August 2006

"My Fellow American, Civilisation As We Know It Is Coming To An End"
Or
Buy, Sell or Hold BP?


We holidayed in the UK this Summer, which for me is always a delight - far preferable to the sun-blasted rotisserie of the Mediterranean, favoured by Mrs Train. The only blot on the Lake District landscape, though, was the expense of getting around it. As you may have noticed, the cost of petrol has gone up rather.

The anguish of refuelling our gas-guzzler set me to thinking about the oil price and BP - related issues that have been nagging at me all year. We own little or no BP, which ranks as an error over Lindsell Train's five year history. Having said that, the performance of the stock is curious, to say the least, particularly in relation to the oil price. In fact, BP has now marginally underperformed the FT All-Share over the past 18 months and more noticeably over the past six. More to the point, though, it is startling to note that the £5.86 price that BP traded at for one day, on June 14th 2006, was lower than the level it reached in April 1999, when it first hit £5.90 and it traded comfortably above £6.00 for part of that year, in line or better than today's £6.05, of over 6 years later. So, during a period when the oil price more than quadrupled, BP's share price has gone sideways (ignoring the very considerable dividends and buy-backs). By contrast, between 1991-1999, when crude oil basically traded flat to down, BP's stock gained six-fold. The question is begged - Is BP actually a proxy for the oil price at all?

To explore that seeming conundrum, I revert to a conversation I had earlier in the Summer with a friend of mine who runs a commodity/natural resources hedge fund. He is an all out bull (and is planning to construct a new wing to his mansion from the resultant performance fees). However, when I asked him what an oil price of over $70 actually means for us all, he became sombre. "Nick", he said, "this is a problem for the world that capital markets will not be able to solve". Next day he emailed me a document, over 100 pages long, entitled "The Oil Age Is Over", written by an American lawyer, one Matt Savinder, who opens his jeremiad with the title of this note. Civilisation as we know it, he argues, is coming to an end.

Savinder's proposition is this - "The Earth was endowed with 2000 billion barrels of oil. We have used about 1000 billion barrels. As of 2003 (he wrote in 2004), we consume 28 billion barrels a year. 1000 billion barrels divided by 28 billion equals 35.7. We have 35.7 years of oil left." He notes that the average age of the world's 14 largest oilfields, which between them produce over 20.0% of global supply, is now 46 years. Of the 44 nations worldwide that pump oil, 24 are clearly past their peak. US oil production topped out in 1970 and has declined at 2.0% pa every year since, despite all efforts. The Saudis have a proverb that summarises the argument - "My father rode a camel. I drive a car. My son flies a jet. His son will ride a camel." Or if Savinder is right, we will all be riding camels, at least those few of us left.

Few, because Savinder argues and it is hard to disagree, that "Oil-based agriculture is primarily responsible for the world's population exploding from 1 billion in the mid 19th Century to 6.3 billion at the turn of the 21st." Once the black stuff runs out, we will not only not be able to pootle around Borrowdale in our Toyota Land Cruisers, we will not be able to feed ourselves. He expects the planet's human population to fall from 6 billion to between 500m-2 billion, as a result of famine, pestilence and war. An example of the sort of unpleasant surprise Savinder anticipates is his suggestion that it will not be long before the USA invades Canada, sequestering its mineral resources for North American use only. Such an action, signalling a spiral into a "Mad Max" dystopia of squabbling robber barons, would indeed mark the end of the market-driven world order, as my hedge fund manager friend fears.

Savinder quotes ex-Texaco geologist, Dr Colin Campbell - "In the Twentieth Century, everyone had the equivalent of several unpaid and unfed slaves to do his work for him, but now those slaves are getting old and won't work much longer. We have an urgent need to find out how to live without them." For Savinder, the exhaustion of the oil-slaves threatens reversion to a pre-oil economic order, one marked by human slavery. Optimists expect technology to ride to humanity's rescue, with an alternative to oil. For example, Julian West, of Cambridge Energy Research, opines "the demand for oil will peter out well before any serious crimp is felt in supply. Something cheaper and cleaner, perhaps the hydrogen-based fuel cell will come along." Savinder scorns such complacency, noting the gross inefficiency of all alternative energy sources to oil so far devised. Importantly, he introduces the concept of an Energy Profit Ratio (EPR), which is the "profit and loss" from generating a given form of energy. Of course, it takes energy to generate energy. Oil used to have an EPR of 100:1. In other words, the energy required to extract 100 barrels of oil was 1 barrel of oil. At that time oil was effectively costless - apparently in the early years it was cheaper to pump Texan oil than Texan water. Our problem is that no alternative to oil as yet discovered begins to match its energy density and EPR. Savinder claims, for instance, that most bio-fuels have an EPR as low as 0.7-1.5:1 and, as he writes, "When any resource requires more energy to extract it than it contains, it ceases to be a resource."

"The Oil Age Is Over" was written in 2004, when the oil price was below $40.0. By mid-2006, with oil where it is and the Middle East in flames, one assumes that Savinder feels vindicated. On a sceptical note, though, I must report that his essay is characterised more by invective than verifiable science - fair enough given his intention to scarify. But he is, moreover, a believer in the, to me, offensive conspiracy theory that argues Bush and the CIA were directly responsible for the 9/11 attacks (to provide an "excuse" for the US Military to safeguard access to oil). Finally, there is the unmistakeable relish with which he details the horrors of the impending Apocalypse. This lip-smacking prose means that Savinder sits squarely in the age-old chiliastic tradition - those seers who yearn to predict and participate in "the end days", in order to be able to say to the rest of us - "I told you so."

On reflection then, I intended to forget all about Mr Savinder and would have done so......until I looked again at BP's share price chart. It seems so obvious that a rampant oil price should result in rampant oil share prices. But, for BP at least, it hasn't happened and, amongst various possible explanations, Savinder's analysis may be helpful in understanding why. Perhaps the market is wiser than we know. The crucial fact is that the Energy Profit Ratio of oil itself is falling, as the stuff becomes harder to find. Savinder reckons that oil's EPR has fallen from 100 to 10:1. I set no particular store by his estimate, but, if remotely correct, it is distinctly bad news for BP and the oil industry.

That bad news can, for example, be seen in this set of assertions from a recent investment bank review of the European oil sector - written from the perspective, mark you, of a strong bull.

- "The oil industry needs $10 per barrel more than it did three years ago to remain equally profitable."

- "Total extraction costs have risen from $9 per barrel in 2000, to $15 in 2005."

- "Average finding costs in 2005 were $3.3 per barrel, versus $1.6 in 2004." (More than doubled in 12 months!)

- "Sustaining long-run upstream production growth of 3.0% per annum requires an 18.0% increase in development capital."

- "The average upstream tax rate in 2005 was 51.0% versus 49.0% in 2004, as a result of adverse changes to tax regimes in Argentina, Bolivia, Russia, Venezuala and China."

- "The average Reserve Replacement Ratio for the European oil sector was 55.0% in 2005, versus 72.0% in 2004. The contribution from proven reserve revisions actually turned negative in 2005, for the first time."

The industry is, on this evidence and as Savinder would predict, increasingly challenged, as oil becomes scarcer. Finding and extraction costs are rising, capital intensity is, well, intensifying and the politics of access to reserves is deteriorating. BP's investment in Rosneft, widely regarded as an over-priced new issue, can be interpreted as the "price" BP must pay to retain the favour of the current set of Russian oligarchs.

The investment bank believes that the European sector trades at a valuation that implies a long-run oil price of only $42.0 and that the gap between that and $71.0 represents stock market upside. The counter argument is, as the analyst himself muses, "the market may believe in a higher oil price, but is anticipating very material incremental destruction of the industry's margins, due to continued cost inflation and tax-creep." Quite so, such an outcome is eminently possible - a falling oil EPR must mean falling industry margins. When there is no oil left, or when its EPR falls below 1, there will not be an oil sector in the stock market (Savinder would argue that there will not even be a stock market). Even more sinister, we can all observe the "friendly" political entities of the states of Alaska and Texas growing increasingly hostile to BP and wonder whether or how long, the company will continue to "own" these and other far-flung reserves.

Paradoxically, BP's shares may perform better if the oil price tumbles, because this would suggest that Savinder is wrong, the commodity is not running out and BP can revert to being a normal company.

Conclusion

We have no opinion as to whether the end of civilisation is nigh, nor do we have any idea where the oil price is heading. However, we do believe, in answer to the question we set in the title, that BP shares are today a Hold and approaching a Buy. This judgement does not rest on fancy geopolitical theorising, but on dividend yield. We have been unwilling to hold BP in recent years, because its dividend yield relative has been at the low end of historic ranges and indeed, BP shares have traded at times at a dividend yield below that of the market average. Recent share weakness and strong dividend growth have resulted in a historic yield of 3.5%, for a yield relative of c110, albeit paid in US Dollars. This income return begins, we think, to offer compensation for the uncertainty.


Nick Train
Sep 2006

LTL 000-040-1 28 September 2006