Where Will Future Oil Production Come From and How Can Investors Profit Today? Part 2

The IEA forecast for a daily increase in global oil production of 31 million barrels by 2030—a 37% jump—sounds like pure fantasy. Do the facts support it? Are big oil companies already searching for that future oil and finding it? Do they have plans to produce it?

To answer those questions we turn to a report published in late March by UBS energy analyst Jon Rigby and his team in London. Their incredibly useful report is called, “Will there be enough production capacity?” UBS has been battered by its huge sub-prime related losses. But their work on where future oil production will actually come from nearly redeems them. They have asked just the right question at the right time, and answered it in detail.

The report reaches a number of surprising conclusions about the global oil market. It also includes a useful database of oil projects scheduled to enter production in the next five years. These are projects which could add meaningful capacity (100kbpd or more) to global oil production. We’ll look at who stands to benefit in a moment. But first, some of the report’s findings [emphasis added is ours]:

• “Declining existing basins, rising costs, increased technical challenges, stretched supply chains, geopolitical blocks and tightening fiscal terms all seem impediments to growing global production capacity for oil and gas, despite the clear pricing signals.
• “There is no obvious wall of new production coming to the market in response to high prices.”
• New projects scheduled to come on-line from National Oil Companies (NOCs) belong mostly to three major firms: Aramco, Petrobras, and Gazprom.
• New project cost is rising and becoming more technologically challenging, especially deep-water.
• “Nominal growth rates tied to global GDP now look more unrealistic as potential upstream growth slows. This appears reasonably consistent with a growing view that oil production may actually not exceed 100Mbbl/d.”

The idea that global oil production may never exceed 100mbbl/d is worth a much closer look. I’ll get to that later. But before we look at the end, let us look at the beginning of the end and where new production might come from as the world’s oil producers try to bridge the gap between 87mbpd and 117mbpd.

The good news is that there IS new production capacity in the pipeline this year and next. Keep in mind that the final investment decision on the projects entering into production this year was made anywhere from 3-6 years ago. That shows you how far in advance you have to plan for new production (assuming you’ve even found oil in the first place).

There is no such thing as just-in-time oil production. But let’s take a look at projects that will come on line between now and 2010. We’ve selected only those projects that will produce more than 200kbp or more:

Country	Project Name	Oil (kb/d)	Operator	Project Type
Kazakhstan	Tengiz Expansion	250	Chevron	Conventional
United States	Thunder Horse	250	BP	Deepwater
Saudi Arabia	Hawiyah NGL	370	Aramco	Conventional
Saudi Arabia	Khursaniya	500	Aramco	Conventional
Saudi Arabia	Shaybah Expansion	250	Aramco	Conventional
Saudi Arabia	Khrurais expansion	1,200	Aramco	Conventional
Azerbaijan	ACG Phase 3	400	BP	Deepwater
Nigeria	Agbami	250	Chevron	Deepwater
UAE	Upper Zakum	200	ExxonMobil	Conventional
Qatar	Pearl GTL	210	Shell	GTL

If you include LNG and the barrels of oil equivalent produced from it, your list expands a little more to include the following projects:

Country	Project Name	Oil (kboe/d)	Operator	Project Type
Qatar	RasGas3, Train 6	291	ExxonMobil	LNG
Qatar	RasGas3, Train 7	291	ExxonMobil	LNG
Peru	Camisea	224	Hunt Oil	LNG
Qatar	Qatargas4, Train 7	251	Shell	LNG

Beyond 2010, the future is murkier. But the UBS team has identified projects for which the final investment decision has been made. Assuming cost blowouts can be avoided and the projects aren’t cancelled, here are some of the bigger projects that could come on-stream between 2011 and 2015:

Country	Project Name	Oil (kb/d)	Operator	Project Type
Saudi Arabia	Manifa	900	Aramco	Conventional
Kazakhstan	Kashagan Phase 1	450	Eni	Conventional
Iran	Yadavaran	300	NIOC	Conventional
Kuwait	Kuwait North Redevelopment	450	KPC	Conventional
Kazakhstan	Kashagan Phase 2	550	Kazakh JV	Conventional

There are some massive LNG and natural gas projects coming on-stream between 2011 and 2015. Gazprom, Shell, BP, and ExxonMobil all look like big winners, should oil prices stay high and pass through to higher LNG prices.

The new oil finds off-shore in Brazil’s Santos Basin are not included in the UBS report because they are not likely to enter into production during the next five years. They will be difficult to produce in any event. Petrobras says the Tupi find may contain as many as 8 million barrels, while the Carioca field may have 33 billion barrels of reserves, of which about 10 billion could be recoverable, according to Citigroup.

Current Production Trumps Reserves

One UBS claim which may surprise older oil hands is that, “the capacity to produce—not reserves—is critical to energy markets.” UBS does not conclude that current producers should be valued differently that companies with large reserves but current production challenges. But it’s worth thinking about.

For example, earlier last week Italy’s Eni reported a two-year delay in beginning Phase one production at the Kashagan field. It’s the fourth postponement on Kashgan’s production date and shows you how even a large oil find (Kashagan was the world’s largest in 30 years at the time it was discovered in 2000) can be years away from alleviating current demand.

When you add up all the projects together, you’ll find that 48% of expected new production volume comes from just five companies—ExxonMobil, BP, Royal Dutch Shell, TOTAL, and Chevron. When you throw in the three large NOCs I mentioned earlier—Petrobras, Gazprom, and Aramco—a full 70% of production already in the pipeline will come from just eight companies.

That doesn’t leave the investor much to choose from. You can’t even invest in Aramco. Though you can invest in Gazprom, we wouldn’t recommend it. The other six companies on the list are already household names. So what are you left with?

Global Oil Services and an ETF

You can be sure that if global oil production is to expand at all in the next five years, oil services companies are going to play a role. There are not a lot of well-kept secrets in the oil services field, either.

The UBS report tips two firms, Halliburton (HAL) and Norway’s Petroleum Geo-Services ASA (PGS). It’s worth noting that PGS just won its biggest contract ever, a US$200 million award from Petrobras to high-density, four-dimensional marine seismic survey work in Brazil’s Santos, Campos, and Espirito Santo Basins.

Other firms in the oil service sector include: Baker Hughes, Intl. (BHI), Diamond Offshore Drilling (DO), Nabors Industries (NBR), National Oilwell Varco (NOV), Noble Corporation (NE), Schlumberger (SLB), Smith Intl. (SII), and Transocean (RIG).

You could buy any one of them, a combination, or simpler still, all of them at once via the Oil Services ETF, OIH.

As the chart below shows, OIH’s rise since 2004 has been steady and impressive. A correction in crude oil prices might bring OIH back down to around 180, a price where the share seems to have long-term support (unless the trend is reversed, in which case oil will go much lower and the global economy will likely be in recession.)

In the last year, crude oil has smashed OIH head to head, with crude doubling and OIH up a mere 29%. The crude oil ETF, the United States Oil Fund (USO:AMEX) has tracked the price of crude and, should crude go higher, is a good bet to follow it up even more. Conversely, USO will get clobbered if oil corrects (making it an intriguing speculation for options traders who could buy puts on it.)

Since USO’s inception in April of 2006, OIH had actually outperformed it until oil’s most recent mad dash. If a short-term correction in the oil price looms—as UBS expects—but a long-term bull is a near certainty, then it might be a good time pick up shares in OIH and benefit from oil’s next big move up.

Politics, Pricing, and Physics

A buy in OIH assumes that oil prices are headed up. Your risk, as a bull, is that oil’s next big move is down, not up. And we should explore that in closing. In the midst of the euphoria over higher energy prices, there are some real risks. We’ve identified three of them.

1. Nationalisation of oil projects currently held by public companies
2. A new pricing mechanism for crude oil
3. The collapse of our complex society

If foreign governments continue to nationalise major development projects, it will be bad for public company earnings, but probably bullish for oil. The heightened politicization of oil has made it harder for companies to decide which projects to invest in. The net effect may be to reduce the number of projects which put real shareholder capital at risk. If earnings decline, valuations may follow.

Another risk is a new pricing scheme for oil. OPEC grouses about the value of the dollar, and periodically, stories surface about pricing oil in euros, or trading it on an Iranian oil bourse. But another possibility to consider is that the oil market moves to a less regular, negotiated, or auction pricing scheme, not unlike the current regime that exists for iron ore and coal between Australian producers and Asian customers.

Oil was “commodified” in 1983 when the NYMEX futures contract began trading. The futures markets provided the world’s growing number of buyers and sellers a little more price certainty and a little less volatility than in the spot markets.

Liquid futures markets see pricing power shift between the buyer and the seller based on changes in the market, including changes to both supply and demand. What we may see with oil in the next few years is shift in pricing power that distinctly and permanently favours the sellers. We may, in fact, witness the “decommodification” of oil as it becomes a crucial strategic asset.

Right now, the sellers currently benefit from market pricing because volatility has led to higher prices. But those prices are denominated in a declining currency, the U.S. dollar. Is it inconceivable that some OPEC sellers or even non-OPEC sellers might agree to sell annual production at a fixed rate to a buyer who pays in something other than U.S. dollars? A buyer who pays in yen, euros, or yuan?

Debtor and Inflater Beware

It’s certainly conceivable. We just conceived it. But it would be a much different world than the one we live in now. What kind of world would it be?

It would be a world where oil is sold for geopolitical reasons and used as an economic weapon. It would be a world where there’s no longer a free market for oil.

Declining production and growing demand puts oil producers in the position of deciding what they want to charge, and who they want to sell to. It would be a world with a bouncer at the front door of the producer’s club and a big velvet cord in front. No debtor nations with dodgy currencies allowed inside.

The last and least desirable possibility is the collapse of our wonderfully complex, energy –intensive society. Globalisation has created a system of interconnected systems; energy, logistics, transportation, food, finance, travel, and entertainment. Up until recently, the system has provided a historical amount of surplus food, leisure, and comfortable sweat pants.

But like any system, it requires energy. Epic amounts of energy. When you start reducing the energy available to the system, it ceases to function in the same way. In some cases, it may cease to function altogether.

That the modern industrial world will cease to function because of structurally higher energy prices is a thought we all should consider and plan for. There is nothing any of us can do to prevent it if the world’s conventional energy resources are already being depleted faster than they can be replaced.

It’s clearly the worst case scenario. It would not be the first time an advanced civilization went from decadence to poverty in one generation. But as it is the first time it has happened to this particular civilisation—the one you and I were born into—we don’t relish the prospect and are cheering for and investing in credible alternatives to the world’s petroleum resources.

Dan Denning
The Daily Reckoning Australia

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Related Articles:

• Crude Oil: The Best Bet for 2012
• Peak Oil – The Rewards
• International Energy Agency Rejects Possibility Crude Oil Output is in Terminal Decline
• Crude Oil Becoming Much Harder to Find
• Supply of Conventional Crude Oil is Very Close to its Peak