Beware of Windfall Profits Taxes

It’s impossible to make the case that there’s a perfectly free market in oil or any other globally traded commodity. Production limitations, depletion, military conflicts, nationalization risks, taxes, and environmental regulations — they all muddy the waters of a market that many would like to be clear and efficient.

The international oil trade does not operate in a vacuum. Despite what energy resources may or may not lie underneath the ground, "aboveground factors" matter very much and tend to matter more as prices rise. Just because we can use computer models to estimate that so many billion barrels of oil are in some reservoir in some remote part of the world doesn’t mean that this potential supply will affect prices five or even 10 years from now, if at all.

As my colleague Byron King pointed out in "Bakhtiari’s Event of the Century ," concerns about oil scarcity are not likely to be taken very seriously until the world faces a crisis — a crisis that could impose serious change on financial markets. I agree with Byron that the issue of future scarcity will be addressed only "if informed people and the industrial and political policymakers of the world actually take Peak Oil as a serious matter and set policy accordingly."

Unfortunately, right now, long-term perspective hardly exists in industrial and political policies. A pair of economists recently tested the logical assumption that most free market operators extract oil as fast as they can, rather than maximize the productive life of a reservoir. Why? From the perspective of those funding massive projects, a barrel of oil produced this year is far more valuable than a barrel produced 15 years into the future.

Technology Cannot Completely Mitigate Oil Scarcity

The history of large oil projects shows that technology — while vital to extending the boundaries of exploration — has rarely been able to reverse a depleting field once it’s passed peak production. In a paper entitled "Technology and Petroleum Exhaustion: Evidence From Two Mega-Oilfields," John Gowdy and Roxana Julia, two economists from Rensselaer Polytechnic Institute, tested the assumption that technology can ramp up oil production on demand. Here’s the abstract:

"In this paper, we use results from the Hotelling model of nonrenewable resources to examine the mainstream view among economists that improvements in recovery technology can offset declines in petroleum reserves. We present empirical evidence from two well-documented mega oil fields: the Forties in the North Sea and the Yates in West Texas. Patterns of depletion in these two fields suggest that technology temporarily increases the rates of production at the expense of more pronounced rates of depletion in later years — in line with Hotelling’s predictions. Insofar as our results are generalizable, they call into question the view of most economists that technology can mitigate absolute resource scarcity. This raises concerns about the capacity of current mega-fields to meet future oil demand."

The "Hotelling model" refers to a rule outlined by 20th-century economist Harold Hotelling. Hotelling was noted for his work on the economics of nonrenewable natural resources. He argued that prices for scarce natural resources rarely include an accurate premium for scarcity. But as we’re seeing, the scarcity premium, or "fear premium," is growing and is likely to increase as more evidence of scarcity arrives.

Generations ago, Hotelling was ahead of his time in arguing for a scarcity premium. It simply can’t develop when aboveground supplies are consistently ample. But this has changed over the past few years. Rather than being seen as a mere commodity price, the price of oil should be viewed as a combination of production costs, profit, taxes, and scarcity premium. Economics textbooks tell us that, over the long run, a commodity will sell at its marginal cost of production, but evidence is growing that the different grades of crude oil are making oil less and less of a "commodity" in the economic sense.

Available Oil Becoming Heavier, More Sour

The widely held assumption that technology can immediately address a shortage of crude oil fails to address the quality of the crude we have to work with. World refining capacity is not optimized to deal with the reserves that remain. David Wood & Associates clearly shows in the following diagram that light, sweet crude is growing increasingly scarce. This diagram, published in the April issue of Petroleum Review, is a great snapshot of the oil production that refiners have to work with. The size of each of these bubbles is proportional to 2005 production volumes:


Wood concludes from his studies that "The average global crude oil currently produced has an API gravity close to 32 degrees and a sulfur content in excess of 1 weight percent (wt %). Only some 20% of global oil production supply can be classified as light and sweet, with the remaining 80% or so classified as medium/heavy and sour [emphasis added]."

But perhaps more importantly, "Medium-gravity, sour crudes dominate the oil production from the Middle East and Russia, and heavier crudes are dominating remaining oil reserves." This chart, from the July 2006 issue of Strategic Investment, shows that over time, crude has become heavier and more sour. The axes on this chart are the opposite of David Wood’s chart, but the red dots show a clear historical trend of declining average crude quality:


This trend is reflected in growing spreads between the prices of West Texas Intermediate blend, which is a type of light, sweet crude, and imported crude oil blends, which tend to be heavier and more sour. If you want to participate in the investment boom, pay close attention to new refinery construction projects and the refiners that are consistently forward-looking.

Economist Ed Yardeni included the following chart in his firm’s latest energy publication:


How are foreign producers reacting to the fact that most of their reserves are of lower quality and will be expensive and difficult to produce and refine? They’ll take their time to ramp production to meet Western demand — and charge higher prices. This involves reasserting control over their remaining resources. Yardeni made a great point in a recent morning briefing:

"We still believe that the cheapest oil in the world is in the U.S. stock market. The sector’s profit margin was 10.4% during Q4 2006, exceeding the S&P 500’s 8.5%. P/Es have been held down by investors’ perceptions that oil prices and forward earnings aren’t likely to rise much from here. We agree, but they aren’t likely to fall much, either, from their lofty heights. So the industry should have lots of cash flow and M&A activity over the next couple of years. The most challenged industry, yet the one most likely to have plenty of cash for acquisitions, may very well be integrated oil and gas, with the sector’s biggest market cap share at 63%. National oil companies are increasingly demanding that the international majors basically accept a service fee for managing their production without much, if any, upside [emphasis added]. This might be one reason why analysts’ long-term expected earnings growth for the sector has dropped from a record high of 12.3% three months ago to 10.0% in March."

Service fees? This goes a long way in explaining why executives at big oil companies like to keep public attention focused on their mega-projects, rather than talk openly about the chance that leaders of oil-rich, underdeveloped countries may choose to follow the Hugo Chavez/Vladimir Putin playbook.

Geopolitics Remains a Wild Card

ASPO-USA’s latest Peak Oil Review describes the situation on the ground in Nigeria in the wake of last weekend’s presidential elections. This country must give several big oil executives sleepless nights, considering the billions they’ve invested in major projects within reach of violent, kidnapping gangs:

"Among the more interesting incidents surrounding the election was a failed attempt to blow up the national election commission’s headquarters with a gasoline truck, plus a massive assault by insurgents on the Bayelsa State Government House in the capital Yenagoa. Nine boatloads of insurgents emerged from the creeks, overcame the police and military forces in the town and burned the governor’s mansion and a police station. The governor, who is also expected to be declared the new vice president of Nigeria, was forced to flee the city for his life.

"The raid illustrates the growing power of insurgents to strike at will and overcome corrupt and ineffective police and military forces. Some weeks back, the insurgents announced a stand down during the run-up to the election but vowed to be back unless the election led to significant changes — which it clearly did not.

"Nigerian oil production dropped by another 100,000 b/d during March to 2.15 million b/d. Although the Nigerian government has been saying recently that Shell will soon resume 300,000 b/d of shut-in production [at Forcados], Shell has yet to confirm this claim. Foreign oil workers in Nigeria now are largely confined to fortified compounds and travel to job sites by armored vehicle or helicopter [emphasis added]. A number of companies have pulled out of the country.

"There was nothing in the recent elections to suggest that the situation will improve soon. The insurgents have said they will step up attacks following the election and usually make good on their promises. Prospects for reduced Nigerian oil production seem likely."

This is a situation in which those fighting for a larger share will keep fighting until they get it. Pressure on the Nigerian government to share the oil wealth will keep mounting. Oil companies operating in the region should beware windfall profits taxes, or even forced changes to production-sharing agreements. Algeria recently set a very alluring precedent for those countries looking to balance the interests of both their citizens and the oil companies.

It’s Mayday for a Few Big Oil Companies

Last week’s Wall Street Journal had a piece describing this trend:

"Even some nations that are new to the oil game are demanding stiff terms. Some of the biggest finds in recent years have been in Angola, which has popularized an oil-production contract built on progressive taxation. As oil prices rise, boosting an oil company’s rate of return, Angola’s share of the proceeds also goes up."

This "progessive taxation" idea will probably catch on elsewhere — a good reason for energy investors to own a few oil service stocks. Regardless of how the resource wealth is shared, more oil field exploration and development must be done. It looks like the Venezulan government has decided to move forward with major development projects practically on its own, but it may enlist the services of companies like Schlumberger or Baker Hughes when it runs into trouble down the road.

Next Tuesday, May 1, marks the end of private control of the vast heavy-oil deposits in Venezuela’s Orinoco basin. This is obviously negative for long-term oil supply, as Chavez has already demonstrated that PDVSA cannot even maintain its conventional oil production. How anyone can expect much out of the Orinoco Basin — as long as Chavez is running things — is beyond logic. The Journal continues:

"To grab more of that profit for itself, the Venezuela government broke existing contracts. Income taxes on heavy-oil projects over the past couple years rose to 50% and royalty rates doubled, to 33%, having previously been raised from the original 1%. The government also legislated that the state oil company, Petroleos de Venezuela SA, be given a 60% stake in existing fields by May — and thus a majority of future profits."

Fadel Gheit, an energy analyst from Oppenheimer & Co., concludes the article with an image any baseball fan will recognize: "’This is like drafting a kid to the major league and he’s making $100,000 a year. All of a sudden, he is hitting 50 home runs. Guess what, he wants to renegotiate his contract, and under the circumstances, one can understand the way Chavez feels.’"

Despite how distasteful it is to view the world from the perspective of a socialist dictator dismantling his country, Gheit makes a good point. It may not be great for oil consumers, or follow the rules of the free market, but a few more emerging oil-producing countries may look to "renegotiate their contracts." What big oil could lose in volume over the coming decade, it must make up in price — if regulators allow such a thing. So energy investors should hedge positions in big oil stocks with positions in leading oil service stocks.

Good investing,
Dan Amoss, CFA

April 26, 2007

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