These are the nascent stages of a very long-term bull market in energy, particularly oil and gas. By our estimates, crude oil prices are set to soar, perhaps even cross $200/barrel by 2010, and will stay high subsequently. This is driven by a geological phenomenon called “Peak Oil”.
When the energy history of the earth is written, our consumption of fossil fuels on a very long timescale would look like what is represented in the chart that is given here. Humans started consumption of coal around 300 years ago, oil and gas around 150 years ago.
In the next 100 years, these would be virtually exhausted.
The problem for us happens not at the tail end of the energy curve but at the mid-point, i.e., the peak of the energy curve. This is the point at which production is the maximum and subsequently enters an “irreversible decline”. Many analysts confuse “peaking” with “running out”—we are not saying that we are running out of fossil fuels and we are quite sure that even 200 years down the line, we would be producing some of these commodities. But it would be very low quantities of poor- quality fuel.
At this point, the marginal increase in production is driven by crude and once we are past the point of maximum oil production (Peak Oil), the decline of the total basket of fossil fuels follows within a few years. There is very strong evidence that we are at Peak Oil right now.
Predicting the timing of Peak Oil is not an exact science. We will know for sure only with the benefit of hindsight. However, there are four distinct ways to predict it.
1. Hubbert linearization: Peak Oil (also known as Hubbert’s Peak) was first proposed by King Hubbert, a geophysicist at Shell, during the mid 1950s. Using Hubbert’s techniques, Kenneth Deffeyes, author of Beyond Oil: The View from Hubbert’s Peak, has now estimated that Peak Oil happened in 2005.
2. Aspo methodology: Colin Campbell, author of The Oil Crisis, from the Association for the Study of Peak Oil & Gas (Aspo) has predicted Peak Oil by doing an estimation of the world’s oil reserves. In his estimates, the peak of crude oil happened in 2006 and for the combined basket of oil and gas would happen by 2010.
3. Production estimates: Chris Skrebowski, editor of the Petroleum Review, conducted a study of new projects coming onstream over the next five years and using some estimations of declines from existing fields, has predicted Peak Oil to occur by 2010.
4. Study of elephant oilfields: Matt Simmons, author of Twilight in the Desert, conducted an in-depth study of the large oilfields (the top 120 of the 5,000+ oilfields account for 47% of the production) and has concluded that Peak Oil happened by 2006.
So, the estimates for the timing of Peak Oil range from 2005 to 2010. We believe that 2006 was indeed the year of Peak Oil and, as a consequence, prices are headed much higher in the years ahead.
One of the premises of efficient markets is that price signals to the markets create awareness and alternatives. But when the price increase is accompanied by high volatility, as is the case with crude oil, then the signals become very confusing.
The fundamental reason for the oil price volatility that we are observing in the last few years is the disappearance of spare production capacity (from a spare capacity of 6mbpd in 2002, we are down to 1mbpd today). This is exactly the same behaviour as could be predicted from queuing theory of a system operating at full capacity. When a system operates at or above rated capacity, then response times becomes erratic and unpredictable. Similarly, due to our just-in-time oil production systems, any small external event —a cold winter, a hurricane or shutdown of a pipeline, exacerbates an already tight supply situation leading to wild price swings.
First, even at the current historically high prices, crude is unbelievably cheap when compared with other liquids (at a price of $75/barrel, crude would be just Rs19/litre). It’s unfortunate that we have been used to an artificially low price of oil that did not reflect its economic value, scarcity, lack of easy substitutes and non- renewable nature. Oil prices would have to double or triple from the current levels merely to have a price comparable with the more commonly used liquids.
There are solutions to the problems of Peak Oil, but nothing which could be implemented in a short timescale. A study conducted by Robert Hirsch, senior energy programme adviser to the US government, indicated that mitigating the impact of Peak Oil would take a 20-year crash programme.
We are great believers in the response system of our society and hence we are actually optimistic on a long-term basis (15-20 years-plus). But in the meanwhile, we are in for a very rough ride on the energy front.
Business as usual would be unlikely beyond 2010 and companies that are not prepared to handle the emerging scenario would face a highly disruptive business environment. At the same time, Peak Oil also represents a great opportunity for companies that can foresee the emerging situation and evolve strategies to benefit from them.
Shanmuganathan N. is a director at Benchmark Advisory Services. Comments are welcome at email@example.com