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Tight Oil Boom Is Changing The World

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Always an independent thinker, Rudi has not shied away from making big out-of-consensus predictions that proved accurate later on. When Rio Tinto shares surged above $120 he wrote investors should sell. In mid-2008 he warned investors not to hold on to equities in oil producers. In August 2008 he predicted the largest sell-off in commodities stocks was about to follow. In 2009 he suggested Australian banks were an excellent buy. Between 2011 and 2015 Rudi consistently maintained investors were better off avoiding exposure to commodities and to commodities stocks. Post GFC, he dedicated his research to finding All-Weather Performers. See also "All-Weather Performers" on this website, as well as the Special Reports section.

Rudi's View | Nov 21 2012

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By Rudi Filapek-Vandyck, Editor FNArena

We live in a time of inflated hyperbole. Every problem immediately turns into a "cliff" or some other portend of doom and gloom scenarios for the global economy.

However, if my recent fact finding mission through Asia and the US is anything to go by, the term "revolution" to describe what is taking place in today's energy sector is more likely to prove an accurate label and the global community is going to be surprised by its many consequences in the decade ahead.

FNArena has repeatedly made the extra effort in years past to highlight the new developments that are taking place around the world and that will, at some point, herald a new era for the energy sector in which natural gas will play an increasingly bigger role. The last time I personally zoomed in on the emerging new gas markets was in the closing week of June, in a Weekly Insights titled "The Next Revolution Is Already Here".

However, it appears we have been too focused on the gaseous side of the shale technology revolution that is reshaping the future of energy in the US right now. Shale gas will continue to impact on the world's energy mix but shorter term the largest impact will be felt through the liquids side of that same technological breakthrough. To avoid any confusion with gas, the shale extraction of liquids has been labeled "tight oil". Same base technology, only the output (oil) is different (plus the liquids extraction is more complicated).

Tight oil has already taken everybody by surprise, including those at the forefront of new developments inside the oil industry. As one industry veteran put it at a recent conference in the US: it was only a few years ago that everybody inside the US oil industry was talking about how to best create value in an industry that was essentially without growth. Today, that dynamic has completely reversed and everybody is getting excited again about the new growth prospects for oil.

This truly is one dramatic change that is going to dominate the decade ahead: for the world, not just for the US.

The International Energy Agency (IEA) jumped on these new developments last week by predicting US oil production is poised to exceed Saudi Arabia's by 2020-2025. The news made a big impact in the US as The Wall Street Journal highlighted the news on the front page in big bold script.

Whether the prediction will be proved correct or not (many remain skeptical), fact remains the US and Canada together now have the tangible prospect of becoming fully energy self-sufficient before the end of the decade and that is something nobody saw coming. Oil production in the US had been on a downward slope since the seventies. Now the country's oil production from both conventional and non-conventional sources is this year projected to grow to the highest output level since 1991, with projections for further strong growth in place for the years ahead.

Today, Saudi Arabia produces some 9.8m barrels a day while US production currently does not reach beyond 6.7m barrels a day. According to some projections, tight oil can potentially add 5m barrels a day for the US by 2023. Including biofuels the US could well produce 12m barrels a day by 2020, according to some studies. The days of Saudi Arabia being the main oil supplier for the US are long gone and neighbour Canada nowadays supplies close to 30% of total US imports, but Arab oil dependency remains very much a feature in the psyche of the general US consumer.

It is now estimated the US can potentially reduce its imports from Arab countries to zero over the next four years.

Already, political analysts in the US are discussing what the consequences might be for the country's international strategy. The Middle East is turning its marketing efforts increasingly towards the Asian region, but allies of the US, including Japan and India, have used their diplomatic channels to try to receive a slice of future US energy exports.

One might argue the tight oil revolution that has occurred in the US since 2009 has already had major geopolitical impact as the increase in US oil production since has compensated for some 80% of the loss from Iranian exports since the US and its allies placed a boycott on Iranian oil.

Tight oil is not going to remain a US phenomenon. Countries including Argentina and Poland have with full enthusiasm jumped on this new opportunity. Even Russia, the world's largest producer of conventional oil, is embracing the new technology as total supply from its traditional sources is projected to start declining as early as from 2015 onwards. Russia's government budget relies heavily on revenues from oil (40% on some estimates), so there's a strong incentive in Moscow to find new sources for oil. Output from Russia's largest source, West-Siberia, peaked in 2007.

Conclusion number one is the world is going to pump out more oil than ever before in the decade ahead. Any thoughts about "peak oil" have been premature, to say the least. But what will it mean for the price? Experts are not sure. The underlying trend in demand remains positive carried by Emerging Economies, not in the least Middle Eastern countries themselves, while demand has clearly peaked in the US and in Europe (in 2005 already). It is estimated that global demand for oil and oil products might grow by up to 50% by 2035. But now supply is moving into a higher gear as well, albeit attached to a higher cost of extraction.

Which is why some experts don't believe all this new supply will suppress the price of fuel in a meaningful manner. On the other hand, some 90% of the fledgling tight oil industry in the US has indicated it is operating at a profit when oil is priced at US$90/bbl, so there is downside potential.

The impact of today's revolution in unconventional liquids will be much broader than simply easing the burden of global fuel consumers. A recent study by IHS Global Investors estimates new investments in the US oil industry will run into the trillions in the decade ahead as a new generation of oil entrepreneurs is embracing the unforeseen opportunities from this technological breakthrough. Imagine what potential impact this can have on the US government's revenues? IHS estimates all this new activity will create some 1.7 million new jobs and ultimately more than 3 million jobs by 2020 (direct and indirect).

One conclusion to draw from all this is that the Super Cycle remains in full swing for services providers to the oil and gas industry. Think WorleyParsons ((WOR)), among others.

The full impact will also include the US chemicals industry and US manufacturing in general. Analysts are now reflecting upon a new age for the US petrochemicals industry as for the first time in three decades new plants are being opened on US soil with the aim of producing PVC products and other plastics for export markets. Other manufacturers become more competitive too as they gain access to cheaper energy sources. One popular term now used among US analysts is the "renaissance" for US manufacturing. Some, like IHS Chief Economist Nariman Behravesh, believe all the ingredients are in place to once again transform the US into a "manufacturing powerhouse".

In Behravesh's view, today's "energy boom is the best thing that has happened to the US in a long time". It is one key reason as to why he is quite optimistic about the US economy's prospects from 2014 onwards with cheaper energy and increasing activity in the oil and gas sector adding on top of the cautious recoveries in US housing and in US consumer spending.

The IHS Chief Economist is far from the only one who believes the tight oil/shale gas technological breakthroughs will set apart the US from Europe and Japan, which both are muddling through "lost decades" with little prospects for sustainable above trend growth. Admittedly, the US has its own demons to deal with in the short term in the form of tax benefits expiries commonly referred to as "the fiscal cliff" while a divided Congress and Obama administration can potentially create yet another political mess over it. With Europe and Japan back in recession and likely to remain weak for the foreseeable future, US exports won't be a big growth driver.

The US has a sovereign debt problem too, but contrary to Europe and Japan, it might just pull it off to tackle its problems with growth, assisted by today's booming energy sector. Growth is what remains missing in Europe and Japan which is why the sovereign debt threats in both economic zones are not going to disappear any time soon.

Potentially the biggest threat to global economies relates to Iran's much maligned ambition to develop nuclear weapons. Chances are high that the current stalemate can escalate within the next six months. Surely any breakdown in negotiations will translate into a premium built into the price of oil. Any act of violence by either party is likely to cause a sudden spike. We were last reminded in 2008 what happens when oil prices spike.

How worried should we be?

Well, there's a lack of trust on both sides of the negotiations. The Supreme Leader in Iran is convinced the ultimate goal of the US and its allies is to try to depose him, just as has happened in Libya and in Iraq and frankly, he has a point. The problem is that because of this conviction, the Supreme Leader appears unwilling to make concessions or to compromise. This automatically means escalation is a genuine possibility as both Israel and the US won't allow the risk for a nuclear arms race in Asia and the Middle East and this would surely commence from the moment Iran claims its first nuclear weapon.

As such, it is well possible that oil will help changing the US and world economies in the decades ahead, in a positive sense, but it's impact in the short term (2013) has the potential to be sharply negative.

(This story was originally written on Monday, 19th November 2012. It was published in the form of an email to paying subscribers on that day).

Good news for FNArena subscribers: colleague Greg Peel recently finished an in-depth market update on rare earths elements (REE) which has been published in e-booklet format, for FNArena subscribers only. If you haven't received your copy yet, send an email to info@fnarena.com

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)

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