Drilling for Inspiration

Sometimes, investment inspiration comes from strange sources. This past weekend, Venezuelan President Hugo Chavez poured gasoline on the Peak Oil argument by claiming that "prices will continue to rise, but oil is running out. . The world right now is producing petroleum at maximum capacity. In Venezuela, for example, we can't produce a single barrel more." These comments made me think about how larger oil companies have been increasing their own production capacity.

Of course, the world is not "running out of oil." There are enough hydrocarbons in the ground to last for hundreds of years. Between the Athabasca oil sands in Canada and the Orinoco tar sands in Venezuela alone, there are hundreds of billions, or even trillions, of barrels of oil locked away. These two non-conventional reserves represent more oil than the total production from conventional sources in all of history.

However, reserves and production capacity are two vastly different things, and right now the world is making huge investments to increase production capacity. Looking at it from a company perspective, there are only two options for increasing capacity -- through the drill or through acquisitions. Increasing capacity through the drill generally results in lower production costs. The lower cost, however, is offset by drilling risk -- the possibility of hitting a dry hole. Drilling also entails long lead times -- often four years from discovery to full production on a new well.

While there is certainly plenty of drilling activity taking place, oil companies are also expanding through acquisition. In the past few months alone, Chevron (NYSE: CVX) bought Unocal, Norsk Hydro (NYSE: NHY) bought Spinnaker (NYSE: SKE), and Occidental (NYSE: OXY) bought Vintage (NYSE: VPI). The average gain for holders of any of the acquired companies was nearly 30% on the day of the announcement.

When I wrote about Spinnaker before the buyout, I couldn't see how a smaller company made a compelling investment, competing in a world of giants like ExxonMobil (NYSE: XOM). Now I see that smaller companies with proven reserves are very attractive acquisition targets. Furthermore, recent oil and gas prices have created huge cash balances at many companies. With governments around the world looking for ways to collect these "windfall" profits, there is significant incentive for the larger companies to invest their cash. An easy way to spend a ton of cash in a hurry is to buy a smaller company that has attractive properties.

While betting on acquisition alone is generally a foolish (with a small "f") investment strategy, oil and gas companies that have growing reserves and sell at a reasonable price-to-reserves ratio should continue to profit from tight oil supplies. Stephen Simpson recently used these criteria to compare a few larger companies here. He looked at the purchase of Spinnaker here, and he examined the purchase of Vintage here.

I normally do not listen to someone like Hugo Chavez for my investment advice. However, if the world really is producing oil at maximum capacity, I would expect more buyouts in the months and years ahead, as the larger companies try to maximize their share of the pie. I am going to keep drilling for some of the price data on independent exploration and production firms to compare against the prices paid for recent acquisitions, to see whether any sell at a discount. I'll update you with any values I find.

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Robert Aronen does not own shares of any company mentioned in this article. He would also like to state for the record that he is not and has never been a member of the Communist Party. Please feel free to share your comments with him at robertaronen@yahoo.com.