The world gets about one-third of its daily oil supply from offshore wells. Over the next decade, this share should grow even larger. Dr. Michael Smith, CEO of EnergyFiles Ltd., has published the most comprehensive research I’ve seen on the world oil supply situation. He’s a very experienced geologist and now consults for the industry. I featured his work in the May issue of Strategic Investments.

In a recent publication, Dr. Smith notes:

Rigs are more costly than ever, and new drilling technologies are very expensive with high startup costs that have led to a consolidation of service providers. Meanwhile, shortages of opportunity, the profitability of the industry, and the historic actions of OPEC with its oil conservation policies have ensured that even the most expensive and marginal of offshore drilling projects go ahead.

In the nearby chart depicting Dr. Smith’s global oil supply forecast, you can see that offshore sources provide about a third of total supply. The gray bars in this chart are historical and projected discovery volumes, the solid black area is onshore production, and the solid red area is offshore production. If the declining trend in discovery volume (gray bars) continues downward, oil supply will have a very hard time keeping up with demand. This is likely, in Dr. Smith’s view, to open up a supply gap by the middle of the next decade - i.e., the “post-peak” part of Peak Oil.



So what, besides higher prices and lower consumption, will be the free market’s main response to Peak Oil? Accelerated exploration and drilling activity.

Deepwater oil drilling in particular should continue growing rapidly. After reaching their peak production rates, offshore wells tend to decline much faster than onshore wells. This tendency means that offshore oil production is more drilling-intensive than onshore production. So the offshore drilling industry is likely to remain very busy for decades to come – a likelihood which will spur growing demand for products and services throughout the offshore drilling production-chain. Floating production systems (FPS), for example, will enjoy booming demand.

Considering the costs and engineering involved, it doesn’t make sense to lay oil and gas pipelines underneath 5,000 feet of ocean water, so the industry is increasingly turning to FPS solutions. A recent issue of Petroleum Review provides figures:

The FPS concept has proved to be a cost-effective method of developing both marginal and world-class offshore fields worldwide. According to the Douglas-Westwood database, by year-end 2006, there had been a total of 290 FPS installations in the various regions of the world. Of these, 187 are currently installed and operational. To date, the Western Europe region has seen the greatest number of FPS installations - 22% of the total - followed by Latin America (21%) and Asia (20%).

Credit Suisse’s energy research team recently published a report that explains why it expects oil prices to average roughly $70 per barrel over the rest of the decade - one of the most bullish oil forecasts on the Street. The team writes:

Production shortfalls, notably in Mexico and the North Sea, longer project development times, restricted global reinvestment, and the maturing of Russia’s Brownfield renaissance, are all [contributing to] global oil decline rates…Decline rates are generally lower in OPEC countries and are currently highest in countries such as the U.K., Norway, and Mexico… Offshore decline rates are meaningfully higher [emphasis added]. If we combine our assumptions for decline rates with our list of new projects in both OPEC and non-OPEC, we [face] a potential production shortfall by 2010.

It is possible that we are not capturing all of the reinvestment trends currently taking place, and the data for OPEC are notoriously incomplete, but the implication is clear: Either supply needs to decline less quickly, or net new investment needs to rise to prevent a supply squeeze around the end of the decade… This piece of our market analysis again suggests that the resolution of the oil cycle will need to take place mostly on the demand curve [emphasis added], where changes are slower to take effect, but where there is still room to moderate consumption growth in the next five years.

Translation: Demand growth will be increasingly constrained by available supply…and oil prices will likely rise. To capitalize on this powerful long-term trend, I’ve recommended several offshore oil services and drilling stocks in the pages of my investment letter, Strategic Investment.

Here’s a brief synopsis of the stocks I’ve recommended. ENSCO Intl. (ESV), an offshore contract drilling company; NATCO Group (NTG), which provides wellhead equipment, systems and services – both onshore and offshore; National Oilwell Varco (NOV), which designs and sells various products used in oil and gas drilling; and Grant Prideco (GRP), which produces tubing products for oil and gas applications. (I wrote about three of these fours companies in prior editions of the Rude Awakening. So if you’re interested in a little more detail, you can check out the following links. To read the July 12, 2006 column about Grant Prideco, click here: Nodding Donkeys. To read the September 18, 2006 column about ENSCO, click here: “All Aboard“. And to read the March 1, 2007 column about National Oilwell Varco and Grant Prideco, click here: “Drilling Down“)

Now that the post-peak oil world is upon us, offshore reserves will assume growing importance to the world’s oil supplies. This trend means that good things will happen to the offshore drilling industry. So we think folks can do themselves a favor by investing in the leading companies of the offshore drilling industry and hanging on for the ride. Please check in tomorrow, when my colleague at Outstanding Investments share a few more ideas about the offshore drilling industry.

Regards,

Dan Amoss
The Daily Reckoning

Dan Amoss, CFA, is managing editor for Strategic Investment and a contributing editor for Whiskey & Gunpowder. Dan joined Agora Financial from Investment Counselors of Maryland, investment advisor for one of the top small-cap value mutual funds over the past 15 years. Dan brings to Strategic Investment the unique experience of an institutional background and a drive to seek out the most attractive investments within favored "big picture" trends. He develops investment ideas for SI readers with a global network of geopolitical and macroeconomic analysts. Copyright © 2007 Dan Amoss