Over the next several years, there will be an unprecedented eagerness among oil producers all over the world to inordinately increase output. This is not only because of the rush to fill the global supply deficit, which has largely been induced by increased political instability in key oil producing states, but also because of how the U.S.'s newly found energy dominance (it recently toppled Russia and Saudi Arabia to become the world's top producer) plays into the overall upstream equation.
To begin with, global producers will be looking to offset the supply deficit that has been inspired by events such as Iraq's recent implosion, and an overall reduction in production in other politically unstable producing states such as Libya. In fact, the U.S. Department of Commerce recently approved the exportation of condensates by Texas-based Pioneer Natural Resources (PXD -0.13%) and Houston-based Enterprise Products Partners (EPD -0.41%), fanning growing speculation that the crude oil export ban could soon be lifted in order to offload domestic surplus and plug the global supply deficit.
Secondly, the U.S. will need to maintain its dominance, which has thus far been driven by fracking. The only obstacle, if I might put it that way, is that output from shale wells declines faster than output from conventional wells. The International Energy Agency says that it will take up to 2,500 new wells a year to sustain output of 1 million barrels per day in North Dakota's Bakken shale.
In contrast, Iraq, which has conventional wells, could comfortably do the same with 60 wells. This essentially means that for the U.S. to successfully sustain its dominance, it will need to employ a multilevel strategy that involves considerably heavier fracking in shale plays and increased exploration and production in conventional plays -- in other words, the U.S. needs to increase production in both conventional and shale plays.
The constellation of these disparate developments sets the stage for an impending increase in global production. This imminent increase in global oil production will be accompanied by a corresponding uptick in demand for drilling and production equipment. This will in turn create an opportunity for long-term investors to participate indirectly and safely in the lucrative bonanza through plays such as National Oilwell Varco (NOV 0.64%).
National Oilwell Varco well positioned
The monstrous demand for drilling and production equipment is sufficiently captured by National Oilwell Varco's rig backlog, which has increased by an estimated 30% over the past year to date to reach an unprecedented $16.35 billion. Moreover, the oil equipment manufacturing industry is relatively unsaturated. This means that National Oilwell Varco can prompt upward adjustments in prices by rationing equipment supply (within ethical boundaries) against the backdrop of increased demand by producers.
Besides being in a position to influence higher unit prices for its equipment, National Oilwell Varco's recent decision to spin off its former equipment sales and distribution arm, NOW, into a stand-alone entity will allow it (National Oilwell Varco) to navigate the equipment manufacturing market more effectively.
The split, which was effected in May, allows National Oilwell Varco to focus almost entirely on equipment manufacturing. In addition to allowing National Oilwell Varco to craft effective and easily executable strategies, exclusive focus on manufacturing allows National Oilwell Varco to achieve higher margins. In National Oilwell Varco's Q1 report, when NOW was part of the company, operating margins in the distribution segment came in at 5.3% compared with a 21% operating margin in the rig segment. An exclusive focus on the higher-margin rig business will thereby allow National Oilwell Varco to grow much faster than before, especially in an environment of increased equipment demand and prices.
Foolish takeaway
Agreeably, the impending oil production upsurge makes direct investments in oil producers very attractive. Notwithstanding, it doesn't come absent risk. While some producers will enjoy high margins due to well informed investments, others, out of euphoria or unrelenting investor pressure, will take up dangerously high levels of debt to finance expanded production, or worse, sink their investments in politically unstable areas.
Investors looking for safe sustainable growth over the long term would be better off investing in equipment manufacturers such as National Oilwell Varco, who will make profits from the sale of equipment, regardless of whether the producers who buy the equipment make a good investment or not. Over the past five years to date, National Oilwell Varco has gained a decent 150%. The impending increase in demand for rigs and a favorable company structure should drive the stock even higher over the next five years.
