Earlier this week, NYMEX crude oil futures, in un-lady like fashion, bolted to an intra-day high of US$127.27. It capped an exuberant dash which saw oil gain over 8% in six trading days, 30% since the beginning of the year, and 100% in the last twelve months. It’s just the sort of thing you’d expect from a ten-year old.

Here is an astonishing fact: on December 10th, 1998 the spot price for a barrel of West Texas Intermediate crude was exactly ten U.S. dollars and ninety eight U.S. cents. Nearly ten years and one thousand and sixty two percent later, it is time to ask some impolite questions about oil.

Impolite questions are not always obvious questions, though. The obvious question is to ask how high oil can go. Arjun Mutri and his team at Goldman Sachs have told us a disruption in supply could send oil to another “super spike” over US$200. Two years ago, the “super spike” was supposed top out at $100. Maybe it will be US$500 two years from now.

It is easy to keep raising the figure, but is probably more useful to ask a different question. The important investment question is not how high oil can go from here. The impolite but important investment question is where future global oil production will come from at all.

The answer, according to a new report from UBS, lies with just eight oil companies, one of which investors can’t even buy. Below, I’ll look at where future production may come from, who stands to profit the most, what investors can do now, and three “Black Swan” possibilities for the oil market that no one has prepared for.

Why Are Oil Prices So High?

An obvious question on the lips of anyone who buys petrol is, “Why are oil prices so high?” Consumers trained in the ways of the free market—and used to cheap clothes and electronics made in China—are right to ask the question.

In a fully-functioning free market, rising demand tends to attract rising supply. The reason?
Profit.

When a market is imbalanced and demand exceeds supply, prices rise. At that point, opportunistic new producers tend to rush in and grab some of the profits by brining on new supply. Prices fall and, for awhile anyway, equilibrium is restored.

That’s how it works in textbooks. That is not how it’s been working in the real world. According to the International Energy Agency, world oil demand has increased in each of the last three years, from 84.9 million barrels per day in 2006, to 86mbbl/day in 2007, to this year’s rate of 87.2mbbl/day. The IEA’s most recent forecast calls for global demand of 87.8mbpd for the rest of this year.

In response to this increase in global demand, OPEC oil production promptly declined by 265kbpd in February (the latest period for which official figures are available) to around 32mpbd. Not exactly helpful. And latest survey from Platts predicts a March decline in production of 347kbpd from the February figure. This brings average OPEC production below 30mbpd for the month.

This past weekend, U.S. President George Bush travelled to the Kingdom of Saudi Arabia, politely requesting the Saudis increase oil production to bring down gas prices in America. The Saudis demurred, and told the President oil production was more than sufficient to meet global demand.

OPEC blames the oil price on the weak U.S. dollar, but admits prices could go higher still. OPEC President Chakib Khelil explained the situation to journalists in late May, saying:

The prices are high due to the fact of the recession in the United States and the economic crisis which has touched several countries, a situation which has an effect on the devaluation of the dollar, and therefore each time the dollar falls one percent, the price of the barrel rises by $4, and of course vice versa.

In other words, OPEC blames the oil price on the sliding U.S. dollar and not inadequate supply. Khelil added that, “If this (the dollar) strengthens by 10 percent, it is probable that (oil) prices will fall by 40 percent.” At today’s prices, that would put a barrel of crude at US$76.

Froth vs. Fundamentals

If you can say with assurance why oil prices are US$127, you are more assured than most. OPEC believes oil strength is really just U.S. dollar weakness. A stronger dollar means lower oil prices, and probably lower commodity prices in general. There are other theories that seek to explain the high oil price, including a “fear premium,” oil as an inflation hedge, and pure speculation by professional traders.

But there are three other possibilities to consider. Exploring them gives us a clue about where oil prices are headed and where future production might come from. These possibilities are:

1. OPEC won’t increase production because it doesn’t want to
2. OPEC can’t increase production
3. Non-OPEC countries cannot increase production enough to bring prices down

It is impossible to answer the first question. Oil producers, from OPEC to large multi-nationals, plan with long time horizons. They view oil markets as cyclical and do not base capital expenditure plans on pie-in-the-sky price forecasts. They are reluctant to recognise and respond to what your editor (among others) believes is a structural revaluation in global energy prices (not a cyclical bubble).

But this institutional skepticism about how long high oil prices can last does not account for the slump in this year’s production. OPEC’s production has fallen this year because of continued disruptions in Nigeria (see table below). Rebels in the Niger River Delta have reminded us all of how vulnerable the global energy system is to systematic sabotage. But excluding Nigeria, the rest of OPEC is running at near capacity.

Does the fact that oil touched US$127 in futures trading contribute to BHP Billiton’s earnings and its war chest for its pursuit of Rio Tinto (ASX: RIO)? BHP thinks the answer is yes.

BHP Billitons’s oil projects showed up in a research report we reviewed yesterday. The report tried to answer the question of where future global oil production would come from. There is a 32 million barrel per day gap between what the world produces today (about 87mbdp) and where the International Energy Agency reckons the world will be in 2030 (117mbpd).

In other words, the world needs another OPEC if oil supply is going to keep up with demand. OPEC currently produces 32mbpd. The IEA says OPEC can double that figure if it invests about US$2.4 trillion in exploration and production. OPEC is not as sure. As you can see, the gab between global production capacity and global consumption is, ahem, pretty tiny right now.

Source: BHP Billiton, IEA

According to BHP’s oil man Mike Yeager, BHP’s cost of production for a barrel of oil is between $6 and $12 a barrel. For the last three years, production at BHP’s various oil fields has hovered around 300k bpd. That makes it the world’s 25th largest oil producer, according to the company, which is not bad if your main business is mining.

It’s an axiom that the mining business and the oil business don’t mix. Energy exploration and production sucks up the capital, while project life is uncertain and cash flows variable. There are lot of known unknowns, and on the exploration side, some unknown unknowns.

But BHP Billiton does know that oil production increased to 378k per day last month, and 415k per day last week. It knows that the fifth LNG train from the North West Shelf is scheduled to begin production this year. It knows that its Neptune field in the Gulf of Mexico, though delayed this week, should begin cranking out 50kbpd in June of this year.

It also knows that by this time next year the Shenzi field in the Gulf of Mexico should begin producing about 100kbpd and that by 2010 the Pyrenees field in Western Australia should produce about 96kbpd. And there are more projects in LNG on the way, too.

That is a lot of good news for an oil company that’s not an oil company. By market value alone, BHP Billiton is bigger than BP (NYSE: BP) and not far behind Exxon Mobil (NYSE: XOM) and Royal Dutch Shell (NYSE: RDS.A). If the company is valued as an energy company and not just a miner, then yet another reconsideration of its value may take place. Rio Tinto should be worried about that. All that energy translate into cash for a bid sweetener.

BHP Billitons’s cost of production is going to rise. There is huge cost inflation across the entire oil industry as projects move further off-shore and deeper underwater. But this is an example of Australia’s exposure to straight-forward bull markets in energy and resources. The businesses aren’t easy, but they are not conceptually complicated.

What’s so astonishing about Australia’s resource economy right now is how it’s filtering down from gold and oil to base metals, bulk commodities, and even lead. “The great minerals land grab by China Inc continues with Hunan Nonferrous Metals Corp looking to buy one of Australia’s best untapped lead deposits,” reports Kevin Andrusiak in today’s Australian.

Lead?

“Yesterday Hunan launched a takeover bid for Perth-based Abra Mining, saying it is prepared to spend just $67.3 million to control one of the nation’s best untapped lead deposits. Hunan, which has received the backing of the Abra board for the takeover play, has offered 83c for 70 per cent of the remaining Abra scrip it does not already own.”

Hunan’s offer puts a 44% premium on Abra shares. A 44% premium on lead. If lead gets that kind of premium, what would BHP’s oil and energy reserves (1.3boe) and its resource base (3.5boe) command? The resource grab is well and truly on, and it’s moving at the speed of lead.

Dan Denning
The Daily Reckoning Australia

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Source: The Oil Company That is Not an Oil Company