FOUR

TOUGH OIL

BY ANY STANDARDS TRANSOCEAN LTD.’S Deepwater Horizon was a tremendous feat of engineering. Designed to drill down 30,000 feet for oil in ocean depths up to 8,000 feet, the immense rig was 396 feet long and 256 feet wide. Eight engines rated at 7,375 horsepower each turned big propellers that could rotate 360 degrees to keep the semisubmersible rig precisely stationed over the drill hole. It could operate in twenty-nine-foot seas and was designed to survive waves in excess of forty-one feet and hurricane-force winds of more than one hundred miles an hour.

In the spring of 2010 Deepwater Horizon was on lease for several hundred thousand dollars a day to BP Group, one of the world’s largest oil companies, and was drilling for oil in the Gulf of Mexico forty-one miles off the coast of Louisiana. The weather Tuesday night, April 20, was good, operations were going well, and among the 126-member crew aboard the rig who weren’t working, some were watching television while others were sacked out in their bunks to grab some sleep. At about 10 p.m. a tremendous explosion rocked the giant rig, and a raging fire followed. The U.S. Coast Guard responded immediately with cutters and helicopters, taking off 115 crewmembers, 17 of whom were taken immediately to shoreside hospitals to be treated for injuries ranging from minor to severe. Eleven crewmen simply disappeared and were never found.

The oil-fueled fire burned for a day and half despite heroic efforts to quell it. Then at midmorning Thursday, April 22, another blast rang out over the Gulf of Mexico and the giant rig toppled and sank. A day later the Coast Guard said there was no evidence that any oil was leaking from the well head, but that assessment changed the next day when remote submersible craft found oil gushing from leaks in a drilling pipe almost a mile below the surface. The gusher continued unabated for nearly three months, dumping an estimated five million barrels of oil into the Gulf of Mexico and contaminating hundreds of miles of fertile marshlands that were a home and breeding ground to millions of fish and fowl. Commercial fishing and oystering, the economic lifeblood of Louisiana’s southern bayous, was banned in large swatches of the Gulf of Mexico. The well was eventually plugged, but the full effects of the Gulf spill are currently unknowable.

There will be many recriminations and much second-guessing of what could or should have been done to prevent the massive spill or to minimize its effects. Litigation will continue for years. Government policy on offshore drilling will be in flux for the foreseeable future. But the lesson for us in the Gulf of Mexico oil spill goes far beyond the precise cause of the disaster. Rather, the explosion of Deepwater Horizon demonstrates the good news and the bad news about our global dependence on oil to drive industrial economies.

First, the good news: the world won’t run out of oil during our lifetimes.

The bad news: the world will run out of easily obtained oil. Soon.

The essential problem is that the world’s big oil companies have apparently found and are currently exploiting all the easy-to-get oil. Mankind has been using crude oil for centuries as a medicinal agent, for illumination, and for machinery lubrication. But until the mid-1800s they had never sought it in a systematic way, instead stumbling on “seeps,” crevasses, and fissures in the earth’s surface that allowed subterranean oil deposits to slowly percolate to the surface. One of the biggest and best-known seeps was in northwestern Pennsylvania, but it was initially considered an irritant. Farmers and landowners drilling water wells kept penetrating oil reservoirs that contaminated the water they needed for drinking and irrigation. Then in 1859 Edwin Drake drilled a well specifically to tap the sub-surface oil. As the commercial potential of crude oil became clear, the global quest for oil began.

Pennsylvania may have first claim as the place where oil became a commercially viable product, but Texas holds the title as the birthplace of the modern oil industry. On January 10, 1901, after months of backbreaking drilling on a hill in southeastern Texas called Spindletop that had yielded only minute quantities of oil, the workmen were lowering their drill back into a drilled shaft that was 1,020 feet. It had been seventeen hours since any drilling had taken place in the shaft, but suddenly oily mud began burbling to the surface of the hole. Then with a furious burst, the heavy drill shaft was blown out of the hole. Nothing else happened for several minutes. Then, with a loud blast, mud, gas and oil began spewing into the air from the drill hole. The plume of crude oil shot up more than 150 feet, twice the height of the drill derrick. It was the world’s first man-made “gusher,” and it flowed at the astounding rate of one hundred thousand barrels per day, more than the combined flow from all the existing wells in the United States.

The success of the purposeful exploration for oil in the United States touched off a global search for more sources of petroleum. Only a few years after the Spindletop gusher erupted it was becoming increasingly apparent that the Middle East had huge oil resources. But it wasn’t until after World War II that serious exploration and exploitation of Middle East oil began. By 1960, when Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela formed the Organization of the Petroleum Exporting Countries (OPEC), it was absolutely clear that the Middle East sat astride the world’s greatest deposits of crude oil. But those Middle Eastern deposits weren’t the only ones, just the largest. Since then big reserves were found in the North Sea and on Alaska’s North Slope. The oceans are still in the early stages of exploration and exploitation. But these more recent discoveries illustrate the problem: extracting large amounts of oil from the Alaskan wilderness and the dangerous North Sea has been neither cheap nor easy. And as the Deepwater Horizon disaster illustrates, tapping the oil reservoirs beneath the oceans will be even more difficult and expensive.

The development of new petroleum discoveries tends to follow the same pattern. At first the newly discovered oil is easy to tap. The drillers at Spindletop were confronted with the problem of how to harness the raging gusher, not how to pull the oil out of the ground. As the geology of a new discovery becomes clearer and additional wells are drilled, production from an oil field continues to increase over a period ranging from a few to many years. But at some point the easy oil is gone. The field still holds lots of petroleum, but getting it from the reservoir to the surface becomes more difficult. The daily flow of each well decreases and new wells drilled in other parts of the reservoir don’t flow nearly as fast as the earliest wells. Eventually the flow slows to the point that the oil company begins to take new measures to extract the oil. Water or steam injection may be used to pressurize the underground reservoir and drive more oil to the surface. Finally there comes a day when further exploitation is simply too difficult or expensive given the price of a barrel of oil. Many of the Texas oil fields that were so productive in the first half of the last century are either depleted today or will be in the near future.

Unfortunately, the global pattern of oil exploitation follows that same course. New oil is easy to extract at first, and production builds over time, but eventually all the easy oil is gone. Today we know that production rates of the Middle East’s vast reservoirs, as well as those of Alaska and the North Sea, are declining. The question is when, not if, we reach a condition that experts call “peak oil.” That’s when global oil production reaches the highest level it ever will. Some experts believe we have already reached that point, others that peak oil may still be twenty or more years away. But whenever peak oil occurs, production of petroleum will gradually decline. How fast it declines is a matter of much conjecture. Some estimates are as low as 2% per year, some posit 5% per year, and the most alarmist projections are 13% a year. But regardless of how fast production declines, the supply of oil runs head-on into the really alarming problem: population growth and oil use are increasing rapidly with no signs of abating anytime soon. Billions of new drivers and millions of new cars will be hitting the road as China and India—among other places—industrialize and become, like the United States, Europe, and Japan before them, mobile nations. The upshot is that demand for oil will far outstrip supply. And in classical economics that means only one thing: higher prices.

As people become more willing to pay higher prices for gasoline and other petroleum byproducts, the world’s oil companies will push harder to extract oil from the deepest oceans and from the shale and tar sands that hold immense amounts of petroleum locked up in their geological structures. But that will only be feasible at much higher prices than the world is now paying for a barrel of oil. Think of rising oil prices as an industrial tax and an increasingly heavy one at that. As we have learned—but not necessarily retained—from previous “oil shocks,” higher energy prices slow economic growth. How high oil prices rise and how soon will determine the impact of peak oil on the world economy. If prices rise gradually, perhaps the world economy can adapt with minimal disruption. But if prices rise suddenly for any number of reasons, the economic effects could be devastating, especially in advanced countries. The trouble is, we’re not well equipped to make those predictions about how fast prices will rise mostly because we don’t have very good information about how much oil is still reasonably easy to access. Both oil producing countries and the oil companies themselves are notoriously unreliable in disclosing their reserves.

Another factor in trying to predict what will happen to oil supplies and prices is the uncertainty about the economic effects of rising oil prices and how quickly the world can adapt. The Great Economic Collapse of 2008 and the global recession it caused put a big dent in oil demand. And $4-a-gallon gas in the United States in 2007 effectively became a great advertising campaign to help Toyota launch its Prius hybrid gasoline-electric car. Today all the major automakers are rushing to produce hybrid or all-electric vehicles in anticipation of rising oil prices.

Oil consumption is also tied to the problems of global climate change and we can’t predict how government policies around the world to deal with climate warming will affect taxes and prices of various energy sources, although it is almost certain that wind, solar, and nuclear power cannot fully substitute for oil in the world’s industrialized economy. A final uncertainty about oil surrounds the conflict between what is essentially a bloc made of the Western economies and Japan on one side and the Islamic nations on the other, the outcome of which is impossible to predict—assuming that there will be an outcome and not just a prolonged battle that extends beyond the foreseeable future.

The only thing that is certain is that over time oil prices will rise, which is the same thing as saying oil will become a more valuable commodity. Perhaps the silver lining in the very dark cloud sewn by the Deepwater Horizon disaster was President Obama’s reversal of his decision to open East Coast waters to oil exploration. Now whatever oil is under those ocean waters will remain there, growing in value over time.

Investment Implications of Peak Oil

Many of us with a few years under our expanding belts recall the Oil Shock of 1973. It was the first really dramatic economic crisis to confront us since the Great Depression. People sat in their cars for hours in lines miles long to get to the gasoline pumps at service stations, all for the privilege of filling the tanks of their gas guzzlers with gasoline that cost four times as much as it had just a few weeks earlier. All that panic was created when OPEC cut production by a mere 5%, sending oil prices to what at the time was an astounding level of $12 a barrel from $3.

There was no geological reason for the 1973 oil shock. Rather it was political. First, it was punishment directed at the United States for lending support to Israel in the Yom Kippur War that started in October 1973 when Egypt and Syria attempted to invade Israel. Second, it was a counterpunch. The United States had been pressuring the oil exporting countries to keep their price increases at no more than 2% a year. Yet the prices of products we sold them had been rising at a much faster rate because of our big inflation problems. Wheat, for example, nearly doubled in price in 1973.

The 5% increase in oil prices triggered a panic in 1973 because our demand for oil was insatiable. Unfortunately, it still is.

Yet while our demand for oil is insatiable, we can see the future in our own supply and demand for the liquid gold. In 1970 the United States produced about ten million barrels per day. Today that production is halved, to about five million barrels per day. In 1970 we could just about supply our own needs of a little more than ten million barrels per day. Now we consume twice as much. As a result we are today undertaking what legendary oil baron T. Boone Pickens describes as “the greatest transfer of wealth mankind has ever seen” as more of our dollars than ever are sent to the Middle East to pay for oil.

We all know that supply and demand determine the price of a commodity. If supply is 85 million barrels a day given the global oil industry’s current technology and resources, we need to examine the demand side of the equation. We need the energy derived from oil for transportation and to power our homes, businesses, and factories. Today demand for oil is about 86 million barrels a day. Estimates are that by 2030 our demand for oil will increase 37% to 118 million barrels a day. These estimates factor in the growth of demand in industrialized countries like the United States, the growth in developing countries like China, and general population growth. If these numbers continue as predicted, we’re clearly in for some problems very soon.

China and India in particular have seen spikes in their demand for oil. In the past ten years Chinese consumption of oil has grown from 3.5 million barrels a day to over seven million barrels a day, while the United States has gone from 17.7 million barrels a day to 20 million barrels. In 2008 alone, China experienced 15% growth in automobile sales, signaling that future demand for oil will most likely continue to increase. India also has more than doubled oil consumption since 2002 and is expected to be up to 5 million barrels a day by 2030.

Long-term Solutions?

The world has long been aware that oil is getting tougher to extract and the price is rising. The result is increasing interest in ways to mitigate the supply and price problems looming in the near future. None come without their own problems, and all should be kept in mind as you make investment decisions about companies connected to the looming peak oil crisis in the future.

Biofuels are created from recently dead biological materials such as corn oil or wood pulp. Still in its infancy, this approach produces nowhere near enough fuel to satisfy our needs. It’s also more expensive to produce biofuel than it is to produce oil, so biofuel won’t likely be economically attractive until oil prices rise considerably farther. What’s more, the biofuel process results in the same kinds of pollution that petroleum refining produces. And finally, diverting resources from the production of food to produce energy could cause significant inflation in food prices.

Natural gas has been a choice favored by Boone Pickens. But natural gas is subject to its own supply limitations and the United States probably has already passed the point of “peak gas.” Natural gas is also difficult to store and ship across oceans.

Hybrid cars driven by a combination of gasoline engines and electric motors have proven very popular, their fuel savings offsetting their often anemic performance. All-electric, plug-in automobiles are just coming to the market and seem, for the moment, to be the best solution to conserving petroleum because they use none, although the electricity to charge them may come from petroleum or coal-fired plants. The downside is that current battery technology can only provide about a forty-mile range, enough for city commuting but not enough to warrant replacing a gasoline car entirely.

Cheap oil fueled the growth of American suburbs and today, in the largest cities, some workers drive more than an hour to get to their jobs. As oil prices rise there is likely to be greater interest in mass transit, even in mid-sized cities. Over a longer period we may see the end of the suburbs and a return to city living. “Local” may become the new buzzword. You work where you live, you meet by teleconference rather than flying from one city to another, and you buy your produce from a local farmers market rather than from a major grocery chain. And the food you buy may be grown with “natural fertilizers” (that means manure) and not the petroleum-based fertilizers that have become so prevalent.

But don’t think we’re painting some idyllic pastoral picture here. There are tough consequences associated with the era of tough oil: inflation, turmoil in the Middle East, and competition, perhaps military, for the dwindling supplies of oil being produced. China already is moving aggressively to secure long-term supply contracts and to partner with Third World nations in a search for more oil reserves in remote parts of Africa.

Investment Opportunities in Oil

BP finally managed to halt the flow of oil into the Gulf of Mexico. Although the specific driller implicated in the spill is Transocean (RIG) the entire sector of drillers came under scrutiny from regulators and investors alike. The fear among investors was that there would be a permanent ban on drillers and oil refiners, especially those with exposure to the Gulf of Mexico. Wrong! The need for oil is going to override the concerns about deepwater drilling. If when you read this the prices of drillers are still below their pre-Gulf accident levels, fade the fear and add them to your portfolio.

Principle One: Fade the Fear

The major oil companies not implicated in the spill—Conoco-Phillips (COP), Chevron (CVX), and Exxon (XOM)—may also be attractively priced as fallout from the disaster. It may be especially interesting to look closely at Exxon, which is the largest company in the world with a market cap of $286 billion as of this writing. This company has survived multiple panics, crises, spills, and worries about gluts or droughts of oil. And along the way it has increased its dividend for twenty-eight consecutive years. Buying shares of companies with a history of steadily increasing dividends is, in and of itself, a very sound investment strategy in that companies raise dividends when they are confident of their future earnings potential.

Let’s take a moment to look at the S&P Dividend Aristocrats Index, a list that Standard & Poor’s compiles each year listing all companies that have increased dividends for twenty-five consecutive years. How has this index done overall? Is it better than simply buying an index of all stocks?

Absolutely! Since 1989 the Dividend Aristocrats have returned 12.93% annually, versus 11.8% for the S&P 500 as a whole. During the 2000–2002 bear market the Dividend Aristocrats returned 0% while the rest of the market collapsed in a severe downturn. In the five years ending in 2009, a period of immense volatility, the Dividend Aristocrats returned 3.32% versus 0.42% for the S&P 500.

Here is the current constituent list:

3M Co.	MMM
Abbott Laboratories	ABT
AFLAC Inc.	AFL
Air Products & Chemicals Inc.	APD
Archer-Daniels-Midland Co.	ADM
Automatic Data Processing	ADP
Bard, C.R. Inc.	BCR
Becton, Dickinson & Co.	BDX
Bemis Co. Inc.	BMS
Brown-Forman Corp. B	BF/B
Centurytel Inc.	CTL
Chubb Corp.	CB
Cincinnati Financial Corp.	CINF
Cintas Corp.	CTAS
Clorox Co.	CLX
Coca-Cola Co.	KO
Consolidated Edison Inc.	ED
Dover Corp.	DOV
Emerson Electric Co.	EMR
ExxonMobil Corp.	XOM
Family Dollar Stores Inc.	FDO
Grainger, W.W. Inc.	GWW
Integrys Energy Group Inc.	TEG
Johnson & Johnson	JNJ
Kimberly-Clark	KMB
Leggett & Platt	LEG
Lilly, Eli & Co.	LLY
Lowe’s Cos. Inc.	LOW
McDonald’s Corp.	MCD
McGraw-Hill Cos. Inc.	MHP
PPG Industries Inc.	PPG
PepsiCo Inc.	PEP
Pitney Bowes Inc.	PBI
Procter & Gamble	PG
Questar Corp.	STR
Sherwin-Williams Co.	SHW
Sigma-Aldrich Corp.	SIAL
Stanley Black & Decker	SWK
Supervalu Inc.	SVU
Target Corp.	TGT
VF Corp.	VFC
Walmart Stores	WMT
Walgreen Co.	WAG

 

When applying our “Fade the Fear” principle during the occasional moments when media-inspired panic grips the markets, you can err on the side of safety by buying the companies that have solidly delivered rising dividends for more than a quarter of a century. While companies like Exxon fell more than 10% in the fears triggered by the Gulf oil spill, there is little question that the company will thrive again, with its stock price hitting new highs and its dividend rising yet again.

Outperformance of the Dividend Aristocrats over the S&P 500 from 1989 to 2008:

Principle Two: Invest through the Back Door

The back door for tough oil includes anything related to alternative energy, and the key with a back-door stock is to be certain that the front-door business is relatively safe and growing despite the fluctuations in the price of oil. As expected, most companies that are tied closely to alternative energy experience a lot of stock price volatility as oil prices rise and fall. Companies that are solely engaged in wind energy, solar energy, or natural gas might be in or out of business depending entirely on whether the price of oil stays above or below certain levels for an extended period of time. That’s just too risky.

A great back-door example in the alternative energy space is Archer Daniel Midland (ADM). This is the largest agricultural processing company in the world, involved in everything from harvesting to the storage and transportation of food commodities ranging from vegetable oils to seeds, tofu, and corn. And where there is corn, there is a back door into alternative energy: ethanol. If oil prices rise, ADM stock will go up as companies depend increasingly on shipments of the ethanol ADM produces. If oil prices go down, no problem: ADM has been in business for a century and is among the dividend aristocrats we discussed earlier.

Another sector that holds potential back-door plays in the alternative energy space is wind power. One great example is AeroVironment, a company that has been around since 1971, has lots of cash and no debt, and generates a ton of cash from its primary business: making unmanned aircraft systems that hang out in the stratosphere spying on potential enemies, checking out hurricanes and forest fires, and carrying out other airborne tasks for its military and corporate customers. The company has been growing at 25% per year for the past several years. But what, you ask, does this company have to do with wind power? The company has used its knowledge of aerodynamics to create and patent miniature wind towers on top of buildings to help supply the buildings’ energy demands. No big, expensive, land-grabbing wind farms required.

Otter Tail, a utility company that uses its excess cash flows to invest in other businesses (much as does Berkshire Hathaway), is another back-door play on wind energy. One of the businesses it invests in is DMI Industries, one of the largest makers of wind towers. It just opened new plants to meet rising demand. But no matter what happens to its wind power business, Otter Tail will always have its foundational utility business, which boasts Bill Gates as its second-largest shareholder, as well as a healthy dividend.

The Department of Energy estimates that wind power will account for 30% of our energy needs by 2030, up from just 3% today. That’s a Nostradamus-style prediction, but if it is right there’s going to be nonstop business for these two stocks. And if it’s wrong, it doesn’t matter, since you can essentially buy the wind businesses of these two companies for free given how well their main businesses are doing.

Principle Three: Invest through the Front Door

The front-door entries for tough oil are those companies we will rely on to get us the difficult-to-find oil as easy reserves dwindle. The spill that ravaged the Gulf of Mexico will not change the basic fact that most of the remaining oil in the world is to be found offshore. Exploiting these deposits will require specialized equipment and techniques very few companies possess. The three big gorillas of offshore drilling are Noble Corp. (NE), Diamond Offshore (DO), and Transocean (RIG). They usually have long-term contracts with the oil majors that provide some stability to their stock prices, and all three are expected to benefit long-term as our demand for oil increases while supplies become increasingly difficult to harvest.