Sunday, September 2, 2012

Trough oil?

After decades of "Peak Oil" talk and warnings about  a global energy crisis, it has become fashionable to claim the opposite: we are awash with the stuff and a  supply crunch has been postponed indefinitely.

This is especially interesting to me as an investor because I largely bought into the Peak Oil theory.  Permanently high oil prices and the knock-on effects of depleting oil supplies have been something of a cornerstone of my thinking about the economic future.  It's why I made what has so far turned out to be a great call on Shell shares last year - How to ease the pain of high fuel prices.

Roughly speaking the Peak Oilers claimed that oil production would peak at 85 million barrels a day (bpd) around the middle of the last decade as production rates from big fields declined.

There is no shortage of oil left in the ground but most of the big easy discoveries have been exploited and it would be increasingly hard and expensive to keep up production levels.  With demand from the developing world, especially China, growing fast a crunch loomed and prices would sky rocket.

As we all know this happened to some extent.  Chinese consumption alone rose by 4 mbd in the 2000s and the world's oil producers struggled to keep up which culminated in $147 a barrel oil in 2008 and $100+ prices most of the time since despite the economic crisis.

The 90s when oil went down as low as $10 and rarely exceeded $10 seem like another era and one that will never be repeated.

But crucially producers have responded and oil production has increased. The high prices have attracted trillions of dollars in investment in traditional oil producing countries (Saudi Arabia is producing record amounts), new frontiers (e.g. in Africa),  and in deepwater drilling.

Throw in a recovery in production from Iraq, which recently became the second biggest producer in OPEC, increased production of "non-conventional" oil extracted from tar sands and new techniques to  increase recovery rates from old fields and you can see why production has continued to increase.

A lot of the "trough oil" talk has been driven by the view from the US where exploitation of shale gas and oil has been something of a game-changer.  US oil production peaked at 10 mbd in the early 70s and had been in steady decline to about 5mbd until recently when output started growing again.  Imports have been reduced by a third and there is talk of the US being self-sufficient in a few years.

But supply is only one side of the price equation; what of demand and especially this insatiable demand from the developing world?  Even on this front optimists see trends that could make oil abundant and cheap again.

I have even seen one article in the New Scientist predicting that, by 2020, oil production will start to fall not because of a lack of accessible reserves but because demand will be declining.  That's a radical claim: an oil crunch will be avoided not because we will find new sources of supply but because the world will - in their words - "dump the pump".

Two reasons are offered:  increasingly fuel-efficient cars, either because of regulations or through consumer choice, and the rise of the electric car.

Developed world oil demand has started falling already including in the US.  Partly that is due to the economic crisis but a trend towards fuel efficiency is a factor and is set to become even more significant as new laws take effect.

Consider US CAFE standards which mandate the average fuel efficiency of cars sold as measured by miles per gallon (mpg).  When CAFE first came in during the 70s the requirement was 18 mpg and this was increased gradually to 27.5 mpg by the 2000s although Bush refused to raise this not very demanding target higher.

Obama has not been so lenient on the car industry and the next target (due 2016) is 35.5 mpg.  Even stricter CAFE laws will bite from 2017 leading to cars with an average 54.5 mpg and a forecast decline of 11% in US oil demand.  The EU has passed similar laws focused on average CO2 emissions across manufacturers' fleets.

So that's how Peak Oil could become Trough Oil - multiple increases in supply meets dwindling demand.  Well that's the theory.  But should we buy into it and, for example, sell oil stocks which would surely tank in a world of Trough Oil?  While there are some undeniably interesting facets of the argument I am sceptical but I'll set out the reasons why in another post.

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