Oil may be the wild card

Alasdair Macleod -29 January 2010

The debate about whether the outlook is likely to be deflationary or inflationary, or perhaps the favoured economic recovery (without alarming monetary developments), generally ignores the supply-and-demand balance for key commodities. The fact is that Asiatic emerging economies with some 40% of the world’s population are having a profound effect on this balance for raw materials, in a way we have not experienced in previous commodity price cycles. Already, we see China stockpiling the materials she needs, particularly metals, and she is even buying the companies that mine them as well as virtually taking over a number of African economies to secure supplies for the future.

This activity has certainly woken up investors and global strategists, but it has also deflected attention from energy, which is probably the most important commodity issue facing us. The energy debate has moved from Hubbert’s “peak oil” which was fashionable during the last energy price cycle, to renewable sources as carbon fuel replacements. However, replacing oil, coal, gas and the internal combustion engine by windmills, wave machines and nuclear reactors will take decades, and over the foreseeable future will not counter the increasing demand from Asia.

It is in this context that “peak oil” should be revisited. The basic argument is that oil production in aggregate follows a bell curve, with accelerating production leading to a peak, followed by an “accelerating decline” until the wells are exhausted. Hubbert first applied the theory to oil production in the US in 1956, when he correctly predicted US oil production would peak in the late 1960s, and others have taken up his theory since. Fortunately the world’s total oil production has actually increased from 73.5 million barrels per day in 1998 to 81.8 mbpd in 2008, which has generally satisfied consumption demand[i]. The production numbers suggest the oil has always been there, albeit at rising prices, so peak oil theory is discredited in many people’s minds. They will point out, logically, that higher prices encourage exploration activity and the extraction of more expensive oil.

While this argument has merit, it glosses over the state of global reserves, which will always determine supply. According to BP’s Statistical Review of World Energy 2009, global oil reserves have increased from 667 billion barrels in 1980 to 1,258 billion barrels in 2008, an increase of 591 billion barrels. On the face of it, this increase in reserves is the equivalent of twenty years’ consumption, so there is little cause for alarm. However, of this increase OPEC members account for 88%, or 519 billion barrels, and they also account for 45% of total production. This concentration of reserves and its increase in the hands of eleven cartel countries must be cause for alarm, even though we have lived with it for the last thirty five years, but perhaps for a different reason than might at first appear.

OPEC members’ production quotas originally reflected their reserves, a policy which encouraged members to overstate them. Saudi Arabia’s official reserves have increased from 120 billion barrels in 1978 to 264 billion barrels with no major oil fields added, and other OPEC members, principally Kuwait, Venezuela, Iran and Iraq have also increased reserves with no new major discoveries. Without new fields, one would expect depletion, or optimistically verifiable reserve increases of minor proportions.

No one knows the true position, since reserves for OPEC members are their individual state secrets, but the point is that we are likely to slide into a post-peak-oil “accelerating decline” sooner than we think. Furthermore the true situation appears unlikely to accommodate the increasing consumption in China and the rest of Asia, which according to the luminaries at Davos this week will require production to increase to 100 bpd over the next two decades.

This developing situation is reminiscent of the oil panics during the seventies, though those turned out to be false alarms in the context of production, though the price effect was dramatic. Today it is likely to more serious with reserves based on falsehoods, and even if the West sinks into an economic slump demand cannot fall sufficiently to compensate. The biggest global slump since the thirties led to a drop in consumption of only 450,000 bpd in 2008.

There is even succour for conspiracy theorists. The big powers, such as the US, Russia and China must be aware of this situation. It might explain the invasion of Iraq, to secure preferential supplies for the United States against the day Saudi production hits its “accelerating decline”. Russia is sitting pretty, and China has a problem. There is also conspiratorial justification for the global panic into renewables, which has been promoted on the back of government-funded dodgy science.

In the cliché of today, here are the makings of a perfect storm; and like the best perfect storms, chaotic events come together with little warning.

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[i] Source: BP statistics.

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FinanceAndEconomics

Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

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