You could have read many of the same arguments here the last couple of months, so it’s a nice summary. Those decline rates in the big oilfields are quite scary, and the investment levels needed to compensate are not forthcoming because the nationals do not have an incentive to invest massively. The outcome is quite predictable and a matter of time..
Oil, Still Oversold
Today we face many economic obstacles; the obvious ones are quite evident. From frozen credit markets and unemployment to the auto industry and housing, there is no shortage of problems. While the world grapples with these issues, we believe the market is underweighting a potential oil supply-crunch that could reignite higher prices. On the supply side, the current economic slowdown has eased significant exploration ventures.
This may cause a bottleneck, as future demand, spurred by emerging market growth, outpaces supply. Looking at the converging paths of new supply coming online and future oil field decline rates, we are lead to believe that the world’s spare oil capacity will be gone by 2011.
Giant oil fields account for the majority of the world’s oil production. Many have seen production rate declines and those that have not are shifting in that direction. Concurrently, the rate of decline for smaller fields could be greater if not equal to their giant brothers. Total decline rates will likely increase considerably from a current average of 6.7% to 8.6% in 2030 [source: IEA]. It is estimated that the world will need 45 mb/d of additional gross capacity to offset decline rates even if demand stays flat for the next twenty years. New production has only served to sustain recent global production levels, and the carrot of optimism being waved in the form of alternative energy will not alleviate the burden oil carries as the world’s main source of energy.
National vs. International
A shift is occurring between national and international oil companies. Oil production at nationals will account for the majority of the increases in future production. State run oil companies face many uncertainties in their ability to attract sufficient private capital or, for that matter, foot the bill themselves. As production becomes concentrated in a small number of countries and emerging markets begin to account for greater consumption of future production, inefficiencies and supply disruptions will likely lead to volatile spikes in pricing.
A Merging Market
We view the recent $16B acquisition of Petro-Canada by Suncor (SU)as a leading indicator of two oil industry themes. First, M&A activity will be driven by large cap energy names with massive war chests that are thirsty for additional reserves. Traditional growth will be spurred from historically non-traditional exploration sources.
Second, large firms will look to snap up smaller cash- and credit-strapped companies whose vulnerabilities have been exposed in this economic downturn. We view this as their ability and desire to double down at current prices, and an acknowledgment of dwindling supply prospects.
Consequently, we believe that investors will benefit from the industry’s rapid pace of M&A activity.
OPEC and Stimulus
The effects of massive stimulus packages by the US and industrialized nations will likely pressure oil prices higher on two fronts; a weakening US dollar and higher consumption. The U.S. and China (FXI-iShares FTSE/Xinhua China 25 Index Fund) alone have committed $1.3 trillion in an effort to reignite global growth. Evidence of the stimulus’ positive effect on oil can be seen by Japan’s recent signal to increase their economic spending, sending oil up 1.5% on the news. Given the accelerating economic decline of many OPEC countries, we believe they will be hard-pressed to increase capacity until oil reaches ~$70 per barrel. If OPEC does not reverse production cuts, growth in future supplies may fall behind a stimulus-driven recovery of demand, leading to higher oil prices. In addition, if OPEC were to delay infrastructure expansion due to inadequate funding and demand, the potential for higher prices increases dramatically with economic recovery.
Exploration and production companies (XOP) can no longer count on easy money to fund their operations. Projects that have been canceled or put on hold will be unable to ramp up quickly enough to take advantage of a quick recovery in demand. Those who would normally access credit markets to ramp up supply in anticipation of higher oil prices will be forced to operate within their current balance sheet constraints, further pressuring supply.
Furthermore, numerous international groups, both private and state-owned, have complained that cash-rich Chinese firms are overpaying for acquisitions in an effort to drive up prices. Unlike the rest of the world, the state-owned Chinese firms have access to their country’s massive reserves, giving them advantages over those who must operate in a tough credit market.
Energy problems have taken a back seat as the world searches for solutions to the current economic crisis. We believe that future supply concerns have the potential to be a Trojan horse, besieging the world again with higher oil prices. It is only a matter of when, not if, oil prices move higher. We prefer to invest in cash-flow generating investments (equity) as the potential M&A speculation will increase multiples while maintaining a relative high beta to the commodity.
- XOP: SPDR S&P Oil & Gas Exploration & Production ETF
- PXJ: PowerShares Dynamic Oil & Gas Services Portfolio
- USL: United States 12 Month Oil Fund LP