Investing in Oil Sector Companies - Peak Oil

By: Elliot_H_Gue

Earnings season is a busy time for the stock market. And the January/February season--when most companies report fourth quarter results--is the busiest of them all. That's because companies typically offer a look at the year ahead, shedding some light on new themes to consider.

There's a handful of companies I watch more carefully than others; I see these firms as key "tells" for the energy market. One such firm is oil services giant Schlumberger (NYSE: SLB). The reason I watch this stock so carefully and listen to all of management's conference calls and presentations is that Schlumberger has its hands in every region of the world and in every conceivable type of oil project currently underway. If you're looking for the 35,000-foot view of the oil market, Schlumberger is your best bet.

The era of cheap oil and natural gas is over and we're in the middle of one of the most powerful bull market cycles of the 21st century. There are no major pockets of untapped "easy" oil left to be exploited. In other words, the easy and cheap-to-recover onshore oil fields are mature and, for the most part, already seeing declining production.

The world's new potential growth plays in oil: deepwater reserves, Artic reserves, oil sands and other technically more-difficult-to-produce reserves. For such resources to be developed, crude oil prices will need to average well north of $55 per barrel.

There's a distinction to be made between the idea that the world is running out of oil and the concept of the end of easy oil. The world will never truly run out of oil; the last barrel of oil will never even be produced. The simple fact is that production from a reserve tops out long before that reserve is even halfway produced. Just because there's a good deal more oil left in the ground doesn't mean you can produce it quickly or even that it's economical to do so.

The question isn't whether the world runs out of oil entirely but whether supply can continue to increase and, more important, grow fast enough to keep pace with demand.

You may have heard of the theory of "peak" oil. One of the most interesting modern books on this topic is Matthew Simmons' Twilight in The Desert ; I heartily recommend this book to all subscribers. The theory of peak oil isn't that the world is literally running out of oil but that actual daily production of oil is at, or very near, a peak. 

In other words, sooner rather than later, the world's rapidly maturing oilfields will see a gradual decline in production; after all, once-prolific fields in the US, North Sea and the rest of the world are already seeing production decline rapidly. Supplies of oil would certainly be unable to keep pace with rapidly rising demand from emerging markets.

The end of easy oil is a slightly different, though not mutually exclusive, philosophy. The theory isn't that world production is necessarily near a peak but that increasing production to meet demand will require tapping more complex and unconventional reserves.

Although I have considerable sympathy for the concept of peak oil, it's almost impossible to know exactly when that peak will occur. I've heard compelling arguments that global oil production will peak in the next three years and equally well-reasoned predictions that we have 20 years of rising production ahead.

But from an investment standpoint, the actual timing of peak oil isn't all that important. The simple fact is that growing production will require tapping more-complex reserves; producing these reserves will require enormous investment and the use of the most advanced oilfield technologies.

That's where Schlumberger fits in. The company stated the basic case for the end of easy oil in its conference call last week--offering the most concise endorsement of this problem I've heard from any company to date. Specifically, management predicted that any moderation in oilfield activity levels would be short-lived because producers have to keep drilling to counteract the effects of "accelerating decline rates" and poorer quality reservoirs. In other words, producers have to drill more wells just to make up for the decline in production from existing wells.

Schlumberger went on to say that producers are beginning to realize that a higher level of investment would be required for a sustained period to have a shot at meeting growing demand. This is manifesting itself in the form of a new era of exploration; producers are shifting their focus from just developing existing reserves more fully to actually going out and looking for new oil reserves.

Management at Schlumberger believes that this new exploration cycle will accelerate in the 2008–09 time frame as a number of new deepwater rigs are scheduled to be launched out of global shipyards. The only reason that the exploration cycle isn't already at full steam is that there just aren't enough rigs out there to handle all the work.

Schlumberger knows that firms are looking to do more exploration work mainly because of its seismic business. For subscribers who are unaware of this technology, seismic shoots involve the use of sound waves to attempt to map underground rock formations. By looking at seismic data, companies can try to pinpoint areas and formations that are likely to hold oil or gas. Seismic shoots can be commissioned by a particular oil company or can be multiclient surveys--basically a database of seismic maps that can be purchased by multiple companies.

Schlumberger has arguably the most advanced seismic equipment in the world. This is particularly true of the company's Q-ships--seismic ships that are used to obtain deepwater seismic data. The important point here is that Schlumberger's seismic division-- WesternGeco --is its strongest division right now. The earnings growth and profit margins from the seismic group have routinely astounded even the most bullish analysts.

As of the fourth quarter, the Q-ship fleet was 99 percent utilized and Schlumberger was already getting requests to book the ships for new work starting in 2008. Demand is so strong, in fact, that the company is building two new ships, one for delivery next year and another for delivery in 2009.

The obvious implication of all this is that producers are doing a good deal of seismic work now in the deepwater. Their plan is likely to start drilling some of the new prospects they identify after deepwater rigs become available in 2008–09. This means the exploration cycle is just getting warmed up; such cycles typically last around eight years.

How To Play It
Deepwater is one of the most interesting and important new oil exploration and production stories of the next few years. The 2007-08 period will be a key growth period for deepwater developments; we're now entering the sweet spot of deepwater production growth thanks to the large deepwater exploration and development investments of the past five years.

I fully expect further announcements along the lines of last year's Chevron /Devon Jack Field deepwater well test in the Gulf of Mexico. The announcement of new deepwater discoveries and successful well tests will help catalyze interest in deepwater.

As such, companies that are leveraged to ongoing deepwater developments will be one of the top oil and gas-related themes for investors. Check out the chart below for a closer look.


Source: Energy Information Administration

This chart uses data and forecasts provided in the Energy Information Administration's (EIA's) Annual Energy Outlook for 2006. To create the chart, I simply took actual and forecast US deepwater oil production and divided it by total production, creating a percentage figure.

In 1990, for example, US deepwater oil production was negligible, accounting for less than 2 percent of overall domestic supply. Now, deepwater production accounts for more than a fifth of US oil supplies; by 2030, that figure is expected to reach close to 40 percent. Deepwater reserves are becoming an ever-more-important piece of the US supply puzzle.

Deepwater developments require large, upfront capital investments and take years to finalize. Once deepwater wells are completed, however, these wells can flow at rates reminiscent of Texas wells a century ago. Although growing deepwater production will be at least partially offset by declining production from mature onshore reserves, it remains one of the most-likely candidates for delaying the actual peak in global oil production.

The good news about deepwater from an investing standpoint is that it's considerably more-complex technologically that onshore or shallow-water exploration and production. That makes deepwater a highly playable theme; there are dozens of companies leveraged to growth in the sector. I see benefits accruing to the following major subgroups:

• Deepwater-focused contract drillers. Drilling deepwater reserves requires the use of very expensive-to-build specialized drilling rigs. There are only a highly limited number of such rigs globally, and right now, they're nearly 100 percent utilized. Producers are bidding up day-rates--the rates charged for hiring rigs--to try to secure availability.

• Oil and gas services. Exploration and development of deepwater reserves requires considerably more-advanced technologies than onshore reservoirs. The list includes advanced deepwater seismic services for mapping reserves and directional drilling services for more efficiently producing oil and gas. Services firms with the advanced technology needed to produce deepwater reserves are in the catbird's seat.

• Subsea equipment. As you may expect, the pressures encountered in reserves located 7,000 feet underwater are considerably greater than pressures in reserves located in shallow-water and onshore. The pipes and valves used to produce deepwater reserves are specialized to handle the extreme conditions. And much of the equipment used to produce deepwater wells has to be installed directly on the seafloor; a handful of equipment firms specialize in this business.

• Producers with deepwater plays. Finally, of course, companies with access to promising deepwater reserves have an opportunity to realize the production growth potential of energy's last frontier.

By Elliott H. Gue

The Energy Letter

Elliott H. Gue is editor of The Energy Letter , a bi-weekly e-letter as well as editor of The Energy Strategist , a premium bi-weekly newsletter on the energy markets. Mr. Gue is also associate editor for Personal Finance , where he contributes his knowledge of the energy markets.

Mr. Gue has a Master's of Finance degree from the University of London and a Bachelor of Science degree in Economics and Management from the University of London , graduating in the top 3 percent of his class. Mr. Gue was the first American student to ever complete a full degree at that university.

© 2005-2010 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.

Comments