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1031 Oil and Gas: yesterday, today and tomorrow

China, India Discovering Oil Ken Spencer Brown
Fri Dec 14, 6:04 PM ET

It was only five years ago that $30-a-barrel oil seemed pricey enough to prompt calls for increased pressure on OPEC member nations. Considering that oil had sold for as little as $11.37 just two years before, the fuss was understandable.

As it turns out, those were the good old days of cheap oil. As prices approach $100 a barrel, demand shows no signs of slowing -- a trend all but certain to push prices even higher.

Not everyone is complaining. Investors have flocked to the sector as sales and profits soar.

The oil crunch has been a boon for international integrated oil and gas companies, which have become sexy again as energy takes the spotlight.

Today, integrated oil and gas stocks rank No. 17 out of IBD's 197 industry groups, up from 126 six months ago.

1. Business

It's hard not to be doing well in oil these days. But even in this lucrative commodity business, not all companies are equal.

Exxon Mobil (NYSE:XOM - News) is by far the largest company in the group, with a market value of around $500 billion and sales of more than $338 billion over the last 12 months. Other giants include the U.K.'s BP (NYSE:BP - News), U.S.-based Chevron (NYSE:CVX - News) and Royal Dutch Shell (NYSE:RDS-A - News) of the Netherlands.

Some of the fastest-growing companies in the group in recent months have been those based in emerging markets, firms such as China Petroleum & Chemical (Sinopec) (NYSE:SNP - News), PetroChina (NYSE:PTR - News) of China and Brazil's Petroleo Brasileiro (NYSE:PBR - News), or Petrobras.

Another emerging-market player is Petroleos de Venezuela, the Latin American oil company that owns U.S. refineries and Citgo. Though the state-owned entity is not publicly traded, its vast oil reserves and presence in the U.S. market afford it some influence. One of the best performances in recent months has come from an unlikely corner of the market. Hess (NYSE:HES - News), a small integrated oil company based in New York, has seen its stock jump 69% this year to new highs.

Once Russia's largest oil producer, Yukos hasn't been as fortunate. The company has been virtually dismantled and sold in the wake of the high-profile arrest of its CEO, Mikhail Khodorkovsky, in what many see as retribution for his political activities.

Together, the companies in the group carry a market value of nearly $2 trillion and produce and sell most of the world's fuel.

Integrated oil and gas companies participate in every aspect of the business: finding and extracting oil, refining it and selling it to customers. This all-encompassing approach helps hedge against market volatility.

Unlike independent refiners, who are at the mercy of supply costs, integrated oil companies benefit directly from rising oil prices at every step of the supply chain.

But while rewards abound, so do risks.

The oil business is capital-intensive at every stage. And being an integrated oil company means mastering several different businesses.

Exploration, crucial to maintaining supply, requires huge investments in technology and exploration rights -- and won't necessarily result in a payoff.

As Exxon Mobil CEO Rex Tillerson put it at the company's annual meeting with analysts last spring: "This is truly a long-term business that requires decisions to be made with a time horizon that is measured in decades rather than quarters or years."

Once found, oil can be just as costly to extract. A single oil rig can cost more than $100 million, depending on location. Refineries cost millions of dollars to operate and are tricky to maintain. And developing and nurturing a retail presence requires constant spending.

Navigating the tricky labyrinth of foreign governments, land-use issues and environmental rules can be equally daunting. Concerns over greenhouse-gas emissions could spark new environmental regulations. And a wave of nationalization or government intervention has complicated business in places such as Venezuela and Russia.

"With an integrated company, you have so many pieces that have to work well," said James DiGeorgia, a longtime energy market bull who publishes the Gold and Energy Advisor newsletter.

Name Of The Game: Maintaining a good supply of reserves is key, as is efficiently extracting, producing and selling the crude to customers worldwide. That means making wise investments in exploration, infrastructure and distribution.

2. Market

Petroleum is used to produce everything from gasoline to plastics to crayons. Gasoline remains the most popular use, followed by diesel fuel, heating oil, jet fuel and heavy fuel oil liquefied petroleum gases such as propane and butane.

Consuming some 20 million barrels a day, the U.S. remains the world's top buyer of oil products by a wide margin. But No. 2 China, which uses about 6 million barrels a day, is gaining quickly. India is another fast-growing market, though its natural resources help mitigate that demand.

"When you look at the overall picture, there is not a lot in place to turn prices tumbling down," said Steve Wilhite, CEO of Summit Energy, which advises companies about their energy usage. "If we were to have some type of global recession, that would certainly have an impact. But we are clearly going to have to open up more sources of supply or make significant changes in consumption."

3. Climate

Demand has never been higher, and all signs point 15 steady growth for years to come.

In mature markets, rising gasoline prices have had little effect on consumption. And the energy needs of emerging economies such as China and India have helped boost the price of oil worldwide.

Average worldwide crude prices started the year at $54.63 a barrel; by the end of November, they had hit $90.32.

"When you used to see wild volatility in prices, it tended to reflect disruption in supply or a downturn or upturn in the economy," said Hess spokesman Jon Pepper. "But what you see now is structural, not cyclical."

But at the same time, oil is getting harder and more expensive to find and extract.

That's putting a premium on the value of oil reserves, and investors are flocking to companies that can count on a steady supply.

Petrobras' stock, already on a tear this year, got an extra boost in November when the company announced it had discovered as much as 8 billion barrels of oil and natural gas off the Rio de Janeiro coast. It might have come across an even larger reserve nearby. The stock has jumped 90% since August.

Still, this silver cloud has a dark lining. Record profits by oil companies have sparked some political backlash and a renewed effort to find alternative sources of energy.

While Americans haven't stopped driving, lawmakers are looking at ways to raise taxes on oil companies. The Senate on Thursday approved a measure to boost auto fuel efficiency, but backed down from billions of dollars in new taxes on oil companies only after a threatened Republican filibuster and veto from President Bush.

Dan Rogers, a partner with law firm King & Spalding who helps oil firms work out large contracts, says his clients used to joke about what some consider California's far-out environmental rules. Now, that mockery is turning into genuine fear.

"I deal with a lot of foreign investors looking to do (energy) investments in the U.S., and to them, the risk is worse here than in their home countries," he said. "This is becoming an increasingly hostile place for the traditional hydrocarbon business."

Heavier taxes, new environmental rules and the revocation of favorable drilling licenses add an element of unpredictability that could hurt stocks.

Over the long term, a broader green-energy push could reduce demand for fossil fuels; high energy prices might provide the impetus for a clean-energy breakthrough, reducing long-term demand for oil.

4. Technology

The oil business is more than grimy roughnecks working on heavy industrial-age equipment. It has long been one of the biggest buyers of supercomputer technology, which helps sift through reams of seismic data and other measurements to find new sources of crude miles beneath the earth's surface.

Now, observers expect a new wave of innovation as demand rises, oil reserves become harder to find and high energy prices draw investment dollars.

Exxon Mobil, for instance, is using electromagnetic energy along with sound waves for even better 3-D pictures of what lies below.

Oil producers are also working to make extraction more efficient. Wells that can drill at an angle -- necessary for many smaller, hard-to-reach reserves -- are replacing standard vertical wells.

Another promising innovation is a new drill that uses heat to break apart rock rather than mechanical force. The technology, recently demonstrated by researchers at the Massachusetts Institute of Technology, is faster and more energy efficient than today's drills. And the drill doesn't need to be brought to the surface to be replaced as often -- a boon for today's deep drilling.

Exxon Mobil researchers patented a system called Liquid Addition to Steam for Enhanced Recovery, which will help it get more oil from older reserves.

At the refinery level, equipment upgrades are making lower-quality crude usable, which helps boost supply.

5. Outlook

The long-term outlook for oil has never been stronger. China and India will need more oil as their economies modernize, and consumers in mature markets appear to have accepted higher prices.

Energy Information Administrator Guy Caruso told Congress this month that he expects the average price of oil to jump 18% to around $85 a barrel in 2008.

Still, oversupply remains a fear. The oil glut of the 1980s and 1990s might seem like a distant memory now, but some experts worry that a headlong rush into oil investments now could lead to too much production over the long term, especially if the economy sours. A global recession could slow overall demand even as emerging markets continue to grow.

Upside: Demand will continue to outpace supply, resulting in a handsome payoff for companies that make good bets on future supplies.

Risks: As oil reserves get harder to reach and environmental regulations mount, oil could become more expensive to produce dampening profits. And higher prices could spark a backlash.

Copyright 2007 Investor's Business Daily

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