09/01/2008 - 22:00

Peak oil's harsh realities to hit hard

09/01/2008 - 22:00

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Australia’s government, its citizens and its industry leaders need to prepare for the end of the oil age.

Peak oil's harsh realities to hit hard

Australia’s government, its citizens and its industry leaders need to prepare for the end of the oil age.

Global oil supply and demand are now finely balanced, so that increasingly restricted supply in the medium to long term will push the oil price much higher in real terms. This environment creates substantial investment opportunities in oil production and in development of alternative energies and energy efficient technologies, as well as in secure food production.

Within the time frame required, the application of alternative sources of energy and new energy technologies is unlikely to fill the threatened energy gap created by slow oil production growth, leading to a much higher oil price going forward.

Oil will not disappear this century, but its use will increasingly be restricted to high value applications, such as plastics, textiles, chemicals and medicine. During the past 200 years, a rapid growth in Western world economic dominance and a global population explosion can be largely attributed to the impact of cheap energy in the form of oil and spin-off technologies in agriculture and medicine.

Adaptation to the new energy environment will cause seismic shifts in the way we live over the coming decade, equivalent to the major shift that occurred as a result of the agricultural ‘green revolution’ from the 1940s to the 1970s.

Unless replacement power sources can be rapidly developed, civilisation will face increasing challenges to maintain the planet’s current population burden without a deterioration of living standards.

Briefcase believes globalisation of the world’s economy, based on cheap, oil-based transportation, will need to be re-evaluated and some level of re-localisation, especially of food production, is likely to become economically feasible as the decade unfolds.

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Global oil consumption now runs at 31.5 billion barrels per year. Since about 1980, when the annual rate of new oil discovery last matched global production, oil discovery rates have declined, so that new oilfield discoveries are currently replacing only between 20 and 25 per cent of annual production, hence proven oil reserves have been in decline for about 27 years.

Briefcase’s calculations indicate that physical oil production limitations will restrict consumption by about 2012, despite rising latent demand. The mechanism acting to limit oil demand so that it matches available production will be its price, which is sure to rise in real terms.

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Russia recently overtook Saudi Arabia as the world’s largest oil producer, but Saudi planners are working to bring on an additional 1.5 million barrels (MMbbls) per day of production by 2011. The country faces a massive task to just maintain its current production, given that its major oilfields, discovered in the 1940s and 1950s, are now in decline. Still, the Arabian Peninsula holds huge exploration potential, but peak oil is not about reserves, it is about daily flow, so Saudi production is unlikely to ever breach an annual average rate of 11.5 MMbbls per day.

Oil production from Angola, Chad, Brazil and Venezuela is on the rise and should score substantial gains over the next five years or so, but the outlook is less clear post 2015. Production from major production centres such as Mexico’s Gulf Coast region and the North Sea is in rapid decline.

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If all goes well, by 2010 oil production should be sufficient to meet expected demand, which is forecast to grow at 1.3 per cent a year. However, history tells us that all does not always go well. There will be labour disputes, cost and project development overruns, wars and civil disturbances, severe storms and a host of other factors impacting on project development and ongoing maintenance of existing production facilities. A severe shortage of skilled drillers, engineers and building materials is also affecting production expansion, so peak oil is not just a geological phenomenon; it is linked to economics and logistics as well. A forecast economic slow down in the US, and the likely flow-on effects to its trading partners during 2008, could also provide some short-term breathing space, limiting demand growth and enabling oil inventories to be replenished from the historically low levels currently prevailing.

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Many observers calculate that peak global oil production will occur before 2012. Some say that it is happening now. Briefcase’s calculations are based on the bold assumption that global oil production conditions do not deteriorate any further, which may prove to be a reckless and unrealistic expectation. Social and political conditions are already making big impacts, restricting production in Nigeria, Colombia and Iraq, while production from Chad and other parts of Africa is also affected.

Interestingly, about 70 per cent of world oil production is controlled by national oil companies, or more if one takes the view that Russian oil is largely a national industry.

Rising political tensions and a growing scarcity of oil supply is likely to result in a gradual breaking down of the free market in oil. Governments from Western Australia to Venezuela are tilting the playing field to ensure local supply or supply to friendly nations.

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Oil is very much a political commodity. Notably, most major producers are wasteful consumers, relying on low cost, often subsidised oil supplies, which does nothing to encourage efficient use or alternative energy solutions, though forward looking states in the Gulf are now working toward developing excellence in solar and nuclear technologies.

Oil consumers are worried. Arguably the US, which now consumes just over 20.7 MMbbls of oil per day but only produces 7.4 MMbbls per day, has been sending its troops around the world, partially to secure its oil supplies.

The Chinese are doing much the same thing, but with fewer troops and more financial support. Chinese consumption is rising towards 8 MMbbls per day while domestic production sits at 3.7 MMbbls per day. On a recent trip to Asia, Briefcase heard strong reports from reliable sources that support alarming rumours of Chinese interests mobilising up to four million pardoned prisoners to Africa as indentured labour to work on development projects and other oil-related infrastructure.

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All over Africa, oil remains a curse whose development and production rarely benefits more than a handful of local citizenry, with profits re-routed into beef cattle property in Brazil or arms to support corrupt regimes.

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The upshot of all this oil intrigue should focus investors on opportunities and threats. If your super fund is betting on the long-term growth prospects for airlines and toll roads, I would be very concerned. As much as we might like to see an alternative, coal mining and power development based on coal still makes financial sense, even though it does not make sense for global warming. Investments in ‘safe’ oil production and exploration will rise to a premium. Stocks such as Woodside, Santos, Beach Petroleum, Arc Energy and Australian Worldwide exploration will find favour against peers with operations in Africa or South America.

Local food producers, along with companies selling alternative and efficient energy technologies, will be on the right path to reward shareholders, subject of course to all the normal risks associated with funding and quality of management.

 

• Peter Strachan is the author of subscription-based analyst brief StockAnalysis, further information can be found at Stockanalysis.com.au

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