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BP PLC, Shell PLC And Petrofac PLC: Why Peak Oil Theory Was Wrong

During the 1990s, the oil price was around $10-20 a barrel. Petrol was cheap and SUVs and gas guzzlers were selling in record numbers. Oil company share prices were low and there was next to no oil exploration. Yet wells from the North Sea to Saudi Arabia were still producing oil — after all, once an oil well has been drilled, the costs of actually pumping out hydrocarbons are marginal.

A perfect theory?

But since there were few discoveries of oil, and as current reserves dried up, production inevitably fell. Round about the turn of the century, inventories started to slide and oil prices began to rise. These rises gathered momentum and soon the oil price was reaching all-time highs, peaking at $147 a barrel. The effects of these high commodity prices rippled around the world.

The shares of companies like BP (LSE: BP.), Shell (LSE: RDSB) and Petrofac (LSE: PFC) soared. Lord Browne, at that time the chief executive of BP, was known as the Sun King, overseeing a series of takeovers and mergers which made the firm one of the world’s leading energy companies. Flush with cash, the Gulf states began an unprecedented spending spree, constructing iconic buildings such as the Burg Khalifa and the Burg Al Arab.

But why were prices rising so quickly? A ten-fold increase in the oil price seemed inexplicable. People heard about a theory proposed by US geophysicist M.K. Hubbert in 1956. It was called peak oil theory.

Peak oil theory says that fossil fuel production follows a roughly bell-shaped curve: production increases, peaks, and then decreases. Commodities theorists began to say that oil production had peaked. Soon peak oil theory was all the rage. This theory seemed to explain perfectly the price rises that were taking place.

A more prosaic explanation

But just stop to think about it. If oil production really had peaked, then surely oil prices would always remain high, as supply would fail to meet demand. This meant that oil company shares were a one-way bet, at least until their reserves began to deplete. But just this past few months we have seen oil, and other commodities, tumbling in price.

It seems that peak oil theory was actually wrong. High energy prices were really due to the commodities supercycle, a multi-decade cycle of supply and demand which has existed since oil was first discovered. And falling oil, gas and mineral prices are part of the end of this cycle.

The question is, how could we have been so wrong? Well, what strikes me is that we tend to over-rationalise. And if we have a choice between a dramatic explanation, and something more prosaic, I know which we will always choose. People have talked about the end of the world, and of imminent calamity, time and time again. Yet the sky still hasn’t fallen in. Yet these explanations appeal to our inner Chicken Little.

I prefer an optimistic explanation: when faced with a shortage of oil, the world has reacted by seeking out oil in the depths of the ocean and the far reaches of the Arctic, by extracting petroleum from the tar sands of Alberta, and by the shale revolution. When faced with a challenge, never underestimate humanity’s ability to innovate.

 

Understanding commodity cycles and the bull and bear markets of stocks and shares is not easy. Yet this is part and parcel of long-term investing. If you want to make your fortune in the market you need to understand these trends.

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Prabhat Sakya has no position in any shares mentioned. The Motley Fool UK owns shares of Petrofac. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.