Can Oil Still Power Portfolios?

This is the first in a series of articles regarding the outlook for investments in the oil industry in 2006 and beyond.

Call me an oil optimist, but I think the people crying out that oil prices have peaked are frankly cuckoo. To put it crudely (pun intended), investors should continue to buy in to the oil patch for the following reasons:

  • Oil demand growth.
  • Declining production rates.
  • Geopolitical uncertainty in oil-producing countries.
  • Limited U.S. refining capacity.
  • Rising exploration and production costs.
  • Increased energy efficiency.

Let's take a quick look at each of these factors. Drumroll, please .

Oil demand growth
Despite the high price of oil in 2005, the International Energy Agency (IEA) recently estimated that the world gobbled up an average 1.2 million more barrels per day, up 1.4% from 2004.

Doesn't sound too bad, eh? Well, consider that the 2.2% projected demand growth in 2006 alone represents an additional 1.8 million barrels a day in production and that OPEC's spare capacity is currently only around 5 million barrels a day.

Not too bad again, right? Except that this growth rate is predicted through at least 2015. In addition, these demand figures will likely turn out to be conservative, given the continued bullish economic growth of the world's two most populous nations -- China (9.2% projected rate) and India (at 8%) -- and the resulting growth in their consumption-minded middle classes.

The additional capacity will likely come from non-OPEC producers. The likes of Russia (the world's second-largest producer, at 9.4 million barrels per day) and Norway will attempt to pick up the slack -- but first they have to get to get their own houses in order.

Declining growth in production rates
According to Russian Industry and Energy Minister Viktor Khristenko, oil production growth is estimated at 2.4% in 2005, down from 10% in 2004. It's likely to drop below 2% in 2006 and even turn negative shortly thereafter.

Norway will save us, right? Nope, our friends the Norwegians are in even worse shape. The Norwegian Petroleum Directorate recently estimated that production itself fell to some 2.5 million barrels per day in 2005. That's down 11% from 2004 and 20% below its 2000 peak. It seems that Norway's North Sea fields are rapidly depleting.

Mexico is in the same boat. Its largest field, Cantarell, which provides 60% of its total production, has gone into irreversible decline this year. Its rate of decline should accelerate to an annual 15% over the next few years. OPEC member Indonesia is even more of a basket case, recently shifting from a net exporter to a net importer.

Will Big Business be our savior? Probably not. ExxonMobil (NYSE: XOM  ) , Chevron (NYSE: CVX  ) , and TotalSA (NYSE: TOT  ) reported an average 3% decline in production in the third quarter of 2005 -- and that doesn't include the effects of the hurricanes.

If these long-term issues weren't enough to turn your hair white, consider that even the above-mentioned capacity from OPEC is suspect in the near term.

Geopolitical uncertainty in oil-producing countries
In Iraq, the U.S. government (not an entirely unbiased entity) recently estimated oil production at an average 1.9 million barrels per day. That's down more than 36% from pre-war levels. Insurgents made an estimated 282 attacks on the oil infrastructure between April 2003 and October 2005.

Nigeria led Africa's oil production with an average 2.3 million barrels per day in 2005, but it also faces constant internal turmoil. Rebel attacks on two Royal Dutch Shell (NYSE: RDSb  ) installations recently cut 10% of its export capacity.

Down in South America, Venezuela combines its own production shortfalls with the market's perception that President Hugo Chavez is just unpredictable enough to use oil as a weapon -- especially against the U.S.

Meanwhile, fundamentalist-run Iran is the world's fourth-largest producer of oil at 4.2 million barrels per day, sitting on more than 10% of the world's remaining reserves. It's currently in a standoff with much of the developed world over its nuclear ambitions. Not exactly a rosy outlook, is it?

Limited refining capacity in the U.S.
The U.S. consumes nearly a quarter of the world's oil (21 million barrels per day), and its refining capacity is stretched to the limit. Any minor hiccup, let alone disasters like Rita and Katrina, will send a shock through the international oil markets. (Remember oil's spike to $70 a barrel after the hurricanes?) It's too bad that 37% of U.S. refining capacity sits in the Gulf of Mexico region and that weather forecasters predict even more intense hurricane seasons over the next 10 years.

Unfortunately, diversification isn't likely to occur any time soon; the United States hasn't opened a new refinery since 1976. A lethal mix of tighter environmental restrictions, an understandable not-in-my-backyard mentality among communities, and high construction costs has inhibited new construction. If this reality weren't sufficiently daunting, it seems that capacity is actually likely to fall in the near term.

The reason: The recently passed Energy Bill omits limited liability coverage for MBTE, an oil additive that pollutes groundwater. As a result, Valero (NYSE: VLO  ) , the largest U.S. refiner, will stop producing the additive in 2006, with a resulting loss of 60,000 barrels per day in capacity. The decline in capacity will likely increase as other refiners follow suit.

Rising exploration and production costs
Producers are depleting mature fields at an annual rate of 6% to 8% (according to Saudi Aramco), driving major oil companies even farther afield to secure new reserves. Royal Dutch Shell's Sakhalin II project, on the like-named island off the east coast of Russia, had an initial development cost of $10 billion. The price tag stands now at $20 billion, with the company forced to operate on an island that is covered in ice for six months out of the year. Little wonder that CNOOC (NYSE: CEO  ) , China's offshore energy company, thought that offering $18.5 billion for Unocal was a steal; it's increasingly cheaper to buy an existing company than to find new oil reserves.

Increased energy efficiency
In 1973, the United States required 2.4 barrels of oil for every $1,000 in gross domestic product (GDP). By 2001, the inflation-adjusted number had fallen to 1.15 barrels, and it's likely fallen further since then. This efficiency enables oil prices to remain higher than in past cycles with less damage to the economy.

Despite oil prices in the mid-to-high $50s throughout much of 2005, the U.S. economy plowed along at a steady 3.5% clip. It's no surprise that OPEC now intends to defend the $50-$55/barrel price range. OPEC's confidence in setting that price floor illustrates the changed dynamics in the global economy, and the advent of the so-called supercycle.

One last thought
Before I exit stage left, I'll leave you with one last whopper of a fact: According to the U.S. Energy Information Agency, the total energy supplied by oil, natural gas, and coal will need to grow by 60% between 2002 and 2025. That's the equivalent of adding four, yes, four Saudi Arabias.

It's a huge amount of energy demand, just waiting to be satisfied. Draw your own conclusions.

Fool contributor Will Frankenhoff is a relatively new contributor to The Motley Fool and welcomes any feedback at elves1us@yahoo.com. He does not own shares in any of the companies mentioned above. Total SA is aMotley Fool Income Investorpick. The Fool has adisclosure policy.


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