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The return of the oil shortage–around 2015–and why the industry’s logical decisions now will make it worse

posted on December 8, 2009 at 8:30 am
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Devonshire Energy’s decision to sell its expensive to develop deepwater assets in the Gulf of Mexico in order to concentrate on its onshore natural gas reserves makes perfect sense.

For that company.

For the oil industry and for the global economy picture, though, could make the predicted energy crisis of 2015 or so much worse.

In the short-term, there’s plenty of oil. The slowdown in the global economy and the addition of new supplies from countries such as Angola assures that. OPEC (Organization of Petroleum Exporting Countries) has a sizable surplus of production capacity.

In the long-term the story is very, very different. In the long-term, say 2030, oil could be in serious shortage again. And I think the likely effects of that shortage now 20 years off will be felt much sooner thanks to perfectly reasonable decisions by individual oil companies to maximize their profits. Maybe as soon as 2015.

If you are a genuinely long-term investor I’ve got a three stocks to suggest at the end of this post for how to profit from what is admittedly a very distant trend. Even if you’re not interested in putting money to work on prospects that are so far away, I think knowing about this trend will give you potentially profitable context for all your investments.

In my December 1 post http://jubakpicks.com/2009/12/01/its-not-the-price-of-oil-but-the-cost-of-oil-that-divides-the-good-oil-stocks-from-the-bad/ I explained the logic of Devon Energy’s decision to sell its promising Gulf of Mexico deepwater and international assets and concentrate on producing more natural gas from its huge reserves in the United States—even though there is a glut of natural gas on the U.S. market right now. The decision comes down to cost and time. Finding and development costs for the onshore North American wells are roughly $6.86 a barrel of oil equivalent, Deutsche Bank has calculated. Working backward from the Deutsche Bank figures, I get an estimate of a finding and development cost of $31.13 a barrel for the assets that Devon has announced it wants to sell.

The result was a situation in which the “tail” of Gulf of Mexico and international assets wagged the dog. These assets ate up 29% of the company’s capital spending in 2009 but equal just 7% of the company’s proved reserves of 2.8 billion barrels of oil equivalent. In 2009, they’ll contribute just 11% to the company’s estimated 248 million barrels of production.

And besides being more expensive, the payback on these new deepwater or overseas fields in really long. Investments in developing new deepwater or overseas fields can take five years before they generate significant cash flow. In contrast investing in drilling new wells in existing natural gas fields in the United States produces cash flow within months.

So Devon Energy’s decision to sell off expensive to develop, long-lead time assets and concentrate on lower cost and quicker to earn out onshore natural gas resources is completely logical.

But follow out the consequences of that logical decision if it is adopted by more companies than just Devon.

You’d have oil companies around the world abandoning expensive to develop, long lead time oil projects and concentrating instead of cheap to develop, shorter-lead time oil and natural gas projects.

That seems to be what has happened in the energy industry, especially the part of the industry inhabited by the investor-owned publicly traded international oil majors. In this shift Devon Energy isn’t a pioneer. The company is, in fact, following a path conspicuously traveled by ExxonMobil (XOM) and other bigger companies.

Take a look at the breakdown in ExxonMobil’s 2008 annual report of the 120 projects now underway that are forecast to produce 24 billion oil equivalent barrels. The pie chart is dominated by the kind of projects that Devon Energy announced that it would focus on after selling off its international and deepwater Gulf of Mexico assets. By far the biggest category for projects is liquefied natural gas. Alone that makes up about 25% of Exxon’s projects. Add in unconventional gas (like the Barnett Shale that Devon owns so much of), acid and sour gas, and heavy oil/oil sands and you’ve accounted for roughly 75% of all the company’s projects. Conventional oil and gas, deepwater oil and gas, and arctic oil and gas add up to just 25%.

There are lots of good reasons for this emphasis. National governments with big undeveloped oil reserves have largely frozen out the international majors. Liquefied natural gas looked like a rapidly growing—and underdeveloped—market years ago when many of these projects were launched. Nobody predicted today’s natural gas glut.(For more on the natural gas glut, its causes, and when it might be over, see my post http://jubakpicks.com/2009/11/30/natural-gas-prices-to-stay-low-into-2010-good-news-for-consumers-bad-news-for-producers/ ) And all these projects—yes, even oil sands—are more predictable in their results (although not always as in the case of oil sands cheaper) than searching for oil in the Arctic or deeper and deeper deepwater.

But even though ExxonMobil’s emphasis, like that of Devon Energy’s and other oil and gas companies, is reasonable, understandable, and logical, it still creates a global problem not too far down the road. You see, with current technologies—and with new technologies that look like they can go mass market in the next 10 years—natural gas and oil aren’t fungible. We can’t now run cars, trucks, and bulk of our decentralized transportation system on natural gas. We need oil. And although the presence of natural gas powered buses rolling past my window in New York City says that it is certainly feasible to power a vehicle on natural gas, the lead time and expense for building out a natural gas supply infrastructure (either in the form of natural gas refilling stations or in the form of recharging stations supplying electricity produced from natural gas) argues that we’re looking at far longer than 10 years to move a significant portion of the global vehicle fleet away from oil.

The International Energy Agency projects that the world will use 105 million barrels of oil a day by 2030. That’s a huge 20 million barrels a day above current global consumption.

If that’s too far out for you, the agency estimates that if oil consumption grows by just 1.4% a year by 2014 global oil consumption will top 89 million barrels a day, about four million barrels a day above current levels of consumption.

Which wouldn’t be so much of an issue except that growth in global oil supply is slowing for reasons that range from the difficulty of finding new oil to financial constraints due to the Great Recession to moves like those by ExxonMobil and Devon Energy.

In June the International Energy Agency cut its forecast for oil supply capacity growth during 2008-2014 to 4 million barrels. That would match the projected increase in global oil consumption by 2014.

But I have to wonder how long that demand/supply equilibrium will last. The agency’s June forecast was for 1.5 million barrels a day of supply capacity less than the agency had projected in June 2008.

And in a wonderful piece of bureaucratic prose the agency said “Supply could be lower still were upstream spending curbs to extend beyond 2009.”

No guarantees to any of this. The forecasts for both supply and demand that far out are so dependent on changes in the global economy, politics in the Middle East, and the cost of capital that they are really little more than educated guesses.

But I’m willing to back an educated long-term guess when the near term trends say that I’m not a likely loser over the short-term no matter how the long term comes out. In the near term oil and gas stocks are a good investment as global demand recovers from the Great Recession. (Although not in the extreme short-term perhaps where the energy sector looks like it might be headed for a dip.) Making a long-term bet in a sector with the wind already at its back just adds a bit of wind speed to the trend.

How to play this long-term supply shortage is a puzzle though. If you think the shortage is limited to oil, you can’t just buy any oil and natural gas producer because a good many of them are emphasizing growth in natural gas supply and de-emphasizing growth in oil supply.

But I can think of a few that are bucking the trend and would be good candidates for making a long-term bet on a return of an oil shortage.

Apache (APA). About 50% of the company’s production consists of oil or natural gas liquid (liquids that flow with natural gas out of the well and can be converted into oil-like liquids). But the long-term story, the reason the stock is in my long-term Jubak Picks 50 portfolio is the company’s expertise in getting more oil out of older fields that the big majors have given up on.

EOG Resources (EOG). Primarily known as a North American natural gas play, the company has been quietly buying up leases in areas where it believes that its expertise in horizontal drilling and completion give it the ability to access major oil reserves. By the end of the decade the company, now 84% natural gas, is projected to have moved to 50% oil and natural gas liquids.

Petrobras (PBR). The Brazilian national oil company has discovered major new oil reserves in the South Atlantic. With the development of these fields a key to gaining Brazil more clout in the world, mere cost/benefit analysis isn’t going to stop the development of these oil resources.

I’d wait on all of these until what seems to be shaping up as a correction in energy stocks runs its course.

Full disclosure: I own shares of Apache, Devon Energy, and Petrobras in my personal portfolio.

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9 comments

  • jamba on 8 December 2009

    Jim,

    What are your thoughts about ECA, especially now that they are breaking up into two companies?

  • cyfairslam on 8 December 2009

    Apache has a great deal of their production on the Shelf in the Gulf of Mexico. As with all oil and gas producers operating on the shelf, they have a great deal of abandonment liability associated with wells, platforms and pipelines that may not be reflected in their balance sheet. In addition, the Shelf pipeline infastructure is erroding. Pipeline companies cannot generate operating costs at some of the low flow rates in thier pipelines. Damaged pipelines are not being repaired, some others are being abandoned even though product is still flowing. This may leave some reserves in the ground.

  • mibnyr on 8 December 2009

    Hi Jim,
    How does your observation, the trend away from oil production in harsh environments, affect RIG in Jubak’s Picks? Should we be looking for an exit before the correction?

    Thanks for all your insight.

  • Jim Jubak on 8 December 2009

    mibnyr, as I hope I said, the trend away from production in expensive environments isn’t shared by all oil companies. It seems to be a feature of the investment strategies of some of the Westrern majors. At the margin that strategy will effect oil supply and it’s the margin that will determine oil prices. But the near-term trend that keeps me in RIG is the rise in global demand with a return to growth in the global economy. That should give RIG plenty of operating improvement in the near-term before any of the trends that I mentioned in this post even begin to click in.

  • fvbridges on 8 December 2009

    Jim,
    I am a rookie investor and have been researching TGA. Any thoughts on this company’s prospects?

  • FrozenFoot on 8 December 2009

    Nat gas burns clean to make electric power which runs small, battery powered cars… no need to distribute the gas, just the power (smart grid)… I think gas will be plentiful for several years because the technology to get it from shale is just coming on line.
    Exxon’s annual 20 yr outlook for energy was just updated… the growth in solar and wind surprised Rex

    http://www.exxonmobil.com/Corporate/files/news_pub_eo_2009.pdf

    chart on top of page 9 is interesting… North Americans can conserve a bunch…

  • David in Shanghai on 8 December 2009

    BQI in Canada appears to have made decent headway into discovering reserves in Saskatchewan. For some reason, I have the opinion that this small cap may have significant growth potential as the price of oil rises. I actually do not have the expertise to truly make this call (I’m a school teacher by trade.) Any advice? I have a decent tolerance for risk so that is not an issue. I would just hate to be sitting up in that cold prairie land (figuratively of course) wasting my time if I’m just chasing the wind.

  • fvbridges on 9 December 2009

    David…..take a look at TGA. It’s a Canadian oil exploration company. It also appears to have decent growth potential.

  • drpearso on 19 December 2009

    Jim – when do you think the correction in the energy stocks will be over …. you said to wait for the correction via your Dec 8 article, and since then Exxon has dropped from $73/share to $67.64.

    Exxon was trading at $76/share Dec 1, thus at $68/share Dec 18 is a drop of approx 11%. Is this the correction you mentioned in your Dec 8 article? regards

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