I have grappled over the past year with the question of just how much speculation is playing a factor in runaway oil prices. I think it is primarily a supply/demand issue, but I feel that such a large flow of money into commodities is also driving the surge.

Not so, says a new article in Fortune:

Hunting for oil villains

NEW YORK (Fortune) — Atlanta hedge fund manager Michael Masters has been a star witness in two recent Congressional hearings on how speculators are supposedly driving up oil prices. Masters and I don’t see eye-to-eye on this issue, so I was surprised to get a call from him after my “Don’t Blame The Oil Speculators” column went up on Fortune.com last week.

Masters contends that without speculators, the price of oil would be $65 or $70 a barrel. He points out that the amount invested in commodities index products has risen from $13 billion to $260 billion in five years, a fact he thinks is key to understanding oil prices.

It certainly makes sense to me that large flows of money into a sector should impact the price. But the author argues that unless the speculators are taking physical delivery and taking product off of the market, then they won’t impact the price:

My own view is that speculators can’t materially impact prices if all they’re doing is making bets on the direction of oil prices by trading futures and not taking delivery of actual oil – hoarding stuff that would otherwise go to consumers.

Masters did pose an interesting question about how the Hunt brothers attempted to corner the market on silver:

In the end, Masters and I simply agreed to disagree. But there was one thing he said that really piqued my interest. “What do you think would happen,” Masters asked, “if the market went into liquidation-only mode [i.e. if speculators started unloading their futures contracts], like we saw with the Hunt brothers in 1980?”

I won’t give away the ending, but the author reviews the history of the Hunt brothers’ dealings. There was one key difference between their silver dealings and most oil speculators.

So, what do you think? Can speculators have such a huge impact on the price? And if not, what of JD’s suggestion at Peak Oil Debunked that it isn’t a supply/demand issue? Somebody is badly wrong here, or oil wouldn’t have broken through $145/bbl this morning. (I just noticed that JD also took on the article on speculation; will need to read it when I get a chance).

This is why I think we have some tough economic sledding ahead as the full impact of the current oil price starts to ripple out:

Beyond gasoline: Prices surge for oil-based goods

New York – Besides gasoline, the Department of Energy calculates, there are 57 major uses of petroleum – everything from cosmetics to ballpoint pens, nylons, and even the waxes in chewing gum.

That is why the effect of high oil prices is now spreading well beyond the pump, where gasoline hit another record price of $3.98 a gallon on Wednesday. Now, consumers will have to brace themselves for other higher costs, since businesses such as Kimberly-Clark, Procter & Gamble, and Colgate-Palmolive are raising prices on their products to recoup energy costs.

In brief, this means less money in consumers’ pockets in the months ahead. But it also goes beyond consumers. For example, the price of asphalt is up 65 percent so far this year – and municipalities’ and states’ road departments are cutting back. This may mean bumpier roads ahead.

Most people don’t realize how many products around them are oil-derived. Oil prices have increased so rapidly that there hasn’t been time for the price of oil-based products to catch up.

We have already seen the airlines get hit hard, but we still haven’t seen the worst of that. Just today:

Continental Airlines to cut 3,000 jobs and 67 planes

Airlines, trucking, and auto sales are the early casualties of high oil prices, but you should brace yourself for higher prices on almost everything. I think the only thing that will prevent that would be an immediate collapse in oil prices back to the $50 range, but I don’t see that happening.

Note: I am flying to the U.S. tomorrow, and will be out of contact for a couple of days.

I have said many times that I think that oil prices have gotten ahead of themselves. Yes, supply is tight, and I figured $100 oil next year was a good bet as supply further tightened, but the recent run-up looks like it is due for a pullback. A story in USA Today quotes analysts who feel the same:

Oil’s record has analysts puzzled

The price of oil again set a record Tuesday, easily blowing through the previous high earlier this month, in a move some analysts said was absurd because there was no solid, supply-and-demand reason for it.

“Very overdone,” commented Mark Vitner, senior economist at Wachovia.

“Fundamental reasons? I don’t see any,” said James Williams, economist at WTRG Economics.

Hitting $100 a barrel either could erase a psychological barrier to even higher prices, or it could trigger a been-there, done-that mentality. “You know, ‘Now we’ve hit $100 and we’re done with that,’ and prices drop back $20 or $30 to something more consistent with supply and demand,” Williams said.

I can see them dropping back to the $80’s in the short-term, before climbing again next year. But these oil prices continue to defy gravity.

I saw a comment from someone yesterday that if this week’s inventory report shows a sharp drop in crude inventories, oil will probably spike up above $100. I do think that because of the storms in the North Sea and the flooding in Mexico we will see a decent inventory draw this week. But I don’t think the price will spike to $100 on the news, because this week is complicated by a number of factors.

The first is that the inventory report will be delayed by a day this week, due to the government holiday on Monday. The second is that the front-month WTI contract expires the day after the inventory report is released. There are a lot of people holding contracts that must be sold by Friday. What I expect then is that any bad news that pushes prices higher will be met by speculators selling into the rise.

Another factor that may cause tremendous volatility is that December options contracts expire on Tuesday. If crude doesn’t trade at or above $100, those options expire worthless. This means that there is a tremendous incentive for a lot of people to talk up the price today and tomorrow. I would expect a load of analysts over the next couple of days to appear on TV and “explain” why things are much worse than they seem.

Today’s Houston Chronicle has a story on the expected roller-coaster this week:

Wild week ahead for price of oil

Here is a quick summary, pulled from excerpts in the story:

It’s a situation one analyst likened to a high-stakes poker game. A showdown between traders who believe the price will rise and those who believe it will fall could bring both results — a brief taste of $100, followed by a rapid sell-off.

Lehman Brothers’ Morse said in the report that the Dec. 7 futures contract for West Texas Intermediate crude — the U.S. benchmark — will expire Friday, and 360,000 contracts remained outstanding. Most of those contracts are held by financial players in the oil market and must be sold by the expiration date, Morse said.

“Presumably, market participants know that the exits are going to be crowded over the next few days if they do not sell their positions soon,” he said.

Adding fuel is the West Texas Intermediate options market on the Nymex, where 42,000 Dec. 7 call options for $100 are set to expire Tuesday.

An option to buy at $100 a barrel will only be profitable if oil costs more than that sometime before the option expires. So those 42,000 call options will “expire worthless” on Tuesday if oil doesn’t reach $100 a barrel by then.

“Perhaps, before Tuesday, holders of these calls will attempt to push oil to $100 in a last effort to force these options into the money,” he said.

So there are 360,000 contracts, most of which must be sold between now and Friday. And there are 42,000 options that will only benefit if oil makes it to $100. The expectation is that the traders holding those 42,000 options will talk the price up. But they are going to face the headwind of those holders of those 360,000 contracts trying to liquidate by Friday. I just can’t see oil reaching $100 in the face of that.

Eric Wittenauer, an analyst with A.G. Edwards & Sons, said 42,000 call options at $100 indicated that the holders expect they will be able to exercise them at that price.

“I think it’s a logical argument that someone’s going to have a lot of money on the line and potentially want to drive the price up to $100 and above,” he said. “If you break through $100 and tack on some more, you make that much more profit on your positions.”

Morse said speculators could back off and take profits before a barrel hits $100, but the price most likely will make “a serious run at $100″ by Tuesday and perhaps reach $105 before selling pressure ensues.

It is certainly a credible argument that the holders of those options will try to talk up the price. But I don’t think it is at all credible that they can actually talk up the price to that level. It will take a major geopolitical event or natural disaster to affect prices that strongly. If we don’t see any major news by Tuesday’s close, and oil trades over $100, I will be stunned. As I write this, WTI is trading at $94.94. It’s not going to make it to $100 by tomorrow just on the basis of traders trying to talk it up.

I do agree that we could see a sharp sell-off by Friday:

Then, with the contracts that must be sold by Friday, the rush to sell “may be stronger than anything the oil market has seen in several years,” Morse said.

He said prices could fall to the low $80 range by early December.

I don’t think oil is going to fall to $80 in 3 weeks, but I have said again and again that I don’t think the current price is sustainable in the short term. I think we will pull back shortly, and make another run at $100 in 2008. However, if OPEC doesn’t say the right things following their meeting this week, they will toss more fuel on the fire and make it more unlikely that prices will have a huge correction.

Full Disclosure: I don’t hold any commodities positions. Although I am beginning to think that I should.

I have said on many occasions that I think Saudi’s recent production decline is voluntary, and that I expected them to raise production by summer. However, judging from record-high crude inventory levels (in the U.S.), in combination with crude prices setting about where they were a year ago, it didn’t look like the market was calling for more oil. I have further stated, in debating people who are insistent that Saudi oil production has peaked, that if inventories start to drop and prices start to rise, and then Saudi doesn’t act, then I will concede that it looks like something fishy is afoot.

Alas, crude inventories have been in free-fall lately. After spending quite a bit of time well-above the upper band of the average range, the following chart from the EIA shows that they have just dropped into the band:

Prices are also up, with WTI closing above $80/bbl for the first time ever this week. This is the situation I have described in which Saudi would be called upon to respond. And they have:

Saudi Arabia Wins OPEC Increase, Defying Iran, Libya

Sept. 12 (Bloomberg) — Saudi Arabia persuaded OPEC members to increase production for the first time in a year, seeking to reduce the record price of oil, over the objections of Iran, Qatar, Venezuela, Libya and Algeria.

Saudi Arabia, the group’s biggest exporter, wanted to boost supplies after crude gained 28 percent this year to $78 a barrel, said Iraqi Oil Minister Hussain al-Shahristani. The 500,000 barrel- a-day increase will be on top of actual production, according to Kuwait’s acting oil minister, Mohammed Abdullah al-Aleem.

How much of that share will come from Saudi? According to PLATTS, most of it:

OPEC says Saudis to assume almost two-thirds of output hike

OPEC kingpin Saudi Arabia will boost its production by 327,000 b/d under the cartel’s output increase announced earlier this week, assuming 63% of the 522,000 b/d OPEC plans to put on the market from November 1, according to figures released by the group Friday.

The Saudis’ new production allocation will be 8.943 million b/d. That is up from August output of 8.616 million b/d, according to figures from secondary sources used by the cartel.

I have to admit that some of the responses from the “Saudi has peaked and is in steep decline” crowd have been entertaining. I won’t say “I told you so” just yet. They still have a ways to go before getting back to peak production. I have yet to see someone say “Well, if they raise production then I was wrong about the involuntary decline.” But if they are in steep, involuntary decline (as opposed to my position that they are trying to manage supply and demand) then surely one must wonder how they think they can increase production by over 300,000 bbl/day.

This debate over Saudi has been very ugly at times. The same people who cheer you on when you tell them that corn ethanol is not an answer, can growl menacingly when you challenge the viewpoint that Saudi has peaked. I think Dave Cohen, a former staff member at The Oil Drum, summed it up well (and captured my position as well):

Why must there always be two extreme polarized positions in this peak oil debate?

Why must the world always be black or white?

I have a scenario, reasonable in my view, that sees the world topping out at somewhere over 87 to 88 million barrels a day (all liquids) in about 4 years. There may be a dozen or more independent variables that must be fixed to get that result. Geopolitical variables, OPEC variables, price variables, inflation variables, other demand-side variables, upstream variables, substitution (for oil) variables, etc. See the problem? My reasonable scenario could be off in either direction, perhaps very badly.

But suppose my scenario is correct. That would entail that the oil supply would continue to increase for a few more years. That doesn’t negate peak oil—it still arrives. It’s just a bit later than many think. Does 4 years and 2 to 3 million barrels a day matter? Not at all. If conventional oil reserves are few hundred billion barrels higher than some people think they are, does it matter? Not at all.

When the peak oil debate takes its usual polarized form, it impoverishes us all.

I generally apologize to anyone I have insulted on this weblog. But I’ll tell you the reason why—all these extreme statements coming from both sides of the debate just make me crazy. It’s hard to stay sane. And because oil is the lifeblood of the world’s economies, it makes everybody extra crazy, including me.

I share Dave’s concern over the extremist positions. I can neither understand the mindset of someone who lashes out if you tell them the world is NOT ending tomorrow, nor of the person who ridicules when you challenge the assertion that there is oil aplenty as far as the eye can see.

An AP story came out today warning (again) that the Saudis will probably not be able to keep up with our oil demand . You know things are bad when the Saudis are telling us we need to conserve. A few excerpts from the story:

“The current out-of-control demand is not good for us,” Ghazi Al-Rawi, head of private equity at Gulf One Investment Bank, said in a recent interview. “When you have this kind of demand, you’re forced to supply beyond the optimal rate. That’s not a positive thing.”

Most urgently needed is energy conservation, especially in the United States, which now burns up a quarter of the oil sold to the world, said Saddad al-Husseini, the former head of production at state-owned Saudi Aramco.

“The crunch is already here. It’s not five years down the road,” Ghalib said. “There is no thought being given in the U.S. to raising gasoline taxes or increasing mileage on U.S. cars. In China, automobile use is skyrocketing.”

Get ready for ever higher oil and gas prices. Without a swing producer who can step into the gap, any global hiccup is going to make the price of oil skyrocket. Combined with several other factors (MTBE phaseout, low-sulfur gasoline specs, more expensive summer gasoline blends) gasoline looks to get very expensive this summer. However, this is a very positive thing in the long run. Another quote from the story:

Keeping prices high is the best way to meet demand over the next decade or two, said Leonardo Maugeri, an executive with the Italian energy company ENI. High prices give investors incentive to spend the billions needed to boost oil production and develop alternate fuels, Maugeri wrote in the current issue of Foreign Affairs.

Keeping prices high will help meet demand because it will force consumers to start conserving. We are already seeing a mild drop in demand. As oil goes to $80 or higher, a larger number of consumers should start making some choices that will further drop demand. I will be writing an essay on this soon, but this is why I don’t believe the world is coming to an end because of Peak Oil. I believe we are in for some hard times (like we have never seen before), but since it looks like we are opening up a supply/demand imbalance before we reach Peak Oil, we can count on higher prices to stem demand and delay the peak. This will give us more time to make the adjustment, which indeed would be disastrous if we peaked and immediately started declining at 4% a year. Higher prices give us hope.

However, if you have the attitude of this person who posted this to the Billings Gazette:

The Point is people shouldnt have to change there life style just because the price of gas is high.

Then you should prepare for very expensive times ahead. People like this will learn, but they will learn the hard way.

Hmm. I am going to have to trademark “Peak Lite.” This viewpoint is gathering momentum. First the IEA, then the NPC, now the former chairman of Shell has come out and endorsed this view:

Oil industry ’sleepwalking into crisis’

Lord Oxburgh, the former chairman of Shell, has issued a stark warning that the price of oil could hit $150 per barrel, with oil production peaking within the next 20 years.

He accused the industry of having its head “in the sand” about the depletion of supplies, and warned: “We may be sleepwalking into a problem which is actually going to be very serious and it may be too late to do anything about it by the time we are fully aware.”

In an interview with The Independent on Sunday ahead of his address to the Association for the Study of Peak Oil in Ireland this week, Lord Oxburgh, one of the most respected names in the energy industry, said a rapid increase in the price of oil was inevitable as demand continued to outstrip supply. He said: “We can probably go on extracting oil from the ground for a very long time, but it is going to get very expensive indeed.

Commenting on whether “peak oil” – the point when global oil production goes into terminal decline – was likely to be reached in the near future, he said: “In a way it scarcely matters; what really matters is the gap between production and demand. I don’t know whether there is going to be a peak in world oil production, whether it’s going to plateau and then slowly come down.

It is hard for me to envision a scenario in which oil prices aren’t under severe pressure going forward. $150? Sure. Within 20 years? I have no doubt. Within 2 years as some are saying? I have a hard time seeing that, as people will start to respond as prices remain elevated.

Front month WTI broke $84 today for the first time ever. I have seen some comments recently from people who think I am sure to lose my bet by year end. I still don’t think so. A devastating hurricane churning through the gulf, or a spectacular geopolitical event could push the price that high in a hurry, but outside of that I don’t see it. I think there would be a lot of profit-taking between here and $100 that will prevent any sort of headlong rush to $100 (again, barring the spectacular event). For the record, I think prices will ease between now and the end of the year, and will close the year somewhere in the $70’s.

In related news:

The debate behind $80 oil

Although top oil executives feel $80 is too high, there’s an ongoing debate among experts as to whether that price is justified.

Since early 2000 the strong and growing oil demand in the U.S. and abroad with fairly static supplies is the main reason behind oil’s surge, according to most analysts. Oil has gone from $20 in 2002 to over $80 today.

That price jump has also attracted lots of investors, which could be the “something else going on” that Tillerson believes is driving up prices.

“There’s clearly some financial players pushing up the price of crude,” said Carol of Johnson Rice & Co. “Given the current supply-demand scenario, $80 is not justified.

“But opinions are split as to just how much speculative investors are driving crude prices.

Beutel notes that only 18 percent of the “long” contracts on the New York Mercantile Exchange – meaning bets where the investor thinks the price of oil is going to go up – are held by investment funds. Seventy five percent are held by people who actually use the oil.

Moreover, he said only nine percent of the total contracts on NYMEX are held by investment funds.

“I just don’t buy the ’speculators are doing it’ argument,” said Beutel.

Fitzpatrick, a speculator himself, said the investment premium of on each barrel of oil is only about $4 or $5. The rest he said can be attributed to the fundamentals:

“China is not going away, India is not going away,” he said “They are going to drink up this oil.”

Personally, I don’t think it’s a big mystery why oil is at $84. When Rex Tillerson says that he “cannot explain why we have $70 oil today. We are not having trouble finding oil. There is something else going on that I don’t get” – I believe the answer is clear.

Excess capacity has largely been used up, and this puts incredible pressure on prices. The fear premium grows as excess capacity decreases, and countries are bidding on that remaining capacity. Consider what might happen if suddenly you took a million barrels per day off the market. How high might the price go? It is really hard to predict, but the math probably looks something like this: Take 1% of the supply off the market, and watch the price increase by 10%.

I think Saudi is about to be called upon to open up the taps more than they agreed upon at the recent OPEC meeting. If they don’t (or can’t) then I do think there is a good probability of seeing $100 oil in 2008.

I don’t think you would want to take it out on the interstate, but it’s pretty cool to see people working on stuff like this.

$2,500 DIY Cars

Tired of high gas prices? For $2,500 and 1,000 hours, you can build a car that gets 100 miles to the gallon.

In a world where the price of oil is trending towards infinity, large companies are quickly seeking alternative energy sources for transportation. Jory Squibb decided he’d build his own fuel-miser, and set about creating it from second-hand motorcycle parts. The resultant vehicle, christened MOONBEAM, gets 80-85 mpg around town and under economy run conditions (max 40 mph) delivers 105 mpg. Two scooters for the bits cost US $500, and the entire project took 1000 hours (a year of 20 hour weeks) to complete, with a total of US $2000 costs beyond the initial scooters. Moonbeam has a Variable speed transmission, so there’s no gear shifting (hand controls only).

He also provides step-by-step instructions for building your own:

How to Build Moonbeam

Here is the final product:

I am also about to post a story about a guy who built his own solar-powered tractor, and is working on a solar-powered car.

Peak Lite and the Current Oil Picture

A few years ago, after spending a lot of time thinking about peak oil, and then watching the price of oil break out of its historical trading range and head higher, the idea of Peak Lite came to me. Over time the price of oil had bounced between $10 and $30 a barrel, but about 5 years ago it broke from that pattern and started the steady climb that culminated in $147/bbl last summer. I had been having various debates about whether we were or weren’t at the global peak in oil production (I was taking the ‘not yet but soon’ position), but it started to become clear to me that we didn’t require a global peak before we started to feel the impact of peak oil.

I proposed the following to explain what I thought was happening. (Don’t get too fixated on the dates or prices as they are just there to illustrate the concept). Figure 1 shows the sort of price behavior if spare oil production capacity is constant. Of course spare production fluctuates up and down, as does price, but my thesis is that constant excess capacity should keep the price relatively stable – as long as the excess is large enough that several different producers have the ability to step up and fill shortfalls. This concept is illustrated by Figure 1, with a constant four million barrels per day (bpd) of excess capacity and an oil price of $25/bbl.

Figure 1. Simulated Oil Price Behavior at Constant Spare Capacity

Figure 2. Simulated Oil Price Behavior at Eroding Spare Capacity

Figure 2 illustrates the case in which demand growth is outstripping supply growth, leading to diminishing spare capacity. This is the mode that we have been in for the past few years. Spare capacity was eroded by several million barrels during the first half of this decade, and as a result the price of oil climbed higher, and became increasingly volatile. This was caused by a combination of stronger demand worldwide, and an oil industry that had not anticipated such strong demand growth. As a result, the global oil industry didn’t invest aggressively enough to meet demand, and while capacity did grow, it didn’t grow quickly enough to keep prices stable.

Figure 3. The Next Five Years?

Figure 3 illustrates a future in which world demand has collided with world supply, and then demand growth continues to stay ahead of supply growth. In the world of peak oil, this happens because supply is falling. In the peak lite world, it can occur even if supply is increasing. In the figure, I show an example of supply and demand colliding in 2010, then demand exceeding supply in future years. Of course demand as defined in Economics 101 won’t actually exceed supply, demand will just be destroyed by rising prices (as shown on the right axis) to keep it in equilibrium with supply. Figures 2 and 3 illustrate what Peak Lite is all about; that you don’t have to have falling supplies to start experiencing the effects of peak oil.

I created the original figures in mid-2007, and as we know by mid-2008 oil prices had risen much higher than the $95/bbl I illustrated on the figure. But circumstances have changed. As a result of climbing oil prices, new projects have begun to come online. Strong price signals from the previous five years had resulted in major investments into new oil production (but it takes a few years to bring new projects online); about 5 million bpd of new capacity was expected to come online in 2008 alone.

At the same time, oil prices climbed much too quickly for the economy to even begin to adjust, and this contributed to the overall economic collapse. The combination of high prices and the economic troubles have taken a bite out of demand (at least temporarily). So we essentially find ourselves back in the position of having perhaps three or four million barrels of excess capacity around the world, and oil prices back in the $40’s. Thus I think Figure 4 explains where we are now – and where I think we are headed.

Figure 4. When Do Prices Bounce Back?

In Figure 4, the year 2007 shows a world in which oil is at $80 and the demand has nearly caught up with supply. 2008 shows an example of no spare capacity, and the oil price sharply higher. Then 2009 shows the situation with reduced demand, some incremental capacity increase over 2008 (new projects scheduled to come online in 2009 will generally be too far along to cancel), and the corresponding price collapse arising from the largest spare capacity situation in several years.

So, where do we go from here? I think it depends on how quickly demand bounces back.

The Next Five Years

What might the next five years look like? Do we revert back to Figure 1, in which we see steady prices for years (except this time in the $40 region)? Or do we return to the eroding capacity case of Figures 2 and 3? I have reason to believe the latter is the case.

One reason for this is that the oil industry needs higher prices to warrant new projects. Sig Cornelius, the Chief Financial Officer of ConocoPhillips, recently stated that oil needs to average $52/bbl in order for the company to break even. The cost of finding and developing oil has gone up, and recently Eni CEO Paolo Scaroni said that oil prices would need to be $60 to keep up the needed investments. As a result of low oil prices, drilling rigs are being underutilized and projects are being canceled:

E&P Capital Expenditure Cutbacks

The International Energy Agency estimates that about $100 billion of worldwide oil production capacity expansion projects have been cancelled or postponed over the past half year. According to Barclays Capital, oil companies have cut worldwide exploration and production spending by 18 percent so far this year. Deutsche Bank estimates that U.S. energy exploration-and-production spending will drop $22.5 billion this year, a 40-percent, year-on-year decline.

Saudi Arabia has cancelled the development of several fields such as the Manifa and Dammam oil field, which would have added about 1 million barrels per day (MMBpd) of capacity. Refinery projects have also been delayed or cancelled while Saudi Aramco reviews cost estimates in the light of the significant weakening of oil prices. Saudi Aramco will consider re-issuing a tender for Manifa’s development at a later date, assuming bids from contractors reflect a reduction in raw materials to match lower oil prices.

Such cancellations come at a price, which the article summarizes:

New oil-and-gas projects usually take several years of development before starting commercial production. According to Cambridge Energy Research Associates, the scaleback in exploration and production could reduce future global oil supplies by up to 7.6 MMBpd in five years, or 9 percent of current production. If demand suddenly comes back as it did in 2003-2004, there could be a resulting shortfall of production and much higher energy prices. The International Energy Agency (IEA) also warns that the credit crisis and project cancellations will lead to no spare crude oil capacity by 2013.

The longer oil prices stay low, the worse the shortfall will be due to the project cancellations and increasing demand. Incidentally, these factors also explain a big part of why the oil industry is historically cyclical; in the good times producers spend money, and then when supply gets ahead of demand and the price falls, they slow down on investing. This eventually leads to tightness again, so the good times return. The steepness of the World Oil Price curve in Figure 4 could be much steeper if demand recovers sooner rather than later.

The prospect of sharply higher taxes on the oil industry is a second factor that threatens to slow the development of new oil projects. A recent study by the American Petroleum Institute concluded that this number is “at least” $400 billion over the next 10 years. That seemed quite high to me, so I wrote to the API for a breakdown. Jane van Ryan, Senior Manager of Communications at the API, responded:

The figure is, according to our tax experts, “at least $400 billion” and could be significantly higher.

Using EIA numbers, our tax analysts have examined the impact on the industry of the administration’s cap-and-trade proposal using five scenarios. The results indicate that about 60 percent of the administration’s proposal, which would raise $645.7 billion in “climate revenues,” would be funded by the oil and natural gas industry. This means the industry would pay about $400-450 billion. We have opted to use the lower figure.

The industry’s share of business-wide tax provisions as well as new taxes on the industry are estimated at $80-90 billion over ten years. Again, we have opted to use the lower figure. These tax provisions include the reinstatement of the Superfund Tax, the repeal of the LIFO provision, internal enforcement/reform deferral/related tax reform policies, an excise tax levy on federal offshore leases in the Gulf of Mexico, the repeal of the enhanced oil recovery credit, the repeal of the marginal well tax credit, the repeal of the expensing of intangible drilling costs, the repeal of the deduction for tertiary injectants, the repeal of the passive loss exception for working interests, the repeal of Sec. 199 for oil and natural companies, the increase of the G&G amortization period for independent producers to 7 years, and the repeal of the percentage depletion for oil and natural gas.

While I won’t get into all of the pros and cons of new taxes, higher taxes will provide a disincentive for projects which are projected to have a marginal financial return. If this further contributes to underinvestment, it will worsen the overall tightness in the oil markets, which will put more upward pressure on prices. Thus, high oil prices will likely again be a campaign issue in the 2012 presidential elections.

Conclusions

While the oil industry is historically cyclical, I believe we are approaching the point at which the industry will no longer be able to build out enough new projects to stay ahead of demand. This could manifest itself as peak oil, in which case the rate of depletion permanently overtakes the rate at which new production comes online. Or it could first manifest as peak lite, in which case new production still stays somewhat ahead of depletion, but can’t keep up with new demand. In either of these situations, I think the historical cyclicality of the oil industry will disappear. In early 2008 I thought we had reached that point, but it appears that we had at least one more cycle ahead.

While it is too early to tell with a high level of confidence just where we are on the depletion curve, the summer of 2008 provided of taste of life in an oil-constrained world. The current level of underinvestment and the prospect of higher taxes are setting up another situation in which spare capacity erodes, leading to higher oil prices and greater volatility. Add to this the prospect of a global oil production peak, and I have trouble seeing a case where oil prices will remain stable in the coming years.

As an investor, I use blue chip oil stocks as a defensive measure against much higher prices. I am not one who subscribes to the idea that oil companies are going to be put out of business by running out of oil, or by ethanol, algal biodiesel, or any other combination of alternative fuel technologies. In fact, I strongly believe that if an alternative technology begins to look attractive enough, oil companies have deep enough pockets to shift their business in that direction. But I think that’s unlikely to happen any time soon.

As a consumer, it would probably pay to evaluate just how much higher prices might impact your budget – and then take action. Can you sustain oil prices that return to $150/bbl or more? Even if you can, do you want that uncertainty hanging over your budget? If not, then it would be prudent to take steps to minimize the personal impact of high oil prices. Steps to consider include utilizing more fuel efficient transportation, public transportation, ride-sharing, and if possible locating closer to your place of employment.

Plan ahead and don’t get caught off-guard like so many did last summer. It is only a matter of time before history repeats itself. Here’s hoping our political leaders make policy decisions that won’t worsen the impact.