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STICKING TO THE SERVICES
by Elliott H.
Gue
Editor, The Energy
Letter
April 21, 2006
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This chart is based on data provided by Baker Hughes that counts only the rigs that are actively in use. Many investors think rigs are actually used to produce oil and gas; that’s not the case. Rigs are used to drill wells--the fact that these wells are active means that there's a good deal of exploration and development activity ongoing globally. It's clear that there are more rigs at work today than at any time since early 1986. Rising commodity prices have prompted a boom in global drilling activity. But what's even more interesting is the location of those rigs. The lion's share of the rigs in the global rig count is located in North America; to produce America's mature fields efficiently they must be heavily drilled. One of the most common ways of increasing production from an aging field is simply to drill more wells, spaced more closely to one another. The other thing to remember about North American drilling activity is that it's highly volatile and commodity price sensitive--when oil and gas prices rise the US and Canadian rig counts tend to rise in lockstep. These rig counts can also reverse just as quickly when commodity pricing falters. The Middle East, in contrast, has traditionally not used many rigs to produce its vast oil reserves. For example, right now, there are more than 1,800 rigs actively drilling for oil and gas in North America and just 221 in the Middle East. Nonetheless, the Middle East produces nearly 25 million barrels of oil per day compared to less than 15 million for all of North America. The reason for that is quite simple: Middle Eastern oilfields have historically been prolific producers. Producers in the region have not been forced to use the latest technology or drill thousands of wells to produce their oil; it flowed easily from just a few wells. Moreover, Middle Eastern rig counts are somewhat less commodity price sensitive than US counts historically. Projects in the region tend to be larger scale multi-year deals. Plenty of oil bears routinely argue that there's more than enough oil in production today to meet the world's growing demands. Many contend that the Middle East's oil reserves are so huge that they'll easily cover demand for at least the next 20 years. OPEC fosters these claims, routinely reassuring the market that there's plenty of oil to go around. Unfortunately, the numbers don't necessarily back up those claims. Check out the chart of the Middle Eastern rig count below.
The total rig count in the Middle East is still far below that in the US. That said, the rise in rig counts has been far more dramatic in the region than almost anywhere else in the world today. The Middle Eastern rig count recently hit an all-time high; there are more rigs at work in the region today than there have ever been, even during the energy bull market of the 1970s and early ‘80s. This is true even of the region's most important producer--there are more rigs at work today in Saudi Arabia than at any time in that country's history. The fact is that Saudi Arabia and most other Middle Eastern countries are actively exploring for oil and attempting to further develop their existing reserves. If this were not the case, there wouldn’t be such an obvious jump in the region's rig count. Development projects underway in the region are large-scale and expensive; Saudi Arabia is now employing some of the most advanced oilfield technologies to produce its fields. And other countries like Kuwait are actively considering partnerships with Western oil producers to modernize and replace decades-old oilfield infrastructure. In the past Saudi Arabia and Kuwait could have easily increased production by simply opening up the taps on their existing wells and letting the oil flow. Well-behaved super giant fields like Burgan in Kuwait and Ghawar in Saudi Arabia flowed easily and reliably. But that is apparently not the case right now. Across the Middle East, producers are drilling more wells in their existing fields to try and produce more oil or, at the very least, halt their production declines. In addition, there is some meaningful exploration activity ongoing in places like Saudi Arabia--they're producing fields that are much smaller in size than giants like Ghawar. If it were truly a simple matter to increase production of oil in the Middle East it's doubtful the Saudis and others in the region would be undertaking so much new drilling activity. They'd simply open up the taps on Ghawar. This leads me to one of the long-standing themes of The Energy Strategist: The global store of easy-to-recover oil has been exploited. Producers will increasingly turn to technically difficult and expensive-to-produce reserves including deepwater, oil shale/sands and heavy oil deposits. Even in the Middle East, the focus will become producing remaining reserves in super giant fields more efficiently and exploiting smaller fields. I’m not saying that oil prices can't come down in the short term. Slowing demand from China or the developed world could ease the currently ultra-tight market. And right now in the US oil inventories are quite high--this can have bearish implications in the short-run. But what’s clear is that oil prices are unlikely to decline much past $50 to $55 per barrel; these prices are what's needed to make all the current drilling and exploration activity underway globally economically feasible. The prime beneficiaries of all this drilling and exploration activity are the oil services and contract drilling companies. While oil and gas producers are certainly benefiting from rising commodity prices, their costs are also rising rapidly--finding and developing large deepwater fields, for example, can cost billions. Much of that cash finds its way into the pockets of the world's services companies. Drillers are currently receiving ultra-high day-rates for hiring out their rigs. Some classes of advanced offshore rigs cost close to $600,000 to hire, up from $200,000 or so less than five years ago. Profits in the group are exploding. And oil services firms that own the technology and expertise to produce these more advanced reserves are similarly in the catbird's seat. This group has long been a favorite within The Energy Strategist. In next week's TES, I'll focus once again on earnings. With the first quarter earnings season in full force for the energy patch it's time to examine our current holdings and look for new trends emerging in the group. In addition, I'll be taking a closer look at one of the world's most promising resources, the Canadian oil sands.
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