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Peak Oil: An Overview

Peak Oil Part I, Peak Oil Part II, Peak Oil Part III

Peak Oil Overview Part I: The Basics

As crude oil and unleaded gas prices have rocketed higher on the New York Mercantile Exchange(NYMEX) and  International Petroleum Exchange (IPE) waves of outcry from Americans have abounded with accusations ranging from X-File type conspiracies between crude oil companies to blaming “that guy in Washington”. Most of us are quick to lay blame on others, however, we really should begin to take a look in the mirror, however, I’ll save that topic for another day.

The current news headlines about rising unleaded gas and heating oil prices have been fueled mostly by weather related stories. However, what most Americans and many others in parts of the world are surprisingly unaware of is that there are much larger and long-term dangerous forces looming on the horizon for the international crude oil and distillate markets, such as unleaded gas and heating oil, then the recent headlines.

Imagine for a moment you are five years in the future and when looking back to 2005 unleaded gas and heating oil prices seemed, in contrast, stunningly cheap. That should give you a very small idea of the potential effects that something called Peak Oil could, according to many top geologists, have on energy prices.

What is Peak Oil? No, it’s not a top in energy prices. Peak Oil, also commonly referred to as Hubbert’s Peak which was named after the late Dr. M. King Hubbert, a Geophysicist who made several important contributions to geophysics but is most well- known for his research on the capacities of crude oil fields and natural gas reserves, is the tendency of crude oil production to follow a bell shaped curve, steadily rising before reaching its pinnacle then entering into a permanent decline hence “Peak Oil”. Whether it be a single individual oil well, an entire nation’s crude oil production, or the production of oil of the entire world, infinite non-renewable resources tend to follow this bell shaped curve of production. However, it should be noted that peak oil is not running out of crude oil but having exhausted all the “cheap oil”. Although, for industrialized economies leveraged on ever-increasing amounts of cheap crude oil the consequences of Hubbert’s Peak may be dire.

Hubbert’s research into forecasting oil production has been stunningly accurate for predicting crude oil production peaks of various countries, such as the U.S. and Russia, many times. Initially, Hubbert’s prediction in 1956 that U.S. crude oil production would peak around 1970 and decline thereafter was scoffed at then but his analysis has since proved to be extraordinarily accurate as U.S. Crude Oil production peak in the early 1970’s and has steadily declined since.

Based on Hubbert’s original research the potential peak in crude oil production, not just for one country, such as Saudi Arabia, but for the entire world has potentially arrived! At present, current crude oil depletion rates are running around 1.25 - 1.5 million barrels/day (Mbd). While Saudi Arabia, the world’s largest crude oil producer, is still technically a swing producer their control over global crude oil markets, along with OPEC’s, has diminished greatly and will continue to erode into the future, as Matthew Simmons, founder and Chairman of the world's largest energy investment banking company, Simmons & Co. International, points out in his new book, Twilight in the Desert. As a commodities futures trader, who began his career on the trading floor of New York Mercantile Exchange COMEX division, it was there that I was introduced to Hubbert’s production curve over eight years ago, I highly recommend reading this book as it will provide insights into potential long-term fundamentals that will affect the prices of crude oil, unleaded gas, and heating oil futures markets for many years to come.

At present, Saudi Arabia could easily witness abrupt and large catastrophic crude oil production declines at any time. For the time being, Saudi Arabia may be able to maintain current crude oil production rates for several years, but will not be able to increase production levels enough to meet ever increasing global demand. Furthermore, renowned petroleum geologists, such as Colin Campbell author of The Coming Oil Crisis and Kenneth Deffeyes, Professor Emeritus at Princeton University and author of Hubbert’s Peak: The Impending World Oil Shortage and Beyond Oil: The View Hubbert’s Peak, subscribe to the belief that Saudi Arabia and global crude oil production in general will soon reach an apex, after which its production will decline and the world will be confronted with an immense and potentially catastrophic oil shortage that will halt economic growth, create run away inflation, potentially destabilize the entire Middle East, and create natural resource based wars between the world’s economic powers such as the United States and China.

In conclusion, the ramifications of Peak Oil shouldn’t be underestimated, as crude oil and its distillate products aren’t just utilized in making your automobile run and to heat your home. For example, byproducts of crude oil, in someway or another, are used in rubber, plastics and many other crucial items that humans make use of each and every day.

In my next segment of this series I shall provide you with a more detailed explanation of Peak Oil and its potential consequences.

Peak Oil Part I, Peak Oil Part II, Peak Oil Part III

Peak Oil Overview Part II: A More In-depth Explanation

For understandable economical reasons, crude oil companies throughout the decades have focused on extracting the easy-to-reach cheap crude oil. At first, oil was extracted near the surface on land. This oil typically was of the “light and sweet ” type or put more simply, refined in to byproducts such as unleaded gas and heating oil very easily. As this process has continued for sometime land based crude oil has and will continue to become even harder to come by, therefore, production rates of crude oil will decrease substantially. Additionally, all oil fields, such as the Guawar field in Saudi Arabia, which is the world’s largest, eventually reach a point in their existence where they become economically unfit to continue to produce oil. If the costs associated with extracting a barrel of oil equates to the profit of producing a barrel of crude oil it obviously becomes a fruitless endeavor.

For over three decades man has producing less and less crude oil than it has been consuming. At present, over 50 crude oil producing countries, such as Russia and the United States have produced less of the black gold than they have in the past. Additionally, the North Sea region, a prolific oil region twenty years ago, has witnessed sharp crude oil production declines. Furthermore, many other crude oil producing nations may not be to far off in witnessing a permanent peak in the crude production.

“We now find one barrel of oil for every four we consume . The general situation sees so obvious” Dr. Colin Campbell, Geologist, in a recent testimony to the British House of Commons.

For example, Saudi Arabia’s big oil fields were all discovered way back in the 1950’s. Some of you may already be aware of that fact, due to recent headlines, that roughly 10 million barrels of crude oil per day are pumped out of Saudi wells. But did you know that along with this 10 million barrels of oil a day comes over 3 million barrels of water according to the Saudi’s official numbers? That significant because. From a historically standpoint, wells that hold a 40% water content typically are near exhaustion from a profitability standpoint.

While oil fields don’t perfectly follow an ideal bell-shaped curve the Hubbert curve is very powerful tool in oil production analysis. Utilizing Hubbert’s techniques and other methods many renowned geologists, such as Colin Campbell, believe that “Peak Oil” may have or will happen in the next few years. Although, the official figures compiled by entities, such as OPEC and the U.S. Geological Survey, forecast a very optimistic forecast of global oil production peaking about 30 years from now. However, it should be noted that the “official” figures have been very unreliable in the past.

So what does this all mean to you? For starters, highly leveraged financial markets, such as those in the United States, are built around the assumption of constant or near consistent growth of their Gross Domestic Product (GDP). Cheap Oil and energy has been at the heart of building superpowers, such as the United States, just like it is in present day China. If crude oil production has peaked or will in the near future prices of crude oil and its byproducts, such as unleaded gas and heating oil, will rise to freighting levels.  The implications of this would have ramifications on sectors and issues ranging from agriculture, geopolitics, transportation, and the economic stability of entire nations. At present crude oil prices are around $65/barrel, and you can already witness a growing uneasiness in global geopolitics over crude oil and energy, here are just a few examples:

  • China’s bid of approximated $18.5 billion to buy Unocal, a U.S. based corporation, a division of Standard Oil.
  • China, the second largest energy consumer in the world behind the U.S., has been assertively infringing on one America’s most important natural gas resources with a national mandate of securing 2 million barely a day from Alberta, Canada.” There is no more secure supplier to the U.S. than Canada.” Report by the Center for Strategic and International Studies, Washington, DC. At present China’s views energy shortages as its top most serious threat to national security and social stability.
  • (Caspian Sea Region) - China, Russia-led alliance wants date for U.S. pullout. The Caspian Sea region, a major oil power area, is presently a location of immense competition between global powers. Much could depend on the outcome of this area because the nation or alliance that, for the most part, can control the pipeline routes in this area could seize new corridors of trade and power
  • Putin’s Aide Warns of Finno-Ugric Conspiracy to Seize Russia’s Oil Assets

Peak Oil Part I, Peak Oil Part II, Peak Oil Part III

Peak Oil Overview Part III: Protecting Your Financial Portfolio

Crude Oil, outside of rising shipping costs of every product we buy, is unlike any other commodity that is traded on a regulated commodity futures exchange. It affects a broad scope of products and services we utilize every day. Here is a small sample:

Plastic containers and moldings of almost every type imaginable, nylon and synthetic fabrics in your clothing, computer and other electronic components, tires - it takes about seven gallons of oil to produce a single tire, brushes, makeup, pens, candles etc. etc.

Should Peak Oil arrive in the next few years, if it isn’t already upon us, constant declining production of this vital commodity will impact virtually everything imaginable. Therefore, in your attempt to find financial nirvana you can’t be locked into last century’s oil model of a mix of just U.S. stocks and bonds. That portfolio mix just wont cut it in today’s environment! And surely it won’t fly in a hyper-inflationary environment. Wouldn’t you agree?

While the U.S. government doesn’t count food and energy cost in its headline Consumer Price Index (CPI) number, which is released around the middle of every month, you and I don’t live in their imaginary statistical rigging world! So what can you do now and in the future to protect or hedge yourself and your family’s financial future against rising energy and natural resources prices?

To shield your portfolio(s) against rising energy costs they are four major investment sectors in the financial world that you could possible allocate capital to:

  • Bonds
  • Equities
  • Commodities
  • Currencies

Of the four choices above commodities and natural resource equities are typically you’re the best sectors to consider for hedging against drastically rising natural resource prices. Additionally, currencies of different nations can also be utilized as a potential sector to consider which I will elaborate on more in-depth shortly.

Natural Resource Based Equities:

Stocks in companies that your may want to consider are those that: produce crude oil or natural gas and those that explore for oil and gas. Additionally, gold and silver equities also qualify. Why? Because, economies that are highly leveraged to cheap energy, such as the United States, could see their respective national currency plummet on the foreign exchange market (FOREX) in the future. Precious metals are negatively correlated to the U.S. Dollar. So, if the U.S. dollar falls on global forex markets, gold should witness an increase in price. Furthermore, precious metals are considered to be and have been considered for centuries as a tremendous hedge against inflation.

One item you may want to consider. If you build a significant position in a few gas and oil related companies that you plan on holding for the long-term I would recommend taking them out of street name a get a stock certificate in your name. While this may seem over cautious I personally would advise it. Additionally, you may want to consider purchasing crude oil and gas related equities on global exchanges, which have equity listings that are priced in Euros, Canadian Dollars, Australian Dollar, or Swiss Francs.

Commodity Futures:

Commodity futures contracts are another avenue to consider. Like stocks, you can trade for yourself but I would recommend that, unless for have a considerable amount of time to watch the markets, you probably should consider a managed futures program. Managed commodity futures programs has been proven through research conducted by various financial scholars to significantly reduce stock and bond portfolio volatility. Why? Because commodity markets are financial instruments that have a low to slightly negative correlation to stock and bonds. One of the key tenets of Modern Portfolio Theory, as developed by the Nobel Prize economist Dr. Harry M. Markowitz, is that more can efficient investment portfolios be created by diversifying among asset categories with low to negative correlations.

Other benefits of managed futures include the easy of global diversification. As the establishment of global futures exchanges accompanied with an increase in actively traded contract offerings have allowed trading advisors to diversify their client’s portfolios by geography as well as by product.

Currency Trading on the foreign exchange (FOREX) markets:

Many of the same concepts, such as reduced overall investment portfolio volatility, that apply to allocating capital in commodity futures markets are applicable toward the Forex sector. Additionally, if you don’t have ample amounts of time to dedicated towards following the global currency markets your ideal avenue of participating in this sector may be a managed forex account.

Peak Oil Part I, Peak Oil Part II, Peak Oil Part III

Paul Skarp
September 26, 2005

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