Are Oil Prices About to Skyrocket?

Seadrill Ltd sees eerily similar circumstances to what led to the super spike in oil prices in 2008.

Sep 3, 2014 at 11:40AM

Seadrill Ltd West Callisto

Source: Seadrill Ltd. 

There are a handful of companies every investor should follow whether or not they own its stock. This is because they just seem to have their fingers on the pulse of their industry, the global economy, or even the future direction of oil prices. By checking out what these leaders have to say each quarter, investors can stay one step ahead.

Seadrill Ltd (NYSE:SDRL) is one of these companies. As a leading deepwater driller, it has keen insight into the oil and gas market, which is a key driver of the global economy. What it has to say about what it's seeing can really help investors position their portfolios to capture future profit opportunities. What's particularly interesting is what Seadrill has to say about the future of oil prices. 

This past quarter Seadrill provided investors, and anyone who would listen, with its outlook on the oil marketplace. In its earnings release, the company noted: 

Oil market fundamentals continue to be strong with high and stable oil prices. Except for very brief periods, oil prices have remained above US$100 for the last 3.5 years, and the global economy continues along its growth path following the financial crisis.

Given that oil markets are strong, one would think oil companies are making a lot of money with oil prices above $100 per barrel. That, however, couldn't be farther from the truth. Seadrill went on to note:

Even with these strong macro fundamentals, oil companies seem to be unable to generate free cash flow to grow their businesses and have entered into a period of selectivity on projects as costs escalated across their entire portfolio of projects.

This has been well documented as big oil is simply drowning in high-cost projects. Large LNG projects like Chevron Corporation's (NYSE:CVX) Gorgon in Australia have run so far over budget that it has producers holding off on new projects. Gorgon was expected to cost Chevron and its partners $37 billion; however, it's now expected to cost well over $54 billion. In fact, it's these high development costs that are leading the mighty Chevron Corporation to seek help in funding its developments in Canada, while others like Apache Corporation (NYSE:APA) are abandoning LNG projects and even deepwater projects in the Gulf of Mexico for safer, less expensive shale development.

This pullback in spending, however, isn't something that's new to the industry. In fact, according to Seadrill, we saw the same thing just a few years ago, and what happened next as a result of the pullback in spending was a spike in oil prices:
  Apache Corporation Gom

Photo credit: Apache Corporation. 

The current situation has some similarities to the situation in 2002-2003, when oil companies had limited free cash flow to develop new reserves. This led to an increase in oil prices between 2003-2008, when Brent moved from approximately US$40 to US$100 and resulted in increased investment by the oil companies. Today, the majority of low-cost inventory has been produced, and oil companies are entering a new phase in which recently discovered oil must be developed in order to grow production. These reserves are in the deep and ultra-deepwater and are far more complex than reserves discovered in prior periods. We can thereby assume that the amount of rig capacity which is needed to produce a barrel of offshore oil in the future will increase.

The question that only time will answer is if it's different this time, which always could be the case. Remember, in 2008, America didn't yet fully realize that oil could be economically produced from shale. Now the world's largest consumer of oil is slated to become its biggest producer.

However, that's not the only thing different this time, as Asia's hunger for energy appears to be insatiable. Further, as long as America's oil remains land-locked because of the export ban, its supply might not have as big an impact on world oil prices as it could otherwise.

If nothing else, Seadrill's thoughts on oil prices potentially moving a lot higher are worth noting. Most of the world's cheap oil is gone, yet oil producers won't produce expensive oil unless money can be made doing it. At some point, either oil prices will head higher, or costs will have to dramatically come down. Given the direction costs have gone for complex oil supplies like those in the deepwater, I wouldn't be shocked if oil prices did move significantly higher in the future.

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Matt DiLallo owns shares of Seadrill. The Motley Fool recommends Chevron and Seadrill. The Motley Fool owns shares of Seadrill. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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