Blog: TheViewFromThePeak: A Law abiding bull market

By Dan Denning

The "peak oil" debate keeps raging on the message boards
and blogs of the Internet. Some folks argue that we're
running out of the precious black goo. Others advance a
more hopeful forecast, or predict that innovation will
spare future generations from the pain of exhausted
hydrocarbon supplies. Both camps present compelling ideas,
but neither camp presents an idea that would prevent oil
prices from soaring much higher than they are currently.

In the end, doesn't it really come down to the Laws of
Physics? Such is the central argument of James Kunstler's
provocative book, "The Long Emergency: Surviving the
Converging Catastrophes of the 21st Century."

The following passage presents the essence of Kunstler's
viewpoint:

"The invention of the steam engine (a magical product of
human ingenuity) provoked the invention of other new
machines, and then of factories with machines, which
prompted the need for better indoor lighting, which
stimulated the use of petroleum, which produced brighter
light than candles (and was much easier to get than sperm
whales), which provoked the development of the oil
industry, whose oil was found to work even better in the
engines than coal did, which led to the massive
exploitation of a one-time endowment of concentrated stored
solar energy, which we have directed through pipes of
various kinds into an immense flow of entropy, which has
resulted in fantastic environmental degradation and human
habitat overshoot beyond carrying capacity."

Let me pause here to say I want to be somewhat skeptical of
Kunstler's claim there is such a thing as a physical limit
to the number of human beings the earth can support. People
have been saying this ever since Thomas Malthus. And
they've been wrong.

But it's important to note that Kunstler is saying that the
entire world cannot live at the same "energy density" as we
in the West currently enjoy. He's not suggesting we'll run
out of oil next year, merely that we will run out of
"cheap" oil very soon. Kunstler argues that the laws of
physics – in particular, the laws of thermodynamics –
preclude a growing global reliance on fossil fuels.

Hydrocarbons, for example, represent billions of years of
stored-up solar energy. And yet, we humans will likely
exhaust our endowment of hydrocarbons in less than 300
years. As this epic depletion proceeds, hydrocarbon fuels
will become much more expensive, thereby spurring
innovation.

Scientific breakthroughs, for example, have already enabled
us to extract "syncrude" from Alberta's tar sands. Future
breakthroughs might enable us to extract oil from
Colorado's oil shale in an economically and environmentally
viable manner. Clearly, the road to innovation will be
paved with high and rising energy prices. Unfortunately,
according to Kunstler, global fossil fuel consumption is
already bumping up against the earth's physical
limitations. He writes:

"It is assumed now that human beings, prompted by the
market, will employ ingenuity to discover a substitute for
oil and gas, once the price starts to ramp up beyond the
'affordable' range. This assumption is apt to prove
fallacious because it ignores the fact that earth is a
closed system, while the laws of thermodynamics state that
energy can't be created out of nothing, only changed from
low entropy to high entropy, and that we have already
changed the half of our oil-endowment that was easiest to
get into dispersed carbon dioxide, which is now ratcheting
up global warming and climate change, which might well put
the industrial adventure out of business before human
ingenuity can come up with a substitute for oil. The solar
energy stored for millions of years in oil will now be
expressed in higher temperatures, more severe storms,
rising sea levels, and harsher conditions for the human
species, which, despite its exosomatic technological
achievements, remains a part of nature and subject to its
laws.

I'm not so sure that I agree with Kunstler's grim prognosis
for humanity, but I do find the central elements of his
argument pretty compelling, almost irresistible. In a
closed system, nothing can prevent entropy. (This is why
all closed political systems like communism die. Without
new inputs – energy, ideas, resources – they cannot sustain
themselves).

So given that the Earth is essentially a closed system,
physically speaking, what is the way out of Kunstler's
dilemma? Well, maybe there is no way out. But if there is
one, it is the variability of human thought. Is it not
possible that we might find better ways to use the
hydrocarbons that remain? Or devise more practical ways of
using renewable energy resources?

Yet, as Kunstler points out, human thought is also
constrained by the laws of physics. For example, Man
cannot, through intense thought and clever innovation,
convert a Bassett Hound into a Boeing 757...or a pile of
computers into pile of caviar. Nor can clever thought
replace the one trillion barrels of crude oil we have
already extracted from the earth's crust...but it can lead
to the more efficient use of our finite natural resources.

Even so, continuing to innovate does not preclude the
possibility of $100 oil...or $263 oil, as one professional
investor recently predicted. In fact, the two go hand in
hand. It seems a pretty safe bet that we will innovate ONLY
if/as/when hydrocarbon fuels become unbearably expensive.

How high could crude oil go? Bill Browder of Hermitage
Capital Management comes up with a nice specific number,
$262. Browder and his team outlined six scenarios where oil
could spike. An article at CNN.Money.com reports:

"To come up with some likely scenarios in the event of an
international crisis, his team performed what's known as a
regression analysis, extrapolating the numbers from past
oil shocks and then using them to calculate what might
happen when the supply from an oil-producing country was
cut off in six different situations. The fall of the House
of Saud seems the most farfetched of the six possibilities,
and it's the one that generates that $262 a barrel.

"More realistic—and therefore more chilling—would be the
scenario where Iran declares an oil embargo a la OPEC in
1973, which Browder thinks could cause oil to double to
$131 a barrel. Other outcomes include an embargo by
Venezuelan strongman Hugo Chavez ($111 a barrel), civil war
in Nigeria ($98 a barrel), unrest and violence in Algeria
($79 a barrel) and major attacks on infrastructure by the
insurgency in Iraq ($88 a barrel)."

Browder's name sounded familiar to me. And then I
remembered. Back in 2001, when I recommended Gazprom to my
Strategic Investments subscribers, Browder was about the
only Western analysts who understood the importance of
Russian natural gas to Europe's economy. And Browder was
years ahead of everyone in realizing that energy would be
viewed by governments as a strategic asset, and used as a
policy weapon.

Other people are catching onto the theme now. Did you
notice Saudi Kind Abdullah paid a visit to China this week,
with all his critical oil and defense ministers in tow?
Saudi Foreign Minister Saud al-Faisal said, "China is one
of the most important markets for oil and Saudi oil is one
of the most important sources of energy for China."

Sounds like a strategic partnership in the making, no?

Chinese Foreign Minister Li Zhaoxing said, "There is a
great deal of understanding between the two countries on
all issues, including the Middle East, Iraq, and the
Iranian nuclear program." I bet there is. The Saudis don't
need customers. But they do need protectors. And who better
to court than a rising economic and strategic power?

Furthermore, China and Saudi Arabia may have more in common
than China and America. Both China and Saudi Arabia are run
by unelected elites who are free to set a national energy
policy and favor certain national oil companies (please
don't send me e-mail that the same is true of the U.S. with
Bush, Cheney, and Halliburton...believe me, I'm aware of
the irony)

Writing on the growing importance of national energy
companies as instruments of national grand strategy, Pam
Boschee of Offshore Magazine states, "It is possible that
NOCs [national oil companies] may gain the upper hand as
geopolitical forces become increasingly critical. The
influence of combining political, economic, security,
defense - and petroleum - may indeed create a volatile
concoction."

Indeed, which is one more reason why the bull market in
crude oil will last until we figure out a way to live
without the stuff. The Laws of Physics would not have it
any other way.

[Joel's Note: Every time a light is switched on somewhere
in the world, another drop of oil is gone forever. There is
no denying that supply is diminishing. Any one of the
scenarios that Dan cites above could see us looking back on
the days of $65 oil with fondness as it skyrockets upwards.
So what to do? Dan Denning's Strategic Investment
newsletter keeps you on the money with news on oil, housing
and a host of other macro-economic insights. You may not be
able to change the laws of physics, but you can at least be
prepared for the outcomes. Learn all about staying ahead
right here: