One of the most important energy theories for investors in energy of any sorts is the notion of "peak oil", or the idea that at some point, we're going to hit a certain amount of oil production, and then we're going to have to naturally start producing less going forward from that middle point.
This makes sense if one doesn't understand the nature of innovation, the basics of economics, or the business of oil production. But once we analyze those angles, the theory falls apart.
Most importantly, let's look at what this all means for those investors of us who are looking forward to being long-term investors in energy of all sorts, including oil and natural gas.
The Theory: What Is Peak Oil?
The Financial Times Lexicon explains the definition:
"The debate over 'peak oil' - the point at which the world's oil supplies go into irreversible decline - is a long-running argument that has not yet had much impact on energy policy."
For the purpose of this article, we're focusing on the notion of "irreversible decline." If production happens to begin declining due to a lack of demand because of electric cars or something, that's not necessarily peak oil.
Peak oil is the notion that we actually begin to run out of oil, and production is less because we can't find enough to produce. Unfortunately, most new research goes against the notion of peak oil.
Every few years, another author comes out and says that we just reached peak oil and should begin preparing for the onslaught that will be starting to occur -- then, of course, it doesn't occur, mostly for the following 3 reasons.
Problem 1: Innovation Changes Economically Recoverable Oil Supply
When economists begin formulating theories, they often make one of the most critical mistakes possible -- something, thankfully, the Austrian school doesn't do. They begin assuming that economics involves static numbers.
George Soros's theory of reflexivity is probably one of the most important concepts investors should learn to understand. It's the notion that people react to people and change their actions, and the other people react to the changes, creating an endless feedback loop.
This feedback loop is why it's impossible to assume that trends are constant when they are about society. This includes economics, innovation, demand for certain goods and services, and other things.
Peak oil might make sense if we were stuck with a set amount of oil, people were not going to begin shifting away from oil consumption 'in time', if innovation didn't exist, and if economically unrecoverable oil couldn't become recoverable with higher prices.
Of course, all of the above aren't true. In fact, this is one reason researchers at Harvard are making the opposite predictions of the oil-peakers.
From Harvard's Kennedy School website on June 26th:
"Oil production capacity is surging in the United States and several other countries at such a fast pace that global oil output capacity is likely to grow by nearly 20 percent by 2020, which could prompt a plunge or even a collapse in oil prices, according to a new study by a researcher at the Harvard Kennedy School...
Contrary to some predictions that world oil production has peaked or will soon do so, Maugeri projects that output should grow from the current 93 million barrels per day to 110 million barrels per day by 2020, the biggest jump in any decade since the 1980s. What's more, this increase represents less than 40 percent of the new oil production under development globally: more than 60 percent of the new production will likely reach the market after 2020."
Far from reaching peak oil and seeing prices increase forever, we're seeing a very real possibility of the opposite. Innovation exists. Oil supply can increase. Not forever, of course, but certainly long enough for society to transition to another energy source altogether, like electric or something else.
Problem 2: Higher Prices Change Economically Recoverable Oil Supply
Innovation makes some oil sources economically recoverable that used to not be recoverable. For example, according to the Economist last year, we were seeing demand outstrip supply. But that doesn't mean we were seeing peak oil. Even with increased demand, we were seeing a boost in production.
When demand begins to outstrip supply, this has an important impact on the market. It makes some oil that wasn't economically recoverable suddenly more recoverable because of the higher prices.
Just look at shale oil. As prices begin to increase, as well as technology, more and more oil is suddenly recoverable and can be put on the market. Apparently, supply and demand still work.
Problem 3: Higher Prices Automatically Cut Demand For Oil Products
This is probably the most important concept we need to understand. Higher oil prices make non-oil based fuels more economical. This means electric cars or something else entirely. We're decades away from even needing electric cars, but if there are long-term trends of oil price growth, then we'll see people transition to fuels that are cheaper. It's the way the market works.
This is one reason having higher fuel standards on cars actually is an economically destructive thing, because higher gas bills for consumers can end up pushing billions toward developing new fuels, allowing us to move to more economically friendly fuels decades earlier than with higher fuel standards.
Once again, government action misses the point of "higher prices" in the first place. Governments often miss the fact that ignoring prices with policy is economically destructive.
What This Means For Investors
This means investors shouldn't be worried about energy companies somehow struggling over the next 30 years, but should look for ways to invest in the new technologies.
Oil companies in general will likely be a great bet over the next couple of decades. Offshore drillers like SeaDrill (NYSE:SDRL) show promising signs, as do companies that help service them like GulfMark Offshore (NYSE:GLF). Alternative fuels are also providing, well, alternatives, like Westport Innovations (NASDAQ:WPRT), which helps build alternative fuel engines, or Clean Energy Fuels (NASDAQ:CLNE).
Of course, getting exposure to the innovative field of oil wouldn't be complete without a hat tip to Exxon and Chevron, two of the biggest corporations helping push us toward better technology, new oil reserves, and an end to the credibility of "peak oil".
Overall, the lesson to be learned is that investors will make far more money if they bet on innovation rather than against it. The coming decades will likely show us this is true time and time again.
Disclosure: I am long CVX, XOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.