Our story begins with "Peak Oil" - the belief that conventional production of crude has already peaked, and has already slipped into an irreversible decline. As "Peak Oil" moves from mere theory to indisputable fact, the global economy will face wrenching changes. But the vigilant investor will gain an opportunity to profit along the way.

As I discussed in yesterday's edition of The Daily Reckoning, oil production seems all-but-certain to decline, despite the huge new discoveries off the coasts of Brazil, Africa and elsewhere. In fact, production is already declining rapidly from some of the world's largest fields. Mexico's "Catarell" Field, like a kind of Peak Oil poster child, was producing more than 2 million barrels a day as recently as 2005. But production from this field is plummeting irreversibly toward 500,000 barrels a day, as the chart below illustrates.

The recent discoveries of deep offshore oil will certainly help slow the decline of conventional crude oil production, but theses discoveries will not come on line for many, many years.

But what about alternative energy sources? Won't they make up for the shortfall of crude oil? No chance. Alternative energies might offset a tiny sliver of falling crude oil production. But solar panels can't lift a fully loaded Boeing 777 off a runway...nor even lift an empty Piper Cub.

So what about the many sources of "unconventional" oil and gas? Won't these compensate for declining production from conventional sources? The short answer is no.

Geologist Art Berman, for example, offers a decidedly negative view of the latest "big thing" - obtaining large volumes of natural gas from "tight shales." In a comprehensive review of production and flow rates from several thousand wells drilled in the past decade in the Barnett Shale of Texas, Mr. Berman presents a gloomy forecast.

Looking at a large sampling of Barnett wells, the overall data reveal that initial gas flows decline rapidly. With some wells, the drop-off is as much as 70% in the first year, with further declines of 20% in the second year.

This hardly dovetails with the happy talk about how "shale gas" will supply US energy requirements for the next several decades, if not a couple of centuries. It appears that most Barnett wells are short-term money losers, with a few prolific wells carrying the bulk of capital expenditure.

According to Mr. Berman, the picture is not much better in other shale plays, such as the Fayetteville and Haynesville shales. And similar gloomy data are just now starting to come in on the embryonic gas play in the giant Marcellus formation of Pennsylvania.

But this bad news does need to be ALL bad. As the world's mature and aging oil fields slip into an irreversible decline, production from the world's new offshore discoveries will become increasingly important.

Therefore, forward-looking investors can begin TODAY to make selective investments in those sectors of the oil industry that will flourish during the coming oil shock. I am particularly fond of the "deepwater" sector...and have been urging my subscribers for several months to focus on the companies that facilitate deepwater oil production.

Marcio Mello, the former "explorationist" from Petrobras (PBR: NYSE) and now independent petroleum consultant, electrified the Denver meeting of the Association for the Study of Peak Oil & Gas (ASPO) with his analysis of several high-profile deepwater discoveries.

In a riveting talk that lasted well over an hour, Marcio detailed the immense petroleum potential of offshore Brazil, as well as the Amazon Basin. If Marcio's estimates are correct, Brazil may be the location of nearly 200 billion barrels of additional petroleum resources. That's well within the range of current resource estimates for Saudi Arabia.

For good measure, Marcio described the petroleum potential of offshore West Africa - another 130 billion barrels - as well as the Congo region, with 50 billion barrels or more.

Finally, Marcio described the "unknown potential of the US back yard, the Gulf of Mexico (GOM)." Marcio offered remarkable insight into the deep regions of the GOM, 100 miles and more offshore Texas and Louisiana. He showed early work he performed on a number of GOM areas, including the site of BP's (BP: NYSE) recent billion-plus barrel find at the Tiber site.

If his analyses of the South American, African and GOM petroleum systems are correct, the world has access to much more conventional oil than people previously believed. But accessing and producing this oil will require a trillion-dollar level of offshore, deepwater investment. It's a 30- to 50-year project.

"Deepwater" will be a BIG business.

Some of the companies that are well-positioned for the deepwater era of crude oil production include Petrobras, Repsol (REP: NYSE), BP (BP: NYSE) and StatoilHydro (STO: NYSE). I am also a fan of subsea equipment builders like Cameron Intl. (CAM: NYSE) and FMC Technologies (FTI: NYSE), plus service companies like Halliburton (HAL: NYSE) and Baker Hughes (BHI: NYSE).

These are a few of my favorite long-term plays for the long-term era of deep-water development.

Regards,

Byron King,
for The Daily Reckoning Australia

• Peak Oil – The Risks
• Supply of Conventional Crude Oil is Very Close to its Peak
• Peak Oil: Supply Data Doesn’t Lie
• Where Will Future Oil Production Come From and How Can Investors Profit Today? Part 2
• Pemex and Mexican Peak Oil Equal Expensive Oil

Look. Skeptics can say what they want; it does not change the fact that our world is struggling to maintain daily flow-rates. Whether you agree with us or not, the energy reality is that the supply of conventional crude oil is very close to its peak and no other fuel source can easily fill the supply gap.

Yes, various governments are now promoting alternative sources of energy and over the following years, we expect this drive to intensify. But those sources will provide too little, too late. So there remains, today, an unbelievable degree of denial when it comes to 'Peak Oil.' Most people simply dismiss it as a conspiracy. Others gleefully point to alternative sources of energy, whereas some believe that the vast improvements in oil drilling technology will save the day. Do not be seduced by these delusional hopes.

Remember, crude oil is the lifeblood of the global economy and roughly 70% of it is used to power transportation. Moreover, a vast amount of crude oil is also used up by agriculture (production of fertilizers, pesticides and irrigation systems). In fact, modern-day agriculture can be best described as a process of converting hydrocarbons into calories. Without cheap energy, the world would certainly have trouble producing half of the current food supply and the result could be far worse.

Thus, crude oil is a key ingredient in two of the most critical processes which make modern life possible - transportation and agriculture. And shortages of this vital natural resource will result in extreme pain. In the initial stages, the price of crude oil will rise remorselessly and eventually, we will face rationing.

Now that we have established the importance of crude oil, we will explain why new drilling technology and alternative sources of energy will not make this problem go away.

First, as far as drilling technology is concerned, it is worth noting that America is home to the best oilfield technology on this planet. However, its oil production peaked in the early 1970s and has been in a relentless decline. Furthermore, apart from America, other technologically advanced nations in the world have also failed in maintaining their daily flow-rates. For instance, after exporting crude oil for over two decades, Britain is now a net importer and its production is in a state of permanent decline. Hard data confirms that two of the most advanced countries in the world now live in a post 'Peak Oil' era, so what are the odds that other less fortunate nations will succeed in averting 'Peak Oil'?

Secondly, as far as alternative sources of energy are concerned, they represent a drop in the energy ocean and will not be able to offset the depletion in crude oil. Despite all the euphoria surrounding renewable energy, the 'sources' like ethanol and solar panels are net energy losers. In other words, it takes more energy to produce ethanol and solar panels than the energy you obtain from them. For sure, hybrid and electric cars will help us to some degree but you must keep in mind the fact that electricity is not a source of energy; it is a carrier of energy. Even if electric cars become popular, how will we generate sufficient electricity?

Elsewhere in the alternative energy patch, a lot of hopes currently rest on unconventional sources of oil (especially tar sands and shale oil). Once again, this optimism is misplaced, as the increased supply from the unconventional sources will not even make a dent in the overall energy picture. The nearby chart confirms that our world currently produces roughly 85 million barrels per day of total liquids and out of this gigantic sum, only 13 million barrels per day of oil is derived from unconventional sources. So, when the production of conventional crude oil finally declines due to 'Peak Oil', it is extremely improbable that unconventional supply will be able to rise to the challenge.

As far as Canada's tar sands are concerned, Alberta currently produces roughly 1.4 million barrels of oil per day and under the best case scenario, this figure is expected to rise to just 3.5 million barrels per day by 2020. To complicate matters even further, the tar sands require huge amounts of water and natural gas. In addition to this, the mining procedure is extremely polluting. For example, the process of extracting 'oil' from bitumen releases at least three times the amount of carbon dioxide emissions as regular oil production. Accordingly, we have no doubt in our minds that Canada's tar is not the Holy Grail.

Finally, the new oil shale discoveries in America are not going to help us either because the 'oil' trapped in the shale is in fact kerogen - a precursor to oil. So far, all major oil companies have struggled to convert the kerogen into usable oil and it will be interesting to see whether any of them succeeds in the future. In any case, this conversion process is extremely expensive and we can assure you that shale will not be producing any oil at today's prices. Recent studies reveal that the price of oil will have to rise to several hundred dollars per barrel to make this process economically feasible.

Well, now that we have covered the supply side, let us briefly discuss the demand side of the equation. According to the IEA, global oil usage in 2009 will amount to 84.4 million barrels per day and it will rise to 85.7 million barrels per day in 2010. This means that oil demand will rise by 1.5% over the next twelve months which is in line with the growth rate over the past two decades. If this growth rate continues over the next 4-5 years, there is no way our world will be able to ramp up production.

Unfortunately, positive thoughts and wishful thinking will not change the equation. Precious time has been wasted and we have no margin of safety. We must prepare ourselves for sky-high commodity prices and periods of acute shortages, which will make wartime conditions seem rosy. In fact, we believe we are already a decade into this painful transition but let us warn you that we have seen nothing yet.

If our assessment is correct, it seems prudent to make a sizeable allocation to the energy sector. However, given the realities of 'Peak Oil', we do not recommend exposure to the oil majors, as their reserves and production are in decline. On the contrary, we urge you to invest your capital in quality upstream oil/gas companies and businesses involved in the energy services sector.

Regards,

Puru Saxena,
for The Daily Reckoning Australia

• Peak Oil – The Rewards
• Peak Oil: Supply Data Doesn’t Lie
• Increased Oil Production Won’t Solve the Energy Crisis
• Peak Oil – The Risks
• We Are Facing a Global Oil Crunch

Most people probably figured that out after reading into the story a bit and realising the report - from Kris Sayce at the Australian Small Cap Investigator - is about which smaller Aussie firms are best placed to see rising share prices from the LNG and natural gas boom. So there you go.

And by the way, Dr. Graeme Bethune, the director of research firm Energy Quest, says Australia could become one of the world's top ten countries as measured by gas reserves. "We expect that Australia, in the very near future, will be among the top 10 countries globally measured by the size of its gas reserves. The size of Australia's gas reserves means that further strong growth in this country's LNG exports is assured," Dr. Bethune said in Energy Quest's latest quarterly report.

At the moment, Australia has the 14th largest known gas reserves on the planet. Dr. Bethune reckons that when you add up proved, possible, and probable gas reserves along with other potential resources, you get a reserve figure of around 200 trillion cubic feet (tcf) of gas.

This is quite a generous use of the word "reserve," which is typically reserved for well-drilled, well-defined resource or ore body that you know you can produce (capital spending and operating costs) economically. You wouldn't typically use the word "reserve" to describe resources that haven't even been drilled yet.

But the point about Australia's growing gas status is well taken. Australia will never compete with countries like Russia (1.5 quadrillion cubic feet of reserves) or Iran (981 tcf), or Qatar (904 tcf). It doesn't have to. Conventional gas from the Northwest Shelf and WA's Carnarvon Basin is already being produced and sold to customers in Asia.

The gas is there and the customers are buying it. When you throw in more projects in the NT, Papua New Guinea, and unconventional LNG projects in Queensland, there are a lot of exciting opportunities. And for the record, Kris tipped his first LNG stock in November of last year. He has three open positions in the sector at the moment.

Here comes the fear. We mentioned yesterday that we reckon now is a good time to look on the short side. Other than the mysterious technical indicators of our colleague Gabriel Andre, how do we come to that conclusion? The volatility index of course!

Bloomberg reports that, "The benchmark index for U.S. stock options closed at the highest level since July 9. The VIX, as the Chicago Board Options Exchange Volatility Index is known, increased 12 percent to 29.15. The gauge, which measures the cost of using options as insurance against declines in the S&P 500, reached a record of 80.86 in November. The index is still above the average over its 19-year history of 20."

The VIX is referred to as the fear index because when the cost of buying put options on S&P 500 stocks goes up, it means investors are actively hedging against a fall in stocks. You can see from the chart above that yesterday's action took the VIX above its 50-day moving average. What's more the entire index remains elevated. That shows you just how uncertain investors are about the stability of this rally.

Is the VIX a good proxy for the amount of fear Aussie investors are feeling? After all, the VIX measures options pricing on S&P 500 stocks, not the All Ordinaries. We put the question to Gabriel this morning when he came in the office. We also asked him if there were other volatility proxies that better fit the Aussie market...and were leading him to believe now is a good time to go short.

Gabriel thought about it and wrote to us a bit later. "Yes," he said. "We can use the VIX as the correlation between markets worldwide is obvious. Choppy markets and high volatility in the US stock markets typically imply choppy market and high volatility here down under on the ASX."

"Even though there's no official volatility tracking index in Australia, there are several ways to track implied volatility. For the biggest stocks, you can have a look at the options pricing. The premium of an option depends a lot on the expected volatility priced by the market makers. That's a good indication. But mainly for all the stocks you can use technical indicators like the Bollinger Bands, the Volatility Chaikin's and of course the daily true ranges (difference between high and low for each session). This will give you the historical volatility (not the implied).

By the way, Gabriel sent out his first short-sell recommendation today to Swarm Trader readers today. We couldn't do it last year when the service launched because ASIC had briefly banned it on all stocks following the collapse of Lehman Brothers in September 2008 and the ensuing financial near-Armageddon. But now that we can do it, we are!

And in case you're wondering, we're not accepting new members to the service at the moment. In fact, the membership level has been permanently capped at 500 for a variety of reasons. The charter members (those who first subscribed in October of last year) are up for renewal in the next month. If they choose not to renew their spot, some membership spaces may open up. If you're interested in getting on the wait list, send us a note to premiummembers@portphillippublishing.com.au

Here's a thought: has the trading in five government-backed stocks accounted for most of the rally? That's the question prompted by a Wall Street Journal article that studied the volume of trading in Fannie Mae, Freddie Mac, Citigroup, and AIG. Those names are all familiar because they all received sizable investments from the U.S. government to prevent insolvency last year.

You might also recognise them because they all go taken to the woodshed in trading action yesterday. The Dow fell 2% yesterday and the S&P 500 2.2%. But that was nothing compared to AIG's 21% decline, or Fannie's 18% fall, or Freddie's 17% fall, or Citi's 9.2% fall. Ouch. The Journal suggests the financials may lead the market down just as they led it up.

But the better question is if the financials led the market up in an honest fashion. Or was it the Plunge Protection Team at work? Over at the Big Picture blog, Brett Steenbarger shows that just a handful of financial stocks accounted for a huge percentage of market volume in August. Just where the capital that was pouring into the stocks came from is a very good question, but let's look at what Steenbarger says first.

"I took C, FNM, and FRE and expressed their *composite* volumes (e.g., the volumes transacted across all exchanges) as a fraction of NYSE volume. What we see is that, early in 2007, those three stocks accounted for only 1-3% of NYSE volume. During the financial crisis of late 2008 and again as the market was bottoming in early 2009, that ratio skyrocketed to well over 50%."

"Recently, however, the volume in these three stocks has hit astronomical levels relative to total NYSE trading, as all three have made phenomenal percentage gains during August. Indeed, the composite volume of these three stocks alone has recently doubled total NYSE volume. If we look at just the NYSE trading of these firms, they are accounting for about 40% of NYSE volume."

Hmm. What do you reckon? The above-board answer is that program traders and institutions are investing alongside Uncle Sam. This would mean big money flows into those fives stocks. If big-money investors are betting that government-backed stocks aren't going to be allowed to fail, that might explain the free-riding.

But you can't help but think that buying these stocks is a back-door way of boosting equity capital without having to directly inject more tax payer money (which didn't prove to be too popular). If you're the Fed or the Treasury and you want to keep the operation low-key, you just need to find a middleman to do the buying for you to bolster the equity capital at these firms. Hmm. You wonder how short Goldman is these firms.

Is that scenario too conspiratorial for you? It reminds us a bit of the rumour that the Fed was loaning out money to other central banks this year under the table so that those banks could come back and support the U.S. bond market. The Fed creates the money with a few keystrokes and then shuffles it around until it eventually makes its way back into the bond market, keeping yields from spiking, the greenback tanking even more, and the U.S. government from having to actually cut spending for a change.

But nah, the government wouldn't actively intervene in financial markets to support asset prices and keep the public from panicking, would it? That's just...not possible...is it? More on the destruction and formation of capital tomorrow.

Dan Denning
for The Daily Reckoning Australia

• Nervous Investors ‘Short’ the Market By Buying Commodities
• Discussing the Dreaded Fibonacci Retracement
• CRB Index Correction Likely to Go Further
• Investors Rushed to Bid Up the Shares of WFC
• A Trader’s Market or an Investor’s Market?

BHP is seeking permission from the West Australian government to mine the Yeelirie deposit in WA. BHP reckons it's a $17 billion ore body at current uranium prices, capable of producing 5,000 tonnes of uranium a year for 30 years. It says the project would increase Australia's uranium exports by 50%.

You don't have to worry about a uranium supply glut quite yet, though. It's a subject we've been covering over at Diggers and Drillers. There are other, smaller ore bodies that could enter into production if the uranium industry ever gets off the ground in Queensland. And many Australian explorers are active in Africa.

But the big story of the week-the one that's got us really excited-has been under-reported. Norway's largest oil company, StatoilHydro, and Chesapeake Energy Corp. from the States are kicking around Asia and Europe for unconventional natural gas projects to develop. Asia includes Australia, according to the story in Bloomberg.

Statol's Olivind Reinertsen, who runs the company's U.S. and Mexican operations told an interviewer that, "At this point in time, we are looking at 14 different plays all over the world together with them to try to narrow it down." The plays will be similar to the Marcellus and Barnett shale formations in the States that helped increase un-conventional U.S. gas production in the last two years.

Australia has some shale formations that are suitable for this kind of production. It's capital intensive. And the formations have to be injected with something to drive the gas out, mostly because the sandstone formations are not porous enough to allow for conventional production. They don't call it unconventional for nothing.

But one thing you'll notice about natural gas produced from shale formations is that it's not coal. It's not uranium either. As the Federal government tightens the noose around the coal industry via the delayed but not-dead-yet emissions trading scheme, we wouldn't be surprised to see unconventional gas production enjoy its own mini boom in Australia.

Uranium, of course, would be a carbon-friendly substitute for coal in terms of generating abundant and cheap electric power for Australia's economy. But there is an irrational fear of developing a domestic nuclear industry. So even though uranium is going to be a valuable export commodity, the fact that only WA, the NT, and SA permit new mines to open means you're not exactly spoiled for choice when it comes to uranium explorers who have ore bodies that can realistically be developed in the next five years.

What does that leave us with? Well , you have conventional off-shore LNG and unconventional on-shore coal-seam-gas. Seeing as how we've got both those stories covered in Diggers and Drillers and the Australian Small Cap Investigator, we're going to bid you adieu for the day and get on the shale story for the May issue of D&D. See you next week!

Dan Denning
for The Daily Reckoning Australia

• Buying Oil on Sale as U.S. Dollar Gets Weaker
• Latest Energy Bull Market Won’t Be Confined to Crude Oil
• Australia Presents Investors With Great Portfolio of Energy Choices
• Thorium as a Nuclear Fuel
• Australia’s Next Big Export Industry

And we've found just the thing.

Everyone has heard the oil story. Everyone knows about iron ore. But who has seen the LNG story? Almost no-one. In fact, the reason so few people know about LNG is that nobody has bothered telling the story. Or if they have not many people have listened.

After doing a lot of research for the recent edition of ASI we have come to the conclusion there will be an increase in demand and an increase in supply for at least one commodity - LNG.

LNG is produced by liquefying natural gas and then sending it on a ship in liquid form to a regasification plant in Japan or the United States where it is converted back into a gas and then distributed to homes and businesses. The reason it is converted into a liquid is due to space. LNG it uses just 1/600th of the space of natural gas.

The reason we are getting onboard with LNG in 2009 is due to the abundance of it in Australia. Yet currently, Australia is producing natural gas and LNG at a fraction of the full potential. You only have to look at the developments taking place off the coast of Western Australia and in Queensland to get an idea at the potential size of this industry.

Also consider two of the major stories in the resources industry during the last few months. BG Group's $6 billion takeover bid for Queensland Gas, and Origin Energy's joint venture with US energy giant ConocoPhillips.

In 2009 the LNG story looks set to be the next market ready to boom.

Kris Sayce
for The Daily Reckoning Australia

• Latest Energy Bull Market Won’t Be Confined to Crude Oil
• Australia’s Next Big Export Industry
• LNG in 2009
• Uranium: A Carbon-friendly Substitute for Coal
• Gorgon LNG Deal with China a Really Big Deal

"This story coming out of Ossetia is very revealing," said a fellow diner last night. "The region is much more complex than I realized. These people have been at each others' throats for centuries. You know, they have about 50 different languages - and none of them related to any of the others. It is only when there is a strong imperial power in place that they settle down and behave themselves. The Tsar pacified the region in the 19th century. Then, the different cultures lived side by side. There were Catholic churches next to Orthodox churches next to mosques. And people mostly got along. And then, Stalin took over. He tried to erase a lot of the ethnic divisions...making them all communists...and forcing them all to learn Russian. But the Russians - either from the time of the Tsars or the time of the Soviets always had trouble along the southern periphery of the empire. They could never very easily bring the Muslims under control. That's what the Crimean war was all about...and then, in Afghanistan, the Muslims kicked them out.

"But what I think is most interesting about this story is the way Russia is asserting itself. I don't know what was going through the Georgian president's head. You don't attack Russia with just 17 tanks. He must have thought he had support from the U.S. and Europe. But what could the U.S. or Europe do? We know that the Russians can cut off natural gas to Europe anytime they want. They have the energy; we don't. If they cut off the gas, it will be a long, cold winter for us. And the United States? Putin knows that the U.S. is bogged down in Iraq. And he knows too that the U.S. doesn't have any money. In geopolitics, the country with the energy and the money wins. And right now, that's Russia."

Yes, dear reader, Russia looks like a winner. And China. And India. And all the countries that seem to be on the way up. Who knows which will succeed...or when? But it looks to us as though these countries are catching up - first in economic terms...later in military terms - to the United States.

What does this mean for investors? It probably means that, over the long run, shares in growing, developing countries are a better bet than those in the United States. And it probably means that the dollar is a bad way to store wealth - since it is tied to an economy in (relative) decline.

It probably also means that limited resources - gold, copper, land, water - will become (relatively) more expensive, because there are more and more people who want them and have the purchasing power to buy them.

Regards,

Bill Bonner
The Daily Reckoning Australia

• Price of Oil May Rise Due to Scale of Georgian Conflict
• Latin America Has Suddenly Become Very Interesting
• The U.S. Took Advantage of Russia During the Soviet Collapse
• LNG in 2009
• BRIC – Brazil, Russia, India and China Suffer High Rates of Inflation