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Tuesday, May 20, 2008

Oil Goes Into The Deep

 
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Investor's Daily Edge
Tuesday, May 20, 2008
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Do Oil Companies Dare Seek
New Buried Treasure?

By Andrew Gordon

Who cares if oil is bullish or bubbly? Prices are going up, baby. Why ask why? 

But if you must know, global demand is outpacing supply – though not by much. Only a couple of million barrels a day prevents supply from keeping up with demand, but that’s enough to push the price of crude to record prices.

Ah, life must be good in the oil patch. Companies are making record or near-record profits. Don’t look now but the good times may be coming to an end for the miners of black gold.

We’ve already addressed in an earlier article the number one problem of oil companies: raising production. It’s a losing battle. The best fields are past their prime. Once they’re gone, they’re replaced with smaller fields with harder-to-get oil.
 
It’s like the Boomer generation looking for the fountain of youth. Boomers can slow down the decline here and there. But the fall from grace is inevitable. Oil producers face the same predicament. They can only see maximum rates of oil production in the rear view mirror.

So, what does the other side of oil production look like? It could be worse. So far, falling production plus soaring prices have brought oil companies huge profits.

The oil companies know they’re thriving on borrowed time. And they’re trying to do something about it. Ideally, they’d like to raise production. But at the very least they’d like to find a way to slow the fall of crude output.

To do so, they’re going after oil that a decade ago was beyond their reach. It lies thousands of feet underneath the oceans of the world.

This is new territory for the oil companies. It’s much too early for the oil companies to have a firm idea of what their costs will be. And while they’re pretty sure they have the technology to get to this oil, they’re still not sure how these technologies will work together.

Here’s a snippet of an earnings call by an offshore drilling contractor I caught last week on this very subject.

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Analyst
“... the issue associated with the debate out there of drill ships versus semis, is the 8500 series equipment capable of something like offshore Brazil, would there be modifications required? Is there deck load issues? Just expand on the pros and cons and how much more opportunity when people debate this drill ship versus semi?”

Jeff Saile - SVP Operations
“Why don't you ask a hard question, Pierre. Certainly we can work offshore Brazil. I don't know if -- I think there's, a lot of that's to be understood in the future. I certainly think the 8500 can get in there and compete. I don't think it's going to compete with a drill ship. It's going to come in behind these ships when they do some of this. Some of these ships are going to do advanced exploration ... the 8500 is certainly equipped to drill. It can drill in 10,000 feet of water. We're going to have to do minor modifications to it. We're reviewing that now. It can certainly drill in deeper water. And we can get out there with the equipment on them and drill these ultra deep wells, as well.”


The semi’s they refer to are semisubmersible rigs. They’re floating offshore drilling units with pontoons and columns. They can be anchored to the sea bottom with mooring chains or dynamically positioned by computer-controlled propellers or "thrusters."

It’s not just the desperate oil majors who are willing to wade into these tricky deep waters. State-controlled oil companies see these basins as their next big money maker.

Deep-sea drilling is the next frontier. And these semis will help make it happen.

They have plenty of drilling to do ... in the 30 billion barrel (from early estimates) Tupi basin off of Brazil ... to Chevron’s estimated 15 billion barrel discovery in the Gulf of Mexico ... to China’s recently discovered offshore field containing perhaps 2.2 billion barrels .. plus others.

These are major reservoirs. If the preliminarily estimated numbers hold up, Brazil’s Tupi would be the third largest underwater oil find ever.

But there’s a fly in the ointment in all of this … costs.

As I said, it’s too early to get a firm handle on costs. But I’ll tell you this much right now. It won’t be cheap.

And it’s getting more expensive all the time.

Petrobras (from Brazil) is hogging the word’s deepwater rigs and singlehandedly causing a shortage of these sought-after rigs. There are only 21 of them in the world. Petrobras is negotiating to lease 17 on top of what it already has to help explore its Tupi basin and nearby fields.

As a result, these rigs are going way up in price. BP leased one for $480,000 per day at the beginning of the year. Now, they’re going for as much as $600,000.

Shallow offshore drilling is also becoming much more expensive. For example, the company in the excerpt above said its jackup rates (jackup rigs operate in waters of 400 feet or less) in Asia went up 5 percent in the first quarter this year (compared to the fourth quarter of 2007).

Then, of course, it’s costing much more to produce oil from the declining fields in the Middle East, Russia, North Sea, and here in the U.S., where oil production has become relatively expensive.

There’s only one inescapable conclusion: the cost of oil production is at the beginning of a steep climb up. The high cost of deepwater drilling is a big part but not the whole story behind the high costs of future oil.

Profits of $20-$30 a barrel will soon be a thing of the past. Investing in oil companies will be tantamount to betting on falling production and smaller margins. Investing in the drilling contractors makes more sense. The squeeze on offshore rigs is shaping up as a great shortage play.

By the way, the name of the company whose earnings report is excerpted above is Ensco (ESV). They’re one of several very attractive offshore drilling contractors. Others include Noble (NE), Atwood (ATW), Pride (PDE) and Transocean (RIG).

Their future looks bright. I can’t say the same for the big oil companies. It’s been a while since the choice as to how to make money from oil has been this clear. And how not to.

Good Trading,

Andrew Gordon

P.S.  To let me know what you thought of today's article, send an e-mail to: feedback@investorsdailyedge.com.

[Ed. Note: With a bear market looming, it’s more important than ever to select safe investments that produce monthly dividend income. Click here to learn about Andy Gordon's INCOME service that selects the best dividend-paying stocks available.]

Market Watch

Death by a Thousand Pings. Just What the Market Doesn't Need.

By Andrew Gordon

Buy. Hold. Sell. That’s what we want to know from brokers. The small print often gets lost.  It is these three words that carry a lot of power with investors. They can make stocks soar or plunge or tread water. But let’s not get carried away. Their influence goes only so far. A huge number of stocks don’t do well even when brokers favor them.

I came across two data points last week. Merrill Lynch said that an average of 40 percent of the companies in the S&P 500 declined every year in the period from 1997 to 2007. And from an interview which appeared in Barron’s, the short-only fund, Seabreeze Partners, said that an average of 42 percent of companies on the New York Stock Exchange declined every year over the past two decades.

Against this 40-42 percent range of declining stocks, brokerages have “sell” ratings on only five percent of the stocks they cover. In the 90’s, it was worse. It was only two percent.

Such a huge disparity between what stocks actually do and the outlook of brokerages as reflected in their buy, sell, hold ratings can do nothing but harm the credibility of advice coming from the big brokerages. With this in mind, Merrill has issued new guidelines. From now on, at least 20 percent of the companies they cover must have a “sell” or “underperform” rating.

I’ve never been much of an admirer of Merrill’s stock recommendations. But this is an interesting development. It could inject some much-needed realism into the company’s rating system. And if other brokerages follow suit?

Then it would get real interesting. We’d see a dramatic increase of “sell” ratings. And a bearish market desperate for good news could be pinged into a noticeably worse performance by a long string of “sell” issuances.

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The Market Minute

Is this the last hurrah for global growth? ... The Baltic Dry Index of shipping costs hit a high on Friday – thanks to strong iron ore demand in China and increasing global demand for foodstuffs and other commodities. As a leading indicator (because all of these items are still to be consumed), it shows that the U.S. economic problems have not significantly hurt global growth. But if the U.S. recession deepens or European growth follows the path of U.S. economic growth, global growth could take a significant hit.
 

 
INCOME
 
In The Markets
 
Last
Change
YTD
Dow 13,028.16 none41.36 -1.78%
Nasdaq 2,516.09 none12.76 -5.13%
S&P 500 1,426.63 none1.28 -2.84%
Gold 905.00 none3.40 8.60%
Silver 16.98 none0.04 14.96%
Oil 127.36 none1.07 32.69%
Nat Gas 10.94 none0.22 46.26%
 
Newsworthy

Billionaire investor Carl Icahn on Thursday launched a bid to take control of Yahoo Inc.'s board of directors, which he called "irresponsible," in an effort to force the Internet pioneer back to the bargaining table with Microsoft Corp.

Some observers say Icahn's involvement could increase the likelihood of reaching a deal. But his decision to try to oust the entire board -- including Yahoo's popular co-founder and chief executive, Jerry Yang, is considered bold and risky. It could destabilize the company should it remain independent. And it's unclear whether he can win shareholders' support at Yahoo's July 3 annual meeting.

Icahn's intuition has served him well in previous contests, observers say. He has engaged in 17 proxy fights since 2000, according to research firm FactSet SharkWatch. In six, he won or was granted board seats. In four, the proxy contest resulted in a spinoff or a share buyback. Two proxy contests are continuing: Biogen Idec Inc. and Yahoo. In the remaining contests, he lost or withdrew.

"This is a 12-round prize fight with each side feeling out each other's strengths and weaknesses in the early rounds," said Chris Young, director of mergers and acquisitions research for advisory firm RiskMetrics Group.

Yahoo is on the defensive. It has received a deluge of letters from shareholders angered by the company's tactics during negotiations with Microsoft. Two of its largest institutional shareholders, Capital Research Global Investors and Legg Mason Capital Management Inc., voiced rare public frustration when talks collapsed.

The manager of a New York hedge fund with more than 1 million Yahoo shares said that by trying to unseat the entire board, Icahn was in effect giving the current directors a July 3 deadline to seal a deal with Microsoft or face certain defeat in the board elections.

Charles Elson, director of the University of Delaware's Weinberg Center for Corporate Governance, agreed. "Either they negotiate with Microsoft or they negotiate with Icahn."

-- Los Angeles Times

 
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Analysts / Editorial Contributors
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