Oil prices have certainly been in the news lately, and I've written here and elsewhere that the concept of Peak Oil has "tipped" in the mainstream media and in the markets. Many people still think that oil prices are just a bubble. Others think that the recent run-up in oil prices are just due to the declining dollar (apparently they haven't viewed a chart of oil price superimposed over the Dollar:Euro price chart lately, as that clearly can't explain the last few weeks' dramatic run-up). Others think it's all evil speculators--I won't repeat what I've said before about why that opinion does little but demonstrate a fundamental misunderstanding of the oil markets. But increasingly people are waking up to the reality that this is simply an issue of geologically and geopolitically constrained supply and rising demand. Over the long-run, we'll either develop a new substitute for oil and/or we'll reduce our demand for oil. Unless some new miracle technology (or miracle cohesive political will) moves us consciously away from oil, or unless the global economy collapses for reasons other than energy, then over the long-run these substitutes or this demand reduction will be a result of prices rising to significantly higher than they are now. The questions, to me, is whether this price rise will be relatively smooth or whether it will come in waves with serious retracements.
In other words, will oil prices make a "head fake," and decline significantly for a few years as current high prices cause a global recession, only to prevent us from mitigating the near-term onset of production declines causing truly dramatic price increases 5-10 years down the road? Charles Hugh Smith seems to think so.
Let's consider the potential for such a "head fake" more closely:
Taken in isolation, I don't see how increased oil prices cause destruction in demand sufficient to cause prices to decline, but rather only enough to prevent or slow additional price increases. The exception to this is the time-delay inherent in demand destruction. If oil prices now make everyone choose a more fuel-efficient car when they buy their next car, then current prices will cause a reduction in demand that continues over several years as we roll-over our auto fleet. Similarly, it may take oil prices staying at current levels before people are adequately convinced that they'll remain high, and therefore incorporate these prices into their decision making. That's a reasonable enough argument, but absent this time delay, I don't see how oil prices alone can cause a massive collapse in demand that isn't already present at current price levels. I do see how we could reach a wall where it would be difficult for prices to rise further because any increase is met immediately with a demand response, but that doesn't seem like a possible cause for a significant price decline--a "head fake." Why would $5 gas suddenly cause people to radically cut consumption any more than $4 gas did? I think there's a generalized perception that at some point there will be a demand response to high prices, but I think the common fallacy is assuming that this response will be digital, that at some magic number everyone will sit up and take action. Rather, demand response to high prices is extremely graduated, with a little bit happening at every rise in demand. Sure, some psychological barriers (e.g. $5 gas) may have a bit of an extra kick, but in general price increases won't cause a decrease in demand sufficient to significantly lower price. It just isn't logical--why would $4 gas cause prices to drop to $3, when people were apparently willing to consume enough gas at $3.50/gallon to sustain that price level? It's difficult to account for the time-lag issue, but I don't think that there's such a large time-lag waiting to unfold to actually decrease prices significantly.
The "head fake" scenario proposed by Smith IS, however, possible if increased oil prices merely act as a catalyst to set off a larger economic chain reaction that, in turn, destroys far more demand than the catalyst alone can account for. This is similar to what happened with the recent credit crunch--mispricing of risk in one area cause an entire risk-pricing industry to suddenly clam up, over-correct, and over-price risk for a brief period. This same thing could happen if gas prices caused a general recession that led to people postponing capital investments and other economic activity until the recession had ended--a sort of chicken and egg problem. While I do think that gas prices alone can cause economic hardship, any recession caused by high gasoline prices seems to be only a problem of the global economy evolving to a new reality, not to an inability to maintain current levels of economic growth. If $500 Billion a year is going to the Middle East, and they are in turn spending it on luxury products, then the global economy must re-tool and re-orient to produce luxury goods for Middle Eastern sheiks rather than Fords for Ohio factory workers. That might be a painful transition, but it doesn't necessarily reflect either a decrease in economic activity OR a decrease in energy consumption, just a shift in where and how it takes place. It is important to differentiate a recession caused by the market's inability to quickly re-tool for a new economic environment due to high oil prices and the very different even of a recession due to an actual decrease in economic production due to a decline in oil production (and, possibly, also total energy available to the economy). This latter event--something that I think is still a few years away--could cause a very serious recession. The former--just high prices due to tight supply/demand issues--should only cause a re-focusing, which might be painful for some, and painful in general in the short-run, but may actually be beneficial in the long-run because it could allocate energy to higher value-added tasks than in the present. I'm not sure that the more minor recession caused by mere high oil prices would be enough to cause a "head fake" in prices, but I think it is a distinct possibility due to issues of market psychology.One think does seem certain--if we accept the assumption that oil prices will rise over the long-term, then a steady rate of increase with minimal volatility will best facilitate adaptation to a lower-energy, costlier-energy world. The "head fake" that Smith writes about is potentially very dangerous because it could cast new doubts over the very notion of Peak Oil at exactly the time when the world must address the problem with great urgency. A "head fake" would breathe new life into the abiotic oil crowd, the "markets will always provide" crowd, the Super-Hummer crowd, etc. Because I think that there is a significant possibility of a "head fake" due to market psychology (or, possibly, due to a short-term increase in supplies if the megaproject and geopolitics stars all align over the next 24 months or so), I think that our outlook and investing in the energy sector needs to incorporate a fairly long-term time horizon. I don't think that $200 oil is a sure thing this year or next (though I think it's a strong possibility). But oil under $200/barrel in 2016 seems highly, highly unlikely absent a general economic collapse (and, in that even, we have equally big problems to deal with).