Whichever way you look at it, oil companies are different.

Think, for example, how an oil producer compares with an ordinary industrial company like supermarket retailer Woolworths: Woolies has a lock on its suppliers and, along with Coles, operates a virtual duopoly that gives it ample pricing power. It has a prominent brand and a supply chain that enhances its market dominance. Most of the factors that affect its profitability are within its control.

That’s far from the case with an oil company. The single most important factor affecting its profitability—the price at which it can sell its oil—is utterly beyond its control. When the price of oil falls, so does the profitability of even the largest, most efficient oil producer. An investment in an oil producer is therefore inherently volatile and more risky than an investment in an ordinary industrial company.

So why would you invest in an oil company at all?

There’s really only one reason; because you’re confident that, over the long term, the price of oil is going to rise. And that’s the case we’re making in this review. After doing so, in subsequent research pieces, we’re going to take an overview of 27 stocks in the sector and then select a handful of the most promising that we’ll subject to more detailed research and recommendations.

Introducing ‘peak oil’

In 1956 the delightfully named Marion King Hubbert, a Shell geologist, predicted that by the 1970s US oil production would peak. He was labelled a madman. For almost a century the US had been one of the world’s largest oil producers and conventional wisdom held that there was plenty of oil remaining. That thinking turned out to be wishful. ‘Hubbert’s Peak’ came to pass. Since the early 1970s US production has declined by almost 50% (see chart below).

Peak oil theory takes Hubbert’s hypothesis and applies it to global oil production, suggesting that worldwide oil production will rapidly decline following its peak, thought to be around 2010. Geologically speaking, this makes sense. Oil fields that perform splendidly in their early stages will progressively deteriorate as they age. But economically speaking, the marginal cost of oil production trumps peak oil theory every time. And this forms the crux of our argument for higher oil prices.

Let us explain. As more hydrocarbons are taken from a reservoir, extraction rates deteriorate. A geological rule of thumb is that the average field will naturally decline by about 5% a year, caused by a combination of deteriorating pressure, increasing levels of water production, or damage to the reservoir rocks. A large proportion—up to 50% or more—of the original oil resource cannot be profitably extracted because it’s simply too expensive to get the stuff out. Long before geological limits are imposed on oil production via peak oil, economic limits kick in.

Peak oil, meet marginal cost

That means total production depends more on the price, rather than the quantity, of oil. So, as investors, we can think about oil as an unlimited resource with a variable price. The absolute quantity of oil in the ground isn’t all that important in discerning the direction of oil prices. What’s important is the cost of extracting an extra barrel. Economists call this the ‘marginal cost of production’ and it’s a more useful way of thinking about oil as a potential investment.

The marginal cost of a barrel of oil incorporates information on the quantity of oil and, through the cost of extraction, where it’s located and how difficult it is to get at. Peak oil theory tells us only about the quantity of oil and nothing about the cost of accessing it. The difference between the two can be immense.

Deep below the Santos basin off the coast of Brazil, several massive new oilfields have recently been discovered. We mean it when we say deep. The Sugarloaf, Jupiter and Tupi fields were found 4km beneath the seabed under a further 2km of thick salt layers. Getting the oil means digging through salt layers rather than rocks, increasing the risk that wells will collapse even when cased in cement. If this weren’t demanding enough, the oil pumped back to the surface can be hot enough to melt the drilling equipment. Needless to say, oil from this source will prove expensive to extract. This goes to show that—despite what first year economics students may be taught—quantity can increase without necessarily causing the price to fall.

The chart below shows the global marginal cost of production for 2008, one of the most successful in terms of exploration in the past 20 years.

In Saudi Arabia, home of the world’s cheapest oil, producers face a full life cycle (that is, including amortisation and cash costs) marginal cost of US$20 per barrel. In Russia, it’s about US$25 per barrel. North Sea fields have a marginal cost of about US$60 while the new deepwater discoveries off the Brazilian coast are expected to cost US$70 per barrel. Deepwater Gulf of Mexico, where a single well can cost US$100 million to drill, has a marginal cost of US$80 a barrel. Deepwater production from Angola and Nigeria, considered (along with offshore Brazil) to be exciting new frontiers within the industry, operate with marginal costs of about US$90 per barrel. And at US$100per barrel and more, Canadian tar sands and unconventional sources come into play.

These are revealing figures. In deepwater Gulf of Mexico and Angola, and in Nigeria, the market price is lower than the price of production, making it uneconomic for the average producer. The most recently celebrated discoveries off the coast of Brazil would only be marginally profitable at today’s prices, suggesting that future supply is under threat unless the price of oil rises.

In fact, at current prices of around US$80 a barrel, global supply will struggle to produce more than 80m barrels of oil per day. That’s not enough, according to the US Department of Energy, to satisfy demand. So far in 2009, global oil demand has been estimated at 84.6m barrels a day and is forecast to rise to 86.4m by 2010.

What does this tell us about future oil prices? In the short term, not much. Over the long term though, the price of oil should equal the marginal cost of production. If the market price is lower than the price of producing an extra barrel of oil, producers will cut production to avoid losing money. Similarly, as the market price rises, new sources of oil with higher marginal costs will be developed. Marginal costs, therefore, are instrumental in determining future oil prices.

Substitution and risks

Having dealt with the supply side, what of demand? Whereas oil producers can adjust their output based on their marginal cost of production, consumers have less flexibility. Oil is central to the global economy and embedded in our lives in a way that is hard to overstate.

The mundane act of eating a home-cooked meal illustrates the point. From the fertiliser used to grow the produce, to the fuel in the semi trailer that delivers it to the retailer, from the bag you use to carry the produce home in, to the heat you use to cook it. And it doesn’t stop there. Oil and its by-products are central to the knife and fork you use to eat your meal and the chemicals you use to clean the pots and dishes you’ve used along the way.

Whilst oil demand in the developed world may remain stable, or even fall, thanks to lower population growth and the higher representation of services in the economies of richer countries, the industrialisation and affluence of the developing world is adding hugely to the demand for oil-based products. Developing nations want the cars and consumables that we’ve enjoyed in the west for decades. It’s hard to see how the demand for oil won’t rise with these aspirations.

Is there a flaw in this thesis? The greatest risk to higher oil prices lies in the substitution effect where, as oil gets more expensive, consumers start to change their behaviour. People drive less, use natural gas and other substitutes more often and car manufacturers develop smaller, more fuel efficient vehicles. When oil hit US$147 a barrel in 2008, we saw the beginnings of such behavioural change - what economists call ‘demand destruction’.

Certainly, substitution and demand destruction will create a natural ceiling for oil prices but, for the reasons we’ve canvassed, this ceiling is likely to be higher than current prices. There’s a slight chance a new substitution technology (cold fusion anyone?—Ed) will be discovered that will adversely affect oil demand. Or breakthroughs in drilling technology might rapidly cut marginal production costs but these are very low probability events.

In summary, there’s a strong case for higher oil prices. As demand rises, higher prices will be needed to encourage more production, the effects of which aren’t likely to have much impact on consumer behaviour.

The investment case is somewhat trickier, as costs for oil producers are likely to rise as the ‘easy oil’ disappears. But there are bound to be a few wonderful success stories in the sector and, over the next few weeks, we’ll be examining 27 stocks in the Australian oil sector, from multibillion dollar giants to budding exploration minnows. We’re hopeful of finding some exciting opportunities for you.