Let’s start with a couple disclosures. First, having lived through the disastrous economic consequences following the first Arab oil embargo in 1973, and having been in the oil business during the late ’70s and early ’80s, I have a heightened sense of just how dependent our economy is on oil. I’m constantly amazed at the lack of concern shown in the media and by more professional observers when oil prices start to climb precipitously, as they have done over the past year or so. I’m puzzled, too, by how the layoffs at Ford Motor Co. and the financial woes of airlines–two industries historically in the path of the initial shock waves from higher oil prices–are treated as unrelated incidents. Virtually everything we Americans have is cheaper because it has been transported by, made with the energy from, or plain made out of petroleum products. So when oil prices go up, our lives get a lot more expensive.

Second, having had a business interest in understanding the dynamics of oil supply and demand, I read extensively on the subject, including the prevailing notion back in the day that world oil supplies were on the wane and prices were destined to climb from $40 a barrel to $80 then $100, and continue through the stratosphere. My research revealed that such dire predictions were nothing new: Every 30 years or so dating back at least to John D. Rockefeller’s formation of Standard Oil in the late 19th century, an academic would pierce the public consciousness by prediction that we are running out of oil.

So when my friend Dick Vodra, a Washington D.C.-area advisor and out-of-the-box thinker, approached me at a conference last fall about his new paper on how we’re running out of oil, I had a strong sense of deja vu and possibly made some tactless mention of it to Dick. But he soldiered on to give me the gist of his paper, “Peak Oil: The Next Energy Crisis,” and convince me to take a copy of it (the paper is available at www.investmentadvisor.com).

I reckoned we wouldn’t run out of oil in the next couple of months, so I put his paper on my to-read stack and turned my attention to more immediate crises. Now, having finally gotten around to reading his paper, I have to admit that it’s more intriguing than I expected: he makes a good case and backs it up with compelling data. Even if Vodra and others are wrong that world oil production will reach its peak and start declining anytime soon, I suspect that as rising oil prices again reach the public consciousness, financial planners will need to have an opinion one way or the other, if only to answer clients’ questions. Here are a few thoughts on the subject that I hope will be of help.

The Theory

The current theory of peak oil didn’t originate with Vodra. It was foreshadowed in 1956 by Shell Oil geophysicist M. King Hubbert, and recently reintroduced by another Shell Oil and now Princeton University geologist, Kenneth Deffeyes, in his book Hubbert’s Peak: The Impending World Oil Shortage (Princeton University Press, 2001). Both Deffeyes and Vodra make much of Hubbert’s original prediction that U.S. oil production would reach its peak in 1970–and he remarkably called that top within a few months. Crude oil production within the United States has been in decline ever since.

For a global picture, Hubbert (who died in 1989) and then Deffeyes applied the same analysis to world oil production: looking at current production, projected production, the frequency of newly discovered oil fields, the likelihood of new discoveries, and the curve of the increase and decline in oil production from all oil fields. Among the findings: No major oil fields have been discovered since the 1960s (North Sea, Alaska, Siberia); 2003 was the first year in decades that no significant fields were discovered; and the world’s consumption of oil has exceeded discoveries for the past 25 years. Add it up, and Deffeyes predicts that global oil production should hit its peak, well, right about now.

Wow. Scary stuff. But before I liquidated our holdings and headed for the mountains (oh, wait, I already live in the mountains), I wanted to get another opinion. So I asked my father-in-law. Fortunately, he’s not just any father-in-law: Dr. Richard Moiola is the former chief of sedimentary geology for Exxon/Mobil, and attended graduate school at the University of California with Deffeyes. Happily, Dr. Moiola was very familiar with the work of Hubbert and Deffeyes.

After a lengthy discussion, I took away two general points. The U.S. is a relatively controlled environment: the political climate and economy are stable, oil production is uninterrupted, and virtually every square mile has been extensively explored for oil and gas potential. Predictions based on such stable data are relatively easy compared to doing so for the rest of the world. So calling the peak of world oil production within decades instead of months would still be largely a stroke of luck.

Still, it seems inescapable that sooner or later there will be a peak in world oil production, and that sooner is probably the more likely scenario. That’s because regardless of production, global oil consumption is climbing steeply. This is the most compelling part of Vodra’s paper. Consider that world oil consumption is currently 84 million barrels per day, and growing at a rate of 2.5% a year. With China, India, and other developing countries just beginning to come online as oil consumers, that rate is sure to rise. Yet even if we remain at that 2.5% growth rate, we will consume 950 billion barrels by 2027–the same as the world used from 1859 until now. Only 15 years later, in 2042, we will have used another 950 billion barrels.

Even if the rest of the world isn’t as explored as West Texas, it just doesn’t seem likely that we’ll find anywhere near enough oil to cover that demand. Which means oil prices will probably continue to rise, long term. Yet here’s where the crystal ball gets cloudy, even for Deffeyes and Vodra: Predicting how the global economy will respond to rising oil prices starts to sound like guessing to me. For instance, since 1999, the price of oil is up nearly 400%, yet our economy has managed to absorb that cost and remain robust.

What to Do?

Yes, Vodra and others can talk about the years it takes for new oil production methods, alternative energy sources, and more efficient uses of current sources to begin to deliver meaningful relief from pricier oil. That’s all based on what we know now. There’s no telling what will happen when the incentives of higher oil prices meet inventors, entrepreneurs, and investors all over the world. Since higher oil prices will themselves dampen consumption, there’s just no telling when these levels of price-hikes will occur.

What is predictable is that all kinds of folks will offer their advice on what we should do about it when it happens. If history’s any indication, some will be knowledgeable, thoughtful, and unbiased. The majority, however, will fall short on some of those criteria.

Even Vodra himself is sadly light on this point. First, he tells advisors to have an “updated conversation about risk and time horizons” with their clients, in light of peak oil. I suppose that means you need to have an opinion yourself, but the direction of such a conversation is left blank. Next, he tells us to decrease debt and increase liquidity, presumably in anticipation of higher interest rates, but he doesn’t say that.

A third suggestion is to increase portfolio exposure to energy and “related” sectors. Finally, he recommends an updated investment policy statement that explicitly states the assumption upon which it was based. I’m guessing here that’s to CYA when those assumptions evaporate in an economic downturn.

My own recommendations would be more on the cautionary side. First, I’d suggest that most of what we were told in the last oil/economic crisis was complete bunk. Back then, we were told that oil prices were going to the sky, inflation was going through the roof, gold was the place to be, they were not making any more real estate, and a properly allocated portfolio held bonds, tangible assets, and direct investments in oil and gas and real estate. How did those portfolios work out?

Then I’d point out that in uncertain times, the primary role of an advisor is to take a page out of The Hitchhiker’s Guide to the Galaxy and Don’t Panic!

Wall Street and the media thrive on scaring people: it sells newspapers and gets them to “act,” but the vast majority of “opportunities” they offer don’t turn out so well for individual investors. Even if the underlying assumptions are right–higher oil prices, rampant inflation, etc.–the loads and deal terms usually wipe out any profits. Your job is to prevent your clients from making these knee-jerk investments.

Remember, you’re not trying to get your clients in on “the bottom floor” of anything: you’re not coaching day traders. Economic conditions will usually give you the heads up in plenty of time to keep your clients whole. As equities decline and interest rates inch up, you’ll naturally transition retirement portfolios toward bonds. By keeping your eye on clients’ goals, when rates get high enough, you’ll lock them in.

As oil prices rise, the big equity winners are usually big oil, because they have oil reserves and stocks they bought for less than the current price. But as your clients pressure you to find “opportunities” in the down market, be careful to avoid energy stocks that the herd has bid up past any reasonable future valuation.

Finally, when the economy is sluggish, lower profits mean lower incomes, which translate into lower tax revenues. A rational government might see that as a time when we need lower taxes to stimulate the economy, but reason doesn’t always triumph in government. So you might plan for higher taxes, and be prepared to fend off the tax-shelter salesmen, too.

Bottom line? Hubbert/Deffeyes/Vodra will undoubtedly be right. But due to the uncertainty of the timing or the result of “peak oil,” that knowledge is of little use to you or your clients. Still, sooner or later your clients will probably need you more than ever (or at least since the last oil crisis). When they do, just keep doing what you do. After all, that’s the point of financial planning, isn’t it?

Bob Clark, a former editor-in-chief of this magazine, sagely surveys the advisory landscape from his home in Santa Fe, New Mexico. He can be reached at rclark7000@aol.com.