04 Nov 2011 | Business

The Surge for Energy 

With oil prices high, and companies going to new
extremes in the hunt for new reserves, Ian Fraser
examines the oil industry and opportunities
for investors.

When the last Hummer rolled off General Motors’ production line in Shreveport, Louisiana in May 2010, it marked a turning point.  With petrol at $3.60 per gallon on American forecourts, up from £1.35 a gallon in 2002, the brand’s demise suggested that Americans – even those with a penchant for outlandish sets of wheels and perhaps little interest in the environment – were willing to exchanges gas guzzlers for more sensible, fuel-efficient vehicles.

THE DEVELOPED WORLD VERSUS EMERGING ECONOMIES

The US still burns its way through 21 per cent of the world’s oil, even though the country contains just 4.5 per cent of the world’s population. And the vast majority of this fuel is used in cars, trucks and buses. There is huge scope for this to be used more efficiently – and government policy is providing an impetus here, with President Obama having set a 54.5 miles per gallon fuel efficiency target by 2025 – then there will be some falls in global demand. 

However, it is much easier for countries in the developed world to reduce their dependence on oil – by bringing in new technologies such as stop-start cars – than for emerging economies, some of which have only recently entered the petroleum age. As Toby Ross, global energy analyst at Baillie Gifford said, “Increased demand from emerging economies, notably China and India, will offset many of these efficiency improvements and the substitution of alternative energy in the West.” 

In China, consumption has leapt from 2.3 million barrels per day in 1990 to 9 million in 2010 – and grew by 8.2 per cent last year alone. Demand growth from China and other emerging economies is, for the time being at least, pretty much unstoppable. This is because, as disposable incomes rise, it is inevitable that emerging markets’ consumers want to drive their own cars. 

This rising demand, and constrained supply, has pushed oil prices from $40/bl in 2005, to $80/bl in 2010, and over $100/bl in early 2011.

PROSPECTING FOR GOLD

With oil prices at these levels, companies are able to push into more challenging frontier areas to seek out ‘black gold’, so-called because of crude oil’s colour and immense value.  This has spurred a surge of technical innovation and real excitement in the sector. The attractiveness of such territories has been further fuelled by the rise of ‘resource nationalism’ which has blocked many oil firms’ access to many better endowed regions such as Russia and some of the Opec countries. 

New frontiers that are opening up include deep water fields (for example off the coast of Brazil); the Arctic Circle; and shale oil from places like the US and Argentina. 

Despite BP’s Deepwater Horizon disaster last year, deep water drilling is one of the most frenetic areas of activity.  The Brazilian company Petrobras is leading the field, having discovered some 15 billion barrels of oil in the ‘pre-salt’ off Brazil’s coast after a flurry of drilling since 2005. This is a risky and costly exercise, given that reserves are located 300km off shore, beneath 2km of water and under a 2.5km layer of salt. However the Rio-based firm is so confident about the region it has launched an audacious $53bn spending programme to explore there over the next five years. 

The Arctic, which has attracted companies including Cairn Energy, Shell, ExxonMobil and Rosneft, is another area of huge promise – and huge technical and political challenge due to the region’s harsh climate and inaccessibility. The US Geological Survey estimates that 90 billion barrels of oil lie under the Arctic floor, some 13 per cent of the world’s recoverable but undiscovered reserves. 

Another new source of oil that is seeing huge investment is shale oil. Shale oil is extracted from tightly packed rocks by ‘fracking’ or injecting high pressure water into the rocks that sit beneath conventional reservoirs. 

A diverse group of oil companies have invested a total of $25bn in extracting oil from shale fields. ‘Tight rock’ fields in the US, such as shale, currently produce just 0.5 million barrels of oil per day, and are expected to yield up to 3 million barrels per day by 2020. “This is very big and it’s coming on very fast,” said Daniel Yergin, chairman of energy markets consultancy IHS CERA. “This is like adding another Venezuela or Kuwait by 2020, except these tight oil fields are in the US.” 

Toby believes that developments such as these show why predictions of ‘Peak Oil’ have so far proved misplaced. “History suggests that, when supplies get tight, prices rise and, over time, we see a new wave of investment. New territories are opened up, new technologies and seismic tools come on stream and oil companies are prepared to take more risk.”

BAILLIE GIFFORD INVESTMENTS

The Monks Investment Trust PLC has its attention on the posse of oilfield services and drilling companies that are working alongside Petrobras in the ‘presalt’ region. Its favoured stocks include Houston-based National Oilwell Varco, which makes highly complex drilling equipment, and Norway’s Seadrill, which uses this equipment to help companies like Petrobras to find oil. Both of these companies are seen as well managed and poised to benefit from consolidation in their sector. 

Monks and Mid Wynd International Investment Trust PLC have also recently bought into the Argentinean oil company YPF, believing it has scope to become a major producer of shale oil and gas in South America using new technologies that have been developed in the US.

Another area where these trusts are finding exciting growth is Turkmenistan, where Dragon Oil is reaping the rewards of a far-sighted investment in oil infrastructure in the Caspian Sea, dating back to the mid-1990s. After many years of investment in its platforms, it is now seeing rapid production growth, in an increasingly strategic location which should be sustained for several years. 

Scottish Mortgage Investment Trust PLC and Edinburgh Worldwide Investment Trust plc are however also looking beyond carbon. Both hold First Solar, the world’s biggest maker of thin-film solar modules, while Scottish Mortgage along with other Baillie Gifford managed trusts has invested in Denmark’s Novozymes, which makes the enzymes that will be used in making cellulosic ethanol. This is expected to fuel the second generation of the bioethanol revolution. 

However Baillie Gifford-managed trusts have in recent years steered clear of traditional oil majors such as ExxonMobil and BP. “These companies are finding it quite difficult to generate much growth,” said Toby. “We prefer to focus on companies with the potential to deliver really exciting growth, and where there’s scope for significant change in the way the market sees them.”

Portfolio holdings correct as at 31 August 2011.

Please remember that the value of a stock market investment and any income from it can fall as well as rise and investors may not get back the amount invested. Investments with exposure to overseas securities can be affected by changing stock market conditions and currency exchange rates.

Investing in emerging markets is only suitable for those investors prepared to accept a higher level of risk. This is because difficulties in dealing, settlement and custody could arise, resulting in a negative impact on the value of your investment.

The views that are expressed in this article should not be taken as fact and no reliance should be placed upon these when making investment decisions. They should not be considered as advice or a recommendation to buy, sell or hold a particular investment.

This article contains information and opinion on investments that does not constitute independent investment research and is, therefore, not subject to the protections afforded to independent research.

Author: Ian Fraser
Ian Fraser writes about business and finance for publications including the Financial Times, The Sunday Times, The Independent on Sunday, Mail on Sunday and Sunday Herald and is consulting editor on Bloomsbury Publishing’s Qfinance. He helped produce the BBC’s documentary on the Rise and Fall of RBS, to be broadcast in November 2011. He is visiting lecturer in financial journalism at the University of Stirling.