Is Oil Nearing Its Peak?

Fighting through the noise in the oil industry can be a challenge for investors. Every time prices increase, the industry is exposed to a chorus of Chicken Little pundits, all crying "The end is near! The world is running out of oil!" In the past, when oil prices went up, the reward for increased production was irresistible, because there was always spare capacity. OPEC opened the spigot, Venezuela cheated on their quotas, and all the stripper wells in Oklahoma returned to service. Increased production caused prices to plummet, and we went back to driving our SUVs. It happened in 1990, and before that in 1980, and before that in 1973. After two years of dramatic price increases, are we at the top of another cycle, or are we approaching "peak oil"?

A peek at peak oil
The term "peak oil" (also known as "Hubbert Peak Theory") was first used by M. King Hubbert, a geophysicist with Royal Dutch Shell (NYSE: RD  ) . In 1956, Hubbert predicted that U.S. oil production would reach a peak between the late 1960s and early 1970s, from which point production rates would forever decline. The production-rate decline results from the nature of oil deposits. Initially, oil is forced to the surface because of underground pressure -- this is what caused "gushers" like Spindletop. As soon as the deposit goes into full production, the underground pressure begins to diminish, and production rates decline. So even though the oil may be in the ground, it can only be pumped to the surface at a slow and declining rate to prevent premature exhaustion. Eventually, the producer reaches a point of diminishing returns until it becomes cost-prohibitive to extract more oil. Currently, wells are considered "dry" when 50% of the oil remains in the ground.

Hubbert's prediction proved accurate in 1970, when U.S. production peaked at 11.3 million barrels per day -- a point from which production has been declining ever since. According to the Department of Energy, the United States produced 7.8 million barrels per day in 2003, representing a 31% drop in production from the peak. With oil now at $66 per barrel, there are plenty of "experts" applying the Hubbert theory to say that world oil production is peaking. Type in "peak oil" to an Internet search and you'll find predictions for the peak production year anywhere from 2007 to 2037 (in the past, 1989 and 1995 were supposed to be peak production years). The peak year is predicted by the growth rate in demand and the growth in production. Using annual demand growth of 3% and annual discoveries of 10 billion barrels -- both near current levels -- the French government recently predicted 2013 as the peak. If these estimates prove true, world oil demand will exceed production capacity, making today's prices look like extraordinary values.

More to the story
Other parties discard the theory entirely, claiming that current peak oil estimates do not account for secondary sources of hydrocarbons such as the Athabasca oil sands in Canada and the Orinoco tar sands in Venezuela. Both sites contain huge volumes of hydrocarbons, each equal to the oil reserves in Saudi Arabia. Because the oil is non-conventional, these sites are not included in world reserve estimates. Furthermore, the non-peak-oil parties argue that traditional extraction methods leave more than 50% of the oil in the ground, and that new technology can extract as much as 95% of the oil from existing sites. So, combining the non-conventional hydrocarbons and improved extraction technology, world reserves are dramatically understated. In other words, Chicken Little is wrong when he says that "the world is running out of oil."

Another argument against peak oil is that as prices rise, consumers will reduce consumption and seek alternatives (hybrid vehicles, for instance). This shift will reduce consumption, restore the supply-demand balance, prices will plummet, and we can return to driving hybrid SUVs. As I recently pointed out, any change in behavior will need to take place on a massive scale to have a significant impact on prices. Oil markets are not particularly elastic: people still need to drive to work, fly to Dallas, and heat their homes. I also doubt that gas prices at $2.50 a gallon are anywhere near the level required to drive a change in consumption. The last time there was a major shift in consumption was the early '80s, when Americans were paying around 6% of their income for gasoline. At today's prices, gasoline represents slightly more than 3% of household income. So, using history as my guide, I doubt there will be a significant shift in behavior unless gas prices exceed $5.00 a gallon.

Foolish final thoughts
Which side is right? That's the million-dollar question. The arguments contrary to peak oil suggest that reserves are much greater than those currently reported -- which is true. However, oil sands and improved extraction technologies do not necessarily increase production rates; rather, these factors indicate that production can continue for a longer time. This is exactly the scenario that peak oil suggests -- that once the peak production rate is reached, new finds will be deeper under the sea, farther under the ground, and more expensive to produce. Reading through annual reports of ExxonMobil (NYSE: XOM  ) , Chevron (NYSE: CVX  ) , ConocoPhillips (NYSE: COP  ) , or Total SA (NYSE: TOT  ) confirms that a larger percentage of new oil finds are coming from these types of sources.

If nothing else, my exploration for peak oil has convinced me that the current trend is driven by strong and sustainable forces. OPEC is not withholding oil from the markets as the cartel did in 1973 or 1980, and prices are not driven by fear as they were in 1990. As for peak oil, I tend to believe market forces will eventually cause the pricing cycle to reverse. However, that reversal looks like it will be several years into the future. Therefore, I am going to continue my exploration, looking at companies that are drilling deeper into the earth like CarboCeramics (NYSE: CRR  ) , going deeper into the oceans like Cal Dive, and helping in the production of non-conventional sources of oil -- like the king of the aforementioned oil sands, Suncor (NYSE: SU  ) .

For related Foolishness, check out:

Fool analyst Mathew Emmert is also searching relentlessly in the energy section. Consider a 30-day free trial to hisMotley Fool Income Investornewsletter, of which Total SA is a recommendation.

Fool contributor Robert Aronen does not own shares in any company mentioned, but he's taking a look at a plot of land in Oklahoma. Rumor has it that there's oil in them hills. The Motley Fool has a disclosure policy.


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