Blue Water Energy - The Offshore Oil Boom

You may have heard about Brazil’s Tupi and Carioca, which may be the two biggest oil fields discovered in the last 30 years. What makes these discoveries particularly remarkable, in addition to their size, is where they are. They lie underwater, hundreds of miles off the coast of Brazil. Call it “blue water energy.”

The Adventures of Tintin is a comic book series started back in 1929. My 9-year-old son loves it. I enjoy reading it along with him because the hero of the series, a young Belgian reporter named Tintin, often finds himself in interesting historical settings and exotic places. (My favorite story is “The Blue Lotus”, which takes place during Japan’s occupation of China in the 1930s.)

In one of these adventures, Tintin discovers oil on old American Indian lands. In a series of panels, a little construction boom transforms a wilderness into a busy city in a matter of hours. It’s funny, but it also makes a point: After you discover oil, there is a whole lot that comes after that. The infrastructure of the oil business, you might say. I was thinking of Tintin after reading more about Brazil’s big oil discoveries.

You’ve probably heard about Brazil’s Tupi and Carioca, which may be the two biggest oil fields discovered in the last 30 years.

The Tupi field may hold 8 billion barrels of oil. If true, only the 15 billion-barrel Kashagan field in Kazakhstan, discovered in 2000, is larger. Tupi, though, may be small potatoes next to Carioca. This latter field may hold 33 billion barrels of oil. Again, if true, Carioca would be the third biggest oil discovery in history, behind only the mammoth Ghawar in Saudi Arabia and the Burgan in Kuwait. Brazil has another field it is assessing now, called Jupiter, which could be of the same scale as Tupi

What makes these discoveries particularly remarkable, in addition to their size, is where they are. They lie underwater, hundreds of miles off the coast of Brazil. Call it “blue water energy.”

Tupi’s oil, for instance, is 7,000 feet underwater and beneath another 7,000 feet of rock, sand and salt. It costs about $240 million just to drill the well there, which is like paying a big cover charge to hear a band you may or may not be happy with. Who knows how many more hundreds of millions it could take to get the oil out and to market?

One thing is for sure. Petrobras, the Brazilian oil company that discovered the oil, will spend a lot of money trying. Already, Petrobras has plans to spend more than $20 billion for marine support vessels and offshore drilling equipment. Those are big numbers, especially when you consider how tight the market already is for these things – not to mention the shortage of men and material to make more.

For perspective, consider that Petrobras has already leased nearly 80% of the world’s deep-water drilling vessels. It will certainly try to lock up more rigs and vessels. But so is the whole industry, which is why drilling companies are making money hand over fist like rose sellers on Valentine’s Day.

It’s not just in Brazilian waters that big prizes lurk. There are meaningful discoveries of oil and gas in the South China Sea, off the west coast of Africa and even in the waters off Trinidad and in many more wet places. Soon we could be poking around for oil beneath the Arctic seabed.

We’ll need lots of subsea wells and platforms and other goodies to put out there in those watery plains. Just consider the pipelines alone. We’ll need miles and miles of offshore pipelines to bring the oil to market. See the next chart, which shows the miles of pipeline needed by region.

According to Quest Offshore Oil, between 2007-2011, the industry will have laid down 35,000 miles of pipeline. That’s a lot of steel. And a lot of pipelay barges to do the work. And crews. It’s a demand that should continue for years to come, even if the oil price comes down.

That’s only part of the story, though. Here’s the other: the existing miles of pipelines that are getting old. This is a familiar theme in our pages. We’ve often talked about the creaky infrastructure surrounding everything from roads and bridges to water and power supply. Matt Simmons, the oft-quoted energy analyst, likes to say, “Rust never sleeps.”

The problem is particularly acute in seawater. It’s more troublesome because you can’t see it. Such infrastructure requires a lot of maintenance, which is not cheap. On the heels of two decades of low oil prices, much of the industry deferred a lot of maintenance. This problem extends beyond just the offshore oil and gas business.

The whole oil and gas infrastructure is a “vast spider web of steel.” There are over 335,000 miles of pipelines in the U.S. alone.

There over hundreds of refineries in the world, as well as thousands of tank farms, gas stations and oil and gas wells. Simmons estimates that 90% of our offshore rigs are too old, pushing the limits of what we know they can do. The average age of the world’s offshore jackup fleet – over 400 rigs – is over 24 years. Our experience running them past 25 years is limited. Plus, newer deepwater projects are pushing the limits of how deep we can go, putting bigger strains on everything.

As Simmons says: “The entire value chain is built of steel. Steel begins to corrode the day it is cast.”

The risk of failure – of leaks or breakages – is high. “If the world wants to continue using energy, its assets need to be rebuilt. Simple law of nature,” Simmons says. “The construction job will rival the combination of building the World War II war machine, the Marshall Plan rebuilding of Europe and the post-World War II Interstate Highway System.”

Simmons gives us one example, just a snippet of the infrastructure the industry is building. It is a $1.5 trillion energy project in the Middle East – Shell’s massive gas-to-liquids plant in Qatar. It is as large as 450 football fields. It will require 300,000 tons of steel and employ 35,000 workers. All the while, the prices of steel, cement, copper, etc., all continue to rise. People, too, are hard to find, like parking spaces in Manhattan. “We let Nintendo work stations replace skilled oil workers,” Simmons says.

It’s a massive opportunity. The offshore boom, and Brazil’s offshore scores, only adds to the urgency of it all. I’m looking now at some of the companies that will participate in the big offshore infrastructure build-out. They also benefit from replacement work, too.

If Herge, the artist behind the Tintin series, were alive today, he wouldn’t be surprised to see the rush of infrastructure that follows big oil discoveries. Some things never change. He probably would be surprised, though, to hear about oil fields deep under the world’s big blue seas.

Sometimes you can buy assets in the stock market for cheaper than what it would cost you to get those same assets in the private market. Taking advantage of the gaps between the two is what investing like a dealmaker is all about. Such a gap, it seems, has opened up in the mining sector.

I think the gap exists because people in the mining business understand two things that stock market investors have yet to fully grasp. First, there is a growing scarcity of high-quality mining assets. Second, there is a shortage of skilled workers. Simmons calls it a “blue-collar boom in mining.” So stock prices don’t yet fully reflect these realities, and prices are cheaper than prices miners get when they buy assets from each other – or start them up from scratch.

First, let’s size up the scarcity of high-quality mining assets, which has led to something of a race to lock them down. For evidence of that, we need look no further than the merger-and-acquisition market. For the first five months of the year, the announced mining takeovers tripled compared with a year ago. The total, about $200 billion in deals, puts mining mergers at the top of the M&A list for the first time since Bloomberg began compiling the numbers, in 1998. Over the prior two years, financial services companies have led the pack.

This feat is even more impressive when you consider the storm in which this financial torch has passed – amid a U.S. recession, growing inflation and an unfolding credit crisis. Global M&A overall is down 37%. Yet there is the mining industry atop the dealmakers’ pile, grinning ear to ear and still flush with cash for even more and bigger deals. The world’s biggest mining transaction ever would be BHP Billiton’s $147 billion bid for Rio Tinto. Transactions this size would have been unimaginable even five years ago.

What this means, in my view, is that mining companies think it is cheaper to buy mining stocks than it is to open new mines. It’s pretty simple. If you can buy eggs for $1 or raise your own for $3, you buy eggs all day long. New mines are hard to bring online. And it takes a lot of time. As a Morgan Stanley adviser recently put it, “If companies want to grow, they can either find something that might take 10 years to develop or buy something,” he said. Even so, exploration is up, as well.

There is a lot of risk with new mines, too. Especially since many of the new sources of mines are in politically unstable parts of the world, like Africa, or are difficult and expensive to mine. What new deposits have been found also tend to have lower grades. That means the resource isn’t as concentrated and there is more filler to process to get to the good stuff, be it copper, zinc, iron ore or what-have-you. Repeatedly, too, I hear mining companies warn about rising costs – for labor, equipment, energy and transportation.

The newer twist to the metals story is the power supply problems of many countries – South Africa, Chile, China and others – all important producers. Years of underinvestment in power supply – an issue I’ve written to you about before – is a global problem. And you can’t fix it by flicking on a switch. It takes years to build power plants and add capacity.

South Africa is a particularly egregious case of power shortages. The effect on production is devastating. In the first quarter, mining output fell 22%, to its lowest level in 40 years. Mining companies in South Africa face the risk of repeated power outages and/or forced reductions.

Chile is suffering from severe power shortages, too. It depends on Argentina and Bolivia for natural gas. As the latter two countries consume more natural gas, they export less to Chile. Chile’s water levels are also 40% lower than a year ago. Since Chile depends on hydroelectric power, this is a big problem. Electricity costs are skyrocketing in Chile. As it makes about 35% of the world’s copper, its ability to expand or even maintain that production in the face of power shortages is in doubt.

These are just two examples, but there are certainly many more. Another factor holding back new supply and making existing mining operations so valuable is the lack of skilled people. Companies doing everything from mining coal to operating offshore rigs all note the big challenge in finding enough qualified people.

The traditional skills are in short supply – people who can run a machine shop or a mining operation, for example. These skills are also not easily acquired. Yet a wide gulf exists between what these people make and what the guy running a mortgage trading desk on Wall Street makes.

As Michael Aronstein, a longtime money manager and strategist, recently put it:

“The relative compensation [difference] between somebody who is sitting on a derivatives desk and a guy who actually can diagnose and repair a locomotive has probably reached its millennial extreme… But that’s going to change. I think we’ll see the narrowing of all these spreads, a process that started at the lows in ’02.”

Add all this up – the hot M&A market, the power supply problems, worker shortages and more – and the bottom line is that supply is having a hard time meeting demand.

And demand is there, fueled by booming economies in China, India and Russia. In fact, much of the M&A business comes from these three countries. They need new supplies of metals to keep up with demand at home. For example, Aluminum Corp. of China and Sinosteel have spent more than $16 billion buying mining assets across the globe. These companies are looking to secure raw materials such as coal and iron ore.

Mining stocks, not surprisingly, have done well over the past couple of years, even as the broader market has gone nowhere.

For example, S&P’s Metals and Mining ETF, a decent proxy for mining stocks, has doubled over the past two years. The overall market has barely budged.

Yet the view from the ground, as the foregoing argues, seems to be that mining stocks may still be too cheap.


Chris Mayer
for The Daily Reckoning
August 13, 2008

This essay was taken from a recent issue of Capital & Crisis.

Chris is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer’s essays have appeared in a wide variety of publications, from the Daily Article series to here in The Daily Reckoning. He is the editor of Mayer’s Special Situations and Capital & Crisis – formerly the Fleet Street Letter.

Chris also recently wrote a book: Invest Like a Dealmaker: Secrets from a Former Banking Insider.

Yesterday, we posed a ‘what if?’ It was not a prediction; just an exploration: what if the world economy goes into a long, slow, soft Japan-like slump?

What if stocks continue to go nowhere? Yesterday, the Dow lost 139 points, after several big gains in the last few sessions. Up. Down. Up. Down. Stocks are down 15%-20% all over the world (except for Shanghai’s big 50% loss) for the year. Over the last ten years, markets in the East and emerging economies are still up – many of them by huge margins. But the United States and other developing markets are mostly flat. Adjusted for inflation, investors have lost 20% to 40% of their money.

And what if the financial crisis that began with subprime infects the rest of the industry? Today comes word that JP Morgan lost $1.5 billion since July – nearly a year after the problems with subprime debt were out in the open. Fannie Mae lost more than $2 billion in the last quarter. Freddie Mac lost $800 million. Those losses were not from subprime loans. Worrisome losses have already been reported in credit card debt, student loans, private equity and auto finance. And now even “borrowers with good credit defaulting on homes,” says CNNMoney.

And what if housing continues to fall? Prices are down nearly 20% nationwide – and still declining. Nearly one third of all buyers over the last 5 years now have negative equity, according to a report out yesterday. Of those who bought in 2006, 45% are upside down.

Erratum: last week, we reported a startling fact: that, taken as a whole, America’s homeowners have negative equity. It was startling…and untrue. We doubted it was true when we reported it, but we must have gotten distracted before we checked it. What is true is that the percentage of their houses owned by Americans – their equity – is less than the percentage owned by the mortgage lenders. They are not “upside down,” as we reported, because their houses are worth more than their mortgages. They are merely “inside out,” people who only appear to be homeowners on the outside. Inside, they are renting from the finance company.

And what if the finance industry and housing don’t ‘bounce back’? It will mean a long period with neither the juice of credit nor the elixir of housing price gains to get the party going again.

And what if consumers react in the way they normally react? That is, what if consumers actually stop consuming so much? There is mounting evidence that what must happen is happening now. The U.S. trade deficit unexpectedly fell last month; Americans are exporting more and buying less. Retail sales are slipping. Unemployment is rising. Drivers are driving fewer miles. Restaurants report fewer customers. Las Vegas reports fewer gamblers; and for the first time in many, many years spiders are said to weave their webs in brothel doorways without being disturbed.

And what if consumers, householders, investors, and businessmen all begin to downsize? Today’s news from Texas is that old people are downsizing their retirements; they’re making them shorter and later. The Dallas Morning News tells of a survey by the AARP showing more people nearing retirement age are continuing to work…or even going back to work. Many had counted on the value of their houses to finance retirement. But house prices are down as much as 40% in some areas, putting a big hole in retirement budgets.

And what if China, India and other emerging markets don’t emerge as fast as we had hoped? What if they, too, suffer from a buyers strike in the developed nations? What if they can’t sell so many toaster ovens…and so much bric a brac? They wouldn’t need as much iron as people estimated. Nor as much coal. Nor copper. Or oil.

And what if the whole world began to slack off – with less lending, less buying, fewer container ships crossing the oceans, fewer commercial airlines, and more saving? What if Americans rediscovered frugality? What if the whole world began to act like the Japanese?

What if the whole, globablized world economy sank into a long, soft, slow Japan-like slump, in other words?

“It should come as no surprise that the U.S. economic malaise is now becoming a global phenomenon,” writes Dana Samuelson. “After dodging the U.S. slowdown last year, the 15-nation eurozone economy appears to have shrunk in Q2, for the first time since the common currency’s introduction in 1999. Firm figures are still coming in, but Italy’s GDP contracted by 0.3% in Q2 after growing by a scant 0.5% in Q1. And Germany, the largest eurozone economy and the engine of G7 growth in recent years, contracted sharply in the second quarter, shrinking by as much as 1.5%, according The Wall Street Journal Europe. Eurozone growth certainly slowed to a crawl in the first quarter. According to RGE Monitor , Q1 growth in the UK fell to 0.4%, Ireland to 0.8%, Italy to 0.5%, and Spain to 0.4%. Estonia and Latvia contracted sharply, while Q1 GDP growth in Canada fell to 0.3% and New Zealand shrank by 0.3%. As in the U.S., housing booms in Spain, Portugal and Ireland are collapsing, while the euro’s recent appreciation hurt companies that export. Japan, too, is at risk of a recession as exports fell in June for the first time since 2003 and unemployment reached 4.1 percent, almost a two-year high.”

And what if the gold market is confirming this worldwide slowdown? Yesterday, the price of gold fell another $13, to $814. What to make of it? Is this some vast conspiracy among central banks to drive the price down? Or have investors – including central bankers themselves – decided that they don’t need gold? Have they figured out that the dollar is as ‘good as gold’ – or better? Gold is falling. The dollar is rising. Paper money – of no intrinsic value – is beating out the old-fashioned, natural, limited, useful (Lenin said he would use it on the walls of public latrines) yellow metal.

Would it make sense…maybe…if our ‘what if’ turned out to be correct? A worldwide slump would take the inflationary pressure off commodities and gold.

But wait. There’s always more to the story….

*** There are only two major problems with our “what if” above. First, America cannot afford a Japan-like slump…and second, the feds won’t allow it.

As to the first, a long, soft on-again, off-again recession may have been survivable – barely – when we first saw it coming in 2000. It would have been similar to the recession of the ’70s. People wouldn’t have liked it, but they might have used it to get themselves in better shape – with less debt and more savings. Instead the feds fought the downturn with the most reckless money policy in U.S. history. And they won – meaning, they succeeded in getting people to throw caution to the wind.

Nouriel Roubini was interviewed in Barron’s last week. He sees a recession coming that will be “more painful than any since the Depression…We are in the second inning of a severe, protracted recession, which started in the first quarter of this year and is going to last at least 18 months, through the middle of next year… A systemic banking crisis will go on for awhile, with hundreds of banks going belly up.”

Roubini notes that 72% of GDP is attributable to consumer spending and that the consumer has no money. The feds handed out billions in ‘tax rebates;’ even so, retail sales in June increased only 0.1%. Most of the money was used to pay down debt…or just to keep up with higher-priced food and fuel. Consumer debt was 100% of disposable income in 2000; now it’s 140%. Bankruptcies are up 30%.

And the economy is still, officially, growing! You can imagine what would happen in a real downturn. Today, a severe, drawn-out recession would be devastating for millions of people. They would lose their jobs and their homes. Naturally, they would expect the government to “do something.”

That brings is to the second problem with our ‘what if’ ramble – it presumes a world in which markets are allowed to function. In the real world we have a very funny monetary system that permits the financial authorities of the United States of America to create money, almost at will. These authorities have said many times that if the U.S. has stable consumer prices it will be over their dead bodies. Which would be fine with us. But the dollar-based system is inherently, inevitably inflationary. And even though this week’s markets are signaling a victory for the natural market forces of deflation, the United States still has a lot of ammunition. It has already nationalized its two big mortgage backers – Fannie and Freddie. It has handed out more than a hundred billion in rebates. It has planned to spend as much as $300 billion to rescue homeowners. And it still has its printing presses.

Thanks to U.S. printing presses, inflation has gone up all over the globe. As reported in Newsweek recently, a Morgan Stanley report released in late June summed it up: “Much to our own surprise, we find that 50 of the 190 or so countries in the world now have inflation running at double-digit rates, including most emerging markets. In other words, about half the world’s population is already experiencing double-digit price increases.”

What will happen? We don’t know. But we doubt the whole world will fall into cotton and sleep like the Japanese…not without a fight!

*** “That movie upset me,” said Elizabeth, after watching Kinsey. We didn’t see it, but we gather that it’s a film about the fellow who tried to make watching pornography respectable and ended up making it boring.

“It was sad. I guess the point of the movie was that you can’t take the romance and mystery out of sex. You can try to study it clinically. But you are caught up in it too. You are one of the people you are looking at. So, it’s like looking at yourself in the mirror; you tend to see what you want.

“It was a good movie, in some ways. It portrayed the complexity of Kinsey’s personality fairly well…and how it affected his marriage…and how they were both affected by the powerful forces of sexuality and love. Still, there was something disturbing about it… it makes you realize how fragile your own situation can be…and how you can be swept along by things your rational mind cannot control…and how your mind merely finds reasons and justifications for doing what you want to do in some deeper, stronger, less rational part of your brain…or maybe your heart.”

Until tomorrow,

Bill Bonner
The Daily Reckoning