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Despite Meager Demand, Oil Companies to Boost Spending

by | published June 30th, 2010

The stock market this week is tanking. Oil prices are way down as new concerns emerge over Chinese expansion. And, oh yes, crude continues to spill out into the Gulf of Mexico.

So it will come as no surprise that the oil sector plans to… increase capital spending?

That is the overwhelming conclusion from oil and gas company execs, at least according to a new survey by KPMG. More than 60% of senior decision-makers also expect a new round of mergers and acquisitions (M&A).

There is one approach you can use to latch on to this train ride early. More on that in just a bit…

First, all of this prompts an obvious question: If there is so much market angst over the possibility of a double-dip decline – and that is largely the reason oil use demand projections are coming under pressure – why do those in the know have such confidence that we are about to see an explosion in oil sector activity?

One overarching reason: Prices are going to rise.

Despite offshore well blowouts, continuing equity market weaknesses beginning to smell of contagion worldwide, significant credit constrictions, and countries like Greece threatening to fall off the map, companies are certain that oil prices will head north.

Significant demand remains off the table. Yet oil prices continue to hover around $78 a barrel. That has prompted company officials across the board to signal a return to spending – both on new projects and in another round of asset purchases.

And the reason for this concerted move back to oil is really rather simple. It stems from the expectation that the demand removed from the market is about to start coming back. And when that happens, moving forward, there will be significant concerns on the supply side.

At the current oil price, just about any new field, virtually anywhere in the world, could be profitable. Brown fields, those in which production has already taken place in the past or where current lifting volume could be increased, can be brought back on-line at higher production levels and in very short order. Green fields – new ones – would take several years longer.

And that is really the point… and the explanation for this counterintuitive boost in spending.

Supply Will Soon Be Hard-Pressed to Meet Expanding Demand

The oncoming wave of new expenditures is not targeted to meet today’s demand picture, but what we are going to experience several years from now . An oil market need only be relatively stable – that is, not subject to excessive external pressures (from, for example, a global financial crisis) – to exhibit its real dynamics. And all projections point to one disconcerting observation: Supply will be hard-pressed to meet growing demand.

Normally, the market price for oil is pegged to the price of the next available barrel. However, in the current climate, we are beginning to see a mindset that questions both the sourcing and the quality of future crude. That will translate into the price being pegged to the highest-priced, next available barrel.

We have certainly seen this accelerated pricing practice recently – the run up to $147.27 for a barrel of oil almost exactly two years ago. This very thinking is behind the expected surge in capital expenses and the “big boys” getting bigger.

But moving forward, the actual underlying sourcing for oil is weaker than the market as a whole recognizes. There are about four million barrels of excess supply, virtually all Saudi. However, demand is slowly moving up, meaning that surplus will be cut in half within the next year. Once we reach daily demand of 89 million barrels, new production will have to kick in, or spot charges will begin developing, and prices will accelerate.

The oil and gas executives expect this to happen fairly soon – within the time window provided for new field development to begin providing volume. In short, the drive to ratchet up capital expenditures now is actually the oil equivalent of a “just in time” management strategy. Keep available volume in line with demand, thereby sustaining a higher pricing structure.

Unfortunately, it is becoming increasingly difficult to meet the demand building up. Much of the new supply, as well as virtually all of the largest fields still thought to be available, are offshore. Most of these are in deep water, and all are now feeling the pinch from the BP (NYSE:BP) disaster. Deepwater drilling will continue elsewhere in the world, but heavier government regulations will increase costs and delay development.

This translates to a heightened inability to correctly assess new supply… at the same time that demand is likely to come in higher than anticipated.

One thing is certain: The overall supply from existing fields is declining.

A few months ago, the International Energy Agency published a long-awaited report on the actual supply coming in from the major fields presently providing some 72% of all global crude. The conclusion was alarming. Supply figures will have to scale back. There is simply less available oil than the IEA had been estimating for years. Other indicators are just as disturbing. Over the past 10 years, the top 15 producers worldwide have replaced about 70% of the extractable reserves they have taken out of the ground.

Upside Profits from More Mergers & Acquisitions

The bottom line: Drilling will increase.

Preceding this will once again be another M&A feeding frenzy. We have already witnessed the resurgence of acquisitions on the gas side, the most visible being Exxon Mobil Corp. (NYSE:XOM) gobbling up XTO Energy Inc. (NYSE:XTO). These will intensify on the oil side, as well.

Larger companies will increase their own booked reserves by absorbing smaller companies and their booked reserves. This will improve market position, support stock prices, and provide additional leverage in advance of new field supply flows.

And here’s the investment play to watch out for. There will be considerable upside profits from positioning in the companies likely to be absorbed, since the objective (increasing reserves) will require the payment of premiums to attract target company stock.

Stay tuned. I will be watching out for early indications of which companies to follow.

Kent

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