Runaway Oil Bull

Jim Brown
 
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Energy stocks finally caught a bid over the last several weeks and quite a few are breaking out to new historic highs. This goes against the conventional wisdom since energy earnings are expected to decline in Q2. Energy is expected to post the worst earnings of any S&P sector.

The decline in earnings is directly related to the drop in oil prices compared to the same period in 2012. In Q1-2012 prices reached $110 and they stayed over $100 until the end of April before crashing back to $80 in June.

The average differential we are seeing in the Q2 guidance is a decline of about $5 to $9 per barrel in the average received prices in Q2. The difference depends on whether the company was producing oil in the U.S. at WTI prices or overseas at Brent prices.

For Q3 the energy earnings should be outstanding since prices are well over $105 compared to an average of about $90 in Q3-2012. Natural gas prices have also picked up to just under $4 per Mcf compared to about $2.90 in Q3-2012.

The sudden surge in energy equities may be more about the expected windfall in Q3 earnings than the weakness in Q2 expectations. You want to buy on weakness well ahead of the good news and late June would qualify with prices the lowest in two months.

With the Middle East putting a security premium into Brent and accelerating takeaway capacity from the U.S. shale fields allowing WTI to be sold for Brent prices the outlook is strong for energy companies.

However, as I have written several times before there is a lot of waterborne crude coming back online after a lengthy outage and this will depress Brent prices in the months to come. How much they will be depressed is unknown. I could see Brent back in the $100 range but with WTI and Brent in parity again that means WTI would also hold in the $100 range. Let's hope that is the entire decline we get. We have seen declined in WTI to the mid $80s twice in the last year. That would be painful to see again but definitely possible.

If Egypt was to suddenly grow calm, Libya to form a real government and Iran return to the negotiating table for real we could see a significantly lower price for crude. We have about as much chance of those three events occurring as pigs flying.

WTI Chart

Gulf of Mexico Alive Again

The number of deep-water rigs working in the Gulf of Mexico today is 36. That is expected to grow to 60 by the end of 2015 according to Brian Uhlmer, an analyst at Global Hunter Securities. That will require roughly $16 billion in additional rigs. Transocean (RIG), Noble (NE), Noble (NBL), Diamond Offshore (DO), Rowan (RDC) and SeaDrill (SDRL) all have new rigs on order.

There is a race to have the newest, most modern, most capable fleet. Newbuild rigs are now rated up to 12,000 feet of water and some up to 40,000 feet total depth. The big limiting factor there is the weight of the drill string. Hanging 8 miles of heavy steel pipe below your drillship is a definite strain on everything. Building components to operate at those depths is also a challenge with Cameron and Schlumberger teaming up to create the OneSubsea joint venture to manufacture and develop products for subsea drilling and production. They will be a driving force in the sector.

The driving force in the exploding activity in the Gulf is the lower tertiary find. This is the layer about 20,000 feet below the seafloor containing giant reserves of crude oil. The depths and pressures are causing serious headaches for the production companies but they are throwing enough money at the problem to solve it.

Currently the GOM is producing about 1.26 mbpd. That will rise to 1.55 mbpd by the end of 2014 and then 1.7 mbpd by the end of 2015. Production peaked at 1.7 mbpd before the Deepwater Horizon disaster. The five month moratorium and subsequent permitorium saw production decline by 500,000 bpd. These wells produce fast and decline fast. If you are not punching new holes on a regular basis the decline rate is dramatic.

In addition to the new rigs being built the rigs that left the GOM after the Deepwater Horizon disaster are beginning to return after their international lease terms expire. The GOM offers a more stable operating environment even after the sharp increase in regulations after the disaster. Drilling overseas carries additional risks in addition to the longer supply lines.

Previously exploration companies were limited to drilling "above the salt" because they could not see what was below the salt layer and the shifting salt was a problem for drillers. With the much improved seismic capabilities we have today we can see below the salt. Recent technology improvements also allow companies to drill through the salt with much fewer problems. The large number of wells drilled in the last five years offshore Brazil into the subsalt layer have helped to add to the understanding of the process.

There were 52 ultra-deepwater discoveries in 2012 in depth over 7,500 feet was a record for the industry according to Noble Corp. IHS Petrodata said the newbuild pipeline for rigs is the fattest since the advent of deepwater drilling in the 1970s. New rigs delivered between 2013-2019 will be more than double the 39 delivered between 2003-2009.

There has been a flurry of new discoveries in the GOM over the last four years. The pace of discovery will continue but we are now looking at strong development phase with tens of billions being spent on new production platforms.

Chevron is spending $7.5 billion to build the Jack/St. Malo semi-submersible production platform. It will be anchored 280 miles south of New Orleans and will produce 170,000 bpd at its peak and 40 million CF of gas per day.

Chevron is also building the Big Foot production platform for $4.1 billion to produce 75,000 bpd and 25 million CF of gas in 5,000 feet of water.

Shell's new Olympus platform is being installed this summer at the Mars field to produce 100,000 bpd at its peak. It took two years and 575,000 man-hours to build. The massive 11 million pound hull was built overseas and transported 18,000 miles from South Korea to the GOM where the topside was built and installed. The Olympus is 406 feet tall to give you a scale of reference. The new platform will extend the life of the Mars field until at least 2050. The Mars A platform was built in 1996 and has produced 700 million barrels.

Shell's Olympus Platform

Hess is building the Tubular Bells spar for $2.5 billion to produce 45,000 bpd in partnership with Chevron (43%).

Anadarko is building the Lucius production platform to anchor in 7,100 feet of water and produce 80,000 bpd and 450 million CF of gas.

These are massive projects that cost billions to build and develop but will produce tens of billions in revenue for years to come. Each of these platforms will service from 6-24 wells and each well costs from $50 to $150 million.

Additional platforms will have to be built for the BP Mad Dog with up to 4 billion barrels, Chevron's Moccasin with 200 million barrels, Shell's Appomattox with 500 million barrels, Anadarko's Heidelberg with 400 million barrels and Shenandoah with 1 billion barrels, etc. Mad Dog is so big BP has already put one platform in place and is building a second.

The sheer size of the recent discoveries has every deepwater explorer in the world looking towards the GOM as their next project.

The real winners here are going to be the drillers and the supply companies. Outfitting these rigs and keeping them in spare parts and drill pipe is going to be a huge task.

If the administration and lawmakers ever open up the rest of the east and west coasts for drilling the rush for equipment will be even bigger. It will take a long period of leasing and seismic capture before that begins but it will eventually happen. I just don't see everyone in the U.S. switching to battery powered cars in the next decade. Oil as a transportation fuel will be with us for decades to come. You can't fly an airplane on batteries or natural gas.

We are approaching the middle of the summer and still no hurricanes. The weather map is still devoid of any potential storms for at least the next week.

Market

The markets set new highs last week but the Dow and Nasdaq faltered on Friday as a result of the big earnings misses by Microsoft and Google. Overall S&P earnings are showing about 3.7% growth on a -1% decline in revenue. This is pretty dismal but expectations were very low so the market is seeing the results as better than expected.

Next week is the busiest week of the cycle for earnings and by next Friday we will know without a doubt how the cycle will end. This is typically when the late summer market fade begins. Historically August and September are the two worst months of the year for the market. It will be interesting to see if the trends hold true in the face of QE and a slowing global economy. The U.S. remains the best house on a bad block so money is still flowing into equities. A record $80 billion flowed into equities last week. That is not a sign that investors are planning on taking a vacation in August. Time will tell.

Subscribers to the energy portfolio should prepare to take profits over the next couple weeks. We are going to exit several profitable positions ahead of the August weakness.

Crude prices typically decline in August-September and then rebound in the fall as winter heating oil demand increases. Investors should wait for the normal end of summer weakness to add long positions.

Jim Brown

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