Peak Oil how about snake oil news story image I keep hearing about peak oil. We are running out of oil. The price can only go one way - up. US production peaked in the 1970s, and as fields decline, they're producing less and less (the average decline in production is 9% a year once a field has passed its peak). No one is finding any new oil, reserves are running down, it's time to panic and within ten years we'll be living in an apocalyptic wasteland reminiscent of Mad Max and the Thunderdome.

Yeah right. Actually there are some very big problems with the peak oil scenario. One is that it's usually the new mantra for those people who in 2007 were telling me that UK residential property could only go up in value because 'They're not making land any more'. No, they're not making land any more - and a good thing too, because if you were making it right now, you'd probably be going bust. Or at least you'd have fired half the staff you had two years ago! Sorry, but peak oil does not guarantee that putting your money in oil stocks is a one-way street. And here's why.

First of all, let's look at the supply side of the equation. There are some very significant untapped fields. There's the Falkland Islands, which could be a major field - whoever it actually belongs to. There's West Africa which has only been partly explored. There's the huge southward and northward extension of the Siberian basin. So it's not as if every field that might be productive has already been tapped.

More importantly, some of the 'exhausted' fields from the 1950s to 1970s are now coming back into production. Technology moves onwards, and the fact that you couldn't get the oil out of a field sixty years ago doesn't mean you can't do it now. Particularly with oil prices around USD 70, fields that were abandoned because they were technically too difficult or not economic at a USD 10 oil price can be quite productive now. True, this opportunity has mainly been exploited by smaller producers and is a drop in the ocean rather than a huge flow of the black stuff - but the opportunity is definitely there.

Then there are new technologies which are making a huge difference to productivity, and in some cases creating whole new oil plays. We've got so much better at water injection and other techniques that can extend the life of a field and improve its production levels. One particular area of interest is shale oil. Now there are two separate technologies here and you'll hear a lot of the peak oil proponents telling you that this is a bust flush. But what they're talking about is kerogen extraction. That's where the oil is distributed throughout the rock, a bit like a mineral ore, so you have to smash the rock up into tiny bits and then heat it up so that the oil runs out - mining, not drilling. That's incredibly expensive - some people reckon it will need USD 100 a barrel oil price to make it work - and the majors have tended to give up on it.

But there's a different prospect for getting oil out of shale and that's seen in the Bakken area in North Dakota. Normal oil production means you have to wait a few hundred thousand years or so (geologists will excuse me if that number's a bit offside but it gives you some idea of the speed of the process) for the oil to flow through the rock until it's all pooled together in a nice little reservoir ready for you to get it out via your drill hole. That's all hunky dory is you're in a sandstone area, where the rock is porous, and the oil flows freely through the rock.

With shales, the oil can't move that readily. So what you tend to find is little puddles of oil dispersed through the shale layers in pores and cracks. Getting your oil out of the little puddles is, obviously, costly. But now, producers are using horizontal drilling to find those little puddles - going sideways, you'll find loads of them, while drilling vertically in the usual way doesn't reach many. And they're also 'fraccing' - fracturing the rock with liquids pumped in under pressure, so that the cracks in the rock provide pathways for the oil to travel and collect.

The great thing is that we know these technologies worked for exploiting gas in the shales, and now they're being used to exploit oil resources. If you can actually produce oil from the source rocks, instead of needing to produce it from a reservoir, it's a whole different ball game!

There's been speculation that if the right production techniques are used, the Bakken gas shales could produce more oil than most of the Middle East. One recent estimate was that this resource could be producing 450 mbo/d within the next three years ^[1] . Another estimate is that there's at least 4.3 bbls technically recoverable oil ^[2] - in fact there's 413bn bls present, but only 10% or so of that can be recovered ^[3] .

At this point some peak oil guys will stick their hands in the air and say 'It's not production, it's reserves that's the issue'. But of course, if you can prove that it's economic to produce this oil, you have actually increased the size of the reserve. (North Dakota has seen a 20% increase in production in the last few years - I can't find figures for the increase in reserves but it must be considerable.) Even better, because there's existing gas infrastructure in the Bakken, there's a cost advantage to the oil producers.

There are other possibilities too. There's the plus the Three Forks - Sanish formation which lies directly under the Bakken. And as Bakken becomes better known, oil companies will doubtless start looking at other similar areas and thinking how they can exploit them.

I think we should also remember that just as demographics has been affected by the baby boom, oil reserves have been affected by major conservatism in funding exploration during the 1980s fall-out from the oil bubble. With a USD 10 oil price, oil companies really had a tough time deciding to authorise new investment. And I remember even in the early 90s many oil companies were using a hurdle rate of USD 18 a barrel as their hurdle rate for investment.

As the oil price increases, besides, we will see reserves moving from the 'technically viable' category to the 'commercially viable' category. It may take a while for it to happen. So the oil price is actually far more important than it looks, because in fact the oil price is one of the major factors on the reserves formulas. This oil is already there - it just wasn't viable at a lower oil price.

So on the supply side, I'm not convinced that we're going to see reserves keep sliding. Now let's look at the demand side. Demand for oil will always increase, right? Well, there's possibly going to be a temporary lull in that increase, if China decelerates at the same time as we have continuing economic stagnation in the developed world. So right now, I suspect even if Peak Oil was the right economic thesis in the long term, it wouldn't necessarily work in the short term. (We may not see demand falling. But that's not the point. If demand fails to grow, or grows more slowly, that gives us several years in which reserves may be able to catch up - in which fields may not be depleted at the same rate.)

But I'd also like to point out that demand for oil and demand for energy are not exactly the same thing. Peak oil proponents do tend to assume that hydrocarbons are the only energy source that counts. That might not remain the case in the medium term. We have several competing sources;
   •   renewables - wind and water power
   •   biofuels
   •   nuclear
   •   'clean' coal
(The fact that I've included that last couple should tell you this is not a 'green' versus 'don't believe in global warming' issue - and needs judging on a more scientific basis than which party you vote for or whether you're politically correct.) But it's renewables where a lot of the focus lies right now.

Now renewables at the moment account for about 15 percent of total energy use in Germany ^[4] , which is probably the most advanced of the major economies. (It's 81 percent in Iceland ^[5] !) It's about 10% in the US and 5% in the UK. That's not a huge slug of the total, but it is increasing, and for some very good reasons. For instance, the technology is becoming increasingly efficient, particularly in the field of photovoltaics. As greater quantities are manufactured, PV is also becoming cheaper, and the same can be said for other renewable technologies - there's a virtuous spiral of great production, lower costs, greater demand.
Now the real importance is not the percentage of total demand that renewables can supply. It's price elasticity. And here, the rise in the oil price doesn't help. As the oil price goes up, renewables become much more competitive as a substitute product. Putting a solar panel in with the oil price at USD 30 won't pay for itself in 20 years - at USD 70 a barrel, the equation obviously looks much better.

So that means that to some extent, 'peak oil' is self-liquidating. As the oil price rises, it actually leads to greater exploration efforts by oil companies, fields becoming viable that were not viable a few years ago, and at the same time renewables and other energy sources becoming much more competitive.

Both on the supply side and on the demand side, peak oil is actually self-liquidating owing to price elasticity. Once supplies are tight enough to move the price up, substitute products take greater market share, and previously uneconomic fields suddenly become money-makers. So making money out of oil is a bit trickier than just blubbing 'They don't make it any more'. Sorry.

I'd like to propose a special category though where peak oil does apply - and it could be very, very interesting for investors. That is - peak oil as applied to government budgets. Oil contributes huge tax revenues. Green energy is usually subsidised. So as renewables increase, and oil falls, the government's tax take declines - and its costs increase. Ouch.

Now that's not a problem if you're an oil importer. But for countries like the US and UK and some of the Central and South American producers, or perhaps Nigeria, that could be a really nasty double whammy on government finances - and a double whammy they really don't need