What's Oil's Future?

by: Andrew Mickey November 16, 2008 | about stocks: BP / PZE / RDS.A / XOM    

Andrew Mickey

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Now is a good time to buy.

The world financial crisis and slumping oil prices have made energy assets more attractive.

That’s what R.S. Sharma, the chairman of India’s national oil exploration company ONGC, said last week.

Is he right?

Well, yes and no. It’s a good time to buy oil. But thanks to a few major changes in the oil industry over the years, a great time is likely on the way.

Oil company shares have been in free fall since oil prices topped out over the summer. There are dozens of oil companies trading at prices 60%, 70%, or more below their highs. A lot of them look attractive, but now is not necessarily the time to go “all in” on oil.

Don’t get me wrong, there will be a time to bet big on oil (it’s soon) and the oil profits over the next few years will make the last five years look like a pittance. To comprehend the opportunities in oil we have to examine the massive shifts that have been taking place in the industry.

The People’s Oil

The oil industry has changed a lot in the past few decades. It’s no longer dominated by what the mainstream press calls “Big Oil.”

The fact is, Big Oil just isn’t that big anymore. Sure, ExxonMobil (NYSE:XOM) is posting 11-digit profits every quarter, but Exxon really is not very big. Exxon is only the 14th largest oil company in the world when you compare its oil and gas reserves to other oil companies. Thirteen oil companies are bigger than Exxon.

The top 13 oil companies in the world are all national oil companies [NOC]. Before the 1970’s, oil was dominated by private oil companies. The predecessors to ExxonMobil and Chevron were the behemoths of oil. The “Seven Sisters,” as they were known, controlled 80% of the world’s oil and gas reserves for decades.

That all changed over the past 30 years. Most of the world’s oil reserves are now controlled by NOCs. The Financial Times reports the “New Seven Sisters” are all state run NOCs.

click to enlarge

Oil

For years, this wasn’t a problem, but the shift to NOCs is about to become a big issue.

National oil companies have two purposes. One is to provide the world with oil and allow the states that control them to exert political power. The other is to fund social welfare services. It’s the second purpose that is the BIG problem.

NOCs at “Work”

You see, for years NOCs have been diverting cash flows out of the company and into government coffers. The cash became a new source of funds for social programs. Diverting oil revenues is an easier political sell than imposing direct taxes. Billions of dollars were diverted away from oil exploration, maintenance, and production infrastructure.

The worst part of it all is NOCs (just like most industries where the government runs interference) are highly inefficient.

For instance, Iran’s NOC was created in 1979. After 28 years of state mis-management, Iran’s NOC produced less oil last year than it did in 1979.

Russian Yukos Oil’s production has flat lined since its nationalization

Hugo Chavez used the profits of Petroleos de Venezuela to fund a large social welfare program.

NOCs can get away with this when oil is selling for $140 a barrel. At those prices, there was plenty of cash to go around. But when oil is $50 a barrel and an NOC still has to pay the same wages, production costs, and other expenses, something has to give.

Typically, it’s the company that suffers, not the social programs. In response to continued demand on their cash flows, NOCs have curtailed capital expenditure to develop new oil fields.

Where to From Here

This exploration pull back comes at a bad time. Our global oil infrastructure is severely underdeveloped. The oil and gas needs trillions of dollars to meet global energy demand.

John Westwood, of oil consultancy firm Douglass Westwood estimates the oil industry is suffering from “two decades of under-investment and [the industry] needs to spend $10 trillion by 2030 to get back on track.”

The International Energy Agency puts the needed investment at $30 trillion.

If not, the IEA warns, “There remains a real risk that underinvestment will cause an oil supply crunch.”

Of course, all of this underinvestment creates a very bright future for oil over the long-term.

No government in the world, especially the United States, has the financial or political will to wean itself off oil in the next decade. It makes for nice campaign talk, but it’s not going to happen.

The world will need more oil. The current economic downturn is going to last a while and oil prices will stay low relative to recent highs, but oil demand is not going to disappear. Just look at what happened during the oil shock of the late 70’s through the mid 80’s recession.

Between 1979 and 1983, U.S. oil consumption actually fell 29%. It wasn’t high oil prices though because oil prices remained relatively flat over that period. The biggest cause of the decline was the recession.

How to Get There

The combination of falling oil prices, the ongoing credit crisis, plummeting values of homes (if REIT values are any indication, a lot more downside to come), inefficient state management of oil supplies, and a wealth of other factors have created a lot of uncertainty about the future of oil. That’s why I look to ExxonMobil to see what’s really going on.

Exxon is the most prudent oil company. It routinely posts some of the most efficient operating numbers of any major integrated oil company. Although oil prices have moved up and down, Exxon has always managed to lead the major oil companies in profit margins, operating margins, and overall efficiency.

Most importantly, Exxon didn’t get caught up in the recent oil frenzy. It didn’t ramp up its capital expenditure program and it didn’t go on a shopping spree buying up smaller oil companies when they were richly valued.

Oilmen who have been through oil booms and busts lead Exxon.

That’s all why I like to keep an eye on what it’s doing. It’s the steady hand of the oil industry. And what they’re doing may surprise you. Exxon continues to spend about $15 or $16 billion a year on development of new projects. Over the past three years, Exxon has averaged about $14.8 billion in annual capital expenditures and that doesn’t appear to be changing much with the recent downturn in oil prices.

Oil’s Slippery Slope

No, I don’t think it’s time to go “all in” on oil stocks…or anything for that matter. We haven’t reached the point of maximum pessimism yet.

We’re still working our way through the financial crisis and uncertainty reigns supreme. There are just too many unanswered questions out there.

Will the government bailout the U.S. automakers? When will unemployment stop rising? When will mutual fund and hedge fund redemptions stop? How much are corporate taxes going to go up under Democrat-dominated government? Many of the policies, if adhered to, will only extend this downturn (i.e. auto bailout - how many million more cars that no one wants to buy will be produced with government funds?).

It Is NOT Different This Time

Frankly, this recession is going to take a while (keep your eyes on unemployment of around 8.5% for a sustainable turnaround to start) and there will be ample time to pick away at your favorite oil stocks.

History says so. When U.S. oil consumption declined 29% between 1979 and 1983 and oil prices fell more than 60% (as they have over the past few months), it still took 24 years for U.S. oil consumption to return to 1979 highs.

Oil prices and oil stock charts will not be “V” shaped. This downturn is big and most oil companies were overvalued before anyway. As a result, it’s going to take quite a while for many of these stocks to get back to their old highs. But they will.

Remember two things. Cyclical industries always overshoot during good times and undershoot during bad times. This is definitely one of the bad times.

So I agree with Mr. Sharma of ONGC, now is a good time to buy oil stocks. It’s certainly the best time in the last five years to buy them. But we can’t forget to always use a conservative investing strategy to allow us to have to keep some cash on hand for what could be a great time to buy oil stocks.

Disclosure: None

 

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This article has 13 comments:

  •  
    Nov 16 06:21 AM
    Good analysis. Even though this recession might somewhat reduce short term oil demand growth it would take minimum 10-20 to rebuild the world's energy infrastructure to some post-oil scenario. A lot of alt energies will help reduce oil needs once the technical problems have been worked out and they are up and running. But to rebuild your physical infrastructure takes a lot of energy and for now that means oil.

    Many producing oilfields (e.g. Alaska's) are mature and output has been declining for years. And you have made the case why national oil companies will starve their business before reducing their social spending. Without large scale new investment oil supplies will decline and we will indeed find ourselves in another supply crunch and god only knows where prices will go next time.

    Today I put in an order for some Suncor Energy Inc (a major tarsands producer who can make profit from $40 oil) at under $24, about 1/3 of its peak price. You say the bottom for oil stocks will come "soon" but today's G20 meeting confirmed that governments are commited to whatever it takes to ease and end the recession, so I wouldn't wait too long to start jumping in.
    Reply | Link to Comment
  •  
    Nov 16 10:11 AM
    I just read that Warren Buffet increased his stake in ConocoPhillips to 84 million shares of COP in the last few months. That's about 6% of the company and one of buffet's largest bets. Oil is going to come back with a vengence. The US has not yet adopted an energy policy:

    thefitzman.blogspot.co...

    so, the sky is the limit for the future price of oil. Unfortunately, for a country like the US that imports 70% of its oil, that's not good news. hopefully obama's team will act as soon as they get in office, and they will acknowledge that perhaps picken's suggestion that we move to nat gas powered transportation will be taken seriously.
    Reply | Link to Comment
  •  
    Nov 16 12:19 PM
    Compressed natural gas' future lies in an alliance between environmentalists, auto/truck manufacturers and the government.

    If the Big 3 auto mfgrs receive the bail out money they need to stay afloat, the government and the environment forces must dictate the roll over to CNG powered vehicles as well as the mandated requirement that a national re-fueling infrastructure be implemented.

    The sooner this alliance comes together the better for all Americans.
    Utilizing OUR fuel; an abundant fuel and considerably cleaner burning (think about cooking with gasoline versus natural gas in your kitchen stove) will create millions of jobs and keep BILLIONS of dollars in our economy. This "roll over" will keep us rolling while the development of solar power is perfected---currently prohibitively expensive for widespread utilization nationally.

    The first step is getting the re-fueling facilities in place and if those are built you can rest assured that the Big 3 will come---and quickly. They don't have much choice to do otherwise3
    Reply | Link to Comment
  •  
    Nov 16 12:58 PM
    Alberta has kept away from NOC as has the Federal Government. But, Alberta has taken a dangerous turn. It switched the Provinces' royalty from US dollar base to Canadian Dollar base. This pumps an additional 16 to 18 percent into the oil coffers.

    A 60 dollar barrel of oil today returns the same profit to the oil companies as a 77.00 barrel of oil last year!

    Having said this, the Alberta treasury has been shorted some 10 billions of dollars which has all gone to the oil companies. The province is about to announce cost cutting of medical and other programs in the province because of cash short fall.

    Whether or not they can win another election remains to be seen!
    Reply | Link to Comment
  •  
    Nov 16 01:02 PM
    I would NOT say Exxon is the most prudent oil company. Rather I would say they are one of the more risk averse oil companies out there. Exxon might spend $15 billion a year on CAPEX, but they spend twice as much ($30 billion per year) on share buy backs. This increases shareholder value in the short term, but diminishes the company's ability to remain an energy leader in the long term.
    Reply | Link to Comment
  •  
    Nov 16 01:51 PM
    Ridiculous assessment. "There might be a better time to buy oil companies". When exactly ? When their p/e is at ZERO? You have profit machines like OXY, CVX, and DVN trading at p/e's of 3. Are you kidding me? These companies are growing EPS 30-35% per year and trading with a PEG as low as 0.3 AS Peter Lynch often said, it doesn't get any better than that. Any company growing earnings trading with a PEG below 0.5 is a "steal". Waiting for a better entry into energy companies is foolhardy indeed.
    Reply | Link to Comment
  •  
    Nov 16 05:45 PM
    You forgot the oil consumption by the BRIC countries. This huge factor was not there in the 70's.
    Reply | Link to Comment
  •  
    Nov 16 07:29 PM
    "Today I put in an order for some Suncor Energy Inc (a major tarsands producer who can make profit from $40 oil) at under $24, about 1/3 of its peak price."

    Got to watch tarsands because some report maybe more BTUs go in [natural gas] than BTUs gotten out.

    I read read the above.

    Energy is an an area of interest for us, not an area of expertise or ability.

    cheers

    www.prosefights.org/nm...

    Reply | Link to Comment
  •  
    Nov 16 07:42 PM
    OBAMA! has publicly declared tar sands oil to be "dirty oil", to use his words. I predict if the extreme inviros, who hold many IOUs on the new administration, get their way, we may experience a severe disruption of the economy because of energy misallocation. Any thinking person knows we have to transition away from dependence on oil, but HOW we do this is critical. The Danes are ahead of everyone on using wind power to supplement their electrical grid, but they clearly state that a grid can only function with a MAXIMUM of 20% from wind. The rest of the grid must come from another source. The energy challenge is complex and I fear that the incoming administration has only simplistic solutions. Of course, the outgoing administration doesn't appear to have had any solutions.
    Reply | Link to Comment
  •  
    Nov 16 10:40 PM
    Oil bulls never die; they simply sit drenched in the glut of oil yelling, Buy!
    Reply | Link to Comment
  •  
    Nov 17 01:34 AM
    Been there seen that. America has something WAAAY better that oil. Just ask ....Sorry I can't say. Smells like a Skunk around here.....
    Reply | Link to Comment
  •  
    Nov 17 05:25 AM
    Due to the huge speculative bubble that occurred this summer, it's possible that there has been an over reaction to sell. That does not mean I want to step in and start buying Oil contracts or USO. The down trend is still intact. Markets are driven by the actions of emotional people, not by logical machines. Who is to say we won't see $10 oil or $200 oil? All I know is that it looks like we continue going lower.
    Reply | Link to Comment
  •  
    Nov 17 02:01 PM
    Jim Rogers said that Mexico, Malaysia andd the UK will be importing oil within a decade. This will be very bullish for oil prices.

    www.jimrogers-investme...
    Reply | Link to Comment
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