Sunday, January 25, 2009

Peak oil investment verities

Like many other verities in the investment world, peak oil investment verities have turned out to be anything but. Investment newsletter writer and author Jim Grant likes to say that knowledge in the sciences is cumulative, but knowledge in finance is cyclical.

And, so it has been with the general run of so-called peak oil investment strategies. Their heavy reliance on energy-linked investments made them a boon to all who followed them at first. But in the last six months such investments have suffered catastrophic reversals. The underlying cause, of course, was a devastating and unprecedented swoon in prices for oil, natural gas, and coal. Even uranium prices came down sharply, but this occurred somewhat earlier. Not surprisingly, the share prices of alternative energy companies, which rely on high prices for conventional fuels in order to remain competitive, followed the price of these fuels down sharply as well.

Even a stalwart of some peak oil portfolios, gold, managed to decline in the face of an obvious crackup in the world financial system. Everything seemed to be going down at once. The cause, in part, was that those who borrowed huge sums to gamble in the markets (mostly hedge funds and investment banks) had to sell at any price to pay back their loans before their investment portfolios completely vaporized. Selling begat more selling begat more selling. And with the selling, confidence in the financial system ebbed. The fundamental cause, however, was a swiftly declining economy, finally toppling under the burden of massive debt that individuals, companies and governments are increasingly unable to pay back.

This is not to say that some individuals who take peak oil seriously have not done well with their investments. But their strategies had to have been different from simply holding energy-related investments for the long run. The expectation for many peak oil investors had been that energy prices would rise more or less continuously due to increasing demand and constrained supply. That has not worked out as planned. Lately, economic contraction has led to declining demand which has had more influence on energy prices than any perceived constraint on production. But, of course, this doesn't mean that energy-laden investment portfolios might not prosper from this point on; no one can know for sure.

While the basic thesis of peak oil (and peak natural gas, coal and uranium for that matter) remains intact, its timing and exact effects continue to be elusive. Peak oil can still rightly qualify as a so-called "black swan event." The term, introduced to the public by former hedge fund manager and author Nassim Nicholas Taleb in his book "The Black Swan," denotes an unexpected and rare event of high impact which few people anticipate. It is precisely because few people anticipate it that is has high impact, and peak oil, though it is a better known concept today, remains poorly understood or unknown to the great majority of people on the planet.

The myriad factors that are leading us toward peak oil are not visible to any one observer. We can calculate, we can hypothesize, and we can prognosticate; but we cannot know for certain the date of its arrival or its ultimate effects on society and the markets. There will always be a gap between what we think we know and what we actually know.

The action in the investment markets ought to be a lesson for all those trying to envision what will happen in any complex system, especially one as complex as human society. Our powers of prediction are weak. We need to keep an open mind and observe carefully.

This doesn't mean we shouldn't try to plan or prepare or even invest. Humans are planning animals. But what they are really good at is improvisation. That's why careful attention to what is right before us rather than what we imagine for the future is of critical importance. The kick in the pants that all those who followed the peak oil investment paradigm received last year (including me to a minor degree) is a reminder that we ought not to allow our fantasies of the future to dominate our every action in the here and now.


Anonymous said...

Kurt - I really enjoy much of your work. I would argue, however, that you are misusing the black swan concept. Peak oil, as the concept of reaching the highest level of fossil fuel extraction, will occur due to the fact that fossile fuels are finite. A black swan event would have to be something much more sudden and profound. For example, a surprise war between Israel and Iran et al. that destroys a substantial portion of oil extraction infrastructure. Or, the collapse of the Mexican government and with it PeMex.

I take your point re how dependent a person or group of persons is on a blackswan NOT occuring is pretty important. However, because there is a big downside to peak extraction does not mean its occurrence qualifies as a black swan.

Keep up the good work.

SoapBoxTech said...

With all the "badness" going on, arguing about his use of the term "black swan" kind of seems like a waste of time over semantics?

Maybe it's just me but it seems like there are a whole lot more important things on which to expend energy. I suppose my response is just as big a waste of energy tho, lol.

Kurt Cobb said...

Ok, let's waste a little more time on the Black Swan idea since I think it is worthwhile to understand more precisely what Taleb means. If you read the totality of Taleb's work, you will find that he says explicitly that Black Swan events can happen suddenly or over long periods of time. A Black Swan event that happened over a long period of time would be the computer revolution, an example which Taleb uses himself. In the late 1940s no one could imagine that more than a few dozen or perhaps a few hundred of such contraptions would be needed. No one even conceived of the possibility of a computer in nearly every home in industrialized societies. That's a surprise, high-impact development that took place gradually over several decades and the penetration of computers into virtually every aspect of modern life really does qualify as a black swan.

So also peak oil, which remains unexpected by the great majority will be a surprise and will have (is having?) a profound impact.

Perhaps you don't think this is a good way to categorize peak oil. Ok, I'm fine with other ways to categorize it.

But, one thing is certain in my mind. If the majority of people on the planet were expecting peak oil to occur and actually understood its implications, the event most definitely would not qualify as a black swan event since we would all have long since been preparing for it. Hence, its impact would turn out to be much less.

SoapBoxTech said...

Heh, slow evening I guess Kurt?

Anonymous said...

Any discussion about peak oil and oil prices over the next decade must include an attempt to quantify emerging economy demand as an important driver at the margin. Here is a simple thought experiment using Chinese demand to give some idea of the magnitude of the supply issues we face:
- China moves from 3 bbls/person/year to the South Korean per capita consumption level of 17 bbls/person/year
- Transition takes 30 years
- No peak in global production

In next 10 years we must find 44 million BOPD. If you superimpose peak production on top of this demand profile using the following parameters oil prices would increase approximately 250% in real terms over next 10 years:
- Oil demand elasticity of -0.3
- Current production 84 million BOPD, current price US$ 80
- Peak production 100 million BOPD
- Post peak decline rate of 3-4%

If you want to try the model for yourself using your own assumptions it can be found at Petrocapita Income Trust: