Taking a chance on oil - thinking beyond the oil market downturn (page 1 of 3)

Recessions don't last long when compared with the average length of energy investments; therefore any forecast of the profitability of capital investment whose output will go on stream perhaps seven to nine years from now must look beyond the short-term, found a new report by Booz & Company.

Following years of high oil prices, many international oil companies (IOCs) and national oil companies (NOCs) have amassed piles of cash, and are in an excellent position to take the long-term view.

NOCs controlling reserves of cheap oil but lacking the technology and capabilities to further their investment efforts should consider acquiring independents and weakened oil service providers.

"Meanwhile, independents in weak financial positions might decide to partner with cash-rich IOCs or NOCs,"

commented Georges Chehade, a partner at Booz & Company.

The oil price roller coaster

In July 2008, oil prices per barrel reached an all-time high of more than $147 and analysts forecasted prices of over $200 by December 2008. But by December, the price of oil had dropped almost 80%, to less than $34. Always difficult to forecast, energy prices have reached a completely new level of unpredictability in the last few months.

"Energy companies whose economics depend on future oil prices must make investment decisions. In the long term, the average price of oil is a lot more stable and more pre¬dictable than its daily spot price - this long-term average is what determines the profitability of energy investments," explained Chehade.

The global liquidity shortage is leading financial markets to underprice long-term value, presenting an opportunity for companies with cash to make these investments now.

The long view

In the current recession, oil prices are seriously depressed. The effects the downturn is causing will last longer than the recession itself and the duration of typical economic recessions are short when compared with upstream oil investment standards: The mean duration of all U.S. recessions since 1854 is 17 months from peak to trough, and the average is just 10 months for the 10 recessions since the end of World War II.

It takes at least seven to nine years for energy exploration efforts to bear fruit in the form of oil or gas coming on stream. What really matters for these investments is the price at which future oil or gas will be sold. Energy prices tend to revert over time to some long-term mean and this more stable and predictable than the day-to-day spot price.

A realistic picture of long-term petroleum price relies on long-term projections of supply and demand. Long-term demand is almost as predictable as short-term prices are erratic. Global oil and gas consumption rates have displayed a constant upward trend for more than 30 years, and the trend is expected to continue at roughly the same pace in the future.

This leads to an oil demand forecast of about 100 million barrels per day by 2020, up from today's 85 million or so, plus 65 million barrels of oil equivalent (BOE) per day of natural gas, up from close to 55 million today. To meet this demand, more than half of the total production by 2020 will need to come from new investments.

Today there are more than 1.2 trillion barrels of proven oil reserves in the world (including about 800 billion in cheap reserves in the Middle East and North Africa). Yet the long-term supply curve is a lot tighter than these figures suggest, because only so much oil (or gas) per day can be pumped.