The Truth About the End of Cheap Oil

Why are gas prices so high? The quick and dirty answer is that a potential Iranian conflict is ratcheting up prices, as speculators and suppliers prepare for possible interruptions to Hormuz shipping lanes. That's one reason, but we can't blame Iran for the cost of crude more than doubling from its recessionary lows. I explored other possibilities last year, pointing to the increasing difficulty of getting oil out of the ground, and the inability of new discoveries to meet rising demand.

But neither answer on its own really tells you why prices are so high, nor can they explain why we're unlikely to see any long-term declines. Oil lubricates the wheels of prosperity. The link between oil consumption and economic growth is so clear that it's likely to be a defining economic factor in the coming decades. Since the evidence weighs against the world's long-term ability to match demand with new supplies, the global path to prosperity may not be as clear as once believed.

Petroleum and prosperity
China's voracious thirst for oil is just as important a global trend as America's shifting oil balance. To see why that's important, all you have to do is look at the clear correlation between oil use and GDP on a per-capita basis.

Source: CIA World Factbook.

In 2010 the United States used just over one and a half times the oil per day as China and India combined. That number's been rapidly approaching parity in recent years. In 2000, we used nearly three times as much oil as both countries put together. In 1990 we used nearly five times as much.

Source: CIA World Factbook.

Hand in hand
The United States, China, and India use very similar amounts of oil when measured against per-capita GDP. But since American GDP per capita is seven times as high as that of China and India combined, we wind up using far more in the aggregate.

The discrepancy between the United States and other industrialized countries can be explained in part by regulatory restrictions. Fuel efficiency standards are stricter in many other industrialized countries -- the EU and Japan each mandate vehicles get more than 40 miles per gallon, and the EU's average vehicle fuel efficiency is about twice what it is in the United States.

The link between petroleum and prosperity is hardly limited to the countries listed. An International Energy Agency report released in 2009 highlighted close relationships between global oil demand growth and GDP growth worldwide. The connection is so tight that the growth and decline in global oil demand run parallel to recoveries and recessions as far back as data are readily available. And oil demand per capita is a clear indicator of economic prosperity as well. Africa and Asia, the world's least prosperous regions, make use of the least oil per person by far.

Rise of the rest
We've heard plenty of punditry on the imminent rise of the BRICs, with special focus on China and India. Eventually these two countries will surpass American GDP as long as they don't economically implode. How are they going to get there without oil? We can talk about renewables, but no alternative is close to easing the addiction of the world's richest countries. For the time being, oil is it.

And just how much oil are these two countries using? Since 1980, China and India have increased their combined oil use from about 2.5 million barrels per day to 12.5 million barrels per day.

Source: U.S. Energy Information Administration.

Both countries now use 150% more oil than they did in 1980. Meanwhile, use in the United States has only increased by 13%, despite the addition of 90 million new people. The United States has even seen a slight decline in oil use over the last decade, but that's been more than offset by average annual demand growth of 6% from China and 4% from India.

If all three countries continue on a course like the one they've charted since 2001, China and India will combine to exceed America's oil use by 2018. By 2023, they'll need more than 25 million barrels of oil per day. By 2030, combined demand from China and India will be just over 39 million barrels of oil per day.

If we really want to go to extremes, China and India would together demand almost as much oil as the entire world currently uses, if each country demands just half the oil per capita as the United States does today and both countries don't endure further population growth. That's not a sustainable trajectory and it's probably not going to happen. But even the "reasonable" trajectory I outlined adds 27 million barrels of oil per day to already stretched global demands, and that may not be sustainable either. The IEA's report anticipates a decline in non-OPEC production until 2014. By then China and India could be fiending for 3 million more barrels of oil per day. That's a lot of slack to pick up.

Assessing the implications
Super-investor Jeremy Grantham came to similar conclusions in a wide-ranging report on the cause of rising commodity prices. Global oil production has been bumping up against a ceiling of about 85 million barrels per day for much of the past decade. The size of new oil discoveries has been trending steadily downward since the 1970s. How can the world enable its poorest nations to grow without stretching oil supplies and prices to their breaking points?

Natural gas conversions are one possibility. The trucks-and-truck-stops tandem of Westport Innovations (Nasdaq: WPRT  ) and Clean Energy Fuels (Nasdaq: CLNE  ) has gotten a lot of love from our analysts of late. But a strong argument for the long-term success of natural gas as a petroleum replacement has hinged on its low cost. Given the inelasticity of oil, why should anyone expect a replacement fuel to remain cheap as it becomes essential? Replacing one fossil fuel with another is only a bridge solution.

A serious and sustained push for alternative energy is another possibility. Although the United States subsidizes alternative options quite heavily per unit of energy produced, there's no focused policy to seriously develop and optimize our energy options. Most countries are similarly haphazard in their efforts. Lacking such vision, it's hard to see private companies making enough progress to offset growing oil demand. The current political climate is hardly conducive to visionaries, which is a tragedy to say the least.

Investing in fast-growing unconventional drillers like Kodiak Oil & Gas (NYSE: KOG  ) and Samson Oil & Gas (AMEX: SSN  ) is one way to take advantage of higher prices if majors such as ExxonMobil (NYSE: XOM  ) aren't your style. But serious energy investors -- and serious global citizens -- should also recognize that without alternatives, scarce oil is as much a liability in the long term as it is an asset. The amount of oil left in the ground means little if it can't be extracted fast enough to meet growing demand, when more oil means the difference between boom and bust.

Looking for other ways to stay ahead of rising prices? The Motley Fool's free report on three great stocks for $100 oil has the info you need. Each of the companies the Fool hand-picked are well-positioned to succeed in this new environment of scarcity. Claim your free copy of this important report now.

Fool contributor Alex Planes holds no financial position in any company mentioned here. Add him on Google+ or follow him on Twitter @TMFBiggles for more news and insights. Motley Fool newsletter services have recommended buying shares of Westport Innovations and ExxonMobil. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (9) | Recommend This Article (30)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 02, 2012, at 9:00 AM, Merton123 wrote:

    Toshiba (Japanese firm that purchased Westinghouse Electric) - just got its nuclear reactors approved by Nuclear Regulatory Commission (NRC) in the USA. They manufacture Modular Nuclear Reactors that act just like a battery. They have already lined up several customers (coal powered utilities) in the United States. GE has to play catch up unfortunately so there is no way for American Investors right now to invest in the next wave of nuclear technology in the USA.

  • Report this Comment On March 02, 2012, at 9:03 AM, CluckChicken wrote:

    "Why are gas prices so high? The quick and dirty answer is that a potential Iranian conflict is ratcheting up prices..."

    All of these 'why are gas prices so high' always look at one side, the price of crude. Is that not just a little short sighted? Last I checked I was not filling my car with crude but with gasoline. Why is there never anything said about the fact we are refining less gasoline.

    Last year in Jan and Feb we produced 502,936,000 barrels of finished gasoline, this year we have produced 489,258,000 barrels of finished gasoline. That is 13,678,000 few barrels or 574,476,000 gallons of less gas.

    http://205.254.135.24/dnav/pet/hist/LeafHandler.ashx?n=PET&a...

    Then there is also more news about the closing of more refineries:

    http://www.eia.gov/analysis/petroleum/nerefining/update/

  • Report this Comment On March 02, 2012, at 10:04 AM, gsned57 wrote:

    To Merton123, More nuclear is great but has little impact on domestic oil usage (http://205.254.135.7/electricity/annual/pdf/table1.2.pdf). The vast majority of oil use in America is transportation and heating oil. These are 2 areas we as American consumers can do something about to lessen our oil consumption to the point of no longer being an oil importer. Switching from oil heat to Nat Gas, Electric, or geothermal in ones home is the first thing we can do.

    As for transportation there are now viable options out there. The Chevy Volt, Nissan Leaf, and Honda Civic Nat Gas car are all options consumers can use today to lessen oil consumption. In my opinion the Volt is the only true replacement for any driver currently requiring only a 4 seater sedan. With the Volt you charge at home with no new infrastructure (110 charging is fine and it doesn't require a special 220 outlet/charging station). You'll get 40 miles of commuting on domestic electric and for longer trips you'll end up using gas. The only impedence is cost since it's a $40,000 car (32500 after tax break). It doesn't get you off oil completely but doesn't leave you stranded either and if you commute 40 miles or less you won't use a drop of oil except on longer trips.

    Moving our trucking fleet to Nat Gas, electrifying our auto fleet, and replacing oil furnaces with something more domestic will reduce our domestic consumption with viable alternatives that can be purchased today for a little more up front cost but significantly less life cycle costs. The government will never fix our trade imbalance short of mandating switches and personally I don't need them telling me what to do but it's plain to see I have 2 options. Complain about high oil prices or buy technology that frees me from supporting dictators, terrorists, and thugs.

  • Report this Comment On March 02, 2012, at 11:30 AM, TopAustrianFool wrote:

    "Oil lubricates the wheels of prosperity. The link between oil consumption and economic growth is so clear that it's likely to be a defining economic factor in the coming decades."

    You forgot that Oil lubricates the wheels of economic dislocations and bubbles brought about by Central Banking currency devaluation. And since the Oil production is restricted by govt and monopolized by a few large corporations then it makes itself a great barometer for inflation. Just like Gold. So there you have it; the price of Oil has increased to the present levels due to inflation. What is next? 1) Fed increases interest rates, and 2) by August you have another Market deflationary drop. Simple as that.

  • Report this Comment On March 02, 2012, at 11:51 AM, DJDynamicNC wrote:

    I purchased Samson for under a dollar and I sold a few weeks ago for well over double my money, which I was happy with.

    Still happy with it, but as always, it's hard not to think "oh, should have held on just a little bit longer." No nense trying to time the market though, it could just as easily have gone the other way.

    I bought it off a rec from right here on this site, too, so respect to the Fool for sound investment advice.

  • Report this Comment On March 02, 2012, at 12:30 PM, DJDynamicNC wrote:

    "You forgot that Oil lubricates the wheels of economic dislocations and bubbles brought about by Central Banking currency devaluation. And since the Oil production is restricted by govt and monopolized by a few large corporations then it makes itself a great barometer for inflation. Just like Gold. So there you have it; the price of Oil has increased to the present levels due to inflation."

    Yes, couldn't possibly be any of the deeply detailed reasons mentioned and researched in this article. It has to be government and central bank interference, as always.

    I admire the ability to address every question with the same answer. I guess the free market really is more efficient!

  • Report this Comment On March 02, 2012, at 1:43 PM, TopAustrianFool wrote:

    DJ,

    If you use a standard medium of exchange, then what do you want me to tell you? If the Central Planners print more of it, what do you expect? I gave you the rational reasons. All you can do is use derision.

    I am sure you can express your opinion with cogent arguments without links.

  • Report this Comment On March 02, 2012, at 1:46 PM, TopAustrianFool wrote:

    DJ,

    For example:

    "2B People and not enough oil"

    Well, I hate to tell you but the 2B people didn\'t just happen in the last quarter. Unless, we are talking about the biggest Baba Boom in history. All of the reasons above didn't just happen. The economic booms and busts due lag the money supply.

  • Report this Comment On March 10, 2012, at 7:15 PM, aleax wrote:

    TopAustrianFool,

    """If you use a standard medium of exchange, then what do you want me to tell you? If the Central Planners print more of it, what do you expect?"""

    If velocity stayed constant (or decreased by less than quantity of money increased) I would expect prices of all products and services to increase at roughly the same speed. So, e.g, oil at the NYME was around $40 in Dec 2008, it's well over $100 now -- if this was mostly about inflation, I would expect other prices to increase roughly by 2.5 times over the same period of time. That's about 35% price increase per year. This is not what I observe over many goods and services I regularly purchase, or whose prices I regularly check, over the same few years -- indeed, we're talking about an order of magnitude difference.

    So, money quantity and velocity (while not totally irrelevant to oil prices) must really be extremely secondary to different considerations (since money quantity and velocity affect all good and services, the amount of their effect on prices can be decently if roughly estimated).

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