“Peak Oil” is a theory that posits a secular rise in oil prices due to a decrease in global oil production at the same time that global demand is rising.
In this essay I will not focus on the question of whether Peak Oil theory has any merit. The problem that I will focus on is the fact that many adherents to Peak Oil ideology have fooled themselves and many others into thinking that oil prices can only go up due to the long-term secular forces that they cite.
Many Peak Oil enthusiasts do not seem to understand that to the extent that their pet theory is relevant at all, it is only relevant in the very long term. For any time frame that is less than a decade, the theory is not just irrelevant to investors; it is a dangerous distraction that can cause investors to lose a great deal of money.
Peak Oil Ideology
The theory that the world will run out of oil has been around at least since the 1880s. The prophets of oil dystopia have been proven to be wrong every single time for essentially the same reason that their Malthusian intellectual forbearers were wrong: The resourcefulness of human beings in a civilized context tends to expand the frontiers of what was previously thought possible.
The theory of Peak Oil essentially rests on the assumption that “this time will be different.” It rests on the assumption that technology will not enable the expansion of recoverable reserves and production (supply). And it rests on the assumption that technology will not enable efficiencies in consumption (demand). Peak oil also requires the assumption that technology will not enable the development of competitive substitutes.
These are very tall assumptions.
For this reason, any investment thesis premised on the theory of Peak Oil is necessarily highly speculative. Nobody can prove or disprove the nature or pace of future innovations that might impact the long-term supply and/or demand for oil.
What the oil market will look like 10 years from now is a matter of wild speculation.
For example, recent developments related to natural gas recovery are literally revolutionizing the global energy industry in ways that could not have been foreseen five years ago.
By the same token nobody can reliably assert that technological developments will prevent peak global oil production from arriving before the projected peak in global oil demand.
Thus, while the debate surrounding “peak oil” is quite interesting and arouses a great deal of passion, it is mostly a rather idle distraction when it comes to investing in oil and/or or energy stocks.
Peak Oil As A Dangerous Elixir
In 2008, even the most elementary cyclical analysis indicated that oil and oil stocks were a screaming sell. However, blinded by peak oil ideology, traders and investors continued to drive the price of oil and oil stocks higher long after it was clear that the bottom was falling out from under the global economy.
In 2008, oil and oil stocks were like internet stocks in 1999 – they could only go up. Skeptics were told they did not understand. “This time it’s different,” they said, “this is the new economy.”
All such talk tends to end badly, does it not?
Certainly, Peak Oil ideology has taken some hits since 2008. First, the collapse of oil and oil stocks injected some realism back into the market. Second, various intelligent analysts have come forward to cast serious doubt on Peak Oil dogma. Finally, recent advancements in the discovery and extraction of natural gas from shale formations have served to remind the world that Peak Oil is not a one-way bet. Ironically, every dollar being invested in Peak Oil, tends to insure the theory’s failure.
Despite all of this, Peak Oil ideology has not gone away. It will never go away, because Peak Oil is a particularly intoxicating idea. It is always the case that ideologies exist because they posit things that people want to believe. Peak oil theories offer an added attraction: Money. After all, who wouldn’t want to believe a theory that tells you that you can get fabulously rich just by buying oil and oil stocks?
Peak Oil rhetoric within the investment community needs to be recognized for what it generally is: It is merely a convenient ideology that disguises unbridled greed with a patina of intellectual respectability. And when greed gets in the way of investment analysis, the result is generally disaster.
Oil Investing Is A Cyclical Pursuit
With the exception of occasional supply disruptions due to political and/or military events, the only thing that has ever really mattered when it comes to oil and gas investing is the global business cycle.
The price of oil and oil stocks go up when global growth is strong; the price of oil and oil stocks go down when global growth decelerates.
Successful energy investing requires correctly timing global business cycles. It’s really that simple. And that complicated.
The China Factor
If there is any contemporary urban legend that is as potent as the notion that oil prices can only go up because of Peak Oil, it is that China’s economy will always grow at 10% per annum because – well, because it’s China.
For reasons spelled out more fully here, investors may soon find out that the concept of the business cycle applies to China too.
China’s economy has been sustaining high growth rates in the past few years based on an unsustainable expansion of private sector and local government debt. The rapid expansion of debt-led investment growth has led to mal-investments in many areas. There are clear signs that these mal-investments have already begun to create problems for entrepreneurs, local governments and the banks that financed them.
China’s economy is highly export-dependent. A slowdown in the export sector of the economy could trigger an unwinding of various accumulated mal investments in the domestic economy. In theory, this could lead to a prototypical recession.
Nonetheless, a slowdown as opposed to outright recession is more likely given the massive fiscal and monetary resources at the disposal of Chinese authorities.
Prospects For Oil and Gas Stocks
All signs point clearly to a severe slowdown in global economic growth. Despite this, the price of oil is incongruously hanging around the $85 level.
This can only be explained by the fact that Peak Oil theory is again serving as a distraction in oil markets just as it did in 2008. However, just as in 2008, all the speculation about shortages ten years from now will not matter if global demand declines and the market becomes oversupplied in the present.
The proverbial “nail in the coffin” for the price of oil and oil stocks will be confirmation that the Chinese economy has entered into a pronounced slowdown. Some signs of deceleration have already manifested including the most recent HSBC PMI reading which shows manuracturing activity to be in contraction territory. However, signals are as of yet contradictory. Indeed, some level of bounce in industrial production might be expected in the next couple of months based on normalization of Japanese supply lines that are critical links in the Chinese manufacturing chain.
Based on my expectations for data regarding global growth in the next two months and Chinese growth within the next four months, it is my belief that in the absence of coordinated aggressive fiscal and monetary stimulus, oil prices may fall below $70. Depending on the severity of the global economic slowdown – and the derivative Chinese slowdown – oil prices could ultimately fall to the $40 area.
As a consequence, oil related stocks, indices (^OIX, ^XOI, ^OSX, ^XNG) and ETFs (USO, XOP, IYE, IXC, IGE, XLE, OIH, IEZ, PXJ, XES) will suffer severe declines, assuming a decline in oil prices to the $70 level.
Integrated oil companies such as XOM, COP, BP, RDS, TOT, CVX, HES, OXY will fall the least. However those most heavily weighted towards E&P will fall proportionately more. As a group, declines in the neighborhood of 15% can be expected.
Finally, the oil services and equipment sector has traditionally been the most sensitive to oil price movements. Despite the fact that the sector has already suffered sharp declines, further downside of around 25% can be expected. Stocks such as SLB, WFT, CAM, HAL, NB, NE, RIG, GLBL, RDC, NBR, BHI, NOV, OII and RDC should be avoided, for now. Having said that, as the developers and owners of the technologies that can eventually overcome Peak Oil, this sector has the most long-term potential of all segments of the oil and gas industry. As such, once the group as a whole has fallen 15%, investors can consider outright purchases and/or sale of puts.
At that point, investors can get back onto the Peak Oil bandwagon – which in reality, will simply be the business cycle bandwagon, dressed up in a sexier outfit.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.