The Truth Behind Low Oil Prices
Watching for the Buying Opportunity of a Lifetime
Yesterday, as I filled up with sub-$2 gas for the first time in years, I was so amazed and happy that I had to fire off a "tweet" about it. (You can follow me on Twitter as "nelderini") Wow, a fill-up for under $40! That's great-a little more money to work with for the holidays.
My elation was short-lived though, as I thought again about the threat that low oil prices pose to the supply in the longer term.
Anyone can see the obvious risk. With the price of gasoline so low, drivers will be more inclined to take those extra trips, or maybe bring the Hummer out of retirement. The recent surge in mass transit ridership may fade away to be replaced again by gridlock. A resurgence in demand now cannot be met by an increase in supply.
There is a not-so-obvious risk as well: retreating investment. Two key factors are slowing the pace at which the industry is developing the new oil and gas projects that are so critical to our future supply.
The first is simply price. As oil prices crashed from $147 this summer to around $50 today, developers withdrew their commitment to drilling new wells and building new distribution and refining projects. Under a rule-of-thumb production cost for a new, marginal barrel at around $65 today, it simply doesn't make sense to throw millions of dollars at drilling new wells when oil futures are selling for $50.
French oil company Total's CEO recently warned that at $60 oil, "a lot of new projects would be delayed."
The same thing is happening in natural gas. At a rule-of-thumb production cost of around $6.50/MMBtu (million Btu), or roughly $6.32/Mcf (thousand cubic feet), unconventional gas projects like the ones we are depending on for future US gas supply become uneconomical. Yesterday, Nymex Henry Hub futures closed at $6.49.
A second, more insidious factor is quietly eroding hopes for our future oil and gas supply however, and that is the continuing global credit crisis. As banks remain reluctant to lend each other money—even money freely given to them by Stammerin' Hank at the Treasury for that very purpose!—credit has also become hard to come by for anyone trying to start a capital-intensive project. And all energy projects need a great deal of capital.
Consequently, a growing drumbeat of news reports about energy projects of all kinds being delayed, cancelled, slowed, or otherwise curtailed has been issuing from the energy sector. Yet the Street seems not to have recognized that the slowdowns will limit supply in just a few years.
Instead it has continued to bid down prices of oil and gas, and the companies that produce them, with the belief that a slower economy means slower demand and a glut of supply.
The data certainly supports that view. Chinese imports of diesel and gasoline have dropped to the lowest level in 14 months, demand projections are being slashed worldwide, and US oil consumption alone is down nearly 1 mbpd.
But by focusing on near term supply, the Street is really fighting the last war when it should be pricing in a long-term shortage. Investment is already falling short of what is needed to ensure a future supply of those marginal, expensive barrels that everyone is counting on.
(In the same way, I have been concerned that with their current focus on deflation, the Fed will miss the turn heading into the next inflationary phase, when oil and gas and commodity prices will once again shoot for the moon. I don't know when it will happen, but at some point, probably within the next year to year and a half, I expect a major reversal of the current trends. The dollar will sharply weaken in recognition of the Treasury's unprecedented printing of money, which could send oil prices back up to $150 and beyond in short order, taking the rest of the commodity complex with it.)
The hardest-to-produce barrel, of course, is the most expensive one and the most vulnerable barrel in an economic crisis. That honor belongs to the tar sands producers of Alberta, where the production cost from existing projects is roughly $40/bbl, from new projects about $65/bbl, and from future projects an estimated $85-$100 per barrel. Tar sand project costs ran up approximately 50% this year even as oil prices fell, putting a double-squeeze on tar sands producers. Companies are now being forced to cut back on financed development and try to fund their expansions out of cash flow.
Here are some very abbreviated highlights of energy project delays announced in the last month alone:
Shell, Suncor, Petro-Canada, Nexen, Teck Cominco, UTS Energy and Opti Canada have all announced delays in their planned investments in the tar sands projects of Alberta. Suncor, for example, cuts its capex budget from $10 billion to $6 billion (Can.) Companies with joint-venture tar sands interests in production, refining and pipelines also announced delays, including EnCana, StatoilHydro ASA, Value Creations, Imperial, and Enbridge. Hundreds of billions of dollars in commitments have been withdrawn or delayed.
Some analysts have predicted a 10-15% drop in capital spending in western Canadian oil projects next year, while the Canadian Association of Petroleum Producers cut its spending forecast by 20%.
The Saudi Aramco executive director of affairs said the Saudi oil company is reassessing all of its projects in light of skyrocketing costs and tight credit, and was uncertain about the future of global oil demand. Several planned field expansions have been put on hold which would have sustained the country's oil flows after 2012.
The state-run Nigerian oil company NNPC is having difficulty guaranteeing funding for its share of joint ventures with Royal Dutch Shell and Exxon Mobil, and development progress has halted. Nigeria is one of the few remaining countries in the world where oil production may yet be significantly expanded.
A director at Oil & Gas UK reported that 60 of 170 new oil and gas exploration projects in the North Sea could be delayed indefinitely due to poor economics. The chief executive of Venture Production PLC, a company which specializes in producing the final dregs of depleted North Sea fields, says the production cost of the field's remaining oil will be in the $100/bbl range. Consequently, the chief executive of Edinburgh-based Melrose Resources says, "I think there will be an abrupt cessation of activity in the North Sea. It's not just the oil price but the access to finance." Oil and gas juniors looking to exploit the dregs from old fields are finding it difficult to round up financing to move their projects forward.
Petrobras, the world's hero of new oil production from Brazil, delayed release of its investment plan due to market "uncertainty." The hardest-to-produce barrels from its offshore subsalt fields might have a production cost of $50 or more, and will require hundreds of billions of dollars, much of it from credit, to produce. The company has delayed the construction of 28 deepwater drilling rigs until next year.
According to an analyst with Pritchard Capital in Houston, about a fifth of the deepwater rigs planned for construction by 2012 have been delayed or cancelled. Such rigs can cost up to $800 million each.
A Wood Mackenzie report concluded that four out of five refinery construction projects announced worldwide since 2005 would be cancelled.
A lack of foreign investment and domestic credit has indefinitely postponed $30 to $40 billion worth of planned expansion in new biofuel projects in Brazil.
A planned $800 million coal-to-liquid fuels plant in West Virginia has been shelved due to "the current state of U.S. credit markets."
In the US, 66 of 262 approved wind farms have been cancelled or postponed due to poor economics and a lack of credit.
A key backer of a major offshore wind project in the UK was unable to raise its share of the project's financing and has pulled out, leaving Norwegian oil company Statoil looking for a new partner to help build the project.
Setting up the Air Pocket
If we are, as I believe, less than halfway through the current economic downturn (recession, depression, choose your word) then we should take the history of the Great Depression into account. Here's an interesting chart showing that non-residential investment—the category that includes big heavy equipment projects—fell more than all other sectors over a period of four years, and its recovery was slow.
Therefore it will take some years before investment returns to the levels needed to support future supply flows against what we know to be serious decline rates. Lead times for oil and gas projects are long, and industry responses to economic news usually lag by six months or more.
Under-investment is precisely what the IEA warned about in its recent World Energy Outlook report, in which they said the world would need to invest over half a trillion dollars per year for the next 22 years just to maintain current supply levels. (See "IEA Oil Report: 'Time is Running Out'" for my analysis of the report.)
I find it hard to imagine any scenario under which that sort of investment is made in current production while the world is going through a global recession and economic contraction...let alone the $35 trillion the agency believes will be needed to meet energy demand and carbon control targets by 2030.
This recession will ultimately set up an "air pocket" in supply. As the global economy recovers, say 18 months from now in mid-2010, and energy demand returns, we could find ourselves without the ability to increase supply because we didn't make the necessary investment today.
By 2010 we will also have reached global peak oil (the "all liquids" peak). The earth will finally say "She can't take anymore, Captain, I'm givin' ‘er all she's got!"
At a petroleum conference in Abu Dhabi earlier this month, the UAE Energy Minister admitted the reality of peak oil, saying "It is common knowledge that the age of easy oil is gone forever," while others at the conference, like BP Chief Executive Tony Hayward, worried aloud about what would happen when the economy rebounds, saying, "Increased demand will stretch the system to its limits, and this will cause another upward spike in the price."
Until the credit markets are cured, the dollar weakens, and oil prices settle firmly back in the $70-$100 range, it's hard to imagine the requisite trillions of dollars flowing back into new oil and gas projects.
So enjoy that sub-$40 tank of gas while it lasts. Within the next year to a year-and-a-half, I think we'll see another astonishing run in commodity prices as money seeks shelter from crashing currencies, and the world begins to price in the permanent peak of supply.
When that happens, we'll be perfectly positioned to pick up the best oil and gas stocks at unbelievable bargain prices.
Until next time,
P.S. Preparing for that "air pocket" in supply should continue to echo in your mind as we move closer to a global peak in oil production. However, finding the right energy plays can be extremely difficult for the average investor. Soon, the window of opportunity will be closed for investors. Make sure you're not left in the dark.