Why the Oil Market Favors the Deepwater Subsector

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 |  Includes: RDS.A, XOM
by: Jason Kelly

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 (NYSE: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 (NYSE: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