The impact of Peak Oil on the world economy has been on my mind for the last few months. I want in this post to look at the initial phase (say – five to ten years) and consider what it means as a context for investment. I also want to air some thoughts about specific investment strategies. I’m more confident of the first half of the analysis though – be warned!!

The context
The specific problem which the world economy faces is the constricted nature of the oil supply, ie there is now almost no ‘spare capacity’ within the system – and this is unprecedented. In previous decades the Saudi government in particular had the capacity to ‘turn on the taps’ to cope with short term fluctuations in supply, and thereby ‘smooth out’ any problems. They no longer have that ability. The Strategic Petroleum Reserves, especially of the US, has some ability to replace that spare capacity, but that is a ‘one shot gun’, and for the purposes of this analysis I consider it largely irrelevant.

Consider a piece of clingfilm placed across a bowl of food. If the clingfilm is loose then puncturing the clingfilm will simply produce a hole. If, however, the clingfilm is tight then a puncture will produce a significant tear. The same phenomenon can be seen in many other contexts: where a covering is taut and under strain, a small breach causes disproportionate adverse consequences. This is the situation that the world oil supply is now in.

Global production (extraction) of oil has not increased significantly for eighteen months, despite the high prices available for more production, and this has been the primary driver of the rapid increase in the oil price over the last few years. The impact of, eg, Katrina, Iraqi shortages, or lack of refining capacity, these are largely irrelevant.

The trigger
In this situation of unprecedented tightness, the question becomes: are there events which could act as the ‘puncture’, causing a disproportionate reaction within the system, causing an oil price shock and consequent recession? I think there are many possibilities; here are four:

1. Iran closes off the Straits of Hormuz in response to an attack by Israel;
2. Al-Qaeda succeed in an attack on Ras Tanura or equivalent facility;
3. There is civil war in Nigeria;
4. Saudi Arabia announces that the Ghawar oilfield has passed Peak production (compare with Kuwait).

I see the first of those as the ‘biggest’ puncture to the system, but any of them – and there are many other possibilities – could serve as the ‘trigger’ to a global recession. The pattern of that recession cannot be determined with precision, but is likely to have some of the following characteristics:

1. the rise in energy prices cause the closing of businesses and a rise in unemployment, thus reducing overall demand;
2. the rise in energy prices causes inflation in essential goods and services, thereby starving the market of purchasing power and reinforcing 1.;
3. the reduction in purchasing power and subsequent contraction of the economy trigger a collapse in the housing market, and that bubble deflates rapidly (esp US/UK);
4. those who have highly geared mortgages find themselves in negative equity; there is a major rise in house repossession; this induces a climate of greater fear and desire for saving – reinforcing 1.;
5. the cycle continues until a new point of equilibrium – probably temporary – is reached.

Investment directions
In this situation it is unclear whether deflation or inflation will be dominant – it is possible that there will be massive deflation in some areas (eg housing market) coupled with inflation in others (eg transport, food). In any case, these are my initial thoughts:

1. oil companies will make a lot of money; as their resource enjoys a relatively inelastic demand, especially as oil becomes scarcer, they will likely thrive in the initial stages (five to ten years) of the recession;
2. commodities, ie all those items which possess intrinsic value, will be ideal hedges against either inflation or deflation. Owning a home outright (ie no mortgage) will be a major determinant of financial health over the next ten years. Precious metals will also be prize investments, not least in the case of silver and platinum for their role in alternative energy systems;
3. some technological firms will be worth investing in: wind and solar, wind-up technology, probably coal also in the shorter term;
4. on the negative side, the housing market, especially new build, will contract hugely; retail will suffer terribly, the main supermarket chains may even fail; tourism and the airline industry will collapse;
5. in international terms, the US dollar is facing a ‘perfect storm’ in any case and will likely drop heavily in value, especially if oil sales become denominated in alternative currencies; consequently all US stocks are poor investments for non-US investors, at least until after the ‘correction’, by which time the opposite will probably apply, and they will be hugely cheaper;
6. alternatively, I see Japan – once the initial shock has passed – as being a better location for investment.

Clearly there are large uncertainties in the above. In particular it may well be the case that 2006 proceeds without interruption, and the ‘trigger’ event is deferred. However, I believe it inevitable that a trigger event will take place – perhaps many together in a short space of time – so these considerations are really directed towards those prepared to ‘buy and hold’, at least until some time has elapsed after the trigger event, and some of the dust has settled. I see no realistic alternative to a general economic contraction over the next ten to fifteen years. That does not, however, mean that all investment accounts have to contract. I do not believe that the economy as a whole will collapse – in that situation, the correct investment strategy would involve seeds and bullets rather than shares and bullion.