If you turn the clock back to the turn of the century you will see oil prices in the $20 range, every middle class family in America with two cars and per capita car growth in Asia growing rapidly. Today we have oil near $90, every middle class family in America with two cars and per capita car growth in Asia growing rapidly.
The only thing that has changed is the price of oil. Oil prices are up four times, yet our lifestyles have not changed and oil demand globally continues to grow. It isn’t speculators in the oil market driving up prices, it is supply and demand. And in the 10 years during which oil prices have quadrupled we haven’t done anything to either address the supply challenges or control the increase in demand.
At the turn of the century the only people talking about peak oil were tree huggers and tinfoil hat wearing eccentrics like Colin Campbell. Now peak oil is a mainstream concept that only rifle carrying politicians think we can drill our way out of.
Those of us who can do simple math can see that we have a big problem. As I wrote for Seeking Alpha we are perilously close to the point where we have no spare capacity in the oil market. That is where demand growth from China and India will have increased far enough to reach the point where everyone (including Saudi Arabia) in the world is producing at 100% capacity and we still can’t meet the global thirst for oil. We aren’t running out of oil. We are reaching the point where we just can’t extract it any faster.
When I see Exxon Mobil (NYSE:XOM) sign a big deal with the Russians (Rosneft which is 75% owned by the Kremlin) to explore the Arctic it does not give me much reason to think that the world’s oil supply situation is going to get any better.
Obviously exploring the Arctic is expensive, difficult and dangerous work. I won’t dwell on the environmental concerns which are significant if you think how long an oil spill leaves a mark in a place where temperatures never exceed freezing (the BP spill had the blessing of hot Gulf of Mexico temperatures which create oil consuming microbes). I think we can all agree that if Exxon thought it had a better place to explore for oil it wouldn’t be heading for a visit with Santa Claus. But what really gets me is how desperate they must be to sign on with the Russians. I mean, did they not watch how well a Russian strategy worked out for Shell (NYSE:RDS.A), BP (NYSE:BP) and Conoco Phillips (NYSE:COP)? At best each of those companies got out without losing any money.
Shell likely had the worst time. In 2006, after years of work and investment, the Russians revoked a key environmental permit for the 55% Shell owned Sakhalin $20 billion LNG project. The revocation of the permit resulted in a sale by Shell of its interest in the project to the Russian controlled Gazprom. When your option is either no permit and no production or a sale to Gazprom the choice is fairly simple. Some might suggest it was more of an expropriation of assets by the Russian government than a negotiated deal.
BP and Conoco Phillips both signed high profile deals with Russians last decade. Conoco bought a 7.6% stake in the Russian energy company Lukoil and BP entered the TNK-BP joint venture with a group of Russian billionaires. The BP joint venture ended badly in 2008 with the BP nominated chief executive getting the boot from the country. Conoco sold its Lukoil interest in 2010 after being disappointed with the results. That would make it zero for three with respect to success in Russia.
But, such is life in the oil business these days for the super-majors. Faced with year-on-year decreases in production and reserves these companies need to try and find large quantities of oil in difficult places because all of the easy oil was found long ago. They aren’t looking in Russia, Africa and miles and miles under the sea because they want to. It is because they have to.
And that leads me to a suggestion for these super major oil companies. Every second week I see a large international or national oil company buy a piece of an unconventional oil and gas property. Clearly they want in the game that the independents like Chesapeake (NYSE:CHK) and EOG (NYSE:EOG) have opened up by cracking the code on these unconventional plays. So why don’t they stop buying pieces of various properties and start swallowing entire companies? The prices that these joint ventures are going for are higher than the implied values of the various properties in the stock prices of the independent producers.
If I was running one of the massive oil companies I would stop looking for oil in difficult places like Russian and instead direct my focus at snapping up domestic unconventional independent producers to provide me with reserve growth for the next several decades.
Now hear me out because I think I’m on to something. Exxon did such a transaction when it acquired XTO in 2009. There are plenty of other targets out there like Chesapeake (CHK), EOG (EOG), Rosetta (NASDAQ:ROSE) or Penn West (NYSE:PWE) in Canada. The major oil companies like Exxon, Shell etc. trade at fairly reasonable cash flow and reserve multiples, but they have stagnant to declining production and reserves. The group of independents focused on unconventional plays trade at very similar cash flows and reserve multiples but have rapidly growing production and reserves. There is no way these independents should trade at multiples that are similar to the stagnant majors.
And that creates opportunity for the majors.
If I’m a major oil company I take my fairly valued stock and use it to acquire undervalued unconventional producers that have years and years of growth ahead of them. I believe such a strategy would be massively accretive.
The first two companies I would take out would be Chesapeake (CHK) in the United States and Penn West (PWE) in Canada. Chesapeake has an inventory of drilling locations that will take decades to exploit and result in a steady run of production growth. Penn West has the largest land position in Western Canada and is just now starting to apply modern horizontal drilling and fracturing techniques to that land base.
And since I don’t run an Exxon or a Shell I’ve been buying Chesapeake and Penn West for my investment portfolio. Maybe someone will take these companies out at a premium. If not I’ll just sit on my shares and watch them grow production over the next 10 years into higher oil prices. Either way I think it will be an enjoyable experience.
Disclosure: I am long CHK, PWE.