The world will continue to run on fossil fuels – and in particular oil – for many years, if not decades, to come. Despite efforts by governments to diversify the global energy mix towards renewable sources, oil demand looks set to increase not decrease over the medium term.
In its 2010 World Energy Outlook, the International Energy Agency (IEA, the inter-governmental energy policy adviser) predicted oil will remain the dominant global fuel to 2035, driven by demand for mobility in emerging economies. Oil can be substituted in many applications, but not yet to power cars or aircraft.
However, the age of cheap oil is over. After the wild fluctuations of 2008 that saw the oil price spike at $147 per barrel in July only to collapse back to $35 per barrel that same December, the oil price settled into a higher trading range, currently $70 to $80 per barrel. While trying to predict the future oil price is an impossible task, the consensus view cannot see oil retreating back to $30 or $40 per barrel on a long-term basis. In fact, some analysts regard the current trading range as potentially the future floor rather than ceiling.
This is another way of expressing the industry mantra that "all the easy oil has been found", which though often repeated should perhaps more accurately read "all the $40 per barrel oil has been found". The reason is that there is plenty of oil and gas out there. BP's latest annual reserves, production and consumption statistics suggest the world still has oil reserves sufficient for 43 years of consumption at current rates and gas reserves sufficient for 64 years of consumption at current rates. And this assumes the industry never discovers another barrel of oil or gas.
However, BP's statistics don't reflect the commerciality of remaining reserves and how likely they are to be produced. Not all barrels of oil are equal. A barrel of oil onshore in Saudi Arabia is considerably easier to get at than a barrel lying beneath thick salt in deep water off Brazil, or beneath frozen Arctic plains.
China still in the driving seat
It's possible that all the $40 per barrel oil has indeed been found, although global demand continues to grow from currently around 86m barrels per day. Developed economies are showing the first signs of recovery, although the engine for demand growth will be the developing economies, particularly in Asia. The reason is simple: these economies are developing at a furious rate and economic development is very energy intensive. As a result, Asia increased its oil demand through the downturn while demand fell across developed Western economies.
"It is hard to overstate the growing importance of China in global energy markets," says the IEA. Its preliminary data suggests that China overtook the US in 2009 to become the world's largest energy consumer, having grown from using only half the US's consumption in 2000. Even after such prolific growth, China's per-capita energy consumption remains relatively low at only a third of the average of developed countries, which suggests substantial capacity for further consumption growth.
The IEA forecasts that global oil demand will grow to 91m-94m barrels per day by 2020. To meet this demand, oil companies will need to produce large quantities of hydrocarbons from far-flung locations, in deep waters and under hostile conditions, where discoveries can be difficult to commercialise. The more remote and challenging the conditions, the higher the oil price will need to be, and this will make "difficult" oil ever more commercial.
Sweet crude oil has peaked
Debate continues to rage over whether the world has passed "peak oil", the point beyond which global oil production enters terminal decline. Different models give different estimates, although most agree this point is years rather than decades away.
Christine Tiscareno, oil and gas equity analyst at Standard & Poor's, takes the analysis a level deeper and says that global peak oil for sweet crude was reached in 2006. Sweet crude is the light, easy flowing, low-sulphur oil that doesn't require much refining, and is characteristic of oil found in the US, UK and Iraq. If sweet crude production has peaked, the extraction and refining of what's left will be increasingly expensive, which provides further upward pressure on the future oil price.
A high oil price (provided it remains relatively stable) is, of course, good news for oil companies, although they have first to overcome the technical and political challenges of finding and extracting it, particularly with many national (state) oil companies increasingly maintaining a stranglehold on reserves for domestic consumption.
Next year will see continued exploration and many juniors will offer attractive opportunities for investors to make substantial capital gains, often over short periods of time.
Dawn of the Caspian
Deepwater drilling will recover from the post-Macondo downturn – the US needs oil from the Gulf of Mexico – but is likely to become increasingly the preserve of oil majors as insurance costs rise and safety procedures become more stringent. All offshore drilling is likely to become more regulated in the wake of Deepwater Horizon. Faroe Petroleum announced that around £6m of the £62m it raised in November was to fund the increased costs of various exploration wells.
The Caspian region should evolve into one of the world's great hydrocarbon producing regions. BP, which – short of another accident – should continue to rehabilitate, is looking to Azerbaijan for much of its future growth. The IEA forecasts that the Caspian region's oil production will increase from 2.9m barrels per day in 2009 to a peak of around 5.4m barrels per day in 2025 to 2030, with Kazakhstan contributing all of this growth. Only Saudi Arabia, Iraq and Brazil are expected to grow output faster over this period. Caspian gas production is also expected to expand substantially, driven by Turkmenistan and, to a lesser extent, Azerbaijan and Kazakhstan.
Oil becoming less crude
Given increasing production challenges and the possible first effects of peak oil, some majors are already struggling to replace their produced crude reserves. Fortunately for them, provided the oil price remains within the higher trading range as analysts predict, the evolution of unconventional oil – mostly oil sands – and natural gas liquids could help them to offset declining flows of conventional oil.
The IEA predicts that unconventional oil is set to play an increasingly important role in global oil supply through to 2035. Some majors are depending on it. Royal Dutch Shell, for example, is heavily reliant on unconventional oil, most notably its Athabasca oil sands project in Canada and Pearl gas-to-liquids project in Qatar, for production growth. BP is also expected to invest heavily in Canadian oil sands.
Natural gas: the game-changer
Natural gas could play an even larger role in helping meet global energy needs over the next couple of decades. Gas is abundant around the world but was until recently regarded as an unwanted by-product of oil production, given the pipes needed to be built to flow it to market, which wouldn't be commercial for remote, isolated gas fields.
The evolution of liquefied natural gas (LNG) has changed all that. Provided gas finds are large enough to justify the substantial cost required to build liquefaction and regasification plants, natural gas can now be transported all over the world.
The commercialisation of shale gas in the US is proving even more of a game-changer. The US was on the verge of needing to import gas only a few years ago, but has been completely transformed by the shale gas revolution over the past two or three years. The US now has enough gas for a century and might even compete with Russia and the Far East as a leading LNG exporter. The challenge facing shale gas producers now is to replicate their success in other gas-hungry parts of the world, particularly in Europe where gas prices are much higher than in the US.
Where to invest now
With growing demand and upward price pressure, oil and gas looks set to remain a good sector for investors. Previous successes have provided clues to where the next windfalls are likely to be made:
Drilling: Exploration, and to a lesser extent appraisal, drilling successes create the strongest share price rises but are inherently hard to predict. This is where proven management teams can help reduce odds that would otherwise be heavily stacked against investors. Tullow Oil and Faroe Petroleum regularly drill high-impact exploration wells and both have enviable track records of success – much better than the industry average.
Being larger and more diversified, the potential for Tullow is more muted, although Faroe's shares will soar on exploration discoveries. Cairn Energy is looking to replicate its Indian success in Greenland and oil strikes in the Falklands will mostly offer triple-digit upside potential.
Production: The market values the initial discovery of oil or gas more highly than the less glamorous and costly process of developing and commercialising finds (although the industry doesn't pay much for exploration potential). However, with elevated energy prices, it's impossible to deny the value of growing production cash flows. Ithaca Energy offers a strongly growing production profile from working its North Sea assets. Victoria Oil & Gas is poised to generate first and substantial commercial gas flows from its Logbaba project in Cameroon.
Farm-ins: Farm-in deals, where juniors sell interests in their licences to other – generally larger – oil firms, often confirm the most compelling reasons for re-rating shares. For example, if a major invests $Xm to acquire a Y per cent interest in a junior's licence, sometimes "carrying" the junior (bearing the costs the junior would otherwise have to pay to meet its share of costs), it is often revealing to calculate the implied value of the entire licence.
The implied value of a single farm-in can be enough to underpin most if not all of a company's capitalisation. Northern Petroleum and Serica Energy have good track records of completing such deals and the market is waiting for Chariot Oil & Gas to announce a second farm-in (its first deal was with Brazilian state giant Petrobras) to help it explore highly prospective licences off the coast of Namibia.
