Penn West: A Low Risk Way of Protecting Your Portfolio Against High Oil Prices

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I just read an article that recaps the Canadian military having peak oil concerns. And I think someone needs to get these folks at the various think tanks a television so they can watch CNBC. Because every time one of those think tanks comes back after doing a few months of hard research they are warning us that the world is facing a potential oil supply crisis, while every day on CNBC I hear that the high price of oil is being driven by speculators and a weak US dollar. Shouldn’t they just save themselves the effort and let the experts on television write their reports for them.

Now who am I to believe? The think tanks that do exhaustive research or the television talking heads who are willing to opine on any subject imaginable so long as someone asks them a question and points a camera at them?

We are at $110 oil in a weak economy, folks. The only thing that stopped this oil train before was a global financial panic in 2008. I expect that as oil keeps going up it will throw us back into a recession at some point and temporarily pop the price balloon again, but then the vicious cycle will resume.

For those keeping track, here are the warnings from pretty credible sources I’ve noticed in the past couple of years. The most recent being from the Canadian military which the Vancouver Sun picked up:

Globally, we find more (oil) all the time, but we haven't actually found as much as we've used in a given year since 1985," said Maj. John Sheahan, another member of the research team.

From the long (term) view, it's guaranteed that something else will take over (as an energy source), we just don't know what or when. . . . Nobody has yet come up with the solution (so) that we can (continue to) do the things we do now and have done for decades. So it is possible that the time line is against us.

Sheahan noted that the price of a full tank of gasoline, even at $100, is a bargain when compared to estimates in some research that it would be equivalent to about 25,000 people each doing one hour of work.

The global quagmire scenario predicts a world ravaged by climate change and environmental degradation in which "markets are highly unstable" and there are high risks of widespread conflicts involving ownership and access to oil, water, food and other resources.

Indeed, the danger of resource wars, both between and within states is acute," said a technical paper produced by the group in December. "Much of the violence occurs in the developing world, as dictators, organized crime groups and revolutionary movements fight for control of increasingly desperate societies. Yet developed countries are by no means immune from strife.

Before the Canadian military, the US military was reaching similar conclusions as reported by the Guardian in the UK:

The energy crisis outlined in a Joint Operating Environment report from the US Joint Forces Command, comes as the price of petrol in Britain reaches record levels and the cost of crude is predicted to soon top $100 a barrel.

"By 2012, surplus oil production capacity could entirely disappear, and as early as 2015, the shortfall in output could reach nearly 10 million barrels per day," says the report, which has a foreword by a senior commander, General James N Mattis.

It adds: "While it is difficult to predict precisely what economic, political, and strategic effects such a shortfall might produce, it surely would reduce the prospects for growth in both the developing and developed worlds. Such an economic slowdown would exacerbate other unresolved tensions, push fragile and failing states further down the path toward collapse, and perhaps have serious economic impact on both China and India."

The US military says its views cannot be taken as US government policy but admits they are meant to provide the Joint Forces with "an intellectual foundation upon which we will construct the concept to guide out future force developments."

And before that there were efforts in Germany and England which drew similar conclusions as reported by the Globe and Mail:

The German study paints a bleak picture of the post-peak world: political power quickly shifts from major oil-consuming economies to major oil-producing economies. Less and less oil is traded on the open market, while more and more is traded between nation states, with national oil companies entering into long-term supply agreements that are tied to broader political and military considerations. And military alliances coalesce around the security of energy supply, rather than between countries with shared political or economic principles.

These military conclusions aren’t influenced by people “talking their books”, they are cold, hard rational conclusions based on data. I’m frightened by the lack of urgency the American government seems to have with respect to securing energy resources for the next few decades. There is no country more exposed to this issue than the United States which requires almost 10 million barrels of oil to be imported every day. This is an issue that needs to be addressed ten years before the crisis hits. I think we might be within ten years of real oil supply shortfall already and we haven’t done anything to prepare for it.

I’m preparing my portfolio by making sure I have plenty of exposure to undervalued oil reserves. There will be bumps along the way, but clearly the next decade is going to bring a very high average price of oil.

And I'm starting to think that the best way to load up on undervalued reserves is through companies that are sitting on vast resource plays that technology is unlocking. One such company that is a pretty low risk way to enter this space is Penn West (PWE).

Penn West has recently moved from an income trust model where most of its excess cash flow was paid out as dividends to more of a growth model. As they step on the gas and ramp up their horizontal drilling production, reserve growth is going to accelerate.

In the past few years in both the United States and Canada there has been a land rush to lock up acreage in resource plays that are newly economical with horizontal drilling techniques. Penn West didn't have to play that game because they are sitting on huge positions in virtually every play that was secured years ago.

Imagine how much more profitable production will be for Penn West, who spent basically nothing on land, than it will be for companies coming late to the party who are spending billions on land alone. It is as if Penn West inherited land that was ten miles outside of city limits, woke up one day and found they now own prime downtown real estate.

Penn West makes an interesting comparison in its recent presentation (.pdf) between their land in the Cardium play in Alberta and a comparable property in the Permian Basin in Texas. The land in the Permian Basin has been previously drilled using 5 acre well spacing. The land in the Cardium meanwhile has been drilled using 80 acre well spacing. The point is that the reservoirs are similar, and there is a whole lot of easy fruit to be picked on their Canadian properties simply by infill drilling to pick up oil that has been left in the ground.

So Penn West is likely going to get a good five or ten years of production and reserve growth thanks to the horizontal drilling revolution. And at the end of those ten years they are still going to be sitting on more oil in place than any other company in Western Canada and by that time there will likely be further advancements in technology to extract even more of that oil.

With a 4% plus dividend and a long runway of growth ahead, I think Penn West could be an attractive and relatively low risk way to protect a portfolio against high oil prices.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.