16 August 2005

$100 Oil?

Worried about the price of oil going
to the moon — or the world running
out of oil? No need to be: at around
$100 a barrel the price of oil
will plateau for decades.

Ever since 1973 when OPEC first jacked up the oil price, the world has lurched from one oil crisis to another.

Now, with oil at $66 a barrel, it’s starting to look as if many of the Doomsayers’ predictions that we’re going to run out of oil might be about to come true.

Chart courtesy of Inflationdata.com                See large chart

On the contrary, the world will never run out of oil. And some time in the future, though probably not for twenty or more years, the price of oil will plateau at around $100 a barrel (in today’s dollars) and stay there for decades, if not centuries.

The first statement — that we’ll never completely run out of oil — is non-controversial (if you’ve done Economics 101). But not very comforting.

Very simply when a commodity becomes scarcer, its price goes up. So if oil ever became really scarce...like there was only one oil well left in the entire world...oil would be more valuable than diamonds and only be used in applications where it was truly irreplaceable.

Of course, then you wouldn’t be able to fill your gas tank with gasoline.

Thankfully, that’s not something we have to worry about.

The Hubbert “Curve” and
the Doomsday Scenario

Back in 1956, a geologist with Shell Oil, M. King Hubbert, predicted that US oil production would peak in the 1970s.

At the time he was widely ridiculed, but he turned out to be right. For the past 25 years, the supply of oil from American oil wells has been falling. New discoveries are not keeping up with the depletion of older wells, so total American oil reserves are declining.

Hubbert’s analysis was summarized in a Bell Curve which has recently been applied to world oil production. The result: world oil production is expected to peak sometime around now.

So far, it doesn’t sound so good. If world oil production starts declining at a time when demand for oil is rising, it’s a recipe for dramatic explosion in the price of oil.

Of course, oil is just one source of energy. For many applications there are substitutes like coal, natural gas, and nuclear power — not to mention wind, solar and tidal sources of energy. And technologies like hydrogen-powered cars and fuel cells may eventually reduce our dependence on oil for our transportation.

Secondly, when the price of something goes up, people economize on its use. That’s natural human behavior. During the first oil crisis, to give an extreme example, Pan Am began vacuuming the carpets on its planes at every stop. This way, they shaved around 40 pounds off the weight of the plane — and a few percentage points off their fuel bill.

As billions of people and businesses economize, less energy is used to produce each dollar of GNP. Which is exactly what has occurred in Europe and the United States in the past two decades.

New, more efficient technology also helps out. For example, what we call coal today was passed over as useless rock 150 years ago. Back then, they simply didn’t have the technology to extract energy from the lowest grades of coal.

However, economizing, or using new technology to squeeze the last drop of oil out of an old well, will merely slow — not stop — the seemingly inexorable rise in the price of oil.

More oil than Saudi Arabia

What will come to the rescue is the price of oil itself.

The Doomsday outlook is based entirely on bringing liquid oil out of the ground.

Canada, though, has more oil in the ground than Saudi Arabia. There’s just one problem: it’s not in easily-accessible oil wells. It’s locked up in oil shale.

Getting oil out of shale is hardly rocket science. Oil was first extracted from shale in France in 1839. By 1881, oil shale production had reached a million metric tons a year.

But when liquid oil was discovered, oil shale production became uneconomic. So, for more than a century, nobody has seriously looked to exploit oil shale deposits. There was simply no money in it.

At around $100 a barrel there is. According to current estimates, at around that price you can easily make a bundle of money digging up oil shale and turning it into oil.

And at $100 a barrel, oil companies will begin looking for oil shale deposits — and inevitably increase the approximately 2.6 trillion barrels of oil now known to be locked up in shale deposits.

That’s enough to fill our gas tanks until the end of the next century (at current consumption levels).

But large-scale production of oil from shale will require billions and billions of dollars to be invested in the mines and processing plants. What’s more, each plant, not to mention the pipelines and other transportation networks required, will take 5 to 10 years to build.

Companies will only put up this kind of money when they’re confident that they’re going to make a profit a decade from the time they start building. That will only happen when they’re certain that the price of oil will not fall under their shale oil production costs for the foreseeable future.

In other words, when $100 a barrel looks like the floor for the oil price, not the ceiling.

I don’t want to imply that we should rush out and load up on oil or oil-related investments.

The current oil spike is part of the current boom in all commodity prices. Since 2002, commodities like zinc, copper, nickel and natural gas have doubled or tripled in price. And along with oil, humble commodities like copper, iron ore and coal reached record highs in the last month.

Increasing demand from fast-growing countries like China and India is certainly one factor behind this boom.

But the most important cause is shortages in these commodities. But the shortages are not because we’re running out of everything. They result from bottlenecks in the supply chain.

If a major discovery of natural gas was made in the middle of the United States it wouldn’t make any difference to the price of natural gas today: the existing pipelines are all full.

And one reason iron ore and coal have nearly doubled in price is because mining companies can’t buy enough tires.

Tires?

You know those giant trucks with wheels 12 feet in diameter that carts the ore out of the mine? Tires for these monsters cost $35,000 each and weigh around 4.5 tons. And they wear out. So if you need to replace them you’re in trouble: there’s a backlog of orders that may not be cleared until 2008.

And if you want to buy one of these moving monsters brand new, if you’re lucky you can get one...but at the moment they come without tires.

These kinds of production bottlenecks are typical in the latter stages of every boom. Remember the scramble to build broadband pipes a few years ago? Remember what happened when all these new pipes came on stream? Prices collapsed.

Miners are reacting to record commodity prices by expanding production, building new mines which will alleviate current shortages...a few years from now.

And when all these new projects come on stream, guess what’s going to happen?

Commodity prices will collapse.

So right now it seems to me a market for traders. Commodity prices may go up a whole lot more — or just a little.

But if you’re an investor, in a few years’ time there should be a lot of superb investments in this sector on the market at truly bargain prices. — Mark Tier

Have a question or a comment? Email it to investorsedge@marktier.com

Email this to a friend