This is a guest post from Ed Rempel (CFP and CMA). For those of you joining us recently, Ed has written a number of controversial articles for MDJ in the past. Today’s article is about a hot topic in everyone’s life, the price of oil and the peak oil argument. This is part 1 of 2.
“No one goes there anymore – it’s too crowded.” – Yogi Berra
Tired of high gas prices? They have risen sharply because oil prices have shot up from $10/barrel in 1990 to $20/barrel in 2002 to $60/barrel in 2005 and now to $145/barrel in 2008. Is this just a temporary spike or just the beginning of a much larger rise in gas prices?
The most significant investment issue now is this big debate – is the huge rise in oil the beginning of a new reality or is it this decade’s version of the tech bubble? Which investments we would want to hold will be very different depending on which of these is true.
It is impossible to know for sure whether or not this is Peak Oil or an oil bubble, since the oil reserves claimed by many of the largest oil producing countries, especially OPEC countries in the Middle East, are widely considered to be unreliable and politically motivated.
Before you answer – let me say there are quite a few very smart people on both sides of this argument. Here are the arguments for both sides. Which do you believe?
The theory of Peak oil states that when you have taken out half the oil from an oil deposit, then the rate at which you withdraw it peaks and only declines after that. It was discovered by King Hubbard and accurately predicted in 1956 that the peak of oil production in the US would happen by 1970. Since then, many other countries have hit their peak production.
If we are at Peak Oil, then we will still have oil for about 100 years, but the amount we can produce each year will decline. If demand continues to climb at the same time, then today’s sky-high price of oil – and gas at the pumps – is only in the early stages of a permanent rise.
The peak of oil is probably inevitable, but the big question is when. I read 2 in-depth books on this about 5 years ago (including “Out of Gas: The End of the Age of Oil” by David Goodstein) and the debate among oil experts was whether we were 10 years or 40 years from the peak. The Association for the Study of Peak Oil and Gas (ASPO) predicts it will happen in 2010, while Cambridge Energy Research Associates (CERA) predicts that we are at least several decades away.
Oil price increases in the past have lasted only a few years, followed by a crash. The recent spike in oil prices is unusual, though, because it is the first not caused primarily by a disruption in supply. Unlike the Arab Oil Embargo of 1973-1974, the Iranian Revolution of 1979 and the Gulf War of 1990-1991, the rise in oil prices from 2002 to the present primarily has been driven by growth in world demand, especially from China and India.
Arguments in favour of Peak Oil:
- Peak Oil is inevitable, since oil was created millions of years ago and there is a finite quantity. Whatever amount of oil exists is all we have, since making new oil would take millions of years.
- World oil production is declining by about 4% per year, since many existing oil fields have reached their peak. If conventional oil production is roughly 85 million barrels per day, then the first 3.4 million barrels of new daily production every year only serves to offset declines in existing fields.
- New discoveries are increasingly rare and small. In the 1960s it was not uncommon to find 40 to 50 billion barrels per year of new oil reserves. Now, 10 to 15 billion barrels is considered a more typical exploration year.
- New discoveries are from sources that are more much costly or environmentally unpopular, such as the tar sands and off-shore. Barrack Obama has said he may ban oil from the tar sands for environmental reasons and environmentalists claim that off-shore drilling would threaten ocean species.
- Oil-producing countries seem unable to increase production. They claim they are trying to increase production, but so far they have been unable to do it.
- Emerging markets demand growth is very strong, especially in China. In the last five years, yearly oil consumption in China has grown from 1.88 billion barrels to 2.80 billion, an increase of 920 million barrels a year, or about 37% of the total increase in world consumption over that time frame. China is obviously at a stage of its economic development where its thirst for oil is growing rapidly. India is following, and there is a long list of future emerging markets countries where development (and therefore oil demand) may take off in the coming years.
- Oil price subsidies in many countries can help maintain this demand. The Chinese government also has been subsidizing oil prices, thus muting the effect of higher prices on Chinese consumers. Fuel subsidies, in fact, are widespread in emerging market nations. Morgan Stanley estimates that half the world’s population enjoys fuel subsidies, as almost a quarter of the world’s gasoline is sold at less than market prices. The cheapest gasoline is in Venezuela, at five cents per liter. Until very recently, Chinese motorists paid $0.79 per liter.
- Governments have not responded either because they are “leaving it to the market” or are unable to do anything. The theory is that market prices will increase oil prices, which will result in alternative energies becoming profitable. However, the development of mass alternative energy sources will likely take years. Oil is a globally traded commodity, so individual country governments may not be able to do anything.
- Oil industry analysts are just being conservative about long term prices when they assume $80-90/barrel when valuing oil companies. They have historically been slow to change their underlying assumptions.
- Many investment experts believe in Peak Oil. Proponents of Peak Oil include Jeff Rubin (economist from CIBC who is predicting $200/barrel oil by 2012, possibly by 2009) and Eric Sprott (hedge fund manager that believes we are going back to 90% of our population being farmers with horses and plows by 2200).
Stay tuned, Ed Rempel will be back for tomorrows post regarding the oil bubble argument. The peak oil argument looks fairly convincing. What are your thoughts on the peak oil theory?