The Latest Oil Crisis

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?