The media is focused on oil as never before. Will it breach $100? Will it decouple from the dollar? Will it cause a recession? What does the giant Brazilian discovery mean? And of primary interest, how much oil could the world really produce if it tried its hardest? Oil is becoming the media’s new Paris Hilton and it’s getting a little hard to decipher the noise from the news. But let’s try.
The most interesting thing to me is how oil moved in the past week against a negative news background. The IEA reduced its forecast for oil demand last week, a U.S., if not global, recession was looking increasingly likely, and the weekly oil numbers failed to deliver the expected inventory decline. What happened? Oil dropped from the mid-90’s all the way down to…nearly $91. And then it bounced right back up.
A second interesting move was a noticeable reduction in the degree of backwardization in the “strip,” the series of oil futures prices going out five years. Backwardization means the prices are lower in later periods. It suggests that traders believe high prices are a more near term phenomenon than one that will persist. The opposite is called “contango” and the market seems to switch between the two for reasons that are not clear to me, or, as far as I’ve been able to discern so far, to anyone else either. If anyone knows of a good analysis of this, I’d love to get a reference to it. Anyway, over the past week or so, the out months of oil contracts have gotten stronger than the front months.
What these two actions say to me is that oil is damn strong and looking to get stronger in the more distant future. Why? The real answer: nobody knows. But for what it’s worth, I think it’s not because we might bomb Iran (we won’t), or because Pakistan may fall apart (it might), or because speculators are speculating (they are). It is simple because the reality of Peak Oil is becoming understood by more and more people. It’s sinking in that demand for oil is simply stronger than supply and that eventually supply will reach a peak and not be able to grow any further. People are starting to get it.
You can see that in the news. Not so much The Wall Street Journal’s front-page story on 11/19, which said that global production might max out at 100 mb/d in a few years (they’re still in denial; it will max out at a good deal less than that). But more because of the story a few days earlier quoting the Russian oil minister to the effect that Russian production will grow about 2% a year through 2010, instead of 10% as in the past. The logical conclusion from that: with the Russian economy growing at 7%, Russian oil exports will be declining. It is no small matter that Russian exports will decline from here because Russia produces more oil than any other country in the world.
In fact, declining exports are the essence of the story behind rising oil prices. They result not just from the exporters’ increasingly difficult production challenge of getting enough oil out of the ground to offset the natural declines in older fields. But just as important, as I have said before, declining exports also have a psychological basis, which is the new trend toward Hoarding. Underlying Russia’s slow projected growth, for example, is a series of decisions made in the Kremlin that Russia will not encourage (or allow) as much investment as is needed to maximize oil production.
Hoarding is a big part of the stalling growth of oil production today even though no country will admit to it. They blame lack of investments (Russia) or fear that alternative fuels will reduce future oil demand (Saudi Arabia) or the need to fund social programs instead of oil production investments (Chavez). But the reality is that they all look at the world and see the same thing: oil is becoming more scarce so it’s better to keep more of it in the ground for future sale or domestic use. They also, incidentally, notice that the U.S. has prohibited drilling off our coasts or in our Alaskan nature preserve, which looks like an excuse by “the smartest guys in the room” to hoard. I wish we actually were that smart.
In addition to the impressive strength of the oil price, another thing to notice is that while the oil price has been rising, stock prices have been falling, including to a lesser degree oil stocks. How ominous is that?
Peak Oil Innocence Is Gone — Is it Time to Panic?
Just as mankind was once expelled from Eden’s world of naked innocence by the knowledge of good and evil, so the Modern Investor is rapidly learning the facts of Peak Oil. That’s inherently unsettling because we know that economic growth has always proceeded apace with the growth in oil supply. So what happens to economic growth when the oil supply peaks and then declines? Is our economy, like Wile E. Coyote, coming to the edge of the cliff? Is it time for an intelligent investor to panic?
My sense is that the primary stock market problem today is a fear of stagflation, which is only partially related to rising oil prices. People are not (yet) selling stocks for fear of Peak Oil. For one thing, oil production probably has not yet reached the peak. There are numerous near term potential sources for rising oil production. Iraq is increasing its production and could add far more. Nigeria, Angola, Azerbaijan, Turkmenistan, Russia, and Saudi Arabia all have the physical capability to produce probably 5 – 10 mb/d more, given sufficient investment. For another thing, oil is not yet sufficiently expensive to inflict massive pain on consumers.
Even if Peak Oil is not motivating the current stock market weakness, Peak Oil writers have hypothesized that when the public comes to understand and accept Peak Oil’s implications, an unprecedented bear market will follow because the public will panic. Well, we may soon find out if that’s true because Peak Oil is becoming a more prominent topic every week. Increasing numbers of public officials and business leaders are accepting the reality of Peak Oil and speaking out about it With high oil prices clearly being an issue in the upcoming election, Peak Oil may also become a debate topic.
So is it prudent for investors to panic now before the crowd does? Not yet, in my judgment, for two reasons. One is that we are likely to get some good oil news. Global oil production is likely to grow slightly during 2008, and U.S. demand for oil may well be able to contract over the next few years even while the economy grows as our transportation fleet becomes radically more fuel efficient. Cars and trucks use about 70% of our oil and we replace 3 – 4% of the car fleet each year. Car buyers could possibly double their fuel efficiency with replacement vehicles and if half of them do then there could be a 1 – 2% demand reduction from cars and maybe .5% from trucks. Such a trend would look very re-assuring to the market, particularly since it would not hurt economic growth.
Secondly, the public relations battle between deniers and believers in Peak Oil will continue for a long time. It will be a ferocious debate that will end up clouding the question in the minds of the public, much like the battle between cigarette makers and doctors in regard to cancer and the one that currently rages in regard to global warming. So long as uncertainty seems plausible it will exist and the public will not panic and sell all their stocks for fear that Peak Oil will destroy the economy.
Thus, any violent stock market sell-off due to Peak Oil is likely to come only after oil production has in fact peaked and has in fact begun to destroy the economy. Once that happens, the need for a very painful Rapid Transition will dominate our economic lives and stocks will tank. So some point before that occurs will be the appropriate time for us to panic and sell all stocks. If Chris Skrebowski, our best oil supply analyst (in my opinion), is correct supplies will fall off a cliff around 2012 when nearly all new fields under development and within sight of being developed are maximized, very few new fields will come on stream, and the decline in old fields will be accelerating.
My forecast for oil prices is a cycle of higher highs and higher lows over the next five years or so driven by demand growth primarily from developing countries combined with more slowly growing oil supplies in the face declining production in our aging giant oil fields. For stocks I see normal (10% per year average) market growth after the housing and mortgage issues play out. In such an environment, I believe the rewards for owning energy assets over the next few years are likely to dwarf those of the past few years. I also think it is reasonable to own calls on physical oil.
Eventually — maybe in 2011 — there will be a prudent time to sell the stocks, but I would not want to miss the returns that I think may be possible on energy equities for the next four or five years.