Big Oil Needs More Oil

Jim Brown
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The oil majors proved once again that spending tens of billions on exploration every year does not guarantee increased production. Exxon and Chevron both reported production declines even though each will spend over $25 billion on exploration this year. Conoco reported a small gain in production due solely to a +47% increase in North American shale production.

Chevron (CVX) reported earnings of $2.77 that missed estimates by 20 cents. CEO John Watson said the -25% decline in earnings was related to lower prices for oil and a heavy schedule of repair and maintenance work on U.S. refineries.

Global production declined -1.6% to 2.58 mbpd. The company said expanded projects in the U.S. and Angola could not overcome the decline from older fields. Chevron will not have any trouble increasing production when it's multiple natural gas projects come online over the next five years. They have multiple LNG products costing well more than $60 billion and they will have ten LNG trains operating by the end of the decade at roughly 250 Bcf per year each.

Exxon (XOM) said production fell -1.9% in Q2 for the ninth consecutive quarter of production declines. They simply cannot bring new fields on fast enough to offset the decline from older fields. Production averaged 4.074 mboepd in Q2. Liquids production declined -1.2% to 2.182 mbpd.

Exxon posted the biggest quarterly earnings miss since 1999. Net income fell -57% in Q2 but they still earned $6.86 billion, down from $15.9 billion in the year ago quarter. That quarter did have some special items from asset sales. Net income fell -19%. Revenue declined from $127.36 billion to $106.47 billion.

Exxon said part of the problem was the sluggish U.S. economy, the slowing economy in China and the two-year recession in Europe. This lowered the price they received for their overseas oil by $10 a barrel.

Shell (RDS.A) said it increased production +3.3% to 3.41 mboepd but has cancelled plans to raise production to 4.0 mbpd by 2018. The company said it was working on 30 major projects around the world and would spend $33 billion on capex in 2013. However, they face the same problems as Exxon and Chevron with older fields declining faster than they can develop new ones.

Conoco (COP) reported a minimal +20,000 bpd increase in production to 1.51 mbpd. This was due solely to a +47% increase in North American shale production. Conoco has the same problems with declining production in existing fields. They did guide higher by another +20,000 bpd for the full year. Conoco sold off a lot of its older fields over the last five years in an effort to restructure and refocus on North America. They returned $20 billion to shareholders in stock buybacks and dividends. They are now the smallest of the U.S. majors but totally focused on exploration and development.

Active gas rigs expanded sharply last week gaining +19 to 388. The 18-year low of 349 was set on June 14th. The peak was 936 in 2011. Higher than normal gas prices have stimulated production as well as completion of some pipeline infrastructure and the addition of several major gas processing plants.

Oil rigs dropped -13 to 1388. Active rigs were rose by +6 to 1,782. The total rig count for the same period in 2012 was 1,924.

Other than the earnings from the majors and several service companies the energy sector was relatively quiet last week.

The crisis in Egypt looked like it was going to peak in a bloodbath this weekend as the army moved to remove the Morsi protestors from their month long camp. The crisis was averted at the last minute with a plan to try mediation before force. The army relented but said time was limited and negotiations must proceed quickly. Top Morsi supporters were indicted and will stand trial in three weeks for inciting to murder during the initial protests after Morsi was deposed.

The U.S. closed 21 embassies and consulates in the Middle East and Northern Africa after a "very credible threat" was discovered in NSA intercepts. Reportedly Al-Qaeda operatives broke mission security and spoke in the clear about the "major attack" planned for this week. The U.S. said on Sunday that 19 embassies will remain closed the entire week. Facilities in Algiers, Kabul and Baghdad would reopen on Monday. Several other countries have closed embassies in Yemen, which appeared to have been the center of the attack conversations. Britain is "strongly urging" all nationals to leave Yemen at once saying there is a "very high threat of kidnap from terrorists."

The security alerts plus some positive economics in the U.S. pushed crude prices to a three week high near $109 on Friday but the bounce was short lived. With the end of the summer driving season ahead and U.S. production rising we should see WTI decline back into the $90s over the next couple of months.

WTI Crude Chart

Longer term crude prices will continue to rise. Demand in China is continuing to rise as well as in the Middle East and the rest of Asia. As China converts from an export economy to a consumer economy the demand for oil will accelerate.

Typically oil demand grows by about the same percentage as GDP. With China targeting 7.5% as the lower level of GDP for this decade that suggests 7.5% annual increase in demand. Over the past five years China's average oil demand rose by 6.3% per year. Over the same period GDP has been declining and that limited demand growth. Once GDP begins to rebound the demand for oil will accelerate. Consumer generated growth increases the demand for refined products while industrial growth uses oil and chemicals.

Total vehicles, cars and trucks, rose by an average annual rate of 19% since 2002 with net sales rising an average of 24% per year. Last year China inhibited auto sales by raising taxes and limiting the number of cars available for sale in certain cities. Sales grew at an 11% pace in 2012.

As the Chinese population becomes more wealthy as a result of the urbanization and commercialization of businesses the demand for cars will grow. China is building 50,000 miles of roads and highways to accommodate future transportation needs and alleviate horrible congestion in some cities. As those roads are completed the demand for cars will grow.

China sold nearly 20 million cars and trucks in 2012. Very few of the older cars are ever scrapped. They are simply passed down the food chain to waiting buyers for cheaper old cars.

In late July Platts reported China's oil demand rose +11.7% to 9.99 mbpd. China only produces about 4.2 mbpd and all their major fields are very old as in 30-50 years. Over the first half of 2013 China's demand has risen +3.9% and growing. Historically their oil demand accelerates in Q3 and Q4.

If demand continues to increase at the roughly 7% annual rate that is an increase of +700,000 bpd per year. China's internal production is actually slowing as a result of the old fields so all that new oil will have to come from imports. Over the next five years that equates to about 5.0 mbpd in demand growth. By 2020 China's demand will be roughly 17.5 mbpd if their GDP growth remains at 7.5% or better and they don't curtail the availability of vehicles. Over that same period they are expected to sell nearly 181.5 million new vehicles. Some will be exported and some older vehicles will finally hit the scrap yard but in any event that will greatly increase the demand for oil.

You can't really speculate today on an oil price in 2020. Futures don't go out that far and the carrying cost would be prohibitive. Over that period we are bound to have another global recession and the increased demand for crude will probably send prices to $150 at least once or twice and that will create demand destruction and eliminate the poorer drivers from owning a car.

The U.S. dollar is sure to collapse over that period as the debt issues come home to roost. The dollar will first strengthen as the Fed eventually removes QE and interest rates climb. A higher dollar means lower oil prices. I would target 2016-2017 for the dollar's demise as the U.S. economy cycles downward again due to high interest rates and higher taxes.

Investing long term in higher oil prices is best done with good quality stocks that pay a dividend. The cost of owning futures and options is only worthwhile on a short term basis. Buy the dips and sell the tops.


The major market moving economic events passed calmly last week with hardly a ripple in the markets. Expectations and worries were high and neither were met leaving the indexes to close slightly positive for the week. The coming week is devoid of any material economic events. The Q2 earnings cycle is winding down with very few reports from blue chip companies. This is the prime week for the seasonal market decline to begin.

Nobody knows if this year will follow the seasonal patterns for an August decline but I would want to err on the side of caution rather than load up with long positions on the first dip.

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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