Tuesday, August 21, 2007

Energy Markets, Peak Oil...a Balanced View

I feel a bit vindicated today by the fact that oil settled below $70/bbl. As you may know, I've predicted (Mar, 2007) that real oil prices will remain in the $50-75 range. Then, in July, when prices spiked above $75 for a few days and many experts, as well as over 65% of Yahoo Finance respondents, expected oil to quickly top $80, I predicted (July, 2007) that the next stop would be $70.

Vindication on one level, perhaps, but a lot has happened since those articles that bears discussion. Foremost among these were release of second quarter results by the major oil companies. The ink around these centered mostly on slightly lower, but still near record, profits. But, digging just a bit deeper, I noticed what I think are much more important trends:
  • Consistently declining production, for both the quarter and year-over-year.
  • The Companies consistently failed to discover oil equal to their production.
  • For the first time, most companies began projecting declining production for the next few years.

All this despite a couple of years of relatively high oil prices. At the same time, I began taking notice of the website of Cobalt International Energy ( http://www.cobaltintl.com/ ). This is a company recently founded by an old friend, Joe Bryant, focused on energy exploration. An industry presentation shown there is entitled "We're Not Running Out Yet", but nonetheless seems to paint a picture of a world near peak oil production.

All this is not conclusive proof, of course. Many smaller oil companies have been increasing production and replacing reserves and some reserves and production opportunities have been migrating from major international oil companies to state owned oil companies, where information is less reliable and transparent. I briefly mentioned the possibility of peak oil arriving soon in a few previous articles, but the combination of these events convince me that we are either past, or very near peak oil.

So, another bold prediction. We are essentially at peak oil production. Many have beaten me to this conclusion, of course, but the debate has been characterized by extreme views on both sides. I hope to contribute a more balanced analysis.

The conclusion, of course, is complex and inexact. Geopolitical events or market conditions could easily move the exact peak by a few years either way. My conclusion that we are there is based on my expectation of energy prices. That could be seen as a copout, since it is relatively easy to project peak oil if you know market prices. But my expectations (Mar, 2007) are built on an analysis of events largely independent of oil supply, so I believe they serve as a reasonable foundation.

Beyond the exact timing, the effects of peak oil are greatly influenced by the sharpness of the peak. Many alarmists project a relatively sharp peak, and consequently, inability of conservation and alternative sources to make up any deficit. I expect a relatively flat peak, with declines averaging 1-3% over the next several years. This is consistent with the evidence for the last few years, as well as the general bell shape theory that most prognosticators use. The same theory implies greater declines later, but the several years of slow declines gives ample time for alternatives to react to market forces. Unlike most Peak Oil theorists, I do not advocate draconian government mandates or guilt-trip driven cultural pressure. Given the gradual nature of the decline and current prices which economically justify numerous conservation measures and alternative supplies, I have confidence that normal market forces will drive the appropriate responses.

All this leads to the obvious question, what you should do if you buy into my conclusions, so let me take a stab at that, keeping in mind that I'm still wrestling with the question myself.

First, I'd take a long look at your energy consumption, identifying investment opportunities for reducing your energy use. I believe that most people are sitting on investment opportunities significantly better than what they can currently expect for their stocks, bonds or CDs. If you are unable to evaluate these on your own, you might consider an energy audit or more study of this and other energy blogs. This, I believe, offers the greatest opportunity for you to mitigate the effects of peak oil, while improving the performance of your investment portfolio. And, if you are a global warming believer, the same applies to reducing your carbon footprint. We're talking programable thermostats, compact flourescent bulbs, insulation, more efficient appliances, air conditioning and heating.

Second, I'd look at investments in coal and clean coal technologies. Coal is the least expensive, most readily available alternative energy source. This, along with environmental concerns, will drive development of cleaner ways to use coal.

Third, look at investments in alternative energy. Wind is currently the most cost effective renewable energy source, generally less expensive than oil or gas generated power. Solar thermal is also competitive with oil and gas, whether you are talking large power generating plants or small local water heating. If you can identify the survivors, solar power may eventually be competitive. While this is not true today, technology could change this in the future. Meanwhile, be cautious, since there are many recent startups in solar photovoltaics that likely will not survive the transition from fad to serious competitor.

Fourth, look at investments in natural gas. Gas is several years from peak world production and is cheaper than oil, as well as more environmentally friendly. It is, unfortunately, limited by transportation issues, but where these can be overcome gas can be a good investment.

What about major oil companies? Since most seem to be priced for lower oil prices, and oil and gas will continue to be the largest component of energy supply for many years, I believe they will be good investments for years to come. Even so, they could eventually become dinosaurs unless they can make the transition to other energy sources. I'd lean toward those who have substantial natural gas and are planning a transition to other sources, as several are.

I could go on, but I didn't intend to write a book. My main point is that I believe, in history, peak oil will be viewed as more of an opportunity than a crisis. I hope to be able to help identify and promote those opportunities. I'd like to see your comments and suggestions.


Jon said...

As the price of oil goes up and alternative (and hopefully cleaner) sources of energy become more cost effective, research in the alternative energies will spike. Since we are at a relatively young age for most of these technologies, I expect to see relatively large increases in the cost effectiveness of these technologies as more money is pumped into the research. While these gains will slow down in the long run, I do not expect a crisis.

max said...


Good point. No doubt alternative sources of energy will eventually replace oil, and as you point out, perhaps they will become more cost effective and cleaner than the current sources.

Whether a crisis occurs, though, is a function of how quickly oil and gas decline and how quickly alternatives can replace them. Supplies of several alternatives would have to increase substantially over a short period, assuming the oil and gas decline is near and fairly quick. Today's price around $80/bbl indicates a gap between supply and demand which is larger than I anticipated. It will be interesting to see how this plays out over the next few days.

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