Over 50 years ago M. King Hubbert published his theory which has become known as the Hubbert Curve. Simply put, when you reach peak production of a finite resource, then half of the original reserves have been produced and the remaining half will be produced in a decline pattern that is a mirror image of the pre-peak production. He used coal, which was known to have peaked, as an example: and the Hubbert Curve fit almost perfectly, in a shape quite similar to a bell-shaped curve.
Then he applied the curve to oil. He first predicted that U.S. oil production would peak in 1968. But, the North Slope was discovered that year. When Hubbert made a presentation in Boston that I attended in the mid-1970’s, his Curve hadn’t worked as planned. So he redefined the Curve to exclude Alaska!
Meanwhile, over my 47 year career as an oil-analyst/investment-adviser, it seems world oil production is always about to peak according to the Hubbert Curve. But in the mid-1970s along came the Norwegian North Sea, then the British North Sea, then a dramatic increase in Russian production, and then higher prices that made water-injection- steam injection and CO2 injection economic. Now we have fracturing. There is also the Venezuela wild card; they have the largest single share of world reserves (20%).
The problem is that oil is a unique resource because there is a big difference between “oil in place” and “recoverable reserves.” The latter is a function of price, which varies tremendously. The 10-year average crude oil price has been about $80 per barrel, about $60 over the past 20 years, and $35 over the past 40 years. It was well under $10 when I got into the business. When Obama took office, the price of crude was only $35/bbl and since then it’s been over $110 and now $65. During the same period, U.S. production is up over 50%! Hubbert never would have believed it.
The most significant year in oil price history was 1971 when the Texas Railroad Commission allowed producers to go to a 100% MER (maximum efficient rate) of possible production for the first time since it was given control of Texas production in 1919. At that very moment, the U.S. handed over control of world oil prices to OPEC. First, Saudi Arabia nationalized its oil industry in stages and raised their price from $3 a barrel to over $5, then to $11. Then, OPEC responded to our support of Israel in the Yom Kippur War by curtailing oil shipments to the U.S. on October 22, 1973. The rest is history.
Today there are three players that call the shots, because they produce far more oil than any other countries: The U.S. where production is increasing, Saudi Arabia where production is flat and Russia where production is declining. What today’s price volatility is all about is the Arabs trying to kick us out of the #1 spot by making high-cost production uneconomic. The Russians are playing along, too.
The Saudis can produce oil for $2/bbl. But, every OPEC country needs higher prices ($90-$110) to balance their country’s budget. So, they are playing a “game of chicken” that can’t go on forever. Unfortunately, supply and demand for oil are both very inelastic. The quantity/price elasticity is only about .10, meaning that demand goes down by only 1% with a 10% increase in price and supply goes up by only 1%, and vice versa. Yet, inventories (a leading short-term indicator of price) are now volatile from week to week. Is world production peaking? It looks like it, but it looked like it many times before. So, where will prices go while the game is going on….who knows?