Oil services a long-term buy

by Levi Folk | January 15, 2007

When a few flakes fell on New York City last week, it marked the latest start to winter in 129 years of recorded history. The weather may be mild but the implications for oil prices have been severe: Markets have sold off recently as though investors believed winter would never return.

The drop in oil prices below US$55 a barrel is a significant blow to OPEC’s production cuts aimed at propping up prices but unlikely the end of a long-term bull market in oil prices, and oil companies are embarking on ambitious spending plans over the next few years to boost production, with the biggest beneficiaries being oil service and drilling companies.

Rather than focus on short term factors as a reason to sell oil, consider the long-term implications for oil demand and capital spending in the oilpatch over the next 10 or 20 years.

For those who cared to look, the writing has been on the wall indicating softer oil markets based on the increased supply from non-OPEC producing countries in 2007. After almost zero net additional supply in 2005, the IEA was calling for 650,000 barrels a day in 2006 and 1.7 million barrels a day in 2007 from non-OPEC countries, swamping demand expected to increase by 1.44mbd in 2007.

The only reason oil markets had stayed firm was OPEC’s response: Announced production cuts of 1.2 mbd in November and another 500 kbd starting Feb. 1, 2007. That they sum to 1.7 mbd is likely no coincidence. That they have not been fully adhered to is also not exactly a shock, either.

So far only 555 kbd of the originally announced cuts (1.2 mbd) had been taken out of the market in November according to the IEA. Saudi Arabia’s Oil Minister Al-Naimi said OPEC members are complying with about 80% of the originally proposed cuts according to Bloomberg newswire, which is probably an exaggeration of the facts. At any rate, it was reasonable to expect the price of oil to be range-bound between US$55 and US$65. The unexpected factor was the milder weather.

Whatever the case, non-OPEC conventional oil production will peak soon despite the most recent jump. With prices above US$70 last year, producers did whatever they could to boost production, but the fact of the matter is that many non-OPEC producing countries are dealing with long-term natural decline rates in production, estimated as high as 11% for some “mature OECD countries” according to the 2006 World Economic Outlook published by the IEA.

Non-OPEC conventional oil and natural gas liquids production is expected to peak in 2010 at 52 mbd and decline thereafter, which means OPEC will have a much stronger hand in the market in coming months and years. That, incidentally, is why oilsands production, while small on an absolute level, is so important, it representing 100% of the increase in non-OPEC oil supply between 2010 and 2030.

The IEA estimates in the “reference scenario” that fossil fuels “remain the dominant source of primary energy as far out as 2030.” They account for 83% of the increase in energy demand between 2004 and 2030. And oil producers will need to boost capital investment significantly over the near and long term to meet demand.

And they have been increasing production spending by 70% or US$340-billion from 2000 to 2005 according to the IEA. However, so much of that investment has been eaten up by rising costs. Only 5% of that increase represented a real increase. The rest was simply cost inflation.

All told, the IEA expects investment to rise to US$470-billion in 2010 and calls for US$8.1- trillion (using 2005 dollars) in capital spending in oil and gas infrastructure between 2005 and 2030, with half that amount being used just to maintain current supply capacity.

Cost increases will obviously account for a portion of the increased investment. Inflation in the energy patch is rampant, which is translating to significantly higher operating margins for oil services companies. Yet valuations remain at or near multi-decade lows. The P/E ratios for oil and gas equipment and services companies, as well as drilling companies listed on the S&P 500 energy sector, are near the lows reached in 1998 when oil stocks were in a bear market.

And oil is not in a bear market, the recent correction in oil prices notwithstanding. Speculative money has definitely headed for the door in recent months on softer demand due in part to warmer weather. But just as the snow will soon fall again, oil demand will likely rise on the margin. Therefore, investors should take a long term view and pick up energy services and drilling companies on the cheap over the next few months on weakness in oil prices.