An Investment Strategy for the Coming Post Petroleum Age

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The evidence is starting to stack up that 2006 will indeed be the year of peak world oil production. You only have to google "peak oil" to find more, but here are three of the most compelling reasons for believing that the peak is almost upon us.

Firstly, world oil production has been at a plateau of just under 85 million barrels per day since December 2004. In spite of sustained prices in the range of 60 to 70 dollars a barrel, extra production just isn't forthcoming. This isn't the market response you learned to expect in Economics 101, and the longer this situation persists, the more apparent it will be that a discontinuity of historic proportions is taking place.

Secondly, OPEC has stopped calling for production changes from its members, either to the upside or the downside. OPEC is increasingly looking like the rider of a rodeo horse who got thrown off. In its lack of relevance, OPEC is starting to resemble the Texas Railroad Commission in 1973. In that year, remember, the Texas Railroad Commission finally abandoned its role of limiting output in order to stabilize prices in the USA. I predict that OPEC will be out of business soon, and probably by 2009.

Thirdly, oil company stock prices are high, but they haven't moved up as much as the oil price warrants. Why? Because oil companies can't use the money the way that classical economics says they should. A dollar invested in oil exploration now delivers less than one dollar's worth of oil. The oil majors know it, but are disguising the truth by drilling for oil in Wall Street. Most reserve growth now is generated by mergers and acquisitions, not by new discoveries in the field.

A peek behind the peak

You have to find oil before you can burn it. This seems quite obvious, but it has profound implications for every investor, as we shall see. The peak year for oil discovery in the United States was 1930, but the peak year for oil extraction occurred 41 years later, in 1971. So what? Well, the peak year for oil discovery in the world as a whole was 1965: add 41 years, and you get ... 2006.

There's no reason why the lag between the peaks of discovery and production in the world should mirror the 41-year lag in the USA, you might reply, and you would be right. However, consider this: the lag in the North Sea was only 18 years. The taxation regime there greatly favored fast extraction, and the latest technology was used. In Russia, on the other hand, the lag was over 50 years: contrary to the situation in the North Sea, the investment regime was usually unfavorable, and the Russians often had to use obsolete equipment. It appears that the US situation was somewhere between these two extremes. There was certainly no shortage of investment in the US, but the latest technology - horizontal drilling, for example - came to be used there too late to affect the production peak. As oil producing nations go, the USA is reckoned to be right in the middle of this investment/technology spectrum.

On Stocks, Bonds, Gold, Fine Art, and Real Estate

If you think that oil is "just another commodity", consider this. The world population is currently 6.5 billion. Without oil, the world population would be no greater than 2.5 billion. More than half of us owe our existence to oil. We almost literally eat oil, because modern agriculture is the process of converting oil into food. Oil in not just another commodity: it is the pre-requisite of most other commodities, and of our modern industrial age. There is a strong correlation between GDP growth and the growth in oil consumption. When oil peaks and starts its inevitable slide downwards, markets will crash and capital will be destroyed. In this environment, stocks will be a very poor bet. Governments won't be able to handle the fallout, and their bonds are likely to be rendered worthless by inflation.

My investment choices? In order of increasing importance: gold, fine art, and real estate. Gold is good, but remember that during the great depression private ownership of gold was outlawed in the US. When times get tough, the government won't be able to resist helping itself to your gold. Fine art is better, but only when the artist is dead: dead artists can't devalue their work by producing more of it. But top of the league is real estate, particularly land that produces food without need of artificial irrigation. Whatever global warming and peak oil do to world markets, one thing is certain: people will still have to eat.

Gerald Smith is a technical consultant at Piedmont Properties, a real estate agency specializing in Italian vineyards. His website can be found at http://www.smithgcb.demon.co.uk/

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