It seems like everyone but me has read Nassim Taleb’s book, The Black Swan. The concept of unforeseen, highly unlikely events has wormed its way into nearly every conversation lately. (The title is a reference to the fact that all swans were assumed to be white until black swans were discovered in Australia.)

Aside from the fact that I have a too-long reading list, perhaps I haven’t read it because it’s something about which I’ve already thought altogether too much. I seem to be one of those people who are predisposed to look for the outlier events, the exceptions to the rules.

Peak oil is a classic case of a black swan event. Nowhere in our history of modern economic theory or industrial civilization is there such an event, so the past will be no help to us as a guide to the future. Still, we act as though our theories are gospel, and our markets are wise. New and unforeseen events like peak oil are never priced in.

Only the few people with a predilection to look out for such things will see it, at first, while the madd’ing crowd dismisses peak oil as a hoax, and disregards the mountains of science and data with blithe assertions about their faith in the markets and technology. They’d rather believe wacky tall tales from an itinerant preacher who spent a little time in Alaska’s oil fields but apparently never learned a thing about oil production than look at the hard data on oil production we do have. And they will continue to do so until precisely the moment at which the whole crowd has seen the proof and knows that it’s true; that is, when the peak is well in the rear-view mirror and nobody has any doubt that the End of the Oil Age is upon us, and it’s far too late to take effective action.

Only when oil prices blew past $120 this year did analysts like me get a little air time to talk about the science on peak oil and not be simply dismissed as “peak freaks” with some sort of presumed pathological desire to destroy the economy. And now, with oil prices dragging well below the trendline, our looming supply problem is no longer in focus at all, even as it quietly becomes more urgent. Nothing to see here, people, move along….

Unfortunately, as I discussed in my article last week, when the prices of oil and natural gas are as low as they are now, it no longer pays some companies to continue to produce it. The ones operating at the margin of profitability—the ones working the most difficult and marginal resources, with the highest cost structures—are simply getting priced out, laying down their rigs and cutting back on their expansion plans.

The contraction of new oil and gas development due to low commodity prices and difficulty in obtaining credit is setting us up for an “air pocket” in energy supply. When we hit that air pocket, somewhere around 2010, it will create an especially fearsome spike in oil prices.

A Massive Reality Disconnect

You wouldn’t know that from watching the tape, though. Oil and gas, which are part of the very foundation of the real, physical economy, continue to get hammered by traders as if they were no different from any other wacky financial instruments we have invented. As oil finally dropped below $50 and stayed there, the whispers about $20 started going around. Vague fears of a reduced outlook for global oil demand, still not verified by the data, have caused oil prices to overshoot far to the downside.

It’s as if traders either don’t know, or simply don’t care, that oil is already below the production cost in those marginal areas where essentially all of the growth in world oil production must come from (if any). If the chart says it could go back to $20, then they believe it could go back to $20.

Such thinking, confined by conventional wisdom and removed as it is from any sort of real world knowledge of petroleum geology, is not only wrong, it will also prove very costly to those to follow it.

On the other hand, one can go broke trying to tell the market what to think. If the market believes that oil’s going to $20, then for a short time at least, it probably will. It doesn’t pay to buck the trend.

What does pay is knowing when the turning point is about to happen, before the herd heads in a new direction.

We had one of those turning points at the beginning of 2005, when the decades-long growth trend in conventional crude oil production was finally broken. In 2005, oil hit the bumpy plateau at the top of its bell curve, where it has remained in the range of 74 mbpd. (Natural gas liquids, biofuels, unconventional oil, and other components make up the remainder that bring world “oil” production up to about 86 mbpd.) That’s when oil prices sharply departed from their past trends, and shot from about $40/bbl to $147/bbl.

Now we have a situation where oil is trading for under $50/bbl, but we know that the global marginal barrel production cost is about $65, that OPEC is signaling it wants to defend $70-75/bbl, and credible forecasts suggest that $100/bbl is the minimum needed to ensure future supply.

That means we have reached yet another massive disconnect between the trade and the reality. Before long, the pendulum will have to swing back the other way, and will probably overshoot to the high side.

Put another way, the markets are currently pricing the tail risk of peak oil by 2010 at approximately zero. The lack of adequate substitutes is also priced at zero. If somebody wants to help me make a CDS-like instrument, we can price that risk correctly and make a killing. But short of that, a long position in oil doesn’t get much more attractively priced than it is right now.

A World Too Complicated

In a recent interview with PBS, Taleb noted that it only took a tiny bit more demand than there was supply to send prices skyrocketing this year for oil and agricultural commodities. Oil is priced at the margin of supply; the last, most expensive barrel essentially sets the price of the whole lot. That’s what we should have been focused on, rather than engaging in a witch hunt for evil speculators.

Few seem to understand the deeply interwoven relationships between oil prices, oil supply, the value of the US dollar, and the health of the banking system and the broader markets. Taleb put it simply: “We live in a world that is way too complicated for our traditional economic structure. It’s not as resilient as it used to be; we don’t have slack; it’s over-optimized.”

It’s is a point I have repeated often. With just-in-time inventory practices dominating every supply chain and every industry, an interruption in the flow of oil can have drastic consequences within mere days. Events like hurricane Katrina foreshadow what can happen: Power plants shut down, trucks stop rolling, shelves and tanks go empty. Much of our infrastructure is extremely vulnerable to energy interruptions, but that isn’t priced in either.

What we build—or don’t build—in energy has indirect but enormously important impacts on the financial markets. Without energy, we can’t have economic growth. The feedback loop also runs the other direction: without a robust economy, we can’t invest in the future of energy.

Monetary policy also has a huge but delayed effect on energy prices, and in time, energy prices feed back into monetary policy. It seems inevitable that the massive creation of money in response to the current credit crisis will eventually result in oil prices spiking again.

Only the next time that happens, totally contrary to conventional market wisdom and the very history of oil production, oil producers will not be able to increase production even with prices again at all-time highs. Simple depletion of mature fields, declining resource quality and quantity, an uncertain financial outlook, skyrocketing project costs, geopolitical tensions and the host of other factors I have documented in these pages will bring us to the peak of oil production sooner than our models projected.

Black swan events are far more common that we might think. The rapid unwinding of the enormous leverage in the financial markets this year was another black swan. The models never priced in everybody being on the same side of the trade in credit default swaps and CDOs, and they never imagined the sudden crash of the markets or the swath of destruction it would carve. History was no help in guiding us through the current crisis.

We also suffer from simple myopia. By focusing on the financial markets without seeing their connection to everything else, we have truly missed the point, which is that energy is the real economy, and money is merely an artificial representation of it. Consequently, twiddling with interest rates, and other measures that don’t produce more energy or decrease demand for it, ultimately don’t cure our problems at all.

Somehow, we have to start making our decisions on energy policy and the economy on a much longer time horizon, and with a much broader view of how all the parts fit together. It takes decades to make any significant changes in energy infrastructure, like replacing a significant portion of the vehicle fleet, or building electrified rail, or a long-distance transmission grid, or renewable energy systems.

Instead of focusing all our attention on how we might try to play the oil game into overtime, we need to start thinking about how we’re going to cope with living on less than half our current energy budget by 2050.

If you only watch the rear-view mirror when driving, you’re going to wreck. Yet that is exactly what we’re doing with our energy supply planning, and exactly what the Street is doing with pricing future energy supply. It’s time to put both eyes squarely on the road ahead, and watch out for that hairpin curve in 2010.

Until next time,

Chris

Yesterday, as I filled up with sub-$2 gas for the first time in years, I was so amazed and happy that I had to fire off a “tweet” about it. (You can follow me on Twitter as “nelderini”) Wow, a fill-up for under $40! That’s great-a little more money to work with for the holidays.

My elation was short-lived though, as I thought again about the threat that low oil prices pose to the supply in the longer term.

Anyone can see the obvious risk. With the price of gasoline so low, drivers will be more inclined to take those extra trips, or maybe bring the Hummer out of retirement. The recent surge in mass transit ridership may fade away to be replaced again by gridlock. A resurgence in demand now cannot be met by an increase in supply.

There is a not-so-obvious risk as well: retreating investment. Two key factors are slowing the pace at which the industry is developing the new oil and gas projects that are so critical to our future supply.

The first is simply price. As oil prices crashed from $147 this summer to around $50 today, developers withdrew their commitment to drilling new wells and building new distribution and refining projects. Under a rule-of-thumb production cost for a new, marginal barrel at around $65 today, it simply doesn’t make sense to throw millions of dollars at drilling new wells when oil futures are selling for $50.

French oil company Total’s CEO recently warned that at $60 oil, “a lot of new projects would be delayed.”

The same thing is happening in natural gas. At a rule-of-thumb production cost of around $6.50/MMBtu (million Btu), or roughly $6.32/Mcf (thousand cubic feet) [corrected from original], unconventional gas projects like the ones we are depending on for future US gas supply become uneconomical. Yesterday, Nymex Henry Hub futures closed at $6.49.

A second, more insidious factor is quietly eroding hopes for our future oil and gas supply however, and that is the continuing global credit crisis. As banks remain reluctant to lend each other money—even money freely given to them by Stammerin’ Hank at the Treasury for that very purpose!—credit has also become hard to come by for anyone trying to start a capital-intensive project. And all energy projects need a great deal of capital.

Consequently, a growing drumbeat of news reports about energy projects of all kinds being delayed, cancelled, slowed, or otherwise curtailed has been issuing from the energy sector. Yet the Street seems not to have recognized that the slowdowns will limit supply in just a few years.

Instead it has continued to bid down prices of oil and gas, and the companies that produce them, with the belief that a slower economy means slower demand and a glut of supply.

The data certainly supports that view. Chinese imports of diesel and gasoline have dropped to the lowest level in 14 months, demand projections are being slashed worldwide, and US oil consumption alone is down nearly 1 mbpd.

But by focusing on near term supply, the Street is really fighting the last war when it should be pricing in a long-term shortage. Investment is already falling short of what is needed to ensure a future supply of those marginal, expensive barrels that everyone is counting on.

(In the same way, I have been concerned that with their current focus on deflation, the Fed will miss the turn heading into the next inflationary phase, when oil and gas and commodity prices will once again shoot for the moon. I don’t know when it will happen, but at some point, probably within the next year to year and a half, I expect a major reversal of the current trends. The dollar will sharply weaken in recognition of the Treasury’s unprecedented printing of money, which could send oil prices back up to $150 and beyond in short order, taking the rest of the commodity complex with it.)

The hardest-to-produce barrel, of course, is the most expensive one and the most vulnerable barrel in an economic crisis. That honor belongs to the tar sands producers of Alberta, where the production cost from existing projects is roughly $40/bbl, from new projects about $65/bbl, and from future projects an estimated $85-$100 per barrel. Tar sand project costs ran up approximately 50% this year even as oil prices fell, putting a double-squeeze on tar sands producers. Companies are now being forced to cut back on financed development and try to fund their expansions out of cash flow.

Project Cutbacks

Here are some very abbreviated highlights of energy project delays announced in the last month alone:

• Shell, Suncor, Petro-Canada, Nexen, Teck Cominco, UTS Energy and Opti Canada have all announced delays in their planned investments in the tar sands projects of Alberta. Suncor, for example, cuts its capex budget from $10 billion to $6 billion (Can.) Companies with joint-venture tar sands interests in production, refining and pipelines also announced delays, including EnCana, StatoilHydro ASA, Value Creations, Imperial, and Enbridge. Hundreds of billions of dollars in commitments have been withdrawn or delayed.

It was quite a spectacle watching the heads of the Big Three automakers beg the Senate Banking Committee for another $25 billion in bailout money yesterday.

Or should I say, watching them attempt to stick-up America.

“This is about much more than just Detroit,” said GM chief Rick Wagoner, “It’s about saving the U.S. economy from a catastrophic collapse.”

Only a “bridge loan,” he argued, could keep their long supply chain alive, and preserve public confidence in the companies so they might survive.

He ticked off the measures GM has already taken: Whacking $9 billion from its fixed cost base, on the way to $15 billion by 2011. Cutting hourly labor costs by $12 billion by 2010. Slashing pension and health care costs. Scaling back manufacturing capacity and discontinuing unprofitable truck models. Bonuses, raises, 401(k) contributions, and post-retirement health care are gone. By next year, the company will offer 20 new models that get at least 30 mpg, he said, as well as nine hybrids. Their hydrogen car test fleet is the largest in the world, he boasted, and they are going “all out” to bring the Chevy Volt PHEV to market “as soon as possible.”

So don’t tell him that GM isn’t doing enough to adapt. Their crisis wasn’t due to a flawed business model or an undesirable line of products, he asserted, but rather the same credit crisis that has sunk the financial sector.

There’s nothing new about the latest crisis in Detroit; this is the same old song and dance we’ve heard again and again. Oh what the heck, let’s play it again:

Since the first amphibians crawled out of the slime
We’ve been struggling in an unrelenting climb
We were hardly up and walking
Before money started talking
And it’s sad that failure is an awful crime.

Well it’s been that way for a millennium or two
But now it seems there’s a different point of view
If you’re a corporate titantic
And your failure is gigantic
Then in Congress there’s a safety net for you.

I am changing my name to Chrysler
I am going down to Washington D.C.
I will tell some power broker
What they did for Iacocca
Will be perfectly acceptable to me
I am changing my name to Chrysler
I am headed for that great receiving line
So when they hand a million grand out
I’ll be standing with my hand out
Yessir, I’ll get mine.

—Tom Paxton, “I’m Changing My Name to Chrysler” (1979)

And after that bailout, immortalized in song, what did Chrysler give us? The infamous “K cars.” I had one of those for a few years, a hand-me-down, and it was a total piece of junk. By the time I got rid of it, it was a veritable death trap, with a two-by-four propping up the driver’s seat and an engine that ran at 4,000 RPM at all times and couldn’t be fixed.

But I digress.

For the good of America, the auto titans argued to Congress, their businesses must be saved…while holding the gun of jobs at our backs.

GM even put out a YouTube video about the potential job losses (which stock analyst Henry Blodget rightly called “propaganda terrorism”) saying that between the Big Three, there are:

• 239,000 employees
• 775,000 retirees and surviving spouses dependent on pensions and benefits
• 610,000 workers employed by suppliers
• 740,000 employees at 14,000 dealerships

One of every 10 jobs-13 million people-are reliant on the US auto industry, the video claimed, and if all of the Big Three’s US operations ceased in 2009, nearly 3 million US jobs would be lost, with a huge blow to the economy.

“We can loan $25 billion now…or lose $156 billion later. What will WE do?” it concluded.

It’s Not About the Jobs

That’s right America: It’s your problem. Just like the banks and insurance companies and everybody else we’ve been bailing out because they’re “too big to let fail.”

After the roughly $2 trillion already committed to stemming the credit crisis, an additional $25 billion in public money for the automakers (on top of the $25 billion loan program created by Congress in September to help them develop more fuel-efficient vehicles) seems almost trivial.

But it isn’t.

Not only is it a moral hazard to reward unprofitable business practices, it’s fundamentally wrong and anti-capitalistic.

It wasn’t about the jobs when the automakers sent so much of their manufacturing overseas; that was about the bottom line.

It wasn’t about the jobs when they built, and then destroyed, the EV-1 electric car program.

It wasn’t about the jobs when they made decades of shoddy vehicles consumers shunned in favor of better products from foreign manufacturers.

It’s only about the jobs when it costs them. For over 50 years, the Big Three have fought anything that was good for the public but which might cost them some profits, like installing $25 catalytic converters to reduce emissions, adding mandatory seatbelts, or making a serious investment in cleaner, next-generation vehicles. Then they’re willing to spend millions to fight it.

They have staunchly opposed fuel efficiency standards for decades, and ignored the impending threat of peak oil even as oil prices drove them out of business. General Motors began dismantling urban mass transit in the US in 1922, and has disrupted countless attempts at public transit ever since.

GM Vice Chairman Bob Lutz even had the gall to call global warming a “a total crock of sh*t.”

(For a painfully detailed history on the Big Three’s shenanigans, check out Taken for a Ride by Jack Doyle, and the 1996 documentary film of the same name by Jim Klein.)

Even as the automakers created those all-important jobs while building their businesses, they also committed the entire country to an unsustainable infrastructure of far-flung suburbs and endless roads. We’re about to pay an enormous price for that.

As it turns out, what has been good for GM is not good for the country in the long term.

Don’t get me wrong. I have a great deal of sympathy for the good people who work in the Big Three’s plants. The first part of my childhood was spent in Detroit, and I know full well how critical the auto industry is to that economy. It has broken my heart to see that once-great city fall into the disrepair and crime that plagues it today. But to my mind, that’s all part of the proof that the Big Three have had their day.

I even have a little sympathy for the Big Three CEOs who are struggling to save their companies now. But the cutbacks they have made amount to pruning a dead tree.

Lead, Follow, or Get Out of the Way

At some point, our concern has to be the long-term sustainability of our economy, not just today’s jobs. A truly sustainable economy has plenty of jobs; they just might be different from the jobs we have today.

And the sooner we commit to building that sustainable economy, the sooner we’ll have the jobs we really need, making the things we really need, like truly high-efficiency vehicles. It’s a bad joke that American manufactured vehicles in Europe already get 60+ MPG while the same models here get under 35.

Now, if GM fails, then so does the promise of the first serious American-made PHEV, the Chevy Volt. And that would be a shame. But I have no doubt that the world’s more progressive automakers will be quick to fill that void. The Japanese manufacturers are already light-years ahead of the Big Three in PHEV technology, and are already tooled up to crank those vehicles out in mass production.

Meanwhile, scrappy young startups in Silicon Valley and elsewhere are preparing to leapfrog the industry in technology, with high-performance PHEVs and all-electric vehicles that blow the doors off of anything the Big Three have planned, like the Tesla and the Aptera. These companies are shooting for 100 mpg, not 30, and they plan to deliver it in about the same time frame.

We can do better, folks. With peak oil essentially already upon us, we must do better. The rest of the world is already doing better. Why cling to this lumbering beast that has done so much permanent damage to the long-term health of our country?

In the short term, I suppose we have no choice but to try to preserve some of the Big Three’s jobs, because such a massive loss will really cut when the economy is as down and out as it is. But any sort of public bailout must come with a lot of strings attached, to force the companies to downsize, shed their obligations and start building vehicles for the 21^st Century.

Eventually, however, I think they must go. For over 50 years, they have worked to ruin the future of transportation, stifle innovation, bury patents, and stop any progress on controlling emissions. They have spent hundreds of millions, and cost the public billions, in obstructing progress. This cannot be allowed to continue.

In the same way that that a redwood tree inhibits the growth of the understory by blocking the light before it can reach the forest floor, the Big Three have become an effective monopoly of bad design. Their company cultures are rotten to the core, and they are about to topple, making room and letting in sunshine where new, nimbler companies may sprout and thrive.

The only real transportation solutions for the future will run on electric power produced from renewable energy, because liquid fuels are going into terminal decline. Transportation of both people and goods will have to be switched rapidly over to electric rail and high-performance PHEVs. With the firm support of the Obama administration for a massive increase in renewable energy generation, a high-voltage long-distance grid, and research and development of battery technology, we can and will build those solutions right here at home. New companies will take over the Rust Belt, reopen Detroit’s shuttered plants, and put everybody back to work.

But we don’t need the Big Three to do it, and we don’t need to do it at gunpoint.

Until next time,

Chris