Is 'Peak Oil' Already Affecting the Stock Market?
By Jim Kingsdale
If I were asked to recommend an energy advisory team for the next President I’d start with Robert Hirsch. Hirsch is a defense planning expert who has headed up major consulting assignments for the Defense Department among other clients and in 2005 he published a major study of the impacts and potential mitigation of Peak Oil. It famously forecast that a successful transition from oil dependency would need to start 20 years before oil production peaked.
In an interview published on a web site operated by Allianz, the German financial giant, Hirsch outlines the problems of Peak Oil as he sees them today. He believes the crisis will be upon us within a few years, which is consistent with the predictions by other experts such as Simmons, Skrebowski, and Maxwell as I have previously reported, all of whom believe oil production will begin declining within a few years.
What Hirsch adds uniquely is a more nuanced vision of the limits to our economy’s ability to cope with peak oil. Hirsch’s discussion of the economic constriction and great weakness in financial markets that he expects will constrain our normal capacity for remediation of the problems is particularly sobering because of his expertise in evaluating exactly such macroeconomic questions. He adds that voluntary reduced oil production (hoarding) by some oil exporting countries will exacerbate the scarcity of oil itself. His essential point is that the dimensions of the global economy’s dependence on oil are so huge that its scarcity will be crippling and will preclude any easy solution.
I think Hirsch is essentially correct. But I am more optimistic that electrical transportation solutions to the oil shortage can be substituted in OECD countries at a faster pace than Hirsch seems to think is possible, thus perhaps limiting the most extreme economic difficulty to a period of only five to ten years rather than twenty. After all, if the U.S. could go from a standing start in 1940 to substantial war production just a couple of years later, we could accomplish a similar transformation of our transportation systems in a shorter period than might be able to be forecasted. The technologies for making cars that get 100 mpg or even more are already in development. The question rests on whether we will have the same political will that was demonstrated by Roosevelt to deal with the oil shortage crisis. Some countries - Israel and Denmark - have already begun down this path.
The Saudi Vision
Contrasting with Hirsch’s longer term view of peak oil is the Saudi’s belief, shared by many others, that currently high oil prices are mostly a function of financial market speculation and secondarily of lack of refining capacity. On the second point the Saudis are undoubtedly correct in that a great deal of high-sulfer heavy crude is available but cannot be used because the refinery capacity for such inputs is insufficient. After all, Iran reportedly has 25 tankers of such oil floating offshore that are unable to unload due to lack of appropriate refining capacity.
Over the next few years a good deal more refining capacity in a number of developing countries for heavy sour crude will come on stream and will no doubt help alleviate the supply problem. The Chinese recently started up one such facility. On the other hand, that won’t have much impact in the next year or two and by the time it comes the decline in conventional oil production after 2010 will probably make supply constraints so much more acute than they are now that the net result will still be much higher oil prices.
The more immediate vision of relief that will apparently be offered by the Saudis Monday, according the The Wall Street Journal Sunday, is an end to financial speculation - if the OECD countries take appropriate action. In other words, the Saudis are suggesting that current supplies are sufficient (the same tune they’ve been singing for the past year) but speculators are hoarding supplies. This is a theory the truth of which is hotly debated by experts above my pay grade. I take no sides (but color me skeptical), but I do hope that Congress and/or the S.E.C. and/or other agencies will take measures to find out if the theory is true.
I have no problem with the idea of banning hedge funds or other large speculators from the oil pits. Clearly the potential understanding of the reality of high oil prices that would come out of such actions would be a far greater benefit to society than the loss of a bit of freedom for hedge funds. Whether speculators have anything to do with currently high oil prices is an important question that we must put to rest. Of course, whether the Saudis in fact have the oil reserves they claim and whether Ghawar is at near term risk of declining is another bit of knowledge to which the world should have access. Somehow, it seems doubtful that the Saudis will offer this important insight this weekend.
What seems clear to me, however, is that if the Journal’s report is correct and the extent of the new short term oil production offered this weekend is fairly limited, the likely result will be higher oil prices in the near term. If that is the upshot, I suspect the Saudi meeting will be seen as a disaster and an indication that there are no real near term solutions for tight oil supplies.
Are We There Yet?
We know that Hirsch is right; there will come a time when oil scarcity will hobble the economy so severely that the stock market will crash and it will not be profitable to own any stocks, even energy stocks. As I finished reading this interview, I asked myself a question that I find is recurring more frequently. Has that time come already?
Friday’s market seemed like a foreshadowing of that time. The market averages were down nearly 2% partly in reaction to higher oil and gas prices. The EIS portfolio made up almost entirely of companies that benefit from higher oil and gas prices was down about .5%. Losing money is not the objective of any investor, so the fact that I lost less than some other portfolios is really not comforting to me.
Maybe the current weakness is primarily a function of the continued implosion of the housing and financial sectors. But clearly these sectors’ problems are seeping into the general economy and starting to destroy consumer demand. My concern is that if oil prices keep rising on the trajectory that has been in place for the past fifteen months, the economy may simply not be able to make a normal recovery.
In other words, oil prices are rising rapidly even though oil production may not yet have actually peaked. If oil supply continues to be very tight, the oil price may simply continue its rise, anticipating the advent of peak oil, regardless of whether production has yet peaked. If that is the way that 2008 and 2009 play out, then the impact on stocks that I anticipate will happen in a few years could be starting to take place already.
The end point of this exercise will be a portfolio made up of high quality bonds, ETF’s that mimic the price of oil and gas (USO), (OIL), and (UNG), and perhaps some very high quality long term oil and gas assets like (SU) and (COSWF) and perhaps (DVN), (APA), (XTO), and (CHK) that will ultimately be bought out for cash by the oil majors. Even the oil service companies may be too risky to own when everyone is cashing out of the stock market in a panic.
For the past year such stocks are lagging the commodities, indicating that they still represent excellent value. But the early stages of a market decline driven by fears of oil shortages is likely to bring a concentration of funds allocated to the oil and gas sector resulting in fairly good gains in most stocks in the EIS portfolio. Oil and gas stocks, including the service and drilling companies to a lesser extent, will probably behave like the Nifty Fifty of the 1970’s. When that happens, when values in these stocks have discounted higher future oil prices instead of lagging behind current oil and gas prices, it will be time to sell them and go to the portfolio of high quality bonds and oil and gas ETF’s.