Why the Oil Market Favors the Deepwater Subsector

Depletion is one of the most important subjects for anybody interested in the oil industry. Easy oil of the light, sweet crude variety is getting scarcer by the month. The steady disappearance of existing deposits forces oil companies to set their sights farther afield in search of replacing the oil volume lost to depletion. Annually, world oil supply is losing about 4 million barrels per day to depletion.

Where do you go to make up for that if you're, say, ExxonMobil (XOM)? Not to Texas or Alaska anymore, there are no more Ghawars (the world's largest oil field and source of more than half of Saudi Arabia's production), and the Canadian oil sands are a very expensive way to get more supply.

The latter is expensive in two ways: first, because it takes a lot of money to process tons of oil-soaked sand into usable oil and, second, because it takes a lot of energy to do so. Financially, Canadian oil sands oil won't make sense until oil trades for more than $100 per barrel again. Energy-wise, they may never make sense. What's the point of using 8 million Btus of energy to extract one barrel of oil that produces only 6 million Btus?

Then, there's the issue of resource nationalism. There's a reason big oil companies are increasingly state-owned, as in China's Sinopec or Russia's Gazprom: countries don't want to leave something as precious as the world's last oil deposits to the whims of free enterprise. This can get nasty in a hurry, as shown in this excerpt from Why Your World is About to Get a Whole Lot Smaller:

As development costs soar and become multiples of original estimates, tensions have risen between companies and host countries, prompting major changes in royalty agreements or even changes in ownership. Just ask the executives at Shell (RDS-B) about their former Sakahlin-II project, one of the biggest they had going.

The company sunk billions of development dollars into this series of offshore rigs in the frigid waters of the Okhotsk Sea in the North Pacific. When staggering cost overruns were about to cut the Russian government out of its royalty share, the project all of a sudden ran afoul of previously nonexistent Russian environmental regulations, and Shell found itself an unwelcome guest. Under duress, Shell was forced to sell out to Russian interests and walk away from 1.2 billion barrels of oil.

If Shell shareholders were asking their board why the company risked billions of dollars in a both geopolitically and politically challenging environment in eastern Siberia, the answer is simple. That's all that's left.

One place where Exxon shines is in its operational excellence. Its top-tier technology and efficient processes make it a very good partner for a host country's national oil company, or NOC. As the above excerpt shows, the ability to work with countries to help them exploit their oil reserves is critical -- and will become more so as the supply of oil continues shrinking. There's no other company on Earth that can top Exxon's capabilities, so its services will become more valuable as the available oil sources become more difficult to exploit. The world is heading toward an environment where nations will say, "If Exxon can't get it out at a price that makes it worthwhile, then it's a non-viable deposit."

That's a good position for Exxon, made better by its $25 billion cash on the balance sheet and long history of solid operations. You won't find mysterious writeoffs or other accounting gimmicks at Exxon.

The risk of a country pulling a fast one remains real, though. Exxon and other majors, like Shell (RDS.A) in the example, can never know for certain that they won't spend billions, work hard, and hold up their end of the bargain only to find a wall of new environmental regulations or similar ploy erected to cheat them out of profits.

Another problem with Exxon and other majors is that they're already so big and new volume is getting so hard to find, that meaningful growth may be hard to create. Just maintaining solid operations with existing supply as prices inevitably soar will help, and Exxon will do so. Also, as oil prices rise over the long term, operations such as the Canadian oil sands should become financially viable, and new technologies may make them viable energy-wise as well.

Yet, we continue to think the best way to benefit from the long-term oil market remains the equipment companies, such as deepwater shops and firms working on the technologies to make hard-access sources viable. The beauty of such firms is that they'll do well regardless of whether their products and services are bought by majors or NOCs or, more likely, both.

Remember the old saying about making money in the Gold Rush? It advised to avoid becoming a miner in favor of selling picks and shovels to miners. Oil is looking a lot like that these days. The picks and shovels of the coming oil rush are more sophisticated than their predecessors in the Gold Rush, but the same idea of everybody needing the same ones applies.

The majors are aware of this situation, of course, as are the NOCs. Both groups are spending their own capital to develop or acquire technologies they think will be critical in the future. Part of our analysis centers on weighing which companies are gaining an advantage, especially a defensible one. So far, the deepwater shops look to hold the best position for the medium term.

We're seeing more and more analyst reports confirming our take, as exemplified by this overview from a report sold by Infield Systems:

Recent years have seen the growth and formalisation of the global deepwater offshore industry. A process that has been driven by increased energy demand stemming from consecutive years of economic growth, the maturing of established hydrocarbon extraction basins, and a growing battle to overcome depleting reserves. Such factors have encouraged operators to invest billions annually chasing this offshore frontier, and across this report we see very few market segments associated with deepwater production not seeing upwards potential.

The report notes threats to the industry but they're the kind we like to see, such as dayrates having climbed too high and growth being so strong that it's hard to hire enough personnel to keep up with demand.

The trends are clear and give you an important to-do: watch the deepwater subsector of the oil industry.

Disclosure: No position

Comments

[Graham and ...:]

If "deepwater" is the way to go, the world's biggest deepwater oil company is Brazil's Petrobras (a very large company even overall).

Jun 18 08:41 AM

[IgnisFatuus:]

Petrobras has locked up a significant portion of Tidewater's Deepwater fleet of drillers for several years out. (disclosure long PBR and RIG)

Jun 18 09:08 AM

[mdpath:]

How about naming names.

Jun 18 09:11 AM

[pockyclips ...:]

Good article. I agree with Graham; PBR and STO are my plays.
Longer term, NG, then hydrogen/methane will hopefully power
transportation use. Oil will be reserved for military/industrial use.

Oil shale is just plain dumb; the amount of water needed, in addition to the amount of waste generated, is staggering. If western Colorado were to develop it's oil shale, it would have to divert at least half of the average flow of the Colorado River to produce 1 million barrels/day. I guess the Grand Canyon could be put to use as a sludge lagoon.

I'm not a big Obama fan, but this is one area change is way overdue. I hope we get off our arse and do something!

Jun 18 09:13 AM

[mr freddo:]

I agree with mdpath. Your premise is a good one, but you did not provide any specific names. I have been looking to add to my oil positions but would like some help here as to where to invest. I like the oil services and will add some OIH to get broad exposure.

Also, what about the high yielding Canadian oil trusts like PWE and PGH? Any opinions there?

Disclosure: Long PBR, RIG, PWE, PGH.


On Jun 18 09:11 AM mdpath wrote:

> How about naming names.

Jun 18 10:26 AM

[Snitzer:]

I agree, and I really hope we're all correct in our assessments, as I'm long in Oceaneering, Transocean and Noble, all less than stellar performers the last few days. But next year should be an interesting one.

Jun 18 10:32 AM

[jimboy:]

Graham - isn't the author suggesting that the way to go is invest in the firms that lease out the deepwater rigs and platforms, rather than the PBRs of this world who have reserves in deepwater? I've been watching companies like Transocean (RIG), Diamond Offshore (DO) and Noble (NBL) using the author's kind of logic. They track the oil price very well and DO for example is a good dividend player. Their expertise and sunk capital investment provide 'a moat' of sorts too.


On Jun 18 08:41 AM Graham and Dodd Investor wrote:

> If "deepwater" is the way to go, the world's biggest deepwater oil
> company is Brazil's Petrobras (a very large company even overall).

Jun 18 10:39 AM

[jerrydd:]

For now oil equipment and Exxon will be a good play but in the 5 yr term they will both start falling as other energy sources come online.

But in the future oil taxes to put their full cost in them and quickly dropping RE and battery costs will cause it to level out, then fall.

That's why 9 yrs ago Chevron bought the NiMH battery patents, stopping them from being produced in EV sizes to stop EV's from being very practical.

But that can't be done again because there are so many new viable Li batteries now. All they need are orders.

Why is a Solectria Sunrise went from Boston to NYC on IO-95 back in 1999 with 3 people onboard on 1 charge. Now with Li of the same weight it will go from Boston to DC on a single charge!

I drive an EV 2 seat sportwagon that gets 250mpg equivalent that can be built profitably for under $10k in mass production. It's similar to Lovin's Hypercar but with FG and Kevlar type composites to make a strong, lightweight EV instead of costly carbon fiber.

My 3wh MC EV gets 600mpge that with a cabin on it could do most US car trips. Once oil gets back to $4/gal next yr you will see a fast change over to much more eff vehicles.

So beware of the oil bubble as it won't be able to sustain it.

Jun 18 11:07 AM

[ripskii:]

The picks and shovels analogy of the gold rush is indeed an apt model for the current oil situation. The capable deep water drillers are a good way to invest as described in the article. There are only a few companies with solid experience in this field and they include RIG (the largest and most experienced), Diamond (DO), Noble (NE), and Atwood (ATW). Pride (PDE) has been moving into deeper water recently. Another company with deep water service capability (not drilling) is OII.

Jun 18 12:16 PM

[techzone12:]

I am long PBR. If you want to be rich, jump on the PBR bandwagon.
The oil sector looks shaky right now, with potential for further short term decline. But long term, I think companies like PBR have huge potential. RIG is also a good play. See you in a year or two!

Jun 18 01:44 PM

[bindlepete:]

Just two quick comments.

1-The oil sands are economic now and the costs are coming under control; for new production and could fall through the floor with PetroBank's THAI/CAPRI.

2-There is evidence that Exxon is moving it's focus from oil to natural gas and will move much faster as the NG price ascends.
Just look at what they have sold in the last 3 years, (retail outlets and refineries) and where there new money is going ( LNG to establish a high marginal price and "deep" gas - check their patents).hidden as they are.

Jun 18 03:39 PM

[HerrHansa:]

I read an interesting story about Seadrill (SDRLF) of Norway, and the premise behind deep drilling. The drive for John Fredriksen to establish that company was that he saw smaller operators have a greater drilling success on deep water wells than on easier to reach tests. Unfortunately, there is no ADR on this, and the OTC trade is very small, since this stock mainly trades in Oslo (OSE: SDRL). Further research led me to a company that owns a few of Seadrill's rigs, and then charters them back to the company. That company is Ship Finance International (SFL). They are involved in shipping too, so I recommend further research prior to investing, though I liked what I saw and invested recently.

Another company heavy in the oil services segment is Weatherford (WFT). A few months ago they relocated their headquarters to Zug, Switzerland in order to take advantage of the low corporate tax structure. They have been moving steady with new contracts, and done well at managing expenses. I invested in them a few months ago, and recently did a little profit taking, though I still hold a long position.

Some good news sources for following the industry:

www.energycurrent.com

www.321energy.com

arabianoilandgas.com

Disclosure: I also hold Statoil (STO), which someone else mentioned, one play involved in natural gas, which is Golar (GLNG), and DHT Maritime (DHT), who operate a tanker fleet.

Jun 18 07:55 PM

[Deepv:]

You need to look at how much you are paying per barell of proven reserves when you look at oil. XOM is TERRIBLE. The big winners are the likes of Suncor and Nexen, not big integrateds that are soon in decline. Loews Corp is a great way to enter deep water drilling on the cheap via its majority stake in Diamond offshore.

Jun 18 10:34 PM

[jimboy:]

Herrhansa - thanks a lot. exactly the kind of leads i am interested in. I will definitely look into these options.


On Jun 18 07:55 PM HerrHansa wrote:

> I read an interesting story about Seadrill (seekingalpha.com/symbo...)
> of Norway, and the premise behind deep drilling. The drive for John
> Fredriksen to establish that company was that he saw smaller operators
> have a greater drilling success on deep water wells than on easier
> to reach tests. Unfortunately, there is no ADR on this, and the OTC
> trade is very small, since this stock mainly trades in Oslo (OSE:
> seekingalpha.com/symbo...). Further research led me to
> a company that owns a few of Seadrill's rigs, and then charters them
> back to the company. That company is Ship Finance International (seekingalpha.com/symbo...).
> They are involved in shipping too, so I recommend further research
> prior to investing, though I liked what I saw and invested recently.
>
>
> Another company heavy in the oil services segment is Weatherford
> (seekingalpha.com/symbo...). A few months ago they relocated
> their headquarters to Zug, Switzerland in order to take advantage
> of the low corporate tax structure. They have been moving steady
> with new contracts, and done well at managing expenses. I invested
> in them a few months ago, and recently did a little profit taking,
> though I still hold a long position.
>
> Some good news sources for following the industry:
>
> www.energycurrent.com
>
> www.321energy.com
>
> arabianoilandgas.com
>
> Disclosure: I also hold Statoil (seekingalpha.com/symbo...),
> which someone else mentioned, one play involved in natural gas, which
> is Golar (seekingalpha.com/symbo...), and DHT Maritime
> (seekingalpha.com/symbo...), who operate a tanker fleet.

Jun 20 07:09 AM