John Rawlins share some long-term plays in the commodity sector....
The Real Cost of ‘Peak Oil’
02/07/2012 9:15 am EST
No, we’re not running out of oil, as some predicted. But petroleum—like some other commodities, including copper—is getting more expensive to find and produce, writes MoneyShow’s Jim Jubak, who also writes for Jubak’s Picks.
Now that oil is a long way from the $145 per barrel peak it hit in July 2008, and nobody on Wall Street is predicting—as Goldman Sachs did in 2008—that oil is headed to $250 a barrel, we’re not hearing much about peak oil anymore.
The peak oil model, initially developed by oil geologist King Hubbert and used to predict a peak in US oil production between 1965 and 1970, says that the production from an oil field grows exponentially over time, then peaks and finally declines. The model has been applied to individual oil fields, national oil industries, and global oil production.
Back in 2008, the fiercest proponents of peak oil as a global model were predicting that the world would start running short of oil sometime around 2020.
Now that the world is awash in oil, the only people talking about peak oil are those who oppose the idea. They are dancing on what they depict as the grave of what they call a "theory" that wasn’t worth the graph paper it was plotted on.
Well, I still think that the peak oil model is a useful description of what we see happening in the oil industry today—even if West Texas Intermediate, the US benchmark, closed at a twitch under $100 a barrel last week. (Brent crude, the European benchmark, closed at $114.58.)
And I’d go on to say that the peak oil model is the best way to understand what’s happening to the prices of other commodities, especially copper.
(Full disclosure: I predicted that oil would go to $180 a barrel shortly before it began its collapse from the $145 a barrel high in 2008. And full, full disclosure: The only one predicting $250 a barrel oil right now is Iran, which is threatening that prices will reach that level if developed economies impose tougher sanctions on the Iranian economy in an attempt to slow or stop that country’s development of a nuclear bomb.)
Why Peak Oil Still Matters
Let me explain why I still find so much value in this "discredited" theory.
The most damage to the peak oil model resulted from the overenthusiasm of its friends during the commodities boom that topped out in 2008. A view that I’ve called "hard peak oil" held that Hubbert’s model had predicted that world oil reserves were about to go into decline, that oil production was about to plunge, and that the world was about to run out of oil.
Those were all extensions—unjustified in my view—on Hubbert’s model. Hubbert’s formulation addressed only production rates and wasn’t a prediction of the measured levels of global oil reserves. Also, Hubbert’s model used a relatively narrow definition of oil, not surprising in an era when the conventional oil production of Texas, California, and Louisiana dominated the US industry.
When oil companies continued to find oil and global reserves and estimates of global reserves continued to climb, peak oil theory took a ding. Then the global oil industry discovered huge, unconventional sources of oil in the Canadian oil sands and the tight shale formations of first the United States, and then Argentina, China, and Europe.
That revived production in mature oil-producing countries, such as the United States, and made the theory look loopy. But to see how useful a peak oil model can be to an investor, look at the latest quarterly results from the big international oil companies.
Spending More to Get Less
Let’s start with Royal Dutch Shell (RDS.A).
Production volumes fell 5% year over year in the fourth quarter. Full-year production was down 3% from 2010. However, Shell told shareholders that it would reverse that downward trend and increase production in the low single digits in 2012.
What interests me is how much money Shell will invest in its attempt to reverse declining production. Shell will increase its total capital investment to $32 billion to $33 billion in 2012, from $31.5 billion. The actual increase in the capital budget for oil exploration, development, and production will go to $24 billion in 2012 from $20 billon in 2011. That’s a 20% increase.
And what will Shell and its investors get for those bucks? If recent history is any guide, not as much as they used to get.
Shell’s return on average capital employed fell to 15.9% in 2011. A few years ago, when oil prices were much lower, this figure checked in above 20%.
Shell has had trouble increasing production in recent years, but the drop in return on average capital employed is an industry-wide problem. For example, Chevron (CVX), one of the international majors that has been most successful at adding reserves in recent years, showed a return on average capital employed 20% lower in 2011 than in 2008.
ExxonMobil (XOM), which is historically more profitable than its peers among the international majors, averaged a return on average capital employed of more than 27% from 2006 through 2010. In 2010, the company’s return on average capital employed fell to what was still an industry-leading 22%.
(ExxonMobil’s big acquisition of XTO Energy in June 2010 makes it tough to compare figures for 2011 with previous years.)
These trends are just about what you’d expect from the peak oil model. As reservoirs mature, oil produced from them gets more expensive, as companies have to invest more in methods to extract oil. As fields and national reserves mature, companies can continue to add new oil discoveries, but the cost of each new discovery is likely to rise.
And I’d add this corollary to Hubbert’s original model: As oil prices rise, oil companies invest in unconventional oil reserves, but producing oil from these unconventional sources—whether from the oil sands of Alberta, the tight shales of Eagle Ford or the deep ocean pre-salt formations off Brazil—is more expensive than producing conventional oil. The world can certainly continue to expand its reserves of oil, but only by increasing its investment in exploration and development.
Investing in Peak Oil
A clear investment strategy results from this peak oil view of the industry: You should invest in the companies that sell the stuff that oil companies are buying with those ever-increasing capital budgets—that means companies like Schlumberger (SLB), National Oilwell Varco (NOV), and Ensco (ESV).
And it means buying smaller oil companies with promising areas of exploration and some proven production. Buying and then expanding already established production is one way the majors can try to beat the rising cost of finding and producing oil.
But there’s no reason to limit your peak oil thinking to oil.
What About Peak Copper?
Right now, the copper industry is probably the best example of peak oil economics among global commodities.
And with the huge $88 billion merger of Glencore (GLCNF), which trades as GLEN.LN in London, and Xstrata (XSRAY) in New York galvanizing the acquisitions in the sector in the same way that the 2001 combination of Billiton and BHP to form BHP Billiton (BHP) did, I think investors are looking at a scenario where just about every producer is potentially in play.
The supply-side story for copper is what I’d call a typical peak oil situation. The world isn’t running out of copper—in fact, if all the copper in the earth’s crust were recoverable, the resulting supply would be just about inexhaustible. But the world is running out of the best grades of copper ores in relatively easily accessible geographies ruled by reasonably stable governments.
In 1906, the average copper ore graded 2.5% for copper. By 1935, the average ore was down to 1.89%. In 2009, copper ore in the United States graded at just 0.43% copper.
The US Geological Survey reported a current reserve base of 1.6 billion metric tons of copper in the United States as of 2005—but the survey considered only 950 million tons of that economically recoverable.
One result of this situation is that copper producers are facing their own version of the oil industry’s declining return on average capital employed—only in the copper industry, it seems to be embodied both in rising capital spending budgets and in more projects facing major delays in reaching full production.
One result of that has been significant declines in 2011 copper production versus 2010 levels, with production year-to-year falling 23% at Anglo American (AAUKY), 25% at Xstrata, 67% at BHP Billiton, and 73% at Freeport McMoRan Copper and Gold (FCX).
Because the copper industry is already so concentrated, I’d look to relatively big companies for potential acquisition candidates. (Smaller producers aren’t going to move the needle for a company like BHP Billiton.) The name that keeps coming up is Anglo American.
The company is big—but at a market capitalization of $60 billion, it’s not so big that BHP Billiton or a combined Glencore/Xstrata couldn’t do the deal. At the moment, it’s relatively cheap, at 6.4 times earnings. Besides copper, Anglo American produces coal and about 40% of the world’s platinum.
The peak oil model also suggests taking a look at silver (long term) and water, through desalination plays such as Singapore’s Keppel (KPELY).
But it doesn’t apply to every commodity. For example, I don’t think it tells investors much about potash fertilizer producers.
But hey, physics is still looking for a unified grand theory, too.
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