The Oil Horror Picture Show

I don’t like to scare people.

Okay, maybe just a little.

In fact, in a previous life, I used to actually write horror stories. The highlight of that mercifully short-lived career was when one of my pieces â€” “Lord of the Creepies” â€” was included in an anthology of 1990’s best horror stories.

These days, I don’t need to make up grim fiction: A very real horror story involving oil is unfolding right in front of us.

But before you cover your eyes, remember, with any crisis comes opportunity for savvy investors. Just like in horror flicks, those who take decisive action often reach the happy ending.

A Very Scary
Picture, Indeed

I’d like to show you a chart I found on OilCEO.blogspot.com. It shows oil production versus price.

In a nutshell …

When prices explode, producers typically ramp up production to take advantage of it.

The scary part: This time around, despite a huge price increase, production is not growing. In fact, no matter how hard they try and no matter how much they may want to increase production, it seems like they’re unable to:

In July, crude oil production by members of the Organization of Petroleum Exporting Countries (OPEC) declined 0.8%, down an average 250,000 barrels per day (bpd) to 29.61 million bpd.
June production was also revised lower.
And this has been the trend for months. OPEC’s production actually peaked in October 2004 at 30.54 million bpd.
Non-OPEC producers are also running into trouble. (More on this in a moment.)

This is why I’ve had a short-term oil price target of $88 a barrel, and a longer-term target of $100 per barrel within a year.

And that’s without a glitch!

But two days ago, that glitch happened, and it’s a big one:

The Prudhoe Bay Monster

A quick summary of what happened:

Severe corrosion in their Alaskan pipelines has forced BP, the operator of and the world’s second-largest oil company, to shut them down. The company is still not sure whether a total shutdown is required.

Tests found losses in wall thickness in the pipeline of between 70% and 81%, despite BP’s anti-corrosion program that was designed to prolong the oil field’s life by another 50 years.

BP will now have to repair or replace 16 of the pipeline’s 22 miles. According to the company, the process will take “weeks or months,” and the shutdown is “indefinite.”

This is a monstrous disaster. It will cut production by 400,000 barrels per day. That’s 2.6% of total U.S. oil supply, or 8% of domestic production. More importantly, that’s about 40% of the excess oil production of the entire globe.

If the Mainstream Media
Only Had a Brain

The media covered the story when it first came out, but they never bothered to drill down or ask the right questions.

Question #1. Since BP’s 22 miles of transit pipelines feed into the 800-mile-long Trans-Alaska Pipeline, is the Trans-Alaska suffering from the same unexpected corrosion?

I mean, the oil that comes out of Prudhoe Bay, through BP’s pipes, is then pumped through the Trans-Alaska.

Moreover, BP relied on ultrasonic technology to tell it if the pipes were okay. We now know how much this technology is worth â€” not much. After all, everything seemed fine until a leak suddenly sprung.

Question #2. Is the same technology used on the Trans-Alaska?

BP is replacing 73% of its pipes at Prudhoe. If the same percentage of the Trans-Alaska is damaged, that would be 584 miles of pipeline. That is a lot of pipe! Not exactly something that can be replaced on short notice.

Question #3. Can we always rely on our foreign friends to replace the missing oil? No …

Don’t Expect Our Friends
To Come to the Rescue

As of May, the countries supplying the most oil to the United States were Canada (2.172 million barrels per day in 2005), Mexico (1.646 million bpd), Saudi Arabia (1.523 million bpd), and Venezuela (1.506 million bpd).

Let’s take a hard look at each of these countries …

Canada’s total crude oil production has been dropping since 2004, and is down 11% since December, according to the Energy Information Administration (EIA).

“But don’t worry,” says the Canadian Association of Petroleum Producers. That product, they claim, should get back up to the 2004 level starting in 2010, thanks to oil sands.

Trouble is, they want you to ignore the fact that every cubic meter of oil produced requires two to five times as much water. In other words, a million barrels a day of oil production translates into roughly 2 to 4.5 million barrels of water used in that same day.

Just among the oil sands projects now planned, the water use will increase to 529 million cubic meters, according to the Pembina Institute’s report, “Down to the Last Drop.”

Considering that the drought in North America is worsening, there may be better uses for Canadian water. Water or oil â€¦ that’s a tough choice, isn’t it?

Mexico’s giant Cantarell oil field â€” the world’s second-largest by volume â€” is declining quickly, already hitting a four-year production low.

Last week, Petroleos Mexicanos, Mexico’s state-owned oil monopoly, said that production at Cantarell will decline 8% in 2006. That’s faster than its December estimate of a 6% decline.

According to experts, Cantarell could be headed for a “catastrophic” decline, due to seawater intruding the offshore field. The Mexican government keeps assuring everyone that “all is well” â€” even when it can’t afford to buy steel pipe!

Saudi Arabia, the “Central Bank of Oil,” is rushing to rent offshore drilling rigs and will spend $283 billion in the next seven years on oil facilities and oil infrastructure.

And yet, despite opening a new oil field at Haradh, oil flows from the Saudis have shrunk by 400,000 barrels a day over the past few months. The Saudis say they’re adding lots of “spare” capacity. Funny, how can they do that when they can’t even pump at regular capacity?

The Saudis are also looking to tap “heavy” oil (Canadian oil sands). That’s odd for a country with a desert full of crude, don’t you think?

Venezuela’s oil reserves (79.7 million barrels) rank 7th in the world, and the country could take the #1 spot if just 10% of its three trillion barrels in the Orinoco basin is deemed recoverable. But this “heavy oil” will be very difficult to get out of the ground.

Venezuela currently provides 15% of our oil. Looked at another way, we buy 60% of Venezuela’s production. Nice numbers, but they believe the fact that this is a match made in Hell.

Venezuela’s leader, Hugo Chavez, hates George W. Bush with a passion (it has something to do with Bush supporting two failed coups against Chavez). Anyway, he’s determined to sell his oil to other people. To that end, Chavez has …

Signed new supply agreements with China, India, Jamaica, Haiti, Paraguay, and Bolivia.

Hiked taxes and fees on foreign oil companies operating in Venezuela much higher.

Brought in the Iranians to help him develop his oil after scaring off the Europeans.

Shipped tankers of oil to China and India, markets that are up to seven times farther away than our shores. He’s doing this even though its eats into his country’s oil profits!

As a result, Venezuela’s oil shipments to the U.S. fell 6% in the first four months of the year.

And Chavez is just getting started. In May, Petroleos de Venezuela said it planned to buy 18 oil tankers from Chinese shipyards at a cost of $1.3 billion.

The goal? To allow increased shipments to Asia. Chavez plans to boost his oil exports to China from 80,000 barrels per day at the end of last year to 300,000 barrels per day by the end of this year.

The End of
Double-Digit
Oil Is Near

When you add up our domestic problems and the things happening with our four main suppliers, it’s easy to see that we’re in big, big trouble.

Bottom line: Oil at $100 a barrel might be much closer than many people realize, and double-digit oil may be a thing of the past.

But there’s no reason to panic. In fact, if you play your cards right, you could protect your portfolio and make a pile of money.

Consider taking these three steps â€¦

First, consider putting money in a good oil and gas mutual fund. One that I like is Profund UltraSector Oil & Gas (ENPIX). It uses leveraged instruments to deliver 150% of the performance of the Dow Jones U.S. Oil & Gas Index.

Second, look at Canadian royalty trusts. Our favorite remains Enerplus Resources Fund (ERF). It has nearly 3,000 natural gas wells and 2,000 oil wells. What’s more, Enerplus pays a hefty dividend â€” it yields more than 8%! And this week, it just made new, all-time highs.

Third, invest in the right energy stocks. Individual stocks are more volatile than funds, but they carry the potential for greater reward, too. Right now, I’m looking at smaller energy stocks that are still growing internally, in places that are geopolitically stable.

It will be the smaller, more nimble explorers and drillers that stand to make a killing when oil goes to $80 … $90 … and beyond.

Good luck and good trades,

Sean Brodrick

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