Are high oil prices here to stay ?

by John Quiggin on May 7, 2004

Paul Krugman has a piece on oil. This is as good a time as any to put up a long post I’ve been working on about oil and whether it’s finally going to run short, points on which I broadly agree with Krugman.

Will the oil run out ?

Oil is the paradigm example of an exhaustible resource (there’s a charming, but apparently false, belief that oil comes from decayed dinosaurs) Whenever the price of oil rises sharply then, it is natural to ask whether this is a mere market fluctuation or an indication of the impending exhaustion of the resource.

A couple of points of clarification are necessary before we come on to the main issues. First, the price of oil is typically quoted in $US/barrel, for some specific grade of oil such as West Texas light sweet crude. This need not be an accurate indicator of the cost of oil in general, because of variations in the purchasing power of the US dollar and because the relative prices of different types of oil fluctuate. The current upsurge in prices is due in part to the devaluation of the dollar against other major currencies and also in part to a particular shortage of the light grades of oil most suitable for producing petrol.

Second, oil will never simply ‘run out’. As the supply of any commodity declines, prices increase and, for relatively low-value uses, the costs exceed the benefits. Where they are available, low-cost substitutes become more attractive. Before the 1973 increase in prices, oil was commonly used as fuel in electricity generation and home heating. Following the increase in prices, most oil-fired power stations were converted to gas or coal. Where natural gas was readily available, the same was true of home heating. The relevant question then, is not whether oil will run out, but whether it will become so scarce as to be uneconomic in its main uses, the most important of which is as fuel for motor vehicles.

Jevons and Hubbert

Critics of predictions of resource exhaustion have plenty of history on their side. In the 19th century, the eminent economist W.S. Jevons predicted the imminent exhaustion of reserves of coal. He was wrong, as were a series of subsequent prophets of resource exhaustion, most notably Paul Ehrlich and the Club of Rome in the 1970s. Time after time, scarcity has been met by new discoveries and by improvements in resource technologies that have made it economic to extract resources from sources that were once considered valueless. In the case of oil, the estimate of ‘proven’ reserves in 1973 was 577 billion barrels. The Club of Rome pointed out that given projections of growing use, reserves would be exhausted by the 1990s. The economic slowdown from the 1970s onwards meant that the actual rate of growth was slower. Nevertheless, between 1973 and 1996, total usage was around 500 billion barrels. Yet at the end of the period, estimated reserves had actually grown to over 1000 billion barrels.

This is a pattern that has been repeated for many other commodities, and should give pause to any advocate of the exhaustion hypothesis. Nearly all the additional reserves came from upward revisions of estimates of reserves in existing fields. (This is seen by optimists as reflecting technological gains, allowing more secondary extraction, and by pessimists as reflecting a shift from conservatism to (excessive?) optimism in estimation procedures).

Believers in the exhaustion of oil reserves have some history on their side too. Their key exhibit is the Hubbert curve which is supposed to show that oil output from a field should peak about 25 years after discovery. If you buy this story, oil output should have passed its peak a year to two ago. The big success for the Hubbert curve was Hubbert’s 1956 prediction of the peak in US oil output around 1970.

The current period of high prices and short supply gives some support to advocates of the Hubbert Curve. The really striking events however, have been those relating to reserves. For the first time, downward revisions to estimated reserves have become commonplace. The Shell company has been the most notably affected so far, being forced to announce a series of downward revisions in estimated reserves, apparently because of problems with Nigerian fields. But there have also been suggestions of similar problems many other oil-producing countries, either because reserves have been overstated for political reasons, or because fields have been mismanaged.

Of course, some fields are still expanding. For example, new leases are being issued for deep water prospects in the Gulf of Mexico. But the very fact that such marginal prospects are being explored is an indicator that oil companies expect high prices to persist.

On balance, I think that current high prices are likely to persist and to rise over time.

What does it matter?

Oil looms large in many geopolitical discussions. While claims that the Iraq war was ‘all about oil’ are unduly conspiratorial, it seems clear that, if it were not for the presence of oil, the Middle East would not be a central focus of US foreign policy. The 1973 OPEC ‘oil shock’ (an embargo imposed in protest against US support for Israel, followed by a quadrupling of prices) was widely blamed for the stagflationary recession of the 1970s, and was seen as indicating the strategic vulnerability of the West to attacks on its supply of oil.

Most of this is and was an illusion. In reality, the oil shock was a consequence rather than a cause of the collapse of the postwar economic order based on the Bretton Woods system of fixed exchange rates. A central element of that system, the convertibility of the $US into gold at the fixed price of $3835/oz had been rendered unsustainable by inflation, and had been abandoned in the early 1970s, beginning with the Smithsonian agreement of 1971. Increases in the price of other commodities, including oil, were an inevitable consequence. The price of wool, for example, had doubled before anyone outside the oil industry heard of OPEC.

Similar points apply to the supposed vulnerability of the West to the cutting off of oil supplies. An embargo similar to that imposed by OPEC in 1973 might necessitate some form of rationing, but this is scarcely the ‘moral equivalent of war’. It makes no sense to maintain military preparations for a possibility that could be dealt with by reducing consumption.

Still the fact that such things make no sense doesn’t mean they won’t happen. Permanently high gasoline prices will be a big psychological shock for US consumers and could produce some irrational responses, such as a desire to invade Middle Eastern countries.

{ 40 comments }

1

tombo 05.07.04 at 10:53 pm

A lame piece in which a leading trade economist merely summarizes comments from a field outside his expertise with “on the one hand” and “on the other hand”. The net of which is that Krugman, like most, has no clue as to where oil prices will be in the near or long term and has no grasp of the relative importance or bearing on same of the various factors he discusses.

Krugman mentions Shell’s downward revision of reserve estimates but fails to mention that oil experts are now increasing their estimates of Russia’s reserves.

He thinks it cute to include as a parting shot the old leftist canard that the US Iraq war was in pursuit of oil. Apparently his editor decided to chop the next sentence, which no doubt was, “Of course, this theory is absurd to anyone who understands anything about the oil industry, whose leading executives were uniform in their expressed desire to DO BUSINESS WITH SADDAM, not overthrow him.”

Nonetheless, Krugman’s little theory does explain the impending US invasion of Venezuela.

2

Pradeep 05.07.04 at 11:10 pm

tombo–I don’t see a reference to Shell in Krugman’s piece. Did you read it?

3

tombo 05.07.04 at 11:43 pm

“The Shell company has been the most notably affected so far, being forced to announce a series of downward revisions in estimated reserves…”

4

tombo 05.07.04 at 11:44 pm

Ctrl + F for “find” function, pradesh. Let me know if I can help further.

Rgds,
Tombo

5

John Quiggin 05.07.04 at 11:55 pm

Tombo, you seem to have mixed up my piece (which contains the reference to Shell) with Krugman’s.

6

"Pradesh" 05.07.04 at 11:55 pm

tombo–Not to be a stickler, but that’s not from Krugman’s piece. . .

7

John Quiggin 05.08.04 at 12:09 am

Not only that, but you seem to have missed the observation “claims that the Iraq war was ‘all about oil’ are unduly conspiratorial”.

It might be an idea to read properly first, before you comment, especially if you are going to adopt the kind of tone you have so far.

8

Anno-nymous 05.08.04 at 12:12 am

John Quiggin: Tombo, you seem to have mixed up my piece (which contains the reference to Shell) with Krugman’s.

Now that’s what I call a compliment!

9

asdf 05.08.04 at 12:15 am

Well, count one Paul Wolfowitz as one of those wacky conspiracy theorists who believes it’s important for the United States to maintain a strategic presence in the Persian Gulf in order to prevent the Chinese from doing so.

10

tombo 05.08.04 at 12:24 am

Fair enough, gents.

But let’s be clear about some future US “desire to invade Middle Eastern countries.”

If the US were to seize control of foreign oil reserves, would it not be vastly easier to do so in our own backyard by knocking off a tinpot dictator such as Chavez? Venezuela’s reserves place it among the ten most oil-rich in the world.

A more pertinent point is that the House of Saud has such a weak grasp over its subjects, and such limited ability to protect its oil production facilities, that there is a very high likelihood that much Saudi production in the near future may be suspended or eliminated outright by one or more terrorist attacks.

Any discussion of oil supply and oil prices should reference this fact and address the issue of when it will become necessary to place Saudi reserves and production facilities under international control.

Or perhaps you’d like us to move our troops and Central Command back from Qatar to Saudi?

11

liberal japonicus 05.08.04 at 12:39 am

Shorter Tombo
Krugman (or Quiggin, these guys all sound alike) says we can’t conquer our way out of the oil problem, but what about invading Venezuela or engineering a takeover of the Saudi ruling class?

12

bob mcmanus 05.08.04 at 12:39 am

“Or perhaps you’d like us to move our troops and Central Command back from Qatar to Saudi?”

Yup

13

robbo 05.08.04 at 1:23 am

Nice piece, John.

…would it not be vastly easier to do so in our own backyard by knocking off a tinpot dictator such as Chavez?

The US Govt. is, on some level, constantly refining its geopolitical targets and goals. Had South American rebels exploded a dirty bomb in Dallas I don’t think it’s far-fetched to speculate on how that might have been turned into an opportunity to occupy Venezuela (no more far-fetched than our present actions in Iraq). Also, the presence of Israel in the Middle Esat figures prominently into American calculus with regard to our policies in that region.

Shorter me: Just because we haven’t taken over everything yet doesn’t mean we don’t intend to, eventually!

14

Matt 05.08.04 at 1:43 am

Well, the US was knee-deep in the attempted coup against Chavez a year or so ago back, happily announcing our support for the coup party before having to take it all back, and supporting it all through a bunch of CIA front NGO’s. So, it’s not so far fetched to think we’re after Chavez, too.

15

Phill 05.08.04 at 3:02 am

Krugman’s main point was that increased competition with China was causing a squeeze on supplies.

There is no way to get an accurate assement of oil reserves on a global scale because the people who know have a big incentive not to tell. The UK has a policy of matching its production of oil to roughly balance consumption. Outside the UK govt. nobody really knows what the reserves are – the Forties field may be declining in output, but there are many blocks that have not been drilled.

I would guess that pretty much every country with oil follows the same policy. The Arab monarchies have a vested interest in pumping as much oil and salting the profits away in swiss accounts as they can before the revolution.

But even though the experts can’t tell you what the real reserves are Krugman is completely right in predicting that world oil output is not going to climb to meet demand.

16

derrida derider 05.08.04 at 3:45 am

I think you have to distinguish between unstable oil prices, due to political developments in low cost producing countries, and gradually rising oil prices as low cost reserves are exhausted. The former is a real worry and is, along with the environmental costs, a good reason to try and reduce our dependence on oil.

But it’s quite different in effects from exhaustion of reserves. For a start, as low cost reservoirs are exhausted then you’d expect to enter a more elastic portion of the long run supply curve, as it becomes progressively more and more worthwhile to find and exploit marginal sources. It would not be long after this before you reach a region where the supply curve again becomes flat – because it is worth exploiting the world’s truly massive reserves of shale oil (yes, I know this is environmentally problematic but we’re talking about the economics of it here).

All of this suggests that we’re unlikely to have sudden price transitions due to reserve exhaustion (indeed the increasing irrelevance of the ME reserves suggests instability might lessen). And capitalist economies have no problems at all adapting to gradual input price changes.

Reserve exhaustion does not therefore need much in the way of a policy response. We should focus instead on the geopolitical and environmental consequences of our oil addiction.

17

asdf 05.08.04 at 3:47 am

Oil reserves estimates are approximately as follows:
Saudi Arabia: 25%
Iraq: 11%
United Arab Emirates: 10%
Kuwait: 10%
Iran: 9%
Venezuela: 8%
Which means two-thirds (65%) of the estimated oil in the world located in the Muslim Middle East, and 8% in Christian Venezuela.
Evidence exists of foreign interference in South American politics, however complete control over South America without any control in the Middle East would leave us having to deal with Arabs around the negotiating table rather than on the battlefield.

18

John Quiggin 05.08.04 at 4:02 am

As has been said by others “shale oil is the fuel of the future and always will be”. Although there are all sorts of estimates out there, my guess is that large-scale shale projects won’t work with prices less than $US50/barrel. Coal-to-oil probably becomes feasible somewhere in the same price range.

19

Shelby 05.08.04 at 6:08 am

Via Donald Luskin’s site (yes, I know…) two links to recent articles announcing significant reserve increases. (Luskin bashes Krugman, of course, but doesn’t address his China thesis.)

http://www.arabnews.com/?page=6&section=0&article=44011&d=29&m=4&y=2004
http://www.mosnews.com/money/2004/04/30/oilreserves.shtml

By the way, what’s the status of the Russian theory that oil is a geological, not biological, phenomenon? (That is, not produced by the decay of organisms.)

20

wcw 05.08.04 at 7:23 am

The Saudis did raise their official reserves by a large factor, but there is a reason this was not above-the-fold news: Aramco is famously opaque, and nobody quite trusts them. About all the detail Al-Naimi gives is, “[w]e are continuing to discover new resources, and we are using new technologies to extract even more oil from existing reserves.”

As for alternate sources, like shales and tars, it’s been a while since I checked, but I thought the issue was less economics and more BTUs: can you now get more BTUs out than you put in to turn them into fuel? I had thought not, or not yet. Also, fwiw I generally thought the whole oil-is-a-geologic-process hypothesis was the discredited domain of crackpots, but I’m open to being convinced otherwise by actual science.

In the end, though, unless you’re a speculator (buy gasoline, short bonds, says the little red hen) it shouldn’t be a big economic issue. Price signals work, and scarcity will lead to higher prices will lead to substitution and conservation and, dare I say it, nukes. Waste is an icky issue, but at high energy prices nukes are economic and don’t soil the air like coal.

21

crayz 05.08.04 at 7:54 am

I’m not generally given over to chicken-little style warnings of the apocalypse, but after reading this site, I certainly find myself a bit worried

22

brown 05.08.04 at 9:05 am

Crayz: This guy is a self-publicizing nutter.

Excerpt:

“[insert here] will likely spell the end of America, the end of the industrialized world, and the end of many, many, lives all around the globe if we don’t start taking massive, sustained, and unprecedented action right now.”

Select which option to insert:

[] = Superviruses
[] = Zionism
[] = Islam
[] = Multiracialism
[] = Peak Oil
[] = Nuclear Weapons
[] = UFO invasions
[] = Genetic Modification

23

crayz 05.08.04 at 9:54 am

brown – You may be right, but does that make him wrong? There seem to be a fair amount of respectable people agreeing with him, or at least half-agreeing with him. And you don’t exactly need to believe in the full-fledged end of the world scenario to see that we’re accelerating towards a nice thick brick wall.

The basic idea is:
1) oil is a non-renewable resource
2) we’re well into the period of diminishing returns, and fast approaching a day when there’s very little oil left to get from the ground
3) our entire society depends on oil. not just energy production and transportation, but many other industries like industrial agriculture, etc.
4) we have no replacement for oil, and without oil our planet cannot sustain the number of people that currently live on it

If you accept all this, things look pretty bleak. If you don’t, I’d like to hear which you don’t. Because, really, I’d be quite happy to know that we’re not in for some Max Max type future.

24

brown 05.08.04 at 12:16 pm

123 basically true 4 yes and no.

See “wcw” above for a start.

On prices and substitution:
Essentially, the higher the price is, the more we can spend getting it out the ground, so effectively supply goes up. There is a lot of wastage in drilling of oil too. Oil has no direct substitute, but many of its uses have alternatives. If you set the oil price at 100 dollars a barrel tomorrow, you will see a reduction in wastage, expensive fields will become economic and substitutes will be used where required.

Another way of looking at it is to look at the percent of spending oil takes up of the world economy…If it was currently 1 trillion dollars a year, and this cost jumps to 2 trillion for half the quantity, this would be very painful, but not “the end of the industrialized world” – it would cause few stockmarket re-alignments though!
Make sense?

25

gavin 05.08.04 at 1:30 pm

A small quibble: The dollar price of gold through the Bretton Woods era was $35 per oz, rising to $38 after the Smithsonian agreement in Decemeber 1971 and then to $42.22 in February 1973.

26

Dean Jens 05.08.04 at 11:13 pm

I’m increasingly thinking that prices are going to stay high, that OPEC has no control over them, and any efforts OPEC makes to attract blame for them is intended to sustain political importance.

Though I could be wrong.

27

David Sucher 05.08.04 at 11:18 pm

Don’t forget to put Canada on the list of nations which we might invade, as it too has significant oil.

28

tombo 05.09.04 at 3:18 am

Don’t forget those massive oil reserves in Bosnia and Somalia. And that crucial Afghan pipeline that will carry one-third of the world’s oil production within ten years.

29

Lance Boyle 05.09.04 at 7:03 am

380+ million gallons of gasoline.
In the US.
A day.
Imagine what that would look, feel, and smell like, if you did it all in one spot, instead of spread out over the continental US.
People that talk about the use of gasoline as though they were speaking of some sensible human practice seem really bizarre.

30

Warren 05.09.04 at 7:25 am

If the US invaded Iraq “Because of the Oil”, then the US would have invaded Saudi Arabia first, it has more oil.

31

crayz 05.09.04 at 7:40 am

brown – you may be right
warren – your antithesis to logic makes my brain hurt

32

Jack 05.09.04 at 8:01 pm

brown: I’m sure that if the price of oil were to rise gradually we would slow down our usage, find substitutes etc. What is less clear to me is the extent to which oil prices are determined by market forces. For example I would expect the price of any finite asset to be sensitive to falling interest rates as consumption preferences switch to the future. It is not clear to me that this happens.

It seems entirely possible that prices are in fact under political control and therefore that it is possible that our heads are in the sand on this issue. It certainly would be painful now if energy costs were to rise to the equivalent of say $100 a barrel. Wider and cheaper access to energy has been a major part of industrial development and it must be big news if the trend reverses.

This relates to Krugman’s point about the coming struggle for resources. While the war in Iraq may not have been at the behest of the oil companies and it may not have been directly to get US hands on Iraqi oil (it would have been cheaper to buy it surely) it would be bizarre to think that it wasn’t a consideration.

Firstly US troops have, as bin Laden requested, withdrawn from Saudi Arabia. Allowing Saudi, Iraq and then, no doubt after much bloodshed, Iran to fall into the hands of Al Qaeda or even Saddam really would be a disaster. I’m prepared to entertain criticism of the efficacy of measures actually taken but I certainly hope someone is thinking about the oil.

Secondly it can be about oil even if oil companies didn’t want it. Oil companies are used to dealling with regimes of dubious virtue and may have a relatively short term view of the situation which one hopes contrasts with a longer term view from policy wonks and sometimes politicians.

Thirdly Krugman doesn’t actually say it is about the oil, he just quotes a major figure expressing hopes that it will cut the oil price. That for some reason being a good thing. He chose Rupert Murdoch but he could have chosen Steven den Beste or many other figures hoping for this side effect.

Fourthly, most “its about the oil” arguments are normally why Iraq and not Sudan or Uzbekistan or Myanmar or North Korea type rather than accusations of naked land grabs. There have been interventions that clearly have not been about the war. Afghanistan is probably the best example, Bosnia was too small, Somalia too short lived to even begin to compare to the commitment in Iraq and in any case happened under a previous regime.

33

Thomas 05.09.04 at 8:31 pm

David makes what might be thought a humorous point–that Canada should be considered a candidate for invasion, as it has substantial oil reserves.

I don’t think that a change in Canada’s borders counts as farfetched. In fact, I expect that the oil-rich provinces will join the US within a generation. But I think that majorities will freely choose that path, so invasion won’t be necessary.

34

brown 05.09.04 at 11:43 pm

Jack-
My original post was disputing the proposition that the reduction in oil reserves would lead to a collapse of society, which is alarmist nonsense. However, it doesn’t mean that oil is not an important issue (just not life-threatening).

You covered two very interesting questions:
1. What determines the price of oil?
2. Did Iraq’s proximity to oil fields affect the decision to occupy Iraq?

We could write a book on each question, and I am not sure all the issues can be covered in a blog.

1. What determines the price of oil?
A lot of factors, some short term. Whether political or economic demand/supply factors are involved, it should be noted that in the last 7 years there have been extremely wide swings in the price of oil (maximum 40USD, minimum 15USD). The major problem with this instability is that it increases risk, which increases (risk premium) the price of large energy projects.
It is also clear that _speculators_ have a role, although it is not clear how much.
Demand is a factor: the future we can definitely say will be “interesting” – let us suppose that China doubles its consumption of oil to 10 mbd this would add an additional 5mbd demand increasing total world imports by more than 10%, which is going to directly feed into the profits of the oil exporting nations: Saudi, Russia, Norway, UAE, Nigeria, Mexico, Iraq, Libya, Algeria, Oman, Canada. (Maybe it is not surprising Mexico opposed the US occupation of an oil exporting nation!). Also note that the oil price now may _seem_ high, but 40 dollars a barrel now is a lot less painful than it was in 1980, any sensible economic plan should include measures to deal with a 100 dollar price. Also, look at the innovations in energy saving that have been made in the last 30 years, so it is possible now that many economies will cope better now with an oil price crisis that they did in the 1970s.

2. Did Iraq’s proximity to oil fields affect the US decision to occupy Iraq?
Iran/Iraq and the ME is mainly of interest because of the oil (it is not the rocky deserts, melons or mosques). Since the 1970s the possibility has existed that Muslim oil nations could agree to stop selling oil to the USA until the Israeli state was dismantled, or reduced to the pre-1967 borders. With this in mind, and the loss of support from Saudi Arabia and Iran over the last 30 years would mean that the creation of a pro-US regime in Iraq could assist in the breaking of any future oil cartel.
With this in mind, a pro-US Iraqi government would be a great help to the US but who knows what goes on in the great minds that formulate policy?

35

tombo 05.10.04 at 5:09 am

My views on “the Iraq War was all about oil” have been misunderstood. Of course it was about oil… for France and Russia. Saddam was by far their best and most lucrative client in the middle east, and the lucre was kicked back in several cases directly to top French and Russian politicians.

LUKoil signed deals worth billions with Saddam, who had stiffed the Soviet Union’s successor state for many billions more. TotalFinaElf, thanks to intervention by Saddam’s old copain, Jacques C. and his boy wonder in the Quai d’Orsay, scored an eleventh-hour deal in Nov 2002 to develop the W. Qurna oilfields, which alone contain about one-third of Iraq’s ENTIRE RESERVES (20B, if memory serves). How many billions was that deal worth? Note also that a billion to the French has about eight times the proportional economic impact on them than it would on the US. For Russia, an economic midget, the ten billion+ they hoped to pimp out of Saddam amounted to about 3% of their entire economy.

In short, the French and Russian policy toward Saddam–ie, sign deals, launder money for him, accept personal kickbacks totaling many millions, all while Oil-for-Fraud enabled Saddam to starve and slaughter thousands every month–was truly an oil-centric policy.

Leftists got the rap correct–it was indeed all about oil; they just got the wrong perp.

36

derrida derider 05.10.04 at 11:16 am

my guess is that large-scale shale projects won’t work with prices less than $US50/barrel. Coal-to-oil probably becomes feasible somewhere in the same price range. – john quiggin

Grist for my mill. Oil prices touched $40 a barrel today. If oil reserve exhaustion causes a slow 25% increase from there I can’t see how that would be catastrophic. Even a fast increase to a sustained $50 might bring a nasty recession but would not be much of a long-run problem.

37

Nat Whilk 05.10.04 at 5:30 pm

Lance Boyle wrote:

“380+ million gallons of gasoline.
In the US.
A day.
Imagine what that would look, feel, and smell like, if you did it all in one spot, instead of spread out over the continental US. People that talk about the use of gasoline as though they were speaking of some sensible human practice seem really bizarre.”

It seems like the same logic would reveal that excreting isn’t a sensible human practice.

38

David 05.10.04 at 10:18 pm

It has to be remembered that oil extraction cannot be considered purely on an economic basis. Just because oil prices rise it does not mean that it is possible to extract oil from more marginal sources. It takes ENERGY to extract oil. If there is a net energy loss required in the utilization of a resource than that resource will not be used. So even if oil hits $200 a barrel then there are still resources which can never be utilized because they would be an energy sink.

39

John Quiggin 05.10.04 at 11:10 pm

gavin, thanks for your quibble, which I have now attended to.

40

shelby 05.11.04 at 12:37 am

David:

To an extent it’s true that “If there is a net energy loss required in the utilization of a resource than that resource will not be used,” but not as true as it used to be.

Increasingly oil is used (certainly in the US, I think elsewhere as well) for internal combustion engines. Cars and trucks are not easily converted to fuels other than gasoline and diesel, compared to (eg) house and office furnaces that burn heating oil. Even if it takes more energy to extract oil than the oil itself yields, oil’s greater utility in vehicles (and perhaps some other applications) will still mean it makes economic sense to extract it.

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