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Oil headed to $200?

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By AdvocatusDiaboli
March 11, 2008

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The most important parts of this page are these illustrations:

The data is taken from an Exxon report published in 2002. Since 2002, the trend in oil discoveries has continued downwards.

Oil discoveries peaked in the 1960s. It is unlikely that we will find any truly big fields in the future, as big fields tend to be found first, cause they're big. (duh!)
It should be noted that oil discoveries have been remarkably insensitive to price. The biggest finds in the US were made in the 1930s (Great Depression) when oil cost a few cents a barrel, and in the 1960s worldwide, when oil prices were very low. This is in contrast to what one would expect according to economic theory, which would predict an increase in drilling activity at higher prices and thus an increase in discoveries. That has historically not been the case. The last 5 years of high oil prices have brought on a mad drilling rush, but the declining trend in discoveries has nevertheless continued.

Today, the majority of the world's oil production is supplied by giant fields like Ghawar which are on average about 40 years old. (Ghawar is in Saudi Arabia and produces approx. 5 million barrels per day. World oil production is about 80 million barrels a day. Ghawar probably held around 100 billion barrels of oil when it was discovered.)
Most of the world's giant oil fields are in decline because they have been in production for so long.

The key date for oil is not "when we run out" but the date of MAXIMUM OUTPUT or Peak Oil. Since oil has to flow through rock on its way to the well shaft where it's being pumped to the surface, the production speed is limited by oil flow speeds. You can speed it up some, by pumping water or gas below the oil, but if you push production too much, you can ruin an oil field (by mixing the water with the oil).

Eventually an oil field goes into decline, and there's a limit of what you can do about it.
A good example for an oil field in decline in the Mexican Cantarell field: It peaked at 2.1 mbpd in 2003 and despite heroic efforts to keep production up is down to 1.26 million barrels presently. At some point, the decline of existing oil fields is going to outpace the new capacity that goes online, and then world crude production is going to drop.

It looks like that has already happened, or will happen in the next few years. There isn't a lot of new capacity in the pipeline (see the chart showing the lack of discoveries), so the oil price will remain high for the foreseeable future. As you can see from the discoveries chart, the oil crisis in the 1970s came on the back of the biggest oil finds in history a few years earlier. It was just a question of getting the oil out of the ground and on the market. That took about 10-15 years, and then oil prices collapsed again in the 1980s and 1990s.

The situation today is very different.
There's little new conventional capacity in the pipeline and any alternative fuel source like oil shale (highly dubious), ethanol (dubious), oil sands (expensive and limited by infrastructure as well as water and gas) and coal/natural gas liquefaction have investment cycles which have a similarly long lead time as conventional crude oil production (think 5-10 years) and they are very capital intensive. I have calculated that offsetting a 3 percent decline in world oil production with coal liquefaction technology will require an investment of around 300 billion dollars, and getting the oil on the market takes a minimum of 5 years from the moment you say "let's do it".

So what does all this mean for investors? First of all, oil is going to remain expensive. In fact, it's likely to get even more expensive than it is now. Expect to see 200 dollar a barrel before 2010. So DON'T buy any stocks which suffer from rising oil prices (e.g. airlines). The company I recommend is SASOL (ticker on the US stock market is SSL), a South African petrochemical giant. They produce oil from coal and from natural gas. They've done this for decades (Apartheid South Africa was always afraid of an oil embargo).

The break-even for their coal liquefaction plants is about 30 dollars a barrel.
They're the only company in the world with any real experience in this sector. The Chinese company Shenhua is set to start producing oil from coal at the end of this year. Their expected capacity is about 100.000 barrels a day in 2010. As you can see, building any kind of capacity for crude oil alternatives quick is difficult.

The total required investment for crude oil alternatives post-peak is maybe 500-1000 billion dollars a year, so the market for solutions is very large. There is room for a lot of players. I picked coal/natural gas-to-liquids because it is a proven and scalable technology. Sasol has decades of experience with process technology in this area that all potential competitors lack. Currently, the valuation of Sasol only reflects its strong earnings, cash flow and dividends resulting from the high oil price. It DOES NOT reflect the potential role of coal liquefaction of saving humanity from the civilization-shaking event of Peak Oil.

I've been holding Sasol stock since 2004, and the rise in oil prices has led to a nice performance (a roughly 170% return). But that's not what I bought the stock for.
What I'm waiting for is the moment when people panic in regard to oil. At that point, companies offering solutions are going to go WAY up. When it will happen, I do not know. It may happen this year, it may happen in 2010. Maybe it won't happen at all. I don't know where all the additional oil could come from so fast (fast meaning "within the next ten years"), but who knows.

If Peak Oil does not arrive, the Chinese will just buy a couple of more cars, soaking up any additional supply. So oil IS going to remain expensive for the next couple of years, meaning the stock is unlikely to decline, and it will likely continue paying a nice (and growing) dividend (currently 3.4%). But the stock can easily go up four or five times if people really panic.

A cautionary note: Sasol stock prices *may* go down if the market crashes because of an oil crisis. That is what happened to oil companies (and gold miners) in the 1973/1974 crash, even as oil and gold prices increased a lot. This is because crashes are caused by a decrease in RISK TOLERANCE on the part of investors. Crashes are never explained fully by economic developments, the most harm is done by the fact that people suddenly view risk differently, and such a decrease in risk tolerance often affects even companies benefiting from the crisis. Nevertheless, both oil companies and gold miners performed well during the 1970s after the crash, far better than the rest of the market.

If you chose to buy Sasol, limit your expectations, be prepared to be invested for at least 7 years, and do not be intimidated by temporary declines, particularly if they are brought about by an energy crisis.

One more thing - I expect the long-term, inflation adjusted oil price to be around 50-60 dollars a barrel. I take that figure from the cost of oil's alternatives. To get to this point, however, requires massive investments which are hampered by all kinds of bottlenecks and very long lead times. You couldn't just pour 2 trillion dollars into oil alternatives and have your facilities pumping out 20 mbpd in 2010. There not enough petrochemical engineers and other qualified personnel, feedstock sources (coal mines, natural gas wells), pipelines and other infrastructure, equipment manufacturers etc. etc. And then there's licenses, feasibility studies, financing and all that.

That's why the investment cycles are so long in the commodity business, why it takes so long before a price signal leads to a serious increase in production output. And the length of these lead times and the capital intensity leads to hesitancy on the part of the producers - you want to be damned sure that prices for the commodity are not going down a few years from now. You require high prices for a long time to recoup your investment. So my timeframe for 60 dollars a barrel (always inflation adjusted!) is in the distant future, 2020-2025. Something to keep in mind in 2015 when you're gloating over your returns during the massive runup in commodity prices between 2000 and 2015.