Occidental Petroleum, Devon Energy: Peak Oil Is Here

A peak in world oil production under 85 million barrels daily (mbd) now looks like fact and supports our buy recommendations of oil and gas producers. Each new monthly compilation of U.S. government statistics confirms that the rising trend of global oil production ended in 2004, contrary to market expectations.

At the same time, forecasts by government analysts, generally in line with investor expectations, keep climbing with targets of 85, 86, 87 and 88 mbd released in September 2004, 2005, 2006 and 2007 respectively. If oil supply expectations are too optimistic as we believe, then it is likely that oil price expectations, currently $72 a barrel for the next six years, are too pessimistic as we also believe to be the case. The reconciliation is likely higher oil price that in turn implies higher stock price for producers.

A stock like buy-recommended Occidental Petroleum (OXY) has had strong momentum lately, but remains priced low at the oil equivalent of $57 a barrel (McDep Ratio of 0.87 time $66 basis for present value). As the supply of oil becomes tighter, the ready substitute, natural gas, could see its price discount disappear quickly. A stock like buy-recommended Devon Energy (DVN) offers both oil and natural gas at the equivalent of $46 a barrel (McDep Ratio of 0.70 times $66 basis for present value).

Mismatched Expectations Imply Higher Oil Price and Higher Stock Price

Investor expectations of continued growth in global oil supply are probably too optimistic because the statistics are bearing out the notion that growth ended three years ago. Widespread expectations of continued growth in demand cannot be met if supply is flat. Higher price would normally be the balancing force encouraging some users to forgo additional volume because it would be too expensive. Investor perceptions of supply growth may parallel the government forecasts.

A widening gap compared to actual results tells a classic story of expecting the trend of the past to carry into the future. Most of us can readily project trends while anticipating a change in trend is more difficult. The forecast made in 2004 anticipated growth that did not materialize as was the case for the forecasts made in 2005 and 2006. We can’t say that yet for the forecast made in 2007 until time passes, but we have to be skeptical. Consensus price expectations are roughly constant at $72 a barrel for the next six years as indicated in the futures market.

We think the reaching of peak oil production implies higher oil price than in the markets today. Controversial increases in taxes would accentuate weakness in supply and interest rate cuts stimulate demand, thus adding more pressure to drive price higher.We think a gap between peak oil supply constraints and demand growth will be closed by oil price increasing. We think a widening gap between stock price and oil price will be narrowed by stock price moving up faster than oil price.

Originally published on October 2, 2007.