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

Duringthe 1990s, the oil price was around $10-20 a barrel. Petrol was cheapandSUVs and gas guzzlers were selling in record numbers. Oil company share prices were low and there wasnext to nooil exploration. Yet wells from the North Sea to Saudi Arabia were stillproducing oil after all, once an oil well has been drilled, the costs of actually pumping outhydrocarbons are marginal.

A perfect theory?

But sincethere were few discoveries of oil, and as currentreserves 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 reachingall-time highs, peaking at $147a 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 madethefirmone of the worlds leading energy companies. Flush with cash, the Gulf states began an unprecedentedspending spree,constructing iconic buildings such asthe Burg Khalifa and the Burg Al Arab.

But why were prices rising so quickly? A ten-fold increase in the oil price seemed inexplicable.Peopleheard about a theory proposedby USgeophysicist M.K. Hubbert in 1956. It was called peak oil theory.

Peak oil theory says that fossil fuel production followsa 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.

Amore 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 theirreserves began to deplete. But just thispast few months we have seen oil, and other commodities, tumbling in price.

It seems that peak oiltheory was actually wrong.High energy prices were really due tothe 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 wehave 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 hasnt 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 theshale revolution. When faced with a challenge, never underestimate humanitys ability to innovate.