Is the Oil Boom Over?

The oil patch is undoubtedly cyclical. If you bought in 1991 during the Gulf War and sold in 1999 when oil was selling for $10 a barrel with headlines predicting $5 a barrel, you lost your shirt. If you bought in 1999, when the industry was down and out, you're probably sipping tea on your own private island right now.

When I looked at high pump prices back in April, it was obvious that the major factor behind the increase was crude oil. If crude prices stay high, the boom continues. If crude prices plummet, we have a bust.

When it all began
It's difficult to predict the end of the boom, or even put a date on when it began. Obviously, the best bargains were available in 1999, when oil was cheap and the investing world was enamored with technology. From 1999 to 2004, the industry was recovering from extremely bad times. The prevailing opinion was that oil prices could return to $20 a barrel any quarter. During these years, service industries tied to the oil patch would have perhaps one good quarter a year, business remained patchy, and money remained tight. Through the middle of 2004, it was unclear whether the turnaround in the industry would stick.

In the fourth quarter of 2004, prices started their jagged march upwards from $30 a barrel to over $70 a barrel. Prices at the pump rose toward $3 a gallon. From the end of 2004 onward, business has been continuously solid, projects have been funded, and that's when the Oil Boom moved into full swing -- at least by my estimates.

For a more objective picture, Baker Hughes (NYSE: BHI  ) has been publishing rig counts dating back to 1944. The number of active rigs measures drilling activity. Looking at a graph of the world rig count dating to 1975, a clear picture emerges. 1999 was obviously the bottom of a long downward trend that started in 1981. After emerging from the depths, in 2004 the rig count rose to levels not seen since 1986, when the last boom went completely bust.

Where are we now?
In the past few months, high prices finally started to curb demand. According to EIA (Energy Information Administration) petroleum statistics, U.S. petroleum demand in 2005 was flat compared with 2004 (available from the "world oil balance" spreadsheet). Furthermore, gasoline demand in April was 1.9% lower than April of 2005, with the reduced demand blamed on higher prices. Furthermore, inventories of crude oil and gasoline have been rising. Reduced demand in the face of increasing supplies will definitely lower prices.

Globally, high prices have not reversed demand growth, but demand does appear to be slowing. In 2005, world demand increased by 1.4% -- from 82.49 million bpd (barrels per day) to 83.62 million bpd. The IEA (International Energy Agency) recently cut its forecast for global demand growth for 2006 from 1.47 million bpd to 1.22 million bpd.

Countering the softer demand situation, geopolitical problems weigh on the market. CERA (Cambridge Energy Research Associates) estimates that there has been an aggregate disruption of 2 million barrels per day of supply from Iraq, Nigeria, and Venezuela, plus the hurricanes in the Gulf of Mexico. Adding to the "fear premium" are tensions in Iran and the threat of terrorism to the Saudi petroleum infrastructure.

Into the future
In the current market, demand growth of even 1.2 million bpd will create a challenge for world oil markets. OPEC has maintained its official output ceiling at 28 million bpd since July 2005, even though it has been producing near-full capacity close to 30 million bpd since 2004. Non-OPEC nations are expected to increase production by 1.2 million bpd in 2006.

Saudi Arabia also has spare capacity estimated at 1.8 million bpd. But as Saudi Oil Minister Ali al-Naimi has pointed out many times, the world cannot absorb the additional oil because there's inadequate refining capacity. To be more precise, the world lacks refining capacity for the heavy, sour crude oil that Saudi Arabia produces. Therefore, the marginal supply that would normally calm markets and bring prices down does not match current infrastructure.

To address these problems, Saudi Arabia and other OPEC nations are investing billions to increase production and develop their own refining capacity. Saudi Arabia claims it is absolutely certain it will be able to boost production capacity by 1.2 million bpd by 2009. Plus, it's building domestic refineries with 2 million bpd of capacity to process its heavy sour crude oil.

Conclusions
So demand is softening, inventories are above average, and supplies are increasing. On the surface, it doesn't look too good for the oil boom. However, going back to 1981, we find striking differences. In 1981, the global rig count was almost 6,500, more than double current levels. The American economy was in a terrible recession. Vehicle fuel economy was rapidly increasing, and new producing regions in Alaska and the North Sea had increasing production. These events are much different from today.

Demand and the global economy are growing. The EIA has a more aggressive forecast than the IEA, predicting demand growth of 1.6 million bpd in 2006 and 2 million bpd in 2007. Economies are growing in the U.S., Europe, and Japan concurrently for the first time in decades. The IMF recently upped its global GDP growth estimate to 4.9% in 2006, followed by 4.7% in 2007. A healthy global economy will keep oil demand rising and make the "bust" scenario unlikely.

The recent slackening of demand is likely temporary. In Europe, drivers have been paying more than $4 a gallon for a long time, with current prices near $7 a gallon. Yet demand in Europe is much higher today than it was 10 years ago. People get used to high prices -- whereas $2 a gallon was unthinkable in 1999, it now looks like a bargain. Basically, Americans have repeatedly voted with their dollars to say they don't want public transportation, they want to drive big cars, and they want to live in large houses far away from urban centers. These are luxuries that most people are unwilling to give up, even to save a thousand dollars a year on gas.

Therefore, barring global recession, the oil boom will continue -- albeit with some violent bumps along the way. The oil-services sector is almost certain to remain very active, as big oil companies make their drilling plans based on $25-per-barrel oil -- a price that would occur only with a global financial collapse. I have my eyes on deepwater drillers like Transocean (NYSE: RIG  ) , Diamond Offshore (NYSE: DO  ) , and Global Santa Fe (NYSE: GSF  ) . Alternatively, fellow Fool Stephen Simpson recently had his eyes on producers like Apache (NYSE: APA  ) and Occidental (NYSE: OXY  ) . With my watch list, I find myself checking the numbers and repeating the Fool mantra: "Down, baby, down."

Related Foolishness:

There's another small company in the oil patch that's at the top of my watch list. It's a recommendation from the April issue ofMotley Fool Hidden Gems. This emerging growth company helps Big Oil maximize output from existing reservoirs. Sign up today for a30-day free trialto learn about this company and all of the Hidden Gems selections that are soundly beating the market.

Fool contributor Robert Aronen owns shares of Transocean and Diamond Offshore. He's looking to buy more. The Fool has an ironclad disclosure policy.


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