Peak oil has arrived and prices are rising once again. The only problem with this story is that demand has peaked -- not supplies. Normalization in oil prices is needed to encourage long-term production; however, the 47% rise in oil prices over the past five weeks is at odds with a well-supplied market for 2009.

The rise in oil prices in recent weeks is partly a U. S. dollar phenomenon and partly a result of less drilling, says Eric Sprott, president and CEO of Sprott Asset Management.

"We all have to get off the focus on U. S. dollar oil prices," says James Cole, portfolio manager at AIC Funds, because Canadian producers have costs denominated in Canadian dollars. The rise in oil prices is still meaningful -- 30% over the past five weeks when denominated in Canadian dollars -- suggesting there is more to the rise than a fall in the dollar.

Investors are waking up to the reality of peak oil, says Sprott, who points to 8% decline rates for existing oil production. Peak oil is in fact a theory about falling oil supplies, and is based on the observation that oil production declines after half the oil is pumped from a field.

"For an industry that has generated massive amounts of cash flow and earnings, it has little to show over the last 10 years in terms of supply," says Norm Lamarche, portfolio manager at Front Street Capital.

"The world is unfriendly to oil producers, and they have nowhere to invest," says Lamarche, who believes that oil production has peaked due to geopolitical factors. He points to Venezuela, for example, where policies hostile to foreign oil companies have led to a halving in the country's oil production.

Higher oil prices are needed to justify investment by the marginal producer, says Cole. "You need US$100 [oil prices] for an integrated project to go ahead and make an economic rate of return in the oil sands," says Cole. Yet the fall in oil prices close to US$30 last winter resulted in roughly two million barrels per day (mbd) of oil production capacity to be "deferred indefinitely or cancelled," according to the International Energy Agency (IEA).

Production has been deferred for good reason: the market is currently well-supplied. "Commodity prices are ahead of themselves, there is no question about that," says Lamarche. Global oil demand collapsed, and will fall by 2.5 mbd (3%) in 2009, according to IEA estimates, for the first time in 30 years.

The market is likely to peak between US$70 to US$80 per barrel, says Cole, because OPEC has plenty of spare capacity that can be readily supplied. It could take three or four years for the market to work off that capacity even if demand recovers next year. Moreover, there is very good reason to believe that the economic growth and global trade will not recover to rates seen prior to the economic crisis.

After a substantial move in oil prices, valuations are no longer compelling in the near term. The S&P/TSX Energy Index has appreciated 54% since Feb. 23. It is telling that Sprott, who believes oil production has permanently peaked, currently would not buy shares of oil sands producers.

www.financialpost.com