Shiv139

Peak Oil - Are We There Yet?

Very well put together article.

The problem with predicting peak oil is that proven, probable & possible reserves are used. The swing factor which can defer peak oil for many, many years is the unknown. To date just about 1/4 of the earth surface has been explored. With technology now available, shallow water and mid water has been explored for some years. We are now well into the age deep and ultra deep-water exploration. It has never been done before because the price of oil never did justify the investment. Driven by demand for oil from emerging markets in India and China, oil prices have now risen well over the marginal cost of ultra deep-water. As a result, there has been huge investment in ultra deep-water. Coming from this economic viability, we will have increased exploration. This combined with technical feasibility & equipment availability, will ultimately bring new reserves. So yes, we will continue to rush towards peak oil; but we are likely several years away.

In the mean time we are in a demand led secular bull market for oil. Increasing demand with supply side concerns have pushed oil prices ahead of fundamentals. Within this bull we have recently entered a cyclical bear. During this period of the cyclical bear (approximately 1.5 to 2 years), I expect oil prices to revert to economic equilibrium (where marginal cost equals marginal revenue - somewhere between $50 and $70 per barrel); at these price levels investment in ultra deepwater is viable.

Then the next cyclical bull within a secular bull will emerge. Over the course of the secular bull (roughly 2003 to 2019), you will see some things happen:

1. Structurally, the world is less energy intense (a $ of GDP has a smaller energy dependency compared to the past) compared with the seventies. The energy intensity of emerging markets will reduce considerably. This will reduce the impact of oil prices on the real economy; this is a net positive because investment can continue at higher price levels because the real economy is able to absorb the higher price with lesser demand destruction.
2. Since oil is a finite resource, there will be many new conservation technologies which will result in demand reduction.
3. For the same reason, there will be new alternative energy technologies which will reduce dependence on oil.

Today, the oil demand curve is generally inelastic; however, we have now reached that part of the demand curve where the price elasticity is high. At these elevated prices, two things will happen in the long term - (a) the demand curve will change from very inelastic to less inelastic as energy alternatives are adopted & (b) the entire demand curve shall shift inwards as a result of shifts to energy alternatives and more importantly, because technologies to improve oil energy utilization will evolve.

From an investor perspective, oilfield services and drillers are very appealing. Integrated Oil Majors, E&P & refiners too, but to a much lesser extent - today most opportunities in exploration and production are led by the State. In addition, in the years gone past, the majors commanded respect because they had the intellectual property & equipment required by the business; this drove nations to production share agreements with the Majors. Today engineering, IP and equipment can be obtained as a service from fantastic companies such as Schlumberger and Transocean. Yet, at this point in time, because of our entry into the cyclical bear, I would wait for valuations to get better before committing to the sector. Trading position (few weeks - risks are low oil is oversold); short term position (few months) risks are high; long term position (a year) risks are high; secular position (12 years) risks are insignificant. Expect a contraction in valuations in oilfield services; but do not expect it to be very harsh; I would say 50% to 65% from peak value is what can be looked for. For drillers, the backlogs created provide a high degree of stability but leverage could end up being a significant risk if new build contracts are terminated (delivery delays & performance are fairly common reasons for termination).