Thursday, March 25, 2010

Oil -- Leading Vitamin for Capitalism

The global population of cars is expected to reach 3 BILLION by the middle of this century. That's up from 600 million today. A five-fold increase is ahead. In other words, pundits predict a lot of prosperity that will appear in the form of cars, trucks, buses, tractors, earth-moving vehicles, farm equipment, aircraft, boats and ships. That means demand for oil is going in one direction. Up. And efforts to find, extract, transport and refine it will move in tandem.

The Prize -- The Epic Quest for Oil, Money and Power

The greenish black gunk spewed 150 feet into the air, drenching men and machinery as it roared up. Welcome to east Texas in 1901. The Spindletop oil discovery produced some 100,000 barrels/day (they expected 5), more oil than anyone wanted or needed. Nevertheless, the gusher started the great east Texas oil boom. A barrel of oil was 3 cents.

Oil is now $80/barrel, gasoline $2.80/gallon. A voracious, continually growing, worldwide fleet of 600 million plus vehicles, consumes much of the world’s daily production of 85 million barrels. Today, oil companies drill through miles of rock and salt, often under thousands of feet of sea water, to find more of the elusive black stuff.

Now, the easy pickings are gone. Salt domes like Spindletop are tapped dry (Spindletop itself quit producing in the 1930's). Though lots of hydrocarbons remain in the earth, extraction is becoming increasingly difficult. Consider:

The U.S. (lower 48): Texas produces more oil than any other U.S. state but production peaked at 3.5 million barrels/day in the early 1970's. Now, Texas production is below 1 million barrels/day and steadily dropping. With the exception of North Dakota and the Gulf of Mexico, the same is true for the rest of the U.S.

Alaska: Prudhoe Bay, the largest oil field in North America, has produced some 13 billion barrels since 1977. BP plc estimated that as of August 2006 only some 2 billion barrels of recoverable oil was left in Prudhoe Bay.

Canada: Canada is the U.S.'s largest oil supplier. Conventional oil production is in decline. Though potential exists in oil sands and shale, possibilities for exploitation are murky due to environmental issues.

Mexico: The woes of Cantarell, at one time the second fastest producing oil field in the world (behind Saudi Arabia's Ghawar), are legendary. Production peaked at 2.1 million barrels/day in 2003, but by 2009 it had dropped to 774 thousand barrels/day and is still falling. Schlumberger (SLB) is now working with Pemex to slow the decline in Mexican production.

The North Sea: North Sea oil production peaked in 1999 and A Wall Street Journal article on January 13, 2010, said about North Sea fields:

... oil and gas fields are in steep decline and nearing the end of their production lives.

The Middle East: Oil reserves and production in the Middle East, especially Saudi Arabia, are unknown. The Saudis, currently pumping 8 million barrels per day, claim to have 4 million barrels per day of spare capacity. But, can you believe the notoriously secretive kingdom? Even if the Saudis are right, a worldwide economic resurgence could easily absorb this extra capacity.

Ghawar, Saudi Arabia's, and the world's, largest oil field, needs increasingly large water injections to keep the oil flowing. Among other Middle Eastern states only Iraq may be able to ramp up production (and then only if it is able to keep the violence under control).

In the Middle East there is always the risk of geopolitical issues flaring up. Currently, we have $80/barrel oil, a sign of relative stability. However, Iranian Shiites have their eye on Sunni oil, Al Qaeda is still around, and Israeli/Arab issues are unresolved. If any of the above flare up you can say goodbye to $80 oil.

However, after oil peaked at $147 a barrel in the summer of 2008, it fell to about $35. Thus, temporary price surges are invariably followed by steep declines.

Elsewhere: Brazil, Russia, Africa, Indonesia, Venezuela are all large oil producers. All, except Brazil, have flat or declining production and/or exports. Several large off shore fields have been discovered in Brazil recently, but they are miles deep in the ocean, under salt and rock. Tapping those resources will require the best the oil services industry has.

This article is not meant to prove or even argue peak oil. Rather, the point is no matter what or who is right about peak oil, it will take more and more effort (read oil service) to keep oil flowing.

The oil services sector supplies the expertise that supports the massive worldwide infrastructure continually turning raw petroleum into useful products, such as the gasoline you put into your car. Whether it be horizontal shale, deep sea basins, getting more out of older fields, transportation or refining, none of it would happen without the oil services sector.

Oil Service Companies

Schlumberger (SLB) is a dominant player. With a market capitalization of over $75 billion, it dwarfs competitors such as Haliburton (HAL) and Baker Hughes (BHI). Schlumberger is a quality leader in almost all aspects of the oil service industry. Recent acquisitions of Smith International (SII) and Nexus Geosciences enhance expertise in drilling and seismic services. If you were to pick just one, Schlumberger would probably be the best choice.

Transocean (RIG) and Diamond Offshore (DO) specialize in offshore contract drilling, while National Oilwell Varco (NOV) is more a "nuts and bolts" type company, designing, manufacturing and selling products used for the production and transportation of petrochemicals.

Exchange Traded Funds (ETFs)

If you wish to avoid corporate risk consider oil service ETFs. Three of the larger ones are: iShares Dow Jones US Oil Equipment Index ETF (IEZ), Oil Services HOLDRs (OIH), SPDR S&P Oil and Gas Equipment Services ETF (XES).

iShares Dow Jones US Oil Equipment Index ETF

IEZ has holdings in over 40 companies and is market-cap weighted. The three largest holdings: Schlumberger, Haliburton, and National Oilwell Varco comprise almost 40% of capitalization.

Oil Services HOLDRs

Like IEZ, OIH is concentrated in the larger oil service area. Transocean is the top holding at 15%. There are only 16 securities in this ETF. The three largest: Transocean, Schlumberger and Haliburton total around 35% of holdings.

SPDR S&P Oil and Gas Equipment Services ETF

This oil and gas equipment and services ETF holds 24 securities, but no one security comprises more than 5-6% of holdings. Smith International is currently the largest holding. Although XES has many of the same companies as IEZ and OIH, there is a greater weighting of smaller to midsize companies in XES.

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