Why oil investors are still smiling

With the rise of China and India, demand for oil is soaring. But supply will remain constrained. That means a soaring price and rich gains for investors. Jody Clarke and Eoin Gleeson report

Before Iran released the 15 British hostages earlier this week, the gloom and doom pundits were out in force. They were worried the situation would escalate and somehow (be it via airstrikes or sanctions) have an impact on oil imports from the region. Every day, 17 million barrels of oil are shipped through the Strait of Hermuz. That's a fifth of global oil exports, so a disruption would have been a nasty business, creating what Goldman Sachs called a "very significant impact on oil balances" and an immediate market shortfall of a couple of million barrels a day. No wonder, then, that the oil price crept up throughout the crisis to end Tuesday (the day before the release) at $67.81 a barrel, 8% higher than it was when the hostages were first taken.

Yet, whatever Goldman feared, the crisis in Iran was never likely to lead to a collapse in exports (no Iranian, from the car driver paying $0.35 per gallon of petrol to Grand Ayatollah Ali Khamenei, has anything to gain from the country being cut off from its only real source of income) and few traders thought it would. So why did the price rise? Simply because the crisis served to remind the market that oil is already in tight supply and that it doesn't take much to push the price up sharply. What Iran has done to the oil price this week, the Nigerian elections, and the inevitable allegations of vote rigging that come with it, will probably do next week, and Venezuelan President Hugo Chvez some time after.

Why demand for oil will continue to rise

Demand for oil is currently rising and expected to continue to do so at around 1.4 million barrels of oil a day. But as ever, the supply really isn't there to meet it. Instead, thanks to falls in production in Norway and Sweden and a cut in Opec output in February, Barclays Capital forecast that global oil production has actually dropped 2.9 million barrels a day since the start of the year. "Do the maths," Paul Horsnell, head of commodities research at Barclays Bank tells The Daily Telegraph. "A great gap has opened up, we're facing a very severe tightening in the oil market."

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According to the Centre for Global Energy Studies, US gasoline stocks are already 5% lower than they were a year ago, as lower-than-expected supply from non-Opec countries and falling temperatures have eaten into supplies. With the spring (driving season') fast approaching, that's a problem. The International Energy Association (IEA) is forecasting that world oil stocks will hit a ten-year low this quarter and subscribers to the peak oil theory (with which we have much sympathy) say that global production is set to peak in 2010, even as demand keeps rising.

The emerging markets of the world still use a fraction of the oil burnt here in the West. China is consuming 1.5 barrels of oil per person a year, while the Indians are using less than one barrel a year each. Those numbers are rising fast as the middle classes throw their new riches at car and air-conditioning salesmen, but the consumption boom in the developing world has only just begun. What happens when all the 1.3 billion people in China have one car and want two or when everyone in Calcutta has a fridge and an air-conditioner? Right now, each person in the UK gets through 10.4 barrels a year and every American gobbles 26 barrels a year. There's no reason to think that the Chinese aren't heading in the same direction, global warming or no global warming. The result? According to the IEA, the 85 million barrels a day the world gets through now will jump to 127.5 million barrels over the next 25 years. That's a 50% jump in demand.

If we want prices to stay low, we must start finding more oil in a hurry and produce more from the reserves we have.

Why oil firms aren't increasing exploration

Unfortunately, neither of these things look that likely. One-third of world oil production and reserves are now under the control of seven, overwhelmingly state-owned firms recently identified by the FT as Saudi Aramco, Petrobas of Brazil, Petronas of Malaysia, CNPC of China, NIOC of Iran, Venezuela's PDVSA and Russia's Gazprom. The problem with this is that the firms tend to be regarded as cash cows by their governments an easy means to either keep chummy with their citizens by maintaining low fuel prices, or, in Venezuela case, heavily to subsidise social programmes rather than as long-term commercial entities. They aren't seeking out new sources of oil effectively nor efficiently maximising production of the reserves they already have. Until the last few years, the private oil firms haven't been doing so either: when oil was under $30 a barrel it simply wasn't worth their while either exploring or fussing about efficient production.

The consequences of all this are now becoming all too evident. Faith Birol, chief economist at the IEA, tells the FT that the world is falling 20% short of making the $20,000bn investment it needs to ensure adequate energy supplies for the next 25 years.

Still, this is good news for investors: oil prices have to stay high and there is money to be made in the short and long term. The most obvious way to get exposure is to buy BP (LON:BP) and Shell (LON:RDSB): they are ludicrously cheap and heavily geared to price rises. But there are other nice ways in too. Below, we look at three of our favourites: the oil services sector, the Canadian oil sands and the unexpected opportunities opening up in the north of Iraq.

Investing in oil: services sector

Having done very little for the last few decades, commodities firms are now all desperately trying to bump up production. But they are facing a problem: the long bear market has left a dire shortage of equipment in its wake. The big miners can't get hold of trucks, tyres, or even the generators they need, while oil producers and explorers can't get their hands on new rigs however much they are prepared to pay. There are just five firms with the capability to drill in very deep waters with only ten rigs that can drill below 10,000 feet between them. Rental rates are the highest they have ever been one Norwegian driller recently secured an $525,000-a-day contract (that compares to a typical day rate of $125,000 in 2004) and the wait for really deep drilling rigs is three years. The silver lining, of course, is that the suppliers of rigs are making a fortune: not only are rates high, but with all the power on their side they can demand four-to-five year contracts and lock those rates in.

The firm with the brightest prospects among deep-sea drillers is probably Transocean (NYSE:RIG). Unlike many of its peers, it has focused on deep-water drilling, rather than shallow-water rigs. This means it's tended to enter into more long-term contracts, which were signed when day rates were lower. As these contracts end, Transocean will be able to resign at new higher rates. The day rate on one of its premium rigs is set to soar from $191,000 to $520,000 at the end of the year, for example. Analysts see Transocean earning $7.49 per share this year, up 75% on last year. The shares trade on a forward p/e of 11.3 times, which, given the growth, seems more than reasonable (although the shares have risen 7% since we last wrote about them on 9 March). The Aim-listed CQS Rig Finance, which finances rig construction, is another good way to play oil services. The firm aims to deliver an 8% dividend yield, plus annual capital growth of 3%-5%.

Otherwise, Tim Price of UPB suggests looking to two UK-listed firms: Wood Group (LON:WG), which specialises in oilfield services, and Weir Group (LON:WEIR), which provides pumps and compressors to the industry. Again, they don't look that cheap on p/es of 22.13 and 19.03 times respectively, but are growing their earnings fast enough to justify their premiums. Citigroup likes US-listed Schlumberger (NYSE:SLB), which "is present in nearly all major oil fields", offering every service under the sun. The shares trade on a reasonable forward p/e of 16 times and the group has put a target price of $82 on the shares (they're currently $66.90). Finally, you can buy into the sector as a whole with the New York-listed Oil Service HOLDRs Trust (OIH), which tracks a bundle of services stocks (including both Transocean and Schlumberger).

Investing in oil: exploring in Iraq

Exploring for oil in Iraq might seem to be a risky undertaking at the moment, but given that the Kurdish authorities in the north have now decided to open their doors to foreign investment, it's worth keeping an eye on the oil-exploration firms taking them up on their offer to get into this fast-growing region. This is the first opportunity for them to tap into Iraqi reserves (estimated to be 110 billion barrels, or about three times the oil and gas extracted from the North Sea to date). That means we could be about to see the beginning of an all-new energy rush, say Steve Hawkes and Carl Mortishead in The Times: Wood Mackenzie, the oil consultancy, estimates that the Kurdish region contains between 12 billion and 45 billion barrels of oil and 100 trillion cubic feet of gas.

So far, none of the big names in the business have turned up with their drills, but a number of small, independent oil firms are operating in the region. Norwegian minnow DNO (DNO) has already struck oil in the region and thinks it can pull out 14,000 barrels per day. But we might be a bit late to the party: the firm's shares have rocketed since the discovery and now trade on a p/e of 190.

Canada-listed Addax Petroleum (TSE:AXC) might be a better bet, currently trading on a p/e of 11.19: it claims to have discovered two billion barrels worth of oil in the region and is securing funding to pay for the infrastructure it needs to exploit the reserves. After raising $18m in several private placements, Calibre Energy (CBRE) is also exploring in the region, and could be set to take off if it enjoys the same success as it peers.

But the real question is how long will it be before the majors go in and hoover up the early moving minnows along the way? "The supermajors won't go in yet, they can't afford the headlines," Peter Newman of Deloitte & Touche tells Forbes. But Statoil has already expressed an interest in DNO and it could only be a matter of time before the rest get snapped up too.

Investing in oil: the black sands

One place where the majors are out in force already is Alberta, Canada.

The region is sitting on the biggest oil deposit outside the Arabian peninsula, with as much as 179 billion recoverable barrels already accessible and the potential for 100 billion more given the right technology. The deposits aren't easy to get to they come in the form of "tar sands", a shale from which extracting the oil itself is an energy-intensive process, requiring millions of litres of water and natural gas. This makes for a high cost of production currently ranging from $11 to $19 a barrel so the oil sands are only really considered viable when oil prices are above $50 a barrel. Good news for Canada then that they are and that the Canadian Association of Petroleum Producers predicts that last 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, making them one of the world's most valuable sources of new oil.

One company sitting on a huge reserve of tar sands in Alberta is Suncor Energy (NYSE:SU). The company has been developing the sands since 1967 and currently leads production with a capacity of 260,000 barrels per day (bpd), projected to increase to 550,000 bpd by 2012.

The firm's shares trade on a p/e of 14. Canadian Oil Sands Trust (TSE:COS.UN), an investment trust, also has excellent exposure. It owns 35.5% of the Syncrude Joint Venture, the largest holder of the region's mineable oil sands leases. The stock has risen 41% over the past year, despite a wobble when the Canadian government cut tax relief on dividends, but the shares trade on a p/e of only 15.8 times, which, if you think, as we do that for oil the only way is up, makes them worth buying.

BP and Shell: the best buys in the stockmarket

While most oil majors should be a decent buy, two in particular look staggeringly cheap. BP and Shell have seen their shares lag behind the rising oil price to such an extent that both are lower than they were five years ago, a time when oil was under $20 a barrel. By comparison, ExxonMobil, which had previously moved in lockstep with the two has doubled since then. The two now trade on forecast p/e ratios of 10.6 times and 9.6 times respectively, compared with an average of 17 times for the FTSE 100. And while some of the other oil majors trade on comparable multiples, few rivals can boast expected dividend yields of around 4%. What's more, there's every prospect of a healthy rise in those dividends the dividend payout ratio for both firms is pretty conservative at around 40% of earnings (although some spare cash has also been distributed as share buybacks).

So why are these stocks so beaten-down? Well, it won't have escaped many investors' notice that both have had some high-profile problems. In 2004, Shell admitted that its proven oil reserves had been overstated, while an accident at BP's Texas City refinery in 2005 killed 15 workers. A steady stream of other negative news, including problems with Shell's Sakhalin-2 project in Russia and a BP pipeline spill in Alaska, helped turn investor sentiment further against them.

But these problems should be largely in the past, while the management changes and corporate restructuring resulting from them will leave the firms in better shape for the future. There are still issues for both to resolve projected production growth is not spectacular and all the majors will struggle to replace reserves in years to come. But at these depressed valuations, the bad news is more than priced in. Both firms have such a large gap to close with their peers (especially Exxon) that investor sentiment should quickly turn in their favour once it becomes clear that expensive oil is here to stay. And while you wait for that to happen, you can pick up a dividend yield that's better than most savings accounts.

Kurdistan: "the other Iraq"

For most people in the West, Kurdistan is just another strife-ridden part of Iraq. However, the regional government recently launched an advertising campaign that made great play out of describing the north as "The other Iraq." And in a way, that's exactly what it is becoming the kind of place Iraq could be if it wasn't being ripped to bits by sectarian strife.

According to Kurdistan Development Corporation, property prices in urban and brownfield areas have risen three fold since 2003. Businesses have migrated north from Baghdad to cities such as Erbil, while oil companies like Norway's DSO have come in to operate the regions vast oil reserves. The reason? "Peace and security", says a representative. "It's the only place in Iraq where you can do business." Indeed, as one speaker told delegates at the council of foreign relations in Washington DC a year and a half ago, the greatest danger in Kurdistan is not being caught up in any kind of military chaos, but "being hit by a Turkish cement truck which is on its way to the building boom that's going on up there."

So how much oil is there in the north? "I think the potential reserves in northern Iraq are enormous," Leslie Blair of Addax Petroleum, a Geneva-based consortium that is drilling at the Taqtaq field with a Turkish partner, Genel Enerji, tells the BBC. Estimates put reserves at about 45 billion barrels of oil against 110 billion for the country as a whole. That means a region of five million people is effectively home to the world' sixth-largest oil reserves in the world and makes Kurdistan a great place to invest in exploration. And given the peace and the natural beauty on offer, it may not be a bad place to buy a house either.