“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?

 

Peak Oil

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:

  1. 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.
  2. 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.
  3. 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.
  4. New discoveries are from sources that are more much costly or environmentally unpopular, such as the tax sands and off-shore. Barrack Obama has said he may ban oil from the tax sands for environmental reasons and environmentalists claim that off-shore drilling would threaten ocean species.
  5. 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.
  6. 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.
  7. 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.
  8. 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.
  9. 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.
  10. 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).

 

Oil Bubble

In his 1998 book, “The Roaring 2002’s”, demographics expert Harry Dent predicted that the large block of baby boomers in their peak earning years would cause one financial bubble after another. Since then, we had the tech bubble, a real estate bubble in the US, nearly an income trust bubble in Canada, Chinese stock market bubble, and now what looks like an oil and resources bubble.

Just like the unlimited potential of the internet that led to the tech bubble, there are real explanations for oil’s rise, but they do not explain a price increase from $10 to $145/barrel.

 

Arguments in favour of a Oil Bubble

Index futures for oil and resources have been created in the last couple of years and have resulted in massive speculation that has driven much of the oil price rise. Many institutional investors are allocating a portion of their assets to commodities primarily through the futures market, which has created incremental “investment demand”. Commodity index futures are about 80% oil. Because of the comparatively high price inelasticity of both oil supply and demand, relatively small disruptions in supply or increments in demand can have outsized effects on price.

According to a May 19, 2008 report titled “Blame It on Your Pension Fund” from Probability Analytics Research in Chicago, open interest in the West Texas Intermediate (WTI) crude and Brent Crude oil contracts traded have more than tripled over the last 5 years, rising by 1.3 million. At 1,000 barrels per contract, this represents incremental demand of 1.3 billion barrels of oil, or about 53% of the increase in world oil “consumption” over that period. Index speculators would not necessarily have accounted for all of that increase in open interest, but Michael Masters (Masters Capital Management), in testimony before a Senate subcommittee on May 20, 2008, estimated that over the last 5 years, index speculators through the futures market increased their net exposure to petroleum products by the equivalent of 848 million barrels of oil, an impact roughly equivalent to the 920 million barrel increase in demand from China over that period.

In a tight market for physical oil, how large a price impact could the incremental investment demand from commodity indexers have had? Probability Analytics Research estimated the equilibrium oil price without investment demand is $60-75 per barrel, with investment demand adding roughly $60 to the price of oil.

In addition to index futures, here are other arguments that we are in an oil bubble:

  1. Demand is not out-pacing supply. In the last 12 months, world oil demand is up only 2%, while supply is up 2.5%. Meanwhile, the price has nearly doubled. How can this be anything other than pure speculation?
  2. Most oil experts assume the proper oil price should be between $60-90/barrel. Almost all oil analysts assume a price of $80-90/barrel when valuing oil company shares. The $60-70 range is often quoted by Saudi Arabian oil minister Ali Al-Naimi as being a realistic price for oil, since that is the marginal cost of production for alternative energy sources. In fact, OPEC, which controls 40% of the world’s oil, states that there is “no justification for oil above $80/barrel” and that “fundamentals do not support a price above $80/barrel”.
  3. Anecdotal evidence is that the long-awaited demand reductions resulting from high oil prices may have begun. The widely-used quote is: “The cure for $145 oil is $145 oil.” Airlines—choking on $4 per gallon jet fuel prices—are slashing capacity. Sales of gas-guzzling SUVs and light trucks are collapsing in the U.S., while small cars and hybrids are flying off the lot. Public transportation use is increasing. Many are changing jobs to be closer to home, or moving closer to their job. Oil demand is starting to drop off throughout the OECD. Demand responses take time, but we may have reached a tipping point. Gary Becker, an economist at the University of Chicago, has calculated that in the past, over periods of less than 5 years, oil consumption in the OECD dropped by only 2% to 9% when oil prices doubled. But over longer periods, consumption dropped by 60%.
  4. Oil supply increases may be on the way. Six years is not a long time in the context of the time it takes to develop an oil field. The last doubling of oil prices has occurred in the last year or so. No supply response over that time frame could have been reasonably expected. The largest new field for years was just discovered in Brazil and is estimated to contain 5-8 billion barrels.
  5. Huge amounts of oil are thought to exist off-shore. George Bush just lifted an executive ban that has existed since 1990 on off-shore oil drilling. If the legislative ban is also lifted, then off-shore drilling can finally start. Drilling is banned in many other regions rich with oil or gas resources due to long-term energy strategies and environmental concerns.
  6. Oil-producing countries do not necessarily have the incentive to increase production as rapidly as oil-consuming nations may want. They may believe that they will maximize the long-term value of their oil reserves by developing them more slowly.
  7. Oil price subsidies in many countries will become increasingly difficult to maintain. Higher gas prices in these countries would result in lower demand. The latest jump in oil prices is making subsidies much more costly, and strains on governmental budgets are forcing some nations to lift subsidies. On May 24, Indonesia raised fuel prices by +30%, followed shortly by Taiwan (+13%) and Sri Lanka (+24%). China has just recently increased its gas prices, since the subsidies that amounted to about 1% of GDP.
  8. Many European geologists, especially in Russia, still believe in the abiogenic theory. Oil is widely considered to be a fossil fuel in the West, but this belief is far from unanimous world-wide. The abiogenic theory states that oil is created by carbon released by microbes that migrates upward from the earth’s mantle. It has been popularized in the West recently by Thomas Gold, professor at Cornell University. If it is correct, then not only can oil be continuously created, but there may be far more oil in the earth than most believe. Oil companies have not drilled in areas most likely to contain abiogenic oil. Most geologists consider oil to be a fossil fuel, but the abiogenic theory has not been proven false.
  9. Governments have not responded with official policies and have not officially expressed concern. Peak Oil has been discussed endlessly in the press and in the financial industry. Governments must know what is going on and are not concerned.
  10. Alternative fuel sources will reduce our need for oil. Humans are adaptive. There are many fuel sources available now and high oil prices will make alternative sources much more viable.
  11. Peak Oil is being marketed. Most of the strongest proponents of Peak Oil are in the investment industry working for companies that have made huge amounts of money from rising oil prices.
  12. Many oil industry insiders believe this is a bubble. Those that believe this is a bubble include OPEC, Saudi Arabian oil minister Ali Al-Naimi, Richard Rainwater (Texas oil billionaire), and George Soros (legendary hedge fund manager).

 

What is your opinion?

Many readers of MDJ are well-read in many issues, so your opinions here would be very interesting. What is your opinion? Which are we currently witnessing?

  1. The beginning of Peak Oil.
  2. An oil bubble.

 

Ed

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Ed Rempel has helped thousands of Canadians become financially secure. He is a fee-for-service financial planner, tax  accountant, expert in many tax & investment strategies, and a popular and passionate blogger.

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