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My case for a higher crude price hinges on two major trends, which do not seem to be reversing anytime soon.

Rising Production Costs

On July 16, the International Energy Agency (IEA) [1] predicted the following about the world supply of oil, between now and 2016,

Conventional crude oil accounts for less than 40% of the increase, while natural gas liquids, biofuels and unconventional oil from onshore the United States account for the lion’s share of new supplies.

Unconventional oil, as opposed to conventional oil, which is drilled using vertical wells, is extracted from rocks using horizontal drilling, the environmentally controversial technique so-called “fracking”. This will be very expensive to produce, and the IEA predicted, will be available to the market only if the crude price stays above $100/barrel. If the crude price stays below $100/barrel for long periods of time, there would not be sufficient economic incentive for the unconventional oil to be added to the world supply.

Most easy-to-get oil has been found. In order to discover new sources of oil, producers have to “get at unconventional shale oil, heavy oil and tar sands as well as sinking wells deep underwater,” according to an article in The Economist [2] dated July 1st. An analyst in it predicted global exploration budgets to increase by 14% in 2011.

World Demand Growth

The same IEA report also predicted China, Asia, and Middle East together to generate 95% of the demand growth through 2016. While the economic outlook for the United States, the EU, and Japan through 2016 is cloudy and pessimistic with chronic fiscal deficits and sovereign debt crisis, the outlooks for those three regions through 2016 are considerably brighter. Inflation seems to be peaking in China, and so far the government has proved able to manage a soft landing of the economy. The other major Asian economy, India, is projected by the IMF to grow at 8.2% by the end of this year. High oil prices will continue to create wealth for oil producers in Middle East.

Thus, with the world’s oil supply at best meeting demand with a small cushion, and at worst, having a shortfall in meeting demand (i.e. in the case of Libya’s military conflicts), and no short term substitute for oil in transportation and petrochemical uses, producers will pass the cost increases onto consumers.

Why Oil Equity?

In relative value terms, integrated oil majors are traded at lower multiples than current crude prices would warrant and other related sectors, such as oil equipments and services. Exxon Mobil (XOM) is traded at 11 times its rolling twelve-month earnings while Halliburton (HAL) is traded at 21 times its rolling twelve-month earnings. For some reasons, the stock prices of these integrated oil majors have not reflected the full impact of rising crude prices, as the stock prices of oil equipments and services have. In my opinion, one overhang over the oil majors comes from the potential tax hikes from cash-strapped national governments. In these dark economic times when drivers are being squeezed at the gas pumps, cash-flush big oil companies make easy targets.

Stock Pick – STO

One way to get around this concern is to buy Noway-based Statoil ASA. This is Norway’s integrated oil major 67% owned by the Norwegian State. Unlike many developed countries including the United States and Britain, Norway is fiscally sound. The Economist [3] estimates Norway’s current account balance and budget balance respectively to be a positive 12.7% and 10.6% of its 2011 GDP. 80% of Statoi’s oil and gas production comes from the Norwegian Continental Shelf.

At a time when the crude price is forecasted to be above $100/barrel, at $24 the stock is trading at 10 times its rolling twelve-month earnings as of March 31, 2011, a historically low multiple, only higher than the multiple at the end of 2008. The general equity market has been in a downward trend since May. Oil majors’ multiples have also been depressed because of their dwindling oil reserves. Statoil is no exception. Its various operational issues and production cuts during the third quarter of last year heightened concerns about the depletion rates of its aging fields in the Norwegian Continental Shelf.

However, Statoil’s oil discovery in April at the Barents Sea was a breakthrough. It was near the Arctic, in a previously unexplored part of the Norwegian Continental Shelf. The Norwegian Petroleum Directorate [4] estimated that Norway’s portion of the Barents Sea could hold up to 6 billion barrels of oil equivalent. It is still too early to gauge the full potential reserves of the area. But whatever gains this news made on the stock have now completely evaporated; the stock is now traded lower than it was before the news of the oil discovery.

The stock is now traded close to its value at the end of 2009 while Statoil’s earnings have more than doubled since then, and its return on capital is back to the low teens after the crude oil’s volatile price move from $43/barrel during the first quarter of 2009 to $101/barrel in the first quarter of 2011. The company’s balance sheet is stronger than ever after recent sales of assets at significant gains. Its production potential is also stronger. Applying a multiple of 13 to its rolling twelve-month earning as of March 31, 2011 would value the stock at $31. I would take the recent downtrends in the equity market, which might persist over the summer, as a buying opportunity for Statoil.

Note: The author owns shares of Statoil.

[1] IEA report looks at oil, gas market prospects through 2016, June 16, 2011, the IEA website.

[2] The oil-services industry rigging the market, The Economist, June 25th – July 1st 2011

[3] Economic and financial indicators, The Economist, June 25th – July 1st 2011

[4] Statoil looks to Arctic field to boost prospects. By Andrew Ward, FT, April 10, 2011

Source: Major Trends Point to Higher Crude Prices: Statoil to Benefit