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Depletion of oil reserves is key underlying factor in investment outlook

by Wayne Cheveldayoff, 2005-05-05

Depletion is a familiar fact of life for those involved in oil and gas production but it is unfortunately little understood by most Canadian investors even though it is likely to be the key factor in the investment outlook for many years to come.

The ongoing depletion of oil and gas reserves explains why the world seems to be short of oil even though oil and gas companies are finding more every year.

In fact, depletion, because of its impact on oil prices, is the key reason behind the upswing in inflation and interest rates and why economists are toning down their economic growth forecasts.

Depletion, in effect, explains why some stocks, mainly those of oil and gas producers, have done so well this year while many others haven’t.

Put it another way, if you as an investor are on the right side of the effects of depletion, you are going to have much better success in growing your portfolio in the coming years.

Here is how depletion works. When a new oil or natural gas well starts flowing, it is usually at peak production. From there on, output gradually declines.

In much of the United States and Canada, the decline rate is 25 to 30 per cent a year for conventional natural gas wells and something in the order of 5 to 10 per cent a year for oil wells.

The only way for an oil and gas company to keep up production is to drill new wells and find more oil and natural gas.

The industry has been extraordinarily successful for decades in finding new sources of cheap oil around the world to offset – indeed exceed – the ongoing depletion of oil reserves.

But, this already has, or is about to, come to an end. Total oil production in the United States reached a peak in 1970 and has since declined to about half of peak level. Russian oil production peaked in the 1980s.

Now, the world as a whole is reaching peak oil production at around 84 million barrels a day. Some oil experts think we are already there, while others say it is still a couple of years away.

In the meantime, demand continues to grow. The International Energy Agency says world oil demand rose 3.4 per cent last year and is expected to rise 2.1 per cent this year.

OPEC, which is pumping around 28 million barrels a day, is trying to meet higher demand but appears to have run out of significant excess capacity for the time being.

Whether we’ve reached peak oil production worldwide or it is close, what is critical is that after the peak, oil production will decline. Henry Groppe, a long-time oil consultant and forecaster with Houston-based Groppe, Long and Littell, believes the decline worldwide will be about 5 per cent a year, or 4 million barrels of oil a day.

“To offset that, we have to find and bring on stream all of Saudi Arabia’s production approximately every two years. It can’t be done.” In effect, he says, the world has run out of cheap oil and prices have to remain high both to stimulate exploration and to restrain demand so that it will match up with what will be declining production.

Mr. Groppe is an advisor to Toronto-based Middlefield Group and his comments can be accessed at the fund manager’s website www.middlefield.com.

Based on his analysis, Middlefield has continued to maintain a bullish stance on oil and has recently launched a closed-end fund, called Vector Energy Fund (prospectus at www.sedar.com), which is designed to provide investors a combination of income (distributions targeted at 9 per cent a year) and growth, as its portfolio will be split, initially 80-20, in oil and gas royalty trusts and exploration companies, including those in the United States.

Investors who have reached the same bullish conclusions can also invest directly in oil and gas royalty trusts and exploration companies and in the several energy and natural resource-focused mutual funds available to Canadians.

One caution is that oil prices are likely to be very volatile as the oil market goes through numerous adjustments and there will likely be large short-term swings in equity and fund valuations.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.



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©2005 Wayne Cheveldayoff