Ratios, rational reasoning or reality: you decide
17 March 2011
Sean Russo
I SAW a presentation last week on Peak Oil given by Bruce Robinson of the Australian Association for the Study of Peak Oil and Gas. There was a great array of data among the 91 slides that made up the full presentation, all suggesting numerous other parties clearly support his view that we aren’t going to be able to replace with exploration, what we consume. Peak Oil is either here already or will be here soon.
To be fair it wasn’t a Chicken Little, the sky is falling approach, the message was simply everyone has a duty to think about what higher oil prices will do for them.
Will they be able to commute to work economically from Sydney’s western suburbs? Should we go overseas now while airlines can still afford to fly? What can governments start doing now to prepare (now there’s a novel concept), etc. The implicit assumption in all the analysis, while never really put out there, was clear. Oil prices must go a great deal higher in the future.
Of course underlying a largely supply side argument that we aren’t going to be able to replace with exploration what we consume (and I saw lots of supply side scepticism), there was an inherent assumption that oil demand would continue to grow (and grow). No other substitute currently being talked about could fill the gap in any reasonable time frame and it is assumed to be a given we will not be denied.
As I left the presentation my head was spinning. Is it a given that oil demand will continue to grow whatever the oil price? Is it a given that oil demand will continue to grow even in the face of much higher prices? Does scarcity push prices higher faster than higher prices push buyers away? Is Peak Oil going to happen in a timeframe that actually has any impact on where prices are going to be five years from now (which is about 20 times the average attention span of managers, investors and politicians)? Is oil’s price just a reflection of other prices and is it more exposed to sentiment and momentum than fundamentals for the foreseeable future? If the fastest cure for high prices is high prices is there something about to come out of left field and shred demand?
I remember reading a column in the Financial Review in 1986 or 1987 talking about the relative merits of Mr Robert Holmes à Court’s play for a US Oil company versus Mr Alan Bond’s growing gold empire getting BIGger by also expanding into North America. I seem to recall it strongly favoured the oil play. The simple logic went like this: there are finite reserves of oil and the product gets consumed so the price should rise over time; whereas, gold has finite reserves and never gets consumed so its price should fall – pulled out of one hole in the ground to be put in another as Mr Buffet is want to say.
We know what happened to Mr Bond and Mr HàC, but what has happened to the relative value of oil to gold over that time?
Twenty-five years on and it’s really not that different from where it was when Bond and Holmes a’Court were both in the ascendency.
Two and a half decades of producing and consuming versus producing and hoarding has meant almost no net change to the relationship. I wouldn’t be surprised if the ratio is unchanged 25 years from now and I also woudn’t be surprised to see it trade to 8 or 25 without the oil price changing!
Sometime in the middle of those two intervening decades I also saw someone (I am sorry I don’t recall who) make a very solid case that if oil is indeed going to run out the last barrels on earth will essentially be worthless. Even if the last few barrels are worth $US50,000/bbl as a collectible curiosity what do we care? Its price will not be on the evening news and we simply won’t care.
To try and prognosticate such a long way into the future is possibly little more than light relief if you are desperately trying to move the after dinner conversation away from real estate!
Even if scarcity does work to raise the price of a consumable, if high prices are only achievable on tiny volumes only a tiny little group of people are going to give a fig! The good news for those few people still in that market is investment banks and hedge funds won’t care about their market so they might have a chance at having a market price that reflects the true nature of the fundamentals.
Gold may not be consumable but it is relatively rare and can only be the product of good old fashioned blood, sweat and tears and not quantitative easing.
Its ability to endure through all time and never spoil seems to suggest to me that 500 years from now, whether it’s still being produced in mines, here or on the moon, extracted from sea water, or we just have above ground supplies, it will still have a value. That value will largely be relative to the volume of the paper or electronic currencies in circulation at that time and the populace’s confidence in them.
While there might be a time when oil prices rise significantly on an outright basis or they even rise strongly relative to gold it seems to my simple mind that the supposed decline of oil production must make it less attractive to investors – less wanted, not more desirable. If I have to hold on to one or the other to pass onto my grandchildren I’m holding gold.
Of course if I produced either of them at present and was doing so at a significant margin over the cost of production I would be thinking very hard about doing whatever I could to ensure I would still be in the business of producing them three to five years from now and that must include sensible hedging. Why? Because what we do know looking back at the late 1980s (and you must admit it does feel a bit like that just now), as good as it all looked then, as terminal as the USD looked then, as good as this cycles’ Bondy’s and Hàca’s are looking right now, as Teflon coated as their bankers seem to be for now, it was a long, long time between drinks for oil and gold producer alike.
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