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The chart above could easily be passed off as that of a high-flying NASDAQ stock, many of which have experienced parabolic rises of 100% and more over the past year. But it really is a chart of the price of crude oil, the commodity that, together with gold, has come to be viewed as a barbarous relic in our 21^st century’s “wired” economy.

Even its recent price rise has brought oil no respect. We recently heard commentators remark on CNBC that the price of oil was not relevant to the economy’s new technology leaders because information did not require hydrocarbons to travel in cyberspace. 

We feel differently about the relevance of black gold. But, more importantly, we are intrigued by the fact that economists and politicians have become convinced that there is a chronic glut of oil in the ground, ready to be poured onto the market at the right price. This is in sharp contrast to the late 1970s and early 1980s, when these same economists (their parents, really) were arguing the exact opposite -- that the growing scarcity of proven reserves would lead to an ever-rising price for oil.

Many professionals still shun oil-related investments for fear that the return to market of currently shut-in production will push oil prices back to the low teens. We, on the other hand, feel that the collapse of oil prices in 1998 was principally the result of the contraction of demand caused by the collapse of the Asian economies and its collateral effects around the rest of the globe. For this and other reasons, we believe that we are in the early stages of a prosperous period for investors in oil-related companies.

Sucking Them Dry

A dirty little secret that is starting to spill out around the oil patches of the world is that the production of oil is not as easy as it was only a few years ago.  The world’s known reservoirs of oil and natural gas are being drawn down much faster than had been anticipated, leading many oil companies to reduce their estimates of future production from these fields.

Matt Simmons, the president and guiding light for Simmons & Co., an energy-focused research and banking firm in Houston, Texas has pointed out that, over the last year, there have been significant discrepancies between reported and traceable inventories of oil.  The “phantom” inventories represented by the difference at one point were so large that there was nowhere in the world that they could physically have been stored.  From this, we infer that some of the production that was reported may not have been actually produced. What if OPEC’s remarkable compliance with its new, self-imposed production quotas, rather than demonstrating a newfound discipline, indicated the cartel’s inability to produce much more than it has been doing?

Technology and Depletion

The most overlooked factor in today’s supply/demand equation for oil is the accelerating depletion of existing oil fields. The reservoirs from which oil and gas are being produced are running out at a much faster rate than originally expected based on the historical norm.   There seems to be two main causes for this new trend: age and technology. 

In many places, especially in the Gulf of Mexico, many of the larger fields have been producing for two or three decades. These fields simply are not as young as they used to be and the production coming out of wells in older fields is naturally lower than for younger fields with higher-pressure rates.

More importantly, the technology used to pull hydrocarbons out of the ground has improved significantly in the last five years or so, with perverse effects.  It has increased throughput from given reservoirs, with a lot more oil coming out of each well at a faster rate than before. As a result, current production is higher, but the ultimate level of recoverable oil has not changed commensurably, so that the ultimate life of a field has been shortened. In effect, one could liken “proven” reserves to an inventory of producible oil. Technology has allowed oil companies to invest less into drilling to “prove reserves”, in the same way that just-in-time techniques have allowed manufacturing companies to work with a lower investment in inventories. But the reduced need for drilling that has resulted is only a temporary phenomenon, and new reserves eventually must be proven to meet the world’s growing demand for oil.

The global oil industry is generally expected to produce about 76 million barrels of oil per day (mm/bpd) in 2000.  Optimistically, in view of the above comments, this forecast assumes that the production shut in by OPEC (3mm/bpd or so) will come back on stream, and that Venezuela can produce 2mm/bpd more than they already are. 

Demand Keeps Growing

On the other side of the ledger, this forecast assumes that supply will equal global demand, which is thus also projected at 76 mm/bpd. But it seldom works out so neatly. For example, consensus projections of a global GDP growth of 4%, or so, generally assume that the US economy stays reasonably strong while Japan remains lackluster, thus holding global demand for oil in check.  This is a tenuous prediction. Many of the bad things that happened to the global oil market were related to the Asian depression of 1997-1999.  However, even with this depression, hydrocarbon consumption remained quite stable, weakening only in the most economically sensitive industries.  We think that the global economic recovery will probably surprise on the high side, led by the rebound of less-developed, faster growing Asian nations like Indonesia, Malaysia and Thailand, whose economies are energy and commodity intensive. Many of these formerly thrashed countries are already experiencing significant “V” shaped economic recoveries.  And, if Japan and some of the European giants like Germany also confirm recent indications of a pick up in economic activity, resulting in what forecasters call a “Synchronous Global Recovery”, the current forecast of global demand for oil may be significantly understated.

Back To Business

This leads us to our main point: with continued growth of demand, and depletion ravaging some of the deposits expected to produce a large part of the world’s oil, where will the supply come from?

Recent studies have shown that the decline rate (the rate at which the flow of oil or gas from a field falls as production proceeds[i]) for many major fields across multiple geographies is accelerating much faster than originally budgeted by producers. These surprisingly high decline rates are showing up in areas where expectations for continued production growth have been “baked into” the consensus opinion of forecasters.

One such area that remains a mystery is OPEC, which is responsible for the lion’s share of the globe’s production. OPEC’s output in 2000 is expected to be approximately 30mm/bpd, of which the majority will come from Saudi Arabia.  In 1999 the cartel shut down approximately 3mm/bpd of production across its member nations, to help move the price of the commodity to a more stable range. Not surprisingly, the wall of worry facing oil is caused by the fear that OPEC will bring all of this production back on and crater the oil price again.

What we see, on the contrary, is growing evidence that OPEC members cannot bring all of this production back, possibly because they have been suffering higher than anticipated decline rates. This places them on a “treadmill” in terms of finding new properties to replace the ones that have been drawn down.

We are not so foolish as to forecast a structural shortage of oil, but we do see a growing impetus for major oil companies to boost oil production -- not only to accommodate growing world demand, but also to make up for the faster-declining production from older fields.  This, in turn, will force oil producers to work harder on the exploration front.

Usually, this would not be a difficult task.  It is not uncommon to sit down with an oil company and be regaled for hours with stories of the wonderful prospects that the company has on their radar screen.  However, the precipitous decline of oil prices in 1998 caused exploration spending by both independent companies and the major integrated oil companies to collapse by almost 40%.  If you look at the chart below (based on data supplied by the firm of Howard, Weil & Co.), you will see that spending in 2000 is planned to increase by more than 30% from the trough of 1999.  However, this does not even bring these expenditures back to their 1997 level, when production was more than 2mm/bpd lower than in 1999.   Yet, replacing production “through the drill bit”, as they say in the oil patch, must be a significant component of any production increase. 

Another way for an oil company to add to reserves and production is through acquisitions of other companies or properties.  However, with some of the disastrous results of some recent acquisitions, such as the Burlington Resources and Poco Petroleum combination, the jury is definitely out on consolidation – at least in the independent oil company sector. Moreover, mergers may improve an individual company’s lot, but they do nothing for the global supply of oil – in fact, often just the contrary.

What Does It All Mean?

What are our conclusions here?  They are threefold:

First, we feel that global oil companies will have a hard time meeting the supply goals set by experts for 2000, e.g. 76mm/bpd of production. They will have an even harder time if demand exceeds current forecasts. This is the primary reason why we expect a sustained high price for oil.

Second, we feel that higher levels of capital spending will be needed to achieve meaningful production increases – perhaps even to avoid decreases. Thus, drilling must rise to a higher plateau over the next two to three years, regardless of what happens to the price of oil (save an unlikely collapse). It is supply concerns that will drive greater exploration over the next few years.

Third, it is clear that oil service companies are “the low hanging fruit” in a scenario of continued strong oil prices and higher levels of spending by independent exploration/production companies.

Despite the rise of oil’s price from its recent lows near $10 to the $26 range now, the cost of hiring a drilling rig (rig rates) remains 60-70% below the highs of 1997, as does the utilization rate of this type of equipment. As utilization and rental rates creep higher, margins at the oil service companies and drillers will begin to expand at a much faster rate than in the past, because companies have reduced their cost structures and removed unnecessary overhead during the industry’s decline from its 1980 peak. 

When margins start expanding, almost all of the solid companies in the Oil Service Index (OSX) will benefit.  One of our largest investments in this group is Nabors (NBR). This well managed company is not a pure oil-service company in that it owns, rents and operates drill rigs for onshore and offshore activity. But it has a solid balance sheet and is in a unique position due to the scarcity value of its major assets – drilling rigs.  A statistic to note is that if we move to levels of rig rental rates seen as recently as 1997, the company could earn nearly $5.00 per share in 2001 or 2002.  The stock currently trades near $30, and we should point out that, even in 1997, equipment-rental rates were well below the levels needed to justify financing the construction of new platforms. This implies that Nabors’ next up-cycle could last more than a couple of years.

The exploration and production sector makes for a harder call. Some companies in the group represent interesting opportunities, but the capital they will need to spend to reverse the starvation of the past 18 months makes us more prudent.

We know that headlines about OPEC, Iraq and gasoline prices, and fuel-efficient cars make for choppy trading over the short term. But we are patient investors, and have positioned our portfolios to take advantage of what we see as an excellent opportunity in an overlooked and unloved area of the market.   In the end, we feel that this is a “heads you win, tails you do O.K.” scenario, as many of the oil service companies will prosper even if we have slightly lower oil prices.

Liquidity factors are compelling as well. The surge in technology stocks has taken that group from 10% of the S&P 500’s total capitalization in 1980 to over 27% today, implying huge inflows of portfolio capital into that sector of the market. That capital has come mainly from the energy sector, which in 1980 accounted for nearly 30% of the S&P 500’s total market value and currently represents less than 6% of that index.   While we do not see that trend fully reversing, as there are many exciting things happening in technology, it is easy to see that there is no excess of optimism over the energy group, even at $26 oil.  When investors’ consensus perception of the oil-service companies’ potential becomes more sanguine, the door may well seem very narrow.

January 2000
^© Tocqueville Asset Management L.P.

We would like to thank Simmons & Co., Houston, Texas for all of their assistance in the research for this article