Why This Is Not a Peak Oil Crisis

Mar. 4.11 | About: iPath S&P (OIL)

In a 1956 paper, Shell (NYSE:RDS.A) research scientist Marion King Hubbert advanced the idea that U.S. oil production would peak in the early 1970s. Turns out, he was correct. Others began applying his approach to global production expectations, and the idea of "peak oil" was born.

Peak oil regards the genuine crisis as emerging when more than 50% of available oil has been extracted. It views the market price as accelerating once the peak hits … and a series of economic contractions issuing from that peak.

Now, if there is a constriction in availability, traders will jack up the price. That's a simple matter of supply and demand. In normal trading, oil prices emerge (essentially) from the cost of the next available barrel. However, in a supply-constricted environment, that changes to reflect the cost of the most expensive next available barrel.

Peak oil, therefore, views this as a matter of how much supply exists.

However, while this may become the issue at some point, I do not believe it is the problem now. Considerable oil remains available – both conventional (traditional oil fields) and unconventional (shale oil, oil sands, gas to liquids).

The crisis unfolding before us is not about the amount of oil but of the quality of that oil. Put simply, the primary flow of crude internationally is of an inferior grade, coming from places beset with political, economic, and infrastructural problems, and requiring additional processing.

The higher prices now unfolding are not a result of insufficient supply, even with the current geopolitical unrest. They are the result of the additional costs needed to extract, transport, and turn that crude into the oil products we need.

As I said, there is plenty of oil out there. But the age of light, sweet crude (low viscosity – or resistance to flow – and low sulfur content) is certainly over. It is heavier, sourer (higher sulfur content) crude that dominates the market. And it is more expensive to process.

That is one of the costs accompanying the unrest in Libya right now. The country is one of the few places left on the globe where significant volume of light sweet is still available. Another is Nigeria – a country also known for its lack of political stability.

If we turn to unconventional sources to maintain the supply side of the equation, we move the costs of processing up even more.

The supply is there. But this supply that will cost more at the pump.