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Posted October 2004
Finding Value After the Cheap Oil Era
By John Mahedy, Director of Bernstein Value Equity Research
RISING OIL PRICES HAVE MADE STOCK MARKETS VOLATILE
AND INVESTORS NERVOUS, even while driving record
profits for oil companies. By early fall of 2004, the
price of oil passed the record-high price of $50
per barrel. The current spike in oil prices is largely
due to short-term risk factors, some of which will
eventually subside. But our research indicates that
more far-reaching changes in supply and demand
have converged to raise the long-term price of oil as
much as 50% higher than its low 20s price through
most of the 1990s. As with many market dislocations, this one too has created opportunity.
But these factors won’t remain dominant over the longrun. OPEC is ramping up its production, which should increase capacity and boost worldwide oil supply. Problems at
Japanese nuclear reactors, which contributed to increased
oil demand, will be resolved in 2005. China’s extremely
rapid growth forced it to use oil to power diesel generators
to run its plants, and transportation problems made it difficult to even get the oil to the plants. We expect each of
these factors to become less prominent, and above-trend
oil demand growth should moderate.
As supply and demand come back into balance, oil prices
will be able to settle at a more sustainable long-term level.
But we now expect that long-term price level to be even
higher than we originally thought. Let’s examine why we
think so.
Short-Term Disruptions Have Driven Recent Price Surge
Oil prices recently soared past the $50 per barrel price,
triggering a severe case of nerves for investors and consumers alike. But we clearly don’t expect oil prices to remain
that high forever, so it’s important to distinguish clearly
between the factors that influence short-term and longterm oil price levels.
The recent price surge does not appear warranted, given
the volume of available worldwide oil inventories (Display
1). But a number of other factors have conspired to drive
oil prices higher than inventory levels would suggest. First,
global oil producers are operating at very high capacity, so
the perception is that little room exists to further boost
oil production. Concerns over geopolitical instability in
oil-producing nations such as Iraq, Russia, Venezuela and
Nigeria have also been prominent. A particularly nasty
hurricane season has displaced substantial oil production
in the Gulf of Mexico and prevented oil imports from
reaching U.S. ports. And fi nally, Asian oil demand has
been particularly strong.
Display 1
Oil Prices Far Higher than Justified by Inventories
Global Commercial Petroleum Inventories and Oil Price*
Days of
Inventories
$ per
Barrel*
52
54
Worldwide Inventories
56
58
60
62
64
Oil Price
66
68
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
55
50
45
40
35
30
25
20
15
10
5
*Average monthly oil price through October 2004; inventories with estimates through December 2004.
Inventories are plotted on a reverse scale.
Source: Bloomberg L.P., Deutsche Bank, International Energy Agency (IEA), OPEC and Bernstein analysis
October 2004
Long-Term Drivers Suggest Higher Prices
to the levels of the 1990s. As distinct from the short-term
factors that we mentioned earlier, we expect these changes
to be far-reaching and pronounced. What does this mean
for oil prices? We have raised our expectations for long-run
oil prices per barrel to the high 20s/low 30s range. This is
the clearing price that is high enough to justify additional
capital investment in new capacity, as producers seek a fair
return on new, and costlier, barrels of oil.
While the short-term risk premium will eventually decline,
consumers shouldn’t expect oil prices to return to the levels
of the 1990s any time soon. Although we’re not in store
for an energy crisis of 1970s vintage, it’s likely that fundamental changes in both consumption and production have
brought an end to the era of cheap oil.
One source of upward pressure on oil prices is a pronounced
reversal of the 80s and 90s trend toward improvements in
energy efficiency. Think of it as the legacy of more than a decade of cheap oil, which derailed our long-term drive toward
fuel efficiency. Gas-guzzling sport utility vehicles dominate
the North American landscape and the replacement of older,
less energy-efficient consumer appliances has flagged. As a
result, efficiency improvements provide less of a buffer for oil
demand as economic growth increases. We also believe that
as developing economies have become more significant drivers of global growth, oil demand has become more sensitive
to increases in economic growth (Display 2).
Supply from Former Soviet Union Abates
The strain on capacity and rising oil costs have been masked
for the last few years in large part due to the enormous
strides in oil production made in the former Soviet Union.
As well-fi nanced western companies were allowed to enter
the newly opened markets of the former Soviet republics in
the mid-1990s, investment capital and better technology
was applied to oil fields in countries such as Russia and
Kazakhstan. As a result, their productivity soared. But our
research suggests that oil companies weren’t fi nding new
oil, just fi xing old problems. The stunning improvements
in Russian oil production stemmed from exploiting existing oil fields with better technology rather than discovering
new fields (Display 4). As the benefit from applying new
technology wanes (a scenario that has unfolded in maturing oil fields across the globe) the productivity of Russian
oil fields is likely to decline sharply.
The cost of fi nding and developing oil is also rising. After
benefiting from a number of technological innovations in
the 1990s, the world’s existing oil supply has become less
productive. Quite simply, it is getting more difficult to fi nd
new oil sources. Even as it gets more difficult to locate
new oil fields, the cost of fi nding and developing oil, and
of transporting and distributing it, has risen steadily and
will continue to do so (Display 3). This will push prices up,
as oil producers strive to earn a reasonable return on their
investments amid falling margins.
Finally, fundamental changes in the relationship between
oil supply and demand, which we’ll discuss in the following
sections, will also work to keep oil prices from returning
Outside of the former Soviet Union and OPEC countries,
production growth has slowed to a crawl (Display 5), as
many oil companies have been reluctant to undertake new
capital investment. Having been turned upside down in the
1990s, when chronically low oil prices forced them to cut
production and restructure operations in order to survive,
large global oil producers are slowly beginning to recog-
Display 2
Display 3
Sensitivity of Oil Demand to Economic Growth Is Rising
Cost of Finding and Developing Oil Has Risen
GDP
Coefficient (x)*
2.00
Responsiveness of Oil Demand Growth
to Global Economic Growth
$ per Barrel of Oil or Oil Equivalent
($)
7
6
1.75
Responsiveness of oil
demand to economic growth
rises after steady decline
1.50
5
4
1.25
3
1.00
2
0.75
1
0.50
1973-87
1976-90
1979-93
1982-96
1985-99
0
1988-02
1994
1995
1996
1997
1998
1999
2000
Includes 18 integrated and exploration & production oil companies
Source: Company reports and Bernstein analysis
* The GDP Coefficient quantifies the magnifying effect of gross domestic product (GDP) growth on oil
demand growth. A coefficient of 2.0 would indicate that oil demand growth would be two times that
of GDP growth. GDP is measured globally, and excludes the former Soviet Union.
Source: World Bank, Bernstein
2
2001
2002
2003
Finding Value After the Cheap Oil Era
nize the dawn of a new era. They are slowly beginning to
deploy capital in search of new oil, but these investments
will take time to bear fruit. As rapid economic growth increases the demand for oil, the call on OPEC production
will be particularly strong. OPEC will have to produce as
many as an additional 5 or even 6 million barrels per day,
based on our estimates, in order to meet this demand.
Display 4
25
10
Saudi Arabia is being counted on to provide much of this
additional supply, but its ability to do so is the subject of
some controversy. In the late summer of 2004, the Saudis
were being forced to produce oil at a rate that was already
beyond their existing maximum sustainable capacity. Having pared back capacity when oil prices were historically
low, they are now working feverishly to increase it again.
New capital investments from Saudi Arabia and other
countries, such as Nigeria, will expand capacity, but will
take time to come online. If Iraq is able to produce at capacity—about two million barrels per day—their contribution will improve the short-term supply picture.
20
8
15
6
Russian Output Growth Not Based on New Discoveries
Reserve Discoveries vs. Production
Discoveries
(Bil. bbl)
Production
(Mil. bbl/day)
Production
30
Few oil
discoveries
since the
1980s
Discoveries
10
5
0
1932
1944
1956
1968
1980
12
1992
4
2
2004E
0
Source: IHS Energy, International Energy Agency and Bernstein
Display 5
Disappointing Production Growth Outside of OPEC,
Former Soviet Union
% Growth in Oil Production
Asian Countries Lead a Surge in Global Oil Demand
(%)
8
7
6
5
4
3
2
1
0
(1)
(2)
The driving force behind the clamor for additional oil is rapid
global economic growth and industrial development in Asia,
particularly China and India. Both countries are building oilintensive industries and, with a growing middle class, enjoying rising automobile ownership. The result has been a much
greater demand for oil: Chinese demand for oil rose 19% in
the first quarter of 2004 alone, and it’s likely to make up over
one quarter of this year’s global oil demand growth.
Many Chinese factories have imported oil-guzzling diesel
generators in an effort to cope with an ineffective national
electrical grid, intensifying the need for oil. And while there
is some effort to slow the rate of economic growth, it is not
sufficient to slow the increasing demand for energy sources.
India remains one of the world’s fastest-growing economies,
with an expected growth rate between 6 and 7 percent in
2004. Economic growth in China, India and the rest of
Asia has become a key factor driving oil demand in the long
run. These countries accounted for half of the additional
oil demand of 6.2 million barrels per day over the last five
years (Display 6). If these economies continue to grow rapidly over the next five years—as we expect—the world will
need an estimated 8 to 9 million additional barrels of oil
per day within five years, and Asian demand would account
for more than five million barrels of that total.
1968
1972
1976
1980
1984
1988
1992
1996
2000
2004
Source: BP Statistical Review, International Energy Agency and Bernstein
Display 6
Growth in Oil Demand Accelerating Due to Asia
Million Barrels per Day
8.6 million additional
barrels demanded
6.2 million additional
barrels demanded
New Asian
All Other Demand
Demand +3.1
82.2
+3.1
90
80
+5.3
90.8
+3.3
76.0
70
The Long-Term Outlook for Oil Prices
60
Fears created by uncertainty and political factors will eventually abate, and prolonged higher prices will ultimately
trigger corrective market mechanisms and behavioral
1999
2004E
Source: BP Statistical Review, International Energy Agency and Bernstein
3
2009E
October 2004
changes. This will drive oil producers to increase their capacity while encouraging oil consumers to consume more
efficiently. Although these periods are painful, they will
push oil prices back down in the long run. However, we
don’t foresee oil prices returning to anywhere near the low
$20 range that prevailed through most of the 1990s.
So what drives the equilibrium, or “normal” price, in the
long run? Oil prices seek equilibrium at a level that provides
the marginal oil producer with a fair return on investment.
If the price of oil remains too high, excess capital investment will take place and excess capacity will be created; if
it falls too low, there’s no fi nancial incentive for producers
to create new capacity.
As part of our research effort, we analyze the production
costs of a group of marginal oil producers, which we represented with a sample of 18 integrated and exploration
& production oil companies. The normal, or long-run,
price is the level at which the marginal producers have a
reasonable economic incentive — an acceptable return on
investment — to produce more oil. We estimate that as
these producers generate new, and costlier, barrels of oil,
the long-run normal per barrel price of oil will eventually
settle in the high 20s or even the low 30s.
with earnings that were highly sensitive to the price of oil.
We focused on producers who possessed long-lived oil reserves—a ready stock of cheaply produced oil that could be
sold at higher prices, even as the cost of producing new oil
continued to rise. These producers are more likely to benefit from a sustained period of higher oil prices, and are also
less likely to pursue costlier new oil in attempts to replenish
their reserves. Even today, we seek companies whose costs
of fi nding and developing oil have risen at below-average
rates during the last five years, since they would be better
insulated from the expected increases in exploration and
development costs. And, of course, we favor companies
with strong cash flows and significant earnings potential.
The state of the oil market provides a good example of the
type of market dislocation—in this case, among oil producers—that represents opportunity for some companies even
while leading to difficulties for others. The story hasn’t
fully played out yet. Our research analysts continue to follow the story — assessing the short and long-term factors
affecting energy prices, but always looking past the current
environment to determine the true winners and losers.
Identifying the Beneficiaries
Our value research specialists have worked diligently for
years to understand the forces behind these historic changes and to identify the companies that are best positioned to
capitalize on them. We actually began laying the foundation
for this investment some time ago, when it wasn’t exactly in
the mainstream to suggest long-term, structural changes in
the costs of fi nding oil that would lead to higher prices.
By last winter it became clear to us that oil prices were poised
to increase even more than we had originally thought, and
we increased our energy exposure. We did so again in mid2004. We emphasized high-quality integrated oil producers
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