Global Oil Fundamentals

By: Scott Wright | Sat, Dec 3, 2005
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With oil being a dominant topic in the media today, prudent investors and speculators have capitalized on the financial fortunes presenting themselves in this soaring commodity. Oil companies are scoring record profits and their stock investors have been greatly rewarded the last several years.

As stock investors we continue to look for opportunities to multiply our capital in riding the momentum of this bull market, but has this oil bull lost its steam? Will we ever see $70 oil again like we did at the end of August? Even at around its $57 level today it is still nearly three times what it was at the beginning of 2002. Oil stocks would surely lose their luster if there was a continued decline in the price of a barrel of oil.

Why the price of oil should continue to rise: Americans along with much of the world will long remember the so-called oil panic of 2005. After a series of powerful hurricanes pounded the Gulf Coast and came ashore in the southern part of the United States, not only did it trigger various tragic disasters, but it caused sizeable disruptions to our precious oil supply. It makes one wonder though, if these storms were to have hit other parts of the world that are not as industrialized and oil dependent as the United States, would its global price have risen so drastically?

Maybe not, but only the layperson witnessed a drastic rise. In the month leading up to the peak of Katrina's damage, oil did in fact increase by about $10 per barrel. But before that month, in which nobody could yet fathom the hurricanes' impact, oil was already trading at $60. Market forces were well at work before the hurricanes, and oil is simply following trend as a dominant member of the great commodities bull of the 00's.

What the hurricanes did do is open the eyes of the everyday person as to how valuable oil truly is in their everyday lives. And regardless of how fast oil rises, when it starts to noticeably affect consumer finances this oil bull will demand mainstream attention. It was at the gas pump in the wake of the hurricanes when $3, $4 and $5 gas spurred this attention. It certainly wasn't the magnitude of that experienced in the early 1970s, but people quickly forget how easy it is for panic to ensue.

Interestingly, gasoline is still much cheaper to buy in America than most other countries in the world. While I was skipping around Europe earlier this year with my family I found that, after the poor currency exchange rate of the mighty dollar was taken into account, it cost more than twice as much to fill my tank in most countries. Americans would still have it good even if gas never again went below the panic-stricken $3.00 per gallon mark.

Truth be told, the simple economic imbalance of current and future supply and demand is what's been driving up global oil prices, not the hurricanes. Uncertainty and instability can certainly make some noise, like such natural disasters as hurricanes, the war in Iraq, Middle East tensions, reserve integrity, the instability of key oil-producing governments and terrorism. But even with this global oil demand has been on the rise, and this is the ultimate driver of its price.

Our first chart below displays global supply and demand figures provided for us by the Energy Information Administration (EIA). The EIA is the statistical branch of the Department of Energy that provides a plethora of useful economic analysis and data on domestic and international energy. The data on this chart represents annual oil supply and demand, or production and consumption, through the second quarter of 2005 represented in millions of barrels of oil per day.

As you can see there has been an incredible increase in oil demand over the years. To put it in perspective, in 1970 global demand was just over 45mbpd. Thirty-five short years later this demand has shot up by 84% to over 83mbpd and will be at a double in the ensuing years to come.

Demand is sloping up as we live in an industrial and high-tech era that requires energy in some form to produce and transport virtually every product we use and consume today. Super economies in Asia are emerging and growing at a pace so rapid that their insatiable demand for oil can barely be met. The chart above shows supply limping along barely able to keep up with demand, but how long can this be maintained?

If demand was to drop off then supply would be more manageable, but that is not about to happen in the foreseeable future. According to the 2005 International Energy Outlook (IEO), which represents the EIA's assessment and outlook for the international energy markets, global demand for crude oil is forecasted to exceed 119mbpd by 2025. This represents a massive 45% increase from today's levels. And being that these are government figures I would be inclined to tag this as a conservative estimate and would expect this number to be even higher.

The IEO projects that of its forecasted 41mbpd increase from 2002 through 2025, 61% of the increase will occur in the transportation sector while 28% of it will occur in the industrial sector. Those increases will be spurred in large part by the emerging markets of China, India and other Asian countries in which the IEO expects a combined 3.5% increase in oil use per year through 2025.

When today's and tomorrow's global demand for oil is put into the big picture there is no relief in sight. It is no wonder supply worries are coming to surface. Will supply be able to keep up with demand in the future, and if so at what cost? Global inventories have been unusually low in recent years and the tightening of supply relative to demand is always going to upwardly affect the price of any commodity, especially one as essential as oil.

In order for supply to keep up with forecasted demand, reserves are going to need to be tapped and capacity will need to be increased. The world, especially the United States, is already having capacity issues and is in dire need of new refineries. Refineries are expensive and time consuming to approve, contract and construct. High oil prices will be the integral incentive for these refineries to come into fruition.

As for where the supply will come from, the EIA reports worldwide proved oil reserves, published by the Oil & Gas Journal, to be estimated at 1.2 trillion barrels. But how easy is it going to be to extract this oil from the ground and refine it?

Just like any other underground commodity the easiest and cheapest oil is pulled from the earth first. As this easy oil slows down or runs dry, it becomes more expensive to extract and refine from those reserves that are more difficult to recover and may contain oil that is not as pure. Light sweet crude oil is much cheaper to refine than sour oil because of its differences in viscosity and sulfur content.

On average, it can now cost $10 - $15 more per barrel to refine sour crude than sweet. And because the quality of the oil drilled these days is not as good as before, we run into even further refining capacity issues. You can't just refine any grade or quality of oil in any given refinery. In order to convert a sweet refinery into a sour refinery it can take many years and cost hundreds of millions if not billions of dollars. So it's not just an overall capacity issue, it's an oil quality capacity issue.

Now if the global reserves reported are in fact accurate, this only represents approximately 42 years of global oil supply remaining at the current annual production rate using the 30 billion barrels produced in 2004. With increases in production this would prove to be even less. In order for oil countries/companies to maintain or increase production life, reserves need to be continually renewed. It is becoming vastly more difficult for countries/companies to renew oil reserves these days as the discovery of new oilfields is very rare.

There are also critics of this global reserves number that claim it to be far overstated. The Middle East commands nearly 60% of these reserves and in many of these countries there is no way to audit their reserve estimates. Many oil professionals are highly skeptical of the quantity and quality of oil lying in the deserts of the Middle East. Even recently Saudi Arabia has had to publicly defend itself from scrutiny over its reserve estimates.

Global oil production going forward will become more costly and will run into many challenges in order to keep up with demand. As long as demand continues to dictate and even outpace supply, the only way to attain an economic balance is for prices to continue to rise. Until alternate energy sources can make enough of an impact on oil consumption or until they figure out how to efficiently extract oil from the faces of teenagers, demand for oil will not subside.

Now as we mentioned earlier, oil is a finite and non-renewable resource. Quantity and quality of oil cannot continue to rise and improve forever. There will be a peak in global oil production at some point in the future either when alternate energy use makes enough of an impact or more logically when supplies diminish.

There are many schools of thought and theories about the future peak in global oil production. A popular one is the Hubbert Peak Theory. This theory graphically forms the shape of a bell curve in which the peak of the curve establishes a peak in global oil production. This peak is associated with a given time in the future in which oil production would never exceed it and is followed by a descending slope in production until oil reserves become completely depleted.

Its creator, geophysicist M. King Hubbert, predicted with his theory in 1956 that oil production in the United States would peak by 1970. This prediction proved to be not far off as U.S. oil production did in fact peak in 1971 and has been gradually decreasing since. In its design, Hubbert's methodology for the peak took into account many factors. Many of the same factors, such as reserve estimates, demand estimates, production estimates and reserve recoverability, are still considered in today's forecasts and theories even though skyrocketing demand is escalating at a much faster pace than Hubbert or anybody in the 1950s probably imagined.

Many experts believe we have already reached the global peak for light sweet crude production, and Hubbert's prediction for an overall global peak is approximately 2008. This seems highly unlikely because of the production technology we have today. But interestingly, many of us may still see this peak in our lifetimes. The IEO predicts a peak in world oil production around 2030, which is probably conservative and would lead me to lean towards a sooner date. Folks, this is not too far off.

What investors can do about it: The fact of the matter is oil demand is on the rise and supply and efficient recoverability will continue to challenge this commodity's resilience. So if today's high oil prices are not enough to curb demand, they should only continue to rise.

Chances are this oil bull has not lost its steam and there should still be plenty of opportunities for stock investors to capitalize on it. As investors and speculators, we need to stay on top of current global oil economics and take advantage of the oil companies that have the best positive leverage to an increase in the price of their underlying commodity.

In the past several months at Zeal we have centered a good deal of focus on this ongoing oil bull market and are identifying tools and resources on how to trade it profitably. In addition to futures trading, stock trading presents wonderful opportunities for investors and speculators alike to profit on this oil bull. In addition to identifying the individual stocks primed to give us the best returns, the timing of our trades is equally important.

In analyzing the oil-stock sector our best proxy for trading is the popular Amex Oil Index (XOI). Since the XOI is an index that we are paying particularly close attention to and are using to help us with our technical trading signals, it is worth a closer look into the fundamentals of its components and its relevance to the global oil industry.

The XOI is currently comprised of 13 major oil stocks. Our next chart below shows where their combined annual production ranks compared to overall global oil production. As you can see, these publicly traded giants that drill oil all over the world consistently pump out approximately 16% of the world's oil supply. This showcases the legitimacy of the XOI as a technically measurable representation of the oil industry useful in gauging overall stock activity relative to the action of its underlying commodity.

Notice in the time period above that the production rate for these companies on a percentage basis has kept up with global supply increases. This global production data is once again gathered from the EIA, but in order to get combined production data and history estimates for each of the XOI component stocks, I had to pull and extract data from their financial statements for about the last ten years in order to sum it all up.

Scouring through these financial statements allowed me the opportunity to pull other important pieces of data, but also reminded me of the countless mergers and acquisitions within this industry. Nine of the major producers have had at least one significant merger or acquisition in the last eight years. It is easy to tell what some of them were by their current names, but some were not so memorable or distinguishable. Either way, it was a difficult and arduous task that seemed like constructing a family tree from scratch in order to get all the appropriate data gathered.

The other story this tells is in order for these companies to compete globally by maintaining and increasing overall production rates, they are virtually forced to consolidate. This turns them into the big bad oil companies they are today, awakening the anti-capitalist and anti-free-market dreamers to get up in arms over the perceived power and control they think these companies have over global oil supply and pricing.

Just like precious metals miners, these companies are positively leveraged to the increase in price of their underlying commodity. Their overall expenses to drill and refine each barrel of oil stay relatively fixed aside from gradual inflationary pressures. Yet as oil prices shoot north each dollar they go up is a dollar added directly to these companies' profits.

Oil companies the last few years have turned legendary profits which in turn has generated great rewards for stock investors. But there's that group of people out there that just don't take a liking to this. These folks that take particular offense to this are simply not educated in economics and capitalism. These are the ones that over time have blamed oil companies/countries/organizations for intentionally colluding to artificially inflate the price of oil.

It has become sport to blame oil companies for high energy prices, especially with record profits hitting their financials, but this is utter nonsense. Unfortunately some of those haters happen to be running our country. And who better to blame for high energy prices than the CEOs of these companies?

Congress recently stooped to a new low by forcing top oil company CEOs to testify in front of the Senate Energy and Commerce Committee about their record profits. They tried their hardest to defame, embarrass, falsely accuse and humiliate these CEOs in front of the country.

These senators only succeeded in humiliating themselves with their lack of knowledge of economics and how to run a business. ExxonMobil CEO Lee Raymond tried explaining the simple economics of supply and demand to these senators several times, but they still admittedly didn't get it. It's scary that these public bureaucrats have policy-making power yet they don't understand simple economic fundamentals or how private enterprises are managed.

What they can't seem to grasp is these record profits are what is needed to help bring oil to the next generation. In addition to the billions of dollars that need to be spent in repairing hurricane damage, oil companies have enormous exploration and construction costs. If oil prices weren't so high and profits weren't as large, there would be no incentive to explore for future reserves or build the next producing oil rig or refinery.

These massive profits are mostly absorbed into the future viability of these businesses. Ultimately the performance of these oil giants that comprise the XOI serves as a good barometer of the health and resiliency of the oil industry.

Another product of my financial-statement research was to gather these oil companies' reserves. Publicly traded companies listed on American stock exchanges are required to have extensively audited reserves in order to prove their future viability. Interestingly, even though XOI components combine for 16% of global oil production, their combined reserves only amount to 4% of global reserves.

Many nationalized oil producers, particularly the Middle Eastern and African countries, tend to not have the strict guidelines these companies do in verifying and proving their oil reserves. So as we mentioned above, it will be interesting as time goes on to see if these countries can pull the oil they say they can.

As you can see on the chart below, the XOI components have done a sufficient job renewing their reserves thus far. With this, their average production life has been hovering at only 11 years at existing production rates. It's no wonder they feel pressure to consolidate.

At the end of 2004, combined XOI reserves were at 52 billion barrels of oil (not including natural gas equivalents). These companies are producing nearly 5 billion barrels of oil per year, but if they want to maintain the 16% global production rate, this will have to increase to over 7 billion barrels per year by 2025. In order for this to happen and maintain a sufficient production life, a lot of money will have to be spent in order to renew these reserves.

As time goes on proved reserves are going to be increasingly difficult to discover, develop and refine. As production rates continue to increase, higher oil prices seem to be the equalizer in this growing economic imbalance. Outside of acquisitions and major discoveries, I can't foresee reserves keeping pace with production for very much longer not only for major XOI producers but for major organizations and oil-producing countries.

If production life starts to noticeably decline for these entities, it would garner attention from not only the investing world but from the mass public. In this situation the global production peak we mentioned earlier will likely have occurred or be on the horizon.

In the mean time, investors should have ample opportunity to take advantage of this continued bull run in oil. Oil companies have been through many bear and bull markets. Good oil companies are almost always able to turn a profit no matter what market environment they are in, but there are typically very few to choose from in this case. And even if they can turn a profit, in a bear market for the commodity investors usually won't touch the stocks anyway.

When oil prices are high though and the bull market picks up steam, stock investors have a plethora of companies to choose from. XOI components are market darlings, can give us help with the timing of our trades and tend to have the least risk when it comes to oil-stock investing. But as a stock investor many times the best stocks may not be the most obvious ones.

At Zeal we have been researching oil and gas companies both big and small to see which may have the best leverage to the price of their underlying commodity. We are actively monitoring hundreds of oil and gas stocks and in our latest newsletter have deployed a round of buy recommendations to our subscribers as well as added 20 oil and gas stocks to our Watch List.

As trading signals are triggered we are layering in stock and option trade recommendations to try to catch the next upleg of this oil bull. Please subscribe today to our acclaimed Zeal Intelligence monthly newsletter and receive cutting-edge market analysis and stock recommendations focused on this continuing commodities bull market.

The bottom line is global oil demand is likely to continue to rise at a blistering pace in the years to come. Global supply seems likely to struggle to meet this demand creating a further economic imbalance. Higher oil prices are likely to be in our future and producers are poised to make record profits in attempting to meet this demand.

As stock investors our best bet is to time our trades within the bull market cycles and choose those companies best positioned to gain as the commodity they produce rises.


 

Scott Wright

Author: Scott Wright

Scott Wright
Zeal LLC.com

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Thoughts, comments, or flames? Fire away at scottq@zealllc.com. Depending on the volume of feedback I may not have time to respond personally, but I will read all messages. Thanks!

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