Great Risk in Our Oil Delusion
By Simon Ratcliffe
ISN't it interesting how some assumptions about the way society works and what keeps it ticking find their way into the collective consciousness and are not challenged or interrogated? Take for example the way we consume energy. Globally, there seems to be a deep-seated, and wholly incorrect, belief that our current patterns of consumption can continue indefinitely because there is an infinite supply of oil. Over the past century and a half we have allowed oil to become vital to almost everything we do. The global consumption of oil is about 85-million barrels a day, or 31-billion barrels a year. There is an almost universal belief that this can go on forever.
The interesting bit is how self-delusionary it is. What I find extraordinary is that our most risk-averse and financially conservative institutions, our banks, do not even mention oil depletion as a risk in any risk category at all. So overriding is the belief that oil is infinite that even the most simple logic is overlooked.
The four major banking groups use a number of categories of risk, which are assessed and managed in order to ensure they do not mismanage the money of their clients and the investments of their shareholders. The banks also use very sophisticated technical, numerical and statistical methods for the quantification of their risk and yet, at a strategic level, they seem to miss the mark completely.
Initially, the primary effect of oil depletion will be felt as an increase in price. The oil price, as we know, works its way through the economy and affects just about everything.
From a risk perspective, it is vital that oil's production life cycle is well understood. Is it seen as a commodity sensitive to supply and demand pressures, to market sentiment and political dynamics on the global stage? Or is it seen as a resource depleting as fast as we are using it with a bell-shaped production curve that reaches a peak and then begins an irreversible decline? All indications are that it is viewed as the former. Oil should come into the picture in the assessment of loans to large, energy-intensive projects which should be assessed from the perspective of their oil-price risk.
Viewed as the latter (and more closely aligned with reality) the risk picture changes dramatically. In fact, viewed as such, the risk of oil depletion cuts through almost all the risk categories tracked by the banks. It becomes the single overriding risk category, which any rational person working in risk assessment would overlook at their peril. Those in risk management would be grossly negligent if they failed to understand just how the risk of oil depletion affects their institutions.
While there is contention over when it will occur, there is consensus among independent researchers that oil production will likely peak in the near future and then go into permanent decline. Declining rates of oil production mean there will be less and less to fuel the global economy, which means less growth. In fact, oil has been so integral to the growth that has been achieved over the past century that some people question whether growth is even possible as global oil production declines. If that doesn't represent a risk factor worth understanding, assessing, quantifying and mitigating, then I don't know what does.
Less oil available globally affects credit risk, as high fuel prices and the knock-on effect affects the likelihood of defaults on loans. Risk in the loan book would be weighted heavily towards those sectors that are fuel dependent, such as road transport, agriculture and distribution. The rising price will quickly change the way many things happen and how many products are made. For example, train travel may become viable again, so investment in that sort of infrastructure will be profitable. Country risk would be weighted towards poorer countries that have a lower oil price threshold.
One thing is certain: banks that have not planned and prepared their mitigating strategies well in advance risk their reputations, if not their businesses. Conversely, those banks that have assessed their risk based on a sound understanding of the oil production curve are likely to have planned investment strategies and reduced their exposure to sectors with a high peak-oil risk and increased their investments in sectors that have low peak-oil risk, thus enhancing their reputations and their long-term prospects.
It is important that we get past the blind spot in our collective consciousness and get to grips with the consequences, because the risks of not planning for them far exceed the time and cost of good planning and preparation.
--Ratcliffe is an energy and sustainability consultant and is the chairman of the Association for the Study of Peak Oil South Africa.