Some crude oil views

Last week's FSO Big Picture dialogue was rather interesting in my opinion. Here is the trasncript.

Oil Facts Wall Street Doesn't Want You to Know

• Ok, we’ve seen oil prices fall over 24% since they reached a high in August. Now the analysts are predicting 40 to $50 oil because of an economic slowdown in the US. Boy, that’s hard to swallow.
  
  JIM: Yeah, I think a lot of these guys are in la-la land, John. That’s a lot of the spin, but you know, those aren’t the facts. Let me begin with the oil service sector. In the second quarter, drilling activity was up 7.3% quarter to quarter – that’s the strongest sequential increase that we’ve seen since Q2 of 2003, when the rig count expanded by over 14%. Now, worldwide, drilling demand is high, and we’ve got tight availability which is driving up day rates. For example, in the Gulf of Mexico, day rates on super drill ships have risen from 190,000 a day, to over $500,000 a day; backlogs at drillers are at record levels. [10:22]
  
  JOHN: Before you go on, give us an example of that.
  
  JIM: Well, for example, one company Pride International, their backlog has risen to 3.1 billion. That’s probably the highest in the company’s history. Their daily rig rate, reflecting what I just said earlier about rig day rates rising, have risen from $43,000 last year to almost $110,000 this year. Now, does that sound like a contracting market to you?
  
  JOHN: Is this a trick question?
  
  Then why hasn’t this translated into higher PE’s for drillers in the oil sector.
  
  JIM: I really believe Wall Street doesn’t get it, they’re still operating with models that were based on large, global production surpluses – you know, going back to the 80s when we had 10 million barrels a day of surplus excess capacity. That surplus has virtually disappeared, we’re down to 1 maybe 2 million barrels. So, in my opinion, those models are no longer valid today. You also have earnings for the drilling sector that is up anywhere from 3800% this year, to 100% in the sector; and then you still have backlogs that are still growing, and the majors are really struggling to keep up with production. [11:36]
  
  JOHN: What about the phenomenon called demand destruction?
  
  JIM: I don’t know about where you live, but I don’t see it anywhere. The economy may slow down here in the US, but you know you have to take a look at the global economy where you have China and India that are now growing at growth rates between 9 and 11%. Their growth rates are red hot. And also when you take a look at the next 5 years, China is going to become the largest consumer and manufacturer of automobiles – the Chinese aren’t going back to bicycles. Car sales continue to expand in China, and once you own a car you become an oil consumer. [12:12]
  
  JOHN: Yes, that society isn’t just going to turn around and go back, so what we really have is a situation where the demand is going to keep growing. And the real question is the supply going to be able to struggle hard enough to keep up. That’s the real issue.
  
  JIM: Well, what you have right now, when you really think about it is production for light sweet crude has already peaked. And I think in non-Western countries you’re seeing a lot of peaking in production. Not only just in the United States, but in other countries: the North Sea; you’re hearing a peak in production in Mexico and Kuwait. So what is enabling us to keep up with rising depletion rates at this time is really an increase in non-conventional oil, which is coming from heavy oil sands, shale, and what we’re seeing now in deep-water.[13:01]
  
  JOHN: And we hear about new oil discoveries such as Jack #2.
  
  JIM: We heard that last November, with PEMEX making a discovery, and then more recently, and of course everybody says, “look, look, there’s plenty of oil out there.” What’s really missing from the news of this discovery is really a realistic appraisal, and quite honestly, whehter the economics of commercial development are favorable. Last week we had Zapata George who said we don’t even have some of the technology to make this stuff work.
  
  And the estimates of this discovery, I’ve seen figures everywhere from 3 to 15 billion barrels – a 15 billion barrel discovery would put it on par with Prudhoe Bay. But you really need to pull the oil out of the sea, over 275 miles of ocean, which would take up at least 35 contiguous lease blocks in the Gulf of Mexico. Furthermore, you’ve got like, for example, the head of Devon stating each new test well – just talking about expense here – that they’re going to drill is going to cost the companies between 80 and $120 million a well. In addition, even if you could discover oil there and make it economically viable, your capital development costs are now approaching close to 1 ½ to maybe as high as 2 billion.
  
  And then you also have a logistical problem in the sense that deep water rigs are very scarce right now, they’re very expensive, and since this oil deposit lies roughly about 275 miles offshore from the coast of Louisiana, you don’t have any pipelines to carry the hydrocarbons back on shore. So what they’re going to have to use and develop is floating storage facilities and offloading vessels instead of pipelines.
  
  And of course, putting that stuff in place making it strong enough to withstand hurricanes – we saw what happened with Katrina and Rita, what they did to the regions oil facilities – imagine what this is going to be like because in sea conditions the further away you get from land the longer the swells can become. We call it fetch in the sailing world. And so you can get bigger waves. And a lot of those platforms that were built close to land in the Gulf of Mexico were designed for 50 to 60 mph winds, they weren’t designed for 100 to 150 mph winds, and 50 to 60 foot seas as we saw during the hurricane season in 2005. [15:32]
  
  JOHN: So I guess this translates into the fact that we aren’t going to see this oil for quite sometime, for years to come.
  
  JIM: No, absolutely. We’re a long ways off. In fact, more testing and drilling needs to be done out there. We need to develop new technology. They’re going to have to build new kinds of structures, as I talked about – offloading platforms and storage facilities. So the best estimates you’re not going to see production until somewhere around 2014. And even then, the most optimistic forecasts are daily production will range anywhere from 300,000 to 500,000 barrels a day. So at that point, we’re probably replacing declining production, we’re not increasing it. And according to the US Energy Information Agency, the supply of oil coming from the Gulf peaked in 2002 at 1.7 million barrels; since then production has declined; and since peaking in 1971, US oil production has fallen, on average, roughly about almost 6% a year. [16:33]
  
  JOHN: Well, that would seem to indicate that we really need to look elsewhere.
  
  JIM: Well, it’s not just us, it’s a problem that all Western governments are going to have. 85% of the world’s oil is controlled by people that don’t necessarily like us. Of that 85%, 75 of the 85% is OPEC, 10% is Russia, so you’ve got countries scrambling to secure supplies. For example, recently Japan, which imports all of its energy, just lost out on securing oil and natural gas from Russia’s Sakhalin Island. Instead of that oil going to Japan – making up to about a fifth of the country’s current natural gas imports – that gas is now going to go to China. And even worse, for Japan’s case, is Iran is now canceling the rights held by Impex holdings as Japan’s largest oil company to participate in a development of a new oil field. [17:28]
  
  JOHN: So what you have here is all the major Western countries competing against each other to secure oil supplies as the demand goes up, and the supplies still remains relatively constant despite the effort to make everything go up. This does not sound like a bubble or what’s being touted as this glut in energy.
  
  JIM: Hardly, in fact as many knowledgeable experts – and I’m talking about real experts, guys like Charlie Maxwell, Matt Simmons – a lot of these guys believe that peak oil is at our front door step. Some as early as 2010, some as late as 2015, but the bottom line here is energy is in a bull market. And what has happened here and what we’ve seen in the month of September is froth has been taken out of the market, and at least now, in my opinion, the correction is over. With the global economy cruising, the oil markets should stay firm, and I think the real opportunity is going to be in oil stocks, both on the international and domestic producers, the drillers and refiners. I just think that it’s going to be one of the key places to be in the next 10 years.