The future of oil - and how to profit from it

High oil prices are driving the quest for new fuel sources. The end of the cheap-oil era could prove very profitable for smart investors, say John Stepek and Graham Buck

Peak Oil the theory that we are very close to, or have perhaps even passed, the point where we are pumping the maximum amount of oil possible from the earth has moved from being a fringe concern of eco-warriors and conspiracy theorists, to becoming generally accepted by the mainstream oil industry. The details are still a matter of debate, but few people doubt that it will happen. The question is when. Some believe the peak has already been reached. Most disagree, but even the optimists reckon we'll run out of easy oil within about 30 years.

This is a frightening prospect for a world that depends on oil for almost every process that makes modern life possible. Conservation is one solution to the impending crisis. But even if we managed to reduce the amount of oil we use in the West, growing demand from China, India and other emerging markets will more than compensate for the saving.

Then there are alternative energy sources. Solar, wind and nuclear power are all options for power generation that are being developed, and in the case of nuclear, rehabilitated. But it will take decades to bring these online and many are sceptical about the capacity of solar and wind power ever to substitute effectively for fossil fuels. And, of course, you can't yet pop a tank full of sunshine in your car.

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The truth is, we still need oil and we'll need it for a long time to come. So that's why it's a good thing that there's still plenty around. The point to understand about Peak Oil is this: it's the cheap oil we're running out of, not oil itself.

Yes, getting oil out of the ground is getting harder and more expensive some of the regions with the most plentiful alternative oil reserves will cost ten times the amount per barrel that it costs to get at Middle Eastern reserves. But with prices sitting at more than $70 a barrel, there's plenty of incentive for us to turn to these different sources. As MoneyWeek friend John Mauldin says: "We are not going to run out of fuel for our cars. We are just going to run out of cheap fuel. When it takes $150 for a good old boy to fill up his Ford F-150, things are going to change."

New sources of oil: heavy oil

Far from running short on reserves, we're sitting on "an oil glut", says Jim Jubak on MSN.com. The trouble is, this is in the form of heavy, sour crude oil, which is harder to refine than the more desirable light, sweet crude. The term heavy' means the oil is thicker, while sour' indicates it contains more sulphur and other impurities. More intensive refining is required to yield less petrol than lighter crude and not all refineries can handle it. But with the energy sector booming, there aren't enough engineers or tools to go round, so construction costs make it prohibitive to build or adapt refineries to process heavier grades of oil. That's great news for the refineries that already do. Several in Europe and the US can process heavy, sour crude and they are working flat out. You can find out which companies give you exposure to these refineries below.

Technology has also enabled companies to get heavier grades of oil from fields that were thought virtually exhausted. Chevron has revitalised the giant Kern River oil field in California, which contains extremely heavy oil, by using a steam-injection process. The same technique can be applied to oil that is heavier still in fields in China, Saudi Arabia and Venezuela. Venezuela claims its Orinoco extra-heavy' oil belt contains about 1.2 trillion barrels of oil. It currently produces around 620,000 barrels of extra heavy crude per day, with projects backed by Chevron, Total and ExxonMobil.

The main problem with the Orinoco oil is not so much the oil quality, but that it is in Venezuela. President Hugo Chavez is the most prominent of several South American left-wing leaders promising mass renationalisation of their countries' resources. He is pushing through reforms that would raise income tax on the Orinoco projects from 34% to 50%. This political instability makes it unattractive to investors. The good news is that there is a similar-sized source of unconventional' oil in a far more stable part of the Americas Canada.

New sources of oil: Canada's tar sands

Canada's tar sands are considered to be one of the oil industry's great hopes. Official estimates put accessible reserves at 179 billion barrels of oil, second only to Saudi Arabia. But with the right technology, it is thought there is enough bitumen in the tar sands to yield over 300 billion barrels of oil. Although refining requires about two tons of tar sands to produce one barrel of oil, it's an economic proposition while crude is at $75 a barrel. The Canadian Association of Petroleum Producers reports that C$60bn (£28bn) has been allocated for new development projects over the next five years. It predicts this year's tar sands output of over a million barrels a day will rise to 3.5 million in 2015 and four million by 2020. These hopes have transformed the province of Alberta, where economic growth at 6.6% is twice the national average.

Canada already delivers more oil from tar sands than from conventional wells. Analyst Jeff Rubin of CIBC World Markets believes Alberta's reserves will become the world's most important source of new oil by 2010 as supplies of conventional crude decline. The news is particularly welcome in the US, where President Bush is keen to reduce dependence on the Middle East.

But not everyone is as enthusiastic. Even the most optimistic scenarios suggest Canada's tar sands will produce no more than 5% of global oil production in 2020, reports Jerome Guillet in European Tribune. And as with most unexplored technologies, projects regularly bump up against unexpected obstacles. When most tar sands projects started life, they were considered viable with the price of crude standing at $25-$35 a barrel. But the boom has meant a squeeze on labour and materials, which has sent development costs soaring expansion costs for Royal Dutch Shell and partners rose by 50% to C$11bn (£5.2bn) in the past year. Citigroup's Doug Leggate suggests the sands now no longer look "particularly compelling" unless the crude oil price remains over $50.

Environmental issues are another worry. Millions of litres of water are needed to generate steam to blast the molasses-like substance out of the ground. Pumping the super-hot steam 1,000 metres underground requires 1,500 cubic feet of natural gas which, even in Canada, is less abundant these days to produce a single barrel of oil. Tar sands mining and refining also produces at least double the amount of air pollutants created by conventional oil wells. Alberta's former premier Peter Lougheed, once a champion of the sands, last month called for a moratorium on expansion while the potential impact is studied.

The prospect of another Saudi Arabia located in a friendly neighbouring country is not a prize the US will give up lightly, environmental concerns or not. As for viability, it seems likely that oil will remain well above $50 a barrel for the foreseeable future. But even if the tar sands run into trouble, there is an alternative fuel source of which the US is the undisputed king coal.

New sources of oil: what about coal?

The US is the Saudi Arabia of coal'. It has the world's largest deposits, with about 268 billion tons of recoverable reserves. All that coal can be turned into oil. The process has a less-than-illustrious pedigree. It was discovered by German coal researchers F. Fischer and H. Tropsch in 1923. The Fischer-Tropsch coal-to-liquids (CTL) process was used to power the Nazi war machine during World War II, providing nearly all of the country's aviation fuel and half of its petroleum needs. It was then perfected in apartheid-era South Africa, reducing the country's reliance on imported fuel while sanctions were in place. Despite its troubled past, CTL may have a glorious future.

HSBC works out that CTL plants in the US are viable at about $39 to $44 a barrel of crude. The bank reckons US coal reserves, if converted to oil, could generate up to 20 times the country's crude reserves enough for 250 years, says Strategic Investment's Dan Denning.

Canadian engineer SNC-Lavalin and clean energy group DKRW Energy are currently working on one of America's first CTL plants. Building on the $1bn coal-to-diesel Medicine Bow plant in Wyoming is set to begin in 2007.

The plant is expected to come on stream in late 2009, and will initially produce about 11,000 bpd of ultra-clean diesel and other fuels, although this is expected to rise to 33,000 bpd. Arch Coal will provide the coal, while GE and Rentech are providing the technology for the conversion process.

The US is not the only one backing CTL. Coal-rich China has "a total of 30 coal liquefaction projects across the country either at the stage of detailed planning or feasibility studies", says the China Daily. State-owned Shenhua, China's biggest coal miner, is working with South African CTL specialist, Sasol, and Royal Dutch Shell, to build two CTL plants in China's northwest. Shell-Shenhua and Sasol-Shenhua will each cost about $5bn-$6bn, and should be operational by 2012. Shenhua aims to generate about 30 million tons of oil products by 2020, through eight CTL plants. That would represent about one-seventh of China's annual oil usage. As Martin Spring says in the On Target newsletter: "The world isn't going to run out of oil while there's all that coal that can be turned into liquid fuels."

New sources of oil: how will all this affect gas?

Gas is both easier and cleaner than coal to convert to liquid fuel. The catch is that it's more expensive than coal, while the peak of gas production is expected to happen in less than 30 years. So the process costs roughly the same as coal liquefaction, around $30-$40 a barrel. But the resurgence of interest in coal has also highlighted another source of gas coal mines.

Coal bed methane (CBM) describes the methane the key component of natural gas found in coal seams. CBM already accounts for about 7% of total US gas production. The methane is extracted by pumping water out of the seam to reduce the water pressure and allow the gas to escape. It is then piped out of the mine. Several firms have sprung up to exploit CBM in locations from China to Italy. As demand for coal and gas rises, this trend will grow. James Finch on StockInterview.com says: "Just as uranium miners were below the radar screen in early 2004, coal bed methane exploration may very well be the next very hot sector later this year and next."

New sources of oil: the impact on oil prices

But won't these alternative sources of oil drive the oil price down? No: it takes time to transfer from one dominant power source to another. The switch from "coal gas for lighting to electric lights took decades, even though electric lights were cheaper and less polluting," says John Mauldin. As he points out, if oil prices fall as the result of a global economic recession, this will just slow the pace of change as people start to assume that prices won't spike again.

"That would be a mistake," he says. "Because as world growth comes back and it always comes back demand will once again rise, but traditional production will be peaking sometime in the next decade (if not sooner). Oil prices will rise dramatically, well beyond today's $70 range. But $100, or even $150, oil is not the problem. It is ultimately the solution."

The oil price is rising for the oldest reason in economics: not enough supply to keep up with demand. As always happens, it's only when one form of energy becomes too costly or inefficient that we make the effort to find a new one. But that change will be a long time in coming and will require sustained high prices to drive it through.

New sources of oil: how to invest

All these methods of finding new oil may sound exotic, but the good news is that one FTSE 100 firm has its fingers in almost all the pies listed above. Royal Dutch Shell (RDSB) is the leading oil major involved in Canada's tar sands, sitting on more than 25 billion barrels of heavy oil and bitumen. It's also involved in developing a Chinese coal-to-liquids plant with Chinese miner Shenhua, as mentioned above, and has built a gas-to-liquids plant in Malaysia and plans one ten times larger in Qatar. And, of course, it also produces plenty of conventional oil, and so benefits directly from high crude prices.

Heavy oil refiners

Jim Jubak on MSN.com and Stephen Simpson on MotleyFool.com recommend Valero Energy (US:VLO), the leading US refiner of heavy, sour oil, which is trading on a forward p/e of just eight, despite soaring profit margins. Others in the sector include Frontier Oil (US:FTO), on a p/e of ten, and Holly (US:HOC), which trades on a p/e of 11.

Tar sands

Other oil majors exposed to the tar sands include ExxonMobil (US:XOM), Chevron (US:CVX), and Total (FP:FP). For purer plays, MSN.com's John Markman suggests Suncor Energy (TSX:SU). Earnings per share are set to rise from $1.98 in 2005 to $4.85 this year and $5.40 in 2007. He reckons the stock could be worth $100 a share in the next 18 months. Other favourites include energy groups Nexen (TSX:NXY), and natural-gas producer Encana (TSX:ECA).

Markman also notes that "this is going to be a long, long secular story: something like investing in Saudi Arabia in the 1940s". With costs climbing and growing environmental pressure in Canada, sentiment may shift temporarily if oil prices retreat in the wake of the US driving season. UK investors might be better off sticking with Shell for now.

Coal-to-liquids

The price of coal has soared in recent years, but fell this year following the mild US winter. Prices of coal in Wyoming's Powder River Basin, the largest US production region, fell from a record $21.50 a ton at the end of last year to $11.50, according to Bloomberg. Shares in coal producers are correspondingly down by almost 40% since May. But the US Energy Information Administration expects demand to grow by almost 3% a year that's about twice the rate for oil. "That kind of meltdown creates a lot of buying opportunities," coal analyst James Rollyson told Bloomberg recently. "It's a short-term weakness because coal is the fuel of choice going forward."

As demand for CTL technology soars, coal producers should benefit from higher prices once again. FTSE 100-listed Xstrata (XTA) is one of the world's biggest producers, but if you're looking for purer plays, turn to US producers Peabody Energy (US:BTU), Arch Coal (US:ACI) or Consol (US:CNX).

HSBC suggests that as well as coal producers, CTL technology providers are worth looking at. Among these is US conglomerate General Electric (US:GE), also tipped by Derek Moorhouse in the Zurich Club newsletter. GE is exposed to clean coal technology, plus you get exposure to desalination plants (vital in a water-short world), wind and solar power. On a forward p/e of 14.5, Moorhouse says the shares are a buy up to $34.40.

Coal bed methane

There's a flood of small firms hoping to exploit the CBM boom. Martin Spring's On Target newsletter highlights promising sounding Australia-listed prospect, European Gas (ASX EPG), which has the rights to exploit methane resources in 8,000 square kilometres of coalfields in France and Italy. As France has to import almost all its natural gas, it'll see the firm as a "strategic asset", which should help it overcome environmental objections.