For the past five years I've been building a portfolio of light oil producers. My belief is that the age of cheap oil is over, and controlling as much oil in the ground as possible is an excellent long term investment strategy.
This week I came across a roundtable conversation that included Berkshire Hathaway's (BRK.A) (BRK.B) eighty-eight year old vice-chairman Charlie Munger. In my opinion, and in the opinion of many people, Munger is one of the most rational thinkers the investment world has ever seen.
Here is some of what Munger had to say about future oil prices and what he thinks should be proper energy policy:
"Oil is absolutely certain to become incredibly short in supply and very high priced. The imported oil is not your enemy, it's your friend. Every barrel that you use up that comes from somebody else is a barrel of your precious oil which you're going to need to feed your people and maintain your civilization. And what responsible people do with a Confucian ethos is suffer now to benefit themselves and their families and their countrymen later. The way to do that is to go very slow in producing domestic oil and not mind at all if we pay prices that look ruinous for foreign oil.
It's going to get way worse later ...
The oil in the ground that you're not producing is a national treasure ... It's not at all clear that there's any substitute [for hydrocarbons]. When the hydrocarbons are gone, I don't think the chemists are going to be able to just mix up a vat and create more hydrocarbons. It's conceivable that they could, I suppose, but it's not the way to bet. We should spend no attention to these silly economists and these silly politicians that tell us to become energy independent.
Let me pose a question for you. It's 1930. Oil in the United States is in glut. We have cartels to get the price up to $0.50 a barrel. Everywhere we drill we find more oil in our own country; everywhere we drill in Arabia we find even more.
What would the correct policy of the United States have been in that time? Well, the correct policy would have been to issue $150 billion of very long-term bonds and cart 150 billion barrels of Middle Eastern oil into the United States and throw it into our salt caverns and leave it there untouched until the current age.
It's easy to see that in retrospect, but who do you see who ever points this out? Zero. We have a brain-block on this issue. We should behave now to do on purpose what we did on accident then."
Yes, Munger thinks that oil prices are headed much higher long term despite the unconventional/shale oil boom that is occurring in the United States. My IQ which is likely about half that of Charlie's has long led me to believe the same thing. We have entered an age of high oil prices and here is why:
Global Oil Demand Growth
We hear all the time from the talking heads on CNBC that China is slowing and oil prices may collapse. The key word though is slowing. It is still growing, and so is its demand for oil. In fact demand for oil is growing in almost all of the world's most heavily populated countries. The International Energy Agency's most recent growth projections for 2014 are for an increase in daily demand of 1.1 million barrels per day.
That rise in demand of about 1 million barrels per day year-on-year is likely what we can expect going forward as China, India and the billions of people in the emerging economies consume more oil. And at a high level, that does provide some context as to how significant the tight oil ramp up in the United States will be to global oil prices.
Every year, the world needs to raise its daily global oil production by 1 million barrels per day in order to keep up with demand. EOG's (EOG) Mark Papa is forecasting that by 2015 tight oil production can increase by 2 million barrels per day. That is 3 years from now, which would mean that daily global oil demand will have increased by 3 million barrels per day and outpaced the growth in tight oil production.
Marginal Cost of Production
The image below is from Exxon Mobil's (XOM) 2013 Outlook for Energy through to 2040.
I think it is important to note that the three main sources of growth that Exxon anticipates for global oil supply are tight oil, deepwater oil and the oil sands.
The cost of producing tight oil, deepwater and oil sands barrels have become the global marginal cost of production. The marginal cost of oil production, defined as the cost of pumping the last and most expensive barrel required to satisfy demand, is fundamentally linked to long-term oil prices. If the oil price falls below the marginal cost, there is no incentive to produce that last barrel of oil, so demand will remain unsatisfied until consumers are willing to pay more.
For the oil supply growth from those three sources to be realized, the producers are going to need to be able to turn a profit when developing them. The cost of those three production sources then becomes very important, because it provides a good idea of the minimum price of oil that we are going to be looking at going forward.
According to Bernstein Research, that marginal cost of production influenced by tight, deepwater and oil sands production, is now in excess of $90 per barrel.
We can certainly have economic shocks that kill short-term demand for oil and periodically drive down the price of oil. But as soon as that happens, the companies operating in the Bakken and Eagle Ford are going to lay down their rigs. Because of the high decline nature of tight oil production (60% to 80% declines in the first year) that rig decrease will quickly cause a fall in oil production, resulting in prices bouncing back.
Implications For Investors
The age of cheap oil is over, in my opinion, and elevated oil prices should make the companies that hold dominant land positions in unconventional oil plays excellent investments.
The reason I believe that is that these companies are currently only able to recover a tiny percentage of the oil in place from their acreage. As time goes on these companies are going to figure out how to squeeze more and more of that oil out.
When you are a company sitting on a billion barrels of oil in place, increasing recovery factors from 4% to only 6% would increase oil reserves by 20 million barrels. That 2% increase in recovery factor is a 50% increase in reserves (from 4 to 6 percent).
EOG Resources provides a good example of the power of increasing recovery factors.
Initially EOG believed that from 640 acres of its Eagle Ford property the company could recover 4.5 million barrels using 65 acre spacing.
Through trial and error, EOG has discovered that 40 acre spacing is actually going to work better which means the company will increase the amount of oil recovered by 42% and the net present value of that acreage from $76 million to $103 million.
In an age of increasing oil prices, I believe holding companies like EOG that control the most oil in the ground is a sound strategy. Time and experimenting with how to develop the land is going to increase the value of the acreage these companies control.