It’s no secret the oil market has been wildly inconsistent in recent years. As such, there are things we know about the oil industry, and there’s a lot more we don’t know. The media say one thing about it one day, and then say the opposite the next day. And the folks in Washington certainly don’t know what they’re talking about – or doing, for that matter.
So the truth is, we as a whole really don’t know as much about the oil market as we think we do.
When it comes to oil, there are many numbers out there, but most of these involve a lot of guesswork. For example, we really don’t know just how much oil the world will need. The U.S. Department of Energy says we’ll need 106.6 million barrels a day by 2030, buy how does it know? It can’t know. It can’t know what the world will look like in 2030.
We don’t really know how much oil we’re discovering or how much will actually come to the market any time soon. We don’t really know how much it will cost to get this oil. We can guess, but our guesses are frequently wrong. Goldman Sachs wrote in a research report issued in February of last year (230 Projects to Change the World) that the cost of bringing on additional oil sands project would come to $80–90 a barrel. It sounds nice, but it’s a guess.
We don’t know a lot, even though we put decimal points on lots of numbers as if we knew precisely. And there is plenty of room for people to fudge numbers and make up stuff. It happens all the time.
Of course, no one knows what the price of oil will be, but there is no shortage of forecasts. Goldman Sachs says it will be $95 by the end of 2010. Deutsche Bank says $65. They are all guessing.
But if You Don’t Know Anything Else…
There is one thing we do know. And fortunately, this is the most important thing to remember as an investor in oil: The market is still pricing proved oil reserves at less than replacement cost.
In other words, it is cheaper in today’s market to buy proven reserves in the stock market than to drill for new ones.
I would cite the 2008 reserve and finding cost study published by Howard Weil. It shows the average cost of reserves through the drill bit is about $43 per barrel, with the median (or midpoint) around $25 per barrel. These are hard numbers, not soft guesses. You can do this yourself and find out how much it costs for your favorite oil company to add a barrel of proved oil reserves by drilling for it.
So we have a good idea of what it costs to create a barrel of proved oil reserves today. Figuring out these numbers is easier than guessing what the price of oil will be in the future. Granted, even these cost numbers will change. There are no constants.
But here is the trick. You want to buy oil companies when you can pick up proved oil reserves for a lot less than what it costs to produce them. In the market, that’s where we are today. In fact, you can pick up proved reserves for less than $15 a barrel.
The math is easy. You have lots of companies here in which you can buy oil in the ground for under $10 a barrel… and remember it costs on average $25 a barrel to replace it.
I could not make a more compelling argument for oil stocks than this.
Buying for less than replacement costs is one of my main compasses in investing — whether I’m buying potash mines or gold mines or factories or oil rigs or what have you. If I can buy it in the stock market for less than it costs to replace those assets — and as long as I’m not buying buggy whips — then I’ve got a good chance of making money.
That’s because the stock market is, after all, just a market. Eventually, prices correct. In the oil market, we’ll see more acquisitions. It’s cheaper and easier to grow reserves that way. The buying pressure will lift the price of oil stocks so that the disparity is not so great. Simple as that.
In the case of oil, we are also looking at strong odds that the costs of producing a barrel of oil reserves will go up. Recently, The Wall Street Journal ran a piece titled "Cramped on Land, Big Oil Bets at Sea."
Moving Ahead into Uncharted Waters
Now, you’ve probably heard of all the big deep-water oil projects. All the major oil companies are moving farther offshore in their quest for oil. The WSJ article leads with this: "Big Oil never wanted to be here, in 4,300 feet of water far out in the Gulf of Mexico, drilling through nearly five miles of rock. It is an expensive way to look for oil."
Yes, it is. This is another of the great unknowns. We don’t know how much it will cost at the end of the day to get this oil. We know that it will cost a lot. Chevron spent $2.7 billion over 10 years on just the first phase of a deep-water oil project in the Gulf.
That’s one of the more tame projects. Some of the sub-salt discoveries involve drilling more than 30,000 feet. They will be the most expensive wells ever drilled. You really don’t need to know a lot about geology or oil to guess that this deep-water oil is going to be more expensive than the good old oil wells onshore.
So that average cost of reserves is likely to go higher. Meaning, that if you can lock in quality, low-cost, long-lived reserves today for only $15 a barrel or less — you should do it. That’s why you own oil stocks today.
But be advised, oil isn’t the only natural resource you should put your money into. There are opportunities elsewhere in the realm of natural resources, and one of the best comes in the form of gas. And you might be amazed as to where in the world you could find it…
Profit from the Middle East of Gas
There’s a gas powerhouse emerging in the Far East. It’s a bet that some of the biggest energy companies are making right now – to the tune of more than $50 billion. And it’s a play that could potentially send your portfolio through the roof in 2010. Here’s everything you need to know…
In Sydney one sunny morning, a group of readers and I met with Kris Sayce, editor of the Australian Small-Cap Investigator. Sayce talked about what could become Australia’s biggest resource boom yet. Australia is on its way to becoming to natural gas what the Middle East is to oil.
Last month, I wrote to you about the liquefied natural gas (LNG) boom, and we picked up a great way to play the growth in LNG spending over the next several years. What follows is another look with new information I gathered while in Australia.
The LNG boom is really an Asia story. (And that makes it an Australian story too, as we’ll see.) As Sayce pointed out, Asia is the fastest growing market for LNG.
Currently, Japan is the largest buyer of LNG. Japan and South Korea together make up 53% of current global regasification capacity. (That is, the ability to import LNG and turn it back into a gas for consumer and industrial use.)
Pressed against this new demand is an aging supply base in places. For instance, there are old LNG fields in Malaysia and Indonesia coming to the end of their useful lives.
Going Down Under for LNG
So how will the market meet this surge in Asian demand? That’s where LNG from nearby Australia comes in. It’s hard to miss this story when you take a look at the Australian resource markets. It’s in the papers nearly every day. And the amount of money going here is just staggering.
The Gorgon project alone — a joint venture between Exxon Mobil, Chevron and Shell in Australia — will cost some $50 billion. It already has supply contracts from India and China worth $60 billion and will surely get more before it opens in 2014. There are other firms pushing ahead with aggressive LNG ambitions. Woodside Petroleum, an Aussie oil and gas company, wants to be the leader in LNG by 2020.
As a result of all this activity, Australia will challenge Qatar as the world’s largest LNG exporter. One analyst quoted here said: "The numbers are phenomenal. When you look at them it’s mind-boggling. It’s going to be LNG boom times."
Asian buyers love Australia because it’s closer. It also seems a more secure supply. The gas doesn’t have to pass through the war zones of the Middle East or the pirate-infested waters off Somalia. For most buyers, Australian gas doesn’t even have to pass through the congested Straits of Malacca, either.
Australia has lots of offshore natural gas. Explorers continue to find sizable new discoveries, which means new projects may yet come on board. Most of these are in western Australia’s waters. But Sayce also shared with us the new discoveries made in Queensland, off the east coast. Queensland has big reserves of coal seam gas. This is naturally occurring methane trapped by water deep underground. Coal seam gas also can be converted to LNG.
The big energy companies are already moving in. Shell, BG Group, ConocoPhillips and Malaysia’s Petronas are among those developing projects in Queensland. The growth in LNG production from Queensland alone has tripled in recent years.
With all these projects, it’s quite possible that in the next decade, LNG will surpass coal as Australia’s most valuable export. The government is certainly supporting LNG projects — it will add a gush of tax revenues to its coffers. Look at what oil did for the Middle East; the same kind of thing could well happen for Australia.
I often hear the objection that LNG won’t ever catch on in the U.S. — at least not in a big way and not anytime soon. I don’t disagree, but we have to think beyond just the U.S.
Why Non-U.S. Markets Are Where It’s At
I’ve taken great pains to argue in past articles to you that we have to move away from a U.S.-centric view of the world. We’ve turned an historic corner in recent years. The end result is that non-U.S. markets — or, more broadly, non-Western markets — matter more now than at any time since before the Industrial Revolution. In size, the emerging market economies are on par with the developed world. The pie is split 50/50.
The best way to play LNG, in my view, is to own the companies that put together the Erector Set that LNG needs to operate. There are cold boxes that turn the gas into liquid. There is special insulated pipe. There are storage systems. There is a whole complex of stuff that has to be put together.
By owning one of the companies that make all of that stuff, you don’t take on the enormous risk that goes along with these huge capital projects. I mean $50 billion (the latest estimate) for Gorgon is a gargantuan bet — too big for any single oil company to go it alone, hence the joint venture. And then there is price risk — no one can say what the LNG will sell for or what kind of returns it might generate.
It’s simpler to own the companies that put it all together. They will enjoy fat cash flows and swollen order books for years to come. In the short term, there is worry that some projects may get delayed or cancelled because of the financial crisis. But that’s what gives you the opportunity today. Longer term, the case looks solid to me.
