One of the most difficult aspects of investing is pricing risk. The reward proposition is exciting and is much easier to calculate than the risk, so it tends to get much more attention from investors. But it’s the risk side of the equation that can break you.

That’s why at the highest levels of the finance world there are analysts who do nothing but price risk — in particular, the tail risk, or the outlier probabilities of the risk bell curve. One way to price risk is by offering derivative contracts, like the Credit Default Swaps (CDS) that contributed to the undoing of the big banks last year, as a kind of investment insurance.

Normally these risk-pricing instruments work well. But when black swan events — those that are considered extremely unlikely — occur, like all the banks suddenly becoming insolvent at once and the risk insurance fails, the damage to the economy can be massive.

In this most uncertain time for the global economic outlook, investors must be unusually alert to mispriced risk: not only because it offers incredible buying opportunities, like natural gas at under $4 and oil at $33 (from which my readers and I have profited handsomely), but because the risks are enormous. Nearly everybody in the market lost half of their wealth in the carnage of the last year.

For nearly three years in this column, I have detailed what I believe to be some of the most important risks for energy investors. Perhaps it would be helpful now to zoom out and take a long look at some of the things that hardly anybody thinks will happen, but which probably will — that is, the tail risks that remain badly mispriced.

Peak Oil

The most important risk, of course, is peak oil. It is better priced now than it was, say, four years ago; when the chief economist of the International Energy Agency (IEA) Dr. Fatih Birol issued a strongly worded warning this week that he sees peak oil occurring in 10 years, and that “we should take this issue very seriously,” it actually got noticed and circulated widely in the press. That’s a huge change.

Still, the risk of peak oil is not properly priced when oil itself is still selling for $70, and the investing press is full of “green shoots” talk, imagining that the economy will be off to the races again in 2012. Nothing could be further from the truth.

Birol deserves praise for his unflinching warnings, and pressing ahead with his message despite the derision of a world that remains deep in denial, uselessly searching for scapegoats and dreaming of an economic recovery that won’t materialize. Unfortunately, his model betrays some wishful thinking as well.

The fact is that peak oil is already here, and has been since 2005. Within the next two years, the increment of unconventional liquids that have temporarily masked this fact will be unable to keep up with the decline of conventional crude. By 2012, just when the global economy should be resuming normal growth rates, the decline of oil will pull the rug out from under it.

Birol was clear on this point: “It will be especially important because the global economy will still be very fragile, very vulnerable. Many people think there will be a recovery in a few years’ time but it will be a slow recovery and a fragile recovery and we will have the risk that the recovery will be strangled with higher oil prices,” he told the UK’s The Independent.

Yet nobody — and I mean nobody — is currently pricing that into their models: “I’m not very optimistic about governments being aware of the difficulties we may face in the oil supply,” Birol said.

Well, I’m sorry to say, neither am I. A substantial contingent of petroleum geologists and observers like myself have certainly made every effort to make them aware, but our words have fallen mostly on deaf ears. Consider the recurring spectacle of Rep. Roscoe Bartlett (MD) lecturing to an empty chamber on Capitol Hill about the importance and urgency of the peak oil challenge.

The implications of failing to act in a timely fashion are vast, yet whole industries are carrying on as if the threat doesn’t even exist. Instead of being priced as a 99% probability, as it should be, the risk of peak oil is currently priced like a 1% probability.

If we accept that the world will wait until the terminal decline of oil sets in before taking effective action, and realize that the consequent changes will affect every industry and every part of the economy, then we can proceed to a long list of other risks that are badly mispriced.

Here then are some eventualities that I believe are highly probable, yet still priced like tail risk. The question now is not if these things will happen, but when.

Some Not-So-Crazy Predictions

Oil and natural gas prices will have a very volatile upward trajectory for decades, as we bump our heads against the supply ceiling, but oil will probably top out around $150-200, where it simply kills demand. Oil supply will decline at the rate of about 5% per year and accelerate to 10% per year. The world will be living with about half its current energy budget by 2050.

The global population will not reach nine billion people. It will probably top out around 7.5 billion circa 2025, and go into decline along with the fuel supply. Nobody programs that into their models.

Once oil decline sets in, instead of worrying about what comes out of the tailpipe we’ll be worrying about finding fuel to put in the engine. Demand will be destroyed first by skyrocketing fuel prices, and then by the population decline, both of which will eliminate more CO2 emissions than our climate treaties ever contemplated. Peak CO2 will probably happen before we even reach 450 ppm.

Cap-and-trade and carbon pricing markets will have a heyday for the next five years or so, until the world figures out that we indeed have a fuel problem that isn’t going to go away. Then they’ll be more useful as a way to ration fuel supply than they are as a carbon reduction tool.

No CO2 will be recaptured by replanting forests. In fact, precisely the opposite will occur, as oil and gas shortages cause people to turn to wood for heat. Still, overall CO2 emissions will drop.

Coal will be unloved and shunned for its CO2 output until higher natural gas prices start to bite. Some CO2 capturing technologies for coal plants will be tried, but long term sequestration will prove problematic. Grid electricity prices will go up accordingly until renewable energy becomes cheaper than coal, at which point coal will be used primarily for things like smelting steel, not generating power.

Overpriced suburbs of McMansions will be abandoned if they remain dependent on car travel. The nouveau riche of places like Orange County will go back home and live in their parents’ basement in Cleveland, or buy a $15,000 house in some small outpost of North Dakota, and try to live on a whole lot less. I call it the Dust Bowl Migration in reverse.

Home buyers may come in for a round of bargain hunting if we have a strong economic recovery and bona fide job growth circa 2011, but that will quickly fade as declining oil production begins to bite.

Some suburbs will transform themselves into small, functional, walkable and self-sustaining towns with electric light rail, electric cars, and solar panels on every roof. The suburbs that fail this test will become mega-slums, but the cool ones will be outside of L.A., with overlords who look like Kurt Russell and Ice T running lo-tech gangs straight out of a William Gibson novel, surviving and thriving amid the ruins of the San Fernando Valley.

High density residential areas near city centers with public transportation will be stuffed to the gills. After having its own brief rally circa 2011, most of the commercial real estate constructed in the last 10 years will sit dead and idle after 2013. Eventually, much of it will be converted into cheap apartments. Few people will be driving cars in the cities.

Food will become increasingly local. The current system of food distribution will eventually break down under the combined pressures of spiking costs and fuel shortages, because modern food production is essentially a process of converting fossil fuels into food. Remember, on average it takes 10 calories of input from oil and natural gas to put one calorie of food on our tables. The whole food distribution chain in the United States is on average 1500 miles long, and three days wide at the most. It’s hugely vulnerable to higher fuel costs and breaks down instantly without a continued supply of fuel. This risk is currently priced at zero.

Farmland and railroads will be the best asset classes of the next several decades. Both sectors will be volatile until the real economic shakeout sets in circa 2013-2015, but then local farms will have to assume the burden of food production and distribution, and rail will have to assume the burden of most transport. You’ll be eating local foods that are in season and drinking wine from your 100-mile radius, instead of from Chile or Australia.

In order to grow all this new local food supply, land will be reclaimed. Parking lots, pavement, and grass lawns will be ripped up and planted for local food supply. Large city parks, like Central Park and Golden Gate Park, will turn over some of their grounds to residents for garden allotments. Think that won’t happen? It already did, in World War II. There were over 800 “Victory Gardens” in Golden Gate Park.

The much hoped-for nuclear renaissance will not happen. Even if voters get over their fears about waste and safety issues, and throw their political support behind next generation plants, the sheer up-front capital costs and long lead times will make it very difficult to do much more than rebuild the aging plants we already have. The cost of materials like cement and steel will continue to fluctuate wildly in tandem with oil and gas prices, making reliable cost projections difficult. Rounding up capital to build new plants in such an environment, especially capital that will be locked up for decades, will be very tough.

The hydrogen economy will also never come to be, for reasons I detailed here.

At the same time, renewable energy costs will continue to fall, as it rapidly grows from 2% today to over 20% of the total energy supply. Global capacity will grow much faster than anyone expects, through the multiplier effect of thousands of innovations. Utility scale solar, rooftop solar, wind, and geothermal power will become significant players. In time, so will marine energy. Europe, China, the United States, and the Middle East will all pour vast amounts of capital into all-electric infrastructure.

The intermittency problem of renewables will be fixed as new storage solutions come to market. The innovation in batteries alone over the last couple of years has been astonishing, but the whole storage area is really just getting started.

“Cash for clunkers” is only the beginning of the federal investment that will be made into more efficient and electric vehicles, as is the $2.4 billion that the Department of Energy just awarded to U.S. manufacturers to produce batteries and electric drive train technologies and vehicles that use them. Likewise, government and fleet vehicles will switch over to natural gas and regenerative hydraulic storage systems. An explosion of new electric and plug-in hybrid vehicles could solve most of the grid storage problem through vehicle-to-grid technology, but we’ll only build them in large enough numbers if we start immediately.

I am particularly excited about a new type of flywheel-based energy storage device from Power Tree Corp. Unlike existing flywheel storage systems such as the ones made by Beacon Technologies, which deliver large bursts of power for seconds or microseconds and are used for applications like grid stabilization and switching station backup, the Power Tree 4th generation flywheel can store up to 30 gigawatts of electricity and discharge continuous megawatt power for hours. The company announced in July that it will complete its first unit for commercial use in December. Put enough of those in operation, and renewable energy could eventually displace nearly all of our fossil fuel demand, instead of topping out at a 20-30% share.

I have two more “outlier” theses on transportation that are absolutely going to happen. First, air travel will be only for the rich. At $100 a barrel — and we’ll be there soon enough — none of the worldwide air travel industry works. The industry will shrink to a tiny fraction of its current size and airports serving less populated areas will close. On the flip side of that, coastal cities who still have working waterfront infrastructure will rebound strongly, buoyed by a resurgence in waterborne shipping and travel.

But Don’t Panic!

I know these predictions may sound terrifying and apocalyptic, but after my long consideration of these questions, I think their likelihood is high. Investors who play these extremely contrarian calls correctly will become wealthy, and those who fail to hedge their exposure to these risks will experience enormous losses.

Still, while some of the changes will be truly awful, others will actually make us happier.

For example, dog manicurists and tanning salon attendants will start doing things that are actually useful and add real value to the economy. A huge barter trade will grow up and we’ll stop feeding the tapeworm economy that is strangling us today. Materialistic soccer moms suffering from ennui will trade their pilates classes for work in the garden, learn to raise chickens, and go shopping on foot at the market in the downtown square (gingham dress optional). Paunchy financial district executives will turn tanned and strong from digging potatoes and wrestling their backyard pigs. Charcuteries and local bakeries will replace all the Starbucks stores. The kids will be doing a lot of work in the real world with their hands, and learn that there is more to life than prescription drugs and video games. Without cheap gas, we’ll stay local and learn to entertain ourselves, maybe even learn to play an instrument. We’ll get to spend more time with our families. We’ll eat good, homemade food — fresh from our gardens. We might even find time for a neighborhood pick-up game of stickball.

Until next time,

Chris