Crude Oil vs. the State

TORONTO () -- The drop in crude oil prices this past week has led to sighs of relief from all the Chicken Littles' warning that high prices would cause global economic contraction and runaway inflation.

Ignoring both that high crude prices the past few years are the result of demand growth, and would not necessarily lead to the same economic results as supply-constriction price hikes, and that a two-week decline indicates nothing on a long-term scale, prices are still well above both nominal and real historical averages and may have experienced a . One possible outcome of such a shift could be the loss of reserve replacement ability from large, publicly-traded producers to OPEC and state-owned firms.

According to a report published in the October issue of Petroleum Review, in the first half of 2005, on average the 22 largest publicly traded oil companies all produced less crude oil than in 2004 and only slightly more than in 2003 and 2002. Specifically:

"For ten of the top 22 companies, and for four out of the five largest private companies, the first half of 2005 saw lower crude and NGLs production than in 2004. Ten companies also produced less in first half 2005 than they did in 2003, while nine companies produced less than in 2002."

The report goes on to state:

"Given the global increase in production and demand over the last three years...it is clear that, in aggregate, the largest private oil companies are losing market share...Clearly, it is no exaggeration to say that the world's largest publicly quoted oil companies are now really struggling to hold production levels, with only a few managing to maintain their market share of global production."

Three years does not a trend make, but it could it indicate a shift.

Meanwhile, a recent study by Andrew Latham of Wood Mackenzie, an energy consultancy, states that only a quarter of the 28 largest oil companies active in international exploration, and representing more than 30% of global oil supply, have fully replaced their production through new field discoveries.

"The industry has reduced its exploration investment in recent years as a response to growing technical risks and uncertain oil prices. The result has been attractive returns for the companies but with diminished reserve replacement performance."

Of course, this doesn't necessarily mean the industry as a whole is spending less. Although the "super majors" remain the industry's top spenders, their share of industry exploration investment peaked in 1998 and is presently at two-thirds this level. According to Latham, this drop-off has led to a 50% decline in overall reserves replacement.

It would appear logical that current high crude oil prices would create the impetus for companies "to step up exploration activity as part of an overall effort to secure future supply."

Yet the same high crude prices have created inflationary pressures throughout the industry, including higher costs for labor and materials, as well as increased competition for exploration areas and capacity constraints.

The result: finding costs for new reserves rose 50% over the last 10 years, says Latham. And there is no sign of this trend abating. This is why so many portfolio managers and analysts are bullish on oil services equities.

In addition to higher costs, it has become more difficult to achieve success, as the more accessible fields have been discovered. The industry has not discovered any new "world-class" fields since 2000 according to Latham.

Since part of being in the resource business is the continual need to replace reserves, an increase in exploration spending is likely. But then again, it may be cheaper for companies to buy reserves on the stock market rather than through the drill bit. Yet mergers and acquisitions do not solve the overall problem of finding new reserves; it just transfers them from one publicly traded company to another.

And a consequence of lower reserves for publicly-traded companies would be, over time, increased dependence on OPEC supplies.

In an October 4, 2005 report, Greg Pardy at Scotia Capital wrote:

"The renewed empowerment of OPEC and national oil companies (NOCs) to set the pace of global spare capacity growth has cast a new dimension on the oil market. This transformation had been unfolding for several years, but was dramatically accelerated by China's surging oil demand growth in 2004, which absorbed much of the globally available spare capacity."

The analyst believes that OPEC-10's net capacity could rise by 850,000 barrels per day (bbl/d) in 2005, but its spare capacity will likely remain contained at 2.3%, or 2 million barrels per day, of global supply. Although this places market forces in control of prices, especially on the downside, Pardy said that OPEC "ultimately holds the trump card via its power to build capacity." He wrote:

"That roughly 85% of (conventional) proven global oil reserves are in the hands of NOCs has not changed appreciably over the past quarter century. But the value-added proposition that the majors and super majors are now able to pitch to resource-rich host governments - which are less capital constrained - has been diluted amid rising crude oil prices and resource nationalism. Indeed, the thrust of NOCs, whose focus on a revenue stream contribution from oil to finance government budgets, has begun to clash sharply with international oil companies, where production growth and returns are key drivers of market performance. "

So if there is a shift of reserve replacement ability from the "super majors" to OPEC and other state-owned oil firms, it could lead to:

  • Mergers and acquisitions among the large, established producers, to secure and grow reserves.
  • More focus on so-called "unconventional reserves," including oil sands and shale, especially in politically-stable countries.

This second point would suggest that shares of major companies involved in Canada's oil sands could be a wise investment to pass down to your great-grandchildren. Yet on the other hand, why couldn't resource nationalism lift its ugly head in Canada?

There is nothing stopping the federal government from implementing punitive taxes on Alberta's oil sands producers. It happened before - the 1980 National Energy Program. In addition, there's no reason why it could not happened sooner rather than later. Canada has a prime minister that, although assumed to be fiscally conservative, has shown he and his cronies were willing to immediately change course and both raise taxes and run deficits to appease his socialist bedfellows.

Of course, this is just pure speculation. Yet such issues apply to Donald Coxe's, chairman and chief strategist of Harris Investment Management Inc., Rule of Page 16 which states "You neither make nor lose serious money by the outcome of a story on Page One. You make or lose serious money from the outcome of a story that's now on Page 16 but is headed for Page One." It's all about getting ahead of the herd.

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