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Thursday, 19 November 2009

Peak Oil, The Revenge Of Planet Earth?

Depletion or Destruction?

A recent report from the UK’s Energy Research Council, a body not known for sounding panicky alarms, suggests that under all reasonable scenarios the rate of global oil production will peak by 2030. By their worst case estimates it’s already done so. The reality of a world of depleting oil resources is upon us: green activists would argue that it’s a race between depletion and destruction.

As this is a situation that will affect the vast majority of people alive today it’s something you might think would be at the top of policymakers’ agendas. However, in the dash to save the world from economic collapse this is about the last thing on their minds. So the question is probably whether the market can save ourselves from ourselves. Based on recent experience of oil trading it'll probably pay not to be too hopeful.

Wanton Irrationality

Oil is no less subject to bizarre and wantonly irrational behaviour by traders than any other market. We certainly saw evidence enough of this in 2008 when oil prices spiked at near $150 a barrel. At this point all sorts of odd behaviour started to appear. There was a bubble in small oil companies with no assets other than a dubious claim on a scrubby bit of land in some far-flung, God-forsaken, hell hole. Well, that’s if they actually had any claims at all.

While all this was going on oil traders spotted that that the futures price of oil had soared, leading to a big gap between it and the actual real ‘spot’ price of a barrel (technically when the future price is greater than the spot price a commodity is said to be in ‘contango’, probably because ancient traders couldn't spell). This situation led many traders to vigorously engage in arbitrage, selling futures and buying actual oil – which they then needed to store until they had to deliver on their futures contracts.

So they started hiring oil tankers to slowly steam around the world carrying the excess oil. Which led to the wonderfully paradoxical situation where the world was awash with the black stuff even as the price climbed to ever more ridiculous levels and everyone started moaning about the price of gas. And, of course, small investors piled into oil and oil stocks.

Fiction and Fact

Then Goldman Sachs suddenly moved their top-of-the-range peak oil price prediction up to $200 a barrel. That, of course, was the cue for a crash even more vertiginous than that of stocks, down nearly 80% at the worst point.

Underpinning all this amusing nonsense, however, are some brutally realistic facts. As the ERC report relates:
"Although there are around 70,000 oil fields in the world, approximately 25 fields account for one quarter of the global production of crude oil, 100 fields account for half of production and up to 500 fields account for two thirds of cumulative discoveries. Most of these ‘giant’ fields are relatively old, many are well past their peak of production, most of the rest will begin to decline within the next decade or so and few new giant fields are expected to be found."
What had started as a upwards move based on some pretty sensible oil market fundamentals ended up as a behaviourally induced rout when the inflated expectations of emotionally compromised investors were burst by a nasty dose of economic reality. Situation normal, then.

The Impact of Oil Depletion

What’s worse, and makes some of the irrational moves in the market even more explicable, is that the data from these giant fields is often not publically available being both commercially and, in some cases, nationally, sensitive information. As we saw in Ambiguity Aversion uncertainty is a major factor in investor perceptions and in situations characterised by it it’s to be expected that you’ll see emotionally driven swings in prices, often quite sharp ones. In reality the facts about peak oil will emerge only slowly and in hindsight.

Normally we can’t know what impact such an event will have. The world is too complex to make multi-faceted predictions about stuff that lies far in the future. Mostly we don't have a clue about what will happen next week. Without knowing future economic conditions we can’t even predict energy consumption requirements – the current downturn has reduced oil usage quite sharply, for instance – let alone oil production levels.

So we don’t know what impact new energy sources will have or whether attempts to reduce CO2 emissions will help. We don’t know how quickly oil fields will deplete or whether new giant ones will be found. We don’t know what effect the huge potential growth in China and India will have. We don’t know if the Middle East will go up in flames and Iran will close the oil gateway to the world, the strategically critical Straits of Hormuz. We don’t know whether governments will wake up and actually do something useful.

OK, maybe we can guess the answer to the last one.

Some Certainty in an Uncertain World?

However, we do know a few things with something approaching unusual certainty. We know that the probability is that the window of peak oil production is upon us. We know that investment in alternative energy resources is woefully lacking. We know that people will not easily be weaned off their energy dependency.

At some point there will have to be a sustained attempt by the developed world to develop new energy sources. An increase in nuclear usage is a virtual certainty. Improvements in wind, solar, agri-power and other sources will also come. Significant and sustained increases in energy prices of all kinds is virtually assured: the problem is that replacing oil completely will take a long time. The Hirsch Report commissioned by the US Department of Energy estimates that it’ll take at least 20 years of sustained investment before the peak to avoid serious energy dislocation. It may already be too late to achieve that.

Pascal's Ultimate Wager

It’s impossible to discuss energy issues without addressing global warming. We know that it’s happening, we just don’t know what effect it will have. Applying Pascal’s Wager suggests that the worst-case downside of allowing it to continue unchecked – the death of most of humanity – is probably worse than the worst-case downside of stopping it – a significant reduction in global economic growth. Of course, Planet Earth would continue without us, no doubt vowing to never repeat that particular experiment.

The way forward in a world in which oil is hideously expensive is not clear-cut. One route leads to a vast increase in global coal consumption, a path that will do nothing to save the polar bear, the other to a more sustainable future but at the cost of much reduced economic growth. As that famed economist Woody Allen opined:
"Today we are at a crossroads. One road leads to hopelessness and despair; the other, to total extinction. Let us pray we choose wisely."
Our past unwillingness to plan properly for the future means that energy is going to become a lot more expensive, at least in the medium term. Everyone should prepare themselves accordingly, we all need to choose which price we prefer to pay.

Related Articles: The Malthusian Prophesy, The Tragedy Of The Financial Commons, Pascal's Wager - For Richer, For Poorer


Rob Bennett said...

Woody nailed it!

As you know, I am not a fan of the Efficient Market Theory or of Buy-and-Hold Investing. I have an article at my site entitled "Woody Allen's Take on the Efficient Market Theory" in which I argue that many of us believe in this idea because we feel that we have to believe in something and we are not aware of anything better. So, like Woody said about his friend who was asked by a psychiatrist why he didn't just tell his brother that he really isn't a chicken, we keep on doin' because we "need the eggs."

I think that pulling in observations from songs or jokes or popular culture can be a big aid to understanding in the investing field. Otherwise, things go around in circle. Sometimes it's only the stuff from outside the usual sources of insights that can work their way up past our radar screens and help us to entertain forbidden thoughts.


Rob said...

As a geologist I get less concerned about global warming than others, like my daughter. Where did the carbon in oil and coal come from? The atmosphere of the Carboniferous Period. The world has been there before.

nick said...


Great post, as usual. One point regarding Pascal's Wager - of course if you don't have any way of estimating the likelihood of the outcome (extinction in this case) is it meaningful to use it?

An awful lot is justified in this way on the altar of 'minimising risk'. Humans are terrible at estimating risk in the first place, as we've seen, and you've posted about before :)


timarr said...

Hi Nick

Very valid point. Of course it also depends on the value you put on that which might be lost - so you might argue that even if there's a very small chance (C) of a very nasty event (E) then C*E would still be a significant risk so, if you put a big enough value on E then the alternatives don't look too hot.

That's essentially the way Pascal used the wager - obviously he couldn't compute the probability of eternal damnation but for him personally the theat of this so vastly outweighed the temporary pleasure of a lifetime of hedonism that it made his choice easy. There's a fairly obvious analogy there that I declined to use :) However, the fact that Pascal's risks are personal calculations does make the use of it pretty dubious for this type of risk analysis but it does help put the issues in a personal context.

You're right of course, that humans are terrible at estimating risk, but it's a two way street - we overestimate the likelihood of quite commonly occurring (but still personally unlikely) events and underestimate the probability of rare but devastating ones. So approximately 100 children a year are abducted by strangers in the US while the (single) Indian Ocean tsunami killed 230,000 people. Meanwhile overreporting of rare events (and the illusion of control) also skews our risk perception - far more people die on the roads each year than in plane crashes, yet what do we worry about?

It's bloody hard this risk stuff ..

nick said...

Yes it certainly is. One particular point I guess is to consider what 'quadrant' the Pascal's risk occurs in - from

Haha, I hadn't picked up on the analogy until reading through your reply :)

A particularly insightful post that I saw regarding AGW was on Slashdot of all places -

Now, without getting into the is-it-or-isn't-it of climate change debate, I think it is a great example of how our perception of, and strategies for dealing with risk are flawed. I guess that is why there is money to be made.

Keep up the good work. Do you have a reading list that you're working through?


timarr said...

Hi Nick

I love that Pascal Wager post, just shows how you can use the thing in multiple ways. Bangs straight up against the Tragedy of the Commons, too. There is, of course, the slight problem that the (S, H) possibility might lead to a runaway heat death and there we tip over into the infinity multiplied by anything equals something or other. Depending on how you frame the problem you get different answers (i.e. PW is personal and relative not global and normative). However the main point, as you astutely note, is whether it’s possible to make money out of this by predicting how people will react.

No, there’s no reading list: years of reading and thinking. Recent good reads were Traffic by Tom Vanderbilt and Buyology by Martin Lindstrom. Lots and lots of academic papers and central bank reading as well. I do a lot of travelling: good job really :)