The peak in global oil production, commonly known as simply “peak oil,” is the point at which new oil production can no longer keep up with declining oil fields. The result is a subsequent yearly decline in the amount of oil produced.

The concept of peak oil really began to enter the mainstream in 2005, the year that:

• Matt Simmons published Twilight in the Desert, an influential book that helped popularize the concept that Middle East oil reserves were less reliable than most believed

• Congressman Roscoe Bartlett spoke about the threat of peak oil on the floor of the US House of Representatives

• The price of West Texas Intermediate crude rose above $50/bbl and remained there

• The aftermath of Hurricane Katrina caused oil prices to spike, focusing the world’s attention on the implications of oil shortages 

Beginning in 2005, Internet searches for the phrase “peak oil” surged as people began to ask serious questions about global oil supplies. The issue began to receive more attention from the mainstream media. Since the world has become increasingly dependent upon petroleum year after year, declining oil production has the potential to severely disrupt our lives through much higher prices and fuel shortages.

What does this mean for investors? Simply put, the possibility of much higher oil prices has the potential to greatly improve the fortunes of oil producers. But to understand what people mean when they refer to “peak oil,” we need to review the basics and clear up some misconceptions.

Peak Oil Primer

The scientific study of peak oil began in the 1950s, when Shell geophysicist M. King Hubbert reported on the evolution of production rates in oil and gas fields. In a 1956 paper, Hubbert suggested that oil production in a particular region would approximate a bell curve, increasing exponentially during the early stages of production before eventually slowing, reaching a peak when approximately half of a field had been extracted, and then going into terminal production decline.

Hubbert applied his reasoning to oil production for the Lower 48 US states and offshore areas. He estimated that the ultimate potential reserve of the Lower 48 US states and offshore areas was 150 billion barrels of oil. Based on that reserve estimate, the 6.6 million barrels per day (bpd) extraction rate in 1955, and the fact that 52.5 billion barrels of oil had been cumulatively produced in the US already, Hubbert estimated that oil production in the US would reach maximum production in 1965.

Hubbert further calculated that if the US oil reserve increased to 200 billion barrels, peak production would occur in 1970, a delay of five years from his base case. Hubbert’s estimate of 1970 US oil production based on the 200 billion barrel reserve case was 3 billion barrels, or 8.2 million bpd—and in fact, oil production in the US did peak in 1970, albeit at 9.6 million bpd.

Peak oil advocates point to Hubbert’s 1970 prediction of a US peak as proof that his method has merit. However, most don’t realize that his prediction was based on a secondary case in which he assumed that US oil reserves grew to 200 billion barrels, and that Hubbert indicated skepticism that this was possible because it would require the US to find additional oil fields equivalent to “eight East Texas oil fields.” So Hubbert is widely credited with precisely calling the US peak in 1970 despite the fact that he was skeptical that the peak would take place that late.

Through 2011, cumulative US production stands at 205 billion barrels, with a remaining estimated reserve of 23 billion barrels. This figure represents an increase of over 1 billion barrels over the proved reserves in 2000. Even correcting for Alaska’s cumulative 15 billion barrels of production and its remaining 3.5 billion barrel reserve that Hubbert didn’t consider, the total reserve of the Lower 48 was ultimately higher than Hubbert’s high estimate case (200 billion barrels) of Lower 48 oil reserves.

Hubbert’s critics argue that while his technique may have some utility, the methodology is simplistic and does not account for reserve growth, unconventional oil production, curtailed production (as we often see in OPEC countries) or geopolitical factors.

For example, in 1980 US proved reserves were 36.5 billion barrels. Thirty years later, in 2011, US proved reserves had only fallen to 30.9 billion barrels. Over the course of three decades, the US produced 103 billion barrels of oil, but US reserves only fell by 5.6 billion barrels. Those “eight East Texas oil fields” that Hubbert was skeptical of finding were actually found within fields that were already known.

These increases in US production, while barely drawing down reserves, are a result of continued improvements in oil extraction technology (e.g., hydraulic fracturing), improving recovery factors and new discoveries (particularly offshore). This history demonstrates that one must allow for reserves growth when looking at any country’s proved reserves. I think it’s a safe bet that even though US proved reserves are 30.9 billion barrels, a lot more remaining oil than that will ultimately be produced in the US.

Hubbert did address the issue of improved extraction techniques, but argued that rather than significantly impacting the date of peak oil in the US, better extraction techniques would slow the rate of production decline—and thus skew the back half of the bell curve. And in fact, the average annual rate of decline in US oil production since the 1970 peak has been under 1 percent—much lower than the natural decline rate of most aging oil fields.

Hubbert also used his technique to estimate the global oil production peak. But as in the case of US reserves, he underestimated global oil reserves.

Hubbert’s model was based on a presumed global reserve of 1.25 trillion barrels of oil, but the ultimate size of the reserve would grow far beyond Hubbert’s estimate. Cumulative global oil production through 2011 is just over 1 trillion barrels of oil, and remaining proved reserves are estimated to be over 1.6 trillion barrels.

Based on this underestimate of global oil reserves, Hubbert estimated that a global peak in oil production would occur around the year 2000 at an annual production rate of 34 million bpd. While it does not appear that global oil production has peaked, it is clear that it did not peak in 2000. The rate of global oil production (crude plus lease condensate) by 2011 was 74.1 million bpd—which represents a slight increase from the 73.6 million bpd rate achieved in 2005—and which many peak oilers confidently predicted was the ultimate global peak year.

Hubbert’s defenders point to his US oil peak prediction as proof of the utility of his methodology, and his critics point to the missed global peak prediction and gross underestimate of global oil production in 2000 as evidence of the shortcomings of his model. In fact, Hubbert’s method is not designed to predict reserve growth; a specific reserve size must be assumed. If the reserve size is accurately estimated, Hubbert’s model would be expected to give a fairly accurate estimate of an oil production peak. Thus, in the US, where the oil reserve estimate was fairly accurate, Hubbert’s model made a fairly accurate prediction on timing of the peak.

Peak Oil Misconceptions

The most common misconception about peak oil is that it means the world is running out of oil. Many articles that seek to debunk the notion of peak oil start with that premise, and then they proceed to tear down that straw man. Peak oil is about flow rates, and the overall flow rate will begin to decline while there is still a lot of oil left in the ground.

Another misconception is that peak oil beliefs are homogeneous. The beliefs among people who are concerned about the impacts of peak oil cover a wide span. There are those who believe that a peak is imminent, to be followed by a catastrophic decline. Included in this group are people who have vocally and (to this point) wrongly predicted dates and catastrophic consequences as a result of peak oil. These are the real targets of those who claim that peak oil is nonsense. What they really mean—but perhaps don’t say due to misconceptions about peak oil beliefs—is that the idea of imminent, catastrophic decline is nonsense. But that isn’t the same thing as arguing that peak oil is nonsense.

A more mainstream peak oil position is that the real threat is much higher oil prices, leading to stagnant economies. Oil-exporting nations would become wealthier at the expense of oil importers, and oil companies will make a lot of money as the price of oil escalates at a far greater rate than production rates decline. Note that it is entirely possible that a 10 percent shortfall in oil supplies could equate to a 50 percent or greater increase in the price of oil.

It is also a common misconception among those writing articles seeking to debunk peak oil to refer to the “peak oil theory.” When someone describes peak oil as a theory, what they are really referring to is the belief that a production peak is both imminent and the results promise to be catastrophic. But peak oil itself is an observation, not a theory.

Summary

Most of us can probably agree that global oil production will inevitably peak and begin to decline. The points of contention are the timing, the steepness of the decline, the impact on the global economy and the ability of other energy sources to fill the supply gap. Some believe we will smoothly transition to alternatives, and some people believe peak oil will be catastrophic.

I think of peak oil as supply struggling to keep up with demand, which will keep prices high relative to historic norms for many years to come. I think that we will probably increase global production for a few more years, and that unconventional oil supplies will play an ever more important role in limiting the impacts of peak oil.

Further, I continue to believe that oil companies will be in a good position to profit from the tight balance between oil supplies and demand for the foreseeable future. That’s one the themes driving my investment recommendations, as I’ll lay out in this week’s issue of The Energy Strategist.

Around the Portfolios

Kinder Morgan Energy Partners LP (NYSE: KMP) signed a 25-year contract to transport natural gas from the US to Mexico, where demand for gas is booming thanks to a fast-growing economy, conversion of power plants from oil to natural gas and the continued low price of natural gas. Under the contract, KMP will build a new 60-mile pipeline in Arizona to serve Mexico. KMP shares have rallied in the past couple of weeks, but remain slightly below our buy target. Buy Kinder Morgan Energy Partners LP below 82.

Tesoro Corp. (NYSE: TES), which I upgraded to a Buy in our Energy Watch List on Oct. 17, is up 8.5 percent since then. The company continues to stand to benefit from its exposure to California’s tight gasoline market, which I view as positive for refiners operating in the state.