The End of 'Easy Oil'

Includes: CEO, PBR, SNP, XOM
by: Elliott Gue

The world isn’t running out of crude oil but it is running out of “easy” oil. That is, the massive, technically easy- and cheap-to-produce onshore oilfields that have been the bastion of global production for decades are reaching maturity.

Mounting evidence suggests that the decline rate on these mature fields is a good deal higher than analysts usually include in their models. The faster the decline rate, the harder it is for producers to generate real production growth; companies must first offset lost production. To compensate, producers are tapping complex, distant and expensive-to-produce oil reserves.

In short, increasing real production is difficult and expensive. And short-term hiccups aside, global demand for oil continues to build as billions of consumers in the developing world ramp up their energy use.

Far too many investors failed to understand the extent to which constrained supply and rising demand have driven crude oil prices over the past several years. In the US investors often attribute higher prices to excess speculation or the weak US dollar, but neither of these arguments provides a valid or complete explanation.

While pundits parade these phantoms and developed-world politicians pursue new regulations on speculation, companies worldwide are scrambling to invest in deepwater oilfields, one of the only sources of actual oil production growth. The Chinese, in particular, have aggressively pursued deepwater plays. Soaring investment in deepwater projects is one of the most powerful investment trends resulting from of the end of easy oil.

Case in point: American oil giant ExxonMobil (NYSE: XOM) is in talks with Kosmos Energy to purchase the latter’s 23.5 percent stake in the giant Jubilee oilfield off the shore of Ghana. But Exxon isn’t alone in its interest; China National Offshore Oil Corporation (NYSE: CEO) is in talks with the Ghanian government about making a rival bid for the Kosmos stake. Two of the world’s largest energy firms are competing over a less than one-quarter share in a deepwater field, illustrating just how crucial deepwater oilfields have become to the global supply picture.

And Jubilee isn’t the first field to attract that sort of global attention and, in particular, interest from resource-hungry China. Back in February when oil prices languished under USD40 a barrel and the global credit crunch limited access to loans, many investors wondered if Brazil’s national oil company (NOC), Petrobras (NYSE: PBR) would be able to justify continued investment in several massive deepwater oilfields discovered in the Santos Basin. These fields take years to bring into production, requiring billions in investment before generating a single dollar of revenue.

But China rode to Petrobras’ rescue. China Development Bank lent USD10 billion to Petrobras in exchange for an agreement to supply oil to Sinopec (NYSE: SNP).

To profit from the boom in deepwater spending, focus on The Deepwater Golden Triangle that connects three hot spots for deepwater exploration and development: Brazil, the Gulf of Mexico (GOM) and West Africa.

Oilfield consulting firm Douglas-Westwood published a deepwater market report earlier this year covering the period from 2009 to 2013. The firm expects deepwater spending to top $160 billion over this period, an average of around $32 billion each year. And given the recently announced deepwater finds since the study was released, that estimate may actually prove to be conservative. Close to 80 percent of that spending is destined for the Golden Triangle--whenever there’s a mound of cash that large heading for a particular market, investors should look for ways to profit.

In the last issue of my subscription-based newsletter, The Energy Strategist, I covered all three legs of The Deepwater Golden Triangle. Here’s a closer look at one of the most exciting legs: the fields off the shores of Brazil.

Brazil is currently the second-largest oil producer in South and Central America--despite its problems, Venezuela still has the edge. But there’s an important difference between Brazil and Venezuela: Brazil’s oil production is rising rapidly, whereas Venezuela’s output is on the decline. Over the past decade, Brazilian oil production has increased 90 percent, or roughly 900,000 barrels per day. Meanwhile, Venezuelan production has fallen more than a quarter, about 920,000 barrels per day.

This trend is expected to continue. Recent moves by the Venezuelan government to nationalize the oil industry and renegotiate contracts with foreign companies operating in the nation have resulted in the exodus of several key producers. To make matters worse, some of Venezuela’s most promising oil plays are relatively difficult and capital-intensive to produce; without help and capital from abroad, Venezuelan oil production will continue to fall.

The picture could not be more different in Brazil. Although proposed oil laws have made investors jittery in recent weeks, the fundamental impact of these new laws would be relatively benign. Several foreign companies are participating in the country’s recent deepwater finds; Brazil has been among the best markets in terms of granting access to resources to foreign producers.

Brazil is unique among global producers in that the vast majority of the nation’s oil production comes from offshore fields. The national oil company Petrobras (NYSE: PBR) accounts for more than 95 percent of Brazil’s production, and 88 percent of this output comes from offshore fields. The contribution of offshore fields to total production has risen steadily in recent years from just over 70 percent in the mid-1990s; offshore and, in particular, production from ultra-deepwater fields is expected to yield most of Brazil’s production growth in coming years.

Historically, the Campos Basin has accounted for most of Brazil’s offshore oil production. In 2008, for example, Petrobras produced more than 1.5 million barrels of oil per day from the region, nearly 90 percent of the company’s total output. But thanks to several recent deepwater discoveries in the Santos Basin, production from that region is expected to ramp up and actually overtake the Campos Basin. The Santos Basin is located roughly off the coast of Rio de Janeiro, just south of the Campos Basin.

Many of the most promising plays recently discovered in the Campos and Santos Basin are deepwater pre-salt fields. Pre-salt oilfields are located deep under the seafloor, under a thick layer of salt; the extreme pressures and temperatures at these depths present myriad challenges to drillers. Penetrating the salt layers is notoriously difficult, and pressures encountered at those depths stress even the most advanced oilfield equipment. Managing temperatures can also be a big challenge, particularly as high-temperature oil moves through pipes that run through extremely cold, deep waters near the sea floor.

Temperatures in a deepwater oilfield can exceed 300 degrees Fahrenheit (150 degrees Celsius) and pressures can top 10,000 pounds per square inch (psi); for comparison, normal atmospheric pressure on Earth at sea-level is just 14.7 psi.

Using cutting-edge technologies and techniques, however, producers are successfully drilling wells in pre-salt regions.

In aggregate Petrobras now plans to spend a total of $179.4 billion from 2009 through 2013. Roughly 60 percent of that amount will go to exploration and production (E&P), while 25 percent will go to downstream/refining operations. That works out to an investment of over $104 billion in exploration and production over the next few years, a major boon for oilfield services and equipment companies that specialize in the technology needed to produce these complex offshore fields.

This latest spending plan represents a $47.9 billion increase over the company’s previous figures; the majority of this money will fund new projects and field developments. And Petrobras’ long-term plan calls for spending more than $111 billion from 2009 to 2020 to develop its pre-salt plays.

The reward for all this spending and new field development: Brazil’s leg of the Deepwater Golden Triangle will generate some of the fastest oil production growth of any oil-producing region of the world out to 2020. The graph below provides a closer look.

Source: Petrobras

This graph tracks how much oil, natural gas and natural gas liquids (NGLs) Petrobras has produced since 2001 and depicts the company’s forecast production through 2020. As you can see, Petrobras has grown total production roughly 5.6 percent annually since 2001. Management expects annualized growth to reach 8.8 percent through 2013 and 7.5 percent from 2013 to 2020.

If Brazil meets its goal of producing a total of 5.729 million barrels of oil per day, its oil production will be more than double current levels. To put this into perspective, consider that Petrobras projects it will produce more oil than giants Total (NYSE: TOT), Chevron (NYSE: CVX), Royal Dutch Shell (NYSE: RDS.A, RDS.B) and ConocoPhillips (NYSE: COP) by 2013.

Even more impressive, if Petrobras meets its 2020 production targets it will eclipse ExxonMobil, which currently produces around 4.25 million barrels of oil equivalent per day. In that event its total reserves would be between 25 and 30 billion barrels of oil equivalent, also well above Exxon’s reserve base. Given these statistics, it’s not hard to see why there’s so much excitement about Brazil’s deepwater oilfields and Petrobras.