Oil sector’s big issue now delivery, not discovery

So, what happened to $100-per-barrel oil? On Wednesday, the price of US light crude reached $78.77, briefly topping last summer’s record and then subsided. A few dreary bulletins about the US economy and signs that American petrol stocks were rising were enough to kill the excitement and stall the rally.

Those investors who are obsessed with the notion of the end of oil tend to forget that the price fluctuates on short-term supply considerations and signals from the underlying economy about energy demand. The oil market is not driven by guesses about how large are the Saudi Arabian reserves.
These are irrelevant on any short term or medium-term view. In the short term, the bears can point to ample oil stocks in OECD countries and economic risk on the downside. The extent of the US credit crunch and some weak jobs data together suggest a slowing American economy, which, in turn, implies less demand for oil. On the bullish side, however, Opec is asserting its discipline and, in any case, crude output from several leading Opec members is stymied by civil disturbance (Nigeria and Iraq) or lack of investment (Iran and Venezuela).

Still, the Gulf states have been investing heavily in new production and these have every interest in ensuring that the US and Chinese economies are both well supplied and continuing to depend on the dripfeed of Middle Eastern crude oil. Over the next few years, Opec will seek to keep prices strong, but not dangerously high. The oil cartel has noticed that the past few years of higher prices have not noticeably depressed demand and these prices are still below their peak of almost $90 (in inflation-adjusted terms) in 1980. It’s a reasonable guess that Opec will seek to keep its average crude price well below that discomfort level.

Does that make oil companies a good or a bad bet for an investor? Speculative exploration stocks have probably peaked for the time being. They tend to ride the oil price and the going has become more difficult for smaller companies. Drilling costs have risen to extraordinary levels; sophisticated offshore drilling rigs are hard to come by and competition for the services of top engineers and geologists is intense. At the same time, the job of the juniors has become more difficult. The easy oil has been found in the easy places. The chase has shifted to difficult oil in troublesome places. It means drilling in very deep water, technically difficult wells at high pressure and high temperatures. It also means difficult countries where smaller independent players can sometimes secure advantage if they accept political and security risks. It is the gamble taken by companies such as DNO and Addax Petroleum in the Kurdish region of Iraq.

If you are not prepared to entertain those risks, you are left with the oil majors where the nature of the game is quietly changing. These companies are gradually shifting their focus from operational output to financial outcomes.

The Times