Why Is Britain's Ministry Of Defense Predicting $500 Per Barrel Oil Prices?

by: Devon Shire

Peak Oil is dead right? I mean Citigroup's analysts even told us so just last year.

And who wouldn't say that Peak Oil isn't dead? The evidence is staring us in the face as oil production in the United States has lurched forward in the past year.

After over three decades of relentless decline American oil production is increasing at a very rapid pace.

However, despite this radical change in American oil production I came across a report today that suggests that Peak Oil is far from dead. The British Ministry of Defense quietly released a study that suggest that by 2040 the price of oil is going to be a dizzying $500 per barrel.

I don't have any idea if oil is going to be $500 per barrel by 2040, but I do have some thoughts on why Britain's Ministry of Defense thinks oil prices are going much higher.

Yes, American Oil Production Is Rising, But What Did You Think Would Happen?

From 1975 through 2000, the world oil price was generally somewhere between $15 and $30 per barrel. The price was sometimes a little more, and sometimes a little less.

Since then, if you ignore the oil price spike and collapse in 2008/2009, we have actually been in a pretty steady trend up to $100 per barrel.

We have had a three to five time increase in the price of oil from what had been the normal level for the previous 25 years.

For the media pundits proclaiming the death of peak oil, this change in the price of oil begs me to ask two questions:

Question 1: Don't you think an increase in production is going to be the expected result of the price of the commodity going up five times?

Question 2: Wouldn't these new higher oil prices, which allow marginal sources of oil production to become economic exactly what you would expect if Peak Oil is real?

Peak Oil isn't dead. It is just playing out differently than some people imagined that it would.

What I believe is that at some point around 2005, the world hit an official peak in the oil that can be produced from conventional sources. That is the vertical, high flow rate oil production that is inexpensive to produce and can make money at $30 per barrel.

The global demand for oil then passed the level that can be supported by this conventional low cost oil production. This pushed the price of oil higher because demand was starting to exceed supply.

As the price of oil was pushed higher it allowed for more expensive oil to be produced profitably. The oil sands, deepwater, and tight oil production can all make decent money at current oil prices.

Conventional oil peaked, that pushed up the price of oil, and the higher price of oil allowed for more oil to be produced from sources that were previously uneconomic.

The graphic below shows perfectly what has happened. The cost of the marginal barrel of oil has risen steadily over the past decade.

$100 per barrel oil has allowed us to figure out how to drill horizontal wells into tight oil resources and use multi-stage fracturing to create wells that have production come on strong and then decline by 60% (or more) in the first year.

These wells make pretty good money at $100 per barrel oil. At $80 per barrel oil, some of them make decent money. At $60 per barrel oil, the economics likely don't work.

When oil was $20 per barrel, there weren't many people even trying to produce oil from the Bakken. Higher oil prices created the incentive.

My point is without the high price of oil that we have, this American production boom wouldn't have happened. Without continued high oil prices, this production boom is not going to continue.

That is what Peak Oil is all about. Progressively higher prices of oil are going to allow us to continue to find new sources of oil.

We aren't running out of oil. We are running out of the easiest to extract oil.

We may have oil prices that stay in this $90 range for a decade as we continue to exploit the Bakken and Eagle Ford. But once those plays enter a production decline (and they will), then the price of oil will likely start moving up again.

And then we may find a way to extract even more oil from new sources because an even higher price of oil allows us to spend more coaxing that oil out of the ground.

If Oil Prices Are Going To Stay High, What Should Investors Do?

I believe that the first thing investors should do is start thinking very long term. If I'm right about oil prices going higher and higher over the coming decades, then we want investments that are built for the long term.

I think the best way to take advantage of long-term high oil prices is to invest in companies that have locked up huge acreage positions in the known oil resource plays in North America.

The acreage positions that these companies have secured has them sitting on hundreds of millions, if not billions, of barrels of oil.

Today with $90 oil and current techniques/technologies, only a small percentage of that oil is recoverable. I believe with each passing year, these companies (and the entire industry) are going to figure out how to get more oil out of these plays. The rising price of oil will also allow for more oil to be extracted profitably.

This is best understood through an example.

A Canadian company I own called Lightstream Resources (PBKEF.PK) has a large position in the Canadian portion of the Bakken. On the acreage Lightstream owns, the company sits on 1.69 billion barrels of oil.

The current reserve bookings for Lightstream assumes only 5% of that oil will be recovered.

With every 1% increase in the amount of that oil in place that can be produced economically, Lightstream is going to add (1% x 1.69 billion) 17 million barrels of reserves. If the company increases recoveries by 10%, it is going to add 170 million barrels.

I believe that time and an increasing price of oil is going to keep making the acres Lightsteam and other companies like it own more valuable with each passing year.

If oil goes to $500 per barrel in 2040 as Britain's Ministry of Defense expects, then these companies are going to be money printing machines.

Five Tight Oil Resource Players To Invest in For the Long Term

Despite the boom in oil production in North America, there really aren't very many oil resource plays. The significant ones are:

- Eagle Ford (Texas)

- Bakken (North Dakota)

- Cardium (Alberta)

The five companies below have leading positions in these key plays and should benefit from those positions for the next 40 years. I think together they make a nice basket of tight oil producers to put in a portfolio.

EOG Resources (NYSE:EOG) - Your exposure to the Eagle Ford and Bakken

Continental Resources (NYSE:CLR) - Your exposure to the Bakken

Penn West Energy (PWE) - Your exposure to the Cardium and other smaller plays

Crescent Point Energy (CSCTF.PK) - Your exposure to the Canadian Bakken and other smaller plays

Lightstream Resources - Your exposure to the Cardium, Canadian Bakken and other emerging plays

I have no idea where the stock prices of these companies will go over the next year. Over the next twenty years, I think these companies have assets that will be the envy of the entire industry.

Disclosure: I am long PBKEF.PK, PWE. 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.