Current Price of Oil is Only the Precursor of Peak Oil

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Remember when most professional investors griped that US$40 per barrel crude was “overpriced,” and then that US$60 crude was “unsustainable,” and then that US$80 crude would “never happen.” But here we sit with the price of oil soaring past US$90 and looking like it wants to take out US$100.

We think crude oil will take out US$100, and then continue higher from there. Sure, crude may decline in the short term, but the destination is clear: much higher prices for oil. That may be bad news for the US economy, but need not be bad news for you, assuming your money is in the right place. So what’s the right place? Let’s start with the big picture…

Simply put, the Earth is running out of that magic combination of oil that is both high quality and cheap to extract.

Twenty years ago, a dozen fields produced a million or more barrels of oil per day. Now there are four, and one of them, Mexico’s Cantarell in the Bay of Campeche, is collapsing. Mexico’s state-owned oil company, PEMEX, projects Cantarell’s output will decline 14% per year from now on. That’s the best-case scenario. 2006 actual production from the ageing field actually fell 27%!

If PEMEX’s worst-case forecast comes true, Cantarell will soon break below one million barrels a day, leaving the world with just three million-barrel-a-day fields by the end of this year.

Taking the place of these former big producing fields are deposits that are complicated and capital intensive: the tar sands of Alberta, oil shale in America, heavy oil in Venezuela and resources in the Arctic. These non-conventional resources are very expensive to operate.

For perspective, North Africa’s conventional oil reserves can be pumped out of the ground for only US$4 per barrel. But the average cost in the tar sands is estimated at US$28 per barrel, and oil shale costs can be upward of US$40 per barrel. It doesn’t take a genius to see that the more we are forced to rely upon non-conventional oil, the higher the price of oil will have to be.

And you know already that competition to buy that barrel is only going up. China and India are elbowing their way onto the global stage, and bidding for their share of Middle Eastern oil. A supertanker of crude is as popular as a New York taxi at rush hour; everyone is trying to wave it over their way.

We’ve reached a turning point in terms of the supply-demand fundamentals of crude. Even Chevron’s CEO David O’Reilly recently announced, “One thing is clear: the era of easy oil is over”.

Your average economist will tell you that once you correct for inflation, the price of oil reached its actual peak in 1980 during the energy crisis spurred by the Iran-Iraq war. From April to July of that year, a barrel of oil sold for US$39.50. Using the government consumer price index (CPI) numbers, that record-high price of oil per barrel is estimated at between US$90 – US$102 in today’s dollars.

But those CPI numbers are highly suspect.

John Williams of Shadow Government Statistics is one of several specialists who independently tracks financial data in an attempt to provide a more honest picture of the economy. Williams recalculates the CPI so that it is more of a continuum with its earlier versions – unlike the government, which fiddles the formula whenever it decides it needs to. If nothing else, undoing the many changes in the CPI formula over the years allows us to compare apples to apples on price inflation, rather than apples to genetically modified pumpkins.

Track the current CPI the way it was calculated in 1980, and today’s inflation rate is about 7% higher than the current “official” CPI statistics. So, rather than inflation running at less than 3% as the government would like us to think, based on Williams’ calculations it is really closer to 10%. Casey Research’s chief economist, Bud Conrad, has confirmed with his own calculations that indeed this figure is a much more truthful estimate of where inflation actually is. Using shadow stats, Bud has calculated the oil price history using the 1980 CPI method. It turns out that 1980 barrel of US$39.50 crude is the equivalent of over US$200 per barrel in today’s anemic dollars.

In that context, the price of oil is nowhere near its all-time high, and US$100 oil still looks to be quite cheap. With all that is going on in the Middle East today, where the world still gets much of its oil, and combined with increasingly proof – as per Cantarell – that peak oil is upon us, the odds are better each day that oil is going much, much higher.

There are other potential shocks to the energy market lurking in the wings. For instance, faced with the depletion of Cantarell, how long do you think the Mexican government will continue to allow the unrestricted export of their country’s oil to the US? We could wake up as early as tomorrow to find a quota in place.

Another way to view the big picture is to examine the weighting of different sectors within the S&P500 over time. With his background in advanced mathematics, Casey Energy Speculator’s chief investment strategist, Marin Katusa, has used this method successfully to assess market dislocations. By looking at the relative size of the various components of the S&P 500 vis a vis each other in modern times, you can readily see when certain sectors are significantly out of step with historical norms.

Viewing Marin’s chart below, you can see the weighting of the energy sector grew most during the 1979-80 energy crisis, reaching a relative peak of almost 30% of the value of the S&P 500. Since that time, energy’s share dropped for two decades since. Only recently, as oil prices have surged, energy stocks have also surged – becoming an even larger portion of the S&P 500. However, even though energy stocks represent a larger proportion of the S&P 500 than they did in 1999, they are still far from their former prominence.

Interestingly, the biggest run has been experienced by the financial sector, which has expanded from 5% to 20% in the last 30 years, catalysed by the expansion of credit and lax governmental monetary policies. That trend now appears to be reversing.

It’s also easy to see how the Internet bubble distorted the stock market. At that time, tech stocks rose to occupy over one third of the worth of the S&P. During the last energy crisis, the energy sector grew to a similar size. The current weighting of 9.3% demonstrates that energy stocks have yet to make their big run. The bull market has been good to all sectors, with only financials starting to take a hit, but, as the burgeoning energy crisis gains momentum, energy companies could very well regain the status that they held in 1979-80.

It’s also worth noting that there is a significant negative correlation between the energy and the financial services sectors. They move in opposite directions 79% of the time: that is, as one increases, the other decreases very nearly four out of five times.

Mathematically speaking, that’s one robust relationship. With financials reeling from the credit crunch, this technical indicator shows that energy stocks are poised to advance.

As the petroleum age reaches a tipping point, the United States, as the world’s largest oil importer, is in an unenviable position. Individual investors need not be similarly disadvantaged, however. The first step to protect your wealth is to see the price of oil and energy stocks in their proper historical context. Ninety dollars per barrel is not a peak price; it is only a precursor of peak oil’s influence.

The significant gains we’ve witnessed in certain energy stocks are nothing compared to the gains we will witness as the next energy crisis comes into full effect.

Chris Gilpin
for The Daily Reckoning Australia

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