Profit from the scramble for alternative oil sources

Amid the turmoil in the Middle East, only one thing has been able to keep any sort of lid on the oil price: the promise that Saudi Arabia can step in to fill any gap in production left by a revolution in Libya, or elsewhere. Saudi is seen as the 'central banker' of oil, as Fatih Birol of the International Energy Agency (IEA) puts it. Of course, investors are frightened of what could happen if Saudi Arabia faces similar turmoil (which isn't out of the question, see below).

But there's a more worrying possibility. What if Saudi Arabia simply doesn't have the capacity to produce as much oil as it says it does? "It is possible that Saudi reserves are not as bountiful as sometimes described," reads a secret report from the US embassy in Saudi Arabia, published by whistleblowing website WikiLeaks. The embassy spent 2008 and 2009 investigating claims that the country with the world's largest oil reserves would struggle to meet future demand. It notes that "the timeline for their production [is] not as unrestrained as Aramco [the state oil firm] and energy optimists would like to portray... Saudi Aramco is having to run harder to stay in place, to replace the decline in existing production."

No US government official has ever said this in public. Saudi Arabia itself is bullish about its reserves and production capacity and claims to have met the shortfall from the recent unrest in Libya. But if it's true that the country, home to most of the world's cheap oil, is unable to raise production, it would pose a huge challenge to the global economy. For many it would be proof that we have entered 'peak oil' the moment that oil production reaches its highest point before falling back.

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Whether or not this is the case, there's no doubt oil is becoming more costly to produce. Indeed, you could argue that even if we haven't hit peak oil, we've certainly seen the end of the era of cheap oil. One reason is that the 'easy-to-find', conventional, onshore fields were the first to be exploited. With most of them already tapped out, oil companies are now being forced to develop fields in more challenging and expensive locations. What's more, most of the new oil being found is lower quality, heavy, sour crude. 'Heavy' means it is thicker, while 'sour' means it contains more impurities. As a result it needs more intensive refining and yields less petrol than lighter crude.

Oil is here to stay Given that it's increasingly expensive, and located in geopolitically volatile regions, why do we still allow ourselves to be hostages to oil? Simple changing our habits would be hugely costly. Oil is "concentrated energy, easily transported and hugely versatile" it's easy to see why we are addicted to it, says Andrew Simms in The Guardian.

In 2010 oil accounted for almost 35% of global energy use. Most of that was to fuel transport. Higher prices will encourage people to seek alternatives, but the uncomfortable truth is that this will not happen overnight. Indeed, it's unlikely to happen in a generation.

The modern order "was built on coal and oil. Indeed, it's still running on coal and oil. And the intractability of this infrastructure is why energy transition is so hard," says energy analyst Gregor Macdonald. In other words, our society is designed to run on oil it's been built with that in mind.

Even if cheap new sources of energy were available, the infrastructure shift required would take a great deal of time and money. Renewable energy and biofuels are often touted as solutions, yet their impact, especially in the short term, is likely to be limited. One reason is cost. Powering an electric car from wind or solar power is far more expensive than a conventional petrol engine and will remain so for the foreseeable future.

The other reason is that, despite the column inches, penetration of renewable energy is remarkably low. It only accounts for 8% of the US's total energy consumption and is rising very slowly. As Macdonald puts it: "Switch the powergrid to 100% renewable resources like wind and solar in ten years? Not likely. But maybe if you are willing to withdraw the entirety of US armed services from overseas, devote the entire military budget for ten years, and match that workforce with highly skilled workers from the private sector, then maybe you can make a dent by 2020."

As for electric vehicles (EVs), "at realistic adoption rates you might be running mostly on EVs in 150-200 years". And where biofuels are concerned, with record agricultural prices and food riots erupting in several parts of the world, environmentalists and economists alike have questioned the logic of using food for fuel. Not only are these resources difficult to develop, they also struggle to compete with oil. As Macdonald notes, "oil is the most energy-dense energy source, with its 5.8 million BTU [British thermal units] hyper-packed into each liquid barrel, no economy would choose freely to get off oil."

So what does this mean? Well, if we want to break our reliance on oil from the Middle East, we'll have to find it elsewhere. The good news is that at current prices, and with new technology, it's possible to do so. Indeed, Fatih Birol of the IEA recently predicted that growing amounts of oil would come from unconventional sources as the world struggled to meet increasing demand.

The Canadian tar sands

Unconventional oil comes in many forms. Among the best known are Canada's tar sands a mix of bitumen, water, sand and clay found in an area the size of England and Wales, in Northern Alberta. Canada's 170 billion barrels of tar sands reserves puts it in second place behind Saudi Arabia in the oil giant stakes. However, at present, just 1.5 million barrels a day are being extracted, although that is expected to rise to more than three million by 2020. Tar sands have been under-exploited largely because obtaining oil from them is dirty and expensive.

There are two ways to do it. Easy-to-access bitumen deposits are mined then 'cooked' in an 'upgrader', a facility similar to a refinery, to extract oil. Harder-to-access reserves are tapped in situ by heating the bitumen so it can be pumped out. The process is water and energy intensive up to five barrels of water is required to produce one barrel of oil and generates more carbon dioxide than conventional oil. The open-cast mines also cause considerable environmental damage, while water used in the process is contaminated.

But like it or not, "the importance of the oil sands in meeting the world's energy needs is going to more than offset the ongoing opposition from environmental groups", says Deborah Yedlin in the Calgary Herald. "The environmental organisations may well want to protest in Washington, DC", but "those barrels are important in meeting the world's incremental demand especially in the absence of other viable substitutes".Production costs vary. Complex processing facilities need high capital expenditure and many projects have total costs above $40 a barrel compared with $5 a barrel in Saudi Arabia. But with prices where they are now, the oil-sands "look especially attractive", says Andrew Bary in Barron's. An added bonus is that they're "in a politically safe nation and offer reserve lives of 50 to 100 years" at a time when most conventional reservoirs are facing declines.

So how can investors profit? Many oil sand stocks trade on higher p/e multiples than their conventional counterparts. Yet "they're probably worth that premium, thanks to their hefty reserves", says Bary. Also, "many oil-sands producers aim significantly to raise their output by 2020 That's a big plus at a time when the energy majors are struggling to boost production."

Imperial Oil (TSX: IMO) generates about 75% of its production from oil sands. It's not cheap on a forward p/e of 16, but earnings should rise when its $8bn oil sands project comes online next year, and low levels of debt make it attractive. Another sizeable 'pure play' is Canadian Oil Sands (TSX: COS). It owns 36.7% of Syncrude, a tar sands facility it shares with Imperial Oil (25%), Suncor (12%) and Sinopec (9%). It trades on a forward p/e of 14 and recently won the tender to develop a $5bn 'upgrader'.

Sifting oil shale

Another unconventional oil benefiting from high prices is oil shale. It is found in oil-bearing rocks. Deposits in Estonia, the US, China and Brazil have been exploited during the last century. But a new breakthrough technology means shale oil is now far cheaper to produce. Producers learned from the shale gas boom that has swept America in the last decade and improved the method of extracting the oil from shale. Instead of mining the rock, firms now drill vertical and horizontal holes that are pumped with a mixture of water, sand and chemicals to 'fracture' the rock and release the oil.

This has dramatically reduced the production cost of oil shale. It used to cost around $90 a barrel. Now the most economic deposits can be exploited for as little as $10, although most oil shale costs upwards of $30 to develop. Oil shale is growing most quickly in the US, whose 1.5 trillion barrels of reserves make up about two-thirds of the world's total. Production at Bakken, America's leading oil shale field, has risen 50% in the last 12 months to 500,000 barrels per day. Shale gas experts, such as Chesapeake Energy, are now busy buying up drilling rights in other oil shale provinces.

Like tar sands, the oil shale industry is environmentally controversial. Critics claim that 'fracking' contaminates underground aquifers that provide drinking water and America's Environmental Protection Agency (EPA) is currently investigating its effects. But given that oil shale has the potential to reduce America's dependence on foreign energy and correct its trade balance, the EPA would need damning and conclusive evidence to introduce a ban.

The first firm to use horizontal drilling and fracking to exploit oil shale commercially was EOG Resources (NYSE: EOG). Led by CEO Mark Papa, it has a good track record and expects to boost production in coming months. The stock has been carried up by the hype and now looks expensive on a forward p/e of 18.

A cheaper way in is through service companies that specialise in fracking for oil shale like Canadian outfit Calfrac Well Services (TSX: CFW). Sales for the fourth quarter hit C$268m, up 54% year-on-year in the last quarter, while profits increased more than 20-fold.

On a forward p/e of 11.3, it is not the cheapest fracking company, but it has more of an oil shale focus than many of its peers who work in the shale gas sector. It has agreements with two major players in the Bakken oil shale field and "oil well completions represented the most significant growth area for Calfrac during the second half of 2010". The firm also has a good geographical spread, with business in Mexico and Western Siberia.

How to hedge against the oil price

Unconventional oil sources are a sensible alternative to depending on the Middle East for our energy. But they aren't going to be produced in sufficient quantities to bring oil prices down immediately. And make no mistake, high oil prices are a major threat to the global economy right now.

You'll read all sorts of analysts quoting rules of thumb, that such-and-such a rise in the oil price leads to such-and-such a fall in GDP. Ignore them they're not especially helpful. The fact is that ten of the last 11 American recessions were preceded by an oil-price spike. Whether that happens again now or not depends on whether oil prices stay high enough for long enough to hurt the global economy or not. For now, that's down to what happens in the Middle East. There's no way of knowing how the situation will pan out. However, as David Fuller notes on Fullermoney, there are three basic scenarios.

The best-case scenario is that Gaddafi leaves or is ejected from Libya quickly, there's a reasonably smooth transition to a new government, and no more dominoes topple. Oil prices would likely ease off and the immediate threat would dissipate.

The worst-case scenario is that more dominoes topple, civil war takes hold in Libya and Algeria, there are uprisings in Iran and Saudi Arabia, and oil spikes. A recent analysis from Nomura suggested prices of more than $220 a barrel would easily be possible in this sort of situation.

Perhaps most likely, there's the middle road the region doesn't descend into chaos, but the disruption rumbles on, the oil price stays high, and makes life very uncomfortable for the rest of us.

So what can you do? The energy sector is certainly worth a look as well as the stocks above, we've regularly covered sources such as natural gas and alternative energy in recent issues of MoneyWeek, and we'll be looking at others in the near future. Outside the energy sector, it seems like a sensible idea to avoid companies that are directly affected by high oil prices travel companies and airlines, for example. We're already seeing fuel surcharges being introduced, which at a time when consumers are feeling the pinch, won't be good for business.

As for companies that can get by under these conditions, we'd be sticking with the big blue-chip stocks we've been recommending for a while now. A high oil price squeezes consumer spending, but it also pushes up inflation, so it's hard for central banks to try to combat with lower interest rates (even if they were in any position to cut rates).

So overall, the picture for stocks is grim there will be pressure on profit margins and falling demand for most products. You really want to be investing in companies that sell goods that consumers need to buy (such as pharmaceuticals or food or utilities), or will trade down to, as these are in a better position to protect their profit margins. And if there's a severe spike, even these stocks will come under pressure as the market as a whole falls back.

And of course, there's gold. It's the ultimate insurance for situations like this. As GMP Securities points out, in the first oil crisis in 1973, the price of gold doubled in less than four months from $85 an ounce to $180. After the crisis was over, it stabilised in a much higher range around $130-$150.

In the 1979 crisis, after oil spiked to $850 an ounce, it again settled into a higher range than it had been in previously. So we'd expect any surge in gold during this crisis (it's already hit a fresh all-time high) to have a lasting impact on the medium-term value as well.