Why peak oil doesn’t matter to higher oil prices

Why peak oil doesn’t matter to higher global crude oil prices, there’s only one reason why you’d invest in the oil market; because you’re confident that, over the long term, the price of oil is going to rise.

In 1956, Marion King Hubbert, a Shell geologist, predicted that by the 1970s US oil production would peak. For almost a century the US had been one of the world’s largest oil producers and conventional wisdom held that there was plenty of oil left. That view was proved wrong and “Hubbert’s Peak” did in fact come to pass. Since the early 1970s US production has declined by almost 50 per cent.

Peak oil theory takes Hubbert’s hypothesis and applies it to global oil production, suggesting that worldwide oil production will rapidly decline following its peak, thought to be around 2010.

Geologically speaking, this makes perfect sense. Oil fields that perform splendidly in their early stages will progressively deteriorate as they age. But in an economic sense, the marginal cost of oil production trumps peak oil theory every time. And this forms the crux of the argument for higher oil prices.

As more hydrocarbons are taken from a reservoir, extraction rates deteriorate. A geological rule of thumb is that the average field will naturally decline by about 5 per cent a year, caused by a combination of deteriorating pressure, increasing levels of water production, or damage to the reservoir rocks.

A large proportion – up to 50 per cent or more – of the original oil resource cannot be profitably extracted because it’s simply too expensive to get the stuff out. Long before geological limits are imposed on oil production via peak oil, economic limits kick in.

That means total production depends more on the price, rather than the quantity, of oil. As investors we can therefore think about oil as an unlimited resource with a variable price.

The absolute quantity of oil in the ground isn’t all that important in discerning the direction of oil prices. What is important is the cost of extracting an extra barrel. Economists call this the “marginal cost of production” and it’s a more useful way of thinking about oil as a potential investment.

The marginal cost of a barrel of oil incorporates information on the quantity of oil and, through the cost of extraction, where it’s located and how difficult it is to get at. Peak oil theory tells us only about the quantity of oil and nothing about the cost of accessing it. The difference between the two can be immense.

Tags:  oil prices, peak oil