Bruce Vanderveen's  Instablog

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.

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