4/11/2008

The Cheap Oil Syndrome
By Conley Turner

The dominant question on the minds of many market participants at this time is whether or not the price of crude oil can sustain its current lofty level.  Is the age of cheap oil really gone forever, or is it that the current high price is just the result of excessive investor speculation and is bound to come back down to earth?  While arguments can be made for both sides of the issue, there is a preponderance of evidence to suggest that the upward trend in the price is secular in nature.

One only has to recall the trip to Saudi Arabia that the President of the United States (the world’s largest oil consumer) made at the beginning of the year.  Neither the President, nor all his horses and all his men, could cajole the Saudi government and other Organization of Petroleum Exporting Countries (OPEC) members to increase oil output.  In a speech given during that visit, he offered that “OPEC should understand that if they can put more supply on the market it will be helpful.”  Mr. Bush went on to say to his good friend and host, “I will say to Abdullah that high energy prices can affect economic growth because it's painful for our consumers ... could cause the U.S. economy to slow down.”  The House of Saud, one of America’s closest allies in the region, balked. This was clearly an augury.  Oil was flirting with the psychologically important $100.00 per barrel threshold at that point, which has since been breached, and is now heading further north.

To the casual and not so casual observers alike, it was reasonable to wonder as to the reasoning behind Mr. Bush’s rather unconventional stand.  The answer to this can be inferred from his subsequent comments that energy demand has “outstripped new supply,” and “that's why there are high prices.”

More evidence supporting the outlook for higher trending oil prices comes from Schlumberger (SLB), the world’s largest Oil Services Company.  The company is uniquely positioned to provide unparalleled insight about the state of global oil production.  This stems from the fact that its clients are located all over the planet and run the full spectrum of oil producers, including National Oil Companies (NOCs) and the major integrated oil companies.  From the company’s point of view, new discoveries of hydrocarbon deposits are not being made to compensate for the rate at which existing reserves are being depleted.  Schlumberger’s CEO, Andrew Gould, expressed that sentiment during a past conference call to investors that the current rate of depletion of non-OPEC reserves being forecasted by rating agencies is “somewhat optimistic.” 

At present, the U.S. relies heavily on oil imports from both of its neighbors to the North and South.  Mexico, which whom the country shares the southern border, is also its second largest oil exporter (Canada is the largest).  It is also well documented that Mexico’s current rate of production is approximately 3.1 million barrels per day, which is actually down from the 3.3 million barrels per day it used to deliver about four years ago. More evidence to suggest that supply is falling and prices are likely to remain elevated.

Perhaps, the most poignant signal of higher oil prices is the declining value of the dollar.  The value of the currency has an inverse relationship with the price of oil and other commodities that are priced in dollars.  Subsequently, a fall in the value of the dollar decreases the amount of the currency that OPEC members and other oil producers collect for oil.  As such, there is a compelling incentive to keep the price of oil high. 

High oil prices increases the size of the U.S trade deficit as the country is a net importer of oil.  A growing trade deficit in turn puts downward pressure on the value of the dollar fueling a vicious continuous loop.  While in the short-term, there is some evidence to suggest that the dollar could rebound this is not likely to be enduring.  The long-term outlook for the value of the dollar recovering meaningfully at this point is rather remote.

At this juncture, it is clear that a paradigm shift in thinking away from an era of abundant oil supply to one of restricted supply needs to be embraced.  Even the Pentagon has made the change with its recognition that in the long-run, the rising cost and shrinking supply of oil diminishes the U.S. military’s capability to respond to conflicts around the world.  It stands to reason then that any thesis forecasting a future of cheap oil is in dire need of substantive review. 

The market forces currently at work clearly suggest that the secular trend for oil prices is up.  With that in mind, a number of companies stand to benefit from the current state of affairs.  Among our favorites are:

Schlumberger (SLB): The increased spending by exploration production companies to find new reserves renders Schlumberger a winner. 

Transocean (RIG): The company is benefitting from the strong demand for offshore drilling assets, especially for those operating in the deepwater segment.  There is currently a dearth of supply of this type of equipment and as such, new contracts are being written at higher rates.  This enables Transocean to take advantage of the rising price environment

Halliburton (HAL): Halliburton management is executing very well and the company is well positioned in the Eastern Hemisphere where demand for its services is likely to be sustained for the foreseeable future.  As such, the anticipated cash flow generation should provide the company with sufficient financial flexibility to pursue its share repurchase program and even possibly increase its dividend.