Shift Investments to Oil? Part 2

The main arguments for the price of oil going through the roof are:

1) Decreased Supply due to Peak Oil. If you haven't heard about Peak Oil Theory, read through the Wikipedia entry and Eric Sprott's Market at Glance articles.

2) Increased Demand. World demand for oil is expected to increase about 35% by 2030. China's consumption has been increasing about 8% a year.

I was going to post a few choice quotes from Eric Sprott in regards to oil from the recent Sprott Webcast, but since everything he talks about is quite interesting and you probably won't watch the webcast, I'm just going to post the whole transcription of the part of his speech on Oil here and bold some notable parts.

Sprott Webcast, Eric Sprott from 30:30 - 36:30 :

Peak Oil. Okay. I just like going to this chart, which shows the rate of discovery and the rates of production. As you all know, M. Hubbard King back in 1956 was working with Shell Oil, said that in 1970, U.S. conventional production lower 48 states would peak. Sure enough, 14 years later after making the prediction, it peaked, and it's gone down ever since. And the same petro-physicists... have suggested that in this decade, oil peaks and forever goes down. And the data on conventional oil production -- when I say conventional, I'm excluding tarsands and ethanol and other forms of energy that don't come from normal hydrocarbons... -- but the data tends to suggest that in December of '05 we *have* peaked: that conventional production of oil in the world is going down.

I wanted to give you some examples here. And probably the most glaring example: There's a field in the gulf of Mexico called the Cantarell, and in 2004 it produces 2.4 million barrels. It was just announced that their production in August (2008) -- I've heard 2 numbers, either 974,000 or 950,000. It doesn't matter much. But from '04 to '08 it fell by 1.4 million barrels.

Now, you live in Canada. You know what it costs to produce a tarsands plant to produce 100,000 barrels a day. It probably costs at least -- It's $10 to $15 billion -- to get 100,000 barrels a day. And it takes you 5 years and stresses the system out. Imagine if we were building 15 plants today just to offset this one field. And that is going down *so* fast.

And most of the prognosticators on oil that the general public is forced to listened to have massively had their head in the sand on oil production and what's likely to happen. And I will forewarn you, that the International Energy Agency back in May said, "Uhh, we're going to look at our formula again on oil production. In November, we'll probably come out with a new forecast, because we may have the depletion rates wrong." And I know what the forecast is going to be, because they do have the depletion rates wrong. When you see a field like Cantarell falling 36% year over year... Imagine if all fields fell at 36%. But even that one, because it's one of the biggest in the world.

And of course one of the bigger fears is Ghawar field [the largest oil field in the world] in Saudia Arabia that produces over 4 million barrels a day. And the same guys who predicted -- I can tell you they predicted back in 2001-02 -- they all talked about Cantarell. I talked about Cantarell back in 2004 and said it's likely to be a problem. But they all talk about Ghawar too. Ghawar's 4 million barrels a day. And they sustain production by pumping in 6 million barrels of water every day to keep production up. Well you know what? Someday that water's going to get up there and you're going to be producing water, not oil. And when it declines, I'd predict it'll decline real fast.

And we all know how difficult it is. We have investments in oil and gas stocks in Canada. We don't use the word 100,000 barrels a day. We're happy if -- If a guy has a well in Canada that produces 1,000 barrels a day, we're kind of happy. A thousand. What does *that* do for you? We have 86 million barrels a day of [worldwide] production, and I think the accepted decline rate today is around 8%. So we have to find 7 million barrels of oil -- new oil -- a year. Well hey, I would certainly predict that we won't.

We have other charts of different countries and their production, and you can see most of them have [gone down] -- Oh hey, there's one that's going up! [said with mock surprise]. Oh, that's 'cause it's consumption - sorry! (Laughter from audience). [Displayed is a chart showing China's consumption over the last few decades, which looks like it has been roughly doubling every 10 years, 4 million barrels per day in 1998 vs almost 8 million barrels a day in 2008].

I don't often talk about consumption. I really don't. I just look at supply and say it's a problem. God forbid that *that* [pointing to China consumption] keeps going. I mean that is a big problem. I don't even talk to it, because I just don't think it can. In fact, if I had to make a prediction, U.S. consumption has to fall by probably 50% in fairness to the world. I mean, here we have 4-5% of the population and it consumes 30% of the world's energy? I mean, it's just anomolous. It's ridiculous. And I'm sure you're going to hear some thoughts about that from some people who need oil, who have bigger populations. And I don't know, maybe the mechanism is just jacking the price up by -- I have no idea what it is -- but this is a problem.

So, we are great believers in peak oil, and that the price of oil, certainly over the longer run, will do *nothing* but go up. Forever. It's a forever trade, trust me, [at least] in your lives. See, I'm probably the oldest guy here...
But it's going to be a problem. I mean, you go and try to find some oil. Look at Pearl Petro-Can in their UTS project, when they said that the cost, which was estimated at $19 billion last year, against which they've already spent something, has now gone to $28 billion. That's what it costs to get oil out of the ground. They probably won't even break even at $100 oil with those kind of costs. And that is just this year's estimates, don't forget. We [still] have next year's estimates.

I like near the end when Eric says that over the longer run, the price of oil "will do nothing but go up. Forever. It's a forever trade...".

"Hold on," you say. What about the decrease in demand with this whole world recession we're entering, which has already caused the price of oil to drop from $145 to $60? Eric gets asked that question later on, and this is what he says (at 47:45 - 49:00):

That's a great question. The question was, "How does demand destruction affect the oil price". You know, we're not naive. We're the guys predicting the economic contraction, so we all know there will be some demand destruction in energy. One of the great things about energy though, is demand is incredibly inelastic. You know, we all have to heat our homes, we all theoretically have jobs and we have to work, the subway has got to run. There's only so much you can cut back on. So I think that energy is one of the most inelastic demand cycles you can be involved in. There is some demand destruction going on now, and I've always imagined that we will see that, but ultimately when this Peak Oil cuts in, it will way more than offset any
demand destruction. So that's our thesis.

Makes sense to me.

I feel like I'm reading too many articles that make it seem obvious the only way for oil to go is up. Long-term, there aren't many people who see oil not going up. Criticisms of the Peak Oil Theory are far and few between (there's one small section on the Wikipedia entry). Am I being deluded by Peak Oil proponents? Could oil drop to $20 due to new discoveries and weakened demand in this recession? I can't really find any articles from this year predicting that oil would go that low and stay there for very long. So with oil being around $65, it seems like one of the best 'guaranteed' good investments in a long-term horizon -- something that would be good for an RRSP.

So we now see that Oil is a great place to be long term, and next post I'll show how an investment in DXO can reap huge rewards with even a mild increase in the oil price.