservoir; these include
injection of steam or chemicals; also known as enhanced
recovery.
Thermal Generation
The generation of electricity by heat, usually from burning

fossil fuels but also including geothermal generation.
Trap
A geological structure that can accumulate oil or gas.
Theory of Normal
Backwardation
A theory which argues that prices in futures markets should

be systematically low relative to ultimate spot prices.
Ultimately Recoverable
Resources
The amount of oil that it will ultimately be possible to

produce.
Upstream
The exploration, drilling, and production side of the oil

industry.
URR
Ultimately Recoverable Resources.
Water Cut
Water that is produced along with oil.
Welfare Economics
The branch of economics that studies how to maximise the

welfare of a society.
West Texas Intermediate
The most well-known grade of crude oil deliverable against

the NYMEX light sweet crude oil futures contract.
Wet Gas
Gas with a high content of Natural Gas Liquids.
Wildcat Well
A well drilled to explore for oil or gas; also known as an

exploration well.
WTI
West Texas Intermediate
93

Oil is New Zealands largest and arguably most problematic energy source.
Policies related to oil have wide impacts, including those on the economy,
the environment, consumers, foreign affairs, and transport planning.
Because of their wide impact, issues related to oil frequently attract
great public interest and, sometimes, contentious debate. Yet oil is also a
sophisticated industry, and to usefully contribute to the dialogue requires
a certain level of technological, economic, and institutional knowledge
that can appear daunting to the newcomer.
Oil: An Introduction for New Zealanders is designed to provide an
easy-to-read background briefing for anyone who will be dealing with oilrelated policy issues. These include elected officials, business leaders, nongovernmental organisation leaders, researchers, students, and concerned
citizens. The book does not attempt to analyse any policy issues, but
rather to provide basic information that will be useful to anyone who
does.
Topics covered include oil production and refining technology; the
uncertainties surrounding statistics on world oil reserves and resources;
the management of New Zealands own oil resources; the structure and
regulation of New Zealands oil industry; and New Zealands involvement
with international efforts to promote oil security. A chapter on Oil and
Financial Markets focuses on the question of whetherquotes from futures
marketsprovide a good means to predict the future price of oil. A chapter
on The Economics of Exhaustible Resources focuses on the question of
whether government intervention in the oil market can be justified on the
basis that oil is an exhaustible resource.
Ralph D. Samuelson is Chief Advisor Energy Modelling at the
NewZealand Ministry of Economic Development. He holds a Ph.D. in
Engineering-Economic Systems from Stanford University and has over 20
years experience with energy as a government official and consultant.
ISBN 978-0-478-31670-4 (paper)
ISBN 978-0-478-31671-1 (PDF)
ISBN 978-0-478-31672-8 (HTML)

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Oil

An Introduction for New Zealanders

1 The Fundamentals of Oil

2 World Oil Resources

3 Exhaustible Resource Economics

4 Oil and Financial Markets

5 New Zealands Oil Industry

6 Oil: The Consumer Side

7 Oil Security and the International Energy Agency

Appendix A Example Tables Illustrating Exhaustible Resource

Available for download at http://www.med.govt.nz/energy/eo/2006/

The Fundamentals of Oil

1.1 The Chemistry of Oil

Chapter 1 The Fundamentals of Oil