Haywood Senior Oil and Gas Analyst Alan Knowles says we haven’t seen a bottom yet, advising investors to watch the large companies when the market strengthens again. Meanwhile, demand continues to slide as OPEC plays catch up on a series of announced production cuts. And a pilot project involving a new oil sands technology is exceeding expectations; Knowles explains the significant advantage of upgrading oil in situ and foresees a bright future for the company that patented it.

The Energy Report: Alan, do you think we have seen the bottom yet? When we get to the bottom, how will the oil and gas sector fare against other sectors in terms of rebounding stock prices? Will they lead it, be in the middle, or lag?

Alan Knowles: I know a lot of investors were buying stocks at the end of November because they thought they were seeing the bottom then and we saw some strength in the market at the time. And as we know the market has fallen drastically since then. I don’t think we have all the bad news yet.

As far as the energy businesses go, the oil business will be stronger. You need oil to do your business. The economy thrives on the use of hydrocarbons, as you well know. I have had fund managers ask me ‘what does this company look like with a $30 oil price?’, and so that is the kind of concern that’s out there. Until we have some clear picture of where the bottom is, share prices will continue to erode. I don’t think there’s too much concern over whether prices will come back over time. They definitely will; it’s a cyclical business. You should be forecasting based on the future expectations.

Right now, the spot price is $43 to $45; but if you go out to December 2010 it is $65, and December of 2011, it’s $71. So, that’s the kind of trendology, if you will, that people think is going to happen here. It might happen sooner because these same contracts that are $45 today were $148 last summer, so while the futures indicate current market sentiment, they are not the best indicator of future prices. The contract that we’re talking about right now is the one for January delivery. Futures are not by any means a crystal ball on the world.

TER: As an analyst, what are you looking for to determine when we hit a bottom? What’s the formula you’ll use?

AK: Well, it’s not a formula. I’d like to see some clear indications that buyers are coming back into the market, and we don’t see that right now. There’s limited buying. I know a lot of funds are continuing to buy a little bit every day, and they’re averaging down, essentially, with the view that in two years anything you buy today is going to be doing very well. But you want to make sure you buy a company that is going to be around in two years; hence, the balance sheet focus.

So many investors have a one-, two- or maybe a three-month investment horizon. We were a little spoiled with the kind of strong returns one could achieve in the last several years. Now, I think you have to get back to the fundamentals and the longer-term view on life and you can do quite well. But if you try to make a lot of money in a short period of time in this market, you’re going to get hurt.

TER: If someone has a longer-term horizon, would this seem like a good time to start getting in? I mean how much more can oil go down?

AK: Well, people said that same thing when oil was $55, and now it’s $10 less. So, there’s nothing wrong with waiting for a clear bottom to be formed, and then maybe you wait until the stocks start to come up or the oil price starts to rise. But at least you’re not going to be putting money into a down market. It may be well into the New Year before this point is reached. There’s still selling pressure; as well there will be a lot of tax-loss selling going on between now and the end of the year.

And I think that’s going to put some—let’s call it arbitrary—downward pressure on the stocks that has nothing to do with the fundamentals, because, at the beginning of the year, there were a lot of people who had a lot of capital gains. If they realized those capital gains, there’s going to be tax-loss selling, and then you will consolidate your stocks into positions that you think will rise the quickest when the market starts rising again.

TER: As I look at the oil business, the price of crude oil is down to $43 today, which I believe is up a little bit from Friday. I look at the U.S. dollar appreciating, and OPEC decreasing production. What’s going on here?

AK: Well, OPEC is reducing production, but so far they’re probably not even at the reductions they made at the September and October meetings, at least it hasn’t been verified. And then on the demand side, we’re seeing the OECD demand decreasing, and the current estimates are that non-OECD demand is increasing by an offsetting amount so that year-over-year in ‘09 you’re looking at no overall demand growth. But the problem is that I think the OECD demand estimates are probably too optimistic. It probably should be lower. And the same with the non-OECD, so the net-net is going to be (the more likely scenario) a decrease in demand in ‘09 over ‘08—a situation we’ve experienced only once since World War II.

TER: Is this decrease in demand being fueled (pardon the pun) by the recession, or by Green/Alternative Energy coming into play? What’s causing it?

AK: It’s not the Green Movement; in fact, with the decrease in commodity prices, the alternative energy efforts are actually struggling because, in the current environment, people are less willing to commit dollars to the more-expensive energy options. The recession has certainly had something to do with it. Prior to this, the $140 oil did set in motion the demand destruction—you saw people driving less and costs went up for airline flights, so people weren’t flying as much. Now that the price has come down, that ball had already been set in motion, and then it gets compounded (in the U. S., particularly) by the banking situation, which has caused a lot of destruction of wealth, so people just aren’t buying goods. Then the lack of buying goods put people out of jobs, people don’t buy as much, goods aren’t being transported around the country, and transportation is one of the single largest uses of hydrocarbons.

TER: So, the fact that gas pumps are down to $2 a gallon isn’t so much the cause for the drop in oil price, but really the drop in transportation of goods around the country?

AK: Well it’s everything, and Europe pretty well followed. Europe had a lot of the same problems as the U.S. with the financial sector and it similarly suffered, having to put a lot of money into the banking sector. So it’s not just the falling prices; if that were true people would be driving again.

Demand is down, therefore, car sales are going to be down—and all those goods get shipped around the continent. And then demand for goods from China, which obviously makes a lot of goods that are shipped around the world (including North America), are going to be down. Consequently, China’s going into an economic downturn and its demand for hydrocarbons is down as well.

TER: Everyone keeps talking about China as somewhat decoupling from the Western economies because it has a growing middle class, and that middle class is starting to demand things like inexpensive cars. Do you see that taking up the slack of the lack of driving and transportation in the Western countries?

AK: No. There’s been a downturn there as well. For example, if a company—Wal-Mart is a good example— if companies are not making goods to be sold by Wal-Mart around the world, then they have to lay off people in China. So people are getting laid off in China I am sure, and they have had to put stimulus packages into their system as well, although not to the same degree as in North America. And so their economy is still on the positive side, but not growing like it was.

TER: Alan, when you talk about the Saudis "getting their house in order," in terms of verifiable decreases in oil production, do you, as the analyst, really see that happening? Do you trust their statements—that they are going to decrease production; and how do we verify that, going forward?

AK: It’s not just the Saudis—it’s OPEC and all the countries in OPEC. How do we verify that? Well, you track tanker movements around the world; that’s one of the most visible ways for third-parties to do that. To the end of October, they were off side by about two million barrels a day from where they said they were going to be, and by the end of November, average production was still off side by a million barrels a day. So, for them to come out here two weekends ago and announce another cut when they really weren’t there yet on the previously announced cuts—their credibility would have suffered. And their credibility is an issue, so there is very much a “wait-and-see, and are-you-going-to-do-it–or-not.” I think that’s why they’re waiting until their meeting coming up here in less than two weeks now. [Note: a week after this interview OPEC announced an incremental 2.2 mmbbls/day cut in production taking the total for the past three months to 4.2 mmbbls/day].

TER: Once they cut the amount, how quickly can they cut the production? Is there normally a delay or can it happen overnight?

AK: Well, once they announce it, it’s allocated to the 11-member countries of OPEC, excluding Iraq. And it’s up to each country to cut its pro rata share of, let’s say, that 1.5 million split between the 11 countries. Now, the Saudis are the biggest, and they seem to have the most flexibility. They are the swing producer within the group, but every country is supposed to do its own share. You can’t just shut in the wells, or even a field quickly. There are procedures to go through to shut in the wells properly. Otherwise, you could damage the well or the reservoir, which could cause some problems when you do want to bring back production.

But assuming that they went from the end of October—from the October average to the end of November—let’s say that they decreased their production evenly through the month as they were shutting these wells, as I mentioned. They’d still be off side by 5-700,000 barrels a day from their 2.0 mmbbls/day target. I think they probably are using the two weeks following that last meeting before the next to get as close as they can to their targets to have some credibility for the additional cuts.

There is no doubt that the Gulf States are particularly hurting with these low prices. They have significant ongoing infrastructure projects in their countries. Costs have gone up for their new production; old production has low costs associated with it, but anything new has a higher cost especially infrastructure projects or grassroots.

TER: That’s true worldwide; new production is going to cost more than the older. That’s not just a Saudi Arabia issue.

AK: No, it’s not, but a lot of people associate Saudi Arabia with costs like $5 or so a barrel and that is the case for their old production. But in terms of the new production, they are faced with the same cost pressures as the rest of the world. There is a sense, I guess, among people who don’t spend too much time on it that their cost base is quite low . . . and it’s not for new production.

TER: Do you agree with the concept of peak oil, and have we gotten there yet or do we have numerous decades to go?

AK: Well, I do agree with the peak oil theory, and there’s evidence that it’s happening. The reason we got to $140 oil is the supply and demand numbers were coming together. There wasn’t a lot of excess supply. Let’s say there was an extra 1.5 to two million barrels between OPEC nations, but that isn’t necessarily easily brought on stream. It would be there, but it might require some capital, and there is some question whether those estimates are even valid as to how much extra there is. But the point is that you are getting to a level that it’s hard to replace natural declines.

As a result of this low price, a lot of large projects are either outright cancelled or deferred. And we have seen a lot of that in the oil sands; probably, when all is said and done, we might see the deferral of between half a million and a million barrels of production. The world is producing 86 million barrels a day now; the decline rate in that production is 6% to 7%. So, just to keep production flat, you have to add five to 5.5 million barrels of production a day per year. In order to meet demand forecasts for 2030, you have to get up to 106 million barrels a day. When you’re deferring projects that add up to the numbers I just mentioned, you’re going to be hard-pressed to come even close to those numbers because once a project is deferred, it’s going to take a year or two just to get back on the drawing board and for the boards of directors to approve it again because the costs will be different.

TER: If everyone recognizes that our production rates are diminishing and our demand, even in a slowdown, is increasing and we have a replacement issue, eventually the oil price has got to go up. Why wouldn’t that future demand cause the current price to go up?

AK: Because the market really tends to pay attention to the near term and near-term prices with decreasing demand, we’re probably looking at low prices for the next year, at least, if not two years. But then when demand does come back, economies strengthen and demand comes back around the world, we’re going to be in an even tighter situation than we were last summer because so many projects—even conventional drilling, a well here, a well there—producers are not going to drill them because at $45 it doesn’t make economic sense to drill those wells. So, it will mean the supply and demand balance will become even tighter and the two will probably get off side even quicker than what happened this last time because projects that were in the queue here a year ago aren’t in the queue now.

TER: So, it sounds like we’re going to yo-yo a bit. We’re going to go from our $140 in July down to something low, and then back up to $140 or more within a couple of years when the economies start to turn around.

AK: Yes, I am not sure how many years it will take. It could take five years. It might even take a little longer, but because the bigger projects have longer lead times, they’re the ones being cancelled; we are running the risk of being whipsawed significantly on the supply side.

Tune in tomorrow for Part 2 of this article.

Alan Knowles joined Haywood in 2000, having previously worked as a senior oil and gas analyst with two Canadian investment firms. In addition, he has held senior financial positions with Petrorep Resources and Sceptre Resources and has over 20 years of oil and gas industry experience. As a key member of Haywood's oil and gas research team, Alan covers a broad mix of energy producers that range from senior to intermediate to emerging companies.