Running on Empty?

If you've been long the oil industry, you've had a nice run. But what next? Should you take your profits and run? After all, the oil industry is once again being made into a political punching bag with Congress threatening to impose a windfall profit tax, anti-gauging laws and other subsidies for the industry to bestow upon consumers. Forget politics for now (if that's possible in non-PC industries

If you've been long the oil industry, you've had a nice run. But what next? Should you take your profits and run? After all, the oil industry is once again being made into a political punching bag with Congress threatening to impose a “windfall profit” tax, anti-gauging laws and other “voluntary” subsidies for the industry to bestow upon consumers.

Forget politics for now (if that's possible in non-PC industries like the oil patch). Rather, start worrying about the supply of oil in the future. Matthew Simmons, the Houston oil and gas analyst and CEO of Simmons & Co. International, an investment bank, argues that the world's supply of petroleum is not running out, per se, but running near “peak.” What he means is, the period of production growth is over, the easy-to-get oil is gone and, yes, it's time get serious about energy conservation. Increased demand from all corners of the earth, but especially China and India, combined with lower production levels will force up the price of oil over the coming decades.

Simmons is worth listening to. Since establishing his firm in 1974, Simmons & Co. has completed hundreds of M&A transactions and debt and equity offerings worth about $62 billion. Its clients include Halliburton, General Electric — even the World Bank. In his 2005 book, Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy (John Wiley & Sons), Simmons examined over 200 technical papers and reservoir records and has concluded, “Every key field faces the risk of rapid decline.” (Naturally, not every expert agrees. Daniel Yergin, founder and head of Cambridge Energy Research Associates, scoffs at Simmons' gloom, claiming, “This is the fifth time we've run out of oil since the 1880s.”)

As for Saudi Arabia, which has been key to more production over the last 10 years, Simmons argues the kingdom doesn't have the 260 billion barrels of oil it claims to hold in its “supergiant” fields. “We are in a deep hole,” Simmons warns.

What should we do? Go green, counsels Simmons (but he is no loony lefty: He was an advisor to the 2000 Bush-Cheney campaign). Reduce energy-wasting transport, pursue local manufacturing — which means turning our backs on globalization — and undertake a burst of energy R&D. If we are lucky, energy prices will climb slowly, not spike higher, and force consumers to conserve. All told, the Texas oilman is bullish on alternative energy purveyors and on equipment-making companies over the exploration and production companies.

Recently, Registered Rep. contributing editor Bob Hirschfeld spoke with Simmons.

Registered Rep.: You don't allow for many happy surprises. You say that one-time oil exporter Indonesia is now an importer and the hydrocarbon output of the former Soviet Union probably peaked in 1988. Are our resources dwindling?

Matthew Simmons: Unfortunately, yes. Once people start realizing that we face scarcity, human behavior is such that we'll try to sneakily lock up resources so that we will have ours and someone else won't have theirs. We need a global economic framework for how we allocate oil use. And we need to give India and China an incremental use of another 50 percent more oil while we go on our diet. If we don't do this, then we will basically end up playing musical chairs. Musical chairs can get violent very fast.

RR: The past few decades were like a roller coaster for energy investors: The 1970s were great — well, for investors anyway — with oil service earnings compounding over 20 percent to 25 percent per year during the decade. The 1980s were lousy, given that the oil drilling rig count all but collapsed. The 1990s were both up and down and, as you point out, characterized by the myth of abundant supply and static demand. How about this decade?

MS: Between 1992 and 2002, we had four violent price collapses: one in natural gas, three in oil. These created the panic downsizing of the industry, setting the pattern in the minds of planners that the minute after prices go up, they collapse. And every time prices collapsed, it made any manager who was expanding look like a village idiot. This decade, we started with a train wreck. In 2001, we had blackouts. Gas prices in California went over $20 and oil prices ran up to $37, then we had the last big price collapse. By the third week of February 2002, we had for the last time, maybe ever, oil prices at $17 a barrel and gas prices at $1.80, and people thought, well, we're back to normal. Since then, the alarm clock's been ringing, but we've ignored it. With $30 oil, people said, it's a recession, don't worry; with $40 oil, they said, it's just Iraq; with $50 oil, it's just hedge funds; with $60 oil, it's just the fear factor. During the last five years, all the energy generals were in agreement that high prices wouldn't last.

More recently, we've started using more nonconventional oil, meaning oil drawn from oil shale and oil sands, which is oil that is far more energy-intensive to draw out of the ground. And we've embarked on what I call an era of conceptual oil, which is oil we like to talk about but remains undiscovered. At the World Petroleum Congress in Johannesburg this September, the Saudi petroleum minister told the world his country has 200 billion barrels of new proven reserves they are about to find. And ExxonMobil President Rex Tillerson spoke about three trillion barrels of oil yet to be recovered, an amount equal to twice all the oil recovered to date. That is conceptual oil.

RR: You've noted that the industry faces a shortage of rigs, many of them old and expensive to replace. Does that mean you favor service companies at the expense of producers?

MS: Right now you should buy the companies that build the equipment and create the tools. That's because the service companies have the assets to keep production from going into a tailspin decline. And it's going to take some time to get the service industry comfortable with expansion, especially since they've had the bejesus beat out of them the last two decades. Their customers hate having to pay a real price. I'll tell you a “crude” story. About 1980 I had a pipe salesman in our office who said, “I loved my conversation this morning with one of my customers who gave me utter hell for five years. Every time I gave him a quote he said, stick that up you're a--. This morning he wanted some pipe and I told him, I'm sorry; I'm going to have to go to a hospital to get it because I have to get an operation.” And then he flipped the guy the bird. That is basically the love-hate attitude that exists between the exploring-and-production companies and the service companies.

RR: How about investment vehicles? Do you recommend that retail investors purchase master limited partnerships or royalty trusts?

MS: Trusts and master limited partnerships are like REITs and very specific to the asset base. Some REITs own great office buildings; some own slums. You have to know your asset base. You need to buy a basket of energy companies; do not bet the farm on just one or two. And remember, energy is the largest business in the world, so there's no reason it should be just 2 percent-to-3 percent of one's portfolio.

RR: Given the increasing difficulty of finding oil, do you foresee more mergers?

MS: ExxonMobil and ChevronTexaco are basically liquidating themselves. They are too big to grow by the drill bit, true, but there aren't many big companies left to acquire anymore. Andrew Gould, the CEO of Schlumberger, says that the average decline rate in production is 8 percent per annum. Now, if you are Exxon and you have a four million-barrels-per-day production rate, you have to add 320,000 barrels per day, per year just to stay flat. To acquire that amount of reserves, you'd have to buy about two-thirds of a Unocal, or 10 medium-sized independents, or 40 smaller sized independents. That would mean making an acquisition every week and a half. There is no easy way out.

RR: Hurricanes Katrina and Rita reminded us that a considerable portion of U.S. energy infrastructure sits right in the middle of hurricane alley.

MS: It's scary that we have all these facilities so tightly clustered. Until deep water [drilling] started you could basically draw a band going out from Galveston Island and along the shore over to New Orleans that included 75 percent of all the platforms and pipelines that we had in the Gulf of Mexico. It was totally vulnerable if we ever had a hurricane, but since we didn't have a hurricane since 1969, people thought we weren't going to have one. Andrew in August 1992 should have been a wake-up call, but it wasn't.

RR: Do you support investing in alternative energy sources, and, if so, which ones in particular?

MS: Absolutely. What we need is R&D to make solar a lot less expensive; we don't need massive amounts of R&D in wind. We need to invest in alternative transportation fuels and we need a fast return to nuclear to take the place of the electricity we thought we were going to create through natural gas. And we need to stop using natural gas to create electricity and to stop using electricity to boil liquids and melt metal in the industrial sector, where we should be using natural gas and putting it directly under the burner tip. We're at the point where we're past the luxury of an either/or; we should be doing everything.

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