The Best Stock For $100 Oil

In investing, it often pays to understand both the large scale trends, as well as company-specific issues – and to know when each is most useful.

After all, there’s not a lot of value in knowing which is the most profitable, best run buggy maker when everyone is driving cars.

In that vein, having a view on the likely direction of the oil price can be helpful.

It’s not a particularly brave call – the market dynamics are firmly in favour of a higher oil price in years to come, and you won’t find many analysts expecting the price to either stagnate or fall.

With that view framing our analysis, we think it prudent to plan for a world in which the oil price stays high and climbs higher.

The company we’re about to unveil is the Australian stock we believe is best-positioned to take advantage of this relentless rise in the oil price.

The case for higher prices

Don’t be put off by the short-term ups and downs on the evening news – we believe the oil price is going higher ove time. Depending  whose numbers you believe, oil reserves are either stable or falling and extraction costs are rising as those reserves become increasingly hard to find and access. We’ve drilled in easy to reach places, then off-shore and into increasingly deep water. We’re now looking for shale oil and even evaluating extracting it from oil sands.

Demand is showing no signs of abating. Continuing industrialisation in Asia and Africa, and the growing affluence there and in the West are underpinning a continued rise in the demand for energy.

We’ve scanned the market to bring you our number one pick to benefit from these trends.

Businesses, not lottery tickets

If you’re new to The Motley Fool, you’ll be relieved to know we’re not interested in trying to read the charts in an attempt to make a short-term gain. We focus on the business, not the share price, and then work out if the market is offering us a reasonable price.

Nor do we have any interest in punting on a ‘penny dreadful’ – that would be pure speculation, and we’re just not interested. Some people will get lucky on a ‘hot tip’ – others will lose their shirts. You can expect more from The Motley Fool.

To Peak or not to Peak

In a recent paper, BP estimated that the world had 45.7 years of oil supply available (in proven reserves) – based on 2010’s oil consumption figures.

Even just allowing for an average annual growth in consumption of 1.4% per annum (the actual growth in production between 1999 and 2008), that 46 year reserve estimate drops to around 40 years.

The scientific and financial worlds are split when it comes to oil reserves. There are many in both camps who subscribe to the ‘Peak Oil’ theory, and others who are much more bullish about our ability to source oil for our energy needs.

The Peak Oil theory suggests our rate of consumption will surpass (or already has surpassed) our rate of oil discovery. Thereafter, the world will inexorably run down our supply of available oil, leading to eventual exhaustion of our global reserves.

It seems logical that a resource pool that has taken millions of years to be created will at some point run out, given our consumption patterns, and our current reserves and exploration technology.

The great unknown is the timing of that event.

If Peak Oil never does arrive, it will probably be because the market is doing its work – steadily increasing the price for an increasingly rare commodity, reducing demand in the process.

Shifting the odds in our favour

Warren Buffett has famously said:

“To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers”

In keeping with that lesson, we’re not trying to assess whether Peak Oil is a legitimate theory, and if so, when it will occur. Instead, we’re focussing on the business implications of a clear reality – a finite resource for which the world demand continues to rise.

Oiling the wheels of progress

Oil truly has been the blood that has pumped through the veins of human progress since the mid-late 1800s. It made the internal combustion engine possible as well as efficient and portable – and is a reasonably safe fuel.

It effectively underpins our entire system of freight and transport in its many forms.

If you studied high school economics, you will remember that the price of something should be the point at which the supply and demand curves intersect. The theory suggests that in most cases, the demand for that widget will be less as the price increases.

However, in some special cases, the demand doesn’t change all that much, despite the change in price. (Both governments and cigarette manufacturers benefit from that very reality, but that’s a discussion for another day!)

Inelastic demand

Between 2000 and 2002, BP’s data shows growth in global oil production was effectively zero. During the depths of the recent Global Financial Crisis, trade slowed, unemployment rose, and uncertainly reigned in financial markets. Despite all of that, oil production fell only 2.6%! Between 1999 and 2009, which includes both of those periods, production grew by 10.5% overall (1% per year, compounded). As a planet, we truly are addicted to black gold.

What about cheaper alternatives?

At this point, you’re probably thinking about alternatives to oil.

It’s fair to say that oil and its derivatives have little role in our fixed power infrastructure.

Coal-fired power stations continue to provide the vast bulk of our electrical power. Nuclear power is a real option for power generation, although it has political, environmental and cost challenges. The famed Snowy Hydro scheme has an important role in providing peak demand in the south-eastern states.

Absent a game-changing breakthrough in battery technology and electrical engine efficiency, however, these power generation assets (and the increasing stable of renewable energy sources such as wind and solar) will remain a source of electricity for fixed, instant use, but will have a secondary role – at best – for readily portable use in freight and transport.

Again, though, we’re bringing you a recommendation that doesn’t require a crystal ball, or a degree in resource engineering.

Yes, it’s likely that over time, our society will be using increasingly renewable and less-polluting energy sources. There are clearly growing social demands for cleaner fuels – a reality that forms part of the opportunity for our recommendation.

Is Australian oil an oxymoron?

Despite the plethora of Australian listed stocks with the word ‘oil’ in their names – 29 at last count – Australian oil production has been in steady decline since the turn of the century. Between 2000 and 2009, oil produced in Australia has fallen by one-third. Measured in years of production, Australian reserves are less than half of the rest of the world, at just over 20 years.

What we think of as the Australian oil industry can be more accurately termed the Australian oil and gas industry – and probably not in that order. In fact, Australia produces over 60% more natural gas than oil (measured in tonnes of oil equivalent).

For ease of transport, natural gas is converted to a liquid, or liquefied – hence liquefied natural gas or ‘LNG’.

It should be noted that LNG doesn’t pack the same punch as oil, per unit of volume, so we can’t make a direct comparison of cost or volume. It is also ‘cleaner’ than oil; LNG is the least polluting fossil fuel, measured by carbon dioxide output per unit of energy produced.

Our Best Stock for $100 Oil is a microcosm of the Australian oil and gas experience, and has a lot to gain from both the continuing demand for oil and the increasing move to LNG as a substitute.

Same, same but different

Oil extraction is a relatively commoditised business. The global price is largely homogenous (there are different types of oil, but each has its own transparent market). Lowest delivered cost nearly always wins, and only rising demand and scarce supply provide some relief for those suppliers who don’t have a low-cost advantage.

LNG shares some of those characteristics, but owing to the relative infancy of the industry (well, relative to oil, anyway) and the extraction and transport costs, pricing is not so straight-forward. In addition, these unique characteristics make LNG mining and supply very different from oil.

Simplified, oil is sold effectively at the market price, either at time of extraction or in advance through futures contracts. These contracts are traded on an open market, and demand and supply are largely known and predictable.

Show me the money

The nature of LNG extraction, however, requires contracted sales before the extraction has even commenced. The incredible cost of the mining infrastructure and transport arrangements (measured in the billions of dollars), and the relative absence of a reliable ‘spot’ market mean a miner cannot afford to have an LNG plant without completely or largely contracted sales.

Once secured, however, the demand risk is largely removed, leaving only operational risk to be managed (though that in itself can be significant).

Our Top Stock for $100 Oil

With all of this in mind, and eschewing the lucky (and all too often not-so-lucky) dip of speculative exploration, our Best Stock for $100 Oil is Woodside Petroleum  (ASX: WPL). The shares recently traded around $35.

Australia’s largest listed oil and gas producer, Woodside produced a profit of $1.6bn in 2010, on sales of $4.2bn – or more than $11.5m per day – up more than 20% on the previous year, despite falling production volumes.

A third straight year of falling production is evidence of the decline of the company’s existing active fields. Price increases on the back of higher oil and LNG prices have offset some of this decline, but the production trend is clear. Falling returns on equity are also evident, with 2010 delivering the lowest return on equity (ROE) for 5 years.

If all of that makes the company a strange choice as our preferred play on higher oil prices, you’d be right – until current events are factored in.

The future is bright – and gas-powered

An investing truism  holds that just as you can’t drive a car by looking only in the rear-vision mirror, you shouldn’t invest only by looking at historical financials.

As the usual disclaimer goes ‘past performance is no guarantee’.

That principle underpins our interest in Woodside. While their ‘foundation’ business continues its natural decline as oil fields are progressively depleted, Woodside has juist achieved ‘ready for start-up’ status at its multi-billion dollar development of LNG fields off Australia’s west and north-west coast, known as Pluto. (As an aside, it’s largely this up front infrastructure investment that has driven the falling return on equity mentioned above).

Woodside has been busy securing customers for the first stage of development of the ‘Pluto’ field, and has active plans for further developments on the same field. Pluto 1 was due to commence distribution in March 2012, but production will commence in April or May.  The 2012 volume from Pluto is expected to be between 17 and 21 million ‘barrels of oil equivalent’ (BOE) and annual volumes are expected to be 37 million BOE once the facility has been bedded down.This potential, on top of current (if declining) production is what positions Woodside for success.

Riding Asian Growth

By Woodside’s own assertion, Asia is its target market, and as with iron ore, Australian LNG is in high demand there. The risks for Woodside aren’t inconsiderable – worldwide LNG reserves are growing strongly and more production is coming on stream.

Prices will be volatile, especially over short timeframes, and Woodside has execution risk, though that has mostly abated now that Pluto is almost on-stream. While oil gets all of the headlines, LNG is its heir-apparent – both if and when oil supply runs out, but equally as an alternative energy source to underpin continued Asian growth.

Overall, we think the current production profile presents significant downside protection, and successful delivery of Pluto should underpin the current share price.

Upside opportunity will come from further successful development of the Pluto field and other developments. Risks do exist, and these aren’t insignificant, but Woodside stands to benefit well into the future from the broader macro trends as well as the resource reserves under its control.

Accordingly, we believe Woodside is the best way for Australian investors to capitalise on $100 oil.

Take Stock

We trust you enjoyed reading our special free report, The Best Stock for $100 Oil.

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Last updated: 12th April 2012

This report has been written by Scott Phillips. Employees and contractors of The Motley Fool, including Scott Phillips and Bruce Jackson, may have an interest in any shares mentioned in this free report. These interests can change at any time. The Motley Fool has a clear and concise disclosure policy.