Despite popular opinion that the oil sector has peaked, RBC Capital Markets analyst Kurt Hallead says the current energy cycle is running broader, deeper and longer than any other in recent memory. What’s more, valuations in the sector are flashing “buy” signals and oil service companies will lead the way in the coming year, he believes.

In RBC’s oil services industry forecast released this week, Hallead says the current energy cycle is entering its 11th year of a 15-20 year secular upward trend. Exploration and production spending will increase 25% in 2006, he says, well ahead of the 15% consensus, and there is still room for oil service companies to raise prices and improve earnings.

Valuations across the sector are compelling. “Recent multiple compression suggests investors think 2006 is the peak. We beg to differ,” he writes. “The industry currently offers opportunities to many investment styles, from value to growth.”

In his discussion of current economic conditions prevailing in this cycle, Hallead points out that China’s industrial revolution, “akin in many respects to the U.S. in the early 1900s,” includes an established five-year plan to double the country’s GDP per capita while at the same time attempting to manage its annual oil demand, limiting it to 5% a year over that same time period. “It’s simple, [we can] just plug in 5% oil demand growth into a supply demand model, knowing full well this may be conservative.”

In other developments, he points to structural changes in Japan leading to economic growth that could come in higher than the 1.3% consensus in the next five years. And exploding highway infrastructure in India, coupled with wealth creation from outsourcing and cultural changes, will put that country at the forefront of global consumerism.

Since 1995 spending on exploration and production (E&P) has grown 8% a year on average. In 2005 however, spending rose 25% compared to the previous year. In the next three to five years, Hallead says spending will likely accelerate, growing at a similar pace in 2006 before pulling back to spending around 15% in 2007.

Interestingly, Hallead also provides a bit of a history lesson that carries with it a warning: During the last secular uptrend, between 1960 and 1981, oil service equipment and rig supply grew in lock step with demand until 1982.

This period of growth saw E&P spending rise 25% a year on average between 1970 and 1981. During that time, the number of oil rigs in North America rose dramatically from 1,747 in 1960 to 3,974 in 1981. At the time, “pricing power remained firmly in the hands of the oil service industry,” he says. The ensuing oil industry depression came as a result of high oil prices.

Between 1981 and 1994 global oil demand declined by 4.3% which lead to the collapse of oil prices, in turn pushing the industry into a 15-year depression. During that time, North American rig activity dropped from 3,974 to 755. The global rig count fell from 5,624 to 1,767.

“As for this current cycle period, one thing is for certain: the longer this trend runs without another cyclical blip, more capacity will be added and the next downtrend will be more painful and extended. Enjoy the run while it lasts, but be vigilant,” he cautions.

Filed by Kate McCaffery, Advisor.ca, kate.mccaffery@advisor.rogers.com

(01/05/06)