Two Energy Stocks For a Post-Oil-Spill World

With the failure of the BP PLC (NYSE ADR: BP) "top kill" strategy, the Deepwater Horizon oil spill takes on a more serious hue, both for the Gulf of Mexico environment and for BP itself. If it indeed proves impossible to cap the oil flow before August, public anger against BP and against deep-sea drilling in general may put BP out of business and set deep-sea drilling around the United States back for years.

The business fallout from the oil spill could be widespread. As was true of the Three Mile Island nuclear accident of 1979, the Deepwater Horizon oil spill could end up causing massive damage to companies that were in no way involved with the BP tragedy. Risks of different types of operation will be reassessed, new rules will be enacted, and the energy business will change radically.

Smart investors will anticipate these changes.

Spilling Secrets

Oil drilling in shallow waters offers only moderate environmental risks. But deepwater drilling is an altogether different animal. It involves much higher pressures, and much greater risks - both to the environment and to companies in the business. Oil leakage from the Deepwater Horizon oil spill may cause a great deal of damage that is nevertheless mostly temporary, with ecosystems recovering in a year or two once the oil spill is cleared.

However, there is huge political damage to the deepwater drilling business - especially to BP and the other oil companies involved. Moreover, the economic damage from clever lawsuits, filed by the eternally and infinitely greedy trial bar, can put even the largest companies - such as BP - out of business. Further, thanks to U.S. Attorney General Eric H. Holder Jr., there is now the danger of criminal prosecutions. As poor Jeffrey K. Skilling of the now-defunct Enron Corp. found out, in a politically poisonous atmosphere, these prosecutions can land a luckless executive in jail for decades.

For the oil companies, there may be structural solutions to this. If I were an oil company wishing to engage in deep drilling with today's knowledge and technology, I would ensure that the deepwater-drilling rig was owned and operated by a thinly capitalized master limited partnership (MLP), with most of the debt being raised through non-recourse junk bonds, and with both the debt and equity being owned by retail shareholders.

I would "second" my experts and other technicians to the MLP - meaning I wouldn't employ them directly - and would content myself with an offtake contract for the oil, at some price that covered the MLP's debt service and left something for its shareholders. If that lot were drafted skillfully, I could basically ensure that if something went wrong, there would be no "deep pockets" for the lawyers to sue and no real venture for the government to harass.

To those who would characterize my plan as immoral, here is my response: Why should the largest oil companies get involved in the deep-water-drilling business if their entire assets can be endangered by an accidental oil spill at one well?

A Growing Global Problem

Don't make the mistake of thinking that oil-spill risks are just a U.S. problem, either: Brazil's Tupi oil field - supposed to be the largest discovery in the last 30 years - sits beneath 7,000 feet of sea and another 22,000 feet of sand, rocks and salt. Given the experience with the Deepwater Horizon spill, and given the technology that would be brought to bear, the Tupi reserves must be equally vulnerable to blowout.

If it were in the hinterlands, this might not matter - the Brazilian government has traditionally not been particularly environmentally conscious, to say the least. However, the Tupi oil field is only 250 kilometers (155 miles) from Rio de Janeiro - and the famed Copacabana Beach.

For the main operator, Petroleo Brasileiro SA (NYSE ADR: PBR) - better known as Petrobras - this may not matter much, since the Rio-based firm is majority owned by the Brazilian government. But I wouldn't want to be a deep-pocketed foreign shareholder in a Tupi project. Nor would I wish to be a deep-pocketed foreign-equipment supplier to the project, either.

After the Three Mile Island accident, power companies learned that however attractive were the economics of nuclear power, the small possibility of a frightening accident - and the minute probability of a truly catastrophic accident - made the political and economic harassment of building nuclear power stations in the United States not worthwhile.

Not surprisingly, there have been no nuclear power stations begun since 1979, and many begun before then were abandoned half-built. In the period between 1970 and 1992, according to studies at that time, only 39 workers at nuclear power plants suffered fatal accidents. That compares with 6,400 at coal-fired power plans, 1,200 at natural-gas power plants and 4,000 public deaths from hydroelectric plants. Nevertheless, the small and almost-theoretical risk of major disaster has made nuclear power uneconomic.

The same may now be true for deep-sea oil drilling.

The Economics of Energy in a Post-Oil-Spill World

For the energy business, therefore, the solution is clear. In a post-oil-spill world, potentially catastrophic risks or environmental damages - even if their likelihood is very remote - add so much to the cost of operations for large companies as to make the projects not worth undertaking. However, in other energy businesses the overall dangers and environmental risks may be greater, but they are relatively contained and certain, so the risks and costs to operators are much less.

Coal mining is one such business; even today, between 20 and 50 coal miners are killed in the United States each year (and 5,000 in China). But because the costs are known and relatively stable, the political and economic risks are only moderate.

In the oil business, the three environmentally damaging - but stable - businesses are onshore: tar sands, oil shale and shale oil (don't blame me, I didn't name them!).

Tar sands, notably in Alberta, are viable at oil costs above $50 per barrel, making that oil highly competitive in today's markets. Oil shale - oil-rich rock that can release oil if heated to around 1,000 degrees Celsius - is not yet fully economically viable, but could be in a few years if prices keep rising. Shale oil is oil trapped in sandstone, which can be released by "frakking" (fragmenting) the rock, and is viable at current prices.

Canada's tar sands are estimated to contain 1.7 trillion barrels of oil, about as much as the entire Middle East. Colorado's oil shale contains about 1 trillion barrels.  Shale oil comes in less-exciting quantities: The Bakken oil shale in North Dakota contains about 4.3 billion barrels, only enough to satisfy two months of U.S. demand, but still enough to make companies rich.

All three of these oil-extraction processes are messy, causing major environmental damage to the mostly remote areas where they are undertaken. There's no doubt that they're also dangerous, in one manner or another. However, provided proper care is taken with groundwater and other environmental issues, the chances of a real catastrophe are nil, meaning they remain financially attractive.

If deep-sea drilling becomes impossible - creating supply shortages that push up the price of crude oil - the near-term big gainers will be those firms involved in the tar-sands and shale-oil markets. In the long run, we can predict victory for oil-shale producers. The one proviso is that investors should stick with firms operating in politically stable areas (which rules out Venezuela).

Here are a few examples to consider:

  • Cenovus Energy Inc. ( NYSE ADR: CVE) is primarily a tar-sands producer, with 719 million barrels of bitumen reserves mostly in Alberta, although it has conventional oil and refinery operations, as well. Based on first-quarter 2010 earnings annualized, Cenovus trades on about 13 times operating earnings, a very reasonable multiple.
  • Whiting Petroleum Corp. ( NYSE: WLL) produces oil and natural gas (mostly the former), primarily from North Dakota's Bakken shale, where the Denver-based firm has an extensive drilling program. Based on first-quarter earnings, Whiting's shares are trading at about 17 times earnings, still a reasonable multiple if you think oil prices are headed higher.

[Editor's Note: Money Morning readers are often amazed by Martin Hutchinson's profit-focused instincts - as evidenced by his unerring ability to paint a picture of what's to come. He's able to show us the big profit opportunities that are still over the horizon - while also warning us about the potentially ruinous pitfalls hidden just around the corner.

So it's no surprise that Hutchinson has pulled off a string of forecasting successes in the face of the worst financial crisis since the Great Depression - a financial crisis that, not surprisingly, Hutchinson is widely credited for having predicted and warned about well ahead of time.

For those who aren't regular readers, and who might like an additional illustration of Hutchinson's abilities, consider dividends, the icon of the super-conservative investing set, and gold, the safe-haven nest of perpetual inflation hawks.

With his "Alpha Bulldog" investing strategy - the crux of his Permanent Wealth Investor advisory service - Hutchinson has managed to combine dividends, gold and growth into a winning, but low-risk formula that has developed eye-popping returns for subscribers.

To take a moment to find out more about the opportunities related to dividends, gold, "Alpha-Bulldog" stocks and The Permanent Wealth Investor, please click here. You'll likely find it time well spent.]

News and Related Story Links: