The International Energy Agency (IEA) warns that the recent oil price collapse has triggered a significant decrease in exploration and and new field development. In essence, market players are using market information (price decline) to signal that there is already enough supply capacity to satisfy demand for the coming decade or so.Well, the IEA seems to think that recent market information has provided the exact opposite feedback needed to ensure the world's future energy needs are met. How does this impact you and your portfolio?

There are some big reasons why we should be afraid of a peak oil scenario. Most of the world's oil comes from a few enormous, but old and rapidly declining fields. Several key fields are located in Saudi Arabia-and the Saudi government actively obscures its production and reserve information! In Twilight in the Desert, Matthew Simmons provides detailed analysis of Saudi field data taken before The Kingdom shut its borders to independent inspectors. The picture he paints is not a nice one!

Specifically, the IEA estimates that key field production is decreasing at an annual 6.7 per cent rate. To make matters worse, global demand is scheduled to increase from 85 million b/d to 106 million by 2030. This means an extra 45 million b/d of capacity needs to be found and brought to market within the next couple decades.

My bet is that this will not happen. Prices will have nowhere to go but up to balance increased demand with insufficient supply. The very loose logic:

1. Required investment schedules to meet increased production are lagging. The IEA estimates that in 2007 the world had to invest $450bn to find and develop capacity; only $390bn made it, despite record prices of $147 per barrel. Governments and corporations are drastically scaling back investment now that prices have collapsed. 2. The oil business is becoming increasingly socialized, with an increasing capacity taken from free markets and relegated to governments. Think Russia, Venezuela, Iran, Sudan, and Saudi Arabia, to name a few - these are not free countries with free markets maximizing production. 3. Increasing political risks are driving investment reductions: Think "windfall profits" tax. When companies invest hundreds of billions and lose money shareholders suffer; when they happen to earn a return, government takes it away. This is not a recipe for increased capacity! 4. Most of the world's oil is found in inhospitable climates or political environments. Every few months Nigerian rebels decide to blow up a rig, pipeline, or abduct oil workers. Every few years the Russian government bullies another company out of its investments after they've proven fruitful. The Iranians talk of obliterating Israel. The Sudanese sponsor genocide in Darfur, there's civil war in the Congo, Chavez would love nothing more than to see America collapse, the Bolivians and Ecuadorians nationalized their oil industries, and Russia targets West-flowing pipelines for bombardment whenever it can (think Georgia).

Oil prices currently reflect a dire economic outlook. Markets are discounting the commodity betting that future demand will temper with cooling growth rates. This is certainly true in the near term, but a decade from now we will wake to realize that supply is desperately imbalanced with demand. Oil is a precious resource upon which our civilization is dependent-prices have nowhere to go but up. In the near term oil can be used as a hedge on inflation. it is denominated in US dollars in global markets, and so when the USD decreases (due to inflation) oil prices will increase. Considering that the US money supply has gone up 111% in the last three months this is a reasonable bet!