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Key investment issues

FEATURE: Daniel O'Sullivan and Martin Li explain the key issues surrounding the oil and gas sector.
February 19, 2010

Last summer we predicted () that despite the bullish prognostications of some investment bank cheerleaders, around the $70 per barrel mark seemed the upper limit for a 'fair' price for oil in the near term. Despite the higher prices through the latter half of last year, oil in fact averaged around $60 through 2009. It seems more probable than not that it will average higher this year, but by how much? Just because we still see $70 as the 'fair' level for the price does not mean it will stay at this level (witness the 2008 bubble). Yet we feel that, while 2009 was a tale of euphoria through the latter half of the year following on the heels of utter dejection at the start, 2010 will be more circumspect - especially if the dollar continues to strengthen.

Through the coming year oil might well edge up towards $80 again on the basis of speculation, perhaps beyond, even though fundamentals remain unsupportive. But we wonder if in fact the risk is now actually more to the downside, and perhaps producers will be lucky if the low $70-ish range turns out to be around the average for 2010, as well as where prices happen to be right now. Why does any of this matter? Because brokers have to pick an oil price to value both current reserves and potential future prospects. In our view, any share price requiring an average in excess of $75 per barrel to justify valuation is asking too much right now.

Impact of increasing Iraqi oil output

Iraq hopes that its oil wealth will pull the country back onto its feet. Its oil ministry recently agreed service contracts to increase output from vast projects, which in total would almost quintuple its production capacity by 2017. The ambitious target is 11.75m barrels a day (from currently some 2.5m barrels a day), which would elevate Iraq to Saudi Arabian volumes.

If Iraq achieves its plan, its extra production might overwhelm expected demand growth over the period. This could weigh on the oil price.

Other Opec members might have some things to say about Iraq's plans, although it's unknown whether Iraq would agree to the imposition of any quotas.

Shale gas boom

The recent boom in North American shale gas production is expected to contribute to "an acute glut of gas supply in the next few years", according to the IEA. Increasing shale gas production will reduce reliance on the developing liquefied natural gas (LNG) industry.

The US majors were slow to seize the shale gas opportunity. ExxonMobil's $41bn (£26bn) acquisition of XTO marked a significant shift in strategy for the US giant and a belated (and relatively expensive) leap onto the American shale gas bandwagon. Exxon and fellow US majors ConocoPhillips, Marathon and Chevron have now turned their attention to the analogous shale gas plays in Poland's Baltic Basin, where each has acquired exploration acreage to ensure they don't miss out again as they did in the US.

Shale gas is an unconventional gas source and its extraction is a drilling-intensive, expensive process that can bear closer resemblance to mining than oil and gas production. US gas prices have already been hit by increased shale gas supply and the growth of LNG. Eastern European gas demand has brighter prospects due to formerly-subsidised prices converging with higher western European rates and eastern European countries wishing to reduce their energy reliance on Russia.

While the majors are grabbing land in Europe for shale gas development, Aurelian Oil & Gas is on the verge of commercialising a cheaper alternative through a tight gas project at Siekierki in Poland. Tight gas is a conventional gas source that requires fracture stimulation to make it flow at commercial rates. Applying technology that has been proven elsewhere in Europe but never before used in Poland, Aurelian hopes to tap the same basin that has already produced prolific volumes in the southern North Sea and western Europe.

Oil facts

■ The world consumes around 84m barrels of oil a day.

■ A barrel contains 35 gallons or 159 litres.

■ A barrel of oil is equivalent to approximately 6,000 cubic feet of natural gas (which is often quantified in units of 'barrels of oil equivalent').

■ Saudi supertanker Sirius Star held 2m barrels of oil when she was hijacked by Somali pirates in November 2008.