The 'peak oil' deja vu

From Wall Street to Main Street, concerns over the phenomenon known as "peak oil" have reached a fever pitch. "Peak oil", of course, is the hypothesis that global crude-oil production has peaked, or will soon, and is destined to start a permanent decline thereafter - with frightful consequences, it is usually argued, for Industrial Civilization as We Know It.

Unfortunately, there are still some laggards who are not sufficiently impressed with the self-evident truth of this theory to be spurred into dramatic action. Consequently, a leading energy expert has slammed the skeptics and, at the same time, elevated the status of the true believers.

Although energy is mainly a secular matter, the expert writes: "This is a question of almost religious importance which needs the study and determination of every intelligent person." His key message is: "It is the material energy - the universal aid - the factor in everything we do. With petroleum almost any feat is possible or easy; without it we are thrown into the laborious poverty of early times."

Straight from today's editorial pages, except for two minor details: these quotations have been provided without a date, and with one key word changed.

The date was 1865; the important energy source was coal, not petroleum; and the writer was Stanley Jevons - a leading economist. His book, The Coal Question, was thoroughly researched and broadcast his personal concerns that the industrialized world was about to run out of coal and civilization would therefore collapse.

Now, of course, the concern is that we are running out of oil and great distress will follow. As with any such concerns both then and now, the intellectual speculation seems mainly driven by soaring prices. Commodity prices had been increasing for 20 years in 1865, and soared further with the American Civil War and the dollar depreciation that went with it.

However, the predicted collapse never materialized. Instead, the market soon attended to the price problem. To this day, there is no shortage of coal; in fact - ironically - plentiful coal supplies are periodically alluded to as an alternative to allegedly "peaking" oil.

Crude oil has the headlines today. If we examine historical crude prices, adjusting by the Producer Price Index (PPI) to eliminate the effects of currency fluctuations, an interesting story is revealed. The real price soared to US$73 with the 1980 oil crisis, before plunging to $16 in 1986. Now, 20 years later, it is again back to $73, and those who insist that their intellect and personal concerns are superior to market forces are again getting the headlines.

This was the case for coal in 1865, but one doesn't have to go back nearly that far to find embarrassingly flubbed predictions about energy supplies. On February 25, 1980, the then-US secretary of energy Charles W Duncan baldly asserted that market forces didn't apply to crude oil: "One thing is for certain, [crude] prices will continue to rise ... [the] traditional criteria of supply and demand don't apply."

It seems that the higher a mania runs, the higher the intellect that succumbs to it. If, indeed, oil prices moved solely on dysfunctional Middle East politics, then the chart would show a relentless rise from lower left to upper right - beginning as the Royal Navy converted from coal to oil in the early 1900s. Instead, crude's actual price history mostly records major changes dependent upon recurring manias in commodities, as well as the four-to-five-year business cycle.

Of course, prior to the development of petroleum as a commercial product, distillation of coal and/or whale oil provided illumination, chemical and cosmetic needs, and prices of these soared with the great commodity inflation era that blew out in the 1860s. Ironically, it was in the late 1860s that petroleum started on its path to become the giant it is today. In the long history of the financial markets, it didn't take long before "King Coal" became "King Crude".

The next mania in commodities climaxed in 1920, and crude-oil investment became extremely compelling when Mexico briefly carteled the price. At the time, Mexico was the world's second-largest producer (after the United States), accounting for some 25% of global production.

This intervention anticipated the modern-day cartel attempted by the Organization of Petroleum Exporting Countries (OPEC), which flourished during the 1970s and flopped in the 1980s. But, as noted above, the chart is rarely a straight line and the 1920 high was slammed by the deflationary contraction that followed the 1929 stock bubble. In gold terms, the price of crude fell to about a quarter of its high, which was about the same as the long slump in whale-oil prices following the 1873 stock bubble.

It is very likely that petroleum prices remain subject to the historical long-term trends, with the ups being provided by great asset inflations, and the downs provided by the lengthy post-bubble contractions.

Fluctuations caused by the four-to-five-year business cycle are also evident in the history of crude prices. On the most recent one, crude prices have rallied from $17.48 (spot West Texas intermediate) in November 2001 to the recent high of $75. However, it's important to peer through the distortions caused by policies of deliberate currency depreciation, and this can best be done by adjusting the price according to the PPI.

The "big" high with the 1980 Iranian crisis was $73. This sets the 2001 low at $21.82, from which it has soared to $75. In 1980, the prediction was that crude would get to $90, which compares to today's touts of $100. Obviously, conditions today are as speculative as at the 1980 high or, for that matter, at the 1920 high.

With such market compulsions evident again, it's natural to ask the question, "Are we there yet?" - meaning at the end of yet another speculative trip in energy prices. In answering this question, it is prudent to observe that every great mania in energy prices has occurred close to the peak of a business cycle. For many, the main prerequisite to a slump in crude prices would be a cessation of the troubles in the Middle East, which is unlikely. For the more disinterested, the best explanation would be just another post-bubble business contraction whereby prices for most commodities go down, including oil.

There are other forces acting on crude prices as well, of course; such as the seasonal pattern with a high in the late spring and a decline into the late-June-to-early-July window. However, one of the most relentless forces acting on commodity prices is deliberate dollar depreciation, and this is subject to influences outside the Federal Reserve Bank.

If the Fed's intentions were supreme, the dollar chart would also be a straight line from the upper left to the lower right, but this is not the case, as there are many occasions when the Fed just can't depreciate. Typically, this also occurs during post-bubble contractions, when implacable market forces deny the policies of depreciation. According to the technical analysis that identified the dollar's low in December 2004, the dollar index is poised for a rally, in which case an essential part of the compulsion to consider commodities as an asset class to "invest" in will diminish.

Nonetheless, speculative excesses have captured the imagination of pundits, punters, policymakers, and intellectuals in a manner uncannily reminiscent of the similar excesses displayed by the same crowd in 1980 - or during any of the other great commodities bubbles in economic history.

Bob Hoye is editor and chief investment strategist of Institutional Advisors.

(Copyright 2006 Bob Hoye.)