Foundations of Peak Oil Investing
In another article that I prepared for this month’s newsletter, I discussed the concept of Peak Oil. Toward the end of the article, I described how one of the world’s leading energy analysts, Dr. Ali Samsam Bakhtiari of Iran, believes that world oil production “peaked” in 2006. Dr. Bakhtiari believes that the world is now entering a phase of irreversible decline in conventional oil production.
What will the future bring? Dr. Bakhtiari believes that world oil production will decline because depletion is outstripping new discovery and reserve growth. He believes that the world’s daily oil output will fall from its present level of about 85 million barrels of oil per day to about 55 million barrels of oil per day by 2020. That is, there will be a 35% decline in available conventional oil within a mere 13 years from now. As you can imagine, the world will change profoundly.
We Are Not Running out of Oil
But declining oil production does not mean “we are running out of oil.” The world is not running out of oil. No, please do not buy into that line of false reasoning. What is happening is that, going forward, there may be less oil and it will be immensely more valuable. And your life may change dramatically because of that fact. But 55 million barrels per day is still one heck of a lot of oil, and life on Earth will go on in some form or another, if the nations of the world do not kill each other while fighting over access to petroleum supplies.
The point to keep in mind is that from now until long into the future, there will still be oil wells pumping oil from oil fields. And this is where our investment idea for this month originates.
What Could Be Better Than Oil in the Ground?
What could be better than oil in the ground? As long as you can get access to it, oil is better than money in the bank over the long term. That is, going forward, the oil will become more and more valuable, particularly in a post-Peak Oil world. With fiat currency, on the other hand, as time passes, inflation robs your deposits of their purchasing power.
And an oil deposit in the ground is something that has already been identified by exploration methods, if not discovered with a drill bit. Now it is an issue of developing the oil field and moving or lifting the oil from the rock formation far below, bringing it up to the surface. On the one hand, we lament Peak Oil, which is caused by the depletion of reserves as they are exploited and extracted. But you cannot have depletion unless you lift that oil out of the hole in the ground. Why not profit from the “lifting” part of the equation?
You Have to Get the Oil out of the Ground
Yes, you have to get the oil out of the ground. And when it comes to developing that oil deposit, you need oil service companies. Oil service companies provide what the name appears to describe -- drilling services, down-hole logging, well completion services and production monitoring.
One of the great things about oil service companies is that, essentially, they carry no geological risk. That is, if you own a company that explores for oil, you run the risk of exploration failure, such as an expensive, dry hole. But the oil service company gets paid for performing the services whether the well is a dry hole or not. And even a company with a field of wells and a proven base of reserves in the oil patch can have problems, particularly in overseas locales, where nationalizations and other forms of host-government interference is a growing problem. But again, the oil service companies merely show up to do some aspect of the drilling and development work or to provide equipment or other articles. If the political climate becomes too burdensome, the oil service company can just pull up stakes, exit the unfriendly locale and watch from the sidelines while the natives screw things up for a few years. Eventually, the oil service companies will be invited back in and given the red-carpet treatment.
So the oil service companies are not in the business of owning -- or even attempting to claim title to -- the oil in or coming out of the ground. They make their money providing the services and technical support to the producing entity. On an international level, the service companies provide services to both the privately and publicly owned oil companies, as well as to the many national oil companies (NOCs) that are rising powers in the world of oil. This is an important point. Russia, for example, might browbeat Shell Oil Co. into surrendering most of Shell’s share in the Sakhalin-2 project. Or the government of Venezuela might seize control of production facilities from the likes of Chevron or Exxon Mobil. But the “new owners” will probably still require, say, drill bits from Baker Hughes, wireline services from Schlumberger or well completion services from Halliburton.
There are many such oil service companies out there, and it almost seems unfair to single out just a few of them, because there are so many good ones. For those of you who want to own an index fund of oil service companies, there are two that I like quite a bit: Oil Services HOLDRs (OIH: AMEX) and the iShares Dow Jones U.S. Oil Equipment Index (IEZ: NYSE).
The OIH index holds shares of common stock issued by companies that when initially selected were involved in the oil service industry. For the most part, the group of companies in OIH does not change, except when a reconstitution event occurs. There are currently 18 companies included in the investment, including these top 10 holdings:
The IEZ index also tracks the performance of the oil equipment and services sector of the U.S. stock market. It includes companies that are suppliers of equipment or services to oil fields and offshore platforms, such as drilling, exploration, engineering, logistics, seismic information services and platform construction. Its top 10 holdings include the following:
As you can see, there is a lot of overlap in ownership between these two index funds. But this is really just a sign of the high quality of the companies that form the basket of stocks of companies in the oil service industry. So generally, when the oil service sector goes up, you benefit broadly. If the oil service sector pulls back, then you ride the wave downward.
The Oil Service Trifecta
But if you want to own one or more of the three biggest and best individual companies in the oil service sector, you have to look long and hard at the larger names that provide oil field services to the industry on a global level. The companies to which I refer are Schlumberger (SLB: NYSE), Baker Hughes (BHI: NYSE) and Halliburton (HAL: NYSE). T hese three companies are considered by many to be the gold standard of the oil service industry.
Do not make the mistake of thinking that just because these firms are part of the oil business that they are somehow old-fashioned, knuckle-dragging industrial behemoths. All three companies are world leaders in oil field technology, and all of them fund aggressive research and development (R&D) programs. They employ thousands of people with advanced technical degrees, and, overall, keep many patent attorneys and patent examiners busy with their literally thousands of patent filings every year.
Schlumberger was founded in 1926 and is best known for its down-hole, wireline logging services. But the company and its 70,000 employees in 140 countries offer many other valuable services within the oil industry, including project management, reservoir evaluation, seismic services, drilling and completion services, well cementing, lift and production services and more. In 2006, Schlumberger operating revenue was $19.23 billion. Schlumberger runs 23 research and engineering facilities worldwide, and in 2006, the company invested $619 million in R&D.
Halliburton was founded in 1919 and presently is one of the world’s largest providers of products and services to the energy industry. With more than 100,000 employees in nearly 70 countries, the company serves the upstream oil and gas industry throughout the life cycle of the reservoir. Halliburton offers technology that assists in locating hydrocarbons and managing geological data, drilling and formation evaluation, well construction and completion and optimization of production through the life of the field. Halliburton’s expertise in down-hole completion services, particularly in the field of cementing oil wells, is second to none. Some of the most complex well completions in the history of the oil patch have been performed by Halliburton. In 2006, Halliburton had operating revenues of $22.5 billion.
Baker Hughes is a combination of many innovative oil field service companies with a combined history that goes back to the early 1900s. During its history, Baker Hughes has acquired and assimilated many famous old names, including Brown Oil Tools, CTC, EDECO, and Elder Oil Tools (in the arena of well completions); Milchem and Newpark (in the arena of drilling fluids); EXLOG ( a mud logging company); Eastman Christensen and Drilex (directional drilling and diamond drill bits); Teleco (a leader in the field of measurement while drilling); Tri-State and Wilson (fishing tools and services); Aquaness, Chemlink and Petrolite (specialty chemicals); and Western Atlas (seismic exploration, well logging). Today, Baker Hughes is a technology leader in drilling, formation evaluation and well completion and production, and the company publishes the highly respected Baker Hughes Rig Count that has been a barometer of the oil industry climate for many decades. In 2006, Baker Hughes had revenues of over $9 billion.
Time to Buy?
The oil service sector funds (OIH and IEZ), as well as the specific stocks that I discussed above (SLB, HAL and BHI), have all had significant run-ups in the past two months as the price of oil recovered from its January lows. Are these stocks “too high to buy” right now? In all candor, this is a close call for me.
I believe in the Peak Oil thesis. I give a lot of credence to Dr. Bakhtiari and his determination that the world crossed the “peak” of conventional oil production in the summer of 2006. So I believe that the long-term price trend for oil is up, up and up some more. Thus, looking back from a long view in the future, all of these oil service stocks are cheap at whatever price they are selling for right now. These are the foundations of Peak Oil investing. Then again, the stock market has been going just nuts lately -- all but melting up with liquidity. A lot of stocks are way overbought, and only some look particularly cheap.
So here is my advice: Begin to accumulate shares of Halliburton (NYSE:HAL) at current market prices. Also keep an eye particularly the sector funds OIH and IEZ, and BHI. SLB is kind of pricey, but it is always kind of pricey. That is just the way it is if you want that level of quality. Be prepared to pounce and buy aggressively on any general market retreat or pullback. You have to be nimble, because a lot of other buyers are watching these same stocks like a bunch of hungry hawks. If the oil service trifecta of SLB, HAL and BHI drops down in price, it will only last for a few days and then the buyers will move in to snap up the shares. Over the long term, these are some of the best investments you can make. When the reality of Peak Oil starts to sink in, these are the companies whose numbers will be on the “speed dial” of the owners of the oil wells of the world. They will be invited to go back into the old oil patches of the world, to try to find some more of that scarce oil.
Action to take: Begin to accumulate shares of Halliburton (NYSE:HAL) at current market prices. HAL is currently trading in the low $30’s.