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Markets: Oil - The Miracle Fuel
New York: February 19, 2007
By John R. Stephenson

For many, the debate rages on. Is oil going to $100/barrel or merely staying put in the fifty and low sixty dollar range? Others argue that we are awash in oil which will lower the price in the future. Some argue that alternative energy is the solution. While it is hard to predict where the price of oil will go over the next few months, let alone years, one thing seems clear — finding a substitute will be no easy task.

That's because oil is a miracle fuel. Today, the entrenchment of crude oil within our society rivals the evolution of the personal computer. It is everywhere. John D. Rockefeller and others who were fortunate enough to spot the emerging market dominance of oil as a fuel of choice made great fortunes. In short, economic growth and prosperity go hand in hand with cheap and reliable access to crude oil.

Oil is the most versatile and affordable fuel of our day. We are totally dependent on it. Oil can be used to power your lawn mower, golf cart, car, heat your home, or for use in large scale electric generating stations — no other fuel is as versatile or affordable. Cheap and abundant oil allowed for the development of suburbs with their larger homes, manicured lawns and cars. Our lifestyle is totally dependent on our access to crude oil.

To replace oil, or any other product for that matter, with a substitute product, you need to come up with an alternative product that offers clearly superior value. Just because you can operate a car that runs on fuel cells doesn't mean that you will. Consumers need to be convinced that there is value there. DVD players were finally able to displace sales of VCRs because they were clearly superior products at a very low cost. Consumers were willing to make the switch from VCRs to DVD players because the cost of switching was low and the value proposition from DVD players was better. To replace oil as the miracle fuel that it has become, a substitute will have to be not only better, but cheaper as well.

Even if a substitute can be found, it will take time for society as a whole to adopt a new product. Many people are surprised to learn that the steam locomotive was still being commercially produced as late as the 1960s. While the diesel locomotive offered clearly superior functionality over the steam locomotive, it took decades to completely phase out steam locomotives from the nation's railways. The transition from VCRs to DVD players has been going on for over ten years now. What can possibly replace oil with all its applications at a cheap enough price and can it happen quickly enough for an oil hungry world to accept? Who knows!

So what is going on with oil today? Everyone acknowledges that we're confronting energy challenges, the sort of which we have never faced before. Your view on the current situation is going to depend on the "expert" that you've just finished listening to. Some argue that the problem will take care of itself. Higher commodity prices will spur greater exploration and development of oil and the price will eventually fall. Others argue that surging world demand, particularly from China, will push the energy usage needle into redline territory.

Our view is that while we still are able to meet the world's energy needs for the foreseeable future, the oil that we need is getting harder to find. Increasingly, we are being driven to the ends of the world to find crude oil. At current rates of demand, the world is consuming a thousand barrels of oil a second. Over time, this demand for crude oil will only increase.

But finding oil and booking reserves (in the case of oil companies) is only part of the problem. The other part is recovering those reserves from the ground economically. In regions of the world where the pores in an oil reservoir are tight and the oil is viscous, recovery rates of only 15 percent are the norm. In Saudi Arabia, where the oil is of a light sweet type (low amount of sulphur) and the reservoirs are very porous, the recovery rates are closer to 50 percent. Globally, oil recovery rates probably average in the 30 to 35 percent range.

To keep the oil markets in balance, the petroleum industry globally, is cranking out oil as fast as it is being consumed. But to do that, the industry is spending more and more money. That's because, it's becoming harder and harder to find the shallow plentiful oil reserves, forcing oil companies to drill deeper and go further afield. Not only that, but oilfields produce less and less oil (decline rate) each and every year. What this means is that the oil industry needs to keep on drilling new oil wells just to replace the oil supply that is being lost by natural declines. At current decline rates, (estimated to be between five and eight percent globally), the oil industry will have to find 4.3 million barrels a day of oil just to replace what we've lost from natural declines. That's a pretty tall order and one that is becoming increasingly expensive to fill.

Of the one hundred and ninety-two countries in the world, nearly all are dependent on oil. Only thirty countries produce oil in significant quantities and only seventeen export more than 500,000 barrels a day (the world demands 85 million barrels a day). Today, the Middle East is the world's dominant supplier of oil and produces the "incremental" or spare capacity barrel that is needed to keep the system in balance globally. With increasing geopolitical tensions around the world, much of it concentrated in the Middle East, is it any wonder that prices for crude oil are so volatile when supply and spare capacity remain very tight?

With more oil being demanded and less opportunities globally, a boom in underground real estate (oil concessions) has taken flight. The price for the right to explore, develop and produce oil in places like Kazakhstan, Libya and Canada is through the roof.

Nowhere is this mad scramble more obvious than in Canada's oil sands. These non-conventional oil sands are now recognized as having the second largest source of recoverable oil globally after Saudi Arabia. Not only that, but the oil sands are a marketer's dream, located beside the largest oil consuming nation (the United States) in the world.

But oil from Canada's oil sands is anything but cheap to produce. The oil in oil sands is literally a mixture of oil and sand — not to mention gravel, water and other particulates. In spite of these problems, the ready supply and the geopolitical stability and close proximity to the United States have made the oil sands the place to be. So much so that, according to some estimates, Canada's oil sands will receive as much as US$90 billion in investment between now and 2015. And this investment is coming, not only from Canadian oil companies eager for the resource, but also from American, Chinese, United Kingdom and French oil interests. The bottom line? If oil could be found more cheaply, or easily anywhere else in the world, would oil companies be going there? Undoubtedly.

Figure 1: Canada's Oil Sands

While oil prices may gyrate in the near term, they are likely to go higher as the costs continue to increase and demand continues unabated. In the one hundred and forty eight year history of oil, there have only been six years when oil demand was lower than in the previous years. All of these years coincided with the development of nuclear power in the United States as an alternative to oil-fired electricity generation. Demand is unlikely to moderate any time soon, particularly with China and India coming on strong. Global economic growth is pegged at 4.5% this year and even if the U.S. stumbles, oil price and oil demand are likely to increase.

For investors, we continue to recommend a core position in Canadian oil sands producers. Until a substitute that is cheap, plentiful and offers superior performance can be discovered, oil, the miracle fuel, is likely to be around for many years to come. The only question is — at what price.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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