"World will face oil crunch in five years."

That's not exactly the kind of headline you want to read when crude oil is already at $73 a barrel. When things are this bad -- crude prices are up 12% in the past two months as of July 12 -- you don't want to hear that they're going to get worse.

Yet that's exactly what consumers -- and investors -- should expect, the International Energy Agency said in its latest Medium-Term Oil Market Report, issued July 9. The market for oil will get even tighter over the next five years. (And in case you're looking for a way out, natural-gas markets may be even tighter still.)

As much as I'd like to believe that the agency has made a mistake, the logic behind its pessimistic assessment of supply and demand is impeccable.

In the best case, the International Energy Agency calculates, supply will grow at 1% annually. Even that might be optimistic, though, because global oil production grew by just 0.4% in 2006. That creates just a teeny-weeny problem, because the agency projects that demand will grow by 2.2% a year over the next five years.

Squeezed From Both Ends

Let me explain what is leading to the squeeze that will be so painful over the next five years, and then I'll give you my pick for the oil stock that's best positioned for this scenario.

This big squeeze is coming from both the demand and supply ends of the oil market.

Higher oil prices so far have not led to lower consumption. That's what's supposed to happen, right? As oil and gasoline get more expensive, people should use less, economic theory says. But not this time.

Why? Lots of reasons:

  • Not everyone is convinced that high prices are here to stay, so changing behavior radically doesn't seem worth it.
  • A lot of consumption is built into the infrastructure of how we live: If you've got to drive to work, you've got to drive to work.
  • Reducing consumption can require a long lead time. The next car purchased will be more fuel-efficient, for example, but that could be years away.
  • Some consumption is subsidized, so higher prices haven't yet fully hit the market in places such as Iran, Venezuela, Indonesia and China.
  • And the U.S., which accounts for 25% of global oil consumption, still doesn't have a national program to reduce demand for oil. The sad fact is that we now use 15% more oil than in 2000.

Developing economies create the biggest addition to global demand. Many consumers in China and India and elsewhere are just now getting paid enough to join the global market for cars, electrical appliances and air travel. Oil consumption in China, for example, is growing at more than 7% a year.

But that's an old story. The crisis that the International Energy Agency is trumpeting now comes from the supply side. Thanks to years of underinvestment, mismanagement, lack of technology or political interference -- or all of the above -- oil production is dropping faster than anyone expected at some of the world's biggest oil exporters.

In 2006, oil production fell by 6.9% in Norway, 10% in the United Kingdom (which shares North Sea oil fields with Norway), 2.1% in Mexico and an estimated 5% in Venezuela. In all of those cases, the rate of decline is accelerating. The problem is geology, not politics (as it is in places such as the Niger Delta, where a collapse of order has shut down 25% of Nigeria's oil production). Any fix for a geologic problem is expensive and can take years to implement.

Keeping Up the Pressure

Let me use Mexico's giant Cantarell oil field, the world's second-largest by production, as an example of the extent of the problem.

When Mexican fisherman Rudesindo Cantarell discovered the field named after him in the shallow waters of the Gulf of Mexico in 1971, the first well drilled was a gusher. The oil in the field was under so much pressure that this first well produced 36,000 barrels of oil a day -- compared with the average 200 to 300 barrels. By 1980, the Mexican oil company Pemex had sunk more than 200 wells, and the Cantarell field was pumping more than 1 million barrels a day. Production peaked at 2.3 million barrels a day in 2004.

But serious problems were building up under the surface. As Pemex pumped more and more oil out of Cantarell, a highly concentrated field that covers only 70 square miles, pressure in the field began to drop. In 1998, Pemex started injecting nitrogen gas into the rocks in an effort to keep up pressure. Still, more and more water seeped into the field and found its way into Pemex's oil wells.

Technology Goes Only So Far

That's a common problem in older oil fields, and oil companies have dealt with it by buying and installing expensive pumping and separation equipment to divide the water from the oil in the flow from a well. Some of the oldest wells in Texas can deal with flow that's 99% water.

But Pemex didn't have the money to invest in this basic technology. The capital budget of the national oil company was set by politicians in Mexico City who were eager to grab as much of the company's revenue as possible for the country's budget. Pemex right now provides about 40% of total government income. Without the cash to invest in water-separation technology, Pemex simply shut any well in the Cantarell field as soon as water content reached 5%. Production at Cantarell fell by 12% in 2006 and is forecast to fall an additional 15% in 2007.

In response, the Mexican government has increased Pemex's capital budget. In 2007, Pemex will invest $2.3 billion in Cantarell. A new water-separation plant will let Pemex handle well output with as much as 9% water. The company began drilling its first horizontal wells in 2006 in an effort to get more oil out of the Cantarell formation. That should slow the decline of production.

Pemex projects that production will decline by only 200,000 barrels a day in 2007, about half the decline projected without these steps. But production is still on track to fall to 600,000 barrels a day by 2013 from 1.5 million barrels a day in 2007.

Looking Past Peak Oil

I'm telling you the story of Cantarell in such detail because it is exactly the scenario sketched out by peak-oil theory. Much of the controversy surrounding that theory is concentrated on when global oil production will peak. Peak-oil believers say global oil production already has peaked or will do so soon. Opponents say that oil production will grow until 2040 or 2050 as new technology opens up new sources of production or gets more out of existing fields.

But the debate over an exact date is largely beside the point. Peak oil, a theory put forward by American oil geologist King Hubbert, describes what will happen as the world moves toward a peak in oil production from conventional sources. Big fields will decline -- at first gently and then rapidly. New finds will become smaller. Finding new oil will become more difficult and more expensive. Producing oil from declining older fields and from these "geologically challenged" new fields will be more difficult and more expensive. The marginal cost of each additional barrel of supply will climb even as it becomes more and more difficult to add enough new barrels to keep production growing.

Look around. Cantarell, the world's second-largest field, is in decline. Kuwait's Burgan field, another top-five field, is showing signs of maturity. The world's biggest field, Ghawar in Saudi Arabia, is either already in decline or is likely to start declining within a decade. Since 1990, only one new field, Kahagan in Kazakhstan, has been discovered that might pump more than 500,000 barrels a day at its peak.

Technology has indeed expanded supply. The percentage of wells drilled that go into production climbed in the 1990s to 45% from 25%. Enhanced production technology has increased the amount of oil that is recovered from an oil field to as high as 60% in some cases, from 20% just a decade or two ago.

But all of this means that we're replacing the cheap oil of the 1990s with expensive oil. The new reserves, the new supplies that result from this technology, the unconventional sources of oil such as Canada's oil sands -- all of these come with higher production costs than the supplies they are replacing. As recently as 1997, the net wellhead cost of Saudi oil was 95 cents a barrel. I've seen estimates that say producers in Canada's oil sands will need oil prices of $60 a barrel to make a 10% profit.

Who Profits?

You can debate whether the world is running out of oil all you want. It is certain, however, that the world has run out of cheap oil.

Almost any oil stock will profit from that scenario, especially if the company owns oil still in the ground. In an era of rising prices for oil, such companies are sitting on an appreciating asset.

But the oil company that is best positioned for the scenario painted by the International Energy Agency is Apache ( APA). Apache has become a specialist in producing more barrels -- often lots more barrels -- out of older, "depleted" oil fields that other oil companies have given up on.

This company is no slouch when it comes to finding new oil. Projects in Egypt, Australia and Canada are projected to add 108,000 barrels of oil a day by 2011. And potential resources are set to climb, according to management, to 8.8 billion barrels from 7.1 billion barrels at the end of 2005.

But it's Apache's ability to get more oil out of old fields that makes this an oil stock that I want to own during the supply crunch of the next five years (or longer). For example, Apache bought the North Sea's Forties Field from BP ( BP) in 2003 for $688 million. Production at the field had declined from a peak of 500,000 to less than 50,000 barrels a day.

Apache invested $911 million in new cranes, pumps and other equipment, and cut operating costs in half. By the end of 2005, the company had increased production to 81,000 barrels a day and raised cash margins per barrel to $24 from $6. The two parts of the company's strategy fit together well: Buying older fields and increasing production there provides a steady cash flow that Apache can then use to explore for new oil.

The stock is a relative bargain in the oil industry, trading at a forward price-to-earnings ratio of 11.5, vs. 13.1 for Devon Energy ( DVN) or 12.90 for Exxon Mobil ( XOM). And its price may keep gushing up as our oil supply starts to sink.

At the time of publication, Jim Jubak owned or controlled shares of Devon Energy. He did not own short positions in any stock mentioned in this column.

Jim Jubak is senior markets editor for MSN Money. He is a former senior financial editor at Worth magazine and editor of Venture magazine. Jubak was a Bagehot Business Journalism Fellow at Columbia University and has written two books: "The Worth Guide to Electronic Investing" and "In the Image of the Brain: Breaking the Barrier Between the Human Mind and Intelligent Machines." As an investor, he says he believes the conventional wisdom is always wrong -- but that he will nonetheless go with the herd if he believes there's a profit to be made. He lives in New York. While Jubak cannot provide personalized investment advice or recommendations, he appreciates your feedback; click here to send him an email.

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