06/08/2008 - 22:00

Planning a portfolio around peak oil

06/08/2008 - 22:00

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In halls of power around the world, some very worried politicians and public servants are beginning to realise that peak oil production is real and it is happening right now.

Planning a portfolio around peak oil

In halls of power around the world, some very worried politicians and public servants are beginning to realise that peak oil production is real and it is happening right now. Briefcase calculates that, by 2012 or 2014 at the very latest, global production of oil will have begun an inexorable decline.

Readers need to adjust their portfolios to better weather turbulent times ahead. Briefcase believes the arrival of peak oil production is the most significant event in global economics since World War II, or possibly since the modern discovery of oil in the 1850s.

Petroleum products provided the muscle to mechanise production during the 20th century, fuelling rapid and cheap transport, which has underpinned globalisation of production and the development of an interlinked global trading economy. A decline in oil production over coming decades will lead to unpredictable consequences, most of which are going to be bad news for all of us.

The application of petroleum products to food production has resulted in modern agriculture becoming, in effect, a means of turning oil into food. Oil fuels the mechanisation of planting, harvesting and irrigation, plus provides fertilisers and pesticides which have made modern agriculture so productive, far outweighing the influence of improved plant genetics.

An inevitable increase in the real price for oil, post peak oil, will leave many people hungry in the coming decade and Briefcase predicts the world's population will begin to decline within 20 years.

In the meantime, the flow of ever more hungry economic refugees from South America to North America and from Africa to Europe will raise global tensions as the century rolls on. Just last week, we saw Italy extend a state of emergency proclaimed in the face of waves of illegal immigrants arriving on its shores.

For much of last year, global oil production, which includes condensate and natural gas liquids, as well as biofuels and oil from tar sands, was stuck at around 86.5 million barrels per day. During the first half of 2008, oil production has moved up to around 87.3 million barrels per day, while high prevailing prices have seen significant demand destruction in developed economies as consumers alter their usage habits.

Treasuries of developing nations, that have been heavily subsidising oil prices for domestic and agricultural use, have buckled under the strain, lifting prices, which will have wide flow-on repercussions on demand and potentially political stability as the year unfolds. These events, combined with a slowing of global economic growth in the wake of the US financial crisis, will take pressure off the oil market in the short term, leading to a weaker oil price, back below $US100 per barrel later this year; but not for long.

New oil developments in the Caspian Sea region and in OPEC nations should boost oil production during 2009 and 2010, but ongoing negatives will offset these gains as production falls sharply from Mexico and the North Sea.

Elsewhere, the oil industry is riven with political, social and industrial issues that negatively affect on production outlook. Briefcase believes that a breakdown of the free market for oil is only a matter of time, once the market tightens. Globally, 70 per cent of the world's oil production is already controlled by national oil companies, which have an eye on energy security rather than free market economics. Venezuela is following along the path previously trodden by Zimbabwe, so oil production there is likely to fall until that regime runs its course, while ongoing difficulties remain in Nigeria and Iraq, despite their undoubted geological ability to deliver higher production. The really scary development is a growing voice from the US in effect, calling for it to go out and take control of oil production facilities in other parts of the world. This comes despite the disaster of Iraq, where this type of policy failed.

The common arguments countering peak oil include those who say there is still plenty of oil around. By most estimates only about half the economically recoverable oil has been produced to date. There are still vast resources of oil to exploit, however the problem is that the flow of oil is peaking. If all drilling activity were to stop tomorrow, global oil production would fall by about 4-5 per cent per annum, due to natural field decline.

Today, industry has to deliver 3 million to 4 million barrels more oil per day each year just to keep production steady. Back in 1970, when global oil production was 50 million barrels per day, the task was to develop a much more achievable 2 million barrels per day of new production. Globally, the industry is straining to come up with the 3.5 million barrels per day required to keep production steady before adding 1.4 million barrels per day to cater for expanding demand.

During the past 30 years, annual global oil production has been running ahead of the rate of new oilfield discovery. Even the large new province found in the Santos Basin offshore Brazil will make little difference to the equation. One new Brazilian field is thought to have potential to produce 5 billion barrels of oil and the whole basin might end up delivering 20 billion barrels. These discoveries are located in deep water below salt horizons where drilling costs upwards of $100 million per well. Given the many engineering challenges to be overcome, it is unlikely that oil production can be achieved prior to 2013 and will most likely come on at around 100,000 barrels per day and ramp up over many years. While these are handy numbers for Brazil, which currently consumes about 900 million barrels of oil per annum, on a global scale, if the Santos Basin holds 20 billion barrels of recoverable oil, it would only feed current global demand for 30 weeks.

Add to this the logistics of production and it is apparent that the Brazilian finds will make no difference to peak oil.

The argument used by economists is that higher oil prices will make the market work. To quote the former head of Abare: "If the price of eggs is high enough, even the roosters will begin to lay eggs". Well, despite rising prices over the past six years, oil production from the North Sea or Gippsland has not increased, because there is a physical limit to production. Where prices will have an impact is on demand, but Briefcase suspects that while we have begun to see some demand moderation, the price of oil will need to be much higher before demand adjusts to falling supply.

The other great white hope is renewable energy. So far, bio-fuels have done little but raise the price of grain. If all of the US's corn crop were to be turned into ethanol, it would only supply that country's car fleet for 12 weeks. Wind and solar technologies are great toys, but they are not yet of a scale required to meet energy demands. Renewables do not yet provide transport liquids and are intermittent, while power cannot yet be stored in the quantities required. These technologies will advance, but Briefcase believes that they will not be capable of bridging a widening energy gap in the 5-15-year time frame required.

When global markets come to grips with peak oil, there is going to be a major adjustment to the way they value a business enterprise. Many businesses, which have grown up in the time of cheap oil, will disappear, new businesses will evolve and globalisation will come under pressure, since cheap transport was the glue that kept it all together.

In the short term, some non-renewable energy sources, such as natural gas and nuclear energy, will flourish, while other technologies, such as solar, hot rocks and electric fuel cells will come into their own.

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

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