However, the big supermajors are comfortable given their low gearing (20-23% net debt to  equity), but with oil entrenched at c$50/bbl , which for most assets is below break-even price, the independent E&Ps are set to fall one by one like pieces of a domino. The credit crunch is taking care of the really small ones, as they are finding it impossible to refinance their development and drilling programs. Oilexco and Bowleven have already succumbed. Others will follow.

For the lucky ones,  the ones that have been smart enough to increase capital and refinance in the past years, enjoy strong assets and attractive development opportunities (Tullow, Dana) the end will likely come through M&A. The supermajors and utilities need access to reserves to either replace their declining assets (BP, RDS, Total) or get the desired access to equity gas (EDF, GSZ, E.On, RWE). We have already seen Centrica buy 23% of Venture at 725p. This means paying less than $6/boe for 2P reserves, a highly attractive valuation compared to developing their declining North Sea assets. The stock trades at 805p. Still below the average historical transaction price of $12-15/boe.

The problem here, is that, as I have mentioned in the past, some of these independents will be taken over and still be the worst performers of the sector (remember when ENI acquired Burren).  Investors will likely stick to the attractive exploration companies with strong balance sheet and the added positive factor of M&A … Tullow, Dana, Venture and Premier are set to deliver strong returns to shareholders as downside is limited at $50/bbl NAV valuations and upside on exploration could deliver between 15 to 35% returns in the short term… and forget about the “boom or bust bets” in really troubled small independent producers. They could be taken over, yes, but at $1 like Oilexco.

So being bearish, what does the market bet on?: Opec capacity additions beyond historical achievements. I call it the Perceived Oil NGO, willing to lose money and develop below cost no matter what.

Remember what bears expected in January:

A) After a disappointing 2008, non-OPEC supply should bounce back “rapidly” in 2H09 (this is essential to strip any geopolitical risk out of the oil price)

B) New start-ups add 1.4MBD to gross production by mid-09, 1.9 MBD by end ‘09

C) Demand is in structural decline and will never recover to 87 mmbpd (and efficiency and the electric car will take care of any bounce).

Starting from the end, demand destruction due to expensive, subsidised marginal technologies would be totally acceptable at $140/bbl, not at $40/bbl (below the marginal cost of several areas), not to mention the impact of credit crunch on marginal technologies, the lack of proven substitution of electric cars (minimum horse power, need more than 60  minutes to charge half the battery) and the huge need of gas and oil as electricity generating sources if electric vehicles are successful.

As for supply, remember the “dead certain projects adding 1.925kboepd of production” in 2008? Either not on stream or flows c60% way below expected.

This image from the great www.oildrum.com shows something I believe is very important: despite an increase in capex of 20% per annum in the period, global oil production did not increase significantly.

This unprecedented level of capex in the oil industry happened thanks to a combination of technology and access to credit.  Widespread access to credit is gone, maybe for a very long time, but more importantly, oil companies’ appetite for investment is not going to increase quickly. When oil fell to $10/bbl in the early 90s it scared an entire generation of oil company managers. This is exactly what will happen after this period. 3D seismic, deep offshore exploration, high cost projects, oil sands, … wave bye bye to capex. Remember, Capex in 2001 was $250bn and in 2002 went to $100bn.

Meanwhile the average requirement of oil per capita in the planet is 4.9barrels and 454 cm of gas a year.

In OECD countries with current demand oil consumption is 18.3barrels a year

So if OECD countries slash their demand by 25% it will still be 14.64 barrels a year

However, if oil exporting countries demand goes up by a mere 7% their consumption will be 4.28 barrels a year.

Indigenous population growth in OECD is +0.1%, and growing 1% from immigration (ie going from countries where the average person consumes 2 barrels a year to countries where they will consume at least 4)

Population growth in oil exporting countries is up 5%.

Doing the maths, the demand doom picture is overestimated.

On to Supply:

A) In a tough credit environment, even large and medium sized E&Ps are and will have to drastically cut expenditure in exploration and development. Even worse, service companies are too small and cannot get credit  for large rig projects (look at SBM and PFC).

B) Large caps are cutting expenditure (albeit selectively) already. If they see a weakening of demand all that RDS has to do is reduce the number of trucks in Canada bringing oil sands product from 35 trucks to 5. Boom.

C) Demand needs to fall at least 3%pa to come back in line with the usual demand-supply balance going forward

D) Even if all these things happen the call on OPEC increases, as non-OPEC supply is doing nothing but shrink.

E) 75% of the current projects require at least $40/bbl (technical, not service charge). Companies are not waiting for oil to fall to $20/bbl to revisit these projects which are only being developed because demand exists. If not, these projects can be shut down rapidly (Khursaniyah, Khurais, Genghis Khan, Atlantis, Kashagan, Rosa, Dalia).

Demand NEEDED to fall more than what consensus and sellside expected. I am happy with demand falling  a lot, because the problem is depletion.

Supply is not there, and deffinitely not from non-Opec as consensus estimates (a ramp up of 1mmbpd when year to date it is down). Depletion rates are 4-6%. Even if you consider 0% depletion you need demand to fall a another 5%.

Call on OPEC increases, and self-consumption of producing countries is rising. Price, as such, is adjusting to see where mid term supply, demand and depletion go. That is not an indicator of bearishness.

I bet:

A) 12 month trail reserve replacement will be less than 90%

B) demand will fall accordingly

C) Demand – supply balance will remain the same

More importantly, I am happy that oil falls because the contango curve is steepening again… and bears have yet to explain why, if this is an anomally and fundamentally unjustified, it has continued and widened for seven months at levels never seen before October 08. As the only true safe havens of the equity market, I expect in less than a month investors will come back to revisit high quality, differentiated stocks that discount $30/bbl, trade at 7xPE 2010, 3-4.5x EV/DACF 2010 and FCF yield of 14%.