How to Invest in Peak Oil

Think back to July of 2008, oil was over $140/barrel and a lot of talk on “Peak Oil” (the point in time when the maximum rate of global petroleum extraction is reached) was floating around. By late December a hard hitting recession (depression?) and a strengthening dollar drove prices under $35/barrel. Suddenly there was very little peak oil talk. Today oil is around $60/barrel - and dropping. It is time to again visit peak oil thinking.

Several factors influence oil’s price. The fundamentals, of course, are supply and demand. Wars and rumors of wars, especially in the oil rich Middle East, can drive prices sharply higher in just minutes. Quantitative easing (printing of money), technological advances, Middle East stability, market manipulation, “herd mentality”, all influence oil prices. So, any discussion on peak oil must also consider non-fundamentals.

Oil fields, once put into production, go into decline as the easiest to recover oil is drawn off first. In fields all over the world, the “easy stuff” is now largely gone. Even the massive Saudi Arabian fields are in decline. This is true of course for all resources. Consider copper: In early settlement days large copper ingots were found simply lying on the ground in parts of Michigan as gold nuggets were found in parts of California.

No one finds gold or copper lying around for the taking any more. We need to dig massive, miles wide, holes in the ground, thousands of feet deep. South Africa goes deeper and deeper to tap their prolific gold fields, yet production is in decline. Yes, I know this article is about oil, not gold or copper. The principle is the same though, we must exert greater and greater effort to extract natural resources.

New discoveries can drastically affect prices. In 1901, in southeastern Texas, after drilling down over a little over 1000 feet, the Spindletop oil well suddenly exploded up, oil gushing 150 feet into the air. Spindletop, originally expected to produce 50 barrels a day, initially produced an unheard for the time 100,000 barrels a day, more oil than anyone knew what to do with. By 1902 the price of oil had declined to an all time low of 3 cents a barrel. Previously most US oil had come from the less prolific Pennsylvania fields. Read about Spindletop here. Now, with over one billion cars worldwide predicted by 2010, we know exactly what to do with with oil and gasoline.

We still occasionally find huge oil fields. However, they are miles deep, under the ocean, rock and salt or locked in tight shale formations. Read Kurt Wulff’s SA article about the large Petrobras finds off Brazil. In the US it has recently been estimated North Dakota’s Bakken shale may contain up to 500 billion barrels, yet only 3-4 billion is recoverable at today’s prices (see here). Conclusion? Another “Spindletop” effect is extremely unlikely.

What about technological innovations? Without a doubt, technology has contributed immensely to enhancing oil and gas recovery. Back in, I think it was the late 1970’s, I read an article that exclaimed “we are running out of natural gas!”. Some genius had measured the annual consumption rate and compared it to proven reserves at that time. Simple math showed we only had 8-9 years left. Needless to say, he was wrong. He forgot to factor in the admittedly imprecise factor of new discoveries. The lesson here is math alone can be very misleading.

Witness the role technology has played in natural gas recovery from shale beds. Thanks largely to the new technologies of horizontal drilling and hydraulic fracturing the price of natural gas is now below $3.40/1000 cf. This trend down shows no signs of abating. Future technological advances will undoubtedly continue to improve oil and gas recovery from old fields.

The Middle East, as always, is a wild card. Rumors, which may be true, hint at vast undiscovered fields in Iraq and Saudi Arabia. Iraq has had little exploration activity due to continual wars and unrest. Recently revived exploration in Libya, however, has not been particularly fruitful. Are there new, undiscovered large oil fields in Saudi Arabia? Maybe, the country is vast, yet it is unlikely another Ghawar (largest oil field in the world) will be found. In a best-case scenario the Middle East can maintain, and possibly increase, to some extent output for the next several years or more. In a worst case scenario unrest and the rise of Islamic fundamentalism can cause all kinds of mayhem. It is worth noting that now is a relatively peaceful time. It probably can’t get much better as far as the Middle East is concerned.

Demand destruction due to the recession/depression is driving prices down. As this article is being written oil price is dropping below $60/barrel. Supply, according to the International Petroleum monthly is stagnating. A stagnant supply and dropping demand in the US, Europe and Japan is driving down prices. In China and India, however, demand is still increasing as millions purchase autos for the first time and road infrastructure is built out.

In conclusion peak oil is real with the supply of cheap oil continually falling. However, there is a “fat tail”, with lots of oil coming on the market as prices rise. The vast Canadian tar sands come to mind. As a result the fundamentals indicate a good chance of price decline in the short term as the recession/depression plays itself out while improving economies in the long term will drive prices higher. Remember that as prices go down more and more wells shut down and supply contracts so supply self-corrects to demand.

Keep an eye on China, India and Indonesia. If these economies contract severely prices will drop sharply from current levels. On the other hand if these economies decouple from the US, Europe and Japan, look for a continue upswing in the price of oil.

Non-fundamentals such as “herd thinking” and speculation can drive prices up (or down) over the short term. My view is that yes, speculation in the short term can drive prices up or down, but ultimately fundamentals determine the price. Use the swings to accumulate or sell oil stocks and exchange traded funds. Quantitative Easing will put more dollars into circulation, devaluing the dollar and driving up oil’s price. Some say deleveraging and deflation due to the recession/depression is much larger than the money printing so oil price deflation is inevitable.

How to invest in today’s environment? I think: play the extremes, at least the best you can - admittedly not easy. Don’t like to play? Wait for a dip, invest in some good companies and hold on. My best guess (hopefully an educated guess, but that is debatable) is that the recession/depression will drive prices down to below the $45 barrel range, then maybe stabilize (though stability in this market is rare) for a few years. Long term, 3-5 years out, prices will rebound much higher as world economies improve and supplies contract. Middle East unrest, of course, will at least in the short term, drive prices up considerably.

Natural gas will be much less volatile as the US if finding lots of it. Look for a slow substitution of natural for gasoline in vehicles. That technology seems to have a bright future and is potential material for a future article.

On the long side you can invest in a basket of oil and gas companies such as Exxon (XOM), Conoco Phillips (COP), Occidental (OXY), Petroleo Brasilerio (PBR) etc. Riskier, but possibly more profitable swings, can be found in the smaller oil and gas companies such as EOG Resources (EOG), ATP Oil and Gas (ATPG), and Southwest Energy (SWN). Diversify on both a corporate and international basis. You can use ETF’s but be sure you read some of the cautionary information about them before investing. I prefer to invest directly in oil and gas companies on the long side. Canadian Royalty trusts such as ERF pay high dividends but are volatile and you are a “partner” rather than an investor with so you will have a different, more complicated tax situation.

On the short side I would use a mixture of cash, short term treasuries and perhaps some reverse ETFs such as SCO. You can play both sides and hedge. I have some oil stocks but keep cash plus a position in SCO to benefit from falling oil prices.

This is a tricky, volatile market but the wild swings can potentially be used to generate large profits and in the long run you probably can’t lose, provided you diversify.

Disclosure: Long OXY, ATPG, APA, ERF, short SCO.

Comments

[basehitz:]

I agree with your balance between long term fundamentals and short term speculation. Da Boyz do like to trade energy. Holding the current $60 has been repeatedly cited this weekend as key to the next short term move. As I see it, earnings this week should provide the catalyst to drive both stocks and oil. I don't think crappy results that are "better than expected" will suffice if revenue and/or guidance shows green shoots are really just yellow weeds.

As an investment strategy, I agree with swing trading here. I'm going into the week light expecting opportunity, but preferring to err on the side of caution. I prefer international oil drillers to integrated, and in particular deepwater drillers. I think few would dispute that future oil will become increasingly more difficult and expensive to obtain. The specs on RIG's newbuilds shows the trend.

NG remains volatile in spite of abundant supply. Recent volume of UNG says Da Boyz found a new play thing. So far, it's not cooperating in spite of a flurry of coincident promotional articles. Of course Da Boyz weren't doing a pump & dump. (cough) Storage is excessive. From EIA's website today "At 2,796 Bcf, working gas stocks are at the second-highest level for any week in July since 1994." It stayed below $2 until well into 1995.
seekingalpha.com/artic...

In spite of idling well over half the NG rigs since last Sept, storage continues to increase. I assume there is a storage capacity limit, which if reached before extraction season would crater NG prices.

Jul 12 09:25 AM

[richjoy403:]

After years of watching controversy result every time one uses the term "peak oil", I have decided one can achieve one's purpose by keeping the focus on supply and demand.

I don't know when, or if ever, we will reach peak oil before we have found a suitable substitute for most applications, but I do invest in oil because I believe (absent occasional recessions) rising demand will increased prices for years to come.

Jul 12 09:26 AM

[Ferdinand E...:]

Interesting article. But after the run-up in the oil price in 2008, it seems clear that the expression 'peak oil' can be dumped: when the oil price gets close to $150/b, who cares about a peak - a peak is simply an event that might show up next year or after 2030, as the IEA once claimed, or for that matter never.

Jul 12 09:54 AM

[Bill James:]

Peak World Oil Exports was in 2005, the amount of oil-energy available to fuel the economies. Net World Oil Exports has declined about 6% since 2005 = the economies have contracted about 6%.

There will be great oil and natural gas investments, but the long-term investments will be in achieving the current economic work using much less power. Example, investing in Personal Rapid Transit (PRT); a paradigm shift in transportation from the highways/automobile to networks of computer controlled 'horizontal-elevators' . seekingalpha.com/artic...

Using 127 watt-hours per passenger-mile instead of 1,000 (900, trains; 1033, cars; 1246, buses) results in 85% of current transportation costs to be converted to jobs and profits. This massive opportunity exists only because communications, transportation and power generation infrastructures have operated under well-meaning to rigid government monopolies since AT&T was monopolized in the mobilization to fight World War I. The great innovations at the founding of these monopolies locked in place the innovations of Bell, Ford, Edison and the Wright Brothers.

De-monopolization of AT&T in 1984 resulted in the Internet boom. Cap & Trade will force a de-monopolization of government road (network) allowing innovations such as PRT and Feed-in Tariffs to re-tool transportation and power generation infrastructure. The boom will exceed that of the Internet.

Jul 12 11:02 AM

[long_on_oil:]

To relate to peak oil one has to imagine a big tank full of oil with a variable flow. Some years the flow is heavy and during economic slow down the flow is low but the tank is constantly being emptied. It is just a matter of time before the tank is empty.
During good times when demand is high and supply can not meet demand the price goes up because several people are bidding on a fixed amount. If you produce 85 million barrels a day and the demand is 86 million, who gets left out.
I can tell you who gets left out, it is the lowest bidder for the product.
Bottom line, peak oil is real and time and degree of global prosperity is the main determinate as to when the end will come.

Jul 12 11:54 AM

[CaptainJJack:]

Peak oil is a function of supply and demand. The world currently uses about 1 billion barrels of oil every 12 DAYS.

If people in China had the same number of cars per household as the US, China alone would use close to 100 million barrels a day -- 15 million barrels a day more than we produce today.

Then there is India and the developing world.

Given the incredible energy efficiency of petroleum, especially gasoline, it will always be the first choice for energy, and oil will be a very valuable commodity as far as anyone can predict.

Natural gas is a wonderful heating source and while it can be converted to petroleum for transportation, it seems to be an unfortunate substitution since it is far more valuable for heating.

According to the just released biennial report of the Colorado school of mines, the US reserves have shot up more last year than they ever have in the 44 year lifetime of the biennial survey.

The US now has the highest total NG reserves, at 2,000 Tcf, followed by Russia, at 1,600 Tcf with Iran in third with roughly half of Russia.

Converting coal to methanol and other energy substitutes becomes theoretically viable with oil at $50 barrel, but that is before greenhouse gas capture.

So, I think that in the foreseeable future, while we may see spikes and dips, we should see a very strong upward drift in prices.

Jul 12 01:06 PM

[The Greates...:]

Maybe the oil industry could re-invest some of the $476 Billion in net profit the have made over the last 6 years.

Jul 12 05:05 PM

[Archman Inv...:]

I like ERF as well. I dont own it yet, however I have a target of about $15 that I would like to buy at. I am waiting to see if the overall correction in the market takes it to that level. If it gets to 16.50, I might start to scale into a position. Yield ! Yield! For a div. guy like me, I love it.

compdivplan.com

Jul 12 07:03 PM

[twotraps:]

Oil is a very emotional and thin trade...worse than the grain markets. Supply and demand are obvious factors but there never seems to be a unanimous view at any one time about peak oil, or even the effects of small changes in inventory numbers. So, it thrashes around and remains subject to the whims of big funds entering and exiting the mkt. There is something to the whole 'peak oil' concept, but I keep wondering how long we will flirt with alternatives or will a year or two with crude at $95 be the back breaker and force another fuel concept.

Jul 12 08:57 PM

[AndyMan:]

Oil and NG are going to be pretty difficult to replace....it will take some time.

With all the technological advancement.......over all these years...we still haven't been able to use other forms of transportation or heating.

Wind has been around for many years......and Solar may never become the low cost solution people think it might be (atleast not in my lifetime).

Huge investments would be needed to make these intermittant sources even workable......as in trillions of dollars just in electrical grid upgrades...and power lines to the renewable sources........then trillions for the renewable sources....maybe even more. We don't even know the evironmental effects of putting wind turbines everywhere....and remember...we already put these turbines in a lot of the best areas.....much like oil and NG production....more and more wind turbines or solar installed will go into less and less returning areas with time.

I am sticking with the oil and NG investments........and only have a small exposure to alternative energy.....as many years have passed when the two have coexisted with not much headway....low prices or not.

Jul 13 08:24 AM

[Bruce Vande...:]

We seem to be in a slow convergence, solar and wind being used more and more while also getting more efficient in our use of fossil fuels (Witness how auto technology has evolved). I am optimistic that these trends will continue and and in yet unknown manner things will work out fine.

Paying the true (unsubsidized) cost for fossil fuels, discouraging waste, will help accelerate this process. I know many don't like it but increasing taxes on gasoline will also help.

Jul 13 02:40 PM

[dsrtwriter:]

only the U.S.,with already some of the cleanest technology for emissions, is embracing the "cap and tax" rules. China, Russia, India, etc. will continue to be major users of petroleum, coal, etc..
It seems we are not allowed to compete in this country.We will be able to buy goods made in China/India duty free, but our own companies face cap/tax/unions/health care/etc,etc..Not a way to restore our industrial base.

Jul 13 04:35 PM