The Looming Energy Crisis

Brian Hicks

Written By Brian Hicks

Posted December 3, 2008

It seems like everyone but me has read Nassim Taleb’s book, The Black Swan. The concept of unforeseen, highly unlikely events has wormed its way into nearly every conversation lately. (The title is a reference to the fact that all swans were assumed to be white until black swans were discovered in Australia.)

Aside from the fact that I have a too-long reading list, perhaps I haven’t read it because it’s something about which I’ve already thought altogether too much. I seem to be one of those people who are predisposed to look for the outlier events, the exceptions to the rules.

Peak oil is a classic case of a black swan event. Nowhere in our history of modern economic theory or industrial civilization is there such an event, so the past will be no help to us as a guide to the future. Still, we act as though our theories are gospel, and our markets are wise. New and unforeseen events like peak oil are never priced in.

Only the few people with a predilection to look out for such things will see it, at first, while the madd’ing crowd dismisses peak oil as a hoax, and disregards the mountains of science and data with blithe assertions about their faith in the markets and technology. They’d rather believe wacky tall tales from an itinerant preacher who spent a little time in Alaska’s oil fields but apparently never learned a thing about oil production than look at the hard data on oil production we do have. And they will continue to do so until precisely the moment at which the whole crowd has seen the proof and knows that it’s true; that is, when the peak is well in the rear-view mirror and nobody has any doubt that the End of the Oil Age is upon us, and it’s far too late to take effective action.

Only when oil prices blew past $120 this year did analysts like me get a little air time to talk about the science on peak oil and not be simply dismissed as "peak freaks" with some sort of presumed pathological desire to destroy the economy. And now, with oil prices dragging well below the trendline, our looming supply problem is no longer in focus at all, even as it quietly becomes more urgent. Nothing to see here, people, move along….

Unfortunately, as I discussed in my article last week, when the prices of oil and natural gas are as low as they are now, it no longer pays some companies to continue to produce it. The ones operating at the margin of profitability—the ones working the most difficult and marginal resources, with the highest cost structures—are simply getting priced out, laying down their rigs and cutting back on their expansion plans.

The contraction of new oil and gas development due to low commodity prices and difficulty in obtaining credit is setting us up for an "air pocket" in energy supply. When we hit that air pocket, somewhere around 2010, it will create an especially fearsome spike in oil prices.

A Massive Reality Disconnect

You wouldn’t know that from watching the tape, though. Oil and gas, which are part of the very foundation of the real, physical economy, continue to get hammered by traders as if they were no different from any other wacky financial instruments we have invented. As oil finally dropped below $50 and stayed there, the whispers about $20 started going around. Vague fears of a reduced outlook for global oil demand, still not verified by the data, have caused oil prices to overshoot far to the downside.

It’s as if traders either don’t know, or simply don’t care, that oil is already below the production cost in those marginal areas where essentially all of the growth in world oil production must come from (if any). If the chart says it could go back to $20, then they believe it could go back to $20.

Such thinking, confined by conventional wisdom and removed as it is from any sort of real world knowledge of petroleum geology, is not only wrong, it will also prove very costly to those to follow it.

On the other hand, one can go broke trying to tell the market what to think. If the market believes that oil’s going to $20, then for a short time at least, it probably will. It doesn’t pay to buck the trend.

What does pay is knowing when the turning point is about to happen, before the herd heads in a new direction.

We had one of those turning points at the beginning of 2005, when the decades-long growth trend in conventional crude oil production was finally broken. In 2005, oil hit the bumpy plateau at the top of its bell curve, where it has remained in the range of 74 mbpd. (Natural gas liquids, biofuels, unconventional oil, and other components make up the remainder that bring world "oil" production up to about 86 mbpd.) That’s when oil prices sharply departed from their past trends, and shot from about $40/bbl to $147/bbl.

Now we have a situation where oil is trading for under $50/bbl, but we know that the global marginal barrel production cost is about $65, that OPEC is signaling it wants to defend $70-75/bbl, and credible forecasts suggest that $100/bbl is the minimum needed to ensure future supply.

That means we have reached yet another massive disconnect between the trade and the reality. Before long, the pendulum will have to swing back the other way, and will probably overshoot to the high side.

Put another way, the markets are currently pricing the tail risk of peak oil by 2010 at approximately zero. The lack of adequate substitutes is also priced at zero. If somebody wants to help me make a CDS-like instrument, we can price that risk correctly and make a killing. But short of that, a long position in oil doesn’t get much more attractively priced than it is right now.

A World Too Complicated

In a recent interview with PBS, Taleb noted that it only took a tiny bit more demand than there was supply to send prices skyrocketing this year for oil and agricultural commodities. Oil is priced at the margin of supply; the last, most expensive barrel essentially sets the price of the whole lot. That’s what we should have been focused on, rather than engaging in a witch hunt for evil speculators.

Few seem to understand the deeply interwoven relationships between oil prices, oil supply, the value of the US dollar, and the health of the banking system and the broader markets. Taleb put it simply: "We live in a world that is way too complicated for our traditional economic structure. It’s not as resilient as it used to be; we don’t have slack; it’s over-optimized."

It’s is a point I have repeated often. With just-in-time inventory practices dominating every supply chain and every industry, an interruption in the flow of oil can have drastic consequences within mere days. Events like hurricane Katrina foreshadow what can happen: Power plants shut down, trucks stop rolling, shelves and tanks go empty. Much of our infrastructure is extremely vulnerable to energy interruptions, but that isn’t priced in either.

What we build—or don’t build—in energy has indirect but enormously important impacts on the financial markets. Without energy, we can’t have economic growth. The feedback loop also runs the other direction: without a robust economy, we can’t invest in the future of energy.

Monetary policy also has a huge but delayed effect on energy prices, and in time, energy prices feed back into monetary policy. It seems inevitable that the massive creation of money in response to the current credit crisis will eventually result in oil prices spiking again.

Only the next time that happens, totally contrary to conventional market wisdom and the very history of oil production, oil producers will not be able to increase production even with prices again at all-time highs. Simple depletion of mature fields, declining resource quality and quantity, an uncertain financial outlook, skyrocketing project costs, geopolitical tensions and the host of other factors I have documented in these pages will bring us to the peak of oil production sooner than our models projected.

Black swan events are far more common that we might think. The rapid unwinding of the enormous leverage in the financial markets this year was another black swan. The models never priced in everybody being on the same side of the trade in credit default swaps and CDOs, and they never imagined the sudden crash of the markets or the swath of destruction it would carve. History was no help in guiding us through the current crisis.

We also suffer from simple myopia. By focusing on the financial markets without seeing their connection to everything else, we have truly missed the point, which is that energy is the real economy, and money is merely an artificial representation of it. Consequently, twiddling with interest rates, and other measures that don’t produce more energy or decrease demand for it, ultimately don’t cure our problems at all.

Somehow, we have to start making our decisions on energy policy and the economy on a much longer time horizon, and with a much broader view of how all the parts fit together. It takes decades to make any significant changes in energy infrastructure, like replacing a significant portion of the vehicle fleet, or building electrified rail, or a long-distance transmission grid, or renewable energy systems.

Instead of focusing all our attention on how we might try to play the oil game into overtime, we need to start thinking about how we’re going to cope with living on less than half our current energy budget by 2050.

If you only watch the rear-view mirror when driving, you’re going to wreck. Yet that is exactly what we’re doing with our energy supply planning, and exactly what the Street is doing with pricing future energy supply. It’s time to put both eyes squarely on the road ahead, and watch out for that hairpin curve in 2010.

Until next time,

chris nelder signature

Chris

Energy and Capital

P.S. Staying ahead of the curve is the one strategy that any investor can use to secure and build their wealth. The trick is to anticipate the unexpected before the herd. My colleague Nick Hodge has found energy’s "black swan" in wind. More importantly, he has 3 stocks lined up right now for Energy and Capital readers. Learn more about the Alternative Energy Speculator simply by clicking here.

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