Where will all tomorrow’s oil come from? And how you can profit today…
By
Dan Denning May 20, 2008
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Dan Denning on the 11 most promising oil investments on the market today
Here’s an astonishing fact. On 10 December 1998, the spot price for a barrel of West Texas Intermediate crude oil was just $10.98. Last Friday, Nymex crude oil futures hit an intra-day high of $126.25. That was 30% up on the start of the year, 100% up on the last 12 months, and about 1,062% ahead over the past decade or so.
So the obvious question now might seem to be, how high can oil go? Arjun Mutri at Goldman Sachs has said that a disruption in supply could send oil to another ‘super spike’ over $200. But two years ago, the ‘super spike’ was meant to top out at $100. It’s easy to keep raising the figure ($500, anyone?), but it’s probably more useful to ask a different question.
The important investment issue is not how high oil can go from here, but where future oil production will come from. The answer, according to a new report from UBS, lies with just eight oil companies, one of which investors can’t even buy. So who stands to profit the most and what should investors do now?
The first question to ask is exactly why it is that oil prices are so high anyway. In a fully functioning free market, increasing demand tends to attract rising supply. Why? Profit, of course. When a market is imbalanced and demand exceeds supply, prices rise. So opportunistic new producers rush in and grab some of the profits by bringing on new supply. Prices fall and, for a while, equilibrium is restored.
At least, that’s how it works in textbooks. But the problem is that when it comes to oil, that’s not how it’s been working in the real world. According to the International Energy Agency (IEA), world oil demand has risen in each of the past three years, from 84.9 million barrels per day (mbpd) in 2006, to 86 mbpd in 2007, to 87.2 mbpd this year. The IEA expects global demand to be 87.8 mbpd for the rest of this year.
So how has oil cartel Opec reacted to this rise in demand? It hasn’t. Opec oil production fell by 265kbpd in February (the latest official data available) to around 32mpbd. And energy information provider Platts expects production to fall by a further 347kbpd in March.
Opec explains its reluctance to raise production by blaming the oil price on the weak dollar, rather than inadequate supply. In May, Opec President Chakib Khelil said “each time the dollar falls one per cent, the price of a barrel rises by $4 and, of course, vice versa”. Khelil added that if the dollar strengthens by 10%, it is probable that oil prices will fall by 40%. At today’s prices, that would put a barrel of crude at $76.
Other theories blame the high oil price on speculation by professional traders, or on demand from those looking for an inflation hedge. But there are three other possibilities to consider:
1. Opec won’t increase production because it doesn’t want to.
2. Opec can’t increase production.
3. Non-Opec countries cannot increase production enough to bring prices down.
It is impossible to know the extent to which the first possibility is true. Oil producers, from Opec to large multinationals, plan with long time horizons. They view oil markets as cyclical and don’t base capital spending plans on pie-in-the-sky price forecasts. They are reluctant to recognise what nearly everyone else thinks is a structural revaluation in global energy prices. So it may be that they don’t want to produce any more oil this year than they had already planned to.
However, all the signs are that there is more to it than that. In fact, it looks like Opec is running at, or very near, to capacity. The only exception to this (and the reason that production has actually fallen this year) is Nigeria, where the systemic sabotage of the Niger River Delta by rebels has caused constant disruption to production. This being the case – and Venezuela’s Hugo Chavez is on record as saying it is – global users have a big problem. If Opec is unable to raise supply now, how will it be able do so 20 years from now, when demand is much higher?
The chart above shows that the IEA expects global production of liquid fuels to reach 117 million barrels of oil and oil equivalent by 2030. That ‘oil equivalent’ includes ‘unconventional hydrocarbons’, such as biofuels, oil shale, and tar sands. Right now, global oil production is around 86mbpd. So the numbers have production rising by 37% – a massive 31mbpd. In other words, the world needs another Opec (Opec currently produces just over 30mbpd). Sadly, that’s not something you can just conjure out of thin air.
Still, that doesn’t seem to worry the IEA. In last year’s World Energy Outlook, the agency said Opec could account for the entire required increase in global oil production if it starts spending the money now. The IEA forecasts Opec oil production of more than 61mbpd by 2030 – in other words, near double what it is now.
If Opec is already at capacity, this sounds like pure fantasy. Do the facts support it? UBS energy analyst Jon Rigby and his team recently published a useful report called Will there be enough production capacity? asking where future production will actually come from. The report reaches a number of firm conclusions about the oil market, many of which, I suspect, will come as a surprise to the IEA. They are as follows:
- “Declining existing basins, rising costs, increased technical challenges, stretched supply chains, geopolitical blocks and tightening fiscal terms all seem impediments to growing global production capacity for oil and gas, despite the clear pricing signals.”
- “There is no obvious wall of new production coming to the market in response to high prices.”
- “The costs of developing new projects are rising and becoming more technologically challenging. Deep water projects are particularly difficult to deal with.”
- “Nominal growth rates tied to global GDP now look more unrealistic as potential upstream growth slows. This appears reasonably consistent with a growing view that oil production may actually not exceed 100mbpd.”
The good news is that there are nonetheless some projects on the way. Aramco has several biggish expansion projects underway in Saudi Arabia, for example, while BP expects to be able to get 400,000 barrels a day out of a new deepwater project in Azerbaijan. If we look at those that will come into production before 2010 and add up the expected volume to come from them, we get about 3.8mbpd. So that’s something. Add in liquefied natural gas (LNG) and barrels of oil equivalent coming from new projects (notably from ExxonMobil in Qatar) and you get another million or so. This is good, but leaves us 25mbpd short.
The next thing to look at are the new projects that could come on after 2010. This is a more murky aspect of the future – there is a long lead time between deciding to finance a project and actually getting oil out of it. Still, the UBS team has identified projects for which the final investment decision has been made. Assuming cost blowouts can be avoided and the projects aren’t cancelled, there are some good-looking bigger ones that might come on-stream between 2011 and 2015.
Aramco is looking to get another 900,000 barrels a day from its Manifa project in Saudi Arabia, for example. There are also some massive LNG and natural gas projects on the way. Gazprom, Shell, BP, and ExxonMobil are all heavily involved in these, so should oil prices stay high and pass through to higher LNG prices, they’ll all be big winners.
Finally, beyond all these projects, there are the new oil finds offshore in Brazil’s Santos Basin. These are huge – Petrobras says the Tupi find may contain as many as eight million barrels, while the Carioca field may have 33 billion barrels of reserves, of which about ten billion could be recoverable, according to Citigroup. It all adds up – but right now it doesn’t look like it will add up to quite enough.
So what are investors to do about all this? The obvious first step is to want to invest in the companies likely to be producing the most new oil over the next decade. But it isn’t that simple. When you add all the projects together, you find that 48% of expected new production volume comes from just five companies: ExxonMobil, BP, Royal Dutch Shell, Total and Chevron. Throw in the three national oil firms – Petrobras, Gazprom, and Aramco – seeing the most new production and you find that a full 70% of production already in the pipeline will come from just eight companies.
That doesn’t leave the investor much to choose from. You can’t invest in Aramco at all, and although you can invest in Gazprom, it’s a risky proposition, given the Russian government’s lack of attention to property rights. The other six firms on the list are good stocks, but hardly obscure plays: most MoneyWeek readers will have stacks of these by now.
Another possibility is to bet directly on the oil price. The crude oil ETF, the United States Oil Fund (USO:AMEX), will do very well if the crude price keeps rising. However, it’s hard to say right now with any certainty that it will – at least in the short term. And if the oil price corrects, this firm will get clobbered.
A better way to invest in the drive to find and produce more oil might be through oil services companies. You can be sure that as the big players work to expand global oil production in the next five years, oil services firms will make good money as a result. However, this is hardly new news either – the sector has been very well followed for the last few years.
The UBS report tips two firms, Halliburton (HAL) and Norway’s Petroleum Geo-Services ASA (PGS). It’s worth noting that the latter just won its biggest contract ever, a $200m award from Petrobras for high-density, four-dimensional marine seismic survey work in Brazil’s Santos, Campos, and Espirito Santo Basins. It probably isn’t a bad investment.
Other firms in the sector include Baker Hughes, Intl. (BHI); Diamond Offshore Drilling (DO); Nabors Industries (NBR); National Oilwell Varco (NOV); Noble Corporation (NE); Schlumberger (SLB); Smith Intl. (SII) and Transocean (RIG). None of these would be bad investments to hold – you could buy any one of them, or a combination.
Simpler still, however, you can get exposure to all of these companies at once via the Oil Services ETF (OIH). As the chart below shows, Oil Services ETF’s rise since 2004 has been steady and impressive. A correction in crude oil prices – which both myself and UBS rather expect – might bring the price back down to around $180, a price where the share seems to have long-term support. A long-term bull market in the oil sector is a near certainty, so watch for the correction, then buy Oil Services ETF and benefit from oil’s next big move up.
Three risks to your oil investments
Judging purely on supply and demand, the long-term bull market for oil seems intact, even if we head into an economic slowdown. But it’s still possible that oil’s next big move could be down, and that’s certainly worth exploring. Here are three of the key risks:
1. The nationalisation of oil projects currently held by public companies.
If hostile foreign governments continue to nationalise major development projects, it will be bad for public company earnings. The heightened politicisation of oil has made it harder for firms to decide which projects to invest in. The net effect of this may be to cut the number of projects that put real shareholder capital at risk.
If earnings decline, valuations may follow. That’s a reason to stay out of the oil majors. On the plus side, nationalisations tend to tighten supply further, so the oil price would be likely to rise.
2. A new pricing mechanism for crude oil appears.
Another risk is the possible introduction of a new pricing scheme for oil. Opec countries constantly complain about the value of the dollar and periodically stories surface about pricing oil in euros, or trading it on an Iranian oil bourse. But another possibility could be that the oil market moves to a less regular, negotiated or auction-pricing scheme, not unlike the regime that exists for iron ore and coal between Australian producers and Asian customers.
Oil was “commodified” in 1983 when the NYMEX futures contract began trading. The futures markets provided the world’s buyers and sellers a little more price certainty and a little less volatility in the spot markets. Liquid futures markets see pricing power shift between the buyer and the seller based on changes in the market, including alterations to both supply and demand.
What we may see with oil in the next few years is a shift in pricing power that distinctly and permanently favours the sellers. Sellers currently benefit from high volatility because it’s led to higher prices. But those prices are denominated in a declining currency, the American dollar. Is it inconceivable that some Opec sellers, or even non-Opec sellers, might agree to sell annual production at a fixed rate to a buyer who pays in something other than American dollars?
It’s conceivable, but it would be a very different world to this one – a world where oil is sold for geopolitical reasons and used as an economic weapon. This would be a world where there’s no free market for oil. Falling production and growing demand puts oil producers in the position of deciding what to charge, and who they want to sell to. This removal of the free market would affect most oil-related investments.
3. The collapse of modern complex society.
The last, and least relevant, possibility is the potential collapse of our current complex society. Globalisation has created a system of interconnected systems: energy, logistics, transportation, food, finance, and travel. Like any system, it requires energy. When you start reducing the energy available to the system, it ceases to function in the same way. In some cases, it may stop working altogether.
That the modern industrial world will cease to function because of structurally higher energy prices is something we should all consider, although there is nothing any of us can do to prevent it if the world’s resources are already over-extended. It’s clearly the worst-case scenario – but it wouldn’t be the first time an advanced civilization went from decadence to poverty in one generation. Still, were this to happen, I suspect the price of your oil shares will be the least of your worries.
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